The European insurance industry is bracing for the beginning of its new regulatory regime as the deadline to implement the Solvency II directive approaches.

Member States have until 31 March to transpose the EU directive into their national law. Beginning in April, insurers will have to seek approvals for their internal models used to calculate their Solvency Capital Requirement (SCR). The new regime, which will be fully in force on 1 January 2016, affects nearly every insurer or reinsurer in the EU.

The European Commission said the previous Solvency I, a combination of 14 directives, needed an overhaul because of structural weaknesses, including a failure to take into account key risk factors in setting capital requirements. The new regime, first adopted in 2009 and amended last year through Omnibus II, takes into account the risk profile of individual insurers, the commission said. In addition to making capital requirements more forward-looking and tailored, the new rules also should boost comparability, transparency, and competition, the commission said.

The new regime includes two levels of capital requirements – the higher Solvency Capital Requirement (SCR) and the lower Minimum Capital Requirement (MCR). Insurers falling below the SCR must work with their national supervisor to implement a recovery plan, but can still write new business. If an insurer falls below its MCR, then it must stop writing new business unless it can remedy the shortfall through a reliable short-term financing plan. The European Insurance and Occupational Pensions Authority (EIOPA) will oversee the regulations, ensuring consistent application throughout all Member States and mediating disputes in cross-border situations.

Solvency II also includes detailed rules for the valuation of assets and liabilities, eligibility of insurers’ own fund items, how the capital requirements will be determined, including guidelines for insurers using internal models to calculate their capital requirements, and how insurers organize their governance functions, including compliance, audit, and risk management. The directive includes new reporting requirements to national supervisors and the public, and criteria on whether a third country’s solvency regime would be considered equivalent by EU regulators.

The new rules also contain provisions to ease the transition for the industry. The commission estimates implementation will cost between €3 billion to €4 billion for the EU insurance industry as a whole, which writes an annual €1.1 trillion in premiums. The directive promises tolerance for insurers breaching the SCR in the first two years, relaxed reporting deadlines for quarterly and annual data in the first three years, and the grandfathering of some existing hybrid own-fund items allowed under the old solvency rules.

Last month EIOPA released the results of its stress test of the industry to test the readiness for the new regime, which found overall insurers are sufficiently capitalized to meet the new requirements. The test’s core module covered 60 groups and 107 companies from the EU as well as Switzerland, Norway, and Iceland, and a low yield module included 225 companies from the EU and Norway. About 14 percent of the companies showed a SCR ratio below 100 percent.

“The results show that the European insurance sector is, broadly speaking, in good health although vulnerabilities have been identified, in particular for some smaller insurers,” Jonathan Hill, commissioner in charge of financial stability, financial services, and the Capital Markets Union, said in a statement. “The new Solvency II framework – to be fully applied from early 2016 – will introduce a new regulatory system in the European Union. It is designed to prevent some of the issues detected in these stress tests, so public authorities and insurers should press on with their preparations for 2016.”

Specifically, EIOPA said the sector is more vulnerable in what it called a double-hit scenario, combining decreases in asset values and a lower risk free rate, with 56 percent of the companies able to sustain sufficient capital levels in that scenario. About 24 percent of the companies would not meet their SCR in a prolonged low-yield scenario, and about 20 percent would fall below the threshold in a scenario of a sudden reverse in interest rates, EIOPA found.

As a result of the findings, EIOPA called on national supervisors to rigorously assess insurers’ preparedness, especially in identified cases in which action is required, examine their own asset and risk management strategies, and ensure the companies they oversee clearly understand their risk exposure and the vulnerabilities exposed.