The primary purpose of Solvency II is to ensure the financial soundness of insurers and the protection of policyholders. By requiring insurers to hold capital that is proportionate to the risks they face, the regime aims to minimise the risk of firm failure and ensure that insurers are able to meet their liabilities, even in adverse conditions. This enhances confidence among policyholders and other stakeholders and contributes to the overall stability of the financial system. The framework establishes a clear and consistent approach for determining capital adequacy, thereby reinforcing solvency as the foundation of prudent insurance supervision.
Risk-Based Approach
A key function of Solvency II is to introduce a risk-based approach to regulation. Unlike earlier rules-based regimes, Solvency II links capital requirements directly to the underlying risks an insurer is exposed to, such as underwriting, market, credit, operational, and counterparty risks. This means that firms with more complex or volatile risk profiles are required to hold more capital, while simpler or lower-risk firms benefit from proportionate requirements. This principle-based design incentivises better risk management and enables firms to make capital and business decisions that are more closely aligned with their actual risk exposures.
Governance
Another critical function is the emphasis on governance and risk management through Pillar 2 of the regime. Insurers are required to implement robust internal governance arrangements, including effective systems of risk management, internal control, and supervisory oversight. The Own Risk and Solvency Assessment (ORSA) is a cornerstone of this pillar, obliging firms to assess their capital needs in light of their business strategy and risk profile. This forward-looking process ensures that capital planning and risk management are embedded into the day-to-day operations of the business and not treated as compliance exercises.
Transparency
Solvency II also aims to increase transparency and market discipline through enhanced disclosure requirements under Pillar 3. Insurers must regularly report on their solvency position, risk exposures, and governance arrangements to both supervisors and the public. This includes the Solvency and Financial Condition Report (SFCR) and the Regular Supervisory Report (RSR). These disclosures provide stakeholders with better insight into the financial health and risk posture of insurers, enabling more informed decisions by investors, policyholders, and counterparties. The public nature of these reports also encourages firms to maintain high standards of accountability and governance.
Harmonisation
A further function of Solvency II is to create a harmonised regulatory framework across the European insurance market. By replacing divergent national solvency standards with a single, coherent set of rules, the directive promotes a level playing field and reduces the scope for regulatory arbitrage. This facilitates competition, improves efficiency, and supports the development of cross-border business within the EU. The consistent application of rules also enhances the effectiveness of supervisory cooperation and ensures that insurers are subject to comparable standards regardless of their location within the European Economic Area.
Structure & Consistency
Solvency II is also designed to improve the quality and consistency of supervision through a structured ladder of intervention. It provides national supervisory authorities with a framework for monitoring insurers’ financial health and for taking graduated action depending on the severity of any capital shortfall. The use of defined thresholds—such as the Solvency Capital Requirement and Minimum Capital Requirement—allows for timely and proportionate supervisory responses, from intensified monitoring to potential licence withdrawal. This structured approach enhances regulatory predictability and supports early intervention to prevent insurer failure.