“It is based on rules that do not properly reflect the economic value of insurers' assets and liabilities. It does not take sufficient account of underwriting and investment risks, and it fails to give adequate credit for risk mitigation instruments,” according to Swiss Re.

The draft directive is likely to be adopted in mid-2007, and implementation should be completed by 2010.

Solvency II will be based on the Basel-type three-pillar approach used in banking: Pillar 1 sets out rules for financial resources; Pillar 2 defines the principles of the supervisory review process and risk management; and Pillar 3 is designed to increase disclosure and transparency to reinforce market mechanisms.

Assets and liabilities will most probably be valued on a market-consistent basis for solvency calculation purposes. Insurers may calculate their solvency requirements by using the standard model provided by the supervisory authorities. Or they could apply their own internal models, which reflect the company's specific risk profile, the study noted.

Solvency II will lead to a more complete picture of an insurer's solvency situation and create greater transparency, the company said.

“One of the main changes will be the introduction of risk-related capital charges for both underwriting and investment risks, which should result in more stringent capital requirements for products with a high claims volatility, long-term products, and products with guarantee and option features,” the Swiss Re study predicted.

Capital charges for investment risks will reflect the relative risk of different investment strategies, the report said.