September 12th, 2008

The Advantage of Custom Scenarios for Solvency II Compliance

Posted at 6:22 PM ET

Frank Achtert, Managing Director
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The objective of Solvency II—expected to take effect in 2012—is simple. The regulation seeks to protect policyholders and the global insurance system through adequate, risk-based capital (RBC) requirements. Carriers will have to demonstrate a 99.5 percent likelihood of solvency for the coming 12 months, based on the risks they hold in their portfolios. There are several ways for European (re)insurers to comply, and the latest Quantitative Impact Study Draft 4 (QIS Draft 4) explains the alternatives for demonstrating compliance. For some, Solvency II signals yet another cost of doing business, but beneath the surface, carriers may find opportunities to turn compliance into market risk management advantage.

Improved and targeted capital management can result in a faster recovery, particularly following a mega-catastrophe. However, success will be determined by a carrier’s ability to identify and manage risk before disaster occurs. With Solvency II, risk-bearers have an incentive to refine risk management practices and ultimately make better use of their capital.

QIS 4 introduces a modified Solvency Capital Requirement (SCR) calculation for non-life catastrophe capital charges. The first two methods are based on a standard, portfolio-agnostic formula. Regional scenarios using the standard formula account for both natural and man-made catastrophes geographically. Or, carriers can take a line of business view of their portfolios via the standard formula. For both approaches under the standard formula, the outcome is basic compliance. While this is important, there is little opportunity for market differentiation, as the standard formula methods for determining the SCR must sacrifice nuance in order to be universally applicable.

But, as we all know, risk management is not prêt à porter.

The third approach to calculating the catastrophe SCR allows carriers to customize their capital needs based on the risks covered in their portfolios. Capital requirements thus would be based on actual catastrophe exposure rather than a basic approach intended to address the broader industry. Under the third method in QIS Draft 4, carriers can use personalized catastrophe model outputs (provided by third-party firms), as long as they are approved by the relevant supervisory authorities. Targeted compliance, in this fashion, can yield a competitive advantage given that the cat risk capital charge is often the main capital-absorbing item.

Since every portfolio is unique, risk management and Solvency II compliance efforts should vary from one firm to another. Using the third method for catastrophe SCR calculation, carriers can demonstrate how they have addressed Solvency II’s 99.5 percent threshold as it relates directly to a specific set of risks. This has the twofold benefit of directly considering the factors that could threaten solvency while possibly freeing capital for use elsewhere.  

The ability to implement carrier-specific catastrophe scenario outputs must be considered in the broader context of using approved proprietary economic capital models for compliance with future regulatory requirements. When deviating from the standard SCR formula, success will be derived substantially from model choice. The ability to generate economic scenarios based on a broad array of assumptions—from changes in interest rates to catastrophe loss implications—will be crucial. Guy Carpenter, for example, has invested heavily in its proprietary simulation platform, MetaRisk®, to account for underwriting, market, credit, and operational risk to ensure that model output drives informed decision-making.

Fundamentally, Solvency II is as much a capital management issue as it is a compliance concern, involving perhaps the most important strategic challenge that carriers face. Effective capital management translates to the potential for market leadership. Proprietary models enable carriers to comply with Solvency II more accurately and could free capital for investment elsewhere. As specific SCR rules begin to crystallize, modeling assumptions and capabilities will be refined to meet the evolving standard. When 2012 arrives, carriers can choose mere compliance or compliance-plus-competitive advantage. The results will be evident in market performance.

Guy Carpenter & Company, LLC provides this text for general information only. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only. Statements concerning, tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice which we are not authorized to provide.  All such matters should be reviewed with your own qualified advisors in these areas.

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