April 6th, 2009

Where Are We on Solvency II?

Posted at 1:30 AM ET

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Solvency II will require insurers and reinsurers domiciled in the European Economic Area (EEA) to assess their regulatory capital requirements within a forward-looking risk sensitive framework. Solvency II has reached a decisive point in its development, as the focus moves to how the directive will be implemented in practice and how it will shape the competitive landscape of the insurance industry. From a quantitative perspective, the results of the Quantitative Impact Study 4 (QIS 4) were published by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) in November 2008. From a political perspective, the group support concept was abandoned to avoid further jeopardizing the targeted implementation by 2012.

Fourth Quantitative Impact Study (QIS 4)

CEIOPS ran QIS 4 from April to July 2008. Areas of particular importance were:

  • Group diversification effects
  • The inclusion of simplifications for the calculations of the Solvency Capital Requirement (SCR) in the perspective of supporting the principle of proportionality1
  • The definition of the Minimum Capital Requirement (MCR) 
  • The comparability of the standard formula with the results from partial or full internal models

The support for the Solvency II project is reflected in the impressive participation: the participation target of 25 percent of solo undertakings and 60 percent cross-border groups (1,412 companies) was largely met. All 30 EEA member countries are represented.Some regulators have questioned the reliability of some of the results. Specific concerns included, among others, consistency in the treatment of deferred taxes, the inclusion of the future premiums, and accounting in countries in which International Financial Reporting Standards (IFRS) are not in force for solo companies.

Under QIS 4, there were only minor differences in balance sheet composition compared to Solvency I. The relative share of technical provisions tends to decreased as a consequence of the abolition of the implicit prudence in the valuation of insurance liabilities. The re-evaluation of technical provisions — along with other valuation adjustments, the reclassification of equalization reserves, and full inclusion of hybrid capital — results in an increase of own funds (eligible capital) across countries of 27 percent. On the other hand, an increase in capital requirements is observable. In general, the solvency ratios declined for non-life companies from a median of 277 percent under Solvency I to 193 percent under QIS 4. However, nearly 90 percent are still in a position to meet the SCR. 11 percent of non-life companies and 28 percent of captives do not meet the SCR target. QIS 4 indicated that the vast majority of companies (98.8 percent) will be able to meet the MCR criteria, though, 7 percent of captives do not currently meet the MCR.

Life insurance technical provisions for most lines of business were calculated by most companies using a deterministic projection of “best estimates” for future cash flows. Calculations were done on a policy-by-policy basis and best estimate assumptions were derived based on analyses of past experience. Best estimate cash flows were generally discounted using the interest rate curves supplied by CEIOPS. For lines of business that include embedded options and guarantees, stochastic techniques tended to be used with a “model points” approach2 by the largest companies, but some simplifications may be forthcoming for smaller entities.

Capital Requirements Drivers

The primary contributors to capital requirements for non-life companies are the premium and reserve risks. The geographical diversification introduced in QIS 4 is crucial for reinsurers and cross-border groups but was found to be too complex at the solo level. QIS 4 allowed for the use of company-specific parameters for reserve and premium risk, but few companies were able to test this feature primarily because the depth of the historic data necessary was not available.

For life insurance companies, market risk is, on average, the largest component of the Basic Solvency Capital Requirement (BSCR) -about two thirds if diversification effects are included. The largest component of this risk module is the interest rate risk sub-module, which forms more than half the market risk capital charge, closely followed by equity risk comprising about 44 percent. However, large differences exist across countries. For the equity risk sub-module, many companies and supervisors stated that the 32 percent calibration of the equity stress was too low for a 99.5 percent calibration and suggested that a figure of around 40 percent might be more appropriate. The alternative approach - using a dampener formula (which consisted of linking the duration of liabilities and the possession of equities) - resulted in approximately a 10 percent reduction in equity risk capital, but many supervisors and companies opposed it because of the lack of theoretical and empirical justification.

For the life underwriting risk (which combines various sub-risks such as mortality, longevity, sickness, lapses and expense inflation through a correlation structure), some concerns have arisen especially on the capital requirement for lapse risks, which was considered to be too high. It was also suggested that a scenario approach would be more appropriate for lapse risk, allowing impacts on different lines of business to be captured. Several companies argued for an age and duration dependent treatment of longevity, reinforcing more general comments that a one-off shock is not the most appropriate form of stress for biometric risks.

Internal Models

Approximately 50 percent of the participants provided some information on internal models, but only 10 percent of companies provided quantitative results for their internal model calculation. Companies are in different stages of developing their internal models, and 63 percent (approximately 450 entities) have considered it a viable option for improving risk management and governance. When comparing results from internal models and the SCR standard formula, the SCRs seem to be lower with internal models. Half the companies expect a 20 percent decrease in their capital requirements based on internal models (especially because of premium and reserve risk). For overall life underwriting risk, internal models tended to give a lower risk capital charge than the standard formula, with the median reduction being 30 percent.

The QIS 4 exercise was based on 2007-year balance sheet figures and therefore does not reflect the current balance sheet distortions caused by the financial crisis. A QIS 5 exercise was originally planned for early 2009. In view of the current turmoil in the financial market, its consequences on the parameterization of the standard formula and to free up the necessary time to deeply review the results of QIS 4, QIS 5 has been postponed until early 2010.

Non-Proportional Reinsurance

Under the QIS 4 approach, recognition of risk mitigation techniques in reducing capital charges is supported. A set of principles regarding financial risk mitigation tools has been defined. However, it is not yet clear which techniques will be allowed and how the reduction would apply in practice. In particular, the implementation in QIS 4 for non-proportional measures - such as non-proportional reinsurance and securitization - is not accurate. Such an objective cannot be reached in the standard formula framework proposed by Solvency II and the QIS grids, while it can be reached in the frequency/severity approach supported by the Swiss regulator in the Swiss Solvency Test (SST).

At present, a (partial) internal model is the only approach that takes full advantage of non-proportional risk mitigation techniques. This method is being increasingly supported by the different stakeholders to Solvency II, but it will be necessary to convince local regulators of the adequacy and measure of the risk transfer.

Catastrophe Risk

The catastrophe risk charge could be derived using one of three approaches. The factor-based approach (known as “Method 1″) — under which a standard formula based on premium income by line of business is used — was selected by 31 percent of the non-life participants. The first scenario-based approach (known as “Method 2″) uses common regional scenarios which vary significantly by country. 39 percent of the non-life participants based their calculation on Method 2. Newly introduced in QIS 4 was ‘Method 3,” under which companies could use personalized scenarios according to the classes of business written and geographical concentration based on their own assessments of non-life catastrophe risk. Twenty-four percent of the non-life participants opted for this personalized approach, which focuses on the risks relevant to a particular portfolio.

Status of the Political Process and Group Support

The most recent draft Solvency II framework directive, written by the EU’s Economic and Financial Affairs Council (ECOFIN), abandons the notion of “group support,” originally a key concept of the directive. Group support acknowledges the benefits of geographic diversification for groups that have subsidiaries and risks in various countries by recognizing that, for a group, less risk capital is necessary than the sum of risk regulatory capital requirement across the local entities. The original proposal allowed local entities to hold less than the SCR (target capital) than they would have needed on a standalone basis, provided that this lower capital ratio was supplemented by group support. It required that capital adequacy be supervised primarily group-wide under the responsibility of a lead supervisor located in the country in which the head of the group is domiciled. According to an informal agreement on the compromise Solvency II framework directive reached at the end of March 2009, group support will be scoped out of the initial launch of Solvency II but will be picked up again three years after the launch. Formal adoption of the Solvency II framework Directive by the European Parliament and ECOFIN is likely to take place beginning of May 2009.

A Parliamentary committee approved a version of Solvency II in October that included group support. The European Commission also views it as a key element of the proposed new capital regime for insurers. Negotiations will now begin between the ECOFIN and the European Parliament to reach a compromise that can be put to a vote of the full Parliament in February. The European Commission has stated that it is still confident that a joint text can be agreed and the Framework Directive adopted before the European Parliament elections in June 2009.

Special Status of Captives

The new version of the Directive adopted in October allows a special position for captives. Due to size and type, as well as the specific nature of the risks they insure, captive insurance companies often lack sufficient data and information of appropriate quality to produce representative historical loss experiences and apply reliable actuarial methods. The simplifications proposed for “common” insurance and reinsurance undertakings, however, may not take into account the specificities of the captive business.

There is a need for specific simplifications to be applied to the calculation of technical provisions and SCR in general for captives in line with the general approach adopted for other small and medium sized insurance and reinsurance companies.

Conclusion

There is no doubt that state-of-the-art solvency schemes such as Solvency II are imperative to maintain the financial stability of the insurance industry globally. The feedback on the current QIS exercise is a sure sign of its acceptance among the insurance industry.

A majority of the QIS participants sees the implementation of Solvency II as an opportunity to gain a better oversight of the risk management function and as a tool for adequate governance. The message is clear: companies that have not taken the Solvency II train yet and have declined participation in the preparatory QIS exercises are strongly encouraged to take advantage of this year to catch up and become familiar with the requirements. On the other hand, companies that have diligently taken part in the QIS exercises should keep their momentum throughout 2009 and consider ways of improving their risk management functions, for example by considering the implementation of (partial) internal models. By doing so, companies will gain invaluable insight, not only into their solvency positions but also to enhance their overall governance and strategic situation by means of improved data quality, better accumulation controls and fostering internal communication.

2012 is tomorrow. Solvency II is much more than just a simple capital adequacy exercise.

Contacts:

  • Susan Witcraft, Managing Director, Minneapolis, +1.952.832.2143
  • Frank Achtert, Managing Director, Munich, +49.89.28.66.03.361
  • Eddy Vanbeneden, Managing Director, Munich, +32.2.674.98.11
  • Benoît Butel, Vice President, Paris, +33.1.56.76.48.26
  • Sebastien Portman, Vice President, Zurich, +41.44.285.9322

Footnotes:

  1. The basic principle of proportionality is that the application of the directive and supervision should take into account the nature, scale and complexity of an entity or a group. This should reduce the burden of regulation on small insurers writing straightforward insurance products compared to larger insurers or insurers writing more complex insurance products.
  2. A model point is a single policy which is used to represent a group of similar policies within a larger portfolio. Instead of modeling each policy in the group individually the model point approach involves modeling a single representative policy and scaling up the result in line with the total sum assured.
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