With 2009 coming to a close, this week we’re taking a look at the most popular stories of the year.

Where Are We on Solvency II?: 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.

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Cat Risk in a Solvency II Environment: Many approaches exist for use in assessing catastrophe risks. Under Quantitative Impact Study 4 (QIS4), the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) provided a list of those that can be used for Solvency II compliance and, in the interim, managing risk and capital effectively. The full stochastic modeling of catastrophe risk using an internal model, such as Guy Carpenter’s G-Cat® tools and MetaRisk®, provides the most information.

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ERM Offers Competitive Compliance for Solvency II, Part I >>

ERM Offers Competitive Compliance for Solvency II, Part II >>

ERM Offers Competitive Compliance for Solvency II, Part III >>

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Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat
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Insurers have choices in evaluating how to allocate capital and its cost. The ultimate goal is to strike a balance between feasibility (based on management acceptance and effort) and capital optimization. Eventually, most companies are likely to migrate towards contribution methods, along the lines of co-xTVaR and the shared asset approach, with thresholds varying with the specific questions being reviewed and specific corporate risk tolerances.

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Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat
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A comparison of the percentages of capital or the cost of capital allocated to each line using each of the proportional methods is shown in Figure 7. As you can see, there are significant differences in allocation percentages among the different metrics.

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Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat
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The shared asset method is a bit different from the other proportional approaches to capital allocation.¹ The cost of capital is allocated to line rather than allocating capital itself. Capital is viewed as a shared asset to support all risks assumed by the insurer, and the company estimates the cost of replacing capital at different levels of loss. Figure 5 shows an illustration of these differing cost of capital levels, with the cost increasing as more capital is lost.

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Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat
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Co-xTVaR has almost the opposite advantages and disadvantages of standard deviation. It is calculated as the amount by which each risk is worse than its expectation in those situations in which the totality of risks being modeled exceeds its expectation. Co-xTVaR can be viewed as the amount by which a segment is “over budget” in those scenarios in which the company as a whole is “over budget.” In other words, co-xTVaR looks at the average amount by which each segment exceeds its mean in the scenarios in which the company result exceeds some threshold.

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Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat
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Covariance is the expected value of the product of the deviations of two variables from their means. In each iteration, the difference between a segment’s value and its mean is multiplied by the difference between the total value and the total mean. The average of these products is the covariance. Capital is then allocated in proportion to the covariances. Figure 3 shows the covariances and allocated capital for the sample company.

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Financial Intelligence Team
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Solvency II compliance should provide more opportunity than burden … if executed properly. The ability to use approved internal models results in a Solvency Capital Requirement (SCR) that’s tailored to the risks in your portfolio - which in itself is advantageous. This benefit translates into more effective capital management, as it reflects the risks you actually cover (rather than the output of a standard formula). Improved operations through the internal model approach may also free capital for deployment elsewhere — if the model-determined SCR is lower than that from the Solvency II standard formula. The newly available capital can be invested in any number of initiatives that can lead to a competitive advantage.

After the jump, you’ll find five ways to attain competitive compliance.

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Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat
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Standard deviation has long been a common allocation basis in actuarial literature. There have been many papers published discussing the use of standard deviation as a basis for allocating capital for pricing either explicitly or implicitly — e.g., in calculating increased limits factors. With this approach, the standard deviation of each segment is calculated independently. Capital is allocated to each segment in the same proportion as its standard deviation bears to the sum of the standard deviations.

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Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat
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To understand the differences in proportional capital allocation methods, it helps to have a reference point. Consider a simple hypothetical insurer that writes auto, general liability, workers’ compensation and property business. The loss distributions are a bit exaggerated to highlight some of the differences among metrics. A profile of the company’s business is shown in Figure 1.

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