Financial Intelligence Team
CP31 sets out the principles an entity must adhere to in order to allow the recognition of financial mitigation techniques (e.g., financial derivatives) for Solvency Capital Requirement (SCR) purposes. It states the capital requirement should allow for an appropriate reduction to reflect the mitigation techniques in place while avoiding allowing deductions based on inappropriate mitigation techniques.
While mitigation techniques may reduce some risks, they raise others (such as operational, counterparty, and liquidity risks) and it is necessary to capture these new risks appropriately in the capital requirements. In the standard formula approach to Solvency II compliance, these two effects are separated: risk transfer is recognized in the individual risk modules, and the acquired counterparty risks are captured in the counterparty default risk module. As a general rule, only financial protection provided by entities rated BBB or better is allowed in the assessment of SCR. It is also necessary to allow for any basis risk, where the underlying assets of the mitigation instrument do not match perfectly the exposures of the entity.
The allowance for risk mitigation in the SCR standard formula is restricted to instruments (regardless of the legal form) and excludes processes and controls the firm has in place to manage the investment risk, as the change in financial conditions is treated as an instantaneous shock. The instruments should meet certain liquidity requirements to prevent the use of financial mitigation techniques that inappropriately tie the entity to an arrangement.
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- Susan Witcraft, Managing Director
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