a french actuary

Review of the Insurance Industry

2009-07-15T22:44:00.001-07:00

The credit crisis has changed the financial world forever and, says Andy Baldwin, there must be a frank dialogue between insurers and regulators on any new fiscal rules

When Bob Dylan sang that The Times They Are a-Changin’ back in the 1960s, he clearly didn’t have the global financial system in mind. But if ever there is a song or particular lyric that has resonance with the situation that we find ourselves in today, it has to be the line: ‘‘Your old road is rapidly ageing, please get out of the new one if you can’t lend a hand.”

In the past 12 months we have witnessed corporate failures, a spate of “shotgun” mergers, government intervention and corporate fraud, the likes of which regulators, the public, policymakers, politicians and indeed the industry do not ever want to see again. The existing regulatory “rule book” has been found wanting and is in the process of being rewritten.

In comparison to the banking and asset management sectors, the insurance industry has weathered the storm relatively well, but it must now be actively involved in the debate. Principally, it must fulfil two roles: firstly, as a major institutional shareholder of UK Plc, and secondly representing the UK and global interests of the UK-based insurance industry. Failure to do so risks allowing a politically motivated regulatory agenda being imposed on the market.

The industry is already deep into the planning phase for Solvency II and International Financial Reporting Standards (IFRS), while life assurers are still working through the implications of the FSA’s recent retail distribution review (RDR) changes. There has never been a greater need for co-ordination between the tripartite regulators in the UK, the EU and across the globe.

The need for “smart” legislation change is particularly important as a recent Ernst & Young global financial services survey suggests it is unlikely that financial services will return to growth before spring 2010. But it is expected that we will see some areas returning to significant profitability this year; ironically led by the trading and investment banking arms of the global banks, which suffered such massive losses in the preceding 18 months. However, in the mainstream UK (and global) retail banking and insurance sector, the majority of players are being driven towards cost reduction, restructuring and selling non-core businesses to navigate back to the required levels of profitability. Those with cash and capital to spare are exploring opportunities to strengthen their primary product, market and distribution strategies.

While managing profitability, the financial services industry has already responded to the underwriting, credit and operational risks presented by the crisis. Our survey showed that the majority of financial institutions have made permanent changes to their risk management strategy; 68% have implemented permanent differences to their regulatory framework and over half (54%) have changed their operating or business model. In difficult trading conditions, insurers must be able to show how they are ensuring the management of underwriting risk in line with target portfolios. The design, placement and management of treaty and facultative reinsurance have received particular attention.

However, it is likely that the final shape of the new risk and regulatory regime will require further investment in risk-management processes. In the current climate, financial institutions may well need to fund these changes by making further cuts or maintaining downward pressure on discretionary spending. This change is likely to be accompanied by a renewed focus on capital-intensive products and activities. Insurers are already seeing the early recognition of the forthcoming Solvency II regime with management attention focusing on certain capital-intensive life products (for example, variable annuities). The underlying investment strategies to support the returns of such products have exposed life insurers in particular to the volatility of the markets drawing greater regulator attention to their own solvency thresholds. It will be interesting to see whether the industry suffers any regulatory “spill-over” effect from the desire to impose counter-cyclicality (that is putting capital away in the good times to ensure it is available in the bad) that appears destined for the UK banking industry.

As the new regulatory framework begins to emerge, it is clear that the landscape for financial services in the broadest sense will never be the same again. While not deemed to be responsible for the original misdemeanours, insurers need to be both vocal stakeholders in shaping the agenda as well as acting as good corporate citizens in the interpretation and operational of any new regime. This is a significant task given the industry is already wrestling with Solvency II, IFRS and a raft of national-specific and EU legislation.

Regulators need to balance two demands: firstly, to make more certain that individual institutions have a fundamentally sound risk profile to protect the consumer; and secondly, to ensure that the amalgamation of individual financial institutions at a country, regional and global level does not again represent a systemic risk to the overall financial system.

The politically charged debate around national versus international regulation will continue for sometime yet. However, it is clear that as regulatory initiatives converge globally, there has never been a greater need for improved dialogue between regulators and insurers, with the latter taking the lead where possible.

If Dylan’s song could be updated, then I am sure hitching a lift would not feature. It is up to the industry to make sure its voice is heard and that it takes a driving seat in the changes ahead.

Article 85(d) - Calculation of the Risk Margin

2009-07-04T23:38:00.000-07:00

1. Introduction
1.1. In its letter of 19 July 2007, the European Commission requested CEIOPS
to provide final, fully consulted advice on Level 2 implementing measures
by October 2009 and recommended CEIOPS to develop Level 3 guidance
on certain areas to foster supervisory convergence. On 12 June 2009 the
European Commission sent a letter with further guidance regarding the
Solvency II project, including the list of implementing measures and
timetable until implementation.1
1.2. This Paper aims at providing advice with regard to the calculation of the
risk margin as requested in Article 85(d) of the Solvency II Level 1 text.2
1.3. The objective of this paper is to specify the overall structure of the calculation
of the risk margin, including the following aspects:
• the definition of the reference undertaking, including the
assumptions this undertaking has to fulfil;
• the stipulation (calibration) of the Cost-of-Capital rate; and
• the projection of the future SCRs related to the reference undertaking.
1 See http://www.ceiops.eu/content/view/5/5/
2 Text adopted by the European Parliament on 22 April 2009, see
http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//NONSGML+TA+20090422+SIT-
03+DOC+WORD+V0//EN&language=EN.
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2. Extracts from Level 1 Text
2.1 Legal basis for implementing measures
2.1 According to the guiding principles referred to in the Commission’s letter,
the legal basis for the advice presented in this paper is found in Article
85(d) and (h) of the Level 1 text, which states:
Article 85 - Implementing measures
The Commission shall adopt implementing measures laying down the
following:
[…]
(d) the methods and assumptions to be used in the calculation of the
risk margin including the determination of the amount of eligible
own funds necessary to support the insurance and reinsurance
obligations and the calibration of the Cost-of-Capital rate;
[…]
(h) where necessary, simplified methods and techniques to calculate
technical provisions, in order to ensure the actuarial and statistical
methodologies referred to in point (a) and (d) are proportionate to
the nature, scale and complexity of the risks supported by insurance
and reinsurance undertakings including captive insurance and reinsurance
undertakings.
2.2 Other relevant Level 1 text providing background to the advice
2.2. Article 75(2) and (4) as well as Article 76(1), (3) and (5) are especially
relevant for the implementing measures on the risk margin.
Article 75 – General provisions
[…]
2. The value of technical provisions shall correspond to the current
amount insurance and reinsurance undertakings would have to pay
if they were to transfer their insurance and reinsurance obligations
immediately to another insurance or reinsurance undertaking.
[…]
4. Technical provisions shall be calculated in a prudent, reliable and
objective manner.
Article 76 – Calculation of technical provisions
1. The value of technical provisions shall be equal to the sum of a best
estimate and a risk margin
[…]
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3. The risk margin shall be such as to ensure that the value of the
technical provisions is equivalent to the amount insurance and
reinsurance undertakings would be expected to require in order to
take over and meet the insurance and reinsurance obligations.
[…]
5. Where insurance and reinsurance undertakings value the best
estimate and the risk margin separately, the risk margin shall be
calculated by determining the cost of providing an amount of eligible
own funds equal to the Solvency Capital Requirement necessary to
support the insurance and reinsurance obligations over the lifetime
thereof.
The rate used in the determination of the cost of providing that
amount of eligible own funds (Cost-of-Capital rate) shall be the
same for all insurance and reinsurance undertakings and shall be
reviewed periodically.
The Cost-of-Capital rate used shall be equal to the additional rate,
above the relevant risk-free interest rate, that an insurance or
reinsurance undertaking would incur holding an amount of eligible
own funds, […] equal to the Solvency Capital Requirement
necessary to support the insurance and reinsurance obligation over
the lifetime of that obligation.
2.3 Moreover, with respect to the specification of the reference undertaking,
reference should be made to recitals (32) and especially (32a):
(32) The value of technical provisions should therefore correspond to the
amount an insurance or reinsurance undertaking would have to pay
if it transferred its contractual rights and obligations immediately to
another undertaking. Consequently, the value of technical provisions
should correspond to the amount another insurance or reinsurance
undertaking (reference undertaking) would be expected to
require to take over and meet the underlying insurance and reinsurance
obligations. The amount of technical provisions should
reflect the characteristics of the underlying insurance portfolio.
Undertaking-specific information should therefore only be used in
their calculation insofar as that information enables insurance and
reinsurance undertakings to better reflect the characteristics of the
underlying insurance portfolio, such as information regarding claims
management and expenses.
(32.a) The assumptions made about the reference undertaking assumed to
take over and meet the underlying insurance and reinsurance obligations
should be harmonised throughout the community. In particular,
the assumptions made about the reference undertaking that
determine whether or not, and if so to what extent, diversification
effects should be taken into account in the calculation of the risk
margin should be analysed as part of the impact assessment of
implementing measures and should then be harmonised at Community
level.
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3. Advice
3.1 Explanatory text
3.1.1 Previous advice
3.1. In its “Further advice to the European Commission on Pillar 1 issues” of
March 2007, CEIOPS discussed in some detail the merits of the percentile
approach and the Cost-of-Capital approach, respectively, for calculating
the risk margin.3
3.2. At that time the European Commission had decided that only the Cost-of-
Capital Approach should be tested in the third Quantitative Impact Study
(QIS3). On the other hand the Commission’s proposal for a Solvency II
Level 1 text had not yet been published, and especially the important
concept of “a reference undertaking” had not been launched.4
3.3. However, CEIOPS’ advice from March 2007 contained several
considerations that in general are still relevant:
To achieve a harmonised approach that is consistent with the supervisory
objectives for a risk margin in technical provisions, for a solvency application
of a Cost-of-Capital approach, the key parameters and assumptions
underlying such an approach would need to be set, including:
• the definition of the future 'capital' to be considered (it would
need to be specified that this is the regulatory capital requirement);
• the setting of the Cost-of-Capital factor (for example, whether
'stressed' factors would need to be used);
• assumptions regarding the extent to which diversifiable risks
would need to be taken into account; and
• assumptions regarding the extent to which future financial risks
would need to be taken into account.5
3See http://www.ceiops.eu/media/files/publications/submissionstotheec/CEIOPS-DOC-08-
07AdviceonPillarI-Issues-FurtherAdvice.pdf, CEIOPS-DOC-08/07, March 2007, para 3.72-3.101
(pp. 37-43) (hereafter “Advice of March 2007”). In addition, reference was made to a stresstesting
approach for life insurance.
4 Hence, in CEIOPS-DOC-08/07 two (alternative) objectives of the risk margin (cf. e.g. para 3.72)
were still mentioned: (i) to transfer the portfolio of liabilities to another (re)insurer with a sufficient
high level of confidence or (ii) to recapitalise the undertaking with a sufficiently high level of confidence
to ensure a proper run-off scenario of the original undertaking.
5 Advice of March 2007, para 3.83.
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3.4. Especially, with respect to the choice of method for calculating the risk
margin the Advice of March 2007 advice stated that:
CEIOPS agrees that for non-hedgeable risks the cost of capital approach
should be used under certain preconditions to be defined in the Framework
Directive.
Reflecting existing market uncertainties the cost of capital must consist of
a risk margin that meets the objectives either to transfer the portfolio to a
third party or to recapitalise the company to ensure a proper run-off
scenario by the original undertaking.6
The calibration of the risk margin must not be left to the discretion of
undertakings but key parameters and assumptions should be prescribed
by supervisors on level 3 using historical volatilities in credit spreads for a
BBB rating (corresponding to a 99.5 % confidence level) or applying
current credit spreads for BBB but adding a stress scenario to also be
developed on level 3.7
3.5. These considerations were also reflected in the specific advice on the principles
for calculating the technical provisions.8
3.1.2 The risk margin in QIS4
3.1.2.1 The QIS4 Technical Specifications
3.6. The QIS4 Technical Specifications (TS)9 contained a rather detailed overview
of (general) principles for calculating the risk margin, a detailed list of
assumptions on which the risk margin calculations should be based as well
as proposals for several layers of simplifications and proxies that could be
used in these calculations.
3.7. As it seems likely that large parts of these principles and assumptions can
be carried over to the Level 2 implementing measures regarding the risk
margin calculations (or the future Level 3 supervisory guidelines regarding
these calculations), this part of the QIS4 TS is summarised only briefly in
the paragraphs below.
3.8. It should be noted from the outset that the concept “reference undertaking”
is not explicitly referred to in the QIS4 TS. This is being developed
further in section 3.1.3 below. However, as a part of the preparation for
the QIS4 exercise, CEIOPS had elaborated a background paper setting out
proposals for the assumptions and characteristics that the reference
undertaking should satisfy.10
6 The recapitalisation and run-off by the original undertaking is no longer an alternative option for
the risk margin assessments.
7 Advice of March 2007, para 3.99-3.101.
8 Cf. Advice of March 2007, para 3.118, 3.120 and 3.121.
9 See http://www.ceiops.eu/media/docman/Technical%20Specifications%20QIS4.doc.
10 See the QIS4 background document: Guidance on the definition of the reference entity for the
calculation of the Cost-of-Capital (CEIOPS-DOC-09/2008),
http://www.ceiops.eu/media/docman/public_files/consultations/QIS/Cost%20of%20Capital%20Ref
erence%20Undertaking.pdf
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3.9. With respect to the general principles for the risk margin calculations, the
QIS4 TS stated that:
The value of the technical provisions is equal to the sum of a best
estimate and a risk margin. The best estimate and the risk margin
should be valued separately, with the exception of hedgeable
(re)insurance obligations […].
[…]
The risk margin is such as to ensure that the value of technical
provisions is equivalent to the amount that (re)insurance
undertakings would be expected to require to take over and meet
the (re)insurance obligations.
The risk margin should be calculated by determining the cost of
providing an amount of eligible own funds equal to the Solvency
Capital Requirements necessary to support the (re)insurance
obligations over their lifetime.11
These general principles mainly reproduced the relevant part of the Level
1 text, including the fact that under Solvency II a Cost-of-Capital methodology
would be used for calculating the risk margin.
3.10. In order to make the risk margin calculations operational, the QIS4 TS
introduced several assumptions to support these general principles:
• The undertakings should make projections of the development of
(re)insurance obligations until their extinction and then, for each
year, determine the SCR to be met by an undertaking facing such
obligations (TS.II.C.2).
• The SCR-calculations should be performed on the basis of the standard
formula. However, undertakings that have developed full or
partial internal models were invited – on an optional basis – to communicate
results of risk margin calculations based on these models
(TS.II.C.4-C.5).
• The risk margins (based on the standard formula) should be calculated
net of reinsurance rather than by carrying out separate calculations
of the risk margin for gross technical provisions and reinsurance
and SPV recoverables, respectively (TS.II.C.6).
3.11. With respect to the risks to be taken into account in the Cost-of-Capital
calculations, the QIS4 TS laid down the following assumptions:
• The calculations should take into account the impact of underwriting
risk with respect to the existing business, counterparty default risk
with respect to ceded reinsurance and operational risk (TS.II.C.7).
• The insurance and reinsurance obligations should not give rise to any
market risk or risk of default of the counterparties to financial
derivative contracts (TS.II.C.8).
11 TS.II.A.6, TS.II.A 14 and TS.II.A 15.
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• Renewals and future business should be considered only to the extent
that they are included in the current best estimate of liabilities
(TS.II.C.9).
3.12. Regarding the segmentation to be used for Cost-of-Capital calculations,
the QIS4 TS requested that these calculations should differentiate between
lines of business in the following manner (cf. TS.II.C.10-C.12):
• Life insurance: The portfolio should be segmented into 16 lines of
business by using two steps, i.e. according to four types of contracts
(first step) and for each type of contracts four types of risk drivers
(second step).
• The calculations regarding health insurance contracts with features
similar to life business should be disclosed separately.
• Direct non-life insurance: The portfolio should be segmented into 12
lines of business.
• Proportional non-life reinsurance should be treated as direct insurance
while non-proportional non-life reinsurance should be segmented into
three lines of business.
3.13. Hence, the segmentation used in QIS4 for risk margin calculations was –
with one exception – identical to the segmentation for (re)insurance obligations
proposed in Consultation Paper no. 27.12 The exception concerns
the Accident and Health line of business which in the QIS4 TS was split
into two sub-lines of business.
3.14. The QIS4 TS assumed that no diversification benefits should be recognised
when aggregating the technical provisions (the sum of a best estimate and
a risk margin) as calculated per line of business.13
3.15. Regarding the Cost-of-Capital rate, the QIS4 TS requested that a rate of 6
per cent should be used by all undertakings.
3.16. The steps to be followed by an undertaking when calculating the risk
margins under the Cost-of-Capital methodology were summarised as follows
(assuming a valuation date at the beginning of year 0):
(a) For each line of business find an SCR for year 0 – as well as for all
future years throughout the lifetime of the obligations in that line of
business – by taking into account the risks listed in para 3.11.
(b) Multiply all SCRs referred to in step (a) by the Cost-of-Capital rate in
order to get the cost of holding these SCRs.
(c) Discount the amounts calculated in step (b) by using the risk free
interest rate term structure at the valuation date (the beginning of
12 See CEIOPS-CP-27-09 Technical Provisions – Lines of business on the basis of which
(re)insurance obligations are to be segmented,
http://www.ceiops.eu/media/files/consultations/consultationpapers/CP27/CEIOPS-CP-27-09-Draft-
L2-Advice-on-TP-Segmentation.pdf
13 However, diversification effects between the different risk modules within a given line of business
were taken into account.
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year 0). The risk margin to be attached to the best estimate (for the
given line of business) equals the sum of these discounted values.
(d) Finally, the overall risk margin of the undertaking is given as the sum
of the risk margins as calculated by lines of business (i.e. without any
diversification effects).
3.17. As stated in the QIS4 TS, the main practical difficulty of the risk margin
calculations consists of deriving SCRs for future years for each line of business
(TS.II.C.16). Hence, in order to reduce the burden of calculation for
the participating undertakings, the QIS4 TS introduced several layers of
simplifications for these calculations. In addition, separate “risk margin
helper tabs” for life and non-life lines of business, respectively, were integrated
into the QIS4 spreadsheets.
3.1.2.2 The QIS4 report
3.18. The calculations of the risk margin under QIS4 are summarised as follows
in CEIOPS’ QIS4 report:14
In general, undertakings and supervisors support the design of the
proposed method for calculation of technical provisions, including the
proposed simplifications and proxies. Many supervisors reported
considerable consistency in the valuation approach used. However
some supervisors reported that a wide variety of methods was used
by undertakings with no evidence of convergence and that there was
also some doubt as to whether the Technical Specifications have been
applied consistently across countries.
[…]
In addition, many undertakings found the specifications for calculating
the risk margin complex and hard to follow. This resulted
mainly from the difficulty involved in accurately projecting the SCR.
Some undertakings also felt that the segmentation of business within
the risk margin was inappropriate and added considerably to the
complexity of the calculation. Most undertakings commented that
diversification between lines of business, between risk types, and
between geographies and legal entities should be taken into account
with some stating that from an economic point of view it is more
correct to value the liabilities based on the undertaking’s own portfolio.
A number of questions were also raised regarding the appropriateness
of the 6% cost of capital rate.
The consistency of technical provisions could be improved by providing
more precise guidance on the above issues.
14 CEIOPS’ report on its fourth Quantitative Impact Study (QIS4) for Solvency II (CEIOPS-SEC-
82/08), http://www.ceiops.eu/media/files/consultations/QIS/CEIOPS-SEC-82-
08%20QIS4%20Report.pdf (hereafter: QIS4 report). See section 7.1 (page 73-74) on the main
findings regarding technical provisions.
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3.19. With respect to the use of simplifications and proxies the QIS4-report
stated that:
The majority, if not all, of undertakings (independently of their size)
used simplifications to project the SCR for the purposes of calculating
the risk margin. The risk margin proxy and helper tab for non-life
were also extensively used by undertakings.15
3.20. Regarding the practicability and suitability of the proposed methodologies
for calculating the technical provisions the feedback from undertakings
participating in QIS4 was in general positive. However, the methodologies
for the risk margin determination received lower marks than the methodologies
concerning the best estimate valuation – especially with respect
to the suitability (and reliability/accuracy).16
3.21. The QIS4 report summarised the participating undertakings’ assessment of
the practicability of the proposed methods to calculate the risk margin
according to the Cost-of-Capital approach in the following manner:
Undertakings in most countries support the cost of capital approach
for determining the value of the risk margin for non-hedgeable risks.
They consider the CoC-approach as clear, the CoC methodology as
appropriate and practicable and the CoC as a robust way to calculate
the market value margin. […] A number of undertakings commented
on the fact that the risk margin depends to a large extent on the
projected SCR so any limitations in the standard formula would also
impact on the risk margin.
A number of participants criticised the technical difficulty of the risk
margin calculation and the lack of more technical support.
Some undertakings stated that the calculation of the risk margin by
LoBs needs a breakdown of underwriting, counterparty and operational
risk SCR by LoBs that is difficult to apply.17
3.22. Regarding the suitability of the proposed approaches for calculating the
risk margin “[s]ome participants commented that the descriptions and
possible simplifications left too much room for interpretation and subjective
judgement”.18 However, according to the QIS4 report most of the
comments regarding the methods for calculating the risk margin were
related to the diversification effects and the cost-of-capital rate:19
Most undertakings commented that diversification between lines of
business, between risk types, and between geographies and legal
entities should be taken into account with some stating that from an
economic point of view it is more correct to value the liabilities based
on the undertaking’s own portfolio.
[…]
15 QIS4 report, sub-section 7.2.5, page 78.
16 QIS4 report, page 85.
17 QIS4 report, see sub-section 7.3.5, page 108-109.
18 QIS4 report , page 110.
19 QIS4 report, page 111.
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A number of questions were raised regarding the appropriateness of
the 6% cost of capital rate and the work of the CRO Forum was
referenced by several undertakings. They argued that it is questionable
whether such a choice would lead to a reliable proxy for the cost
of transferring a portfolio to a willing third party. Others felt that the
cost-of-capital factor of 6% may overstate the true CoC for companies
that may hold or acquire these liabilities, and argued for a factor
in the range of 2%-4% instead. […]
Further consideration should be given to the appropriateness of the
6% cost of capital factor in light of the CRO Forum research.
3.23. The issues related to diversification effects and the choice of the Cost-of-
Capital rate are being discussed in more detail in the section hereunder.
3.1.3 The overall structure of the risk margin calculations
3.24. It follows from the wording of Article 85(d) and recitals 32 and 32(a) of
the Level 1 text, as well as from the QIS4 feedback that the implementing
measure regarding the risk calculations should focus on the following
aspects:
• the definition of the reference undertaking, i.e. a clarification regarding
the assumptions that this undertaking has to fulfil;
• the calibration of the Cost-of-Capital rate;
• the general/overarching methodology for calculating the risk margin
in accordance with the Cost-of-Capital approach; and
• simplified methods including the criteria to be fulfilled in order to
apply these simplifications.
CEIOPS’ advice on simplifications regarding the risk margin calculations
is included in the its draft Level 2 advice on Article 85(h).20
3.1.3.1 The reference undertaking21
A. Assumptions to be fulfilled by the reference undertaking
3.25. In order to be able to determine “the cost of providing an amount of
eligible own funds equal to the Solvency Capital requirement necessary to
support the insurance and reinsurance obligations” (Article 76(5)) in a
clear and unambiguous manner, the definition of the reference undertaking
is a key issue. The assumptions that the reference undertaking has
to fulfil if this object shall be achieved, as well as a rationale for these
assumptions, are presented and discussed in the paragraphs below.
3.26. Assumption 1: The reference undertaking is not the undertaking itself
(i.e. the original undertaking), but another undertaking.
20 See CEIOPS-CP-45-09, http://www.ceiops.eu/content/view/14/18/.
21 This section is based on the QIS4 background document on the reference entity.
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3.27. This assumption is reasonable in light of the wording of Article 75(2)
where reference is made to the current amount a (re)insurance undertaking
will have to pay if the (re)insurance obligations are transferred
“immediately to another insurance or reinsurance undertaking”.
Moreover, by assuming that the reference undertaking is another undertaking
(than the original undertaking) there is no need to make artificial
assumptions regarding the original undertaking (e.g. with respect to the
available capital of the original undertaking) as was the case in QIS3 –
when the reference undertaking was defined as the original undertaking.
In general, it seems reasonable to believe that this assumption will reduce
(if not eliminate completely) potential inconsistencies in the framework for
risk margin calculations.
3.28. Assumption 2: The reference undertaking is an empty undertaking in the
sense that it does not have any insurance or reinsurance obligations and
any own funds before the transfer takes place.
3.29. By making this assumption the risk margin will depend only on the
insurance and reinsurance obligations transferred to the reference undertaking
and the assets covering these obligations.
3.30. On the other hand, if the reference undertaking is assumed to be nonempty
there will be ambiguities related to the assumptions to be made
regarding (the composition of) the reference undertaking’s assets and
liabilities before the transfer takes place. The assumptions made may have
a substantial impact on the risk margin due to the fact that the SCRcalculations
allow for diversification (correlation effects) between the
business existing prior to the transfer and the transferred business.
3.31. Moreover, if the reference undertaking is assumed to have positive eligible
own funds (but no (re)insurance obligations) before the transfer, the risk
margin would not measure the cost of holding an amount of eligible own
funds to cover the SCR, but the cost of holding an amount of eligible own
funds (at least partially) in excess of the SCR. This is not intended by the
definition given in Article 76(5) of the Level 1 text and would not make
much sense from an economic point of view.
3.32. Assumption 3: After the transfer the reference undertaking has eligible
own funds corresponding exactly to the amount of SCR that is necessary
to support the transferred insurance and reinsurance obligations.
3.33. If the reference undertaking is assumed to be an empty undertaking
before the transfer takes place (cf. assumption 2), Article 76(5) can be
interpreted in such a way that after the transfer all eligible own funds in
this undertaking will be necessary to support the transferred obligations.
3.34. On the other hand, if it is assumed that the reference undertaking is nonempty,
the interpretation of Article 76(5) will be more difficult, due to the
fact that this undertaking will have eligible own funds and be subject to a
capital requirement related to its existing business prior to the transfer.
After the transfer the eligible own funds would exceed the amount being
necessary to support the transferred obligations.
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3.35. Assumption 4: After the transfer of insurance and reinsurance
obligations, the reference undertaking has assets to cover the Best
Estimate net of reinsurance and SPVs, the risk margin and the SCR. These
assets should be considered to minimize the market risk of the
undertaking. The reference undertaking should only be subject to market
risk that is unavoidable in practice.
3.36. After the transfer the reference undertaking will have on its balance sheet
both assets covering (re)insurance obligations (technical provisions) and
assets covering capital.
3.37. In a transfer of (re)insurance obligations, a transfer of assets that cover
those obligations will typically also take place. Therefore, immediately
after the transfer, part of the assets of the reference undertaking would be
formed of assets that originate from the original undertaking. As a result it
is possible that there would be market risk linked to those assets.
In this context, it can be assumed that the reference undertaking will derisk
these assets22 in order to reduce the part of SCR related to market
risk. For example, the reference undertaking can sell investments in equity
or property to avoid the corresponding risks. It can sell corporate bonds
and buy government bonds instead to avoid credit spread risk, or it can
restructure the investments to achieve a better cash-flow or currency
matching and thereby reduce interest rate and currency risk.
3.38. In principle, the time needed for this de-risking will depend on the selection
of assets that are transferred from the original undertaking. For
reasons of practicability it should be assumed that the de-risking takes
place immediately after transfer.
3.39. On the other hand, Article 75 mentions the transfer of obligations and
Article 76 refers to the amount of eligible own funds that would be needed
to take over and meet these obligations. Neither of the two articles makes
reference to any transferred assets. Therefore it could also be argued that
the nature of assets held in the reference undertaking is independent of
those of the original undertaking. This would also be supported by the
requirement that the assumptions made about the reference undertaking
should be harmonised throughout the European union and that
undertaking-specific information should only be used where it better
reflects the underlying portfolio characteristics. Hence, even according to
this argument it is justified to assume that the reference undertaking
covers the transferred obligations with assets that minimise the market
risk.
3.40. In QIS4, CEIOPS proposed that market risk should not been taken into
account in the calculation of the risk margin for reasons of practicability.
In many cases this is justified as the assets can be completely de-risked.
However, for particular kinds of insurance obligations not all market risk
can be avoided. For example, if the insurance obligations have a very long
22 In the present context an asset is considered as de-risked if there is no capital requirement
linked to it.
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duration, it may not be possible to match the cash-flows completely. The
mismatch may give rise to a significant interest rate risk.
3.41. Stakeholders noted that the QIS4 approach neglected the unavoidable
market risk. For example, the CRO Forum gave in its paper “Market Value
of Liabilities for Insurance Firms” the following examples of market risks
which cannot be avoided in practice:23
(i) 60-year USD, EUR or Yen cash flow or interest rate option,
(ii) 15-year emerging markets cash flow,
(iii) 30-year equity option.
3.42. If market risk is excluded from the risk margin calculation also in cases
where it cannot be eliminated in practice, the resulting technical provisions
would be lower than the transfer value, because any undertaking taking
over insurance obligations bearing unavoidable market risk would require
a compensation for the risk bearing.
3.43. The unavoidable market risk can be determined by analysing the possibilities
to reduce the SCR for market risk. For example, let CF1, CF2, …,
CF30 be the expected cash-flows of an insurance portfolio. Let it be
possible in practice to match cash-flows up to 20 years with risk-free
instruments but not above this threshold. The reference undertaking could
match the cash-flows CF1, …, CF20 and cover the cash-flows CF21, …, CF30
with instruments of 20-year duration. In this way, the market risk would
only consist of a residual interest rate risk. Alternatively, the reference
undertaking could match the cash-flows CF21, …, CF30 with corporate bonds
or risk-free instruments of another currency (where risk-free instruments
of longer duration are available). In these cases, the market risk would
only consist of credit spread risk or currency risk. The investment portfolio
with the lowest market risk SCR determines the SCR that needs to be
allowed for in the risk margin.
3.44. A perfect replication of the liability cash flows is one that completely eliminates
all risks (not only market risk) associated with the liability. In
practise, perfect replication is expected to be relatively rare. It should
therefore be noted that replication of cash-flows and elimination of market
risk SCR are different concepts. It is not necessary to perfectly replicate
the cash-flows of the obligations to eliminate the market risk SCR. It is
sufficient to replicate the liability cash-flows on best estimate level to
reduce the standard formula SCR to zero for the purposes of calculating
the risk margin.
3.45. For non-life insurance obligations and short-term life insurance obligations
the market risk SCR can usually be reduced to zero.
3.46. As with all other risks which are included in the risk margin calculation, the
allowance for market risk should be done in a practicable and proportionate
way with particular consideration of its materiality. For example, in
23 CRO Forum: Market Value of Liabilities for Insurance Firms – Implementing Elements for Solvency
II (July 2008).
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QIS3 market risk was captured in the calculation by allowing for the
current market risk SCR in the first year but not any of the following years
of the SCR projection. CEIOPS will give advice on simplifications of the risk
margin calculation at a later stage.
3.47. Question to stakeholders: Regarding the treatment of market risk in the
risk margin, CEIOPS is proposing a substantial change compared to QIS4.
Stakeholders are asked to comment in particular on the conceptual soundness
of the proposal and its implications on the size of the risk margin.
Moreover, comments in order to ensure a practicable inclusion of market
in the risk margin are welcomed.
3.48. Assumption 5: The SCR of the reference undertaking consists of:
(a) underwriting risk with respect to the transferred insurance and reinsurance
obligations;
(b) counterparty default risk with respect to ceded reinsurance and SPVs;
(c) operational risk; and
(d) unavoidable market risk.
3.49. The reference undertaking is subject to underwriting risk corresponding to
the transferred insurance and reinsurance obligations, and these risks
exist throughout the lifetime of the obligations. On the other hand, underwriting
risk related to new business is not included. With respect to the
non-life underwriting risk, the (non-life) catastrophe risk should only
include pre-claims obligations (i.e. claims related to catastrophe events
incurring after the balance sheet day).
Moreover, it seems obvious to take into account
• counterparty default risk related to risk mitigation contracts (e.g.
reinsurance contracts) covering the transferred insurance and reinsurance
obligations; and
• operational risk related to transferred insurance and reinsurance
obligations.
However, for reasons of practicability it is assumed that the reference
undertaking does not carry any risk of default of counterparties to financial
derivatives contracts.
3.50. Assumption 6: The loss absorbing capacity of technical provisions in the
reference undertaking corresponds to those of the original undertaking.
3.51. It seems reasonable to assume that the profit sharing commitments of the
original undertaking carry over to the reference undertaking as far as they
are confined to the line of business. Hence, the risk mitigating effects of
future profit sharing should be taken into account to the same extent as in
the original undertaking.
3.52. Assumption 7: There is no loss absorbing capacity of deferred taxes
related to the reference undertaking.
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3.53. It follows immediately from the assumption that the reference undertaking
is an empty undertaking that the loss absorbing capacity of deferred taxes
should be excluded from the valuation of the risk margin.
3.54. Assumption 8: The insurance and reinsurance obligations of each line of
business (as defined in Article 85(e)) are transferred to the empty
reference undertaking in isolation. Hence, no diversification benefit
between lines of business arises.
For the purpose of determining the risk margin, the SCR of the reference
undertaking should be calculated (using a standard formula or internal
model) at least by line of business, based on the segmentation laid down
by the implementing measures referred to in Article 85(e).
If the SCR of the original undertaking is calculated by using an internal
model, the segmentation may differ from the one laid down by the implementing
measures referred to in Article 85(e). However, the risk margin
shall always be valued at least at the level of lines of business laid down
by those implementing measures.
3.55. It seems reasonable to apply an approach starting from the risk margin
calculations per line of business as it is required according to Article 85(e)
to allocate this margin to the individual lines of business.24 Especially,
there will be no ambiguity involved in the allocation of the risk margin
when this approach is applied.
3.56. The requirement that the (re)insurance obligations of the individual lines
of business are transferred in isolation can make the risk margin calculations
somewhat more complex (or may at least increase the number of
calculations), since it requires the SCR to be calculated by line of business.
However CEIOPS does not believe that the calculation of the SCR by line of
business poses a significant practical problem particularly since the main
input to the risk margin calculation is the SCR for underwriting risk which
is straightforward to calculate by line of business. Furthermore, simplifications
can be introduced in order to make the calculation more feasible.25
3.57. If instead an approach starting from the risk margin calculations for the
overall portfolio – taking into account all possible diversification effects
(related to the SCR-calculation) – would be applied, several complicating
aspects would be introduced, including the following:
• It is not obvious how to allocate the overall risk margin across the
individual lines of business. (e.g. the earned premiums will not be a
suitable set of weights for this allocation. Nor will the best estimate
technical provisions (in non-life insurance) do, cf. the percentages
used in the risk margin proxy proposed for QIS4 purposes).
• If only a part of the (re)insurance obligations (e.g. the obligations
related to a single line of business) are transferred from the original
undertaking to the reference undertaking, this will require a recalcu-
24 Article 85(e) stipulates the segmentation of (re)insurance obligations into lines of business for
the calculation of technical provisions. In this context, no distinction is made between the best
estimate and the risk margin (per line of business).
25 See CEIOPS-CP-45-09, http://www.ceiops.eu/content/view/14/18/.
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lation of risk margins – both for the portfolio of obligations that are
being transferred and for the portfolio of obligations remaining in the
original undertaking – and the sum of these risk margins will be
higher than the risk margin originally calculated for the overall
portfolio (taking into account all diversification effects). In general,
this would mean that after the transfer has been carried out, the risk
margin related to the (re)insurance obligations that remain in the
original undertaking must be increased.
3.58. A more detailed assessment of the merits of alternative approaches to the
treatment of diversification effects in the context of risk margin calculations
is given in subsection B below.
3.59. Since the risk margin depends on (future) SCRs calculated per line of
business and shall be allocated to best estimate technical provisions per
line of business, a natural solution would be to use the same segmentation
for the calculation of best estimate technical provisions, risk margins and
the SCR, respectively.
3.60. Especially, there seems to be no reason for a (re)insurance undertaking
using the standard formula for the SCR-calculations to apply a more
granular segmentation than the one that follows from the implementing
measures regarding Article 85(e) as this in general will increase the overall
risk margin. Moreover, a finer segmentation will lead to laborious recalculations
of the (standard) SCR (e.g. per homogenous risk groups) and this
may also raise some issues related to the reliability of the (input) data for
these calculations.
3.61. The requirement that the risk margin should be valued at least at the level
of lines of business also in cases where the SCR of the reference undertaking
is calculated by an internal model is introduced in order to ensure
that all reference undertakings apply the same granularity with respect to
these calculations, i.e. in order to avoid ambiguities in the assessing of the
(relevant) technical provisions when a portfolio of (re)insurance obligations
is transferred between two undertakings. Moreover, this requirement
should be seen as a measure to achieve harmonisation of the (calculated)
technical provisions between undertakings, including improved comparability
etc (see also assumption 9 hereunder).
3.62. Assumption 9: The internal model of the original undertaking (partial or
full) can be used to measure the SCR of the reference undertaking to the
extent that these models cover at least the risks referred to in assumption
5 as defined by the standard formula.
3.63. The internal model is only approved for the calculation of the current SCR,
while the determination of the risk margin requires the calculation of all
future SCRs as well. The internal model may not be fully adequate for the
latter calculation.
3.64. However, when Article 76(5) of the Level 1 text refers to the “amount of
eligible own funds equal to the Solvency Capital Requirement necessary to
support the insurance and reinsurance obligations” it does not distinguish
between SCR calculations based on the standard model and internal
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models, respectively. Hence it may be argued that the SCR-calculations to
be applied in the Cost-of-Capital assessment can be based on either the
standard model or internal models.
3.65. An argument in favour of applying SCR calculations based on internal
models when determining the risk margin, may be that these models are
designed in order to capture the risk of the portfolio in question (i.e. the
portfolio of the original undertaking) in a better way. However, if an internal
model portrays levels of risks that are specific for the original undertaking
but cannot be assumed to be similar for the reference undertaking,
this may be an argument for not relying on internal model calculations
when determining the risk margin. Hence, some conditions should be in
place with respect to using SCR-results from internal models in the risk
margin calculations.
3.66. Assumption 10: The Cost-of-Capital risk margin is defined net of reinsurance
and SPVs.
3.67. This assumption is consistent with assumption 5 regarding the SCR calculations
to be carried out for the reference undertaking and especially the
calculation of the partial SCR for underwriting risk as this partial SCR is
only calculated net of reinsurance and SPVs.
3.68. A requirement to calculate the risk margin also gross of reinsurance would
imply a doubling of the number of calculations regarding future SCRs for
underwriting risk and these gross calculations would be relevant only for
the determination of the risk margin.
3.69. Moreover, a likely consequence of calculating the risk margin both gross
and net of reinsurance could be that a (positive) risk margin is attached
also to the reinsurance assets (the reinsurance recoverables), when these
results are presented in the financial statement (of the original undertaking).
However, this would probably not be in line with the accounting
standards for insurance contracts, see e.g. the relevant provisions in
IFRS4 regarding valuation of reinsurance assets.26
B. An assessment of other approaches regarding the reference
undertaking and the treatment of diversification effects
3.70. The proposed assumption 8 to be fulfilled by the reference undertaking (cf.
para. 3.54) covers both the segmentation to be used in the risk margin
calculations and the treatment of diversification effects (caused by
correlations).
3.71. It should be noted that the treatment of diversification effects in the risk
margin calculations and the allocation of calculated risk margins among
the individual lines of business are two separate issues – even if they
apparently coincide in the approach proposed by CEIOPS. However, if the
approach starting from the overall portfolio (at undertaking or group level)
is chosen, this distinction becomes clearer. Although diversification effects
between lines of business (and possibly undertakings within a group) are
26 A discussion of this issue is beyond the scope of the present paper.
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taken into account, this does not imply that the overall risk margin would
not be allocated back to the individual lines of business. What it implies, is
that this allocation will become more challenging to perform.
3.72. The potential impact of assumption 8 should be viewed in light of the other
assumptions defining the reference undertaking (per se), i.e. especially
assumptions 1 and 2.27
3.73. The CEA and CRO Forum have both provided input on the assumptions
underlying the calculation of the risk margin. CEIOPS appreciates the
contributions of both the CEA and the CRO Forum in this area. However,
after careful analysis, CEIOPS’ position nevertheless differs from those of
the CEA and CRO Forum particularly with regard to the framing of assumption
8. A comparison of the positions taken by CEA, CRO Forum and
CEIOPS regarding the above-mentioned aspects of the reference undertaking
are summarised in table 1. However, as indicated in the table,
some reservations are taken with respect to especially the position of the
CRO Forum.
Table 1. A comparison of approaches regarding the reference undertaking (RU).
Assumptions
regarding the RU
CEA CRO Forum CEIOPS
Assumption 1 Mirror of original
undertaking (?)
Another
undertaking (?)
Another
undertaking
Assumption 2 Non-empty Empty (?) Empty
Assumption 8:
• Allowance for
diversification
At least up to
the level of
the undertaking
Up to
the group level
Up to the lines
of business
• Allocation of
the risk margin
Does not believe
the allocation is
required
No response
to date
Per line of
business
Assumptions 1 and 2
3.74. CEIOPS understands CEA’s position with respect to assumption 1 and 2 to
be that the reference undertaking should be a “mirror” of the original
undertaking and as such a non-empty undertaking (before a transfer takes
place). This position is described as follows in a recent paper:28
Firstly, a transfer of business is only one possible outcome in case an
insurer runs into difficulty. The disposal of individual portfolios is rare
and instead a very likely scenario would be that the insurer was
closed to new business and then the existing business was run-off.
[…] Therefore, it is important to refer to business being retained and
27 Assumptions 3-7, 9 and 10 are concerned more with the calculation of the future SCRs for the
reference undertaking.
28 CEA paper on the allowance for diversification within the market value risk margin (4 March
2009),
http://www.cea.eu/index.php?mact=DocumentsLibrary,cntnt01,details,0&cntnt01documentid=617
&cntnt01returnid=100.
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‘own entity’ assumptions being used, rather than artificial 3rd party
‘hypothetical’ assumptions. […]
Secondly, […] the CEIOPS methodology seems to be based on the
assumption that the business would be transferred to an empty shell
company. This is not a plausible assumption and not in line with past
practice.
3.75. This is in line with previous statements from CEA, e.g. in their position
paper on the Cost-of-Capital methodology, where CEIOPS’ background
document on the reference undertaking was commented upon as follows:29
However, a number of different assumptions could be made in respect
of the reference entity, e.g. that the entire portfolio is transferred to a
single, empty reference entity, a well diversified non-empty entity,
etc. […]
As such rather than advocating a particular approach it is more
appropriate to specify what attributes/features the CEA should require
of a market value risk margin approach.
3.76. However, CEIOPS does not believe that this approach can be considered to
be in line with the provisions of the Level 1 text where it is referred
explicitly to an immediate transfer of obligations to another (re)insurance
undertaking or the statements in the recitals regarding the reference
undertaking as well as the limitations regarding the use of undertakingspecific
information.
3.77. In its proposal for general principles regarding the calculation of the
market value of liabilities, the CRO Forum asserts that30
Entity-specific assumptions should be made when projecting future
cash flows so that the valuation reflects the particular characteristics
of the portfolio in question. […]
Therefore, the CRO Forum believes it to be more economically sound
to value insurance liabilities on the basis that they are kept in the
company’s own portfolio […] rather than to base the valuation on a
hypothetical transfer.
And moreover,
We note that the draft directive wording utilises the 'transfer' concept
as the basis of valuation of technical provisions and subsequently
defines how the calculation should be carried out. We believe that our
approach is equally consistent with this basis when it is assumed that
the whole entity is being transferred into an empty reference company.
Both approaches can lead to similar conclusions when determining
market consistent value for insurance liabilities.
29 CEA: Cost of capital methodology (30 May 2008),
http://www.cea.eu/index.php?mact=DocumentsLibrary,cntnt01,details,0&cntnt01documentid=519
&cntnt01returnid=100
30 CRO Forum: Market Value of Liabilities for Insurance Firms – Implementing Elements for Solvency
II (July 2008), http://www.croforum.org/publications.ecp (hereafter CRO Forum Report).
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3.78. CEIOPS notes that the basis underlying the CRO Forum’s approach (liabilities
are kept in the undertaking’s own portfolio) is not consistent with
the Level 1 text but that the CRO Forum nevertheless believes that this
position can be reconciled with the Level 1 text by assuming that the
overall portfolio is transferred to an empty reference undertaking. CEIOPS
has reservations with regard to this interpretation as this does not allow
transfer of the insurance obligations by line of business.
Assumption 8 – Allowance for diversification
3.79. CEA’s paper from March 2009 referred to above also confirms CEA’s
previous position that the risk margin should be calculated at the level of
the undertaking allowing for all diversification effects. In this context it is
stated (with a reference to Article 74(1)) that the valuation process under
Solvency II is based on “the overlying principle of the recognition of
diversification” and that (parts of) CEIOPS’ position is not in line with the
Level 1 text. Beyond this, the CEA’s arguments in favour of the allowance
for diversification effects rest implicitly on their position regarding assumptions
1 and 2 referred to above and their belief that the allocation of the
overall risk margin among the individual lines of business is not required.
3.80. According to the CRO Forum the projection of the SCRs in respect of nonhedgeable
risks should be carried out allowing for diversification benefits
between non-hedgeable risks up to the group level. Moreover, it should be
assumed that the insurer’s risk profile evolves according to realistic best
estimate assumptions, meaning that the capital necessary to support nonhedgeable
risk in future years will depend on future new business written.
3.81. CEIOPS does not consider the reference made to future new business to
be in line with the Level 1 text, cf. the wording of Article 75(2) and Article
76(5).
3.82. Moreover, according to recital 32 of the Level 1 text “the value of technical
provisions should correspond to the amount another insurance or reinsurance
undertaking (reference undertaking) would be expected to
require to take over and meet the underlying insurance and reinsurance
obligations”. The Level 1 text does not give any justification for a treatment
where the value of the technical provisions would fulfil this requirement
only if it were valued on the level of an insurance group. On the
contrary, the valuation principle should apply to any portfolio of insurance
and reinsurance obligations.
3.83. This also applies to CEA’s position that the risk margin should be calculated
at the undertaking level only. Taking into account diversification at
the level of the undertaking would undermine partial transfers, i.e. transfers
of less than the overall portfolio.
3.84. In this context it should be noted that although the transfer concept can
be seen as a theoretical framework, it also has an important practical
bearing from the point of view of the supervision of insurance undertakings.
Transfers of insurance portfolios are relatively common in the
insurance sector, including both full and partial transfers. Portfolio trans23/
54
fers are also a particularly important supervisory tool as regards policyholder
protection when an undertaking becomes or is in danger of
becoming insolvent.
3.85. From a supervisory point of view there are also obvious merits if the same
segment of insurance obligations results in the same value of technical
provisions regardless of the whereabouts of those obligations. This would
ensure that the value is objective and not affected by undertaking-specific
information, cf. recital 32 which states that “undertaking-specific information
should […] only be used in the calculation of technical provisions
insofar as that information enables undertakings to better reflect the
characteristic of the underlying insurance portfolio”.
Assumption 8 – Allocation of the risk margin
3.86. Finally, with respect to the issues regarding the allocation of the overall
risk margin among the individual lines of business, the CEA feedback has
been limited to the following:
[…] there may be practical issues with attempting to calculate isolated
line of business figures. […] This is particularly likely to be the case
under the stress circumstances reflected in the SCR which is then
used to compute the market value risk margin. […]
[…] we believe there is little to be gained from allocating the market
value risk margin across different lines of business and we do not
believe it should be a regulatory requirement to do so. The split of the
risk margin would also necessarily involve an element of subjectivity,
as diversification effects would need to be allocated per line of business.
[…]
However […] for internal management purposes, some companies
may wish to allocate the market value risk margin by line of business,
[…] Companies should be allowed to do this by whichever method
they believe is most suitable. However, as stated above, they should
not be compelled to do so for regulatory solvency purposes.
3.87. CEIOPS does not agree with the CEA position that allocating the risk
margin to different lines of business is not required. This is based on the
rationale for assumption 8 (cf. para. 3.55-3.57 above), which refers to the
problems an undertaking (or group) will face, if the risk margin
calculations start from the overall portfolio – taking into account all
possible diversification effects.
3.88. The issues related to allocation of the overall risk margin among lines of
business are not covered in the CRO Forum’s paper.
3.1.3.2 The Cost-of-Capital rate
3.1.3.2.1 A general approach for stipulating the Cost-of-Capital rate
3.89. According to Article 76(5) of the Level 1 text the Cost-of-Capital rate “shall
be the same for all insurance and reinsurance undertakings and shall be
reviewed periodically”. Moreover, the Cost-of-Capital rate used
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shall be equal to the additional rate, above the relevant risk-free
interest rate, that an insurance or reinsurance undertaking would
incur holding an amount of eligible own funds, […], equal to the
Solvency Capital Requirement necessary to support the insurance and
reinsurance obligation […].
3.90. As the “additional rate, above the relevant risk-free interest rate” referred
to in Article 76(5) shall be the same for all insurance and reinsurance
undertakings, it should be calibrated in a manner that is consistent with
the assumptions made for the reference undertaking. In practise this
means that the Cost-of-Capital rate should be consistent with the Valueat-
Risk-assumption corresponding to a confidence level of 99.5 per cent
over the stipulated one-year time horizon as laid down for the calculation
of the Solvency Capital Requirement (SCR). Especially, the Cost-of-Capital
rate should be independent of the actual solvency position of the original
undertaking.
3.91. In the third and fourth Quantitative Impact Study for Solvency II (QIS3
and QIS4) the Cost-of-Capital rate had been fixed at 6 per cent as such a
rate has been assumed to reflect the cost of holding an amount of eligible
own funds for an insurance or reinsurance undertaking being capitalised
corresponding to a confidence level of 99.5 per cent Value-at-Risk over a
one year time horizon.
3.92. The required consistency between the stipulated Cost-of-Capital rate and
the (Value-at-Risk) assumptions for the SCR-calculations has was
explained as follows: the 6 per cent Cost-of-Capital rate corresponds to
the cost of providing eligible own funds for BBB-rated insurance or
reinsurance undertakings, cf. the Cost-of-Capital rate used by the Swiss
regulator in its Solvency Test for BBB-rated reference undertakings.
3.93. As part of the QIS4-feedback, questions have been raised regarding the
appropriateness of the assumed Cost-of-Capital rate of 6 per cent.
Especially, reference was made to the work carried out by the Chief Risk
Officer Forum (CRO Forum), and a substantially lower Cost-of-Capital rate
has been indicated (cf. also section 3.1.2.2 above).
3.94. However, a critical analysis of the CRO Forum’s report31 – as well as other
reports on this issue32 – does not support the QIS4-feedback referred to
above. On the contrary, the analysis which is summarised in the
subsection below, confirms that an assumed Cost-of-Capital of at least 6
per cent could be seen as appropriate. In this context it should be noted
that although the CRO Forum has indicated in its report that its research
suggests a Cost-of-Capital rate in the range of 2 ½ - 4 ½ per cent, it also
acknowledges that its research did not prove conclusive. Moreover, it
seems that the CRO Forum first and foremost has focussed on results
leading to the lowest estimates of the Cost-of-Capital rate.
31 CRO Forum: Market Value of Liabilities for Insurance Firms – Implementing Elements for Solvency
II (July 2008).
32 GNAIE (Group of North American Insurance Enterprises): Market Value Margins for Insurance
Liabilities in Financial Reporting and Solvency Applications (October 2007),
http://www.insuranceaccounting.org/images/Market%20Value%20Margin10CA985.pdf
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3.95. The analysis summarised in the following subsection does not discuss the
required periodical review as referred to in Article 76(5) of the Level 1
text. However, CEIOPS points out that the frequency and procedures to be
followed for this review would need to be developed.
3.1.3.2.2 Assessment of the Cost-of-Capital Rate
(a) Introductory remarks
3.96. The Cost-of-Capital rate is an annual rate applied to a capital requirement
in each period. Because the assets covering the capital requirement
themselves are assumed to be held in marketable securities, this rate does
not account for the total return but merely for the spread over and above
the risk free rate.
3.97. The risk margin shall guarantee that sufficient technical provisions for a
transfer are available even in a stressed scenario. Hence, the Cost-of-
Capital rate has to be a long-term average rate, reflecting both periods of
stability and periods of stress.
3.98. A rate of at least 6 per cent is assessed to be an adequate placeholder for
the Cost-of-Capital rate in the context of the Solvency II regulation. In
order to reach this conclusion it may be argued along the following lines:
• Shareholder return models provide the initial input.
• Some objective criteria may cause upward and downward adjustments
of the initial input.
• A final calibration of the Cost-of-Capital rate, in order to obtain risk
margins consistent with observable prices in the marketplace, may be
necessary.
Before discussing this three-step procedure, this advice will reflect on the
assumptions that would be reasonable to make regarding the funding of
the capital requirement in a stressed scenario.
(b) Funding of the capital requirement
3.99. In CRO Forum’s report, the Cost-of-Capital rate is calculated as a weighted
average of the cost of equity and the cost of debt. It is assumed that 20
per cent of the capital requirement can be funded by issuing debt and that
only the remaining 80 per cent have to be funded by raising equity capital.
Moreover, by assuming an effective company rate of taxation of 35 per
cent over all jurisdictions, the estimated cost of debt is in practise outweighed
by the adjustments for tax relief on interest payments made to
service the debt. As a result the Cost-of-Capital rate equals only approximately
80 per cent of the estimated cost of equity rate.
3.100. Contrary to this, CEIOPS finds it more reasonable to assume that the
capital base33 used when calculating the risk margin under a Cost-of-
33 In the remainder of the present sub-section it is referred to “the capital base” and not “the
eligible own funds” since the first concept is closest to the terminology used in CRO Forum's report.
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Capital methodology is funded solely with equity capital.34 As the capital
base is defined as the solvency capital requirement in an adverse
situation, i.e. as the amount of capital that is substantially at risk, it would
be inconsistent to assume at the same time that this requirement can be
funded by debt investors at costs substantially below the equity costs.
Accordingly, this approach has been used in the assessments summarised
below.35
(c) The three-step procedure for assessing the Cost-of-Capital rate
(c1) Shareholder return models
3.101. The research carrried out by both CRO Forum and GNAIE has been
analysed. As the most commonly used models in the market seem to be
the Capital Asset Pricing Model (CAPM) and versions of the Fama-French
multi Factor Model (FFmF), CEIOPS’ analysis has been confined to the
results given for these models.
• The Frictional Cost-of-Capital approach
3.102. In CRO Forum’s research the rate of return above the risk free rate that
shareholders of insurance undertakings demand in order to assume
broadly diversified insurance risks, are estimated using different methods
and assumptions. CRO Forum deems that the so-called Frictional Cost of
Capital approach is the most appropriate to capture the rate of return an
insurance company requires on the capital it deploys to support nonhedgeable
risk over a given year. This is likely the reason why they rely so
heavily on the results from this method when drawing their conclusions.
3.103. However, CEIOPS has strong reservations regarding the results based on
this approach36 as reproduced in the CRO Forum’ report. Firstly, the
results of the method are very dependent on a number of key assumptions
– effective tax rate, loss carry forward period and risk free rate – for which
it is difficult to assess reasonable parameter estimates in an EU context.
Secondly, of the main components of the frictional costs – double taxation
costs, financial distress costs37 and agency costs38 – only the two first
have been modelled.
3.104. Moreover, the CRO Forum has drawn e.g. the following conclusions after
having modelled double taxation and financial distress costs:39
34 This is seen as a more appropriate assumption also by GNAIE, cf. their report.
35 It may also be questionable whether an insurance undertaking being in a stressed situation will
be in a position to benefit from further tax credits.
36 Under this approach, the total return required by shareholders may be thought of consisting of
the base cost of capital, the frictional costs and the expected economic profit. Only the frictional
costs are taken into account in determining the Cost of Capital rate.
37 These are direct and indirect costs which arise when an insurer has difficulties meeting its
financial obligations to policyholders or debt holders.
38 Agency costs are associated with the misalignment of the interest between management and
shareholders or between policyholders and shareholders. The lack of transparency and informational
asymmetry are also deemed to be part of agency costs.
39 Cf. CRO Forum's report, page 36.
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For highly capitalized companies, the cost of capital rate is
determined mainly by the cost of double taxation and the cost of
financial distress is negligible. […]
The cost of capital rate depends linearly on a jurisdiction’s tax rate for
all confidence levels. This means that the cost of capital rate (and
therefore the MVM) in a jurisdiction with a tax rate of 10% is only half
of that in a jurisdiction with a tax rate of 20%.
In CEIOPS’ opinion the result implied by these conclusions seems
unreasonable for Member States in which the effective tax rate is low.
Furthermore, CEIOPS also questions the assertion that financial distress
costs are negligible for well capitalized companies.
• The CAPM and the FF2F-method
3.105. In CRO Forum’s research related to the CAPM and the FF2F method, the
cost of equity rate above the risk-free rate has been estimated for three
markets: the European, the Asian and the US market. From these estimated
rates a “Global World” rate has been derived for both methods. The
Global World rates are in general lower than the European rates, cf. table
2 below.40 When concluding on an appropriate level of the Cost-of-Capital
rate, CRO Forum has taken into account only the lower Global World rates
without giving any explicit rationale for this choice.
3.106. CEIOPS finds it more reasonable to base the assessment of the Cost-of-
Capital rate on CRO Forum’s results for the CAPM and the FF2F method for
European insurance undertakings. In this context it may also be noted that
the FF2F-results for the European non-life insurers are in line with the
results referred to in GNAIE’s report for US non-life insurers (an equity risk
premium of 14.2 per cent).
Table 2. Equity Risk Premiums as assessed in the CRO Forum’s report.41
CAPM FF2F
European Global European Global
market market market market
Life 10.0 pct 5.1 pct 11.8 pct 9.4 pct
Non-life 7.4 pct 4.2 pct 12.5 pct 9.6 pct
3.107. Taking into account only the results from the shareholder return models a
Cost-of-Capital rate of at least 7 ½-10 per cent seems to be adequate.
40 In the CAPM-case the reported Global rates are lower than the reported rates for all three
markets – a result that could have been better explained in the report.
41 Cf. CRO Forum's report, page 58, 60 and 61.
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(c2) Adjustment of shareholder return
3.108. To the output from the shareholder return models both upward and downward
adjustments are needed when assessing the cost of capital rate in a
solvency context.
3.109. Downward adjustments: In order to account for the fact that a key source
of return that exists for going concerns (the so called franchise value
related to expected profit from new business) may not be demanded by
capital providers in a transfer context, a downward adjustment is needed.
No reliable quantitative results are available concerning the size of this
adjustment.
3.110. Upward adjustments: Additional costs, i.e. costs beyond those required to
compensate investors for the risk they are assuming, make an upward
adjustment necessary. These additional costs may stem from:
• Frictional costs of carrying capital. These are additional costs42 which
reflect a variety of indirect costs, as frictional costs related to managers’
incentives, information asymmetries, and so on. Again, these
costs are very difficult, if not impossible, to quantify.
• Initial costs of raising capital. These are fees for underwriting, listing
and regulation, which in most jurisdictions are not negligible43.
• Corporate income taxes on the risk margin in some tax jurisdictions.
This is the case if the risk margin is considered as taxable profit at
inception and not as taxable income only over the time of its release
from the risk margin.
3.111. As already indicated, the aggregate effect of both upward and downward
adjustments is difficult to quantify in a reliable manner. However, as it is
unlikely that the downward adjustment outweighs the upward adjustments
by a large margin, a range for the Cost-of-Capital rate after these adjustments
of 6-8 per cent is deemed as reasonable.
(c3) Calibration to market prices
3.112. The output for the cost of capital rate has to be calibrated further to give
final risk margins consistent with observable prices in the marketplace.
The risk margin together with the best estimate shall be “equivalent to the
amount insurance and reinsurance undertakings would be expected to
require in order to take over and meet the insurance and reinsurance
obligations” (Article 76(3)).
3.113. In the Solvency II context an allowance may be necessary for the methodologies
applied when calculating the capital base (i.e. the future SCRs).
42 Cf. the GNAIE-report, page 30.
43 Underwriting fees, which generally constitute at least half of the direct IPO costs, amount to
about 3.5% of the raised equity in the UK, Germany or France, and to more than 6.5% in the USA.
Source: Oxera report (2006), “The Cost of Capital: An International Comparison”. Available at
www.oxera.com.
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This is especially the case for any simplifying methods allowed.44 All other
assumptions equal, especially for unchanged best estimate, the cost of
capital rate has to be set higher if methods used in the solvency context
give systematically lower capital bases than the capital bases assessed
through the markets in real insurance portfolio transfers. Otherwise the
technical provisions will be insufficient.
3.114. As long as the method used in assessing the capital base does not
systematically underestimate the needed amount, a Cost-of-Capital rate of
at least 6 per cent could be seen as adequate. In order to avoid procyclical
effects, the Cost-of-Capital rate should not be adjusted to follow market
cycles.
(d) A final comment
3.115. It should be noted that some recent academic work45 suggests that the
proportional method46, as used as a simplification for calculating the future
SCRs (e.g. as in QIS3 and QIS4), systematically understates the capital
base needed. If this proves true – and a proportional method is still to be
allowed as a simplification in the Solvency II context – a Cost-of-Capital
rate higher than the rate of 6 per cent could be necessary in order to compensate
for this bias.
44 In QIS4 a majority of undertakings (independently of their size) used simplifications when
making SCR-projections for the risk margin calculations.
45 Cf. Gareth Haslip: “Risk assessment”, The Actuary (December 2008). See also the example
given on page 27 in the GNAIE-report.
46 I.e. a method where the ratio of the SCR to the best estimate technical provisions (or another
exposure measure reflecting the underlying risks) is assumed to be constant throughout the whole
run-off period of the (re)insurance obligations.
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3.1.3.3 Calculation of the risk margin
The general approach
3.116. Based on the assumptions laid down for the reference undertaking and
the assessment regarding the Cost-of-Capital rate referred to in sections
above, a general approach for the risk margin calculations according to the
Cost-of-Capital methodology can be summarised as shown in paragraphs
below.
3.117. It follows from assumption 8 regarding the reference undertaking that the
risk margin should be calculated per line of business and that no diversification
effects should be taken into account. This means that
CoCM = ΣlobCoCMlob,
where
CoCM = the overall risk margin for the portfolio; and
CoCMlob = the risk margin for an individual line of business (lob).
3.118. According to assumption 2 and 3 laid down for the reference undertaking,
this undertaking is empty before a transfer of (re)insurance obligations
takes place, whereas it after the transfer has eligible own funds corresponding
exactly to the SCR that is necessary to support the transferred
(re)insurance obligations. This means that the reference undertaking at
time t = 0 (when the transfer takes place) will capitalise itself to the
required level of eligible own funds, i.e.
EOFRU(0) = ΣlobSCRRU,lob(0),
where
EOFRU(0) = the eligible own funds raised by the reference undertaking
at time t = 0 (when the transfer takes place); and
SCRRU,lob(0) = the SCR for a given line of business (lob) at time t = 0
as calculated for the reference undertaking.
The cost of providing this amount of eligible own funds equals the Cost-of-
Capital rate times the amount.
3.119. An assessment as sketched in the previous paragraph applies to the
eligible own funds that the reference undertaking needs to provide in all
future years, in order “to support the insurance and reinsurance obligations
over the lifetime thereof” (Article 76(5)).
3.120. As the transfer of (re)insurance obligations is assumed to take place
immediately (cf. Article 76(3)), the method for calculating the overall risk
margin can in general terms be expressed in the following manner:
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CoCM = CoC·Σt≥0EOFRU(t)/(1+rt+1)t+1 = CoC·Σt≥0ΣlobSCRRU,lob(t)/(1+rt+1)t+1
= Σlob{CoC·Σt≥0SCRRU,lob(t)/(1+rt+1)t+1} = ΣlobCoCMlob,
where
SCRRU,lob(t) = the SCR for a given line of business (lob) for year t as
calculated for the reference undertaking,
rt = the risk-free rate for maturity t; and
CoC = the Cost-of-Capital rate.
3.121. The Cost-of-Capital rate “shall be the same for all insurance and reinsurance
undertakings” (Article 76(5)). According to CEIOPS’ view this rate
should be fixed to at least 6 per cent (i.e. CoC ≥ 0.06), cf. the assessment
made in the previous sub-section. However, a reservation should be made
with respect to the outcome of the periodic reviews to be carried out.
3.122. The general rules for calculating the risk margin as laid down in the
previous paragraphs should apply to all undertakings irrespective of
whether the calculation of the SCR of the (original) undertaking is based
on the standard formula or an internal model.
Calculations based on the standard formula
3.123.If the SCR of the (original) undertaking is calculated using the standard
formula, all SCRs (for t ≥ 0) for a given line of business should be calculated
as follows:
SCRRU,lob(t) = BSCRRU,lob(t) + SCRRU,lob,op(t) – AdjRU,lob(t),
where
BSCRRU,lob(t) = the Basic SCR for the given line of business (lob) and
year t as calculated for the reference undertaking,
SCRRU,lob,op(t) = the partial SCR regarding operational risk for the
given line of business (lob) and year t as calculated
for the reference undertaking; and
AdjRU,lob(t) = the adjustment for the loss absorbing capacity of
technical provisions for the given line of business
(lob) and year t as calculated for the reference undertaking.
3.124. It should be ensured that the assumptions made regarding loss absorbing
capacity of technical provisions that need to be taken into account in the
SCR-calculations per line of business, are consistent with the assumptions
made for the overall portfolio (of the original undertaking).
3.125. The Basic SCRs for a given line of business (i.e. BSCRRU,lob(t) for all t≥0)
should be calculated by using the relevant SCR-modules and sub-modules
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per line of business (meaning that the input to be used in the relevant
modules should be restricted to the line of business in question).
3.126. Moreover, the calculation of the Basic SCRs (as referred to in para. 3.123)
should be based on the correlation assumptions laid down in Annex IV of
the Level 1 text although only the unavoidable market risk and the
counterparty default risk with respect to ceded reinsurance is taken into
consideration.
3.127. It should be noted that to the extent that market risk can be considered
avoidable for a line of business (either from the very beginning (i.e. from
t = 0) or after some years (i.e. from t ≥ t*)), the calculation of the Basic
SCR would be simplified. Further simplifications may arise if the
underwriting risk of a given line of business is confined to only one of the
three modules for this risk.
The risk margin for lines of business within non-life insurance
3.128. With respect to the lines of business within non-life insurance the risk
margin (as calculated per line of business) should be attached to the
overall best estimate (i.e. no split between risk margins for premiums
provisions and for provisions for claims outstanding).
Simplifications
3.129.General issues regarding simplifications for the risk margin calculations,
including principles and criteria for using such simplifications, are
addressed in CEIOPS’ advice on Article 85(h). Specific simplifications will
be consulted upon in the third set of advice.
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3.2 CEIOPS’ advice
The reference undertaking
3.130. The reference undertaking assumed to take over and meet the insurance
and reinsurance obligations of an insurance or reinsurance undertaking
shall fulfil the following assumptions:
1. The reference undertaking is not the undertaking itself (the original undertaking),
but another undertaking.
2. The reference undertaking is an empty undertaking in the sense that it
does not have any insurance or reinsurance obligations and any own funds
before the transfer takes place.
3. After the transfer the reference undertaking has eligible own funds corresponding
exactly to the amount of SCR that is necessary to support the
transferred obligations.
4. After transfer of the insurance obligations, the reference undertaking has
assets to cover the Best Estimate net of reinsurance and SPVs, the Risk
Margin and the SCR. These assets should be considered to minimize the
market risk of the undertaking. The reference undertaking should only be
subject to market risk that is unavoidable in practice.
5. SCR of the reference undertaking consists of
(a) underwriting risk with respect to the existing business,
(b) counterparty default risk with respect to ceded reinsurance and SPVs,
(c) operational risk; and
(d) unavoidable market risk.
6. The loss absorbing capacity of technical provisions in the reference undertaking
corresponds to those of the original undertaking.
7. There is no loss absorbing capacity of deferred taxes for (related to) the
reference undertaking
8. The insurance and reinsurance obligations of each line of business (as
defined in Article 85(e)) are transferred to the empty reference undertaking
in isolation. Hence, there does not arise any diversification benefits
between lines of business.
For the purpose of the calculation of the risk margin, the calculation of the
SCR of the reference undertaking (using a standard formula or internal
model) should be done at least by line of business, based on the segmentation
laid down by the implementing measures referred to in Article
85(e).
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If the SCR of the original undertaking is calculated by using an internal
model, the segmentation may differ from the one laid down by the implementing
measures referred to in Article 85(e). However, the risk margin
shall always be valued at least at the level of lines of business laid down
by those implementing measures.
9. The internal models of the original undertaking (partial or full) can be
used to measure the SCR of the reference undertaking to the extent that
these models cover at least the risks referred to in no. 5 (assumption 5
regarding the reference undertaking) as defined by the standard formula.
10.The Cost-of-Capital risk margin is defined net of reinsurance only.
The Cost-of-Capital rate
3.131. The Cost-of-Capital rate should be calibrated in a manner that is
consistent with the assumptions made for the reference undertaking. In
practise this means that the Cost-of-Capital rate should be consistent with
the Value-at-Risk-assumption corresponding to a confidence level of 99.5
per cent over the stipulated one-year time horizon as laid down for the
calculation of the Solvency Capital Requirement (SCR). Especially, the
Cost-of-Capital rate should be independent of the actual solvency position
of the original undertaking.
3.132. The risk margin should guarantee that sufficient technical provisions for a
transfer are available even in a stressed scenario. Hence, the Cost-of-
Capital rate has to be a long-term average rate, reflecting both periods of
stability and periods of stress.
3.133. In order to stipulate an adequate placeholder for the Cost-of-Capital rate
in the Solvency II regulatory context, the following procedure should be
applied:
• Shareholder return models should be used to provide the initial input.
• Some objective criteria for upward and downward adjustments of the
provided initial input should be established.
• A final calibration of the Cost-of-Capital rate should be carried out in order
to obtain risk margins consistent with observable prices in the marketplace.
3.134. Based on available information a Cost-of-Capital rate of at least 6 per
cent is assumed to reflect the cost of holding an amount of eligible own
funds for an insurance or reinsurance undertaking being capitalised corresponding
to a confidence level of 99.5 per cent Value-at-Risk over a one
year time horizon.
Calculation of the risk margin
3.135. In general, the overall risk margin according to the Cost-of-Capital methodology
(CoCM) should be calculated as follows:
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CoCM = Σlob{CoC·Σt≥0SCRRU,lob(t)/(1+rt+1)t+1} = ΣlobCoCMlob,
where
SCRRU,lob(t) = the SCR for a given line of business (lob) for year t as
calculated for the reference undertaking,
rt = the risk-free rate for maturity t; and
CoC = the Cost-of-Capital rate.
3.136. If the SCR of the (original) undertaking is calculated using the standard
formula all SCRs (for t ≥ 0) for a given line of business should be calculated
as follows:
SCRRU,lob(t) = BSCRRU,lob(t) + SCRRU,lob,op(t) – AdjRU,lob(t),
where
BSCRRU,lob(t) = the Basic SCR for the given line of business (lob) and
year t as calculated for the reference undertaking,
SCRRU,lob,op(t) = the partial SCR regarding operational risk for the given
line of business (lob) and year t as calculated for the
reference undertaking; and
AdjRU,lob(t) = the adjustment for the loss absorbing capacity of
technical provisions for the given line of business (lob)
and year t as calculated for the reference undertaking.
It should be ensured that the assumptions made regarding loss absorbing
capacity of technical provisions to be taken into account in the SCR-calculations
per line of business, is consistent with the assumptions made for the
overall portfolio (of the original undertaking).
The Basic SCRs for a given line of business (BSCRRU,lob(t) for all t≥0) should
be calculated by using the relevant SCR-modules and sub-modules per line
of business (i.e. by restricting the input to be used in the relevant modules
to the line of business in question).
Moreover, the calculation of the Basic SCRs (as referred to in the previous
paragraph) should be based on the correlation assumptions laid down in
Annex IV of the Level 1 text although only the unavoidable market risk and
the counterparty default risk with respect to ceded reinsurance is taken into
consideration.
3.137.With respect to non-life insurance the risk margin as calculated per line of
business should be attached to the overall best estimate (i.e. no split
between risk margins for premiums provisions and for provisions for claims
outstanding).
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Annex A Impact assessment on the cost-of-capital rate for
the risk margin
In its Call for Advice of 1 April 2009, the Commission has asked CEIOPS to
contribute to the Commission’s impact assessment of the Level 2 implementing
measures.47 To this end, a list of issues has been set up by the Commission and
CEIOPS, identifying the Level 2 implementing measures that should be
accompanied by an impact assessment. The objectives of the issues have been
selected among the list of objectives used by the Commission in its Level 1
impact assessment.48 On 12 June 2009, the Commission has issued an updated
list of policy issues and options, to which reference is being made.49 This impact
assessment covers issue 2 (sub-issue A) of the list of policy issues and options.
Two summary tables accompanying the impact assessment are published in a
separate excel document.
1. Description of the policy issue
A.1. The Level 1 text states that technical provisions shall correspond to the
current amount (re)insurance undertakings would have to pay if they were
to transfer their (re)insurance obligations immediately to another
undertaking. They are calculated in a “prudent, reliable and objective
manner”. Their value is equal to the sum of a best estimate and a risk
margin where the best estimate corresponds to the probability-weighted
average of future cash-flows taking into account the time value of money.
If future cash flows associated with insurance or reinsurance obligations
can be reliably replicated using financial instruments for which a reliable
market is observable, the separate calculation of best estimate and risk
margin shall not be required.
A.2. This impact assessment only concerns those insurance or reinsurance
obligations for which a separate calculation of the risk margin is required.
A.3. The valuation of technical provisions should be based on sound economic
principles. This means that the technical provisions should be consistent
with the valuation of assets and other liabilities, they should be market
consistent and in line with international developments in accounting and
supervision.
A.4. The Level 1 text further defines the amount of technical provisions as the
value which correspond to the amount an insurer would have to pay if it
transferred its contractual rights and obligations immediately to another
undertaking and the amount that another undertaking would be expected
47 http://www.ceiops.eu/media/files/requestsforadvice/EC-april-09-CfA/EC-call-for-advice-Solvency-II-Level-
2.pdf.
48 http://ec.europa.eu/internal_market/insurance/docs/solvency/impactassess/final-report_en.pdf.
49 http://www.ceiops.eu/media/files/requestsforadvice/EC-June-09-CfA/Updated-List-of-policy-issues-andoptions-
for-IA.pdf.
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to require to take over and meet the underlying (re)insurance obligations.
Due to the nature and uncertainty embedded in the best estimate, the
value of the best estimate should be adjusted by increasing the best
estimate with a risk margin to achieve a market consistent valuation of
technical provisions. The risk margin represents the cost of providing the
amount of eligible own funds to cover the Solvency Capital Requirement
necessary to support the obligations over the lifetime thereof. The Level 1
text in Article 76(5) further requires that the rate used to determine the
cost of providing the amount of eligible own funds should be the same for
all (re)insurance companies and be reviewed periodically. The annual rate
used, which is called cost-of-capital rate, should be equal to the additional
rate above the relevant-risk-free interest rate, that a (re)insurance
undertaking would incur to hold the necessary eligible own funds.
A.5. The issue at hand concerns the appropriate level of the cost-of-capital rate
and, if necessary, the modalities for its periodic review.
2. Detailed description of policy options and assessment of the relative
impacts on the different affected parties
Detailed description of policy options
A.6. Option 1: Cost-of-capital rate equal to 6%, as specified in QIS4
Under this option, the level of the cost-of-capital rate should be equal to
6%, as specified in QIS4. The QIS4 calibration of the cost-of-capital rate
was based on the Swiss Solvency Test. However, as described further in
this document, the level of 6% is also consistent with the results of models
such as the Capital Assets Pricing Model (CAPM) and the Fama-French
multi Factor Model (FFmF).
A.7. Option 2: Cost-of-capital rate lower than 6%
Under this option, the level of the cost-of-capital rate should be lower than
6%. This would mean that the cost-of-capital rate could be determined
based on models such as the Capital Assets Pricing Model (CAPM) and
versions of the Fama-French multi Factor Model (FFmF) which are
commonly used in the market.
If the cost-of-capital rate were to be calibrated based on current data, its
calibration should be periodically reviewed based on the selected model.
A.8. Option 3: Cost-of-capital rate higher than 6%
Under this option, the level of the cost-of-capital rate should be higher
than 6%. Similarly to Option 2, its calibration should consider the selection
of the model and the periodic review of the cost-of-capital rate.
A.9. Specific questions that were addressed in the discussion of the policy
options include:
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What would be an appropriate level?
A.10. CEIOPS believes that (at least) 6% is an appropriate level for the cost-ofcapital
rate.
How should it be calibrated / updated?
A.11. The cost-of-capital rate should be calibrated according to the three-step
procedure laid out in annex 1.
A.12. CEIOPS believes that the cost-of-capital rate should not be updated too
frequently. An annually updated cost-of-capital rate would be seen as too
frequent as it may increase the volatility of the balance sheet since
different cost-of-capital rates will be applied at the end of each financial
period. This may have an effect on the sustainability of the value of
technical provisions as well as on risk management and consistency
because it would be more difficult to predict the cost-of-capital rate.
Should it be the same for both life and non-life business?
A.13. The cost-of-capital rate should be the same for life and non-life business.
There seems to be no evidence that the cost of providing the amount of
eligible own funds necessary to support the (re)insurance obligations
would be substantially different for life and non-life insurance
undertakings.
Impact on industry, policyholders and beneficiaries and supervisory
authorities
A.14. CEIOPS believes that the level of 6% (option 1) most closely represents
the market cost of capital. This is based on the analysis summarised in
Annexes 1 and 2 in this paper and the calibration from the Swiss Solvency
Test. The impact assessment is therefore based on this assumption.
However, CEIOPS notes that the assumption that a single cost-of-capital
rate is applicable for the whole European Union is a significant
simplification as the cost-of-capital varies across markets. Furthermore,
the market cost-of-capital evolves over time. There is some scope in the
Level 1 text for periodic reviews of the cost-of-capital rate. However this
has not been addressed in the impact assessment (i.e. the impact
assessment is based on the assumption that the cost-of-capital rate will
not be reviewed).
Likely industry response
A.15. Considering the CRO Forum study50 which concluded that the annual costof-
capital rate should be between 2.5% and 4.5%, CEIOPS expects that
some members of the industry are likely to disagree with options 1 and 3.
50 http://www.croforum.org/publications.ecp (Market Value of Liabilities for Insurance Firms – Implementing
elements for Solvency II).
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A.16. QIS4 results show that for 75% of undertakings, the risk margin in
proportion to the best estimate was less than 5% for life insurance and
less than 10% for non-life insurance.
A.17. The ratio of the risk margin (RM) to the best estimate (BE) for some
alternative choices of the cost-of-capital rate is illustrated in Table 1.
Table 1.
Cost-of-capital Ratio of RM to BE
rate Life insurance Non-life insurance
6 % 5 % 10 %
4.5 % 3.8 % 7.5 %
2.5 % 2.1 % 4.2 %
7.5 % 6.3 % 12.5 %
A.18. It seems reasonable to believe that a change of the cost-of-capital rate in
the order of +/- 1 to 1,5 percentage point (e.g. from 6 % to a value in the
interval 4.5% – 7.5%) would not lead to significant changes in the
industry behaviour.
Costs and Benefits
• Policyholders and beneficiaries
A.19. Policyholders and beneficiaries can be affected in two different ways, one
minor and one major. A minor effect is that a higher cost-of-capital rate
means a higher risk margin and consequently higher premiums to pay if
premiums were to fund the risk margin. However, a higher risk margin
would also mean higher technical provisions and better protection of the
policyholders and beneficiaries.
A.20. The cost-of-capital parameter impacts the amount a (re)insurance
undertaking would require to accept a transfer of insurance and
reinsurance obligations. There is considerable uncertainty with regard to
the calibration of this parameter. As stated above, CEIOPS believes that
option 1 is most consistent with the market cost-of-capital. Therefore
option 2 will have a permanent negative effect compared to options 1 and
3 as technical provisions will not be sufficient to effect a transfer leading to
lower protection of the policyholders. On the other hand, option 3 may
lead to technical provisions which are higher than necessary without any
additional benefit.
• Insurance and reinsurance undertakings
A.21. Regarding the impact on the (re)insurance undertaking, option 2 results in
lower technical provisions compared to the other two options. Option 3 will
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generate the highest technical provisions compared to the other two
options.
A.22. However, as already indicated, it is unlikely that the alternative choices of
cost-of-capital rates within a reasonably bounded interval (e.g. from 4.5%
to 7.5%) will lead to significantly different industry behaviour.
• Supervisory authorities
A.23. The determination of the option which will have a neutral effect depends
on which cost-of-capital rate is consistent with the market “cost of
capital”. There is a risk that the value of technical provisions will not be
sufficient to transfer the portfolio to another undertaking.
A.24. From the perspective of the supervisory authority, the option which in
most cases results in technical provisions which are consistent with the
current transfer value is also the most acceptable. As stated above,
CEIOPS believes that option 1 is most consistent with the market cost of
capital. Also option 3 results in an amount of technical provisions which
would be enough for a transfer of the portfolio to another undertaking.
However option 3 may lead to undertakings holding unnecessarily high
technical provisions. On the other hand, option 2 results in technical
provisions which are not sufficient to enable the portfolio transfer.
A.25. In general, there is also a potential risk that it would not be possible to
transfer the portfolio of a distressed insurer to a third party insurer if the
cost-of-capital rate is expected to increase from one year to the next.
3. Relevant objectives
A.26. The calibration of the cost-of-capital rate falls under the scope of the
following general and operational objectives:
A.27. The general objective relevant for this policy option is to “enhance the
protection of the policyholders and beneficiaries”.
A.28. The relevant operational objectives are to “harmonise the calculation of
technical provisions”, “introduce risk-sensitive harmonised solvency
standard”, “introduce proportionate requirements for small undertakings”
and to “promote comparability of valuation and reporting rules with the
international accounting standards elaborated by the IASB”.
4. Comparison between the different options based on the efficiency and
effectiveness in reaching the relevant operational objectives
A.29. The comparison and ranking of the policy options is based on the
effectiveness and efficiency of each option in reaching the relevant
objectives. Effectiveness is defined as the extent to which options achieve
the objectives of the proposal. Efficiency is defined as the extent to which
options can be achieved at the lowest cost (cost-effectiveness).
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A.30. The sources of evidence available to CEIOPS are the research
commissioned by the CRO Forum51 and the research commissioned by
GNAIE52 (see Annex 1).
A.31. It is expected that all options achieve harmonisation of the calculation of
technical provisions as all insurance and reinsurance companies will use
the same cost-of-capital rate to calculate the risk margin.
A.32. It is impossible to determine which option better promotes compatibility of
valuation rules with international accounting standards elaborated by IASB
because this could only be checked when the portfolio will be transferred
to another undertaking. A fixed cost-of-capital rate does not introduce
risk-sensitive harmonised solvency standard but introduces proportionate
requirements for small undertakings.
A.33. Option 1 is most likely to facilitate the transfer of liabilities in practice
since this is closest to the market cost-of-capital and therefore meets the
objective of policyholder protection.
A.34. Option 2 will not meet the objective of policyholder protection as the risk
margin will be low and hence the technical provisions will not be sufficient
to transfer the liabilities.
A.35. Option 3 also meets the objective of policyholder protection as it is
expected that the technical provisions will be more than sufficient to
facilitate a transfer. However there may be unintended costs to
policyholders if technical provisions are unnecessarily high.
A.36. Finally there is also a potential risk that it would not be possible to transfer
the portfolio of a distressed insurer to a third party insurer if the cost-ofcapital
rate increases from one year to the next.
A.37. In conclusion, taking into account the potential cost and benefits for
policyholders and beneficiaries, insurance and reinsurance undertakings
and supervisory authorities, the effectiveness and efficiency level to meet
the relevant objectives, and its sustainability and comparability levels,
CEIOPS recommends in its advice that the cost-of-capital should be fixed
to at least 6 per cent.
51 http://www.croforum.org/publications.ecp (Market Value of Liabilities for Insurance Firms –
Implementing elements for Solvency II).
52 Study prepared by Ernst & Young: ”Market Value Margins for Insurance Liabilities in Financial
Reporting and Solvency Applications“, dated October 2007, commissioned by GNAIE – Group of
North American Insurance Enterprises.
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Annex 1 CEIOPS' assessment of the cost-of-capital rate
1. Introductory remarks
A.38. The cost-of-capital rate is an annual rate applied to a capital requirement
in each period. Because the assets covering the capital requirement
themselves are assumed to be held in marketable securities, this rate does
not account for the total return but merely for the spread over and above
the risk-free rate.
A.39. The risk margin shall guarantee that sufficient technical provisions for a
transfer are available even in a stressed scenario. Hence, the cost-ofcapital
rate has to be a long-term average rate, reflecting both periods of
stability and periods of stress.
– A rate of at least 6% has been assessed to be an adequate placeholder
for the cost-of-capital rate in QIS2, QIS3 and QIS4. Shareholder return
models provide the initial input.
– Some objective criteria may cause upward and downward adjustments
of the initial input.
– A final calibration of the cost-of-capital rate, in order to obtain risk
margins consistent with observable prices in the marketplace, may be
necessary.
A.40. In addition, one needs to reflect on the assumptions that would be
reasonable to make regarding the funding of the capital requirement in a
stressed scenario.
2. Funding of the capital requirement
A.41. In the CRO Forum’s report, the cost-of-capital rate is calculated as a
weighted average of the cost of equity and the cost of debt. It is assumed
that 20% of the capital requirement can be funded by issuing debt and
that only the remaining 80% have to be funded by raising equity capital.
Moreover, by assuming an effective company rate of taxation of 35% over
all jurisdictions, the estimated cost of debt is in practise outweighed by the
adjustments for tax relief on interest payments made to service the debt.
As a result the cost-of-capital rate equals only approximately 80% of the
estimated cost of equity rate.
A.42. Contrary to this, CEIOPS finds it more reasonable to assume that the
capital base used when calculating the risk margin under a cost-of-capital
methodology is funded solely with equity capital.53 As the capital base is
defined as the Solvency Capital Requirement in an adverse situation, i.e.
as the amount of capital that is substantially at risk, it would be
inconsistent to assume at the same time that this requirement can be
funded by debt investors at costs substantially below the equity costs.
53 This is seen as a more appropriate assumption also by GNAIE, cf. their report.
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Accordingly, this approach has been used in the assessments summarised
below.54
3. The three-step procedure for assessing the cost-of-capital rate
3.1 Shareholder return models
A.43. The research carried out by both CRO Forum and GNAIE has been
analysed. As the most commonly used models in the market seem to be
the Capital Asset Pricing Model (CAPM) and versions of the Fama-French
multi Factor Model (FFmF), CEIOPS’ analysis has limited itself to the
results given by these models.
(a) The frictional cost-of-capital approach
A.44. In the CRO Forum’s research the rate of return above the risk-free rate
that shareholders of insurance undertakings require in order to assume
broadly diversified insurance risks, are estimated using different methods
and assumptions. CRO Forum deems that the so-called frictional cost-ofcapital
approach is the most appropriate to capture the rate of return an
insurance company requires on the capital it deploys to support nonhedgeable
risk over a given year.
A.45. However, CEIOPS has strong reservations regarding the results based on
this approach55 as set out in the CRO Forum’ report. Firstly, the results of
the method are very dependent on a number of key assumptions –
effective tax rate, loss carry forward period and risk-free rate – for which
it is difficult to assess reasonable parameter estimates in an EU context.
Secondly, of the main components of the frictional costs – double taxation
costs, financial distress costs56 and agency costs57 - only the two first have
been modelled.
A.46. Moreover, the CRO Forum has drawn e.g. the following conclusions after
having modelled double taxation and financial distress costs:58
For highly capitalized companies, the cost-of-capital rate is determined
mainly by the cost of double taxation and the cost of financial distress
is negligible. […]
The cost-of-capital rate depends linearly on a jurisdiction’s tax rate for
all confidence levels. This means that the cost-of-capital rate (and
therefore the MVM) in a jurisdiction with a tax rate of 10% is only half
of that in a jurisdiction with a tax rate of 20%.
54 It may also be questionable whether an insurance undertaking being in a stressed situation will
be in a position to benefit from further tax credits.
55 Under this approach, the total return required by shareholders may be thought of consisting of
the base cost of capital, the frictional costs and the expected economic profit. Only the frictional
costs are taken into account in determining the cost-of-capital rate.
56 These are direct and indirect costs which arise when an insurer has difficulties meeting its
financial obligations to policyholders or debt holders.
57 Agency costs are associated with the misalignment of the interest between management and
shareholders or between policyholders and shareholders. The lack of transparency and
informational asymmetry are also deemed to be part of agency costs.
58 Cf. CRO Forum's report, page 36.
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A.47. In CEIOPS’ opinion the result implied by this conclusion seems
unreasonable for Member States in which the effective tax rate is low.
Furthermore, CEIOPS also questions the assertion that financial distress
costs are negligible for well capitalized companies.
(b) The CAPM and the FF2F-method
A.48. In CRO Forum’s research related to the CAPM and the FF2F method, the
cost of equity rate above the risk-free rate has been estimated for three
markets: Europe, Asia and the US. From these estimated rates a “Global
World” rate has been derived for both methods. The Global World rates
are in general lower than the European rates, cf. table 2 below.59 When
concluding on an appropriate level of the cost-of-capital rate, CRO Forum
has taken into account only the lower Global World rates without giving
any explicit rationale for this choice.
A.49. CEIOPS finds it more reasonable to base the assessment of the cost-ofcapital
rate on CRO Forum’s results for the CAPM and the FF2F method for
European insurance undertakings. In this context it may also be noted that
the FF2F-results for the European non-life insurers are in line with the
results referred to in GNAIE’s report for US non-life insurers (an equity risk
premium of 14.2%).
Table 2. Equity Risk Premiums as assessed in the CRO Forum’s report.60
CAPM FF2F
European Global European Global
market market market market
Life 10.0 % 5.1 % 11.8 % 9.4 %
Non-life 7.4 % 4.2 % 12.5 % 9.6 %
A.50. Taking into account only the results from the shareholder return models a
cost-of-capital rate of at least 7.5% - 10% seems to be adequate.
3.2 Adjustment of shareholder return
A.51. To the output from the shareholder return models, both upward and
downward adjustments are needed when assessing the cost-of-capital rate
in a solvency context.
A.52. Downward adjustments: In order to account for the fact that a key source
of return that exists for going concerns (the so-called franchise value
related to expected profit from new business) may not be demanded by
59 In the CAPM case, the reported Global rates are lower than the reported rates for all three markets, a result that
could have benefited from a more thorough explanation in the report.
60 Cf. CRO Forum's report, page 58, 60 and 61.
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capital providers in a transfer context, a downward adjustment is needed.
No reliable quantitative results are available concerning the size of this
adjustment.
A.53. Upward adjustments: Additional costs, i.e. costs beyond those required to
compensate investors for the risk they are assuming, make an upward
adjustment necessary. These additional costs may stem from:
– Frictional costs of carrying capital. These are additional costs61 which
reflect a variety of indirect costs, as frictional costs related to
managers’ incentives, information asymmetries, and so on. Again,
these costs are very difficult, if not impossible, to quantify.
– Initial costs of raising capital. These are fees for underwriting, listing
and regulation, which in most jurisdictions are not negligible.62
– Corporate income taxes on the risk margin in some tax jurisdictions.
This is the case if the risk margin is considered as taxable profit at
inception and not as taxable income only over the time of its release
from the risk margin.
A.54. As already indicated, the aggregate effect of both upward and downward
adjustments is difficult to quantify in a reliable manner. However, as it is
unlikely that the downward adjustment outweighs the upward adjustments
by a large margin, a reasonable range for the cost-of-capital rate taking
into account these necessary adjustments would be 6% to 8%.
3.3. Calibration to market prices
A.55. The output for the cost-of-capital rate has to be calibrated further to give
final risk margins consistent with observable prices in the marketplace.
The risk margin together with the best estimate shall be “equivalent to the
amount insurance and reinsurance undertakings would be expected to
require in order to take over and meet the insurance and reinsurance
obligations” (Article 76(3)).
A.56. In the Solvency II context an allowance may be necessary for the methodologies
applied when calculating the capital base (i.e. the future SCRs).
This is especially the case for any simplifying methods allowed.63 All other
assumptions equal, especially for unchanged best estimate, the cost-ofcapital
rate has to be set higher if methods used in the solvency context
give systematically lower capital bases than the capital bases assessed
through the markets in real insurance portfolio transfers. Otherwise the
technical provisions will be insufficient.
61 Cf. the GNAIE-report, page 30.
62 Underwriting fees, which generally constitute at least half of the direct IPO costs, amount to about 3.5% of the
raised equity in the UK, Germany or France, and to more than 6.5% in the USA. Source: Oxera report (2006),
“The Cost of Capital: An International Comparison”. Available at www.oxera.com.
63 In QIS4 a majority of undertakings (independently of their size) used simplifications when making SCRprojections
for the risk margin calculations.
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A.57. As long as the method used in assessing the capital base does not
systematically underestimate the needed amount, a cost-of-capital rate of
at least 6% could be seen as adequate. In order to avoid procyclical
effects, the cost-of-capital rate should not be adjusted to follow market
cycles.
Annex 2 On CAPM and FFMF Models
1. Quantification using the Capital Asset Pricing Model
A.58. The CAPM is a traditional model from financial theory. It is the most
popular method used to estimate the cost of equity capital among large
publicly traded companies.
A.59. The expected cost of equity for a firm “j”, written E(Rj), can be derived
from the risk-free rate Rf, the expected price E(Rm) of the market portfolio
Rm and the firms beta, which reflects the correlation of the firm’s returns
with those of the equity market overall:
( ) * ( )
( , )
with j ( * ),where j ( ), m ( ) and jm
( ) * ( ( ) ),
R j Rm
Cov R j Rm
R j Rm
m
j
jm
j f j m f E R R E R R
σ σ
σ σ σ σ ρ
σ
σ
β ρ
β
= = = =
= + −
This gives the cost of equity above risk-free return (equity risk premium
ERP) for a firm “j”, as beta of this firm times market returns over risk-free:
( ) *( ( ) ) j j f j m f ERP = E R − R = β E R − R .
A.60. In the research commissioned by the CFO Forum equity risk premium
rates for the European market were estimated64 to be 10.03% for Life and
7.35% for Non–life.
A.61. In the above calculation the average over the estimated betas for
European insurance companies from 1998 – 2006 was used: 0.94 for Non-
Life insurance companies and 1.28 for Life companies. The expected
excess market risk premium used was 7.81%, assessed on US-data from
years 1926 to 2006.
2. Quantification using a Fama-French Multi Factor Model
A.62. The Fama-French multi factor-asset pricing model was developed because
the systematic risk factor in the CAPM model alone does not adequately
explain stock returns. Fama and French have shown that adding a second
or third factor significantly increases the explanatory power of the model.
A.63. In the research commissioned by the CRO Forum, the equity risk premium
rates from the Fama-French 2-factor model (the second factor is related to
the ratio of the book value of equity relative to the market value) were
64 CRO Forum Research, “Table 4: Full Information Beta CAPM Dollar Denominated Cost of Equity
Capital Estimates for the U.S., European, Asian and Global Insurance Industry: 1998 – 2006”, on
page 58.
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estimated for the European market to be 12.54% for Life and 11.76% for
Non-life.65
A.64. In the research commissioned by the GNAIE the equity risk premium rates
for US-based non life insurers was estimated to be 14.17%. Thereby a
market risk premium of 8.4%, a risk free rate of 4% and the parameters
for the Fama-French 3 Factor model resulting from an exhaustive analysis
of US-based P&C insurers by Cummins and Phillips66, were used.
65 CRO Forum Research, “Table 5: Full Information Beta International Fama-French Two Factor
Dollar Denominated Cost of Equity Capital Estimates for the U.S., European, Asian and Global Non-
Life Insurance Industry: 1998 – 2006”, on page 60 for non life and Table 6 on page 61 for life
companies.
66 J. D. Cummins and R. D: Phillips, Estimating the Cost of Equity Capital for Property-Liability
Insurers, The journal of Risk and Insurance, 2005, Vol. 72, No 3.
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Annex B Impact assessment on diversification benefits in
the risk margin
In its Call for Advice of 1 April 2009, the Commission has asked CEIOPS to
contribute to the Commission’s impact assessment of the Level 2 implementing
measures.67 To this end, a list of issues has been set up by the Commission and
CEIOPS, identifying the Level 2 implementing measures that should be
accompanied by an impact assessment. The objectives of the issues have been
selected among the list of objectives used by the Commission in its Level 1
impact assessment.68 On 12 June 2009, the Commission has issued an updated
list of policy issues and options, to which reference is being made.69 This impact
assessment covers issue 2 (sub-issue B) of the list of policy issues and options.
Two summary tables accompany the impact assessment, published in a separate
excel document.70
1. Description of the policy issue
B.1. The Level 1 text states that the technical provisions correspond to the
current amount (re)insurance undertakings would have to pay if they were
to transfer their (re)insurance obligations immediately to another
undertaking. The calculation of technical provisions should make use and
be consistent with information provided by the financial markets and
generally available data on underwriting risk. They are calculated in a
“prudent, reliable and objective manner”. The technical provisions are
equal to the sum of a best estimate and a risk margin (unless the criteria
for calculating the technical provisions as a whole are fulfilled). The risk
margin shall be such as to ensure that the value of technical provisions is
equivalent to the amount another (re)insurance undertaking (a reference
undertaking) would be expected to require in order to take over and meet
the insurance and reinsurance obligations.
B.2. In other words, the risk margin shall be calculated by determining the cost
of providing an amount of eligible own funds equal to the Solvency Capital
Requirement necessary to support the insurance and reinsurance
obligations over the lifetime thereof. The amount of technical provisions
should reflect the characteristics of the underlying insurance portfolio.
Undertaking-specific information should only be used in the calculation
67 http://www.ceiops.eu/media/files/requestsforadvice/EC-april-09-CfA/EC-call-for-advice-
Solvency-II-Level-2.pdf
68 http://ec.europa.eu/internal_market/insurance/docs/solvency/impactassess/final-report_en.pdf
69 http://www.ceiops.eu/media/files/requestsforadvice/EC-June-09-CfA/Updated-List-of-policyissues-
and-options-for-IA.pdf.
70 http://www.ceiops.eu/media/files/consultations/consultationpapers/CP42/CEIOPS-CP-42-09-
Annex-IA-Risk-Margin-CoC-rate.xls
http://www.ceiops.eu/media/files/consultations/consultationpapers/CP42/CEIOPS-CP-42-09-
Annex-IA-Risk-Margin-Diversification.xls
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insofar as that information enables insurance and reinsurance
undertakings to better reflect the characteristics of the underlying
insurance portfolio.
B.3. In order to harmonise the calculation of the risk margin throughout the
European Union the assumptions to be fulfilled by the reference
undertaking should be determined. In particular, whether or not
diversification effects should be taken into account in the calculation of the
risk margin, should be analysed as part of the impact assessment of
implementing measures.
B.4. Recognising diversification benefits leads to lower financial requirements.
Diversification benefits are explicitly allowed for in the calculation of the
Solvency Capital Requirement between different risks and risk modules.
The issue to be analysed is to what extent diversification effects should
also be taken into account in technical provisions, more specifically in the
risk margin. The outcome of this analysis will depend on the assumptions
made regarding the reference undertaking assumed to take over and meet
the underlying insurance and reinsurance obligations for each line of
business.
2. Detailed description of policy options and assessment of the relative
impacts on the different affected parties
Detailed description of policy options
B.5. Option 1: The reference undertaking is a well-diversified undertaking.
If the reference undertaking is assumed to be well-diversified, then this
would imply that market-wide diversification effects are recognised by all
undertakings, even if they are not diversified themselves.
B.6. Option 2: After the transfer has taken place, the reference undertaking is
a mirror image of the undertaking transferring the risk.
If the reference undertaking – after the transfer of insurance and
reinsurance obligations has taken place – is assumed to be a mirror image
of the insurer transferring the risk, then the insurer could take into
account the diversification effects assumed to be present in its own
business.
B.7. Option 3: Before the transfer takes place the reference undertaking is an
empty undertaking.
If the reference undertaking is assumed to be empty before the transfer of
insurance and reinsurance obligations take place, then it is also reasonable
to assume that no diversification effects across lines of business could be
taken into account in the risk margin.
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Impact on industry, policyholders and beneficiaries and supervisory
authorities
Likely industry response
B.8. Option 3, which leads to no recognition of diversification benefits will
generate the highest technical provisions compared to the two other
options.
B.9. An integral part of the risk management is to reduce risk through the
diversification of insurance and reinsurance obligations. In the case of
options 1 and 3 the management of undertakings would not be
incentivized to minimise the insurance risk through diversification of the
insurance portfolio across different lines of business. Both options may
therefore affect risk mitigation through the diversification of risks.
Costs and Benefits
• Policyholders and Beneficiaries
B.10. Policyholder protection stems in part from the possibility to transfer
liabilities. However, a transfer of the liabilities is only achievable in practice
if the ensuing increase in the technical provisions of the transferee
(accepting undertaking) is not bigger than the amount of the technical
provisions transferred. Otherwise the risk margin of the transferee would
be insufficient to support the cost of providing an amount of eligible own
funds equal to the Solvency Capital Requirement necessary to support the
(re)insurance obligations over the lifetime thereof.
B.11. Option 1 may lead to inappropriate policyholder protection as the majority
of undertakings would not be as well diversified as the reference
undertaking. Therefore, the risk margin based on a well diversified
reference undertaking would not be adequate for the undertaking to
provide the eligible own funds needed to run- off its own insurance and
reinsurance obligations.
B.12. More generally, from a policyholder perspective, because recognising
diversification benefits leads to lower financial requirements, the
protection against the risk of the insurer not meeting its commitments, is
higher.
B.13. Policyholder protection could also be threatened under option 2 as it would
only be possible to transfer liabilities to (re)insurance undertakings which
after that transfer are at least as well diversified as the undertaking which
is transferring the liabilities. Furthermore, if the undertaking would
transfer (re)insurance obligations of only a part of its lines of business, the
technical provisions for the lines of business that remain at the
undertaking, would not be adequate.
B.14. Option 3 ensures the highest level of policyholder protection since it
assumes the lowest level of diversification of the reference undertaking. It
is therefore possible in practice to transfer the liabilities to any
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(re)insurance undertaking. There would also be no need to increase the
value of the remaining liabilities if the undertaking transferred only part of
its obligations.
• Insurance and Reinsurance Undertakings
B.15. Options 1 and 3 enable comparing the amount of technical provisions for
similar (re)insurance obligations. However, with respect to option 1 on
would have to agree on the assumptions to be fulfilled by the welldiversified
undertaking and especially the criteria to be applied when
allocating the overall risk margin among the individual lines of business. A
comparison of the amount of technical provisions would not be possible
under option 2.
B.16. Under option 3 transfers of obligations would not be limited by the size
and portfolio diversification of the accepting undertaking, which is
necessarily not the case with options 1 and 2. Under options 1 and 2 the
amount of technical provisions of the (re)insurance company that transfers
the obligations would need to be increased if only the (re)insurance
obligations related to some of the lines of business are transferred to
another undertaking. Under option 1 the technical provisions would be
insufficient also in cases where the undertaking has to run-off its own
obligations.
B.17. Under option 2 the value of the risk margin would be volatile, following
changes of the portfolio mix over time, which is not the case for options 1
and 3.
B.18. Based on the determination of the risk profile of well-diversified
undertakings (option 1), the valuation of the risk margin may not be
harmonised between big and small (re)insurance undertakings with similar
portfolio mix, due to the bigger relative impact of diversification effects on
risk margin for smaller portfolios.
• Supervisory authorities
B.19. As explained above, there is a risk that under option 1 and to some extent
under option 2 technical provisions for a given line of business would not
be sufficient to be transferrable to another undertaking.
B.20. Furthermore, options 1 and 2 could be workable for a (re)insurance
undertaking only if the risk margin would be calculated as a whole and
there would be no requirement to distribute the risk margin between the
lines of business. Options 1 and 2 are therefore in conflict with Article 79
of the Level 1 text, which requires segmentation of technical provisions –
i.e. both the best estimate and the risk margin – into homogenous risk
groups and as a minimum by lines of business.
B.21. Option 1 is also problematic in terms of how to determine the risk profile
of the well-diversified undertaking. This definition is crucial as it would
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have a direct impact on the amount of technical provisions in every
insurance and reinsurance undertaking within the European Union.
B.22. If this artificial, well-diversified reference undertaking should reflect the
amount of diversification observed in the market, it has to be decided
whether it should be constructed based on national markets or if it should
represent the whole European market. If the reference undertaking
depends on the national market then the criterion that the assumptions
regarding the reference undertakings should be harmonised throughout
the European Union is not satisfied. Furthermore, a decision would need to
be made on how to determine the reference undertaking in those Member
States where old composites, new composites, pure life and pure non-life
insurance undertakings co-exist, as well as where both pure reinsurers and
direct insurers underwrite reinsurance business. Since not only the
diversification but also the absolute size of the reference undertaking has
an impact on the amount of the risk margin, there are great difficulties
also with the definition of a European Union-wide reference undertaking. It
could easily be criticized that whatever the choice, it would not be market
consistent.
B.23. Under option 2, even if the technical provisions are sufficient to transfer
the whole portfolio to another undertaking, the technical provisions would
not be sufficient to transfer selected lines of business separately. This is
problematic from a supervisory point of view since transfers of portfolios
are an important tool in the supervisory toolkit when the interests of
policyholders and beneficiaries are in jeopardy. From a supervisory point
of view the same portfolio of obligations should result in the same amount
of technical provisions (except consideration of expenses which could be
differently integrated in the assessment). This is not the case with option
2.
B.24. From a supervisory perspective, option 3 is the most acceptable since it
results in the highest likelihood of achieving a transfer of the full portfolio
in practice and also facilitates the transfer of selected lines of business to
another undertaking. The undertaking would also be able to run-off its
obligations. The same insurance portfolio would result in the same amount
of technical provisions for each line of business independent of the other
lines of business in the undertaking. This would mean that undertakingspecific
information is only used to better reflect the characteristics of the
underlying insurance portfolio. Moreover, this option will not raise
questions with regard to the determination of the well-diversified portfolio
for the reference undertaking.
3. Relevant objectives
B.25. The assumptions made about the reference undertaking that is assumed
to take over and meet the underlying insurance and reinsurance
obligations fall under the scope of the following general, specific and
operational objectives.
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B.26. First, the general objective relevant for this policy option is the “enhanced
protection of the policyholders and beneficiaries”.
B.27. Secondly, the specific objectives relevant for this policy are to “improve
the risk management of the EU (re)insurer” and to “increase
transparency”.
B.28. Finally, the relevant operational objective is “harmonise the calculation of
technical provisions” “introduce risk-sensitive harmonised solvency
standards”, “introduce proportionate requirements for small undertakings”
and “promote compatibility of valuation and reporting rules with the
international accounting standards elaborated by the IASB”.
4. Comparison between the different options based on the efficiency
effectiveness in reaching the relevant operational objectives
B.29. The comparison and ranking of the policy options will be based on the
effectiveness and efficiency of each of them in reaching the relevant
objectives. Effectiveness is defined as the extent to which options achieve
the objectives of the proposal. Efficiency is defined as the extent to which
objectives can be achieved at the lowest cost (cost-effectiveness).
B.30. Taking into account the discussion in section 2 of this paper on the
difficulty of achieving a transfer in practice, option 1 does not fulfil the
general requirement of enhancing the protection of the policyholders and
beneficiaries. Allowing all undertakings to take into account a welldiversified
portfolio will not encourage management to improve the risk
management of the (re)insurers. Depending on the choice of the reference
undertaking, option 1 could meet the operational objective to harmonise
the calculation of technical provisions but it will not increase transparency
because it does not take into account the insurance or reinsurance specific
risk profile. Option 1 does not introduce a risk-sensitive harmonized
solvency standard. Simplified methods will most probably be necessary for
small undertakings under option 1. This option also does not promote
comparability of valuation and it goes against the objective of convergence
with the work of the IASB on international accounting standards as well as
that of the IAIS .
B.31. Option 2 encourages undertakings to improve risk management through
diversification across lines of business, but it will only partly meet the
objective of enhancing the protection of the policyholders and
beneficiaries. This option is unlikely to contribute to the specific objective
to increase transparency and the operational objective to harmonise the
calculation of technical provisions. Option 2 introduces a risk-sensitive
harmonized solvency standard. Under Option 2 simplified methods should
probably be determined for small undertakings. Option 2 might not
promote comparability of valuation nor convergence with the work of the
IASB on international accounting standards nor that of the IAIS.
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B.32. Option 3 fully meets the general objective to enhance the protection of
policyholders and beneficiaries. This option also fulfils the specific
objective to increase transparency and the operational objective to
harmonise the calculation of the technical provisions. The specific objective
to improve the risk management of the EU (re)insurers would probably not
be harmed although undertakings will not be rewarded for diversification
between lines of business. To some extent option 3 introduces a risksensitive
harmonized solvency standard. Under option 3 no simplified
methods will be needed specifically for small undertakings. Not including
diversification effects goes towards comparability of valuation and
convergence with the work of the IASB on international accounting
standards and that of the IAIS.
B.33. In conclusion, taking into account potential costs and benefits for
policyholders and beneficiaries, insurance and reinsurance undertakings
and supervisory authorities, the effectiveness and efficiency level to meet
the relevant objectives, CEIOPS recommends option 3 in its advice.

Market risk

2009-07-04T16:30:00.000-07:00

1.3. The equity risk sub-module and the correlations between the market risk
sub-modules and between the market risk module and other modules are
not covered in this draft advice as they will be addressed in a separate
consultation paper due to be published in a third set of advice in
November 2009. In addition, advice on simplifications to the standard
formula will also be published at this stage.
1.4. The objective of this Paper is to give draft advice on the structure and
design of interest rate risk, spread risk, currency risk, property risk and
concentration risk sub-modules. With the exception of concentration risk,
the calibration of the market risk module is not covered by this paper.
CEIOPS will be producing a further consultation paper, covering the
calibration of the market risk module as part of third set of advice.
2. Extract from Level 1 Text
2.1 The legal basis for the advice presented in this paper is primarily found in
Article 109 of the Level 1 text which states:
“1. In order to ensure that the same treatment is applied to all insurance
and reinsurance undertakings calculating the Solvency Capital
Requirement on the basis of the standard formula, or to take account of
market developments, the Commission shall adopt implementing measures
laying down the following:
[…]
1 See http://www.ceiops.eu/content/view/5/5/
2 Text adopted by the European Parliament on 22 April 2009, see
http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//NONSGML+TA+20090422+SIT-
03+DOC+WORD+V0//EN&language=EN..
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(c) the methods, assumptions and standard parameters to be used, when
calculating each of the risk modules or sub-modules of the Basic Solvency
Capital Requirement laid down in Articles 104, 105…
[…]
2. The Commission may adopt implementing measures laying down
quantitative limits and asset eligibility criteria in order to address risks
which are not adequately covered by a sub-module. Such implementing
measures shall apply to assets covering technical provisions, excluding
assets held in respect of life insurance contracts where the investment risk
is borne by the policyholders. Those measures shall be reviewed by the
Commission in the light of developments in the standard formula and
financial markets.
[…]”
2.2 Article 104 states the design of the Basic Solvency Capital Requirement:
“1. The Basic Solvency Capital Requirement shall comprise individual risk
modules, which are aggregated in accordance with point 1 of Annex IV.
It shall consist of at least the following risk modules:
[…]
(d) market risk
[…]
5. The same design and specifications for the risk modules shall be used
for all insurance and reinsurance undertakings, both with respect to the
Basic Solvency Capital Requirement and to any simplified calculations as
laid down in Article 108.
[…]
It should be noted that there is no possibility based on the Level 1 text
(art. 104 7) for the use of undertaking-specific parameters in the market
risk module.”
2.3 Article 105 requires that:
“[…]
5. The market risk module shall reflect the risk arising from the level or
volatility of market prices of financial instruments which have an impact
upon the value of assets and liabilities of the undertaking. It shall properly
reflect the structural mismatch between assets and liabilities, in particular
with respect to the duration thereof.
It shall be calculated, in accordance with point 5 of Annex IV, as a
combination of the capital requirements for at least the following submodules:
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(a) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the term structure of interest rates, or in the
volatility of interest rates (interest rate risk);
(b) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or in the volatility of market prices of
equities (equity risk);
(c) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or in the volatility of market prices of
real estate (property risk);
(d) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or volatility of credit spreads over the
risk-free interest rate term structure (spread risk);
(e) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or in the volatility of currency
exchange rates (currency risk);
(f) additional risks to an insurance or reinsurance undertaking stemming,
either from lack of diversification in the asset portfolio, or from large
exposure to default risk by a single issuer of securities or a group of
related issuers (market risk concentrations).
[…]”
2.4 On simplifications in the standard formula, Article 108 states:
“Insurance and reinsurance undertakings may use a simplified calculation
for a specific sub-module or risk module where the nature, scale and
complexity of the risk they face justifies it and where it would be
disproportionate to require all insurance and reinsurance undertakings to
apply the standardised calculation.”
2.5 The Level 1 text also mentions concentration risk in the following
provisions:
“Article 13 – Definitions
29) concentration risk means all risk exposures with a loss potential which
is large enough to threaten the solvency or the financial position of
insurance and reinsurance undertakings; “
“Article 130 – ‘Prudent person’ principle
4. (last alinea) Investments in assets issued by the same issuer, or by
issuers belonging to the same group, shall not expose the insurance
undertakings to excessive risk concentration. “
2.6 Title III of the Level 1 text, dealing with group supervision, also refers to
to concentration risk (eg. Article 248, which specifically relates to the
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supervision of risk concentration in a group)3. There are also some
references to concentration risk in the provisions referred to risk
management (Pillar II)4. The treatment of concentration risk in this paper
is limited to the solo standard formula SCR, since the treatment of this risk
in the context of groups and for internal models is being dealt with in other
draft Level 2 CEIOPS advice.
2.7 From a legal perspective, it is relevant to point out that Article 13(29)
defines concentration risk in the widest and most comprehensive manner.
This interpretation shall apply when referring to concentration risk in the
Level 1 text (eg. in the context of risk management, capital requirements,
investments and group supervision...).
3. QIS4 outputs and industry feedback
3.1 Market risk (except concentration risk)
3.1 From April to July 2008, CEIOPS carried out the fourth Quantitative Impact
Study on Solvency II (QIS4). This included testing each of the submodules
of the market risk module, according to the structure set out in
Article 105.
3.2 For both life and non-life undertakings, as well as for composites, the
quantitative results indicated that market risk represented one of the most
significant modules for the standard formula SCR.
3.3 The largest components of the market risk charge were interest rate and
equity risk (though equity risk is not considered in this paper), with each
of these typically contributing around 40-50% of the total market risk
requirement. Property risk and spread risk contributed less: property
contributed between 8% and 15% of the total market risk, and spread risk
contributed 11-21%. Currency risk contributed less than 7% of the total
market risk. These statistics are useful to bear in mind when considering
the design and structure of the market risk module and when assessing
the merits of any simplifications.
3.4 In general, feedback from the QIS4 exercise indicated few difficulties with
the design and structure of the market risk module and its sub-modules.
The main comments were as follows:
Structure
- For the interest rate module, there were suggestions that sensitivity to
changes in the shape of the yield curve could be introduced.
3 See CEIOPS-CP-61-09, http://www.ceiops.eu/content/view/14/18/
4 See CEIOPS-CP-33-09, http://www.ceiops.eu/media/files/consultations/consultationpapers/CP33/CEIOPS-CP-
33-09-Draft-L2-Advice-on-Governance.pdf .
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- Volatility of interest rates was not modelled in the QIS4 approach.
-Some undertakings suggested use of a correlation matrix for the
treatment of currency risk.
- The QIS4 specifications did not address the treatment of inflation-linked
bonds.
- For the property risk sub-module, some undertakings felt that the
situation where buildings are used for the insurer’s own activities
rather than as an investment was not adequately reflected in the QIS4
approach.
- Some undertakings suggested that property risks could be split into sublines
(residential, commercial, offices, etc.)
- In the spread risk sub-module, it was suggested that a distinction should
be drawn between losses due to migration risk and default risk, and
those due to a general change in the market price of credit risk.
-Some undertakings felt that the approach taken for spread risk in QIS4
did not allow for risk mitigation instruments.
- There were confusions as to which sub-modules should be used to assess
the market risk in mortgage-backed securities with one country stating
a preference for treating these instruments via the spread and interest
rate sub-modules rather than using the counterparty default risk
module.
Practical issues
- It was suggested that the use of a delta-NAV (i.e. change in net asset
value) approach is overly complex and would require sophisticated
modelling techniques
- Many insurers found the application of the look-through approach for
investment funds impractical.
- The approach to currency risk was viewed as problematical for
undertakings writing international business, particularly if this were to
be applied to the currency of the free assets relative to the Euro rather
than to the currency in which the liabilities are denominated (or the
currency of the local regulator).
3.5 This paper takes into account the results and comments from the QIS4
exercise with the aim of refining the design and structure of the market
risk module further.
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3.2 Concentration risk
3.6 According to the QIS4 report, the concentration risk sub-module presented
on average 7.2 % (life), 17.9 % (non-life) and 9.5 % (composite) of the
market risk SCR (before diversification benefits).5
3.7 The QIS4 report also contains quantitative references to the impact of
concentration risk on each Member State and market segment (non-life,
life and composite).
3.8 The issues commented on by the industry with regard to concentration risk
in the solo SCR in QIS4 report can be summarized as follows:
3.9 Treatment of participations. The inclusion of participations into the
concentration risk sub-module was rejected by some undertakings as
double counting. Some undertakings were concerned that intra-group
operations are faced with a too high capital charge.6
CEIOPS will produce an advice on participations and their treatment in the
solvency assessment of an undertaking at the end of October. Therefore,
this advice does not consider the treatment of participations.
3.10 Treatment of properties. The QIS4 report mentions the need for
clarification of concentration risk on properties.7
3.11 First of all, it is worth clarifying that concentration risk on properties does
not refer to having a high percentage of properties in respect of equities,
bonds, or the total balance sheet. This lack of diversification is captured
with the use of a correlation matrix to add the SCRs derived in each of the
market risk sub-modules.
3.12 When dealing with concentration on properties, the difficulty arises from
the fact that the core drivers of diversification are both the type of
property (office premises, residential property, grounds, etc) and mainly
the geographical spread.
3.13 Regarding the first criterion (the type of use of the property) a huge
percentage of properties held by undertakings corresponds to office
premises and commercial non-residential properties, and therefore this is
considered in the calibration of the ‘property risk’ sub-module. Outliers in
respect of this assumption may be better treated via internal models.
3.14 The second criterion (geographical diversification) has revealed to be
extremely difficult to model in an appropriate manner. Experience from the
recent crisis shows that in case of a severe stress, geographical
diversification has no significant effect, since property prices tend to
contract almost worldwide.
5 See CEIOPS' Report on its Fourth Quantitative Impact Study, November 2008,
http://www.ceiops.eu/media/files/consultations/QIS/CEIOPS-SEC-82-08%20QIS4%20Report.pdf, p. 176.
(hereafter: QIS4 report).
6 QIS4 report, p. 179,186..
7 QIS4 report, p. 179, 186.
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3.15 At the same time, it is generally agreed that an undertaking with a
significant percentage of its assets invested in a single property, in
principle would have a higher exposure to market risk than an undertaking
with a diversified portfolio of properties.
3.16 Having this in mind, this advice only contains a specific provision regarding
concentration risk in a single property, considering that the market risk
associated to this type of assets is not geographically diversifiable in case
of severe crisis, and this feature has been considered in the calibration of
property risk sub-module within the standard calculation of the SCR.
3.17 Assets to include in the denominator. Undertakings asked for a clearer
description and rationale of the treatment. In order to solve this point, this
advice contains a better definition of the amount to include in the
denominator.
3.18 Treatment of bank deposits. Undertakings in one country criticized the
concentration risk sub-module with respect to bank deposits from financial
entities under Basel II and investment funds harmonized at a European
level. In their view, these elements should be excluded from the module,
as their issuers are subject to anti-concentration regulation.
3.19 The recent crisis has shown several practical examples demonstrating the
inappropriateness of the proposed exemption. Nevertheless, this empirical
evidence does not preclude the possibility of taking into account
government guarantees provided for bank deposits and cash-accounts. In
fact, this allowance seems aligned with the economic assessment
underlying Solvency 2.
3.20 Risks derived from concentration in cash held at a bank are captured in
the counterparty default risk module, while risks corresponding to
concentration in other bank assets are reflected in the concentration risk
sub-module (no-hole, no-overlap).
3.21 Geographical and sectoral diversification. Although not reflected
explicitly in QIS4 report, it seems relevant to comment on geographical
and sectoral diversification referring to financial investments. An
undertaking concentrating its investments in the same geographical area
or in the same economic sector is bearing higher risks than in case of a
geographically/sectorally diversified portfolio. The difficult point here is
how to measure these types of concentration.
3.22 In the case of geographical concentration, most large groups are present
worldwide and it is difficult to find a reliable and publicly disclosed
measure of their geographical investments. Management of geographical
exposures requires an in-depth insight of each investment and a rather
complex monitoring process. Furthermore, the calibration of different
parameters according to each geographical area is not immediate. In fact,
such differentiation may be not meaningful in an increasingly globalised
context. The crisis has shown that diversification benefits (among lines of
business, asset classes, geographical, etc.) tend to diminish or not be
realizable in stressed times. CEIOPS recognizes the existence of
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diversification effects (both benefits and risks), but notices that they don’t
operate in the same way in normal and crisis times. 8
3.23 A similar statement is applicable to sectoral concentration, perhaps with a
slightly different intensity and some nuances. Examples of tobacco groups
with huge dietary business or utilities groups moving towards the service
sector are sufficiently illustrative of the blurred frontiers that sectoral limits
have in the modern economy. Furthermore, contagion risks and 'domino'
effects have increased the inter-sectoral correlations in times of crisis, in
such a manner that in some cases the correlation among entities of
different sectors closely related is significant, even similar to the
correlation of one entity with its sectoral competitors.
3.24 Summing up and for all the reasons described above, the present advice
does not contain any formula to quantify capital requirements regarding
geographical and sectoral concentrations of financial investments.
Therefore these risks shall be primarily considered as part of Pillar 2
activities (risk management, ORSA, etc.) and via internal models when it
be necessary to ensure that the SCR appropriately reflects the risk profile
of each undertaking.
4. Advice
4.1 General structure of the market risk module
4.1 For the purposes of this quantitative advice and from a technical point of
view, one issue to consider is which types of concentration can be taken
into account a manner that would be compatible with the degree of
simplicity desirable for the standard calculation of the SCR.
4.2 In general, undertakings and supervisors should verify that the SCR
provides an appropriate reflection of the risk profile of the insurance or
reinsurance undertaking. Should this not be the case with respect to the
concentration of assets or liabilities, necessary action will need to be
adopted in a relevant manner, i.e. via internal models or through capital
add-ons.
4.3 There were no major difficulties arising as a result of the structure of the
market risk module and its sub-modules as tested in QIS4 and as set out
in the Level 1 text quoted above.
4.4 However a number of (re)insurance undertakings highlighted that volatility
of interest rates was not captured by the standard formula. In that regard
this advice considers the impact of interest rate volatility on the shape
(i.e., slope and curvature) of the term structure of interest rates.
8 See CEIOPS Lessons learned from the crisis (SII and beyond), March 2009
http://www.ceiops.eu/media/files/publications/reports/CEIOPS-SEC-107-08-Lessons-learned-from-the-crisis-
SII-and-beyond.pdf, section 1.1.4.
11/41
4.5 With the exception of interest rate volatility, we propose no changes to be
made to the module/sub-module structure. Instead, effort will be focused
on refining the design of the sub-modules and (later) on reassessing the
calibration of the modules.
4.6 One suggestion arising from QIS4 has been that liquidity risk could be
included in the market risk module. However, this has been discussed as
part of the development of the Level 1 text and it has been concluded that
this risk is better captured in Pillars 2 and 3.
4.2 General considerations where a delta-NAV approach is used
4.2.1. Explanatory text
4.7 A number of the market risk stresses are based on a delta-NAV (change in
value of assets minus liabilities) approach. The change in net asset value
should be based on a balance sheet that does not include the risk margin
of the technical provisions. This approach is based on the assumption that
the risk margin does not change materially under the scenario stress. This
simplification is made to avoid a circular definition of the SCR since the
size of the risk margin depends on the SCR.
4.8 Where a delta-NAV approach is used, the impact of hedging instruments
shall be allowed for as part of the sub-module: use of the delta-NAV
calculation ensures the impact of the stress scenario on the hedging
instrument is captured alongside the impact on all other assets and
liabilities. (Re)insurance undertakings shall have regard to CEIOPS-CP-31-
09 in determining whether a financial risk mitigation instrument may be
taken into account.9
4.9 Furthermore, where a delta-NAV approach is used, the revaluation of
technical provisions should allow for any relevant adverse changes in
option take-up behaviour of policyholders in this scenario.
4.2.2. CEIOPS’ advice
Delta-NAV Approach
4.10 The change in net asset value shall be based on a balance sheet that does
not include the risk margin of the technical provisions.
4.11 The impact of interest rate hedging instruments shall be allowed for as
part of the scenarios. (Re)insurance undertakings shall have regard to
CEIOPS-CP-31-09 in determining whether a financial risk mitigation
instrument may be taken into account.
4.12 The revaluation of technical provisions should allow for any relevant
adverse changes in option take-up behaviour of policyholders in this
scenario.
9 See CEIOPS-CP-31-09, http://www.ceiops.eu/index.php?option=content&task=view&id=549
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4.3 Interest rate risk
4.3.1. Explanatory text
4.13 As set out in TS.IX.B.1 of the QIS4 Technical Specification, interest rate
risk exists for all assets and liabilities for which the net asset value is
sensitive to changes in the term structure of interest rates or interest rate
volatility.
4.14 Assets sensitive to interest rate movements will include fixed-income
investments, insurance liabilities, financing instruments (for example loan
capital), policy loans and interest rate derivatives.
4.15 Liability cash-flows received in the future will be sensitive to a change in
the rate at which those cash-flows are discounted.
4.16 The values of assets and liabilities that are sensitive to changes in interest
rates can be determined using the term structure of interest rates – which
can change over time.
4.17 QIS4 describes a methodology that derives a capital charge for interest
rate risk based on a delta-NAV (change in value of assets minus liabilities)
approach. Some respondents suggested that this approach is overly
complex. However, the quantitative QIS4 results demonstrated the
significance of interest rate risk not only within the market risk module but
also within the total SCR. As a result, CEIOPS considers the delta-NAV
approach should be retained in order to capture as effectively as possible
this important risk.
4.18 Accordingly, the input information required for this module will the net
asset value (i.e., NAV) calculated as the value of assets minus liabilities.
4.19 The capital charge arising from this sub-module will be Mktint and will be
calculated based on two pre-defined scenarios: one scenario will consider
an upward shock to interest rates and will deliver Mktint
Up; the other
scenario will consider a downward shock and will deliver Mktint
Down. The
capital charge Mktint will then be determined as the maximum of the capital
charges Mktint
Up and Mktint
Down, subject to a minimum of zero.
4.20 The capital charges Mktint
Up and Mktint
Down will be calculated as
Mktint
Up = ΔNAV|upwardshock and Mktint
Down = ΔNAV|downwardshock
where, ΔNAV|upwardshock and ΔNAV|downwardshock are the changes in net values
of assets and liabilities due to revaluation of all interest rate sensitive
assets and liabilities based on:
1. Specified alterations to the interest rate term structures
combined with:
2. Specified alterations to interest rate volatility.
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4.21 The altered term structures used in calculating the capital charge for this
sub-module will be composed of several factors, although there will only
be one upward shock and one downward shock to be applied at each
maturity.
4.22 The intention will be to provide a decomposition of the shocks so that the
assumptions underlying the calibration are transparent: the factors will
capture changes in level, slope and curvature of the term structure.
4.23 The slope and curvature of the term structure of interest rates may be
materially affected by the volatility of interest rates. Interest rate volatility
has further material impact on the assets and/or liabilities of (re)insurance
undertakings that have embedded guarantees in their business.
4.24 The proposed increase in interest rate volatility is therefore likely to affect
traditional participating business, certain types of annuity business and
other investment contracts.
4.25 The calibration of the upward and downward interest rate stresses will be
considered further in the forthcoming consultation paper on calibration of
the market risk module.
4.3.2. CEIOPS’ advice
Interest rate risk
4.26 The input information required for this module is the net asset value (NAV)
calculated as the value of assets minus liabilities.
4.27 The capital charge arising from this sub-module will be Mktint and will be
calculated based on two pre-defined scenarios: one scenario will consider
an upward shock to interest rates and will deliver Mktint_Up; the other
scenario will consider a downward shock and will deliver Mktint_Down. The
capital charge Mktint will then be determined as the maximum of the
capital charges Mktint_Up and Mktint_Down, subject to a minimum of zero.
4.28 The capital charges Mktint_Up and Mktint_Down will be calculated as
Mktint_Up = ΔNAV|upwardshock and Mktint_Down = ΔNAV|downwardshock
where, ΔNAV|upwardshock and ΔNAV|downwardshock are the changes in
net values of assets and liabilities due to revaluation of all interest rate
sensitive assets and liabilities based on:
1. Specified alterations to the interest rate term structures
combined with:
2. Specified alterations to interest rate volatility.
4.29 The calibration of the interest rate shock will capture changes in level,
slope and curvature of the term structure.
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4.4 Currency risk
4.41. Explanatory text
4.30 Currency risk arises from changes in the level or volatility of currency
exchange rates.
4.31 Undertakings may be exposed to currency risk arising from various
sources, including their investment portfolios, as well as assets, liabilities
and investments in related undertakings. The design of the currency risk
sub-module is intended to take into account currency risk for an
undertaking arising from all possible sources.
4.32 Respondents to QIS4, however, highlighted the situation where an
undertaking’s liabilities and local currency are not denominated in euros.
In such a case, the undertaking should consider currency risks relative to
that local currency. Conversion of the components of undertaking’s overall
solvency position (including SCR, MCR, technical provisions and other) into
euros for reporting will not incur currency risk.
4.33 A scenario-based approach was used for the assessment of the currency
risk capital charge in QIS4. Although this can be considered more complex
than a factor-based approach, it is likely that for smaller undertakings the
extent of any cross-currency holdings may be sufficiently limited as to
make a scenario-based approach relatively simple in practice. Moreover, a
scenario-based approach allows currency hedging programmes to be
captured appropriately.
4.34 We propose therefore to retain a scenario-based approach, but to make
some refinements to better capture more complex scenarios without
adding excessive complexity to the standard formula methodology:
4.35 The QIS4 approach considered the effect of two scenarios (a rise and a fall
in exchange rates) on the net value of assets minus liabilities. The
scenarios implicitly assumed that all currencies experience the same rise
or fall in reference to a local currency, whilst ignoring the interdependencies
between currencies other than the local currency.
4.36 As an example, consider the case of an insurer with regulatory accounts
denominated in EUR who has US$ denominated liabilities of value EUR 1
million and assets in £ sterling of value EUR 1 million at the 2007 year
end. In addition, suppose that all other balance sheet items are
denominated in EUR. In this case, the scenarios fx upward and fx
downward do not lead to a change in basic own funds, because pound and
dollar both are assumed to rise or fall in relation to euro. According to the
scenarios, the insurer seems to be perfectly hedged against currency risk.
During the year 2008, the value of the US dollar liabilities have risen to
EUR 1.05 million and the value of the pound sterling assets have fallen to
EUR 0.77 million. Consequently, there is a loss of basic own funds of EUR
0.28 million, more than a quarter of the initial exposure.
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4.37 The example shows that significant currency risks may not be detected if
the QIS4 approach is applied. The two currency scenarios imply that the
exchange rate between pound and dollar is fixed. This is not a realistic
assumption. Moreover, the current approach incentives a currency risk
mis-management as illustrated in the above example: If no appropriate
assets in US dollar are available to cover the dollar liabilities, then the
undertaking can reduce its capital requirement by covering the liabilities
with another foreign currency. However, if the dollar liabilities are covered
with euro assets then the resulting capital charge will be 20% of the
liabilities.
4.38 This issue can be addressed by refining the QIS4 approach to consider
each currency separately.
4.39 Under the refined approach, the local currency is the currency in which the
undertaking prepares its local regulatory accounts. All other currencies are
referred to as foreign currencies. A foreign currency is relevant for the
scenario calculations if the amount of basic own funds depends on the
exchange rate between the foreign currency and the local currency.
4.40 The capital charge arising from this sub-module will be Mktfx and will be
calculated based on two pre-defined scenarios: for each currency C, one
scenario will consider a rise in the value of the foreign currency against the
local currency and will deliver Mktfx,C
Up; the other scenario will consider a
fall in the value of the foreign currency against the local currency and will
deliver Mktf,Cx
Down. All of the participant's individual currency positions and
its investment policy (e.g. hedging arrangements, gearing etc.) should be
taken into account. For each currency, the contribution to the capital
charge Mktfx,C will then be determined as the maximum of the results
Mktfx,C
Up and Mktfx,C
Down. The total capital charge Mktfx will be the sum over
all currencies of Mktfx,C.
4.41 For each relevant foreign currency C, the capital charges Mktfx,C
Up and
Mktfx,C
Down will be calculated as:
max(0, | upward_ ) , Mkt up NAV C shock fx C = Δ
max(0, | downward_ ) , Mkt downward NAV C shock fx C = Δ
where ΔNAV| C upward shock and ΔNAV| C downward shock are the changes
in net values of assets and liabilities due to the rise and fall respectively in
value of the foreign currency against the local currency.
4.42 Note that for each relevant foreign currency C, the currency position
should include any investment in foreign equities where the currency risk
is not hedged. This is because the currency risk is not captured by the
equity stress which is calibrated based on currency hedged time series.
4.43 For the example presented in 4.366 above, the modification would require
the analysis of a dollar shock and a pound shock. The dollar shock would
be an increase of the dollar value compared to the euro by 20%. The
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pound shock would be a loss in value of the pound of 20%. The resulting
capital charge would be Mktfx = 0.2 million + 0.2 million = 0.4 million.
4.44 In situations where two foreign currencies are matched as in the example,
the proposed approach leads to the assumption that - compared to the
local currency - one exchange rate moves up and the other one down.
Consequently, the exchange rate between the two foreign currencies
moves more strongly than the assumed 20%. This could be considered to
be a drawback of the proposed approach. The effect could be avoided by
allowing for diversification between the shocks on different currencies. For
example the results of the different currency shocks could be aggregated
with a correlation matrix. However, there are three arguments against
such an amendment: Firstly, it would be difficult to quantify the
diversification between two exchange rates, even if the simple approach is
taken that the correlation factor for each pair of foreign currencies is the
same. Secondly, the amendment would increase the complexity of the
calculation. And thirdly, situations as illustrated in the example can usually
be avoided in practice.
4.45 The calibration of the upward and downward currency stresses will be
considered further in the forthcoming consultation paper on calibration of
the market risk module.
4.4.2. CEIOPS’ advice
Currency risk
4.46 A scenario-based approach shall be used for the assessment of the
currency risk capital charge.
4.47 The local currency is the currency in which the undertaking prepares its
local regulatory accounts. All other currencies are referred to as foreign
currencies. A foreign currency is relevant for the scenario calculations if
the amount of basic own funds depends on the exchange rate between the
foreign currency and the local currency.
4.48 The capital charge arising from this sub-module will be Mktfx and will be
calculated based on two pre-defined scenarios: for each currency C, one
scenario will consider a rise in the value of the foreign currency against the
local currency and will deliver Mktfx,C
Up; the other scenario will consider a
fall in the value of the foreign currency against the local currency and will
deliver Mktfx,C
Down. All of the participant's individual currency positions and
its investment policy (e.g. hedging arrangements, gearing etc.) should be
taken into account. For each currency, the capital charge Mktfx,C will then
be determined as the maximum of the results Mktfx,C
Up and Mktfx,C
Down. The
total capital charge Mktfx will be the sum over all currencies of Mktfx,C.
4.49 For each relevant foreign currency C, the capital charges Mktfx,C
Up and
Mktfx,C
Down will be calculated as:,
max(0, | upward_ ) , Mkt up NAV C shock fx C = Δ
max(0, | downward_ ) , Mkt downward NAV C shock fx C = Δ
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where ΔNAV| C upward shock and ΔNAV| C downward shock are the
changes in net values of assets and liabilities due to the rise and fall
respectively in value of the foreign currency against the local currency.
4.50 For each relevant foreign currency C, the currency position should include
any investment in foreign equities. This is because the currency risk is not
captured by the equity stress which is calibrated based on currency
hedged time series.
4.5 Spread risk
4.5.1. Explanatory text
4.51 Spread risk is the part of risk that reflects the change in value of net
assets due to a move in the yield on an asset relative to the risk-free term
structure. The spread risk sub-module should address changes in both
level and volatility of spreads.
4.52 QIS4 respondents suggested it would be helpful to have greater clarity on
the scope of the spread risk sub-module. There are two particular areas of
concern: first, the interaction between this sub-module and the
counterparty default module, and second, the way in which certain
financial instruments would be treated under this sub-module.
4.53 The interaction between the spread risk sub-module and the counterparty
default risk module is also addressed in the draft advice relating to the
counterparty default risk module. The Level 1 text relating to the
counterparty default risk module is the starting point for this analysis:
Article 105(6) states:
The counterparty default risk module shall reflect possible losses due to
unexpected default, or deterioration in the credit standing, of the
counterparties and debtors of insurance and reinsurance undertakings over
the next twelve months. The counterparty default risk module shall cover
risk-mitigating contracts, such as reinsurance arrangements,
securitisations and derivatives, and receivables from intermediaries, as
well as any other credit exposures which are not covered in the spread risk
sub-module.
For each counterparty, the counterparty default risk module shall take
account of the overall counterparty risk exposure of the insurance or
reinsurance undertaking concerned to that counterparty, irrespective of
the legal form of its contractual obligations to that undertaking.
4.54 The definition of spread risk in the Level 1 text allows a certain amount of
freedom in setting the boundary between the spread risk sub-module and
the counterparty default risk module However, wherever the dividing line
between these two modules is drawn, the principle should be that no risk
is left unaddressed and no risk is double-counted.
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4.55 The QIS4 Technical Specifications identified three areas of application for
the spread risk sub-module:
• bonds
• asset-backed securities
• collateralised debt obligations
• credit derivatives (e.g. credit default swaps (CDS), total return swaps
(TRS), credit linked notes (CLN)) where:
- The (re) insurance undertaking does not hold the underlying
instrument or another exposure where the basis risk between that
exposure and the underlying instrument is immaterial in all possible
scenarios; or
- The credit derivative is not part of the undertaking's risk mitigation
policy
In QIS4, credit derivatives were only covered in the spread risk submodule
in relation to the credit risk transferred by the derivative: the
credit risk of the counterparty to the derivative treaty was not covered,
being addressed instead in the counterparty default risk module.
4.56 In general the QIS4 approach seemed to be accepted by the stakeholders.
We therefore propose to clarify the scope of the spread risk sub-module as
follows:
4.57 The spread risk sub-module should cover the credit risk of:
• investments for the benefit of life-insurance policyholders who bear the
investment risk
• credit derivatives
• other credit risky investments including in particular:
- participating interests
- debt securities issued by, and loans to, affiliated undertakings and
undertakings with which an insurance undertaking is linked by virtue
of a participating interest
- debt securities and other fixed-income securities
- participation in investment pools
- loans guaranteed by mortgages
- deposits with credit institutions
In relation to credit derivatives, only the credit risk which is transferred by
the derivative is covered in the spread risk sub-module.
4.58 Following the methodology tested in QIS4, we propose that no capital
charge applies for the purposes of this module to borrowings by or
guaranteed by national government of an OECD or EEA state, issued in the
currency of the government
4.59 The spread risk module therefore applies to at least the following classes
of bonds:
• Investment grade corporate bonds
• High yields corporate bonds
• Subordinated debt
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• Hybrid debt
4.60 Furthermore, the spread risk module is applicable to all types of assetbacked
securities as well as to all the tranches of structured credit
products such collateralised debt obligations. This class of securities
includes transactions of schemes whereby the credit risk associated with
an exposure or pool of exposures is tranched, having the following
characteristics:
(a) payments in the transaction or scheme are dependent upon the
performance of the exposure or pool of exposures; and
(b) the subordination of tranches determines the distribution of losses
during the ongoing life of the transaction or scheme.
4.61 The spread risk sub-module will further cover in particular credit
derivatives, for example (but not limited to) credit default swaps, total
return swaps and credit linked notes that are not held as part of a
recognised risk mitigation policy. As indicated in paragraph 4.57 above,
the spread risk sub-module will also applicable to all tranches of structured
credit products like collateralised debt obligations. In addition, traditional
forms of asset backed securities, that is commercial and residential
mortgage backed securities, home equity loans, credit card receivables,
auto loans, student loans as well as whole-business securitisations,
infrastructure finance notes and other covered bonds are also addressed
by this sub-module.
4.62 Instruments sensitive to changes in credit spreads may also give rise to
other risks, which should be treated accordingly in the appropriate
modules. For example, the counterparty default risk associated with the
counterparty should be addressed in the counterparty default risk module,
rather than in the spread risk sub-module.
4.63 The QIS4 approach to the spread risk sub-module relied on a factor-based
methodology. In general, QIS4 participants seemed broadly happy with
this approach.
4.64 The proposed design for the sub-module implies that credit spread risk
hedging programmes can still be taken into account when calculating the
capital charge for this risk type. This enables undertakings to gain
appropriate recognition of, and allowance for, their hedging instruments –
subject to proper treatment of the risks inherent in the hedging
programmes.
4.65 The capital charge for spread risk will be determined by assessing the
results of a factor-based calculation which considers a rise in credit
spreads. Empirically, spreads tend to move in the same direction in a
stressed scenario, and therefore the assumption is made that spreads on
all instruments increase. This also helps to avoid excessive complexity.
4.66 The spread risk sub-module will not explicitly model migration and default
risks. Instead, these risks will be addressed implicitly, both in the
calibration of the factors and in movements in credit spreads. For
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example, the impact of intra-month changes in rating will be reflected in
any indices used to inform the calibration of the factors. The factors will
also implicitly address not only change in the level of credit spreads but
also term structure for the level of spreads. The sensitivity of the
underlying portfolio to changes in level of volatility of credit spreads is also
indirectly considered in this sub-module.
4.67 In that regard, CEIOPS is considering developing risk factors that vary by
spread duration to take into account the non-linearity of spread risk across
duration and credit rating.
4.68 The factor-based approach will be built from the market value of the
instrument in question, and will take into account the credit rating of the
instrument and its duration.
4.69 The approach to be taken for collective investment vehicles is set out in
section 4.8 below. Similarly, a look-through approach should be applied to
assets representing reinsurers' funds withheld by counterparty.
4.70 For collateralised debt obligations it will be important to take into account
the nature of the risks associated with the collateral assets. For example,
in the case of a CDO-squared, the rating should take into account the risks
associated with the CDO tranches held as collateral, i.e. the extent of their
leveraging and the risks associated with the collateral assets of these CDO
tranches.
4.71 For credit derivatives, the capital charge will be scenario-based. The
scenario will consider both a rise and fall in credit spreads. The capital
charge is determined by the more onerous of the two scenarios.
4.5.2. CEIOPS’ advice
Spread risk
4.72 The spread risk sub-module shall cover the credit risk of
• investments for the benefit of life-insurance policyholders who bear
the investment risk
• credit derivatives
• Other credit risky investments including in particular:
- participating interests
- debt securities issued by, and loans to, affiliated undertakings
and undertakings with which an insurance undertaking is
linked by virtue of a participating interest
- debt securities and other fixed-income securities
- participation in investment pools
- loans guaranteed by mortgages
- deposits with credit institutions
In relation to credit derivatives, only the credit risk which is
transferred by the derivative is covered in the spread risk sub-module.
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4.73 No capital charge shall apply for the purposes of this module to borrowings
by or guaranteed by national government of an OECD or EEA state, issued
in the currency of the government
4.74 The spread risk module applies to at least the following classes of bonds:
• Investment grade corporate bonds
• High yields corporate bonds
• Subordinated debt
• Hybrid debt
4.75 Furthermore, the spread risk module is applicable to all types of assetbacked
securities as well as to all the tranches of structured credit
products such collateralised debt obligations. This class of securities
includes transactions of schemes whereby the credit risk associated with
an exposure or pool of exposures is tranched, having the following
characteristics:
(a) payments in the transaction or scheme are dependent upon the
performance of the exposure or pool of exposures; and
(b) the subordination of tranches determines the distribution of losses
during the ongoing life of the transaction or scheme.
4.76 The spread risk sub-module will further cover in particular credit
derivatives. , for example (but not limited to) credit default swaps, total
return swaps and credit linked notes that are not held as part of a
recognised risk mitigation policy. The spread risk sub-module will also
address spread risk sensitivities of both mortgages and mortgage
derivatives.
4.77 The sensitivity of the underlying security to changes in level of volatility of
credit spreads should also be considered in this sub-module;
notwithstanding that such instruments may also give rise to other risks
(which should be treated accordingly in the appropriate modules).
4.78 The capital charge for spread risk shall be determined by assessing the
results of two factor-based calculations: the first of these considers a rise
in credit spreads and the second considers a fall in credit spreads. The
capital charge is determined by the more onerous of these two scenarios.
4.79 The spread risk sub-module will not explicitly model migration and default
risks. Instead, these risks will be addressed implicitly, both in the
calibration of the factors and in movements in credit spreads. The factors
will also implicitly address not only change in the level of credit spreads
but also term structure for the level of spreads as well as features of the
volatility surface.
4.80 The factor-based approach will be built from the market value of the
instrument in question, and will take into account the credit rating of the
instrument and its duration.
4.81 For credit derivatives, the capital charge will be scenario-based.
4.82 The proposed design for the sub-module shall take account of credit
spread risk hedging programmes.
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4.6 Property risk
4.6.1. Explanatory text
4.83 Property risk arises as a result of sensitivity of assets, liabilities and
financial investments to the level or volatility of market prices of property.
4.84 The capital charge for property risk is calculated based on the impact of a
shock scenario on the net value of assets and liabilities. Although feedback
from QIS4 indicated that some undertakings found a delta-NAV approach
complicated, a shock to net asset value is less complex for property risk,
as properties are only likely to be included in the undertaking’s assets,
making application of the stress scenario more straightforward.
Furthermore, property risk can be a significant component of the market
risk capital charge, as evidenced by QIS4.
4.85 In QIS4, a single stress (a 20% fall in real estate benchmarks) was applied
to the net value of assets less liabilities. However, some respondents to
QIS4 noted that this does not take account of the differences between
different types of properties.
4.86 The capital charge for property risk Mktprop will be calculated as the result
of a pre-defined scenario(s),
shock
prope
rty
ΔNAV
Mk
tprop=
.
4.87 The property shock is the immediate effect on the net asset value of a fall
in real estate benchmarks taking account of all the participant’s individual
direct and indirect exposures to property prices. The calibration of the
shocks will be considered in the forthcoming draft advice on calibration of
the market risk module.
4.88 As part of the calibration exercise, CEIOPS will investigate whether
distinctions between commercial, retail and other types of property is
possible. If this is the case it is possible that more than one scenario will
be defined for property risk. CEIOPS believes that there may be merit in
this approach, as there are structural market differences between the
different types of property.
4.89 Participations in real estate companies shall be treated as property, if they
only give rise to property risk. Usually, this is only the case if the business
of the real estate company is restricted to the direct or indirect holding of
property. Otherwise, if the company engages also in real estate
management, project development or similar activities, the participation
shall be treated as equity. Further, if the real estate company takes out
loans in order to leverage its investments in properties, the participation
should be treated as equity.
4.90 Investment in collective investment vehicles where the underlying includes
property will be considered in the section on investment funds below.
4.91 It would not be proportionate to explicitly test changes in the volatility of
property prices as part of the standard formula approach. However, these
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factors will be implicitly taken into account when considering the
calibration of the shock scenarios.
4.92 Where undertakings have property investments that consist of properties
for their own use, these would be regarded as office properties.
4.6.2. CEIOPS’ advice
Property risk
4.93 The capital charge for property risk Mktprop will be calculated as the result
of a pre-defined scenario(s).
4.94 The property shock is the immediate effect on the net asset value of a fall
in real estate benchmarks taking account of all the participant’s individual
direct and indirect exposures to property prices. The calibration of the
shocks will be considered in the forthcoming draft advice on calibration of
the market risk module.
4.95 As part of the calibration exercise, CEIOPS will investigate whether
distinctions between commercial, retail and other types of property is
possible. If this is the case it is possible that more than one scenario will
be defined for property risk.
4.96 Participations in real estate companies shall be treated as property, if they
only give rise to property risk. In any other case participations shall be
treated as equities and their risks considered accordingly in the equity risk
sub-module.
4.7 Concentration risk
4.7.1. Explanatory text
4.7.1.1 Scope of the module
4.97 The scope of the concentration risk sub-module extends to assets
considered in equity, interest rate, spread risk and property risk submodules
within the market risk module, and excludes assets covered by
the counterparty default risk module in order to avoid any overlap
between both elements of the standard calculation of the SCR.
4.98 An appropriate assessment of concentration risks needs to consider both
the direct and indirect exposures derived from the investments included in
the scope of this sub-module.
4.99 Regarding direct exposures, it is relevant to discriminate between at least
two cases:
a) those investments where the failure or default of the issuer is borne,
totally or partially, by the holder of the investment. This is the case of
equities and a large number of bonds. (Independent of the fact that
the risk described in this paragraph could be appropriately hedged);
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b) those investments where the failure or default of the issuer does not
imply any economic loss for the holder of the investment under any
scenario. This might be the case of some bonds or securitizations
(Mitigating tools are not relevant in this case, since the direct
exposure risk simply does not exist).
4.100 Regarding indirect exposures, two cases can be distinguished:
a) those investments where it is sensible and workable to apply a lookthrough
approach, or where there is no evidence that the indirect
exposures are reasonably well-diversified, and therefore for the sake
of prudence it is relevant to require a look-through approach. This
may be the case of instrumental holdings or hedge funds.
b) those investments where there is an evidence or legal guarantee that
indirect exposures are reasonably well-diversified, in such a manner
that it is possible to reach a certainty on the lack of materiality of
each individual indirect exposure.
4.101 Government bonds are exempted from the application of this module. The
exemption concerns borrowings by the national government, or
guaranteed by the national government, of an OECD or EEA state, issued
in the currency of the government.
4.102 Due to its frequent presence in undertakings’ investment portfolios, it may
be worthwhile to clarify the treatment of UCITs.
4.103 The UCITS Directive 85/611/EEC includes diversification requirements
regarding the issuers of the assets held by the UCITS. Article 22(1) of the
UCITS Directive stipulates that a UCITS may invest no more than: [...]
- 5% of its assets in transferable securities or money market
instruments issued by the same body, and
- 20% of its assets in deposits made with the same body.
4.104 There are several Member State options to relax these limits. For example,
the 5% limit may be raised to: [...]
- 10% (without further conditions);
- 35% for bodies which are states, local authorities and
certain public international bodies;
- 25% for credit institutions which are supervised in a certain
way;
- 35% if the UCITS tries to replicate an index and certain
conditions are fulfilled;
- 100% for bodies which are states, local authorities and
certain public international bodies if additional requirements
are met.
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4.105 Obviously, the diversification requirements in the UCITS Directive are not
sufficiently strict to exempt all UCITS from the concentration risk submodule.
However, for most UCITS the degree of concentration is known,
for example measured with the relative share of the largest exposure. This
allows setting up an exemption rule as contained in this advice.
4.106 The method proposed in this advice may be illustrated with a simple
example, where we assume the concentration threshold to be equal to
2%. The reference magnitude Assetsxl in the example is equal to 100. The
undertaking holds a UCITS investment with a market value of 20 (i.e.
quite a relevant investment). The UCITS is exempted from the
concentration sub-module if the share of no single investment of the
UCITS exceeds 2% · 100 / 20 = 10%.
4.107 This approach ensures that no single counterparty exposure of an
exempted UCITS exceeds the concentration threshold (CT). Compared to
applying a look-through approach to all UCITS, concentrations may be
missed if they are spread over several UCITS or spread over UCITS and
the remaining assets of the undertaking. Moreover, the definition of a
body in the UCITS Directive and the definition of the independent
counterparty in the concentration module may differ. It is difficult to
capture in a simple manner within the standard SCR calculation all these
more sophisticated or complex to identify types of concentration. In these
circumstances, the approach proposed below seems acceptable and
workable in order to maintain the balance between simplicity and
accuracy.
4.108 Considering its practical importance in some markets, this advice also
contains specific rules regarding mortgage covered bonds and public
sector covered bonds.
4.109 CEIOPS would like to hear stakeholders’ views on a preferred option for
the concentration threshold for mortgage covered bonds and public sector
covered bonds:
4.110 Threshold applicable shall be a 10 per cent (Option A) or 20 per cent
(Option B)10 when (under option A as well as under option B) all the
following requirements are met:
• the asset has a AAA credit quality
• the portfolio of mortgages backing the asset is diversified into a
sufficiently high number of borrowers
• there is no evidence of high correlation or connection among the
default of one or few borrowers
• the covered bond meets the requirements defined in Article 22(4) of
the UCITS directive 85/611/EEC
4.111 While QIS4 specifications considered some national exemptions, this
advice proposes specific thresholds for the assets referred in the previous
paragraph, thereby removing any national reference.
10 CEIOPS majority supports option A, i.e a concentration threshold of 10 per cent.
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4.112 Specific thresholds are considered to be a more economically consistent
solution than exemptions, since it cannot be ascertained that the
aforementioned assets are fully riskless, both from a default perspective,
from a look-through approach and from a managerial consideration.
Obviously the application of specific thresholds is subject to adequate
requirements, taking into account which categories of these instruments
have demonstrated to provide sufficient safety during the current crisis.
4.113 Another feature to consider in this advice refers to the treatment of assets
which are allocated to policies where the policyholders bear the investment
risk. To the extent that the risk in these assets is passed on to
policyholders, it lacks economic sense to consider those assets in the
calculations of this sub-module.
4.114 Financial derivatives on equity and defaultable bonds should be properly
attributed to the net exposure, i.e. an equity put option reduces the equity
exposure to the underlying ‘name’ and a single-name CDS (‘protection
bought’) reduces the fixed-income exposure to the underlying ‘name’. The
exposure to the default of the counterparty of the option or the CDS is not
treated in this module, but in the counterparty default risk module. Also,
collaterals securitising bonds should be taken into account. Similarly, a
look-through approach should be applied to assets representing
undertakings' funds withheld by counterparty.
4.115 Exposures via investment funds or such entities whose activity is mainly
the holding and management of an undertaking’s own investment need to
be considered on a look-through basis unless otherwise stated in this
advice. The same holds for CDO tranches and similar investments
embedded in ‘structured products’.
4.7.1.2 Design of the module
4.116 Market risk concentration in financial investments presents an additional
risk to an insurance or reinsurance undertaking because of:
• additional volatility that exists in concentrated asset portfolios; and
• the additional risk of partial or total permanent losses of value due
to the default of an issuer.
4.117 In the case of properties, the second bullet point above is not applicable.
Since for the sake of simplicity the calculations of this sub-module for
properties are those applicable to financial investments, the lack of
relevance of the second bullet point is reflected in the parameters
proposed for properties.
4.118 The model approach included in this advice is the same used in QIS3 and
QIS4, since it is simple to understand and captures the targeted risk in a
rather straightforward manner, which was confirmed in QIS4.
4.119 The approach is based on the setting of certain thresholds depending on
the credit quality of the exposure. For those exposures that are kept below
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the threshold there is no capital charge, while above it a capital
requirement is triggered.
4.120 All exposures to the same party are cumulated. Exposures of different
entities within the same group considered in the calculation of own funds
are taken jointly, in order to provide a fair reflection of the group risks,
whose importance has been demonstrated in the current crisis.
4.121 In particular, entities (regulated or not) which belong to the same group
as defined in Article 210 of the Level 1 text11 or to the same financial
conglomerate as defined in Article 2(14) of the Financial Conglomerate
Directive (2002/87/EC) should be treated as dependent exposures.
Consequently, the different legal entities of the group or financial
conglomerate considered in the calculation of own funds should be treated
as one exposure in the sub-module calculations and no diversification
effects between the entities are taken into account in the capital
requirement. Cross-sectoral developments on the treatment of intra-group
relations may be taken into account for further developing the notion of
dependency.
4.122 The process of calculation is simple. The bulk of the analysis lies in the
identification of all the exposures borne, directly or indirectly, explicit or
hidden, by the undertaking. Since this analysis and identification of the
exposures is necessary to achieve an appropriate risk management and to
allow for a risk-oriented SCR, the concentration risk sub-module uses as
input the results of other existing risk management actions.
4.123 As one of the lessons learnt from the crisis and as a reflection derived
from some comments of the industry on QIS4, the present advice
proposes a reduction of the thresholds of this sub-module. The crisis has
demonstrated that should QIS4 thresholds be used, the impact of failures
(such as for example Lehman Brothers), or downfalls of equities prices
(such as for example Fortis or AIG), would have had devastating
consequences.
4.124 Considering that on average own funds represent around 25 per cent of
total assets, setting a 5 per cent threshold referring to total assets, would
mean that an undertaking would be allowed to risk about 20 per cent of its
own funds with a single exposure, without imposing any capital
requirement for such concentration. The crisis has demonstrated the
inappropriateness of this allowance, not only with respect the worst credit
quality exposures, but even with respect to the best ones.
4.125 Therefore, this advice proposes using thresholds of 2 per cent in respect
AAA-AA-A rated exposures, which means on average not to require capital
up to 8 per cent of total own funds. For other rated and all non-rated
exposures, the proposed threshold is 1 per cent of total assets.
Furthermore, it is likely that the equity risk stress and the credit spread
risk factors will be calibrated based on well diversified indices. For
11 "Group" means a group of undertakings, which consists of a participating undertaking, its subsidiaries and the
entities in which the participating undertaking or its subsidiaries hold a participation, as well as undertakings
linked to each other by a relationship as set out in Article 12(1) of Directive 83/349/EEC.
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example, the MSCI World Index that was used to calibrate the equity
stress of the previous QIS exercises comprises about 1600 titles and the
largest constituent contributes about 2% to the total market capitalisation
of the index. Since the concentration risk charge is the mechanism for
correcting the assumption underlying the equity stress that the insurer
holds an equally well diversified portfolio, CEIOPS believes that the
proposed reduction in the thresholds is reasonable.
4.126 The calibration process and methodology have been adapted to give
appropriate allowance to this reduction.
4.127 In the case of properties, the thresholds proposed are higher in order to
take into account the different features mentioned at the beginning of this
section.
4.7.1.2 Calibration
4.128 The calibration of this sub-module is based on quite simple evidence: the
risk (volatility - VaR) of a badly diversified portfolio is higher than in the
case of a well-diversified basket of investments.
4.129 The calibration process, detailed in annex A to this advice, is based on the
comparison of the historical VaR of a well-diversified portfolio and the VaR
of a set of portfolios where the representativeness of a concrete exposure
is increased step by step by 1 per cent. In other words, the initially welldiversified
portfolio is progressively being transformed in a more and more
badly diversified portfolio, by increasing successively the importance of a
single concrete exposure.
4.130 In each step the initial VaR (well-diversified portfolio) is compared to the
VaRs of the progressively worsened portfolios, deriving a raw line charting
the 2-dimensional link between the increase in the level of concentration
of investments and the increase of VaR. Fitting a straightforward function
is the final step to deliver the parameters reflected in this advice.
4.131 The aforementioned process is repeated for each of the exposures of the
initially well- diversified portfolio, in order to derive specific parameters for
exposures with different credit quality.
4.132 This calibration process was applied in QIS3 and QIS4 without receiving
substantial comments. The current calibration has included the experience
of the current crisis till 30 April 2009.
4.7.2. CEIOPS’ advice
A. Assets covered by concentration risk sub-module
4.133 The concentration risk sub-module covers assets considered in equity,
interest rate, spread risk and property risk sub-modules within the market
risk module, to the extent that those assets are not covered by the
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elements of the standard calculation of the SCR.
4.134 The assessment of concentration risk needs to consider both the direct
exposures and the indirect exposures derived from the investments
considered in this sub-module.
4.135 Assets which are allocated to policies where the policyholders bear the
investment risk should be excluded from this risk module. However, as
these policies may have embedded options and guarantees, an adjustment
(calculated using a scenario-based approach) is added to the formula to
take into account the part of the risk effectively borne by the undertaking.
4.136 For the sake of simplicity and consistency, the definition of market risk
concentrations regarding financial investments is restricted to the risk
regarding the accumulation of exposures with the same counterparty. It
does not include other types of concentrations (e.g. geographical area,
industry sector, etc.).
4.137 Undertakings and supervisors shall verify that the SCR provides an
appropriate reflection of the risk profile of the undertaking. Should this not
be the case with respect to any type of concentration of assets or liabilities,
necessary actions shall be adopted in a relevant manner, i.e. via internal
models or through a capital add-on.
4.138 According to an economic approach, exposures which belong to the same
group as defined in Article 210 of the Level 1 text or to the same financial
conglomerate as defined in Article 2(14) of the Financial Conglomerate
Directive (2002/87/EC) should not be treated as independent exposures.
The legal entities of the group or the conglomerate considered in the
calculation of own funds should be treated as one exposure in the
calculation of the capital requirement.
4.139 Government bonds are exempted from the application of this module. The
exemption concerns borrowings by the national government, or guaranteed
by the national government, of an OECD or EEA state, issued in the
currency of the government.
4.140 Risks derived from concentration in cash held at a bank are captured in the
counterparty default risk module, while risks corresponding to
concentration in other bank assets shall be reflected in the concentration
risk sub-module (no-hole, no-overlap).
4.141 Furthermore, bank deposits considered in the concentration risk submodule
can be exempted to the extent their value is covered by a
government guarantee scheme in the EEA area, the guarantee is applicable
unconditionally to the undertaking and provided there is no double-counting
of such guarantee with any other element of the SCR calculation.
4.142 CEIOPS will produce an advice on participations and their treatment in the
solvency assessment of an undertaking at the end of October. Therefore,
this advice does not refer to participations. This exclusion does not mean
any position in advance regarding the treatment of participations in
concentration risk sub-module.
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4.143 In general, undertakings and supervisors should verify that the SCR
provides an appropriate reflection of the risk profile of the insurance or
reinsurance undertaking. Should this not be the case with respect to the
concentration of assets or liabilities, necessary action will need to be
adopted in a relevant manner, i.e. via internal models or through capital
add-ons.
B. Inputs required for financial concentration risk
4.144 Risk exposures in assets need to be grouped according to the
counterparties involved.
Ei = Net exposure at default to counterparty i
Assetsxl = Amount of total assets considered in this sub-module
according the paragraphs contained in this advice in the
item 'Assets covered by concentration risk sub-module'.
Government bonds should be included in this amount,
notwithstanding the exemption specified in 4.139.
ratingi = External rating of the counterparty i
4.145 Where an undertaking has more than one exposure to a counterparty then
Ei is the aggregate of those exposures at default. Ratingi should be a
weighted rating determined as the rating corresponding to a weighted
average credit quality step, calculated as:
Weighted average
credit quality step
= round (average of the credit quality steps
of the individual exposures to that
counterparty, weighted by the net exposure
at default in respect of that exposure to
that counterparty)
4.146 The net exposure at default to an individual counterparty i shall comprise
all assets contained in Section A of this advice (Assets covered by
concentration risk sub-module), including hybrid instruments, e.g. junior
debt, mezzanine CDO tranches ….
4.147 When calculating the net exposures, financial mitigation techniques shall be
considered in this sub-module except to the extent that they have already
been taken into account in other modules or sub-modules. They shall be
considered only when they meet the requirements set out for financial
mitigation techniques (see CEIOPS-CP-31-09,
http://www.ceiops.eu/media/files/consultations/consultationpapers/CP31/C
EIOPS-CP-31-09-Draft-L2-Advice-on-SCR-Standard-Formula-Allowance-of-
Financial-mitigation-techniques.pdf).
4.148 Financial derivatives on equity and defaultable bonds should be properly
attributed to the net exposure, i.e. an equity put option reduces the equity
exposure to the underlying ‘name’ and a single-name CDS (‘protection
bought’) reduces the fixed-income exposure to the underlying ‘name’. The
exposure to the default of the counterparty of the option or the CDS is not
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collaterals securitising bonds should be taken into account. Similarly, a
look-through approach should be applied to assets representing
undertakings' funds withheld by a counterparty.
4.149 Exposures via investment funds or such entities whose activity is mainly
the holding and management of an undertaking’s own investment need to
be considered on a look-through basis unless otherwise stated in this
advice. The same holds for CDO tranches and similar investments
embedded in ‘structured products’.
C. Output
4.150 The module delivers the following outputs:
Mktconc = Total capital charge concentration risk sub-module
Mktconc_financial = Capital charge for financial concentration risk
Mktconc_properties = Capital charge for properties concentration risk
D. Calculation
4.151 The calculation is performed in three steps: (a) excess exposure, (b) risk
concentration charge per ‘name’, (c) aggregation.
4.152 The excess exposure is calculated as:
⎭ ⎬ ⎫
⎩ ⎨ ⎧
= − CT
Assets
E
XS
xl
i
i max 0; ,
where the concentration threshold CT, depending on the rating of
counterparty i, is set as follows:
ratingi Concentration
threshold (CT)
AA-AAA 2%
A 2%
BBB 1%
BB or lower 1%
4.153 The risk concentration charge per ‘name’ i is calculated as:
Conci = Assetsxl • XSi • gi + ΔLiabul
where XSi is expressed with reference to the unit (i.e. an excess of exposure i
above the threshold of 8%, delivers XSi = 0.08) and the parameter g ,
depending on the credit rating of the counterparty, is determined as follows:
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ratingi Credit Quality Step gi
AAA
AA
1 0.12
A 2 0.21
BBB 3 0.27
BB or lower,
unrated
4 – 6, - 0.73
and where
4.154 ΔLiabul means the overall impact on the liability side for policies where the
policyholders bear the investment risk with embedded options and
guarantees of the stressed scenario, with a minimum value of 0 (sign
convention: positive sign means losses). The stressed scenario is defined as
a drop in value on the assets for counterparty i used as the reference to the
valuation of the liabilities by XSi * gi.
For “names” which can only be found on the assets used as the reference to
the valuation of the liabilities, the risk concentration charge per name ‘i’ is
calculated as follows: Conci = ΔLiabul,i
4.155 The financial concentration risk capital requirement is calculated as
Mktconc = Mktconc - ΔLiabfuture profits
4.156 ΔLiabfuture profits = the overall impact on technical provisions with future profit
features of this sub-module, provided the undertaking is able to assess
such impact with the same requirements applied to the calculation of best
estimate values, and preventing that double counting of this effect is
allowed with other sub-modules or modules.
4.157 This capital charge is calculated for financial concentration risk under the
condition that the assumptions on future bonus rates (reflected in the
valuation of future discretionary benefits in technical provisions) remain
unchanged before and after a presumed change in volatility and/or default
level of concentrated assets.
4.158 Additionally, the result of the calculation should be determined under the
condition that the participant is able to vary its assumptions in future bonus
rates in response to the shock being tested. If this calculation is not feasible
in a reliable manner, the capital requirement for financial concentration risk
shall be the obtained according the previous paragraph.
4.159 The capital requirement for financial concentration risk is determined
assuming a correlation of 0.25 among the requirements for each
counterparty i.
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Mkt Conc Conc Conc for j i
i j
conc i i j ≠ ⎟
⎟⎠
⎞
⎜ ⎜⎝
⎛
= Σ 2 +Σ0.25∗ ∗ ,
E. Special reference to UCITS
4.160 Investments in a single UCITS i are exempted from the concentration risk
sub-module if the maximum share of the UCITS assets which are invested
in a single body does not exceed
UCITS i
xl
UCITS i MW
Assets
CT CT
,
, = ⋅ ,
where
CTUCITS,i = concentration threshold for UCITS i
MWUCITS,i = market value of the undertaking’s investment in UCITS i
CT = concentration threshold of the sub-module
Assetsxl = comparative measure of the sub-module
4.161 Whether the UCITS is sufficiently diversified to meet this criterion, may for
example be determined
• from the composition of the UCITS’ assets at the valuation date (e.g
from list of top holdings),
• if the UCITS’ investment policy is to replicate a certain index, from the
composition of the index or
• from the diversification requirements for UCITS of the Member State
that the UCITS is situated in.
4.162 A look-through approach should be applied to all UCITS which are not
exempted from the sub-module.
F. Special reference to mortgage covered bonds and public sector covered
bonds
4.163 In order to provide mortgage covered bonds and public sector covered
bonds with a treatment in concentration risk sub-module according their
specific risk features, the threshold applicable shall be a 10 per cent
(Option A) or 20 per cent (Option B).12
when (under option A as well as under option B) all the following
requirements are met:
• the asset has a AAA credit quality
• the portfolio of mortgages backing the asset is diversified into a
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sufficiently high number of borrowers
• there is no evidence of high correlation or connection among the
default of one or few borrowers
• the covered bond meets the requirements defined in Article 22(4) of
the UCITS directive 85/611/EEC
G. Concentration risk capital in case of properties
4.164 Undertakings shall identify the exposures in a single property higher than
10 per cent of ‘total assets’ considered in this sub-module according to
contained in Section A of this advice (Assets covered by concentration risk
sub-module). Government bonds should be included in this amount,
notwithstanding the exemption specified in 4.139.
4.165 For this purpose the undertaking shall take into account both properties
directly owned and those indirectly owned (i.e. funds of properties), and
both ownership and any other real exposure (mortgages or any other legal
right regarding properties).
4.166 Properties located in the same building or sufficiently nearby shall be
considered a single property.
4.167 This capital charge is calculated for properties concentration risk under the
condition that the assumptions on future bonus rates (reflected in the
valuation of future discretionary benefits in technical provisions) remain
unchanged before and after a presumed change in volatility and/or default
level of concentrated assets.
4.168 Additionally, the result of the calculation should be determined under the
condition that the participant is able to vary its assumptions in future bonus
rates in response to the shock being tested. If this calculation is not feasible
in a reliable manner, the capital requirement for financial concentration risk
shall be the obtained according the previous paragraph.
4.169 Exposures exceeding the threshold shall deliver a capital requirement
calculated applying the formula reflected in this sub-module for financial
investments rated as AA. Capital requirements for different properties shall
be aggregated assuming a correlation factor 0 between the requirements
for each property.
= Σ
i
conc i Mkt Conc2 .
H. Aggregation of capital requirements reflecting financial and properties
concentration risks
4.170 Capital requirements for financial investments and properties shall be
added using the same correlation applied to sub-modules regarding
properties and equity risk.
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4.8 Treatment of investment funds
4.8.1. Explanatory text
4.171 Respondents to the QIS4 exercise suggested it would be helpful to have
greater clarity as to the treatment of collective investment vehicles, and
other investments packaged as funds, in the market risk module.
4.172 In order to properly assess the market risk inherent in these instruments,
it will be necessary to examine their economic substance. Wherever
possible, this should be achieved by applying a look-through approach in
order to assess the risks applying to the assets underlying the investment
vehicle. Each of the underlying assets would then be subjected to the
relevant sub-module stresses and capital charges calculated accordingly.
4.173 The same look-through approach shall also be applied for other indirect
exposures.
4.174 Where a number of iterations of the look-through approach is required
(e.g. where an investment fund is invested in other investment funds), the
number of iterations shall be sufficient to ensure that all material market
risk is captured.
4.175 Other case where it is impractical or disproportionate to apply a full lookthrough
approach shall be considered in CEIOPS’ advice on simplifications
(CEIOPS-CP-45-09, http://www.ceiops.eu/content/view/14/18/).
4.176 The above recommendations can be applied to both passive and actively
managed funds.
4.8.2. CEIOPS’ advice

First article

2009-07-04T02:03:00.000-07:00

3.1.1. Explanatory text
Design and structure
3.1. A number of the life underwriting risk stresses are based on a delta-
NAV (change in value of assets minus liabilities) approach. The
change in net asset value should be based on a balance sheet that
does not include the risk margin of the technical provisions. This
approach is based on the assumption that the risk margin does not
change materially under the scenario stress. This simplification is
made to avoid a circular definition of the SCR since the size of the risk
margin depends on the SCR.
3.2. Furthermore, where a delta-NAV approach is used, the revaluation of
technical provisions should allow for any relevant adverse changes in
option take-up behaviour of policyholders in this scenario.
Calibration
3.3. The calibration of the life underwriting parameters should capture
changes in the level, trend and volatility of the parameter. However,
for QIS 3, it was decided to reduce the complexity of the design of
the underwriting risk module by maintaining the level and trend risk
components only. It is assumed that the volatility risk component is
implicitly covered by the level, trend and catastrophe risk
components. This is considered to be acceptable since, for QIS2, the
volatility risk proved to be considerably lower than the trend risk.
CEIOPS therefore proposes to retain this approach.
3.1.2. CEIOPS’ advice
General considerations
3.4. The change in net asset value shall be based on a balance sheet that does
not include the risk margin of the technical provisions.
3.5. The revaluation should allow for any relevant adverse changes in option
take-up behaviour of policyholders in this scenario.
3.6. The calibration of the life underwriting parameters shall capture changes in
the level and trend of the parameters only. It is assumed that the volatility
risk component is implicitly covered by the level, trend and catastrophe
risk components.
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3.2 Mortality risk
3.2.1. Explanatory text
Introduction
3.7. Mortality risk is associated with (re)insurance obligations (such as term
assurance or endowment policies) where a (re)insurance undertaking
guarantees to make a single or recurring series of payments in the event
of the death of the policyholder during the policy term.
3.8. It is applicable for (re)insurance obligations contingent on mortality risk
i.e. where the amount currently payable on death exceeds the technical
provisions held and, as a result, an increase in mortality rates is likely to
lead to an increase in the technical provisions.
3.9. The capital charge for mortality risk is intended to reflect the uncertainty
in mortality parameters as a result of changes in the level, trend and
volatility of mortality rates and capture the risk that more policyholders
than anticipated die during the policy term.
3.10. This risk is normally captured by increasing the mortality rates either by a
fixed amount or by a proportion of the base mortality rates. The
calibration (of the increase) should capture the impact of each of the
above factors (level, trend and volatility).
Mortality risk in QIS4
3.11. The QIS4 approach to the SCR standard formula included a mortality risk
sub-module in the life underwriting risk module (section TS.XI.B of the
QIS4 Technical Specifications (MARKT/2505/08)). The calculation of the
capital requirement for mortality risk was a scenario based stress. The
scenario tested was a permanent 10% increase in mortality rates.
3.12. QIS4 feedback from several Member States suggested that a gradual
change to inception rates and trends would be more appropriate than a
one-off shock for biometric risks.
3.13. QIS4 feedback on the calibration of the mortality stress was varied. Some
undertaking felt that the calibration was too strong and without sufficient
granularity whereas other undertakings thought that the calibration was
below the 99.5th percentile.
3.14. QIS4 also tested alternative approaches for dealing with (re)insurance
obligations which provide benefits on both death and survival. The first
option proposed that where the death and survival benefits are contingent
on the life of the same insured person(s), the obligation should not be
unbundled. Under the second option, all contracts were unbundled into
two separate components: one contingent on the death and other
contingent on the survival of the insured person(s). Only the former
component was taken into account for the application of the mortality
scenario.
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3.15. Feedback from QIS4 indicated that the vast majority of (re)insurance
undertakings chose not to unbundle the obligations (option one). The
practical difficulty in unbundling obligations was cited as the main reason
for choosing this option. Undertakings in one Member State also noted
that this (option one) was consistent with IFRS classifications. Where
supervisors offered views, they generally agreed with undertakings.
However one Member State argued that more analysis would be
necessary before deciding on the most appropriate option.
Calculation of the capital requirement
3.16. QIS4 participants suggested that a gradual change to inception rates and
trends would be more appropriate than a one-off shock for biometric
risks. However CEIOPS has considered this proposal (see in particular
discussion under longevity risk below) and has concluded that a one-off
shock is more appropriate in the context of the standard formula.
3.17. The capital requirement should therefore be calculated as the change in
net asset value (assets minus liabilities) following a permanent increase
in mortality rates of x%.
Calibration of mortality stress
3.18. The basis for the QIS4 calibration of the mortality risk stress is described
in the CEIOPS paper “QIS3 Calibration of underwriting risk, market risk
and MCR”. This paper is available from the CEIOPS website3.
3.19. As mentioned above, QIS4 feedback on the calibration of the mortality
stress was varied. However an analysis of the mortality stress parameters
provided by firms using internal models indicated that the standard
formula parameter was relatively low. Based on a sample size of 21
internal model, the median stress was 22%, with an inter quartile range
of 13% to 29%. This is significantly higher than the standard formula
calibration of 10%.
3.20. CEIOPS therefore proposes to amend the calibration of the mortality
stress to a permanent increase in mortality rates of 15%.
Unbundling of (re)insurance obligations
3.21. Where (re)insurance obligations provide benefits both in case of death
and survival and the death and survival benefits are contingent on the life
of the same insured person(s), these obligations should not be
unbundled. For these contracts the mortality scenario should be applied
fully allowing for the netting effect provided by the ‘natural’ hedge
between the death benefits component and the survival benefits
component (note that a floor of zero applies at the level of contract if the
net result of the scenario is favourable to the (re)insurer).
3.22. Where model points are used for the purposes of calculating the technical
provisions and the grouping of the data captures appropriately the
mortality risk of the portfolio, each model points can be considered to
3 http://www.ceiops.eu/media/files/consultations/QIS/QIS3/QIS3CalibrationPapers.pdf
9/51
represent a single insured person for the purposes of applying the above
advice.
3.2.2. CEIOPS’ advice
Mortality risk
3.23. The mortality risk sub-module is applicable for (re)insurance obligations
contingent on mortality risk i.e. where the amount currently payable on
death exceeds the technical provisions held and, as a result, an increase in
mortality rates leads to an increase in the technical provisions.
3.24. The calculation of the capital requirement for mortality risk shall be a
scenario based stress.
3.25. The capital requirement shall be calculated as the change in net asset
value (assets minus liabilities) following a permanent increase in mortality
rates of 15%.
3.46. Where (re)insurance obligations provide benefits both in case of death and
survival and the death and survival benefits are contingent on the life of
the same insured person(s), these obligations should not be unbundled.
For these contracts the mortality scenario should be applied fully allowing
for the netting effect provided by the ‘natural’ hedge between the death
benefits component and the survival benefits component (note that a floor
of zero applies at the level of contract if the net result of the scenario is
favourable to the (re)insurer).
3.47. Where model points are used for the purposes of calculating the technical
provisions and the grouping of the data captures appropriately the
mortality risk of the portfolio, each model points can be considered to
represent a single insured person for the purposes of applying the above
advice.
3.3. Longevity risk
3.3.1. Explanatory text
Introduction
3.26. Longevity risk is associated with (re)insurance obligations (such as
annuities) where a (re)insurance undertaking guarantees to make
recurring series of payments until the death of the policyholder and where
a decrease in mortality rates leads to an increase in the technical
provisions, or with (re)insurance obligations (such as pure endowments)
where a (re)insurance undertaking guarantees to make a single payment
in the event of the survival of the policyholder for the duration of the
policy term.
3.27. It is applicable for (re)insurance obligations contingent on longevity risk
i.e. where there is no death benefit or the amount currently payable on
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death is less than the technical provisions held and, as a result, a decrease
in mortality rates is likely to lead to an increase in the technical provisions.
3.28. The risk that a policyholder lives longer than anticipated is longevity risk.
Longevity risk is particularly significant as a result of an increasing life
expectancy among policyholders in most developed countries.
3.29. The capital charge for longevity risk is intended to reflect the uncertainty
in mortality parameters as a result of changes in the level, trend and
volatility of mortality rates and capture the risk of policyholders living
longer than anticipated.
3.30. This risk may be captured in a number of different ways: a simple
approach of a reduction in base mortality rates, a more realistic approach
of using improvement factors which leads to a two dimensional mortality
table, or a combination of these two approaches. In any event, the
calibration (of the increase) should capture the impact of each of the
above factors (level, trend and volatility).
Longevity risk in QIS4
3.31. The QIS4 approach to the SCR standard formula included a longevity risk
sub-module in the life underwriting risk module (section TS.XI.C of the
QIS4 Technical Specifications (MARKT/2505/08)). The calculation of the
capital requirement for longevity risk was a scenario based stress. The
scenario tested was a permanent 25% decrease in mortality rates.
3.32. QIS4 feedback from several Member States suggested that a gradual
change to inception rates and trends would be more appropriate than a
one-off shock for biometric risks.
3.33. With regard to the calibration of the longevity stress, several undertakings
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. An improvement of x% per
annum (over base mortality) was suggested as an alternative by one
respondent.
3.34. Some undertakings felt the longevity shock was too conservative.
Calculation of the capital requirement
3.35. QIS4 participants suggested that a gradual change to inception rates and
trends would be more appropriate than a one-off shock for biometric risks.
For example, one respondent suggested that an improvement of x% per
annum (over base mortality) could be used as an alternative.
3.36. Subsequent to QIS4, an analysis by UNESPA proposed an alternative
structure to the longevity shock which depended on age and duration.
3.37. CEIOPS has considered the above mentioned proposals but has concluded
that a one-off shock to longevity is more appropriate for the purposes of
the standard formula for the following reasons:
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• It is more straightforward to apply
• With respect to differentiating by duration, CEIOPS’ investigations (see
Appendix B to this paper) indicate that shocks for different durations
are small and are not monotone.
• With respect to differentiating by age, portfolios of (re)insurance
obligations for which longevity risk is applicable are generally heavily
weighted in favour of older age groups.
• We do not believe that there is sufficient reliable data to calibrate at a
more granular level
3.38. The capital requirement should therefore be calculated as the change in
net asset value (assets minus liabilities) following a permanent decrease in
mortality rates of x%.
Calibration of longevity stress
3.39. The basis for the QIS4 calibration of the longevity risk stress is described
in the CEIOPS paper “QIS3 Calibration of underwriting risk, market risk
and MCR”.4
3.40. Subsequent to QIS4, an investigation has been carried out by the Polish
FSA which analysed the mortality data for nine countries indicated based
both on historic improvements and a stochastic model of future mortality
improvements.
3.41. The results of this analysis indicated that, on average (across the nine
countries for which data was analysed), historic improvements in mortality
rates over 15 years from 1992 to 2006 were higher than 25%. Although
the results of the stochastic model of future mortality improvements may
imply a lower stress, CEIOPS has attached more weight to the analysis of
historic improvements because of the significant uncertainty inherent in
modelling mortality.
3.42. Furthermore feedback from internal model firms as part of QIS4 indicates
that the median stress was 25%.
3.43. CEIOPS therefore proposes to maintain the QIS4 calibration of the
longevity risk stress i.e. the stress shall be based on a permanent 25%
decrease in mortality rates.
Unbundling of (re)insurance obligations
3.44. Where (re)insurance obligations provide benefits both in case of death and
survival and the death and survival benefits are contingent on the life of
the same insured person(s), these obligations should not be unbundled.
For these contracts the longevity scenario should be applied fully allowing
for the netting effect provided by the ‘natural’ hedge between the death
benefits component and the survival benefits component (note that a floor
4 http://www.ceiops.eu/media/files/consultations/QIS/QIS3/QIS3CalibrationPapers.pdf
12/51
of zero applies at the level of contract if the net result of the scenario is
favourable to the (re)insurer).
3.45. Where model points are used for the purposes of calculating the technical
provisions and the grouping of the data captures appropriately the
longevity risk of the portfolio, each model points can be considered to
represent a single insured person for the purposes of applying the above
advice.
3.3.2. CEIOPS’ advice
Longevity risk
3.48. The longevity risk sub-module is applicable for (re)insurance obligations
contingent on longevity risk i.e. i.e. where there is no death benefit or the
amount currently payable on death is less than the technical provisions
held and, as a result, a decrease in mortality rates is likely to lead to an
increase in the technical provisions.
3.49. The calculation of the capital requirement for longevity risk shall be a
scenario based stress.
3.50. The capital requirement shall be calculated as the change in net asset
value (assets minus liabilities) following a permanent decrease in mortality
rates of 25%.
3.51. Where (re)insurance obligations provide benefits both in case of death and
survival and the death and survival benefits are contingent on the life of
the same insured person(s), these obligations should not be unbundled.
For these contracts the longevity scenario should be applied fully allowing
for the netting effect provided by the ‘natural’ hedge between the death
benefits component and the survival benefits component (note that a floor
of zero applies at the level of contract if the net result of the scenario is
favourable to the (re)insurer).
3.52. Where model points are used for the purposes of calculating the technical
provisions and the grouping of the data captures appropriately the
longevity risk of the portfolio, each model points can be considered to
represent a single insured person for the purposes of applying the above
advice.
3.4. Disability-morbidity risk
3.4.1. Explanatory text
Introduction
3.51. Morbidity or disability risk is associated with all types of insurance
compensating or reimbursing losses (e.g. loss of income) caused by
illness, accident or disability (income insurance), or medical expenses due
to illness, accident or disability (medical insurance).
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3.52. It is applicable for (re)insurance obligations contingent on a definition of
disability. However CEIOPS expects that the majority of (re)insurance
obligations for which disability-morbidity risk is applicable will be covered
by the health module rather than by the life underwriting module. This
sub-module of the life underwriting risk module is therefore likely to be
applicable only in cases where contracts cannot be unbundled.
3.53. The capital charge for morbidity or disability risk is intended to reflect the
uncertainty in morbidity and disability parameters as a result of changes in
the level, trend and volatility of disability, sickness and morbidity rates
and capture the risk that more policyholders than anticipated are
diagnosed with the diseases covered or are or unable to work as a result
of sickness or disability during the policy term.
3.54. The (re)insurance obligations may be structured such that, upon the
diagnosis of a disease or the policyholder being unable to work as a result
of sickness or disability, recurring payments are triggered. These
payments may continue until the expiry of some defined period of time or
until either the recovery or death of the policyholder. In the latter case,
the (re)insurance undertaking is also exposed to the risk that the
policyholders receives the payments for longer than anticipated i.e. that
claim termination rates are lower than anticipated (recovery risk).
3.55. Morbidity and disability risk is normally captured by increasing the claim
inception rate either by a fixed amount or by a proportion of the base
inception rates and, where applicable, reducing the claim termination
rates. The calibration (of the increase) should capture the impact of each
of the above factors (level, trend and volatility).
Morbidity and disability risk in QIS4
3.56. The QIS4 approach to the SCR standard formula included a morbidity and
disability risk sub-module in the life underwriting risk module (section
TS.XI.B of the QIS4 Technical Specifications (MARKT/2505/08)). The
calculation of the capital requirement for morbidity and disability risk was
a scenario based stress. The scenario tested was an increase of 35% to
“disability rates” for the first year followed by a 25% increase in “disability
rates” for all subsequent years.
3.57. An alternative scenario was also proposed by the UK under which the
capital charges for critical illness, income protection and long term care
obligations were calculated separately and there was an additional capital
charge in respect of recovery risk.
3.58. There were a number of comments from QIS4 participants on the general
methodology of the morbidity and disability stress:
• One respondent argued that recovery rates should be taken into
account.
• There was some confusion over the treatment of disability in terms of
catastrophe risk.
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• Support for the UK alternative approach was noted by one Member
State.
3.59. With respect to the calibration of the morbidity and disability stress, some
(re)insurance undertakings commented that the calibration was too
strong.
Calculation of the capital requirement
3.60. As described above, there are two aspects to morbidity/disability risk:
• The risk that the number of claims are greater than anticipated
• The risk that the duration of the claim is higher than anticipated
The second risk is only applicable for (re)insurance obligations where
benefits consist of recurring payments which continue until either the
recovery or death of the policyholder.
3.61. Therefore the capital requirement should be calculated as:
• The change in net asset value (assets minus liabilities) following an
increase of x1% in morbidity/disability inception rates for the first year
followed by an increase of x2% in morbidity/disability inception rates
for all subsequent years.
• Plus, where applicable, the change in net asset value (assets minus
liabilities) following a permanent decrease of y% in morbidity/disability
recovery rates
Calibration of morbidity and disability stress
3.62. The basis for the QIS4 calibration of the morbidity-disability risk stress is
described in the CEIOPS paper “QIS3 Calibration of underwriting risk,
market risk and MCR”. This paper is available from the CEIOPS website.
3.63. Subsequent to QIS4, an investigation by the Swedish FSA indicated that
an increase of 50% in morbidity/disability inception rates for the first year
would be more appropriate.
3.64. This investigation also suggested that the appropriate calibration of the
decrease in morbidity/disability recovery rates was 20%.
3.65. The results of the investigation by the Swedish FSA are explained further
in Appendix A.
3.66. In addition, the UK Actuarial Profession Healthcare Reserving Working
Party has undertaken a survey which investigated the levels of 1 in 200
year morbidity stresses used by the major UK life insurance firms.5
3.67. The range of stress used by the major UK life insurers for income
protection business averaged 27% for inception rates and 15% for
5 http://www.actuaries.org.uk/__data/assets/pdf_file/0006/136707/reserving_survey.pdf
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termination rates. For critical illness, morbidity margins, intended to
represent a 99.5% confidence over 1 year, averaged around 40%.
3.68. Furthermore, on average, the average morbidity margins for statutory
reserving for critical illness and income protection (both inceptions and
terminations) were about 20%. The margins in a statutory reserving basis
are partly to allow for adverse deviations of the inception and termination
rates used in the pricing. As such, a 1 in 200 stress should be at least
greater than these margins as these margins are not normally set at the
same level as a 1 in 200 year scenario.
3.69. Looking at the results of this survey in conjunction with the results of the
investigation by the Swedish FSA, we would propose the following
calibration of the disability-morbidity stress:
• The change in net asset value (assets minus liabilities) following an
increase of 50% in morbidity/disability inception rates for the first year
followed by an increase of 25% in morbidity/disability inception rates
for all subsequent years.
• Plus, where applicable, the change in net asset value (assets minus
liabilities) following a permanent decrease of 20% in
morbidity/disability recovery rates. This should be applied together
with the above increase in inception rates i.e. it is a combined stress.
3.4.2. CEIOPS’ advice
Morbidity-disability risk
3.70. The morbidity-disability risk sub-module is applicable for (re)insurance
obligations contingent on a definition of disability.
3.71. The calculation of the capital requirement for disability risk shall be a
scenario based stress.
3.72. The capital requirement shall be calculated as the change in net asset
value (assets minus liabilities) following:
• An increase of 50% in morbidity/disability inception rates for the
first year followed by an increase of 25% in morbidity/disability
inception rates for all subsequent years.
• Plus, where applicable, a permanent decrease of 20% in
morbidity/disability recovery rates.
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3.5 Life expense risk
3.5.1. Explanatory text
Introduction
3.73. Expense risk arises from the variation in the expenses incurred in servicing
insurance or reinsurance contracts.
3.74. It is likely to be applicable for all (re)insurance obligations.
3.75. The capital charge for expense risk is intended to reflect the uncertainty in
expense parameters as a result of changes in the level, trend or volatility
the expenses incurred.
3.76. This risk is normally captured by increasing expected future expenses by a
fixed proportion, increasing expected future expense inflation or a
combination of both.
Expense risk in QIS4
3.77. The QIS4 approach to the SCR standard formula included an expense risk
sub-module in the life underwriting risk module (section TS.XI.F of the
QIS4 Technical Specifications (MARKT/2505/08)). The calculation of the
capital requirement for expense risk was a scenario based stress. The
scenario tested was:
• An increase of 10% in future expenses compared to best estimate
anticipations,
• An increase of 1% per annum of the expense inflation rate compared
to anticipations
For policies with adjustable loadings6, 75% of these additional expenses
can be recovered from year 2 onwards by increasing the charges payable
by policyholders.
3.78. There was a range of opinions with regard to the calibration of the
expense risk as a result of which no useful conclusion could be drawn.
Calculation of the capital requirement
3.79. QIS4 participants did not raise any significant issues with the design and
structure of this module and CEIOPS has therefore concluded that the
approach adopted in QIS4 is appropriate.
3.80. The capital requirement should therefore be calculated as the change in
net asset value (assets minus liabilities) following:
6 Policies with adjustable loadings are those for which expense loadings or charges may be adjusted within the next
12 months.
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• An increase of x% in future expenses compared to best estimate
anticipations,
• An increase of y% per annum of the expense inflation rate compared
to anticipations
3.81. However CEIOPS does not intend to retain the specific reference to policies
with adjustable loadings. This is because any future change to charges
payable by policyholders is, in essence, a management action and should
thus be considered in light of CEIOPS’ advice on management actions
rather than specified by CEIOPS.
Calibration of expense stress
3.82. The basis for the QIS4 calibration of the expense risk stress is described in
the CEIOPS paper “QIS3 Calibration of underwriting risk, market risk and
MCR”. This paper is available from the CEIOPS website.
3.83. As mentioned above, QIS4 feedback on the calibration of the expense
stress was varied. However the expense risk capital charge from the
internal model tended to be, for many undertakings, in line with the
standard formula. The median ratio was equal to 100% and the inter
quartile range was 85% to 166%.
3.84. CEIOPS therefore proposes to maintain the QIS4 calibration of the
expense risk stress i.e. the stress shall be based on:
• An increase of 10% in future expenses compared to best estimate
anticipations,
• An increase of 1% per annum of the expense inflation rate compared
to anticipations