12 Solvency (2)

Question 1

What are the three components of assets in the Solvency 2 balance sheet? (3)

Answer 1

1. Investments (equities, bonds, property).
2. Reinsurance recoveries.
3. Participations (companies in which the insurance company owns at least 20% of the voting rights).

Question 2

What are the factors to consider when valuing assets under Solvency 2? (6)

Answer 2

1. Use market values if available.
2. If MVs not available, market-consistent mark-to-model techniques can be used.
3. Use the “prudent person principle” for non-linked assets. Only make investment decisions that a prudent person would make.
4. Reinsurance recoveries are shown as an asset on the balance sheet rather than a reduction in gross liabilities.
5. Reinsurance recoveries should be adjusted to allow for the best estimate of expected losses due to default of the reinsurer.
6. Use a market-consistent approach when valuing participations in other companies within a group.

Question 3

What are the factors to consider when calculating technical provisions? (3)

Answer 3

1. TPs = BEL + Risk Margin.
2. They should represent the amount that the insurance company would have to pay to transfer the liability to another insurance company.
3. Segment the calculations by homogeneous product type (i.e. group the model points appropriately).

Question 4

What are the factors to consider regarding the calculation method for best estimate liabilities? (7)

Answer 4

1. BEL = PV of expected future cashflows discounted using a risk-free yield curve.
2. Grouped model points may be used if these can be validated for accuracy.
3. For unit linked business, the BEL must be calculated separately for the unit and non-unit components.
4. The BEL for the non-unit part can be negative.
5. Discretionary benefits for with profit business must be allowed for, and the guaranteed and non-guaranteed parts must be valued separately.
6. Options and guarantees should be valued using a stochastic model, unless a deterministic “closed form” approach is deemed appropriate on the grounds of materiality.
7. The calculations for with profit BEL should reflect realistic management actions (dynamic bonus rates, EBRs and charges, consistent with PPFM).
8. The with profit BEL should not include distribution of the inherited estate or the value of shareholder transfers in respect of future bonuses.

Question 5

What are the factors to consider regarding the assumptions used (other than the yield curve) for calculating for best estimate liabilities? (7)

Answer 5

1. All assumptions best estimate, no prudential margins.
2. Allowance should be made for all expected decrements and policyholder actions, including lapses.
3. All relevant available data must be used.
4. Future premiums can be taken into account up to the “contract boundary”, defined as the point at which the company can unilaterally terminate the contract or change the premiums. Normally means the maturity date.
5. Investment returns should be projected on a market consistent basis, and consistent with the EIOPA risk free yield curves.
6. Future expenses must be allowed for - both overheads and direct costs.
7. Inflation must be allowed for in the expense basis.
8. No closure reserve is required.

Question 6

What are the factors to consider regarding determination of the discount rates to be used for calculating the best estimate liabilities? (7)

Answer 6

1. A prescribed risk free yield curve is used, published monthly by EIOPA.
2. The calculation is based on a stated methodology so as to be replicable.
3. Yield curves published for each of the key currencies in the EU.
4. Based on swap rates, or on government bond yields where swap rates are not available, adjusted to reflect credit risk for the bonds.
5. For the UK, the rates are based on LIBOR swap rates with a credit risk adjustment.
6. A matching adjustment (addition to discount rate) is allowed where the insurer has long term predictable liabilities and can hold matching assets to maturity.
7. A volatility adjustment is allowed for liabilities not eligible for a matching adjustment.

Question 7

What are the factors to consider when calculating the Risk Margin for Solvency 2 technical provisions? (6)

Answer 7

1. The risk margin is intended to increase the technical provision to the amount that would have to be paid to another insurance company in order for them to take on the BEL.
2. It represents the theoretical compensation for the risk of future experience being worse than the best estimate assumptions and for the cost of holding regulatory capital against this.
3. A “cost of capital” calculation method is used, based on the cost of holding capital to support the risks that CANNOT BE HEDGED. These include insurance risk, reinsurance risk, operational risk and residual market risk.
4. The risk margin must be disclosed separately for each line of business.
5. The overall risk margin can be reduced to allow for diversification between lines of business up to legal entity level.
6. The allocation of diversification benefit can be approximated by apportioning the total diversified risk margin across lines of business in proportion to the SCR calculated on a stand-alone basis for each line.

Question 8

What are the factors to consider when calculating the Solvency Capital Requirement (SCR) for Solvency 2? (7)

Answer 8

1. The SCR is a value-at-risk measure based on a 99.5% confidence interval of the variation over one year of the amount of “basic own funds”.
2. There is a prescribed list of risk groups that the SCR has to cover.
3. A Standard Formula or Internal Model approach may be used.
4. The Standard Formula approach uses prescribed stress tests which are aggregated using prescribed correlation matrices.
5. Use of an Internal Model must be approved by the regulatory authority and must meet a number of standards.
6. A combination of the Standard Formula and Internal Model approaches may be used, referred to as a Partial Internal Model.
7. Simplifications can be applied, provided they are proportionate to the nature, scale and complexity of the risks.

Question 9

What are the risk groups that the SCR must cover? (6)

Answer 9

1. Non-life underwriting risk.
2. Life underwriting risk.
3. Health underwriting risk.
4. Market risk.
5. Counter-party default risk.
6. Operational risk.

Question 10

What are the Standard Formula risk sub-modules for life assurance business? (7)

Answer 10

1. Mortality risk
2. Longevity risk
3. Disability / Morbidity risk
4. Lapse risk
5. Expense risk
6. Revision risk
7. Catastrophe risk (e.g. pandemic)

Question 11

What are the prescribed risk sub-modules within the market risk module of the SCR Standard Formula?. (6)

Answer 11

1. Equity
2. Property
3. Interest Rate
4. Credit Spread
5. Currency
6. Concentration

Question 12

Describe the Standard Formula calculation of the SCR. (7)

Answer 12

1. An SCR is calculated separately for each sub-module and module using prescribed stresses.
2. The SCR for each stress is calculated as the difference between the net asset values in the stressed and unstressed balance sheets.
3. The SCRs are then aggregated across the various risks using a specified correlation matrix.
4. The SCRs for each risk module are then combined using another correlation matrix to give the basic SCR (BSCR).
5. The BSCR is then adjusted by an allowance for operational risk and an allowance for the loss absorbing capacity of technical provisions and deferred taxes.
6. For some parts of the Standard Formula, insurance companies may apply for the use of “undertaking specific parameters” instead of the prescribed parameters.
7. Dynamic hedging is not permitted under the Standard Formula approach, but may be used in an Internal Model.

Question 13

What are the tests that an internal model must pass before it can gain approval? (6)

Answer 13

1. The “Use Test” that the model is widely used throughout the business and plays an important role in risk management and governance.
2. Statistical Quality Standards (SQS) relating to assumptions and data.
3. Calibration Standards which aim to assess whether the SCR derived from the internal model has a calibration equivalent to the 99.5% value at risk confidence internal.
4. Profit and Loss Attribution to demonstrate how the risk categorisation is used to explain sources of profit and loss.
5. Validation Standards to show that the model has been fully validated and subject to regular control cycle review.
6. Documentation Standards for the design and operational aspects of the internal model.

Question 14

Describe the Minimum Capital Requirement (MCR). (4)

Answer 14

1. The MCR is the ultimate point of supervisory intervention, below which a company would lose its authorisation.
2. The MCR is defined as a simple factor-based linear formula targeted at a Value-at-Risk over one year with 85% confidence.
3. The MCR has a floor of 25% and a cap of 45% of the SCR.
4. There is an absolute minimum of €3.7m for life insurance companies.

Question 15

Explain what “Own Funds” means. (4)

Answer 15

1. Own Funds refers to assets in excess of technical provisions and subordinated liabilities.
2. Own Funds are split into basic and ancillary own funds and then tiered within those categories based on loss absorbency and permanence.
3. Basic Own Funds is broadly capital that exists within the insurer.
4. Ancillary Own Funds is capital that may be called upon in certain adverse circumstances, but which does not currently exist within the insurer.

Question 16

What restrictions are placed on the quality of capital that can be used to cover the Solvency 2 MCR and SCR? (2)

Answer 16

1. The SCR must be backed by at least 50% Tier 1 capital and less than 15% Tier 3.
2. The MCR must be backed by at least 80% Tier 1 capital and non Tier 3 capital.

Question 17

What are the factors to consider regarding the use of a matching adjustment? (4)

Answer 17

1. A matching adjustment (addition to discount rate) is allowed where the insurer has long term predictable liabilities and can hold matching assets to maturity.
2. The adjustment is derived by taking the spread on the portfolio of matching assets and deducting the “fundamental spread”, an allowance for the credit risks retained by the insurer. EIOPA publishes the fundamental spreads insurers must use.
3. Any matching adjustment must be approved by the regulator.
4. There are strict requirements on the eligibility of the assets and liabilities.

Question 18

What are the factors to consider regarding the use of a volatility adjustment? (6)

Answer 18

1. A volatility adjustment is allowed for liabilities not eligible for a matching adjustment.
2. A volatility adjustment prevents forced sales of assets in the event of extreme bond spread movements.
3. It is based on the spreads on a representative portfolio of assets for each relevant currency.
4. Risk free discount rates, including the addition of a volatility adjustment, are published by EIOPA.
5. Use of a volatility adjustment is subject to certain risk management requirements, such as a liquidity plan and sensitivity analysis.
6. Its use is subject to regulatory approval.

Question 19

Describe the “cost of capital” method for calculating the Solvency 2 Risk Margin. (4)

Answer 19

1. Calculate a projected SCR to the end of each projection period during run-off of the existing business.
2. Multiply the projected SCRs by a cost of capital rate (representing the cost of raising incremental capital in excess of the risk free rate).
3. Discount the amounts using the risk-free rate to give the risk margin.
4. Since the projection of the SCR is potentially complex, various simplified approaches can be used that involve the selection of risk drivers that are correlated in some way with the required capital.

Question 20

What adjustments are made to the basic SCR (BSCR) to give the final SCR in the Standard Formula? (3)

Answer 20

1. Operational Risk: based on simple percentages of premiums and technical provisions.
2. Loss Absorbing Capacity of Technical Provisions: could include the ability to reduce discretionary benefits under stressed conditions.
3. Loss Absorbing Capacity of Deferred Taxes: could include a reduction in any base balance sheet deferred tax liability as this would no longer be fully payable in a stressed scenario.

Question 21

Describe the S2 rules for intervention by the regulator. (4)

Answer 21

1. If a company’s eligible capital falls below the MCR or a breach is likely within the next three months, the regulator must be informed.
2. Within one month of a breach, the insurance company must submit a short-term finance scheme for approval by the regulator.
3. The company must rectify the breach within three months of it occurring.
4. If the short term financing scheme does not work, the regulator would remove the company’s authorisation to sell new business.

Question 22

What are the restrictions placed on the quality of capital that can be used to cover the MCR and SCR? (2)

Answer 22

SCR at least 50% Tier 1 and <15% Tier 3.

MCR at least 80% Tier 1 and no Tier 3.

Question 23

What are the sub-sections to remember when discussing Solvency 2 (16)?

Answer 23

1. Valuation of Assets
2. Technical Provisions
3. BEL
4. Risk Free Rates
5. Matching Adjustment
6. Volatility Adjustment
7. Risk Margin
8. SCR Calc
9. SCR Risk Groups & Sub Modules
10. SCR = BSCR + Adjustments
11. IMAP
12. MCR
13. Own Funds
14. Quality of Capital Resources

Question 24

Draw the diagram of the Solvency 2 balance sheet.

Answer 24

Question 25

Draw the diagram of all the Standard Formula Risk Modules.

Answer 25