4 - Regulation Solvency II

Question 1

What are the reasons for introducing Solvency II?

Answer 1

1) Increasing the level of solvency harmonisation across Europe
2) Introduce capital requirements that are more sensitive to levels of risk being undertaken
3) Provide appropritate incentive for good risk management

Question 2

What is pillar I?

Answer 2

This comprises quantitative requirements including risk based capital requirements
Assets and liabilities must be valued on a market consistent basis
Contains two solvency levels- MCR and SCR

Question 3

What is the SCR?

Answer 3

Solvency capital requirement. Its the level above which there is no supervisory intervention for financial reasons.

Question 4

What is the MCR?

Answer 4

Minimum capital requirement. It is the level below which the supervisors strongest actions are taken.

Question 5

How is the SCR calculated?

Answer 5

The SCR may be calculated using a standard formula or subject to prior approval, an internal model.

Question 6

How is the MCR calculated?

Answer 6

The MCR is calculated using a linear formula and must fall between 25% and 45% of the SCR.

Question 7

What is Pillar II?

Answer 7

Comprises qualitative requirements focusing on governance, risk management and required functions (internal audit and actuarial).
Includes the supervisory review process.
Insurers required to carry out ORSA
Includes ‘prudent persons’ investments principles.
Can impose capital additions for govenance failings

Question 8

What is pillar III?

Answer 8

Comprises reporting and disclosure requirements.
Includes a SFCR (Solvency financial and condition report)
Includes Regulatory Supervisory Report (RSR) and quantitative templates.
The aim of the public disclosures is to instill market discipline.

Question 9

How are assets valued under SII?

Answer 9

Assets are to be valued at the amount that they could be exchanged between knowledgable and willing parties at an arms length transaction.
Use of quoted market values is default.
Where quoted values are not available mark to mark values should be used.

Question 10

How are recoveries shown on a SII balance sheet?

Answer 10

Recoveries are shown as an asset rather than a negative liability. Must be reduced for risk of default.

Question 11

What are basic own funds?

Answer 11

Broadly capital that already exist within the insurer.

Question 12

What is ancillary own capital?

Answer 12

IT is capital that can be called upon in certain adverse circumstances but which does not currently exist within the insurer.

Question 13

What are the 6 criteria for tiering capital?

Answer 13

1) subordination
2) loss absorbency
3) Sufficient duration
4) Free from incentives to redeem
5) No mandatory fixed charges
6) No encumbrances

Question 14

What is the % of Tier I capital that must cover MCR and SCR?

Answer 14

80% MCR

50% SCR

Question 15

What is the risk margin intended for?

Answer 15

It is the margin required to take the best estimate up to the amount that an insurance company or reninsurance company would need to take over the liabilities.
It is calculated by estimating the lifetime amount of SCR needed to suppport the risk that can’t be hedged.

Question 16

What complicates the calculation of the risk margin?

Answer 16

It can get very complicated involving nested stochastic loops.
It must be disclosed by line of business, accounting for diversification benefit.

Question 17

How are premium provisions calculated?

Answer 17

Best estimate of future cashflows in respect of unexpired exposures.
No credit is taken for DAC
No allowance is made for claims equalisation provision.

Question 18

How is a contract boundary defined?

Answer 18

It is the point at which a compnay can unilaterally terminate the contract or
Ammend the premiums or benefits to reflect the risk.

Question 19

Describe and give examples of legal obligation basis

Answer 19

It is where tech provisions need to allow for legally obliged uninepted contracts.

• Delegated authorities
• Brokers where ther are backlogs of aggregated pipeline premiums
• Tacit renewal agreements where the business is automatically renewed unless the policyholder decided to move the cover to another provider.

Question 20

Why might a company use an internal model?

Answer 20

If the risk profile differs substantially from the standard formula
The company wants one for risk management or decision making purposes

Question 21

What is the probability of loss covered by SCR?

Answer 21

99.5% over a one year time horizion

Question 22

What are the tests that an internal model must pass?

Answer 22

Use Test
Statisitcal quality standards
Calibration standards
Profit and loss attribution
Validation standards
Documentation standards

Question 23

What is the use test?

Answer 23

This is where companies need to demonstrate that the internal model is widely embedded in the company.
Must prove it plays a significant role in decision making .
Must be used for capital assessments and allocation

Question 24

What are statistical quality standards?

Answer 24

• The methods used are based on adequate, applicable and relevant actuarial and statistical techniques.
• The methods usesd are based upon current and credible data and realistic assumptions
• Diversification effects measurement is adequate

Question 25

What are callibration standards?

Answer 25

-Need to demonstrate that internal model does give protection to a 1 in 200 year event

Question 26

What is profit and loss attribution?

Answer 26

- Companies required to review at least annualy the causes and sources of profit and losses for each major business unit. - Includes requirement to show how categorisation of risk in internal model can explain sources of profit and loss

Question 27

What are validation standards?

Answer 27

- Monitoring the performance of the model - Reviewing the ongoning appropriateness - Testing against experience

Question 28

What are documentation standards?

Answer 28

Requirement to document deisgn and operation of internal model

Question 29

What are the practical difficulties of the internal model?

Answer 29

- use test- difficult to embed and evidence - Quality of data. Historical data for 1 in 200 year event very limited - Setting correlation assumptions under extreme events is challenging - 6 month deadline for submission of internal model to approval

Question 30

How do companies get round the 6 months deadline issue?

Answer 30

-By engaging the supervisor early in the model development and refinement process. Effectively getting pre approval

Question 31

For pillar II. What functions must have written policies in place?

Answer 31

- Risk management - Internal Control - Internal audit - Actuarial - Outsourcing (if applicable)

Question 32

What areas does the risk managment function need to cover?

Answer 32

- Underwriting and reserving - Asset liability managment - Investments - Liquidity and concentration risk - Operational risk - Reinsurance

Question 33

What is the scope of interal control?

Answer 33

Administrative and accounting procedures Internal control framework Appropriate reporting arrangements at all levels of undertaking A compliance function

Question 34

What is the purpose of internal audit?

Answer 34

Its responsible for evaluating the adequacy and effectiveness of interal control systems and other elements of the system of governance. Must be objective and independent from the other operational functions.

Question 35

What are the roles of the actuarial function?

Answer 35

- Coordinate the technical provisions. - Ensure the appropriateness of methedologies and underlying models used - Verify assumptions made in the calculation of technical provisions - Assess the sufficiency and quality of data used - Compare best estimate against experience - Inform the supervisor of the reliability and adequacy of the calculation of technical provisions - Oversee the calculation of technical provisions as set out in Article 82. - Express an opinion on the overall undewriting policy - Express an opinion on adequacy of reinsurance arrangements - Contribute to risk management system and ORSA

Question 36

What is the ORSA?

Answer 36

The entirety of the processes and procedures employed to identify, monitor, manage and report the short and long term risks an insurance undertaking faces or may face and to determine the own funds necessary to ensure that the undertakings overall solvency needs are met at all times.

Question 37

What does the ORSA require?

Answer 37

- Identify all risk to which it is subject and the mitigating risk management and controls - This will include risks not covered under pillar I such as reputational risk - Also needs to quantify its ability to meet the MCR and SRC over the business planning horizon, allowing for new business - Must be reported to the supervisor

Question 38

What does the insurance company need to evidence to the supervisor in regards to ORSA?

Answer 38

That it is used by senior management and that it has an impact on strategic decisions.

Question 39

What are the components of ORSA?

Answer 39

- The assessment of overall solvency needs - Compliance on a continuous basis with capital requirements and technical provisions - consideration of the extent to which risk profile deviates from assumptions underlying internal model

Question 40

How often should the ORSA be peformed?

Answer 40

At least annualy or following a significant change in risk profile.

Question 41

What 5 elements of the ORSA do companies need to explain and justify?

Answer 41

1) Methedology and assumpitons 2) Results and sensitivity or results to assumptions 3) Appropriateness of methedology used 4) Sources of data and systems and controls around the data 5) Approach for dealing with paramater uncertainty and fluctuations

Question 42

What should the documentation of the ORSA include (7)?

Answer 42

1) Description of areas included 2) Description of process of of conducting ORSA and key persons involved 3) Stress tests used and their results 4) The amount of overall solvency needs and financial condition of the undertaking including sign off by the management body. 5) Strategies for raising additional own funds where necessary 6) a description of the independed assessment and results of last assessment 7) The frequency and contents of internal reporting.

Question 43

What should SFCR allow an analyst to assess?

Answer 43

System of governance applied by the undertakings Business they are pursuing Valuation principles applied for solvency purposes Risks Faced Risk management systems Capital structure

Question 44

What are the principle sections of the SFCR?

Answer 44

``` Summary Business and performance System of governance risk profile Valuation for solvency purposes capital management Additional voluntary information ```