FSI 4-Calculation of SCR using Standardized Formula Flashcards
Outline the responsibilities of the board of directors regarding SCR calculation using standardized formula? (4)
- Once again the board of directors are responsible for the financial soundness of the insurer
- A particular area of focus is the SCR calculated using a standardised formula allows for a choice of methodologies (including possible simplifications)
- The directors should be aware of where, why and the impact of methodologies and simplifications in the calculations
- Furthermore the methodologies may change over time and this needs to be assessed/approved by the board of directors and communicated to the prudential authority
Outline key elements and approaches in the determination SCR using a standrised formula? (8)
- SCR establishes a critical level for financial soundness below which regulatory intervention would occur
- The SCR is risk-based and forwarding looking which mostly involves stress-testing assets and liabilities to determine the impact on own funds
• The risk categories that are addressed are:
o Market
o underwriting
o operational
- The SCR also include the risk of loss in movements of value in insurer’s participation (i.e. influence and control in company/subsidiary)
- The standardised formula method takes a modular approach to the calculation of capital required for each risk category (as well as individual risk within each category)
- This approach enables insures to determine capital requirements for individual risks and the aggregate then to obtain the overall capital requirement
- SCR is calibrated to correspond to the VaR of basic own fund at a 99.5% confidence level over a one year time horizon
- The standardized formula approach is standardised in the sense that stress scenarios and computations are prescribed by the prudential authority
Outline the risk categories and individual risks included in the calculation of SCR?
• Market risk is the risk of loss from movements in market variables that impact assets and liabilities as well as the risk of credit default from a counter party. The calculation of market risk takes into account the following risk components: o Interest rate risk o Equity risk o Property risk o Currency risk o Spread and default risk o Concentration risk o Illiquidity premium
• Underwriting risk is the risk of loss from insurance obligations such as poor claims experience, expenses over-runs and policy lapses • The calculation takes into account the following risk components: o Mortality o Longevity o Morbidity o Expense o Lapse o Catastrophe o Retrenchment
• Operational risk is the risk of loss from inadequate internal controls or failure of process, people or systems or external events
Outline how participation risk is quantified in SCR? (3)
• SCR participation risk must be calculated using one of the following approaches depending on the nature of the activities of the participating business
o Asset holding intermediaries (AHIs) must have their capital requirement assessed using a look-through approach treat their assets as if it were included in the assets and liabilities of the insurer
o The value of all participation in financial and credit institutions has a deduction of excess value above 15% of tier 1 own funds therefore these participations attract a capital charge commensurate with value recognised in calculating own funds
o The participation in insurance related business within the same sector must be treated separately with no diversification benefits. (additional details are provided in Attachment 3 of FSI 4)
o All other participations are calculated in the same way as market risk capital requirements
Outline how liquidity risk and default assossiated with risk mitigation instruments is handled? (4)
- The SCR calculation does not include a capital requirement for liquidity risk as this is not necessarily related to solvency
- FSI 6 (liquidly risk assessment) set out measure of how liquidity risk should be managed
- An ORSA should also set out further details regarding the management of liquidity risk
- The default risk associated with reinsurance and risk mitigation instruments should be taken into account additional details in attachment 2
Outline the methodology of calculating SCR? (6)
- For most categories and components the calculation of SCR is based on applying stressed scenarios to the assets and liabilities of the insurer
- In the case where a scenario approach does not apply due to the nature of the risk a linear capital factor is applied instead
- The capital requirement is measured by the impact on the insurers own funds. The change in own funds is taken to be positive if the scenario results in a decrease in own fund.
- If the scenario results in an increase in basic own funds then this is usually set to zero when contributing to overall SCR
• The revaluing of assets and liabilities for the determination of capital requirements should take into account
o future management actions as well as
o eligible risk mitigation instruments
o policyholder behaviour
• The reference to technical provisions in the calculation of SCR excludes risk margins to avoid circularity in the calculation
Describe the treatment of new business in the calculation of SCR using the standardised formula? (5)
- Reflecting its forward-looking nature SCR covers existing business as well as new business expected to written over the next 12 months
- For life insurance the capital required of underwriting risk consist of applying instantaneous stresses at the valuation date
- The capital requirements are set to the immediate loss in basic own funds resulting from the stresses
- The risk of new business is implicitly included by assuming that capital released from existing business is sufficient to cover the capital required from new business over the year
- The expected profit/loss from new business written in the coming 12 months is not included in the standardised formula for calculating SCR
Describe the allowance for management actions in the calculation of SCR? (4)
Future management actions may be taken into account in determining the capital requirements for individual components subject to the following conditions:
- To the extent that the stress scenario is regarded as an instantaneous stress no management actions may be assumed during the stress
- However the insurer may be able to reassess the value of the technical provisions after the stress and future management actions may be taken at that stage
- Any management actions taken should be objective, realistic and verifiable. It should be ensured that management actions impact overall have a realistic impact.
Significant deviations for planned management actions must be reported to the PA including reasons and impact of the deviation
Provide allowances for policyholder behaviour in the calculation of SCR?
Examples of policyholder behaviour that should be included in the calculation of SCR are:
- Decreases in policy lapses as guarantees become more valuable
- Increases in the exercise of guaranteed annuity options due to permanent decreases in mortality
- Increases in policyholders exercising the option to extended the term of a policy where changes in the market increase mortality and term assurance rates
Describe the allowance of risk mitigation in the calculation of SCR? (5)
• Risk mitigation through risk transfer takes on of two main forms:
o Reinsurance –where insurer cedes part of underwriting risk to another insurer/reinsurer (this may also include risk transfer through a SPV)
o Financial Risk mitigation-the purchase of instruments (including derivatives) to pass risk to the financial market
- Subject to meeting certain qualification conditions an insurer may include the effect of eligible risk mitigation in the calculation of capital requirements
- The counterpart credit risk for the risk mitigation instrument should also be allowed for in the calculation of SCR
- The risk mitigation instruments in SCR is limited to market and underwriting computations
- The HAF must ensure that the effect of eligible risk mitigation instruments on SCR is materially reflective of a risk mitigation reduction with 99.5% confidence level
describe the allowance of ring-fenced funds in the calculation of SCR? (5)
• Some insurance products results in ring fenced structures that give one class of policyholders greater rights to assets within a particular fund
• Adjustments to both eligible own funds and SCR related to ring fenced funds are required where the restricted eligible own funds have reduced capacity to full absorb losses on a going concern basis due to lack of transferability as they are only used to cover
o Defined portion of insurer’s polices
o Particular policyholders or beneficiaries
o Losses in relation to a particular risk
• Ring fenced arrangements arise most commonly in
o Cell structures-where assets of the promoter business may not be available to meet the liabilities of individual cells
o Discretionary participation bonuses-where there may be eligible own funds to attributable to with-profit policyholders but cannot be used to meet losses on other business
Describe the aggreation of capital requirements from individual categories to determine overall SCR ? (5)
- The calculation of an insurer’s SCR is calculated in stages.
- Firstly the capital requirements for individual risk components within market risk and underwriting risk categories are aggregated in a way such that the insurer takes advantage of diversification benefits
- The SCR for each risk category is calculated as sum of the risk so calculated for all pairwise combinations of risk components within that category
- In the second stage the capital for market and underwriting risk is aggregated to derive what is known as Basic Solvency Capital Requirement (BSCR)
- In the third stage, the total SCR for an insurer is calculated as a simple sum of the BSCR plus capital required for operational risk plus the capital required for insurance participation in same sector and an adjustment for the loss absorbing capacity of deferred tax
What is the primary purpose of the Solvency Capital Requirement (SCR) established by this Prudential Standard?
The SCR sets out the basis on which insurers calculate their required capital using the standardised formula. It establishes a critical level of financial soundness, below which regulatory intervention by the Prudential Authority will occur. The SCR, along with the Minimum Capital Requirement (MCR), is designed to ensure the security of policyholder obligations and to provide triggers for regulatory intervention. The SCR is the primary requirement within the Financial Soundness Standards for Insurers.
How is the SCR calculated under the standardised formula, and what time horizon and confidence level does it reflect?
The SCR is calculated using a standardised formula that is forward-looking and risk-based. In most cases, this involves applying specified stress scenarios to an insurer’s assets and liabilities to assess the impact on basic own funds. The SCR is calibrated to correspond to the value-at-risk of the basic own funds of an insurer at a confidence level of 99.5% over a one-year period.
What are the main risk categories addressed by the standardised formula in the calculation of the SCR?
The key risk categories addressed by the standardised formula are:
• Market risk.
• Underwriting risk (covering both life and non-life insurance).
• Operational risk. The SCR also accounts for the risk of loss arising from movements in the value of an insurer’s participations.
Describe the approach used by the standardised formula for calculating the capital required for different risks and how these are combined to determine the overall SCR.
The standardised formula uses a modular approach to calculate the capital required for each risk category and the individual risk components within those categories. This allows for the identification of capital requirements for specific risks. The capital requirements for market risk and underwriting risk are aggregated using a correlation matrix prescribed in the Standard, which allows for diversification benefits between some risk categories. This aggregation results in the Basic Solvency Capital Requirement (BSCR). The total SCR is then calculated as the simple sum of the BSCR, the capital requirement for operational risk, the capital requirement for insurance-related participations in the same sector, and an adjustment for the loss-absorbing capacity of deferred taxes. No diversification benefits are recognised between these components when aggregating to derive the total SCR.
Does the SCR calculation explicitly account for new business, liquidity risk, and credit risk?
Yes, the SCR calculation considers new business expected to be written over the coming 12 months. For non-life insurance, this is included in the premium risk sub-component, while for life insurance, the formula implicitly accounts for it. The standardised formula does not include a capital requirement for liquidity risk. Instead, liquidity risk is addressed through monitoring and management measures. Credit risk is incorporated as a component of market risk, specifically through the spread and default risk module.
Can insurers using the standardised formula account for risk mitigation techniques and future management actions in their SCR calculation?
Yes, the standardised formula makes allowance for the risk-reducing impact of risk mitigation instruments, changes to policyholder behaviour, and future management actions, subject to certain conditions. For risk mitigation instruments, they must meet specific eligibility conditions, and counterparty default risk must be appropriately captured. Future management actions may be considered if they are objective, realistic, and verifiable. Insurers should also consider changes to policyholder behaviour under stress scenarios.
What is the role of simplifications in the standardised formula, and how are they applied?
The standardised formula allows for the use of simplified calculations under certain conditions, adhering to the principle of proportionality. Standardisation does not imply simplicity, although the Prudential Authority permits simplifications where provided for and where they can be justified as proportionate to the nature, scale, and complexity of the risks. Insurers do not require prior approval but are expected to justify the use of simplifications if asked by the Prudential Authority, who may disallow their use if the justification is not satisfactory.
