FSI 4 PZ Flashcards
Who holds the ultimate responsibility for the prudent management of an insurer’s financial soundness, including meeting the Solvency Capital Requirement (SCR)?
The insurer’s board of directors holds the ultimate responsibility for the prudent management of the financial soundness of an insurer.
What are some key responsibilities of the board of directors concerning the SCR?
The board of directors must:
Ensure the insurer maintains an appropriate level and quality of eligible own funds to meet the SCR continuously.
Ensure the insurer has appropriate systems, procedures, and controls in place to meet the principles and requirements of this Standard on an ongoing basis.
Pay particular attention to areas where the standardised formula provides a choice of methodologies (including simplifications). They should be aware of these choices, the reasons for the selected options, and their impact.
Be responsible for assessing and approving changes to these methodological choices over time due to changes in factors like modelling capability or risk profile.
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Ensure that the Prudential Authority is kept informed about planned changes to the chosen methodologies.
Ensure that any required approvals from the Prudential Authority are obtained before implementing changes.
What is the role of the head of actuarial function regarding the SCR?
An insurer’s head of actuarial function is responsible for expressing an opinion to the board of directors regarding the accuracy of the calculations to derive the SCR,
including the appropriateness of the underlying assumptions.
They also have a specific responsibility concerning risk mitigation instruments, ensuring their effect on the SCR is materially reflective of the expected risk reduction at a 99.5% confidence level.
If weaknesses in assumptions lead to a material SCR reduction, the head of actuarial function should reduce the effect of these instruments accordingly
What are the responsibilities of an insurer’s auditor concerning the SCR?
The insurer’s auditor, appointed under section 32 of the Insurance Act, 2017, must audit the financial soundness of an insurer in accordance with their legal and regulatory obligations.
The auditor is required to report to the board of directors and the Prudential Authority any matters identified during their responsibilities that may indicate the insurer is not financially sound.
insurer and report any matters indicating the insurer is not financially sound to the board and the Prudential Authority.
Where can I find more detailed information about the roles and responsibilities of the board of directors and the head of actuarial function?
More detailed information can be found in the Governance and Operational Standards for Insurers (GOI 3).
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 are market risk, underwriting risk (covering both life and non-life insurance), and operational risk.
Describe the approach used by the standardised formula for calculating the capital required for different risks.
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 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 allows for the risk-reducing impact of risk mitigation instruments and future management actions, subject to specific eligibility conditions and verifiability.
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.
What is the primary method for calculating the SCR for most risk categories and components under the standardised formula?
For most risk categories and components, the calculation of the SCR is based on applying stress scenarios to the assets and liabilities of the insurer. However, in cases where the scenario approach is not suitable due to the nature of the risk, a linear capital factor is applied instead.
How is the capital requirement measured when a stress scenario is applied?
When the capital requirement for a risk component is calculated by applying a stress scenario, it is measured by its impact on the level of basic own funds. The change in basic own funds (△ 𝐵𝑂𝐹) is considered positive when the stress scenario results in a loss of basic own funds.
If a scenario results in an increase in basic own funds (a negative △ 𝐵𝑂𝐹), the contribution of the scenario outcome to the overall SCR must be set to zero, unless explicitly stated otherwise in the detailed Standards.
What happens if a stress scenario results in an increase in basic own funds?
If a scenario results in an increase in basic own funds (a negative △ 𝐵𝑂𝐹), the contribution of the scenario outcome to the overall SCR must be set to zero, unless explicitly stated otherwise in the detailed Standards.
What factors can an insurer take into account when revaluing assets and liabilities under stress scenarios?
When revaluing assets and liabilities for stress scenarios to calculate capital requirements for individual risk components, an insurer may take account of any likely future management actions as well as the effects of any eligible risk mitigation instruments, provided certain conditions are met. Insurers should also consider possible changes to policyholder behaviour under the assumed stress scenarios if there is a causal link between policyholder behaviour and the scenario.
How should technical provisions be interpreted for the purpose of the standardised formula SCR calculations?
For the purposes of the SCR standardised formula calculations, references to technical provisions within the calculations for the individual SCR modules should be interpreted as excluding the risk margin to avoid circularity in the calculation.
An insurer may elect to calculate its SCR using technical provisions including the risk margin, but this is subject to the approval of the Prudential Authority. This approach will require an iterative process to determine both the SCR and the risk margin until they stabilise.
Can an insurer choose to calculate its SCR using technical provisions including the risk margin?
Yes, an insurer may elect to calculate its SCR using technical provisions including the risk margin, but this is subject to the approval of the Prudential Authority. This approach will require an iterative process to determine both the SCR and the risk margin until they stabilise.
How does the standardised formula treat the forward-looking nature of the SCR in relation to new business?
Reflecting its forward-looking nature, the SCR covers the risk of existing business at a point in time as well as new business expected to be written over the coming 12 months
For life insurance business, the formula implicitly allows for the risk of new business by assuming capital released from existing business will cover the capital required for new business, so no explicit allowance is made.
Expected profits or losses from new business are not included in the SCR calculation for either life or non-life business.
Can future management actions be considered when calculating the capital requirement for individual risk components?
Yes, future management actions may be taken into account when calculating the capital requirement for individual risk components, but this is subject to certain conditions.
a)To the extent that the stress scenario under consideration is regarded to be an instantaneous stress, no management actions may be assumed to be taken during the stress, unless explicitly stated otherwise;
b) However, an insurer may need to reassess the value of the technical provisions after the stress. Assumptions about future management actions may be taken into account at this stage. The approach taken for the recalculation of the best estimate to assess the impact of the stress should be consistent with the approach taken in the initial valuation of the best estimate, but based on the post-stress assumed environment
c) Any assumptions regarding future management actions for the assessment of the standardised formula SCR should be objective, realistic and verifiable. Insurers should ensure that the overall allowance for future management actions, after allowing for aggregation across risk components, does not exceed the maximum realistic impact of such actions.
What are the conditions for taking future management actions into account during an instantaneous stress scenario?
To the extent that the stress scenario under consideration is regarded as an instantaneous stress, no management actions may be assumed to be taken during the stress, unless explicitly stated otherwise.
When can assumptions about future management actions be considered after an instantaneous stress?
An insurer may need to reassess the value of the technical provisions after the stress. Assumptions about future management actions may be taken into account at this stage. The approach for recalculating the best estimate should be consistent with the initial valuation but based on the post-stress environment.
What general criteria must assumptions about future management actions meet for the SCR calculation?
Any assumptions regarding future management actions for the assessment of the standardised formula SCR should be objective, realistic, and verifiable. Insurers should ensure that the overall allowance for these actions does not exceed the maximum realistic impact after considering aggregation across risk components.
What are the reporting requirements if there are significant deviations from planned management actions?
Significant deviations from planned management actions that may have a material impact on the SCR must be reported to the Prudential Authority, along with an analysis explaining the reasons for the deviation and its consequences.
Should insurers consider changes in policyholder behaviour when calculating the SCR?
Yes, in calculating the SCR, insurers should consider changes to policyholder behaviour under each stress scenario.
a) Decreases in policy lapse as investment guarantees become more valuable;
b) Increases in the exercise of guaranteed annuity options due to a permanent decrease in mortality rates; and
c) Increases in policyholders exercising their options to extend the term of existing guaranteed policies (rather than taking out new policies) where there are changes in market conditions that lead to an increase in mortality and term assurance rates.
What are some examples of changes in policyholder behaviour that insurers should consider?
Examples of changes to policyholder behaviour include:
• Decreases in policy lapse as investment guarantees become more valuable.
• Increases in the exercise of guaranteed annuity options due to a permanent decrease in mortality rates.
• Increases in policyholders exercising their options to extend the term of existing guaranteed policies (rather than taking out new policies) where there are changes in market conditions that lead to an increase in mortality and term assurance rates.
What level of justification is required for assumptions about policyholder behaviour?
While precise modelling may not always be possible, insurers should consider the likely behaviour of policyholders for each stress and adjust assumptions accordingly. An insurer should be able to justify its assumptions to the Prudential Authority. If the Prudential Authority is not satisfied with the reasonableness of these assumptions, it may require the application of alternative assumptions.
What are the two main forms of risk mitigation through risk transfer for insurers?
Risk mitigation through risk transfer by insurers usually takes one of two main forms:
• Reinsurance – whereby the insurer cedes part of its underwriting risk to another insurer or reinsurer (including risk transfer through Special Purpose Vehicles (SPVs)).
• Financial risk mitigation – whereby the insurer purchases financial instruments (including derivatives) to transfer risk to participants in the financial markets.
Under what condition can an insurer include the effect of a risk mitigation instrument in the SCR calculation?
Subject to meeting certain qualifying conditions, an insurer may include the effect of an eligible risk mitigation instrument when calculating capital requirements for individual risk categories or components, provided that the counterparty default risk related to the instrument is properly captured in the SCR computation. Attachment 1 of the Standard sets out the qualifying conditions, and Attachment 2 details the approach to calculating the adjustment for counterparty default risk.
In which risk categories can risk mitigation instruments be used in the standardised formula?
The inclusion of risk mitigation instruments in calculating the SCR is limited to the computations for market risk and underwriting risk. No allowance is made for risk mitigation instruments in the standardised formula approach to measuring operational risk.
What are ring-fenced funds in the context of insurance?
Ring-fenced funds are structures arising from some insurance products that give a specific class of policyholders greater rights to assets within a particular fund. This can apply to both life and non-life business arrangements.
Why are adjustments needed for insurers with ring-fenced funds?
Adjustments to both eligible own funds and the SCR are required because surplus eligible own funds within a ring-fenced fund might not be fully available to cover losses outside that ring-fenced fund due to a lack of transferability.
What are some common examples of arrangements that can lead to ring-fenced funds?
Common examples include cell structures where the assets of the general account are generally not available to meet the liabilities of individual cells until the cell’s own assets are exhausted, and discretionary participation business where eligible own funds attributable to these policyholders might not be available to cover losses elsewhere. However, the existence of a discretionary participation feature alone does not define a ring-fenced fund; the key is the restriction on loss absorbency.
Are all segregated funds considered ring-fenced funds?
No. For clarity, the following are generally outside the scope of ring-fenced funds: conventional linked policies, provisions and reserves set up under financial accounting standards, and conventional reinsurance business (unless individual contracts restrict the insurer’s assets).
What are the two main aspects to consider when assessing the solvency of an insurer with ring-fenced funds?
The two main aspects are the availability of eligible own funds within the insurer, considering the restrictions within ring-fenced funds, and the extent to which ring-fenced funds reduce the benefits of diversification at the overall insurer level.
How is the SCR calculated for an insurer with ring-fenced funds?
The calculation involves determining a notional SCR for each ring-fenced fund and for the insurer as a whole (including all business). The methodology for this is detailed in Attachment 4.
How are eligible own funds determined when ring-fenced funds are involved?
Eligible own funds must be calculated per ring-fenced fund as if each fund were a stand-alone entity. Further details on this calculation are provided in Attachment 4.
Under what conditions can insurers use simplified calculations for the SCR using the standardised formula?
Insurers may apply simplifications where provided for in the Financial Soundness Standards for Insurers and where these simplified calculations can be justified as proportionate to the nature, scale, and complexity of the risks involved.
Does an insurer need to obtain approval from the Prudential Authority before using a simplification?
The Prudential Authority takes a principles-based approach to simplifications and does not require approval before an insurer applies one. However, the insurer is expected to justify the use of simplifications if asked and the Prudential Authority may disallow their use if not satisfied with the justification.
What principle guides the use of simplifications in calculating the SCR?
The principle of proportionality guides the use of simplifications. This means that the resources devoted to calculating the SCR should be consistent with the nature and complexity of the risks involved.
Where can insurers find further guidance on the application of the principle of proportionality to simplified methods?
Guidance Note FSI GN 2.2, which addresses the application of proportionality to simplified methods in valuing technical provisions, also applies broadly to the use of simplified methods in calculating the SCR.
What is the purpose of Section 6 of this Prudential Standard?
The purpose of Section 6 is to outline how an insurer’s total Solvency Capital Requirement (SCR) is calculated by aggregating the capital requirements for individual risk components and risk categories.
What is the first stage in calculating the total SCR?
The first stage involves aggregating capital requirements for individual risk components within the market risk and underwriting risk categories. This aggregation process allows insurers to take advantage of diversification benefits between different risk components.
What is the effect of allowing for diversification benefits at this stage?
Allowing for diversification benefits results in a lower overall capital requirement for the risk category compared to a simple sum of the individual risk component capital requirements.
How is the capital requirement for each risk category (market risk, life underwriting risk, and non-life underwriting risk) calculated when aggregating individual risk components?
The capital requirement for each of these risk categories (𝑆𝐶𝑅𝑐𝑎𝑡𝑒𝑔𝑜𝑟𝑦) is calculated using a square root formula that incorporates a correlation matrix (𝐶𝑜𝑟𝑟𝐶𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡𝑖,𝑗) and the capital requirements for each pair of risk components (𝑆𝐶𝑅𝑖 , 𝑆𝐶𝑅𝑗) within that category.
What is the second stage in calculating the total SCR?
The second stage involves aggregating the capital requirements for the market and underwriting risk categories to derive the Basic Solvency Capital Requirement (BSCR). This stage also allows for diversification benefits between these risk categories.
How is the BSCR calculated?
The BSCR is calculated using a square root formula and the correlation matrix (𝐶𝑜𝑟𝑟𝐵𝑆𝐶𝑅) specified in the Standard, along with the capital requirements for the market, life underwriting, and non-life underwriting risk categories.
What are the correlation factors between the market and underwriting risk categories in the 𝐶𝑜𝑟𝑟𝐵𝑆𝐶𝑅 matrix?
The correlation matrix 𝐶𝑜𝑟𝑟𝐵𝑆𝐶𝑅 specifies the following correlations:
- Market and Life Underwriting: 0.25
- Market and Non-life Underwriting: 0.25
- Life Underwriting and Non-life Underwriting: 0
What is the third stage in calculating the total SCR?
The third stage involves calculating the total SCR as the simple sum of the BSCR, the capital requirement for operational risk (𝑆𝐶𝑅𝑂𝑝), the capital requirement for insurance-related participations in the same sector as the insurer (𝑆𝐶𝑅𝑃𝑎𝑟𝑡), and an adjustment for the loss-absorbing capacity of deferred taxes (𝐴𝑑𝑗𝐷𝑇).
Are diversification benefits recognized between the BSCR, operational risk, same-sector participation risk, and the adjustment for deferred taxes when calculating the total SCR?
No, diversification benefits must not be recognized between these risks when aggregating to derive the total SCR.
What is the formula for calculating the total SCR (SCR)?
The total SCR is calculated as: 𝑆𝐶 = 𝐵𝑆𝐶𝑅 + 𝑆𝐶𝑅𝑂𝑝 + 𝑆𝐶𝑅𝑃𝑎𝑟𝑡 + 𝐴𝑑𝑗𝐷𝑇.
What is the purpose of the correlation coefficients used in aggregating capital requirements under the standardised formula?
The correlation coefficients are intended to reflect potential dependencies in the tail of the distributions, as well as the stability of any correlation assumptions under stress conditions.
Is there a capital requirement for operational risk that involves the aggregation of individual risk components?
No, there are no individual risk components for operational risk. Therefore, the calculation of the operational risk capital requirement under the standardised formula does not require the aggregation of individual risk components.
Where is the adjustment factor for the potential double-counting of the loss-absorbing capacity of technical provisions calculated?
This adjustment factor is calculated as part of the calculation of the market risk capital requirement and is detailed in FSI 4.1 (Market Risk Capital Requirement).
