Solvency II Pillar 1 Detail

Question 1

What are the 3 components of assets in SII balance sheet?

Answer 1

1. Investments (market value)
2. Reinsurance recoveries (asset not liab reduction)
3. Participations

Question 2

List the ideas on how to specify the discount rate?

Answer 2

1. Swap rates or government bond yields

2. Extent to which each should be adjusted e.g. swaps adjusted to allow for credit risk

Question 3

What are the risk groups the SCR covers

Answer 3

1. non-life/life/health underwriting risk
2. Market risk (equity/prop/interest/credit/currency/concentration/illiquidity)
3. Counterparty default risk
4. ops risk

Question 4

What are the possible ways to calculate SCR?

Answer 4

1. internal model
2. standard formula
3. sf with part im
4. sf with simplifications
5. sf with undertaking specific parameters

Question 5

What are the main sections in calculating BSCR (basic SCR)

Answer 5

market (equity/prop/interest/credit/currency/concentration/illiquidity)
counterparty default
insurance (life/health/non-life separated)
intangible assets

Question 6

Under insurance risk module for BSCR, what risks are there?

Answer 6

mort
longevity
morbidity
lapse
expense
revision
catastrophe e.g. pandemic

Question 7

Give 2 examples of stresses in the market/insurance risk modules?

Answer 7

property down 25%

mortality permanently up 15%

Question 8

How do we calculate the individual SCR from a stress

Answer 8

NAV (unstressed) - NAV (stressed) gives the capital required to survive the stress
e.g. 50 free before, 20 free after means stress causes a 30 decrease. so definitely need 30 as a cap req!

Question 9

What are type 1 and 2 exposures for counterparty default risk?

Answer 9

1 = counterparty likely to be rates, not diversified default risk (bonds/deposits/reinsurance etc.)
2 = counterparty unlikely to be rates, diversified default risk (receivables from intermediary/policyholders)

Question 10

What adjustments are made to the BSCR to get the SCR?

Answer 10

SCR=BSCR+SCR(ops risk) + Adj

Where Adj = allowance for deferred tax or loss absorbing technical provisions e.g. reduction of discretionary benefits

Question 11

Why is good quality data crucial?

Answer 11

1. More consistent/accurate results
2. Wider range of methodologies possible
3. Validation of methods is more reliable and leads to more credible conclusions
4. Effective comparisons over time possible

Question 12

What tests must the IMAP pass?

Answer 12

1. use test
2. statistical quality standards
3. calibration standards
4. profit/loss attribution
5. validation standards
6. documentation standards

Question 13

What makes up the liabilities side in the pillars diagram (include free surplus and what technical provisions are)

Answer 13

Technical Provisions = BEL + risk margin
SCR (including MCR)
Other liabs
Free capital

Question 14

What type of capital is needed to voer the SCR/MCR?

Answer 14

Tier 1-3

Question 15

2 ways to value assets? Why is this a change?

Answer 15

1. market value (MC)
2. Marked to model as long as consistent with market consistent approach ie. amount to exchange between 2 parties etc.
   Most of europe were using book values

Question 16

What is a market consistent basis for technical provisions?

Answer 16

Amount insurer would have to pay in order to immediately transfer its liabs to another insurer

Question 17

What are technical provisions?

Answer 17

BEL + risk margin

Question 18

What are BEL?

Answer 18

PV expected future cashflows (ben + expenses - prem) on BE assumptions and risk free disc rate

Question 19

If a liability is hedgable what can you do?

Answer 19

Use the hedging instrument’s MV

Question 20

How are non-par/par/ul business BEL likely to be determined?

Answer 20

ungrouped/grouped with validation of accuracy/unbunbled unit res and non-unit res

Question 21

What types of assumptions are there in SII BEL?

Answer 21

BE
No prudence
Allow for all expected decrements and ph actions
Include lapses
Allow for future premiums up till contract boundary (at which point company can change contract to reflect experience)
Discretionary benefits in WP need to be accounted for and reflect realistic management/ph actions

Question 22

How will financial guarantees and options be modelled under SII

Answer 22

1. MC stochastic model and sims

2. Deterministic closed form solution

Question 23

In determining the sII discount rate, how are currencies takeninto account?

Answer 23

Consistent between currencies

Including those with no active bond/swap market or one without long enough durations

Question 24

What is illiquidity premium and when would an illiquidity premium be used? What is the suggested alternative?

Answer 24

Compensation an investor gets for holding illiquid asset (or a long term insurance liability!)
Used in the discount rate to increase it, hence lower BEL
Alternative is to use counter cyclical premiums - only increase discount rate in times of financial stress

Question 25

What is a matching adjustment? When is it used?

Answer 25

1. Used for companies with 'hold to maturity' assets and long term predictable liabs which are very well matched even after allowing for impacts on cashflows of defaults/downgrades 2. Allows the company to take account of extra return from illiquid bonds and so use higher discount rate 3. Applies to annuity business

Question 26

What is the main method to calculate the risk margin above the BEL?

Answer 26

Cost of capital method

Question 27

Explain what the risk margin is for and how this relates to the technical provisions and BEL

Answer 27

1. TP = BEL + RM 2. Remember that TP is the amount that a company would have to pay to exchange its liabs with another insurer 3. and BEL is the best estimate of its future profits 4. So Risk margin is that extra amount in compensation a company would want to take on the liabs, as it has the risk of experience not being as expected and their being a cost of holding reg. capital against the liabs

Question 28

What risks are included in the cost of capital method

Answer 28

it's the cost of holding capital for RISKS THAT CAN'T BE HEDGED in financial markets examples: insurance risk reinsurance credit risk ops risk residual market risk (like when no assets in market of matching duration of liabs)

Question 29

Explain how to calculate the risk margin using the cost of capital method in 10 steps.

Answer 29

1. Project future capital required to hold at end of each year assuming run-off business - these amounts are risks that can't be hedged and are subsets of the SCR 2. Multiply amounts in (1) by cost of capital rate 3. Discount each value in (2), using risk free rates to give overall risk margin

Question 30

In the cost of capital method, why is there a circular reference, how is it overcome?

Answer 30

1. Circular because step (1) of CoC requires SCR, but SCR calculation requires CoC 2. Simplified approaches are used, especially because SCR calc is complex too

Question 31

Give examples of simplified approaches to calculate step 1 in the CoC method?

Answer 31

1. Select a driver with an approximate linear relationship with capital requirement or components e.g. sum at risk or reserves 2. Express cap reqs as % of the driver e.g. sum at risk at time 0 = 100, SCR = 10, so 10/100=10%. So if at time 2 SaR was 200, then approx SCR = 0.1*200=20 3. Could combine multiple drivers and use correlations

Question 32

what can also be accounted for when calculating the risk margin between lines of business?

Answer 32

diversification between lines up to entity level