Solvency ii - Risk Margin
in the Quantitative Impact Study 4
TS.II.A.6. The value of the technical provisions is equal to the sum
of a best estimate and a
risk margin.
The best estimate and the
risk margin
should be valued separately, with the exception of hedgeable (re)insurance
obligations
TS.II.A.8. Separate calculations of the best estimate and the
risk margin
are not required, where future cash-flows associated with insurance
obligations can be replicated using financial instruments for which
a market value is directly observable.
In this case, the value of technical provisions should be determined
on the basis of the market value of those
financial
instruments.
Risk Margin
TS.II.A.14.
The risk margin is such as to ensure that the value of
technical
provisions is equivalent to the amount that (re)insurance
undertakings would be expected to require to take over and meet the
(re)insurance obligations.
TS.II.A.15.
The risk margin should
be calculated by determining the cost of providing an amount of
eligible own founds equal to the Solvency Capital Requirements
necessary to support the insurance (re)obligations over their
lifetime.
Hedgeable and non-hedgeable (re)insurance obligations
TS.II.A.16. Note the two-step approach for “hedgeable” and
“non-hedgeable” (re)insurance obligations.
The first step focuses on the split of the (re)insurance obligations
into “hedgeable” and “non-hedgeable”, and the second step focuses on
how an explicit
risk margin
for nonhedgeable cash-flows is to be calculated.
The valuation of the technical provisions should cover both
hedgeable and non-hedgeable (re)insurance obligations.
TS.II.A.17. In line with the principle set out in TS.II.A.8, where
the future cash-flows associated with (re)insurance obligations can
be replicated using financial instruments, those obligations are
considered as "hedgeable" and separate calculations of the best
estimate and
risk margin
are not required.
In this case participants should follow the guidance provided in
paragraphs TS.II.A.22 to TS.II.A.28.
TS.II.A.18. Conversely, where (re)insurance obligations are
considered as "non-hedgeable" because the future cash-flows
associated with those obligations cannot be replicated using
financial instruments, separate calculations of the best estimate
and
risk margin
are required.
Please note that "non-hedgeable" (re)insurance obligations are still
to be valued on a market consistent basis as set out in paragraph
TS.II.A.3 above.
In particular, where financial markets provide for relevant,
credible and up-to-date information for valuation purposes, this
should be duly taken into account.
TS.II.A.19. If within a contract an option, guarantee or other part
of the contract can be completely separated and as such be perfectly
hedged on a deep, liquid and transparent market the separate benefit
is classified as a hedgeable component and is valued as set out in
paragraphs TS.II.A.22 to TS.II.A.28.
TS.II.A.20. Where there is an unsure distinction between hedgeable
and non-hedgeable cashflows, or where market-consistent values
cannot be derived, the non-hedgeable approach should be followed
(separate calculations of best estimate and
risk margin).
TS.II.A.21. The respective values of hedgeable and non-hedgeable (re)insurance
obligations should be separately disclosed.
For non-hedgeable (re)insurance obligations, the
risk margin
should be separately disclosed.
Hedgeable (re)insurance
obligations
TS.II.A.22. Future cash flows from obligations towards policyholders
and beneficiaries of insurance contracts
are hedgeable if they
can be replicated using financial instruments for which a market
value is directly observable on a deep, liquid and transparent
market.
TS.II.A.23. The financial instruments shall completely replicate all
possible payments corresponding to the liability cash-flow, taking
into account the uncertainty in amount and timing of these payments
(theoretical perfect hedge).
TS.II.A.24. A perfect hedge or replication is one that completely
eliminates all risks associated with the liability.
In practice perfect hedges are expected to be
relatively rare.
If in practice the hedge is not perfect but the remaining basis risk
is immaterial, in the interest of proportionality the undertaking
may consider the risks as hedgeable.
TS.II.A.25. Circumstances where cash-flows are hedgeable could
include, for example, some options and guarantees embedded in life
insurance contracts, some unit-linked (equity-indexed for instance)
life insurance contracts, cash flows where there is no uncertainty
in the amount and timing, etc.
TS.II.A.26. For a hedged portfolio or replication, the non-arbitrage
principle implies that the market consistent value of the hedgeable
cash-flow should be acceptably close to the market value of the
relevant hedge or replicating portfolio.
TS.II.A.27. A market is defined to be deep, liquid and transparent
if it meets the following requirements:
(d) market participants can rapidly execute
large-volume transactions with little impact on prices;
(e) current trade and quote information is readily available to the
public;
(f) the properties specified in a. and b. are expected to be
permanent.
TS.II.A.28. Basis risk originates from differences between the
exposure in an undertakings liabilities and the contract terms of
what may be purchased from the market.
Non-hedgeable (re)insurance obligations
TS.II.A.29. Where the cash-flows associated with the (re)insurance
obligations contain non hedgeable financial (due to incomplete
markets) or non-financial risks (due to options and guarantees on
mortality and expenses for instance) that, when combined in a single
insurance contract, cannot be hedged or replicated using instruments
on a deep, liquid and transparent
market, the obligations may be valued by inter/extrapolating from
directly observable market prices.
Market consistent valuation techniques may be used to set the
assumptions for, say, financial risks within a non-hedgeable
contract and, for the remaining risks (the non-financial risks in
this example), valued using best estimate assumptions.
The
risk margin
should then be determined according to a cost-of-capital (CoC)
approach.
The cost of capital calculation excludes market risk as this would
otherwise double-count margins which are implicitly
included in market prices.
TS.II.A.30. Not all financial risks can be
hedged or replicated using instruments traded on a deep, liquid and
transparent market.
For instance, different kinds of embedded financial options and
guarantees in life insurance contracts may include risks where there
is a non-traded underlying4, or risks where the duration exceeds a
reasonable extrapolation from durations traded on the financial
market, or risks relating to traded financial instruments that are
not available in sufficient quantities, etc.
Where this is the case and if the remaining risk is considered
material, alternative methods to find a “hedgeable cost” may be used
to adjust market information and capture an additional
market-consistent
risk margin.
Please see TS.II.D.60 on the calibration of stochastic models.
TS.II.A.31. Even if it would be desirable, the values of hedgeable
and non-hedgeable risks might not be separable under all
circumstances (for instance, because a market consistent valuation
has been used).
Simplifications
TS.II.A.32. According to the proportionality principle, undertakings
may use simplified methods and techniques to calculate insurance
liabilities, using actuarial methods and statistical techniques that
are proportionate to the nature, scale and complexity of the risks
they face.
TS.II.A.33. A continuum of methods is suggested ranging from low to
high complexity to determine the value of (re)insurance liabilities.
In accordance with the proportionality principle, an undertaking may
choose a simplified method if it is proportionate to the underlying
risk.
TS.II.A.34. The use of a simplification is not directly linked to
the size of the insurance or reinsurance undertaking, but to the
nature, scale and complexity of the risks supported by the
undertaking.
TS.II.A.35. Simplified methods may be applied in the valuation of
the (re)insurance liabilities where the result so produced is not
material, or not materially different from the result which would
result from a more accurate valuation process.
TS.II.A.36. However participants are not required to re-calculate
the value of their technical provisions using a more accurate method
in order to demonstrate that the difference between the result of
the simplified method and the result of a more accurate method is
immaterial.
It is sufficient to have reasonable assurance
that the difference between those two amounts is likely to be
immaterial.
TS.II.A.37. Participants may use simplified actuarial methods and
statistical techniques if the criteria outlined in TS.II.A.38 are
satisfied or are likely to be met. Of course, as indicated in
TS.II.A.36, it is not necessary to re-calculate the best estimate
using a more appropriate approach in order to demonstrate that the
absolute / relative quantitative criteria set out below are met.
It is sufficient to meet those quantitative criteria when using the
simplified method. All criteria should be applied on a best effort
basis.
TS.II.A.38.
Simplified actuarial
methods and statistical techniques may be used if:
• the types of contracts written for each line of business or
homogenous group of risk is not complex (e.g. path dependency does
not have a significant effect; for example: life contract that
doesn’t include any options or guarantees, non-life insurance that
doesn’t include options for renewals);
• the line of business or homogenous group of risks written is
simple by nature of the risk (e.g. insured risks are stable and
predictable in a sense that the amount of the claims paid could be
predicted with a great certainty, or that the future claims-related
cash flows can be projected with a high level of confidence).
For example: term assurance, insurance of damage to land - property
or motor vehicles, etc.; and
• any additional nature and complexity standards set out for each
liability are met; and
• the liability that is valued is not material in absolute terms, or
relative to the overall amount of the total best estimate.
For the purposes of QIS4, please
use the following guidance on materiality to determine when
simplifications may be used for the technical provisions:
• the result from the simplified approach (sum of all best estimates
of liabilities determined with simplified actuarial methods and
statistical technique) is no more than 50 million Euro for life
business, and 10 million Euro for non-life
business; or
• the value of best estimate determined with simplified actuarial
methods and statistical technique for each homogenous group of risks
where simplified method is used is no more than 10% of the total
gross best estimate; and
• the sum of all best estimates determined with simplified actuarial
methods and statistical technique is no more than 30% of the total
gross best estimate.
This guidance on materiality is applicable with respect to all
simplifications to determine the value of the best estimate and/or
risk margin.
TS.II.A.39. If a participant (e.g. a captive (re)insurer) does not
meet the threshold indicated, but nevertheless thinks it should be
allowed to apply a simplified approach because of the specificities
of its situation, it can do so provided that it 1) explains the
reasons for this and 2) indicates the criteria it considers relevant
in its situation.
The participant is also invited to carry-out the more accurate
calculation to allow CEIOPS to benchmark the simplified
calculation.
All participants are invited to comment on the level of the
quantitative thresholds.
TS.II.A.40. For further clarity, all simplifications have been
included in boxes.
Proxies
TS.II.A.41. Proxies for the valuation of technical provisions come
into play where there is insufficient company-specific data of
appropriate quality to apply a reliable statistical actuarial method
for the determination of the best estimate.
Proxies can be regarded as special types of simplified methods which
are positioned at the “lower end” of continuum of methods that could
be applied
TS.II.A.42. Under the future Solvency II regime, proxy methods will
be needed whenever a lack of sufficiently credible own data cannot
be avoided.
This is the case, for example:
• for entirely new types of insurance in the market that won’t have
any historic data to act as a guide (e.g. cyber risks);
• for classes of business that are being written for the first time
by an insurer;
• where due to legislative or significant underwriting changes the
characteristics of the terms of the insurance contracts are changed
in such a manner that historic data is rendered useless; or
• when the insurer (or the class of business in question) is too
small to allow the build-up of credible historic claims data.
TS.II.A.43. Under the Solvency II framework,
proxies can be used to determine technical provisions if:
• the proxy is compatible with the general principles underlying the
valuation of technical provisions under Solvency II; and
• the use of the proxy is proportionate to the underlying risks.
TS.II.A.44. An appropriate valuation of technical provisions under
the Solvency II principles (including the use of proxies) will
require sufficient actuarial expertise.
Consistent with this, the Framework Directive Proposal requires
insurers to provide an actuarial function to ensure the
appropriateness of the methodologies and underlying models used as
well as the assumptions made in the calculation of technical
provisions.
However, it should be acknowledged that currently a significant
number of insurers have not yet built up their actuarial expertise
to the level which will be required under Solvency II, especially in
non-life insurance where in some markets the use of actuarial
techniques has traditionally been less widespread than in life
insurance.
In the light of this, and in order to increase the participation of
the insurance industry in QIS4, the QIS 4 package includes a
technical tool which is intended to facilitate the “best estimate”
valuation of technical provisions in non-life insurance.
TS.II.A.45. Section TS.IV of these specifications contains a
description of a range of proxy valuation techniques for technical
provisions, including criteria under which these proxies could be
applied.
TS.II.A.46. When applied with sufficient actuarial expertise and
professional judgement, these techniques (or parts of these
techniques) can in certain circumstances be regarded as sound
actuarial techniques.
It should be noted, however, that over-reliance on any one proxy
method would seem inappropriate, considering that each may, at a
point in time, produce sensibleestimates, but changing circumstances
may render its accuracy and validity of limited use.
Therefore, to the extent this is practicable, participants should
not rely on a single proxy method, thought to be appropriate, but
rather consider a range of approaches before making a final decision
on which method they take.
TS.II.A.47. When using proxy techniques,
participants are also requested to provide additional qualitative
information.
In particular, participants are invited to comment on the
appropriateness and suitability of the proposed proxy techniques,
including the extent to which these techniques are consistent with
the overall philosophy of Solvency II.
Such information will allow for the further development of proxy
techniques (including technical descriptions as
well as application criteria) for the valuation of technical
provisions under Solvency II.
TS.II.C
Risk margin
TS.II.C.1 A cost-of-capital methodology should be used in the
determination of the
risk margin.
TS.II.C.2 Under the cost-of-capital approach, the
risk margin
is calculated by determining the cost of providing an amount of
eligible own funds equal to the SCR necessary to support the
insurance and/or reinsurance obligations over their lifetime.
In order to do so, participants should produce a projection of their
insurance and/or reinsurance obligations until their
extinction and then, for each year, participants should determine
the amount of the SCR to be met by an undertaking facing such
obligations.
TS.II.C.3 The calculation of technical provisions is based on their
current exit value which means that the cost of providing capital is
assessed starting from the valuation day of the best estimate
(denote it by t = 0).
TS.II.C.4 For the purpose of QIS4, participants are requested to
perform their SCR calculationson the basis of the standard formula,
when calculating the
risk margin,
even if it should be possible to use the output of an approved
internal model to perform the SCR calculation under the future
Solvency II framework.
TS.II.C.5 On an optional basis, participants which have developed a
full or partial internal model are also invited to communicate the
result of their
risk margin
calculations based on these models, provided that the results using
the standard formula are also communicated.
TS.II.C.6 Where the
risk margin
calculation is based on the standard formula, it should be
calculated net of reinsurance.
In other words, a single net calculation of the
risk margin
should be performed, rather than two separate calculations (i.e. one
for the
risk margin
of the technical provisions and one for the
risk margin
of reinsurance and SPV recoverables).
Where participants calculate the
risk margin
using an internal model, they can either perform one single net
calculation or two separate calculations.
Risks to be taken into account
TS.II.C.7 The risk modules that need to be taken into account in the
cost-of-capital calculations are operational risk, underwriting risk
with respect to existing business and counterparty default risk with
respect to ceded reinsurance.
TS.II.C.8 It is assumed that related to the insurance and
reinsurance obligations there does not arise any market risk or risk
of default of the counterparties to financial derivative contracts.
TS.II.C.9 Renewals and future business should be considered only to
the extent that they have been included in the current best estimate
of liabilities (See TS.II.B.32 and TS.II.B.33).
Distinct calculations for each segment / line of business
TS.II.C.10 Participants are requested to differentiate calculations
on different segments.
TS.II.C.11 For Life insurance, the value of the
risk margin
should be reported separately for each segment as defined in
TS.II.D.1 - TS.II.D.5.
TS.II.C.12 For non-life insurance, the value of the
risk margin
should be reported separately for each line of business as defined
in TS.II.E.1- TS.II.E.3.
Aggregation of Technical Provisions as calculated per segment
TS.II.C.13 To obtain the overall value of technical provisions,
participants should assume that no diversification benefits arise
from the grouping of technical provisions calculated per segment.
Cost-of-Capital rate
TS.II.C.14
All participants
should assume that the Cost-of-Capital rate is 6%.
Steps to calculate the risk margin
TS.II.C.15 The steps to calculate the
risk margin
under a Cost-of-Capital methodology can be summarised as follows (it
is here assumed that the valuation date is the beginning of year 0,
i.e. t=0):
• For each insurance / reinsurance segment find an SCR for year t =
0 and for each future year throughout the lifetime of the
obligations in that segment. SCR for year 0 corresponds to the
capital requirement that the firm should hold today with the
exception that only part of the risks are considered.
The risks to be taken into account are operational risk,
underwriting risk with respect to existing business and counterparty
default risk with respect to reinsurance ceded.
• Multiply each of the future SCRs by the Cost-of-Capital rate to
get the cost of holding the future SCRs.
• Discount each of the amounts calculated on the previous step using
the risk free yield curve at t=0. The sum of the discounted values
corresponds to the
risk margin
to be attached to the best estimate of the relevant liabilities at
t=0.
• The total amount of
risk margin
is the sum of the risk margins in all the segments.
Finding the future SCRs
TS.II.C.16 The main practical difficulty of the method is deriving
the SCR for future years for each segment.
The calculation of the different risk charges for the future SCRs
can either be done by the direct application of the SCR formulae or
through simplifications.
In the following paragraphs there is a list of the risks to be taken
into account and a short description of possible simplifications
that could be used.
TS.II.C.17 The overall SCR estimate for each segment determined by
combining the corresponding charges for non-life underwriting risk,
life underwriting risk, health underwriting risk, operational risk
and reinsurance counterparty risk by means of the aggregation method
of the SCR standard formula.
If the participant is carrying out the optional calculation where a
full or partial internal model is used for the estimation of SCR for
each segment, the participation should rather use the aggregation
method of its internal model.
Estimating operational risk
TS.II.C.18 The operational risk capital charge can always be
calculated using the SCR standard formula.
The formula uses as input parameters earned premiums gross of
reinsurance and best estimates of technical provisions (comprising
both premium provision and outstanding claims provision) gross of
reinsurance.
There is also an upper limit with respect to BSCR. These input data
have to be estimated for each respective year in each segment.
Participants are reminded that the best estimates are valued at the
time value of money of the development year in
question (consistent with the use of the interest rate term
structure at the valuation date).
Risk Margin Simplifications (1)
TS.II.C.19 Estimating counterparty default
risk
Counterparty default risk charge with respect to reinsurance ceded
can be calculated directly from the definition for each segment and
each year.
If the exposure to the default of the reinsurers does not
vary considerably throughout the development years, the risk charge
can be approximated by applying reinsurers’ share of best estimates
to the level of risk charge that is
observed in year 0.
According to the standard formula counterparty default risk for
reinsurance ceded is assessed for the whole portfolio instead of
separate segments.
If the risk of default in a segment is deemed to be similar to the
total default risk or if the default risk in a segment is of
negligible importance then the risk charge can be arrived at by
applying reinsurers’ share of best estimates to the level of the
total capital charge for reinsurers’ default risk in year 0.
TS.II.C.20 Estimating non-life underwriting
risk
Underwriting risk charge for non-life business (other than
catastrophe risk) can be calculated directly from the formula using
best estimate for outstanding claims provision net of reinsurance
(other than annuities) and earned premiums net of reinsurance as
input parameters.
Renewals and future business are not taken into account. For
simplicity it can be assumed that the undertaking-specific estimate
of the standard deviation for premium risk remains unchanged
throughout the years.
Underwriting risk charge for catastrophe risk (CAT) is taken into
account only with respect to the insurance contracts that exist at t
= 0. If no better estimate of the catastrophe risk charge for a
segment in year y is accessible then the size of the risk charge can
be assumed to be in direct proportion to the earned premiums net of
reinsurance in that segment.
If it is not possible to differentiate the catastrophe risk charges
in between segments then it can be assumed that the exposure is
proportionate to the net earned premiums.
Usually the periods of insurance are not very long in non-life
insurance so that the earned premiums differ from zero only for the
first few years.
This provides for a further simplification.
Since there does not exist any premium or catastrophe risk for the
years when earned premiums are zero the underwriting risk module for
non-life consist only of the reserve risk.
The risk charge for the reserve risk in a segment is simply of the
form constant times the best estimate of the outstanding claims
provision net of reinsurance.
TS.II.C.21 Estimating health underwriting risk
In short term health insurance, the lifetime of the obligations is
short by definition.
Typically the capital charge for the first 12 months will suffice
(t=0).
If there are obligations that are not negligible beyond the first
year, simplifications similar to those in non-life underwriting risk
can be used.
For simplicity it may be assumed that the overall standard deviation
σ remains the same over time.
Similarly, the underwriting risk charge for the workers’
compensation general module should be calculated using the
guidelines proposed for non-life underwriting risk.
However, the workers’ compensation annuities risk charge should be
calculated using the methods proposed for the life underwriting risk
charge.
TS.II.C.22 Estimating life underwriting risk
As an approximation, the future SCRs for sub-modules can be
calculated using the simplified SCR approaches (See paragraphs
TS.XI.B.10, TS.XI.C.9, TS.XI.D.8, TS.XI.E.10, TS.XI.F.6 and
TS.XI.G.5).
Future SCRs should then be calculated using inputs projected into
the future required to calculate the simplified SCRs.
TS.II.C.23 Estimating the risk-absorbing effect of future profit
sharing Undertakings should project the SCR net of the
risk-absorbing effect of profit sharing (see TS.VI.H) for the
purpose of calculating the
risk margin.
Profit sharing may be ignored where this is largely a result of
risks which have been excluded from the projection (e.g. market
risk).
Alternatively, the effect of profit sharing can be approximated by
calculating the SCR at future periods calculated gross of the profit
sharing effect multiplied by the ratio of the SCR net of profit
sharing effect at t=0 (excluding market risk) divided by the SCR
gross of profit sharing effect at t=0 (excluding market risk).
Risk Margin Simplifications (2)
TS.II.C.24 If participants are unable to use above simplifications,
then the following can be used.
The simplified calculations shall be made per segment. They may only
be applied if the standard formula is applied to calculate the SCR.
For those segments which include risks calculated by the non-life,
life and/or health methods below, the overall
risk margin
is calculated by combining the results from the simplifications by
means of the aggregation method of the SCR
standard formula.
Risk Margin in the QIS4
Risk Margin in the QIS5
CEIOPS Advice for Level 2 Implementing Measures on Solvency
II: Technical Provisions – Article 86 (d) Calculation of the
Risk Margin
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