Solvency ii - Risk Margin
in the Quantitative Impact Study 5
Technical specifications for QIS 5
The Cost-of-Capital rate is an annual rate
applied to a capital requirement in each period.
Because the assets covering the capital requirement themselves are
assumed to be held in marketable securities,
this rate does not account for the total return but merely for
the spread over and above the risk free
rate.
The risk margin shall guarantee that sufficient technical
provisions
for a transfer are available even in a stressed scenario. 
Hence, the Cost-of-Capital rate has to be a
long-term average rate, reflecting both periods of stability and
periods of stress.
Otherwise, the rate would vary from year to year, and would be
higher
in times of economic uncertainty (when providers of capital would
be expected to seek greater returns for the comparatively higher
risk) and would therefore contribute to higher technical
provisions than in more stable economic situations.
A rate of at least 6 per cent is
assessed to be an adequate placeholder for the Cost-of-Capital
rate in the current context of the Solvency II regulation.
In order to reach this conclusion it may be argued along the
following lines:
• Shareholder return models provide the initial input.
• Some objective criteria may cause upward and downward
adjustments of the initial input.
• A final calibration of the Cost-of-Capital rate, in order to
obtain risk margins consistent with observable prices in the
marketplace, may be necessary.
Before discussing this three-step procedure, it will be
reflected on the assumptions that would be reasonable to make
regarding the funding of the capital requirement.
The technical details of the calculation of the risk margin shall be
carried out on a best effort basis,
although respecting the assumptions
regarding the reference undertaking assumed to take over and meet
the insurance and reinsurance obligations of an insurance or
reinsurance undertaking.
See the “Final CEIOPS’ Advice for Level 2
Implementing Measures on Solvency II: Technical Provisions –
Article 86 (d). Calculation of the Risk Margin (former CP 42)”
and especially sub-section 3.1.3.1
(para 3.25–3.71) of this advice.
However , with regard to the diversification
allowed in the risk margin, undertakings should
deviate from CEIOPS' advice as
follows:
The risk margin calculation should be based on the
assumption that the whole insurance and reinsurance portfolio is
transferred to an empty reference
undertaking. Consequently, the calculation of the risk
margin should take the diversification
between lines of business into account.
The calculation shall be based on the assumption that the
reference undertaking at time t = 0 (when
the transfer takes place) will capitalise itself to the
required level of eligible own funds, i.e.
The cost of providing this amount of
eligible own funds equals the
Cost-of-Capital rate times the amount.
The assessment referred to in the previous paragraph
applies to the eligible own funds to be
provided by the reference undertaking in all future years, in
order “to support the insurance and reinsurance obligations over
the lifetime thereof” (Article 76(5)).
The transfer of (re)insurance
obligations is assumed to take place
immediately (cf. Article 76(3)). Hence, the
method for calculating the overall risk
margin (CoCM) can in general terms be expressed in the
following manner:
The general rules for calculating the risk margin referred to
above apply to all undertakings irrespective of whether the
calculation of the SCR of the (original) undertaking is based on
the standard formula or an internal model.
If the undertaking calculates its SCR by using the
standard formula, all SCRs to be used in the risk margin
calculation (i.e. all SCRRU(t) for t ≥ 0) should be calculated as
follows:
It should be ensured that the
assumptions made regarding loss absorbing capacity of technical
provisions to be taken into account in the SCR-calculations
per line of business, are consistent
with the assumptions made for the overall portfolio of the
original undertaking (i.e. the undertaking participating in the
QIS5 exercise).
The Basic SCRs (BSCRRU(t) for all t ≥ 0) should be
calculated by using the relevant SCR-modules and sub-modules.
Moreover, the calculation of the Basic SCRs (as
referred to in the previous paragraph) should be based on the
correlation assumptions laid down in Annex IV of the Level 1 text.
However, with respect to market risk and counterparty default
risk, respectively, only the unavoidable market risk and the
counterparty default risk with respect to ceded reinsurance should
be taken into consideration in these calculations.
With respect to non-life
insurance the risk margin should be attached to the overall best
estimate, that is with no split between risk margins for premiums
provisions and for provisions for claims outstanding (including
IBNR provisions).
The Cost-of-Capital rate
The Cost-of-Capital rate is the
annual rate to be applied to the capital requirement in
each period.
Because the assets covering the capital
requirement themselves are assumed to be held in marketable
securities, this rate does not account for the total return
but merely for the spread over and above the
risk free rate.
The Cost-of-Capital rate has been calibrated in a manner
that is consistent with the assumptions made for the reference
undertaking.
In practice this means that the
Cost-of-Capital rate should be consistent with the
Value-at-Risk-assumption corresponding to a confidence level of
99.5 per cent over the stipulated one-year time horizon as
laid down for the calculation of the Solvency Capital Requirement
(SCR).
The Cost-of-Capital rate does not depend on
the actual solvency position of the original undertaking.
The risk margin should guarantee that sufficient
technical provisions for a transfer are
available in all scenarios. Hence, the Cost-of-Capital rate
has to be a long-term average rate,
reflecting both periods of stability and periods of stress.
Based on the information currently available a
Cost-of-Capital rate of 6 per cent is
assumed to reflect the cost of holding an
amount of eligible own funds for an insurance or reinsurance
undertaking being capitalised corresponding to a confidence level
of 99.5 per cent Value-at-Risk over a one year time horizon.
The methodology applied in these specification aims to
guarantee that there will be sufficient technical provisions even
in case of a partial transfer of some of the
lines of business of the undertaking’s portfolio.
For this purpose:
– the calculations carried out in the context of the risk
margin should start on the SCR, furthermore using in the Basic SCR
the relevant SCR-modules and sub-modules, and the correlation
assumptions laid down in Annex IV of the Level 1 text.
However,
with respect to market risk and counterparty default risk,
respectively, only the unavoidable market risk and the
counterparty default risk with respect to ceded reinsurance should
be taken into consideration in these calculations.
– the loss absorbing capacity of technical provisions is taken
into account,
– the loss absorbing capacity of deferred taxes is not allowed
for,
– the risk margin is defined (and should be calculated) net of
reinsurance only.
Level of granularity in the risk margin calculations
The risk margin should be calculated per line of
business. A straight forward way to determine the margin per line
of business is as follows:
First, the risk margin is calculated
for the whole business of the undertaking, allowing for
diversification between lines of business.
In a second step the
margin is allocated to the lines of business.
The risk margin per line of business
should take the diversification between
lines of business into account.
The sum of the risk margin per line of business should be equal to
the risk margin for the whole business
The allocation of the risk
margin to the lines of business shall be done according to the
contribution of the lines of business to the overall SCR during
the lifetime of the business.
The contribution of a line of business can be analysed by
calculating the SCR under the assumption that the undertaking's
other business does not exist.
Where the relative sizes of the SCRs per line of business do not materially change over the
lifetime of the business, undertakings may apply the following
simplified approach for the allocation:
Simplifications for the calculation of the risk margin of the
whole business
If a full projection of all future SCRs is necessary in
order to capture the participating undertaking’s risk profile the
undertaking is expected to carry out these calculations.
Participating undertakings should consider whether or not
it would be appropriate to apply a simplified valuation technique
for the risk margin.
As an integral part of this assessment, the
undertakings should consider what kind of simplified methods would
be most appropriate for the business.
The chosen method should be
proportionate to the nature, scale and complexity of the risks of
the business in question.
When an undertaking has decided to use a simplified
method, it should consider whether the method could be used for
the projections of the overall SCR or if the relevant (sub-)risks
should be projected separately.
In this context, the undertaking
should also consider whether it should carry out the simplified
projections of future SCRs individually for each future year or if
it is possible to calculate all future SCRs in one step.
A hierarchy of simplifications
Based on the general principles and criteria referred to
above, the following hierarchy should be
used as a decision basis regarding the
choice of (simplified) methods for
projecting future SCRs:
1. make a full calculation of
all future
SCRs without using simplifications;
(2) approximate the individual risks or
sub-risks within some or all modules and sub-modules to be
used for the calculation of future SCRs;
(3) approximate the whole SCR for each future year, e.g. by
using a proportional approach; and
(4)
estimate all future SCRs “at once”, e.g. by using an approximation
based on the duration approach.
2. (5) approximate the risk margin by
calculating it as a percentage of the best
estimate.
In this hierarchy the calculations
to be carried out are in general getting simpler step by step.
In
order to be able to use the simplifications given on each step
appropriate eligibility criteria, based on quality and materiality
considerations, have to be fulfilled.
When using this approach, it is
not required that the aspired complexity of the calculations
should go beyond what is necessary in order to capture the
undertaking’s risk profile.
In any case, this approach should be
applied consistently with the framework set out when defining the
proportionality principle and the necessity of assessing risks
properly.
Remark: It
should be noted that the distinction between the levels in the
hierarchy sketched above is not always clear-cut.
This is e.g. the
case for the distinction between the simplifications on level no.
2 and level no. 3. An example may be a proportional method (based
on the development of the best estimate technical provisions)
applied for an individual module or sub-module relevant for the
calculation of future SCRs for the reference undertaking.
Such
simplifications can be seen as belonging to either level no. 2 or
level no. 3.
Specific simplifications
The simplifications referred to in this section are
described in the context of the standard formula.
The application
of simplifications for cases where the SCR is calculated with
internal models should follow the general approach proposed in
this paper with an appropriate case-by-case assessment.
With respect to the simplifications allowing for all
future SCRs to be estimated “at once” (the duration approach), it
will be natural to combine the calculations of the Basic SCR and
the SCR related to operational risk.
Accordingly,
in order to simplify the projections to be made if level no. 3 of
the hierarchy is applied, a practical solution could be to allow
projections of the future SCRs in one step, instead of making
separate projections for the basic SCR, the capital charge for
operational risk and the loss absorbing capacity of technical
provisions, respectively.
In order to avoid circularity issues the best estimate
technical provisions (and not the sum of the best estimate and the
risk margin) should be applied when calculating the present and
future SCRs for operational risk.
Finally, the
simplifications allowed for when calculating the SCR should in
general carry over to the calculation of the risk margin.
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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