Solvency ii in comparison with ICA

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Table of content

  1. Introduction ……………………………………………………………………………………………………….
  2. Solvency II ………………………………………………………………………………………………………….
  3. Solvency II in comparison with ICA
  1. General features of solvency II regulations……………………………………………….
  2. Similarities between Solvency II and ICA…………………………………………………..
  3. Differences between Solvency II and ICA…………………………………………………..
  1. Unit linked products under Solvency II
  1. Technical provisions………………………………………………………………………………….

introduction

solvency ii in comparison with ICA

General features of solvency ii regulations

Solvency II affects the corporates’ ability to fund and mitigate financial risk negatively. It is created with the intention of enhancing and providing more consistent level of protection for policyholders and encouraging the safety and soundness of insurance companies throughout Europe. (Regulations under solvency ii pdf)

  • Solvency II has a ‘maximum harmonising’ regulatory framework. Under this, a single set of requirements will be applied consistently across Europe. A consistent framework would promote more competition across Europe.
  • It incorporates a ‘total balance sheet’ (Figure) approach. This includes the risks to liabilities, assets and their interaction. This needs to be considered in setting capital requirements.
  • It will adopt the ‘three pillar’ (figure) approach. This system is intended to provide incentives to insurance companies to measure and manage their risk situation.(ica and solvency pdf)
  • General features of the Solvency II regulations:
    • A forward-looking and risk-based approach in setting higher capital requirements to enable timely intervention (0_solvencyIMP pdf).
    • Market-consistent valuation of assets and liabilities.
    • Strengthening market discipline through company disclosures.
    • Taking full account of the costs of options and guarantees. (villet_IMP pdf).

similaties between SOlvency ii and ica

Solvency II is a risk-based regulatory framework whereas ICA is the firm’s own assessment of its capital requirements based on the given risk exposures.

  • Both are defined as 99.5% confidence level over one year that assets will be equal or greater than liabilities.
  • They follow a three pillar approach??
  • They have a supervisory review process. Solvency II follows a dual supervisory intervention though the creation of a Minimum Capital Requirement and a Solvency Capital Requirement (SCR). Under solvency II, regulatory intervention is when the capital falls below the Solvency Capital Requirement (SCR). Under, ICA, regulatory intervention is when it falls below the Individual Capital Guidance (ICG).
  • ICA is possibly very similar to internal model SCR in Solvency II.

(villet_IMP pdf)

differences between SOlvency ii and ica

Much of the groundwork for Solvency II has laid down by the ICA and it has proven to be a useful risk management platform. However, there are some areas of Solvency II that impose different standards. Solvency II differs from ICA in the following ways:

  • It includes risk margins in addition to the best estimate reserves.
  • It requires disclosing reports and requirements on actuarial work and judgements.
  • It requires market consistent valuation of liabilities using cost of capital method rather than the percentile method.
  • It incorporates the asset localisation rules under which the assets in relation to the EU insurance technical reserves must be held in the EU itself.
  • Under Solvency II Pillar 1, own funds are separated into 3 tiers based on the quality of capital. This is not the case in ICA. (http://www.theactuary.com/archive/old-articles/part-3/solvency-ii/)
  • Solvency II takes into account the European Union (EU) whereas ICA is just for the UK.
  • The fundamental risk parameters (i.e. volatility, yield, correlation matrices, and credit defaults) in the standard formula used under Solvency II are specified by the regulator and calibrated to industry experience even though some credit can be given to one’s own experience through credibility factors. While this is not the case under ICA.
  • ICA follows an internal risk-based capital model and there is no standard formula but the Financial Services Authority (FSA) specifies the rules and regulations. But, Solvency II gives the option to use both, a standard formula (SCR formula), internal model or partial model.
  • The concept of ‘Own Risk and Solvency Assessment’ (ORSA) is now embedded in Solvency II. It is a continuous process and is determined by the firms’ “own” short and long term risks. ORSA will help the firms to manage and understand some risks (such as; cyber risk, risks faced due to long term effects of climate change which cannot be observed over the time span of a year) that they are exposed to. (regulations under solvency ii pdf AND vol5_orsa pdf)

unit linked product under solvency ii

A unit linked contract represents the policyholder with explicit charges of various kinds from which the insurer must meet its expenses and make profit. It directs the premiums less charges into investment funds of the policyholder’s choice whose gains and losses the policyholder shares explicitly.

The new unit linked product that the company is launching needs to be accommodated under Solvency II. From the given structure of the new unit linked product, it is evident that there is no investment risk for us and expenses are explicit to the policyholder.

In order to maintain to protect the policyholders with unit linked and index linked life insurance products, the FSA proposed rules taking account of new European requirements for insurers. Solvency II directive suggests how the insurers’ assets, including the unit linked and index linked funds, must be managed which replaces the current FSA approach which simply lists the assets that can be used by the insurer. (http://www.actuarialpost.co.uk/article/fsa-on-solvency-ii-transposition-and-unit-linked-products-1408.htm) AND (http://www.theactuary.com/archive/old-articles/part-4/fsa-moves-to-protect-unit-linked-life-policyholders-under-solvency-ii-/)

According to the recent figures, the UK unit linked long term life sector has assets of £815bn under management and an additional £24bn in index linked policies. Solvency I includes matching of the face value of the liabilities with the same assets, holding a reserve to cover the extra expenses and recognising the Value of In-Force (VIF) (i.e. the future profits). Whereas Solvency II replaces this rule and now we only have to match the lower Best Estimate Liability (BEL) with units and can freely invest in VIF. Hence there is a decision which needs to be made on the investment strategy and the potential use of risk mitigations (i.e. derivatives and reinsurance) keeping in mind our strategy to minimise capital, minimise volatility or maximise returns. In other words, unit linked assets need to be matched to the unit linked technical provisions instead of the face value of the unit linked liabilities. And the excess of the unit linked assets could be invested in other ways. (https://www.barnett-waddingham.co.uk/comment-insight/blog/2015/01/06/unit-linked-business-it-just-keeps-getting-harder/) AND (unit linked solvency ii pdf)

technical provisions under solvency II

The technical provisions form the largest part on an insurance undertakings’ balance sheet. The ‘prudent person principle’ (Article 132 in Solvency II directive) states that for unit linked contracts, the technical provisions with respect to the (unit-linked) benefits must be represented as closely as possible by those units or by those assets (in the case where units are not established). Technical provisions includes the (re)insurance undertaking’s Best Estimate Liability (BEL) and the risk margin.

Technical provisions should be calculated consistently with the valuation of liabilities and assets along with market consistency and with respect to the international developments in accounting. The value of technical provisions should then be consistent with the amount that our company would have to pay if we transfer its contractual obligations and rights to another (re)insurance undertaking. It is necessary for us to calculate the expected present value of the insurance liabilities on the basis of our current information and realistic assumptions, bearing in mind financial guarantees in the insurance contracts. (Unit linked solvency ii PDF) AND (solvency_2-consultant…IMPPP pdf)

Assumptions made in the calculation of technical provisions include:

  • The value of the technical provisions should correspond to the existing amount that the (re)insurance undertakings would have pay if they transferred their (re)insurance obligations immediately to another undertaking.
  • The calculation of technical provisions should be consistent, making use of the information provided by the financial markets and data available on underwriting risks (i.e. market consistency).
  • We use the Cost-of-Capital rate in determining the cost of providing the amount of eligible own funds. And this shall be the same for all the (re)insurance undertakings and would be analysed periodically.
  • Appropriate assumptions with respect to inflation should be a incorporates into the cash flow projection taking into consideration the type of inflation the cash flows are exposed to (e.g. Salary inflation, consumer price inflation)
  • Cancellation assumptions must be incorporated implicit to the premium projections under the existing contracts.
  • Risk-free interest rate term structure should be defined following a uniform methodology. This structure should be then used to measure the time value of the cash flows payable in each currency.

(Section7-technical provisions Lloyd’s pdf)

Other elements that need to be taken into account for the calculation of technical provisions include:

  • Expenses incurred in servicing reinsurance and insurance obligations,
  • Time value of money and inflation (involves claims and expenses inflation), and
  • All payments made to the beneficiaries and policyholders which includes bonuses.

(CELEX-32009L0138-en-TXT pdf)

Best Estimate Liability

The BEL is the probability weighted average of the future cash flows considering the time value of money and using a suitable risk-free interest rate term structure. It is based on realistic assumptions and up-to-date and credible information and can be performed using relevant statistical and actuarial methods. (Section7-technical provisions Lloyd’s pdf)

It can be calculated as the discounted value of the future cash flows associated with the unit linked business or as the sum of the face value of the unit linked liabilities in addition to the present value of the future profits (PVFP) of the unit linked business. (For profitable contracts, PVFP is usually a negative liability). (Unit linked solvency ii PDF) AND (solvency_2-consultant…IMPPP pdf)

The Best Estimate is to be calculated gross, without any deductions of the amounts which can be recovered from the (re)insurance contracts. The time horizon to be considered in the calculation of BEL must be the full lifetime of the current (re)insurance contracts on the valuation date.

Considering the new unit linked product, we could classify the information into unit linked fund and non-unit linked (sterling) fund.

Unit linked funds

Non-unit linked funds

Consists of :

  • Allocated premium(single premium)
  • Fund management charge
  • Surrender charge
  • Other additional charges

BEL = Fund value

Consists of :

  • Unallocated premium (here: £0)
  • Charges included in the unit fund
  • Benefit (i.e. maturity and/or death benefit)
  • Interest
  • Expenses (i.e. commission, admin cost etc.)

BEL = PV(Future cash flows) = PV(Charges) – PV(Expenses)

– PV(Benefit)

Reason to include risk margin

BEL doesn’t take into account the sensitivity of the interest rate and hence the insurers may choose to hedge this interest rate risk of their liabilities by forming a portfolio of assets which matches the movement in the value of liabilities. BEL doesn’t consider the volatility of the assumptions made and hence there is a need to calculate the risk margin. In other words, risk margin is calculated to make sure that the value of the technical provisions corresponds to the amount that our firm would be expected to require to take over and meet another firm’s undertaking’s obligations. This reduces the firm’s volatility of the balance sheet.

Risk Margin

Risk margin represents the additional amount an insurance firm needs to hold to take on the obligations of another given insurance firm. This implies that the company would still have enough assets to safely wind-up and transfer its obligations to a third party in a situation where the firm had to use its free surplus and capital. In other words, it is the cost of holding the additional capital to cover the uncertainty in the evaluation of the best estimate of the future cash flows and its volatility. This concept has been recently taken up by the Swiss regulator in their new solvency regime and this concept is gaining support from insurers in UK and Europe. (http://www.theactuary.com/archive/old-articles/part-4/solvency-ii/) AND (http://www.theactuary.com/features/2012/06/solvency-ii-risk-margin-to-hedge-or-not-to-hedge/) AND (risk Margin_IMP pdf)

Risk margin is calculated per line of business which involves calculating the risk margin for the whole business (allowing for diversification between the lines of business) followed by allocating the margin to the lines of business.

Risk margin, under Solvency II, needs to be calculated[1] using the Cost of Capital approach which involves determining the cost of providing a fixed amount of eligible own funds which equals the SCR necessary to support the business-in-force until the run-off. The rate used to determine this cost is called the Cost-of-Capital rate. Low profit is generated when a firm invests its solvency capital in risk free investments. Since the investors demand a certain return which is more than the risk free rate on all capital, the company makes a cost by holding this extra amount of the capital. This is namely the Cost of Capital. (risk Margin_IMP pdf)AND (http://www.theactuary.com/features/2012/06/solvency-ii-risk-margin-to-hedge-or-not-to-hedge/) AND (A_-_Revised_technical_Specifications_for_the_solvencyII….)

(Mention the 5 risks)

(How to calculate risk margin + formula)

Solvency Capital Requirement (SCR)

SCR is the amount of funds that the (re)insurance are expected to hold in the European Union. It covers the quantifiable risks that a (re)insurance firm faces which also includes non-life underwriting and involves any risk-mitigation techniques. It determines the amount of capital that the firm should hold to back their risks. SCR needs to be recalculated at least once per year and it covers the existing as well as new business over a year. (http://www.investopedia.com/terms/s/solvency-capital-requirement.asp) AND (solvency_2_consultation_annex_a_IMPP pdf)

The SCR is set at a level which ensures that the (re)insurers hold enough capital to ensure that ruin doesn’t occur more often than once in 200 cases i.e. it ensures that they can meet the obligations made to the policyholders with a probability of at least 99.5% over a year (also referred to as the 99.5% Value-at-Risk measure). (Same as above + Calculating_the_Solvency_Capital_Requirement-1-2 pdf)

1


[1]. Risk margin can be calculated using either the Cost of Capital approach or the Percentile approach. However, under solvency II the later isn’t used. So we’ll focus on the Cost of Capital approach for the remainder of this section.

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