The road to Solvency II – A UK perspective

Solvency II will come into regulation as per 1 January 2014. This resulted in a dramatic increase in demand for Solvency II experts, notably actuaries, within Europe, resulting in an influx of actuaries from overseas and actuaries starting their own 1 person companies (contractors). As the English Solvency I regime has several similarities to the proposed Solvency II framework it is interesting to assess the underlying reasons for previous regime changes. However, although Solvency II will replace the previous regulatory regime and create a level playing field for new people entering the insurance industry, a good understanding of the historical developments that have led to the Solvency II regime, will enhance the understanding of the structure of the proposed framework.

The following regimes are discussed:

• The current English Solvency I regime consisting of:
  • Pillar 1 consisting of Peak 1 and Peak 2 regulatory valuations;
  • Pillar 2 Individual Capital Assessment (ICA) under the Individual Capital Adequacy Standards (ICAS) regime.
• The future Solvency II regime consisting of:
  • Pillar 1 regulatory capital requirement framework;
  • Pillar 2 company-specific qualitative framework.

Please note that the pre 2002 regime, the net premium approach, falls outside of the scope of this paper. Figure 1 shows a timeline of past and future developments:

Solvency I – Pillar 1 – Peak 1

The English Solvency I framework introduced a valuation based on a regulatory basis (Peak 1) and a realistic framework (Peak 2, only for larger with profits (WP) firms). The overall framework is referred to as Twin Peaks. Peak 1 prescribes a prudential valuation method to ensure that future payments can be met. Furthermore, the framework is deterministic as a flat discount rate is applicable, independent of the timing of cash flows. Deterministic computer programs can be used to calculate balance sheets and profit and loss.

Assets are classified as either admissible or inadmissible assets (for the last category no easy valuation is possible). Examples of inadmissible assets are deferred tax assets/liabilities, works of art, future profits on in force business (VIF), and non-covered derivatives.

Liabilities are valued on a prudent basis and discounted on a flat yield curve based on 97.5% of risk adjusted yield on backing assets. This discount rate is calculated as the weighted average of dividend yield on equities and redemption yield on bonds. Adjustments are made for credit default risk. Furthermore, there is no allowance on future lapses and negative reserves (e.g. products that will incur more income due to management charges than costs due to expenses).

The total assets are then compared to the sum of liabilities to determine the level of the remaining surplus.

The LTICR  is added to the liabilities such that another insurance company would be willing to take over these liabilities. The calculation of LTICR is based on several components and differs between linked and non-linked liabilities as shown in Table 1:

Table 1: LTICR calculation under the Peak 1 framework

So far the Peak 1 framework has been based on prudent best estimate assumptions and expectations. To withstand any more extreme scenarios, a resilience test is performed leading to a resilience reserve (RCR, only for WP companies that have less than £500m in liabilities). In this test, assets are stressed under a single market scenario combining several shocks:  equity and property fall, and interest rate rise/fall depending on which one is more onerous. Furthermore, a dampener effect is applicable: the level of the stresses depends on the economic cycle, e.g. when equity prices have dropped, the equity stress will be downward adjusted.

To assess the company’s solvency the Minimal Capital Requirement (MCR), which is max(LTICR+RCR, BMCR), where BMCR is the industry-wide minimum capital requirement, is compared with the surplus assets.  Solvency II has a similar MCR metric: once a company is unable to support its MCR with surplus assets, supervisory intervention will take place.

Table 2 summarizes the strengths and weaknesses of the Peak 1 framework:

Table 2: Peak 1 strengths and weaknesses

Solvency I – Pillar 1 – Peak 2

As a result a Realistic Balance Sheet (RBS) approach was introduced for larger WP funds (>£500m) to reflect the underlying risks better. The time value of options and guarantees is either determined by stochastic simulation such as Monte Carlo (most common) or by a closed formula approach. Moreover additional assets and liabilities are taken into account such as uncovered derivatives and the NP VIF written in the WP fund. The liability also consists of particular WP balance sheet items as planned enhancements (extra bonus) or deductions (reduction in bonus), and costs of smoothing (difference actual and projected payout).

On top of this reserve a “realistic resilience test” is performed aka the Risk Capital Margin (RCM).  This test consists of a fall in equity and property prices, a widening of credit spreads, a parallel up and down shift in the yield curve, and a persistency shock. These scenarios happen instantaneously and any mitigating effects due to management actions (change in asset mix, change in expense policy) are allowed after the scenario has happened.

Table 3 summarizes the strengths and weaknesses of the Peak 2 framework:

Table 3: Peak 2 strenghts and weaknesses

Which Pillar bites?

Despite RBS, the overall framework remains prudent. In case the realistic surplus exceeds the regulatory surplus an additional reserve is added to the regulatory balance sheet, aka WPICC, which equals:

Max(Peak 1 surplus – Peak 2 surplus – future transfers , 0).

Equation 1

Either the realistic surplus exceeds the regulatory surplus, or the other way around.

1. When the regulatory surplus exceeds the realistic surplus, this can be represented as in Figure 2:

Figure 2: no WPICC when Peak 2 surplus exceeds Peak 1 surplus

When the regulatory surplus (10) is smaller than the realistic surplus (15), the regulatory balance sheet is “biting”, and the company is required to steer on the regulatory surplus.

2. If we increase the RCM component from 12 to 20, the regulatory surplus (10) would exceed the realistic surplus (7). As a result, the WPICC balancing item is added to equalise the surplus levels for Peak 1 and Peak 2 as representation in Figure 3:

Figure 3: WPICC when Peak 1 surplus exceeds Peak 2 surplus

The overall idea behind the framework is that the regulatory Peak sets the minimum capital requirement to ensure there is consistency within the industry to provide policyholders the same level of assurance. However, as there is a level of prudence within the framework, this methodology does not provide shareholders the best insight into the actual value of the company is. As a result, first EEV and later MCEV were developed to remove the prudence from the calculations and to align calculations with the market valuation view from shareholders.

The Twin Peaks framework is quite similar to the Prudential Filter framework in the Netherlands.

Similar to pension funds, insurance companies will define their risk appetite (i.e. which and how much risks they are willing to take) and define a ladder of intervention that defines which actions need to be taken depending on their solvency level.

Solvency I – Pillar 2

Consequently a new regime was introduced which removed prudence by including future profits on current business (i.e. VIF) in current surplus. This extra capital can either be counted as an increase in assets or a decrease in reserves. Also, the extra prudence in the regulatory balance sheet, LTICR, was removed.

The capital requirement is calculated as a series of independent stresses which are then aggregated using a correlation matrix. However, there is an obligation to report the diversified and undiversified capital requirement for every risk driver (a risk driver is a homogeneous variable that requires the insurance company to hold capital, e.g. equity, property, mortality, etc). This provides more insight into which risks are harder to diversify, and therefore require closer monitoring. The capital requirement for risk driver i can be calculated as follows (C=correlation matrix, z is capital requirement individual risk drivers):

Equation 2

There are several ways to assign diversification benefits arising on group level to the business unit levels. A pro rata formula is one of these approaches and works as follows:

Equation 3

Furthermore there is an option to run a combined scenario: in this scenario, all risk drivers are affected simultaneously at a combined 1 in 200 probability. The combined scenario takes into account the impact of the individual risk drivers, but also their correlations (higher correlated risk drivers are more dangerous and therefore require more capital). To determine the level of the risk drivers in the combined scenario the following steps are required:

1. Calculate the diversified capital requirement for risk driver i, i.e. the marginal contribution of risk driver i to the total required capital:
2. Divide the result under 1 by the total capital requirement,
3. Multiply the ratio of 1 over 2 by the original stress level of risk driver i.

The combined scenario will give more insight about the risks the company faces when several risks happen simultaneously.

An example of a combined scenario is when we have individual stresses and required capital for each of the risk drivers as shown in Table 4 and the correlation between the risk drivers in Table 5:

Table 4: undiversified capital requirement per risk driver

Table 5: correlation between risk drivers

Applying matrix multiplication for Tables 1 and 2 results in a diversified capital requirement of 13.23. Using Equation 2 leads the capital requirement for each risk driver which can be represented as a percentage of the individual stress levels as shown in Table 6:

Table 6: diversified stress

Although the insurance risk has a high individual capital requirement, after taking into account diversification benefits it is less material.

When the regulator is unsatisfied with either the level of the capital requirement for a risk driver (too low) or about the governance, an additional amount will be added to the capital requirement: Individual Capital Guidance. This ICG is usually expressed as a percentage.

Solvency II – Pillar 1

Pillar I under the Solvency II regime will be the regulatory framework under which insurance companies will provide the regulator a 1 year Value-at-Risk based on a 99.5% confidence interval (Solvency Capital Requirement). Furthermore, part of this SCR will be called Minimal Capital Requirement.  Within Pillar 1, there are 3 options:

1. Standard formula: the European regulator prescribes the level of the stresses and the correlation between the risk drivers. Stresses are performed individually as in the ICA methodology;
2. Internal model: the insurance company develops its own model with assumptions for each risk driver and correlation assumptions. The insurance company will make an application to their regulator to get approval for the use of the internal model, IMAP;
3. Partial internal model: some parts of the model will be company specific while others will be based on the standard formula. Especially for risk drivers for which there is a lack of available data, such as operational risk, some insurance companies won’t be able to model this risk yet. On the longer run, the partial internal model will develop into a full internal model.

Although the framework is new, it has several similarities with the Twin Peaks and ICA framework:

• On top of the best estimate liabilities, an extra measure of prudence is added like the LTICR in Peak 1. This prudence represents the increase in liabilities that another insurance company would take into account when taking over the reserve. This Risk margin only applies to non-hedgeable risks (risks which cannot be removed by market instruments).
• Furthermore, QIS5 prescribed the use of a single equivalent scenario in which several risk drivers were stressed simultaneously. This is comparable to the ICA combined scenario.
• During QIS5, the discount rate for valuing liability cash flows was derived by adding a Liquidity Premium depending on the nature of the assets backing these liabilities. Currently there are proposals to make the yield curve for discounting liabilities dependent on the return on assets (matching premium). This would actually imply a return to a Peak 1 like discount rate.
• Also in this system a ladder of intervention will apply such that intervention of the supervisor is required when capital is unable to sustain MCR and increased monitoring will take place when capital is unable to sustain SCR.
• An equity dampener applies for the QIS5 standard formula, the Peak 1 resilience reserve also applies an equity dampener.
• Mitigation due to management actions happens after the stress scenario has taken place in QIS5 and ICA.

Solvency II – Pillar 2

Pillar 2 is the core of the Solvency II framework as it promotes the embedding of the Solvency II framework within the organisation. This involves governance, internal control and risk management. The Own Risk and Solvency Assessment (ORSA) is part of Pillar 2 and entails a process to reflect the firm’s own view on the following aspects:

• Risk based calculation based on own risk appetite: as firms have a different willingness for taking risks, a different credit rating objective, the ORSA allows firms to perform a Pillar 1 calculation on a different VaR limit (e.g. 1 in 2000);
• It will provide the company with more information regarding sensitivities in the tail of the distribution. Also, a company can perform the calculation on a different metric as VaR such as TailVaR;
• It provides flexibility regarding the frequency of the assessment, while the Pillar 1 frequency is prescribed;
• Includes some non-quantifiable risks, which won’t be included in Pillar 1. Examples are strategic risk, reputational risk and liquidity risk;
• Business planning, and scenario analysis (e.g. market fall, closure to new business) which was previously done in the Financial Condition Report.

10 years later and how much progress has been made?

Solvency II will be introduced 1 January 2014, about 10 years after the introduction of the English Twin Peaks approach. In those 10 years, an enormous amount of consultation has taken place between the European supervisors and the industry, however the similarities between the old Solvency I and new Solvency II regime are striking. A better understanding of the development of the English regime is hence beneficial for people working in the Dutch insurance industry.

However, one can wonder how much progress in truth has been made in these past years: especially the inclusion of a discount rate which depends on the rate of return on assets feels like a u-turn back to the previous framework and away from a truly market based valuation methodology.

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Links:

Twin Peaks:

• Martin Muir and Richard Waller, Twin Peaks – The Enhanced Capital Requirement for Realistic Basis Life Firms, November 2003
• David Dullaway and Peter Needleman, Realistic liabilities and risk capital margins for with-profits  business, November 2003
• FSA, Enhanced capital requirements and individual capital assessments for life insurers, August 2003

EEV:

• O’Keeffe et all, Current developments in embedded value reporting, February 2005

FSA website:

• FSA handbook: http://fsahandbook.info/FSA/html/handbook/

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This article was also published in AENORM 73 volume 19 December 2011, see page 14-18 of the following link:

http://epub02.publitas.com/76/7/

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