Solvency II

Tougher line: Higher capitalcharges under Solvency IIstandard formula

Key messages

• If all the proposed changes to thestandard formula go through, theforthcoming QIS5 is likely to see greatercomplexity in some areas and potentiallyhigher capital charges for many insurersusing this approach.

• The tougher line includes more exactingstress tests to demonstrate capitaladequacy and the effective elimination ofcertain allowances that might havereduced capital requirements such asgeographical risk diversification.

• This may encourage more companies touse partial or full internal models thanotherwise would have been the case.

• Even companies planning to use theirown internal models should be aware ofthe changes to the standard formula as itis expected that they will initially need touse this approach in parallel with theirown models or in case they do not obtainmodel approval.

• The proposed changes will be road testedas part of QIS5, which is due to begin inthe autumn of 2010.

• Many of the second wave of CPs do notaddress calibration, which may offsetsome of the impact of the proposedchanges. Calibration will be considered inthe next set of CPs, which are expectedto be released in November 2009.

Life underwriting risk (CP49)Risk evaluation under all modules is moreprudent and the verification threshold higherthan under QIS4. This includes an increasein the percentage stresses. The assessmentof morbidity risk now also includes a stresstest on the rate of policyholder recovery andallowance can no longer be made forincreased policyholder charges whencalculating expense risk.

The impact of life underwriting and marketstresses on policyholder behaviour,including lapse rates, needs to be taken intoaccount across all risk modules rather thanjust lapse risk. The Committee of EuropeanInsurance and Occupational PensionsSupervisors (CEIOPS) has proposed twosimplifications to the scenario-basedapproach used to calculate lapse risk, whichcan be applied where proportionate.CEIOPS has specifically requestedfeedback. Further simplifications will beaddressed in the next wave of CPs.

Non-life underwriting risk (CP48)Key sources of risk mitigation will no longerbe allowed. In particular, CEIOPS hasproposed that geographical diversificationand allowance of own historical data (lossratios and premium data) to estimatevolatility parameters should be removedfrom the standard formula as the Committeedoes not consider the approach tested inQIS4 to be sufficiently robust and reliable.In addition, CEIOPS acknowledges that

QIS4 did not sufficiently take into accountthe risk that premium provisions set up atthe start of the year may subsequentlyneed to be increased. While CEIOPSacknowledges the need for a moreappropriate approach, CP48 does notprovide details on how this will be achieved.

One of the limitations of the standardformula is that certain risk mitigating effects,in particular non-proportional reinsurance,cannot be allowed for appropriately. Toavoid increasing the intricacies of an alreadycomplex standard formula, CEIOPS hassuggested that undertakings with complexrisk mitigation arrangements consider usinga partial model.

Catastrophe riskCEIOPS has suggested a standardisation ofthe scenarios for catastrophe risk withinhealth, life and non-life risks to ensureconsistency across territories. Scenarios willbe developed by CEIOPS with support fromthe industry in time for QIS5. Morbidity riskwill no longer be included in the catastrophescenarios due to the difficulty in identifying asuitable stress.

Health underwriting risk (CP50)QIS4 feedback suggested a lack of clarityaround allocation of risks between the life,non-life and health underwriting riskmodules and the approach used for thevarious health insurance products. A revisedapproach has been proposed in CP50,which considers the health obligations intwo separate groups of sub-modules:

• SLT health (Similar to Life techniques)underwriting risk

• Non-SLT health (Non similar to Lifetechniques) underwriting risk

Eight of the ‘second wave’ of Solvency II consultation papers (CPs) proposesome significant modifications to the ‘European Standard Formula’ forcalculating capital requirements. The changes reflect the tougher line oncapital adequacy that is emerging from the financial crisis and the findingsof the fourth Quantitative Impact Study (QIS4).

Solvency IITougher line: Higher capital charges under Solvency II standard formula

© 2009 PricewaterhouseCoopers. All rights reserved. ‘PricewaterhouseCoopers’ refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separateand independent legal entity.

Calibration is currently underway and will bedeveloped consistently with the life and/ornon-life underwriting risk modules asappropriate.

Market risk (CP47)The QIS4 approach for modelling currencyrisk was considered to be crude, with allcurrencies assumed to rise or fall by thesame amount relative to the local currencyat the same time. CP47 proposes a morerefined approach where a separate capitalcharge will be calculated for each currency.In addition, currency risk related to foreignequity holdings should be explicitly includedin the currency risk sub-module.

The interest rate risk sub-module is to beexpanded from QIS4 to include a stress onvolatility of interest rates. It is not clearwhether the stress scenarios will distinguishbetween real and nominal interest rates ordomestic and foreign interest rates.

In respect of property risk, CEIOPS willinvestigate whether a distinction should bemade between different types of properties.CEIOPS concluded that liquidity risk isbetter captured under Pillars 2 and 3.

In response to QIS4 feedback, CEIOPS hasprovided some guidance on the interactionbetween the spread risk and counterpartydefault risk sub-modules. However, itacknowledges that the Framework Directiveallows a degree of freedom in allocating risk.The basic principle remains that no riskshould be either left out or double counted.

Equity risk is not explicitly consideredwithin CP47, but will be covered in thenext set of CPs.

Operational risk (CP53)The operational risk charges under QIS4tended to be lower than under internalmodels. CEIOPS is therefore proposing thatthe range of operational risk parameters isincreased to ensure it is more consistentwith internal model assessments.

Counterparty default risk (CP51)CEIOPS has proposed that this calculationbe simplified, following unanimous feedbackfrom QIS4 that the approach wasdisproportionately complex. There is stilllimited consideration of intra-grouparrangements and unrated counterparties.

Reinsurance mitigation (CP52)Insurers are set to face tighter rules on theuse of reinsurance in capital management.CP52 focuses on effective transfer ofunderwriting risk to a third party. Firmswill need to be able to show that anyincrease in available capital or decreasein Solvency Capital Requirement (SCR)is commensurate with the level of risktransfer achieved.

Loss-absorbing capacity oftechnical provisions and deferredtaxes (CP54)Each sub-module of the SCR is calculatedgross of the effect of any assumed changesto future discretionary benefits. CP54 setsout two possible definitions of this grossamount for feedback.

The adjustment for loss-absorbency oftechnical provisions is calculated as thedifference between the total SCR gross andnet of the effect of assumed changes tofuture discretionary benefits. CP54 sets outtwo possible options for this calculation –either a modular approach or a singleequivalent scenario.

The second approach offers practicaladvantages in terms of a reduced numberof calculations and more obvious avoidanceof double counting of the risk mitigationeffects, but was not fully tested in QIS4 dueto limited understanding. CEIOPS plans toprovide a spreadsheet to allow the singleequivalent scenario to be determined.

Minimum Capital Requirement(‘MCR’) (CP55)The mechanism for evaluation of the MCRhas now been finalised as a simplepercentage of the SCR (based on standardformula or approved internal model) subjectto a maximum (45% known as the ‘cap’)and a minimum (25% known as the ‘floor’),together referred to as the ‘corridor’.Calculations of the MCR and supportingown funds are required quarterly.Consequently, firms need to estimate theSCR quarterly to establish the corridor,though CEIOPS proposes that this would bea proportionate calculation.

If you would like to discuss any of theareas covered in this paper, as well asthe implications for yourself and yourfirm, please contact one of our experts:

James McPhersonPricewaterhouseCoopers (UK)44 20 7213 4462james.mcpherson@uk.pwc.com

Gauri ShahPricewaterhouseCoopers (UK)44 20 7212 2638gauri.n.shah@uk.pwc.com

Mark TrainPricewaterhouseCoopers (UK)44 20 7804 6279mark.train@uk.pwc.com

Ainsley NormandPricewaterhouseCoopers (UK)44 0 131 260 4233ainsley.m.normand@uk.pwc.com

www.pwc.co.uk/solvencyII