Review of the Insurance Industry

The credit crisis has changed the financial world forever and, says Andy Baldwin, there must be a frank dialogue between insurers and regulators on any new fiscal rules

When Bob Dylan sang that The Times They Are a-Changin’ back in the 1960s, he clearly didn’t have the global financial system in mind. But if ever there is a song or particular lyric that has resonance with the situation that we find ourselves in today, it has to be the line: ‘‘Your old road is rapidly ageing, please get out of the new one if you can’t lend a hand.”

In the past 12 months we have witnessed corporate failures, a spate of “shotgun” mergers, government intervention and corporate fraud, the likes of which regulators, the public, policymakers, politicians and indeed the industry do not ever want to see again. The existing regulatory “rule book” has been found wanting and is in the process of being rewritten.

In comparison to the banking and asset management sectors, the insurance industry has weathered the storm relatively well, but it must now be actively involved in the debate. Principally, it must fulfil two roles: firstly, as a major institutional shareholder of UK Plc, and secondly representing the UK and global interests of the UK-based insurance industry. Failure to do so risks allowing a politically motivated regulatory agenda being imposed on the market.

The industry is already deep into the planning phase for Solvency II and International Financial Reporting Standards (IFRS), while life assurers are still working through the implications of the FSA’s recent retail distribution review (RDR) changes. There has never been a greater need for co-ordination between the tripartite regulators in the UK, the EU and across the globe.

The need for “smart” legislation change is particularly important as a recent Ernst & Young global financial services survey suggests it is unlikely that financial services will return to growth before spring 2010. But it is expected that we will see some areas returning to significant profitability this year; ironically led by the trading and investment banking arms of the global banks, which suffered such massive losses in the preceding 18 months. However, in the mainstream UK (and global) retail banking and insurance sector, the majority of players are being driven towards cost reduction, restructuring and selling non-core businesses to navigate back to the required levels of profitability. Those with cash and capital to spare are exploring opportunities to strengthen their primary product, market and distribution strategies.

While managing profitability, the financial services industry has already responded to the underwriting, credit and operational risks presented by the crisis. Our survey showed that the majority of financial institutions have made permanent changes to their risk management strategy; 68% have implemented permanent differences to their regulatory framework and over half (54%) have changed their operating or business model. In difficult trading conditions, insurers must be able to show how they are ensuring the management of underwriting risk in line with target portfolios. The design, placement and management of treaty and facultative reinsurance have received particular attention.

However, it is likely that the final shape of the new risk and regulatory regime will require further investment in risk-management processes. In the current climate, financial institutions may well need to fund these changes by making further cuts or maintaining downward pressure on discretionary spending. This change is likely to be accompanied by a renewed focus on capital-intensive products and activities. Insurers are already seeing the early recognition of the forthcoming Solvency II regime with management attention focusing on certain capital-intensive life products (for example, variable annuities). The underlying investment strategies to support the returns of such products have exposed life insurers in particular to the volatility of the markets drawing greater regulator attention to their own solvency thresholds. It will be interesting to see whether the industry suffers any regulatory “spill-over” effect from the desire to impose counter-cyclicality (that is putting capital away in the good times to ensure it is available in the bad) that appears destined for the UK banking industry.

As the new regulatory framework begins to emerge, it is clear that the landscape for financial services in the broadest sense will never be the same again. While not deemed to be responsible for the original misdemeanours, insurers need to be both vocal stakeholders in shaping the agenda as well as acting as good corporate citizens in the interpretation and operational of any new regime. This is a significant task given the industry is already wrestling with Solvency II, IFRS and a raft of national-specific and EU legislation.

Regulators need to balance two demands: firstly, to make more certain that individual institutions have a fundamentally sound risk profile to protect the consumer; and secondly, to ensure that the amalgamation of individual financial institutions at a country, regional and global level does not again represent a systemic risk to the overall financial system.

The politically charged debate around national versus international regulation will continue for sometime yet. However, it is clear that as regulatory initiatives converge globally, there has never been a greater need for improved dialogue between regulators and insurers, with the latter taking the lead where possible.

If Dylan’s song could be updated, then I am sure hitching a lift would not feature. It is up to the industry to make sure its voice is heard and that it takes a driving seat in the changes ahead.

Article 85(d) - Calculation of the Risk Margin

1. Introduction
1.1. In its letter of 19 July 2007, the European Commission requested CEIOPS
to provide final, fully consulted advice on Level 2 implementing measures
by October 2009 and recommended CEIOPS to develop Level 3 guidance
on certain areas to foster supervisory convergence. On 12 June 2009 the
European Commission sent a letter with further guidance regarding the
Solvency II project, including the list of implementing measures and
timetable until implementation.1
1.2. This Paper aims at providing advice with regard to the calculation of the
risk margin as requested in Article 85(d) of the Solvency II Level 1 text.2
1.3. The objective of this paper is to specify the overall structure of the calculation
of the risk margin, including the following aspects:
• the definition of the reference undertaking, including the
assumptions this undertaking has to fulfil;
• the stipulation (calibration) of the Cost-of-Capital rate; and
• the projection of the future SCRs related to the reference undertaking.
1 See http://www.ceiops.eu/content/view/5/5/
2 Text adopted by the European Parliament on 22 April 2009, see
http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//NONSGML+TA+20090422+SIT-
03+DOC+WORD+V0//EN&language=EN.
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2. Extracts from Level 1 Text
2.1 Legal basis for implementing measures
2.1 According to the guiding principles referred to in the Commission’s letter,
the legal basis for the advice presented in this paper is found in Article
85(d) and (h) of the Level 1 text, which states:
Article 85 - Implementing measures
The Commission shall adopt implementing measures laying down the
following:
[…]
(d) the methods and assumptions to be used in the calculation of the
risk margin including the determination of the amount of eligible
own funds necessary to support the insurance and reinsurance
obligations and the calibration of the Cost-of-Capital rate;
[…]
(h) where necessary, simplified methods and techniques to calculate
technical provisions, in order to ensure the actuarial and statistical
methodologies referred to in point (a) and (d) are proportionate to
the nature, scale and complexity of the risks supported by insurance
and reinsurance undertakings including captive insurance and reinsurance
undertakings.
2.2 Other relevant Level 1 text providing background to the advice
2.2. Article 75(2) and (4) as well as Article 76(1), (3) and (5) are especially
relevant for the implementing measures on the risk margin.
Article 75 – General provisions
[…]
2. The value of technical provisions shall correspond to the current
amount insurance and reinsurance undertakings would have to pay
if they were to transfer their insurance and reinsurance obligations
immediately to another insurance or reinsurance undertaking.
[…]
4. Technical provisions shall be calculated in a prudent, reliable and
objective manner.
Article 76 – Calculation of technical provisions
1. The value of technical provisions shall be equal to the sum of a best
estimate and a risk margin
[…]
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3. The risk margin shall be such as to ensure that the value of the
technical provisions is equivalent to the amount insurance and
reinsurance undertakings would be expected to require in order to
take over and meet the insurance and reinsurance obligations.
[…]
5. Where insurance and reinsurance undertakings value the best
estimate and the risk margin separately, the risk margin shall be
calculated by determining the cost of providing an amount of eligible
own funds equal to the Solvency Capital Requirement necessary to
support the insurance and reinsurance obligations over the lifetime
thereof.
The rate used in the determination of the cost of providing that
amount of eligible own funds (Cost-of-Capital rate) shall be the
same for all insurance and reinsurance undertakings and shall be
reviewed periodically.
The Cost-of-Capital rate used shall be equal to the additional rate,
above the relevant risk-free interest rate, that an insurance or
reinsurance undertaking would incur holding an amount of eligible
own funds, […] equal to the Solvency Capital Requirement
necessary to support the insurance and reinsurance obligation over
the lifetime of that obligation.
2.3 Moreover, with respect to the specification of the reference undertaking,
reference should be made to recitals (32) and especially (32a):
(32) The value of technical provisions should therefore correspond to the
amount an insurance or reinsurance undertaking would have to pay
if it transferred its contractual rights and obligations immediately to
another undertaking. Consequently, the value of technical provisions
should correspond to the amount another insurance or reinsurance
undertaking (reference undertaking) would be expected to
require to take over and meet the underlying insurance and reinsurance
obligations. The amount of technical provisions should
reflect the characteristics of the underlying insurance portfolio.
Undertaking-specific information should therefore only be used in
their calculation insofar as that information enables insurance and
reinsurance undertakings to better reflect the characteristics of the
underlying insurance portfolio, such as information regarding claims
management and expenses.
(32.a) The assumptions made about the reference undertaking assumed to
take over and meet the underlying insurance and reinsurance obligations
should be harmonised throughout the community. In particular,
the assumptions made about the reference undertaking that
determine whether or not, and if so to what extent, diversification
effects should be taken into account in the calculation of the risk
margin should be analysed as part of the impact assessment of
implementing measures and should then be harmonised at Community
level.
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3. Advice
3.1 Explanatory text
3.1.1 Previous advice
3.1. In its “Further advice to the European Commission on Pillar 1 issues” of
March 2007, CEIOPS discussed in some detail the merits of the percentile
approach and the Cost-of-Capital approach, respectively, for calculating
the risk margin.3
3.2. At that time the European Commission had decided that only the Cost-of-
Capital Approach should be tested in the third Quantitative Impact Study
(QIS3). On the other hand the Commission’s proposal for a Solvency II
Level 1 text had not yet been published, and especially the important
concept of “a reference undertaking” had not been launched.4
3.3. However, CEIOPS’ advice from March 2007 contained several
considerations that in general are still relevant:
To achieve a harmonised approach that is consistent with the supervisory
objectives for a risk margin in technical provisions, for a solvency application
of a Cost-of-Capital approach, the key parameters and assumptions
underlying such an approach would need to be set, including:
• the definition of the future 'capital' to be considered (it would
need to be specified that this is the regulatory capital requirement);
• the setting of the Cost-of-Capital factor (for example, whether
'stressed' factors would need to be used);
• assumptions regarding the extent to which diversifiable risks
would need to be taken into account; and
• assumptions regarding the extent to which future financial risks
would need to be taken into account.5
3See http://www.ceiops.eu/media/files/publications/submissionstotheec/CEIOPS-DOC-08-
07AdviceonPillarI-Issues-FurtherAdvice.pdf, CEIOPS-DOC-08/07, March 2007, para 3.72-3.101
(pp. 37-43) (hereafter “Advice of March 2007”). In addition, reference was made to a stresstesting
approach for life insurance.
4 Hence, in CEIOPS-DOC-08/07 two (alternative) objectives of the risk margin (cf. e.g. para 3.72)
were still mentioned: (i) to transfer the portfolio of liabilities to another (re)insurer with a sufficient
high level of confidence or (ii) to recapitalise the undertaking with a sufficiently high level of confidence
to ensure a proper run-off scenario of the original undertaking.
5 Advice of March 2007, para 3.83.
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3.4. Especially, with respect to the choice of method for calculating the risk
margin the Advice of March 2007 advice stated that:
CEIOPS agrees that for non-hedgeable risks the cost of capital approach
should be used under certain preconditions to be defined in the Framework
Directive.
Reflecting existing market uncertainties the cost of capital must consist of
a risk margin that meets the objectives either to transfer the portfolio to a
third party or to recapitalise the company to ensure a proper run-off
scenario by the original undertaking.6
The calibration of the risk margin must not be left to the discretion of
undertakings but key parameters and assumptions should be prescribed
by supervisors on level 3 using historical volatilities in credit spreads for a
BBB rating (corresponding to a 99.5 % confidence level) or applying
current credit spreads for BBB but adding a stress scenario to also be
developed on level 3.7
3.5. These considerations were also reflected in the specific advice on the principles
for calculating the technical provisions.8
3.1.2 The risk margin in QIS4
3.1.2.1 The QIS4 Technical Specifications
3.6. The QIS4 Technical Specifications (TS)9 contained a rather detailed overview
of (general) principles for calculating the risk margin, a detailed list of
assumptions on which the risk margin calculations should be based as well
as proposals for several layers of simplifications and proxies that could be
used in these calculations.
3.7. As it seems likely that large parts of these principles and assumptions can
be carried over to the Level 2 implementing measures regarding the risk
margin calculations (or the future Level 3 supervisory guidelines regarding
these calculations), this part of the QIS4 TS is summarised only briefly in
the paragraphs below.
3.8. It should be noted from the outset that the concept “reference undertaking”
is not explicitly referred to in the QIS4 TS. This is being developed
further in section 3.1.3 below. However, as a part of the preparation for
the QIS4 exercise, CEIOPS had elaborated a background paper setting out
proposals for the assumptions and characteristics that the reference
undertaking should satisfy.10
6 The recapitalisation and run-off by the original undertaking is no longer an alternative option for
the risk margin assessments.
7 Advice of March 2007, para 3.99-3.101.
8 Cf. Advice of March 2007, para 3.118, 3.120 and 3.121.
9 See http://www.ceiops.eu/media/docman/Technical%20Specifications%20QIS4.doc.
10 See the QIS4 background document: Guidance on the definition of the reference entity for the
calculation of the Cost-of-Capital (CEIOPS-DOC-09/2008),
http://www.ceiops.eu/media/docman/public_files/consultations/QIS/Cost%20of%20Capital%20Ref
erence%20Undertaking.pdf
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3.9. With respect to the general principles for the risk margin calculations, the
QIS4 TS stated that:
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 […].
[…]
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.
The risk margin should be calculated by determining the cost of
providing an amount of eligible own funds equal to the Solvency
Capital Requirements necessary to support the (re)insurance
obligations over their lifetime.11
These general principles mainly reproduced the relevant part of the Level
1 text, including the fact that under Solvency II a Cost-of-Capital methodology
would be used for calculating the risk margin.
3.10. In order to make the risk margin calculations operational, the QIS4 TS
introduced several assumptions to support these general principles:
• The undertakings should make projections of the development of
(re)insurance obligations until their extinction and then, for each
year, determine the SCR to be met by an undertaking facing such
obligations (TS.II.C.2).
• The SCR-calculations should be performed on the basis of the standard
formula. However, undertakings that have developed full or
partial internal models were invited – on an optional basis – to communicate
results of risk margin calculations based on these models
(TS.II.C.4-C.5).
• The risk margins (based on the standard formula) should be calculated
net of reinsurance rather than by carrying out separate calculations
of the risk margin for gross technical provisions and reinsurance
and SPV recoverables, respectively (TS.II.C.6).
3.11. With respect to the risks to be taken into account in the Cost-of-Capital
calculations, the QIS4 TS laid down the following assumptions:
• The calculations should take into account the impact of underwriting
risk with respect to the existing business, counterparty default risk
with respect to ceded reinsurance and operational risk (TS.II.C.7).
• The insurance and reinsurance obligations should not give rise to any
market risk or risk of default of the counterparties to financial
derivative contracts (TS.II.C.8).
11 TS.II.A.6, TS.II.A 14 and TS.II.A 15.
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• Renewals and future business should be considered only to the extent
that they are included in the current best estimate of liabilities
(TS.II.C.9).
3.12. Regarding the segmentation to be used for Cost-of-Capital calculations,
the QIS4 TS requested that these calculations should differentiate between
lines of business in the following manner (cf. TS.II.C.10-C.12):
• Life insurance: The portfolio should be segmented into 16 lines of
business by using two steps, i.e. according to four types of contracts
(first step) and for each type of contracts four types of risk drivers
(second step).
• The calculations regarding health insurance contracts with features
similar to life business should be disclosed separately.
• Direct non-life insurance: The portfolio should be segmented into 12
lines of business.
• Proportional non-life reinsurance should be treated as direct insurance
while non-proportional non-life reinsurance should be segmented into
three lines of business.
3.13. Hence, the segmentation used in QIS4 for risk margin calculations was –
with one exception – identical to the segmentation for (re)insurance obligations
proposed in Consultation Paper no. 27.12 The exception concerns
the Accident and Health line of business which in the QIS4 TS was split
into two sub-lines of business.
3.14. The QIS4 TS assumed that no diversification benefits should be recognised
when aggregating the technical provisions (the sum of a best estimate and
a risk margin) as calculated per line of business.13
3.15. Regarding the Cost-of-Capital rate, the QIS4 TS requested that a rate of 6
per cent should be used by all undertakings.
3.16. The steps to be followed by an undertaking when calculating the risk
margins under the Cost-of-Capital methodology were summarised as follows
(assuming a valuation date at the beginning of year 0):
(a) For each line of business find an SCR for year 0 – as well as for all
future years throughout the lifetime of the obligations in that line of
business – by taking into account the risks listed in para 3.11.
(b) Multiply all SCRs referred to in step (a) by the Cost-of-Capital rate in
order to get the cost of holding these SCRs.
(c) Discount the amounts calculated in step (b) by using the risk free
interest rate term structure at the valuation date (the beginning of
12 See CEIOPS-CP-27-09 Technical Provisions – Lines of business on the basis of which
(re)insurance obligations are to be segmented,
http://www.ceiops.eu/media/files/consultations/consultationpapers/CP27/CEIOPS-CP-27-09-Draft-
L2-Advice-on-TP-Segmentation.pdf
13 However, diversification effects between the different risk modules within a given line of business
were taken into account.
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year 0). The risk margin to be attached to the best estimate (for the
given line of business) equals the sum of these discounted values.
(d) Finally, the overall risk margin of the undertaking is given as the sum
of the risk margins as calculated by lines of business (i.e. without any
diversification effects).
3.17. As stated in the QIS4 TS, the main practical difficulty of the risk margin
calculations consists of deriving SCRs for future years for each line of business
(TS.II.C.16). Hence, in order to reduce the burden of calculation for
the participating undertakings, the QIS4 TS introduced several layers of
simplifications for these calculations. In addition, separate “risk margin
helper tabs” for life and non-life lines of business, respectively, were integrated
into the QIS4 spreadsheets.
3.1.2.2 The QIS4 report
3.18. The calculations of the risk margin under QIS4 are summarised as follows
in CEIOPS’ QIS4 report:14
In general, undertakings and supervisors support the design of the
proposed method for calculation of technical provisions, including the
proposed simplifications and proxies. Many supervisors reported
considerable consistency in the valuation approach used. However
some supervisors reported that a wide variety of methods was used
by undertakings with no evidence of convergence and that there was
also some doubt as to whether the Technical Specifications have been
applied consistently across countries.
[…]
In addition, many undertakings found the specifications for calculating
the risk margin complex and hard to follow. This resulted
mainly from the difficulty involved in accurately projecting the SCR.
Some undertakings also felt that the segmentation of business within
the risk margin was inappropriate and added considerably to the
complexity of the calculation. Most undertakings commented that
diversification between lines of business, between risk types, and
between geographies and legal entities should be taken into account
with some stating that from an economic point of view it is more
correct to value the liabilities based on the undertaking’s own portfolio.
A number of questions were also raised regarding the appropriateness
of the 6% cost of capital rate.
The consistency of technical provisions could be improved by providing
more precise guidance on the above issues.
14 CEIOPS’ report on its fourth Quantitative Impact Study (QIS4) for Solvency II (CEIOPS-SEC-
82/08), http://www.ceiops.eu/media/files/consultations/QIS/CEIOPS-SEC-82-
08%20QIS4%20Report.pdf (hereafter: QIS4 report). See section 7.1 (page 73-74) on the main
findings regarding technical provisions.
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3.19. With respect to the use of simplifications and proxies the QIS4-report
stated that:
The majority, if not all, of undertakings (independently of their size)
used simplifications to project the SCR for the purposes of calculating
the risk margin. The risk margin proxy and helper tab for non-life
were also extensively used by undertakings.15
3.20. Regarding the practicability and suitability of the proposed methodologies
for calculating the technical provisions the feedback from undertakings
participating in QIS4 was in general positive. However, the methodologies
for the risk margin determination received lower marks than the methodologies
concerning the best estimate valuation – especially with respect
to the suitability (and reliability/accuracy).16
3.21. The QIS4 report summarised the participating undertakings’ assessment of
the practicability of the proposed methods to calculate the risk margin
according to the Cost-of-Capital approach in the following manner:
Undertakings in most countries support the cost of capital approach
for determining the value of the risk margin for non-hedgeable risks.
They consider the CoC-approach as clear, the CoC methodology as
appropriate and practicable and the CoC as a robust way to calculate
the market value margin. […] A number of undertakings commented
on the fact that the risk margin depends to a large extent on the
projected SCR so any limitations in the standard formula would also
impact on the risk margin.
A number of participants criticised the technical difficulty of the risk
margin calculation and the lack of more technical support.
Some undertakings stated that the calculation of the risk margin by
LoBs needs a breakdown of underwriting, counterparty and operational
risk SCR by LoBs that is difficult to apply.17
3.22. Regarding the suitability of the proposed approaches for calculating the
risk margin “[s]ome participants commented that the descriptions and
possible simplifications left too much room for interpretation and subjective
judgement”.18 However, according to the QIS4 report most of the
comments regarding the methods for calculating the risk margin were
related to the diversification effects and the cost-of-capital rate:19
Most undertakings commented that diversification between lines of
business, between risk types, and between geographies and legal
entities should be taken into account with some stating that from an
economic point of view it is more correct to value the liabilities based
on the undertaking’s own portfolio.
[…]
15 QIS4 report, sub-section 7.2.5, page 78.
16 QIS4 report, page 85.
17 QIS4 report, see sub-section 7.3.5, page 108-109.
18 QIS4 report , page 110.
19 QIS4 report, page 111.
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A number of questions were raised regarding the appropriateness of
the 6% cost of capital rate and the work of the CRO Forum was
referenced by several undertakings. They argued that it is questionable
whether such a choice would lead to a reliable proxy for the cost
of transferring a portfolio to a willing third party. Others felt that the
cost-of-capital factor of 6% may overstate the true CoC for companies
that may hold or acquire these liabilities, and argued for a factor
in the range of 2%-4% instead. […]
Further consideration should be given to the appropriateness of the
6% cost of capital factor in light of the CRO Forum research.
3.23. The issues related to diversification effects and the choice of the Cost-of-
Capital rate are being discussed in more detail in the section hereunder.
3.1.3 The overall structure of the risk margin calculations
3.24. It follows from the wording of Article 85(d) and recitals 32 and 32(a) of
the Level 1 text, as well as from the QIS4 feedback that the implementing
measure regarding the risk calculations should focus on the following
aspects:
• the definition of the reference undertaking, i.e. a clarification regarding
the assumptions that this undertaking has to fulfil;
• the calibration of the Cost-of-Capital rate;
• the general/overarching methodology for calculating the risk margin
in accordance with the Cost-of-Capital approach; and
• simplified methods including the criteria to be fulfilled in order to
apply these simplifications.
CEIOPS’ advice on simplifications regarding the risk margin calculations
is included in the its draft Level 2 advice on Article 85(h).20
3.1.3.1 The reference undertaking21
A. Assumptions to be fulfilled by the reference undertaking
3.25. In order to be able to determine “the cost of providing an amount of
eligible own funds equal to the Solvency Capital requirement necessary to
support the insurance and reinsurance obligations” (Article 76(5)) in a
clear and unambiguous manner, the definition of the reference undertaking
is a key issue. The assumptions that the reference undertaking has
to fulfil if this object shall be achieved, as well as a rationale for these
assumptions, are presented and discussed in the paragraphs below.
3.26. Assumption 1: The reference undertaking is not the undertaking itself
(i.e. the original undertaking), but another undertaking.
20 See CEIOPS-CP-45-09, http://www.ceiops.eu/content/view/14/18/.
21 This section is based on the QIS4 background document on the reference entity.
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3.27. This assumption is reasonable in light of the wording of Article 75(2)
where reference is made to the current amount a (re)insurance undertaking
will have to pay if the (re)insurance obligations are transferred
“immediately to another insurance or reinsurance undertaking”.
Moreover, by assuming that the reference undertaking is another undertaking
(than the original undertaking) there is no need to make artificial
assumptions regarding the original undertaking (e.g. with respect to the
available capital of the original undertaking) as was the case in QIS3 –
when the reference undertaking was defined as the original undertaking.
In general, it seems reasonable to believe that this assumption will reduce
(if not eliminate completely) potential inconsistencies in the framework for
risk margin calculations.
3.28. Assumption 2: The reference undertaking is an empty undertaking in the
sense that it does not have any insurance or reinsurance obligations and
any own funds before the transfer takes place.
3.29. By making this assumption the risk margin will depend only on the
insurance and reinsurance obligations transferred to the reference undertaking
and the assets covering these obligations.
3.30. On the other hand, if the reference undertaking is assumed to be nonempty
there will be ambiguities related to the assumptions to be made
regarding (the composition of) the reference undertaking’s assets and
liabilities before the transfer takes place. The assumptions made may have
a substantial impact on the risk margin due to the fact that the SCRcalculations
allow for diversification (correlation effects) between the
business existing prior to the transfer and the transferred business.
3.31. Moreover, if the reference undertaking is assumed to have positive eligible
own funds (but no (re)insurance obligations) before the transfer, the risk
margin would not measure the cost of holding an amount of eligible own
funds to cover the SCR, but the cost of holding an amount of eligible own
funds (at least partially) in excess of the SCR. This is not intended by the
definition given in Article 76(5) of the Level 1 text and would not make
much sense from an economic point of view.
3.32. Assumption 3: After the transfer the reference undertaking has eligible
own funds corresponding exactly to the amount of SCR that is necessary
to support the transferred insurance and reinsurance obligations.
3.33. If the reference undertaking is assumed to be an empty undertaking
before the transfer takes place (cf. assumption 2), Article 76(5) can be
interpreted in such a way that after the transfer all eligible own funds in
this undertaking will be necessary to support the transferred obligations.
3.34. On the other hand, if it is assumed that the reference undertaking is nonempty,
the interpretation of Article 76(5) will be more difficult, due to the
fact that this undertaking will have eligible own funds and be subject to a
capital requirement related to its existing business prior to the transfer.
After the transfer the eligible own funds would exceed the amount being
necessary to support the transferred obligations.
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3.35. Assumption 4: After the transfer of insurance and reinsurance
obligations, the reference undertaking has assets to cover the Best
Estimate net of reinsurance and SPVs, the risk margin and the SCR. These
assets should be considered to minimize the market risk of the
undertaking. The reference undertaking should only be subject to market
risk that is unavoidable in practice.
3.36. After the transfer the reference undertaking will have on its balance sheet
both assets covering (re)insurance obligations (technical provisions) and
assets covering capital.
3.37. In a transfer of (re)insurance obligations, a transfer of assets that cover
those obligations will typically also take place. Therefore, immediately
after the transfer, part of the assets of the reference undertaking would be
formed of assets that originate from the original undertaking. As a result it
is possible that there would be market risk linked to those assets.
In this context, it can be assumed that the reference undertaking will derisk
these assets22 in order to reduce the part of SCR related to market
risk. For example, the reference undertaking can sell investments in equity
or property to avoid the corresponding risks. It can sell corporate bonds
and buy government bonds instead to avoid credit spread risk, or it can
restructure the investments to achieve a better cash-flow or currency
matching and thereby reduce interest rate and currency risk.
3.38. In principle, the time needed for this de-risking will depend on the selection
of assets that are transferred from the original undertaking. For
reasons of practicability it should be assumed that the de-risking takes
place immediately after transfer.
3.39. On the other hand, Article 75 mentions the transfer of obligations and
Article 76 refers to the amount of eligible own funds that would be needed
to take over and meet these obligations. Neither of the two articles makes
reference to any transferred assets. Therefore it could also be argued that
the nature of assets held in the reference undertaking is independent of
those of the original undertaking. This would also be supported by the
requirement that the assumptions made about the reference undertaking
should be harmonised throughout the European union and that
undertaking-specific information should only be used where it better
reflects the underlying portfolio characteristics. Hence, even according to
this argument it is justified to assume that the reference undertaking
covers the transferred obligations with assets that minimise the market
risk.
3.40. In QIS4, CEIOPS proposed that market risk should not been taken into
account in the calculation of the risk margin for reasons of practicability.
In many cases this is justified as the assets can be completely de-risked.
However, for particular kinds of insurance obligations not all market risk
can be avoided. For example, if the insurance obligations have a very long
22 In the present context an asset is considered as de-risked if there is no capital requirement
linked to it.
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duration, it may not be possible to match the cash-flows completely. The
mismatch may give rise to a significant interest rate risk.
3.41. Stakeholders noted that the QIS4 approach neglected the unavoidable
market risk. For example, the CRO Forum gave in its paper “Market Value
of Liabilities for Insurance Firms” the following examples of market risks
which cannot be avoided in practice:23
(i) 60-year USD, EUR or Yen cash flow or interest rate option,
(ii) 15-year emerging markets cash flow,
(iii) 30-year equity option.
3.42. If market risk is excluded from the risk margin calculation also in cases
where it cannot be eliminated in practice, the resulting technical provisions
would be lower than the transfer value, because any undertaking taking
over insurance obligations bearing unavoidable market risk would require
a compensation for the risk bearing.
3.43. The unavoidable market risk can be determined by analysing the possibilities
to reduce the SCR for market risk. For example, let CF1, CF2, …,
CF30 be the expected cash-flows of an insurance portfolio. Let it be
possible in practice to match cash-flows up to 20 years with risk-free
instruments but not above this threshold. The reference undertaking could
match the cash-flows CF1, …, CF20 and cover the cash-flows CF21, …, CF30
with instruments of 20-year duration. In this way, the market risk would
only consist of a residual interest rate risk. Alternatively, the reference
undertaking could match the cash-flows CF21, …, CF30 with corporate bonds
or risk-free instruments of another currency (where risk-free instruments
of longer duration are available). In these cases, the market risk would
only consist of credit spread risk or currency risk. The investment portfolio
with the lowest market risk SCR determines the SCR that needs to be
allowed for in the risk margin.
3.44. A perfect replication of the liability cash flows is one that completely eliminates
all risks (not only market risk) associated with the liability. In
practise, perfect replication is expected to be relatively rare. It should
therefore be noted that replication of cash-flows and elimination of market
risk SCR are different concepts. It is not necessary to perfectly replicate
the cash-flows of the obligations to eliminate the market risk SCR. It is
sufficient to replicate the liability cash-flows on best estimate level to
reduce the standard formula SCR to zero for the purposes of calculating
the risk margin.
3.45. For non-life insurance obligations and short-term life insurance obligations
the market risk SCR can usually be reduced to zero.
3.46. As with all other risks which are included in the risk margin calculation, the
allowance for market risk should be done in a practicable and proportionate
way with particular consideration of its materiality. For example, in
23 CRO Forum: Market Value of Liabilities for Insurance Firms – Implementing Elements for Solvency
II (July 2008).
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QIS3 market risk was captured in the calculation by allowing for the
current market risk SCR in the first year but not any of the following years
of the SCR projection. CEIOPS will give advice on simplifications of the risk
margin calculation at a later stage.
3.47. Question to stakeholders: Regarding the treatment of market risk in the
risk margin, CEIOPS is proposing a substantial change compared to QIS4.
Stakeholders are asked to comment in particular on the conceptual soundness
of the proposal and its implications on the size of the risk margin.
Moreover, comments in order to ensure a practicable inclusion of market
in the risk margin are welcomed.
3.48. Assumption 5: The SCR of the reference undertaking consists of:
(a) underwriting risk with respect to the transferred insurance and reinsurance
obligations;
(b) counterparty default risk with respect to ceded reinsurance and SPVs;
(c) operational risk; and
(d) unavoidable market risk.
3.49. The reference undertaking is subject to underwriting risk corresponding to
the transferred insurance and reinsurance obligations, and these risks
exist throughout the lifetime of the obligations. On the other hand, underwriting
risk related to new business is not included. With respect to the
non-life underwriting risk, the (non-life) catastrophe risk should only
include pre-claims obligations (i.e. claims related to catastrophe events
incurring after the balance sheet day).
Moreover, it seems obvious to take into account
• counterparty default risk related to risk mitigation contracts (e.g.
reinsurance contracts) covering the transferred insurance and reinsurance
obligations; and
• operational risk related to transferred insurance and reinsurance
obligations.
However, for reasons of practicability it is assumed that the reference
undertaking does not carry any risk of default of counterparties to financial
derivatives contracts.
3.50. Assumption 6: The loss absorbing capacity of technical provisions in the
reference undertaking corresponds to those of the original undertaking.
3.51. It seems reasonable to assume that the profit sharing commitments of the
original undertaking carry over to the reference undertaking as far as they
are confined to the line of business. Hence, the risk mitigating effects of
future profit sharing should be taken into account to the same extent as in
the original undertaking.
3.52. Assumption 7: There is no loss absorbing capacity of deferred taxes
related to the reference undertaking.
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3.53. It follows immediately from the assumption that the reference undertaking
is an empty undertaking that the loss absorbing capacity of deferred taxes
should be excluded from the valuation of the risk margin.
3.54. Assumption 8: The insurance and reinsurance obligations of each line of
business (as defined in Article 85(e)) are transferred to the empty
reference undertaking in isolation. Hence, no diversification benefit
between lines of business arises.
For the purpose of determining the risk margin, the SCR of the reference
undertaking should be calculated (using a standard formula or internal
model) at least by line of business, based on the segmentation laid down
by the implementing measures referred to in Article 85(e).
If the SCR of the original undertaking is calculated by using an internal
model, the segmentation may differ from the one laid down by the implementing
measures referred to in Article 85(e). However, the risk margin
shall always be valued at least at the level of lines of business laid down
by those implementing measures.
3.55. It seems reasonable to apply an approach starting from the risk margin
calculations per line of business as it is required according to Article 85(e)
to allocate this margin to the individual lines of business.24 Especially,
there will be no ambiguity involved in the allocation of the risk margin
when this approach is applied.
3.56. The requirement that the (re)insurance obligations of the individual lines
of business are transferred in isolation can make the risk margin calculations
somewhat more complex (or may at least increase the number of
calculations), since it requires the SCR to be calculated by line of business.
However CEIOPS does not believe that the calculation of the SCR by line of
business poses a significant practical problem particularly since the main
input to the risk margin calculation is the SCR for underwriting risk which
is straightforward to calculate by line of business. Furthermore, simplifications
can be introduced in order to make the calculation more feasible.25
3.57. If instead an approach starting from the risk margin calculations for the
overall portfolio – taking into account all possible diversification effects
(related to the SCR-calculation) – would be applied, several complicating
aspects would be introduced, including the following:
• It is not obvious how to allocate the overall risk margin across the
individual lines of business. (e.g. the earned premiums will not be a
suitable set of weights for this allocation. Nor will the best estimate
technical provisions (in non-life insurance) do, cf. the percentages
used in the risk margin proxy proposed for QIS4 purposes).
• If only a part of the (re)insurance obligations (e.g. the obligations
related to a single line of business) are transferred from the original
undertaking to the reference undertaking, this will require a recalcu-
24 Article 85(e) stipulates the segmentation of (re)insurance obligations into lines of business for
the calculation of technical provisions. In this context, no distinction is made between the best
estimate and the risk margin (per line of business).
25 See CEIOPS-CP-45-09, http://www.ceiops.eu/content/view/14/18/.
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lation of risk margins – both for the portfolio of obligations that are
being transferred and for the portfolio of obligations remaining in the
original undertaking – and the sum of these risk margins will be
higher than the risk margin originally calculated for the overall
portfolio (taking into account all diversification effects). In general,
this would mean that after the transfer has been carried out, the risk
margin related to the (re)insurance obligations that remain in the
original undertaking must be increased.
3.58. A more detailed assessment of the merits of alternative approaches to the
treatment of diversification effects in the context of risk margin calculations
is given in subsection B below.
3.59. Since the risk margin depends on (future) SCRs calculated per line of
business and shall be allocated to best estimate technical provisions per
line of business, a natural solution would be to use the same segmentation
for the calculation of best estimate technical provisions, risk margins and
the SCR, respectively.
3.60. Especially, there seems to be no reason for a (re)insurance undertaking
using the standard formula for the SCR-calculations to apply a more
granular segmentation than the one that follows from the implementing
measures regarding Article 85(e) as this in general will increase the overall
risk margin. Moreover, a finer segmentation will lead to laborious recalculations
of the (standard) SCR (e.g. per homogenous risk groups) and this
may also raise some issues related to the reliability of the (input) data for
these calculations.
3.61. The requirement that the risk margin should be valued at least at the level
of lines of business also in cases where the SCR of the reference undertaking
is calculated by an internal model is introduced in order to ensure
that all reference undertakings apply the same granularity with respect to
these calculations, i.e. in order to avoid ambiguities in the assessing of the
(relevant) technical provisions when a portfolio of (re)insurance obligations
is transferred between two undertakings. Moreover, this requirement
should be seen as a measure to achieve harmonisation of the (calculated)
technical provisions between undertakings, including improved comparability
etc (see also assumption 9 hereunder).
3.62. Assumption 9: The internal model of the original undertaking (partial or
full) can be used to measure the SCR of the reference undertaking to the
extent that these models cover at least the risks referred to in assumption
5 as defined by the standard formula.
3.63. The internal model is only approved for the calculation of the current SCR,
while the determination of the risk margin requires the calculation of all
future SCRs as well. The internal model may not be fully adequate for the
latter calculation.
3.64. However, when Article 76(5) of the Level 1 text refers to the “amount of
eligible own funds equal to the Solvency Capital Requirement necessary to
support the insurance and reinsurance obligations” it does not distinguish
between SCR calculations based on the standard model and internal
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models, respectively. Hence it may be argued that the SCR-calculations to
be applied in the Cost-of-Capital assessment can be based on either the
standard model or internal models.
3.65. An argument in favour of applying SCR calculations based on internal
models when determining the risk margin, may be that these models are
designed in order to capture the risk of the portfolio in question (i.e. the
portfolio of the original undertaking) in a better way. However, if an internal
model portrays levels of risks that are specific for the original undertaking
but cannot be assumed to be similar for the reference undertaking,
this may be an argument for not relying on internal model calculations
when determining the risk margin. Hence, some conditions should be in
place with respect to using SCR-results from internal models in the risk
margin calculations.
3.66. Assumption 10: The Cost-of-Capital risk margin is defined net of reinsurance
and SPVs.
3.67. This assumption is consistent with assumption 5 regarding the SCR calculations
to be carried out for the reference undertaking and especially the
calculation of the partial SCR for underwriting risk as this partial SCR is
only calculated net of reinsurance and SPVs.
3.68. A requirement to calculate the risk margin also gross of reinsurance would
imply a doubling of the number of calculations regarding future SCRs for
underwriting risk and these gross calculations would be relevant only for
the determination of the risk margin.
3.69. Moreover, a likely consequence of calculating the risk margin both gross
and net of reinsurance could be that a (positive) risk margin is attached
also to the reinsurance assets (the reinsurance recoverables), when these
results are presented in the financial statement (of the original undertaking).
However, this would probably not be in line with the accounting
standards for insurance contracts, see e.g. the relevant provisions in
IFRS4 regarding valuation of reinsurance assets.26
B. An assessment of other approaches regarding the reference
undertaking and the treatment of diversification effects
3.70. The proposed assumption 8 to be fulfilled by the reference undertaking (cf.
para. 3.54) covers both the segmentation to be used in the risk margin
calculations and the treatment of diversification effects (caused by
correlations).
3.71. It should be noted that the treatment of diversification effects in the risk
margin calculations and the allocation of calculated risk margins among
the individual lines of business are two separate issues – even if they
apparently coincide in the approach proposed by CEIOPS. However, if the
approach starting from the overall portfolio (at undertaking or group level)
is chosen, this distinction becomes clearer. Although diversification effects
between lines of business (and possibly undertakings within a group) are
26 A discussion of this issue is beyond the scope of the present paper.
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taken into account, this does not imply that the overall risk margin would
not be allocated back to the individual lines of business. What it implies, is
that this allocation will become more challenging to perform.
3.72. The potential impact of assumption 8 should be viewed in light of the other
assumptions defining the reference undertaking (per se), i.e. especially
assumptions 1 and 2.27
3.73. The CEA and CRO Forum have both provided input on the assumptions
underlying the calculation of the risk margin. CEIOPS appreciates the
contributions of both the CEA and the CRO Forum in this area. However,
after careful analysis, CEIOPS’ position nevertheless differs from those of
the CEA and CRO Forum particularly with regard to the framing of assumption
8. A comparison of the positions taken by CEA, CRO Forum and
CEIOPS regarding the above-mentioned aspects of the reference undertaking
are summarised in table 1. However, as indicated in the table,
some reservations are taken with respect to especially the position of the
CRO Forum.
Table 1. A comparison of approaches regarding the reference undertaking (RU).
Assumptions
regarding the RU
CEA CRO Forum CEIOPS
Assumption 1 Mirror of original
undertaking (?)
Another
undertaking (?)
Another
undertaking
Assumption 2 Non-empty Empty (?) Empty
Assumption 8:
• Allowance for
diversification
At least up to
the level of
the undertaking
Up to
the group level
Up to the lines
of business
• Allocation of
the risk margin
Does not believe
the allocation is
required
No response
to date
Per line of
business
Assumptions 1 and 2
3.74. CEIOPS understands CEA’s position with respect to assumption 1 and 2 to
be that the reference undertaking should be a “mirror” of the original
undertaking and as such a non-empty undertaking (before a transfer takes
place). This position is described as follows in a recent paper:28
Firstly, a transfer of business is only one possible outcome in case an
insurer runs into difficulty. The disposal of individual portfolios is rare
and instead a very likely scenario would be that the insurer was
closed to new business and then the existing business was run-off.
[…] Therefore, it is important to refer to business being retained and
27 Assumptions 3-7, 9 and 10 are concerned more with the calculation of the future SCRs for the
reference undertaking.
28 CEA paper on the allowance for diversification within the market value risk margin (4 March
2009),
http://www.cea.eu/index.php?mact=DocumentsLibrary,cntnt01,details,0&cntnt01documentid=617
&cntnt01returnid=100.
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‘own entity’ assumptions being used, rather than artificial 3rd party
‘hypothetical’ assumptions. […]
Secondly, […] the CEIOPS methodology seems to be based on the
assumption that the business would be transferred to an empty shell
company. This is not a plausible assumption and not in line with past
practice.
3.75. This is in line with previous statements from CEA, e.g. in their position
paper on the Cost-of-Capital methodology, where CEIOPS’ background
document on the reference undertaking was commented upon as follows:29
However, a number of different assumptions could be made in respect
of the reference entity, e.g. that the entire portfolio is transferred to a
single, empty reference entity, a well diversified non-empty entity,
etc. […]
As such rather than advocating a particular approach it is more
appropriate to specify what attributes/features the CEA should require
of a market value risk margin approach.
3.76. However, CEIOPS does not believe that this approach can be considered to
be in line with the provisions of the Level 1 text where it is referred
explicitly to an immediate transfer of obligations to another (re)insurance
undertaking or the statements in the recitals regarding the reference
undertaking as well as the limitations regarding the use of undertakingspecific
information.
3.77. In its proposal for general principles regarding the calculation of the
market value of liabilities, the CRO Forum asserts that30
Entity-specific assumptions should be made when projecting future
cash flows so that the valuation reflects the particular characteristics
of the portfolio in question. […]
Therefore, the CRO Forum believes it to be more economically sound
to value insurance liabilities on the basis that they are kept in the
company’s own portfolio […] rather than to base the valuation on a
hypothetical transfer.
And moreover,
We note that the draft directive wording utilises the 'transfer' concept
as the basis of valuation of technical provisions and subsequently
defines how the calculation should be carried out. We believe that our
approach is equally consistent with this basis when it is assumed that
the whole entity is being transferred into an empty reference company.
Both approaches can lead to similar conclusions when determining
market consistent value for insurance liabilities.
29 CEA: Cost of capital methodology (30 May 2008),
http://www.cea.eu/index.php?mact=DocumentsLibrary,cntnt01,details,0&cntnt01documentid=519
&cntnt01returnid=100
30 CRO Forum: Market Value of Liabilities for Insurance Firms – Implementing Elements for Solvency
II (July 2008), http://www.croforum.org/publications.ecp (hereafter CRO Forum Report).
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3.78. CEIOPS notes that the basis underlying the CRO Forum’s approach (liabilities
are kept in the undertaking’s own portfolio) is not consistent with
the Level 1 text but that the CRO Forum nevertheless believes that this
position can be reconciled with the Level 1 text by assuming that the
overall portfolio is transferred to an empty reference undertaking. CEIOPS
has reservations with regard to this interpretation as this does not allow
transfer of the insurance obligations by line of business.
Assumption 8 – Allowance for diversification
3.79. CEA’s paper from March 2009 referred to above also confirms CEA’s
previous position that the risk margin should be calculated at the level of
the undertaking allowing for all diversification effects. In this context it is
stated (with a reference to Article 74(1)) that the valuation process under
Solvency II is based on “the overlying principle of the recognition of
diversification” and that (parts of) CEIOPS’ position is not in line with the
Level 1 text. Beyond this, the CEA’s arguments in favour of the allowance
for diversification effects rest implicitly on their position regarding assumptions
1 and 2 referred to above and their belief that the allocation of the
overall risk margin among the individual lines of business is not required.
3.80. According to the CRO Forum the projection of the SCRs in respect of nonhedgeable
risks should be carried out allowing for diversification benefits
between non-hedgeable risks up to the group level. Moreover, it should be
assumed that the insurer’s risk profile evolves according to realistic best
estimate assumptions, meaning that the capital necessary to support nonhedgeable
risk in future years will depend on future new business written.
3.81. CEIOPS does not consider the reference made to future new business to
be in line with the Level 1 text, cf. the wording of Article 75(2) and Article
76(5).
3.82. Moreover, according to recital 32 of the Level 1 text “the value of technical
provisions should correspond to the amount another insurance or reinsurance
undertaking (reference undertaking) would be expected to
require to take over and meet the underlying insurance and reinsurance
obligations”. The Level 1 text does not give any justification for a treatment
where the value of the technical provisions would fulfil this requirement
only if it were valued on the level of an insurance group. On the
contrary, the valuation principle should apply to any portfolio of insurance
and reinsurance obligations.
3.83. This also applies to CEA’s position that the risk margin should be calculated
at the undertaking level only. Taking into account diversification at
the level of the undertaking would undermine partial transfers, i.e. transfers
of less than the overall portfolio.
3.84. In this context it should be noted that although the transfer concept can
be seen as a theoretical framework, it also has an important practical
bearing from the point of view of the supervision of insurance undertakings.
Transfers of insurance portfolios are relatively common in the
insurance sector, including both full and partial transfers. Portfolio trans23/
54
fers are also a particularly important supervisory tool as regards policyholder
protection when an undertaking becomes or is in danger of
becoming insolvent.
3.85. From a supervisory point of view there are also obvious merits if the same
segment of insurance obligations results in the same value of technical
provisions regardless of the whereabouts of those obligations. This would
ensure that the value is objective and not affected by undertaking-specific
information, cf. recital 32 which states that “undertaking-specific information
should […] only be used in the calculation of technical provisions
insofar as that information enables undertakings to better reflect the
characteristic of the underlying insurance portfolio”.
Assumption 8 – Allocation of the risk margin
3.86. Finally, with respect to the issues regarding the allocation of the overall
risk margin among the individual lines of business, the CEA feedback has
been limited to the following:
[…] there may be practical issues with attempting to calculate isolated
line of business figures. […] This is particularly likely to be the case
under the stress circumstances reflected in the SCR which is then
used to compute the market value risk margin. […]
[…] we believe there is little to be gained from allocating the market
value risk margin across different lines of business and we do not
believe it should be a regulatory requirement to do so. The split of the
risk margin would also necessarily involve an element of subjectivity,
as diversification effects would need to be allocated per line of business.
[…]
However […] for internal management purposes, some companies
may wish to allocate the market value risk margin by line of business,
[…] Companies should be allowed to do this by whichever method
they believe is most suitable. However, as stated above, they should
not be compelled to do so for regulatory solvency purposes.
3.87. CEIOPS does not agree with the CEA position that allocating the risk
margin to different lines of business is not required. This is based on the
rationale for assumption 8 (cf. para. 3.55-3.57 above), which refers to the
problems an undertaking (or group) will face, if the risk margin
calculations start from the overall portfolio – taking into account all
possible diversification effects.
3.88. The issues related to allocation of the overall risk margin among lines of
business are not covered in the CRO Forum’s paper.
3.1.3.2 The Cost-of-Capital rate
3.1.3.2.1 A general approach for stipulating the Cost-of-Capital rate
3.89. According to Article 76(5) of the Level 1 text the Cost-of-Capital rate “shall
be the same for all insurance and reinsurance undertakings and shall be
reviewed periodically”. Moreover, the Cost-of-Capital rate used
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shall be equal to the additional rate, above the relevant risk-free
interest rate, that an insurance or reinsurance undertaking would
incur holding an amount of eligible own funds, […], equal to the
Solvency Capital Requirement necessary to support the insurance and
reinsurance obligation […].
3.90. As the “additional rate, above the relevant risk-free interest rate” referred
to in Article 76(5) shall be the same for all insurance and reinsurance
undertakings, it should be calibrated in a manner that is consistent with
the assumptions made for the reference undertaking. In practise this
means that the Cost-of-Capital rate should be consistent with the Valueat-
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). Especially, the Cost-of-Capital
rate should be independent of the actual solvency position of the original
undertaking.
3.91. In the third and fourth Quantitative Impact Study for Solvency II (QIS3
and QIS4) the Cost-of-Capital rate had been fixed at 6 per cent as such a
rate has been 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.
3.92. The required consistency between the stipulated Cost-of-Capital rate and
the (Value-at-Risk) assumptions for the SCR-calculations has was
explained as follows: the 6 per cent Cost-of-Capital rate corresponds to
the cost of providing eligible own funds for BBB-rated insurance or
reinsurance undertakings, cf. the Cost-of-Capital rate used by the Swiss
regulator in its Solvency Test for BBB-rated reference undertakings.
3.93. As part of the QIS4-feedback, questions have been raised regarding the
appropriateness of the assumed Cost-of-Capital rate of 6 per cent.
Especially, reference was made to the work carried out by the Chief Risk
Officer Forum (CRO Forum), and a substantially lower Cost-of-Capital rate
has been indicated (cf. also section 3.1.2.2 above).
3.94. However, a critical analysis of the CRO Forum’s report31 – as well as other
reports on this issue32 – does not support the QIS4-feedback referred to
above. On the contrary, the analysis which is summarised in the
subsection below, confirms that an assumed Cost-of-Capital of at least 6
per cent could be seen as appropriate. In this context it should be noted
that although the CRO Forum has indicated in its report that its research
suggests a Cost-of-Capital rate in the range of 2 ½ - 4 ½ per cent, it also
acknowledges that its research did not prove conclusive. Moreover, it
seems that the CRO Forum first and foremost has focussed on results
leading to the lowest estimates of the Cost-of-Capital rate.
31 CRO Forum: Market Value of Liabilities for Insurance Firms – Implementing Elements for Solvency
II (July 2008).
32 GNAIE (Group of North American Insurance Enterprises): Market Value Margins for Insurance
Liabilities in Financial Reporting and Solvency Applications (October 2007),
http://www.insuranceaccounting.org/images/Market%20Value%20Margin10CA985.pdf
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3.95. The analysis summarised in the following subsection does not discuss the
required periodical review as referred to in Article 76(5) of the Level 1
text. However, CEIOPS points out that the frequency and procedures to be
followed for this review would need to be developed.
3.1.3.2.2 Assessment of the Cost-of-Capital Rate
(a) Introductory remarks
3.96. 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.
3.97. 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.
3.98. A rate of at least 6 per cent is assessed to be an adequate placeholder for
the Cost-of-Capital rate in the 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, this advice will reflect on the
assumptions that would be reasonable to make regarding the funding of
the capital requirement in a stressed scenario.
(b) Funding of the capital requirement
3.99. In CRO Forum’s report, the Cost-of-Capital rate is calculated as a weighted
average of the cost of equity and the cost of debt. It is assumed that 20
per cent of the capital requirement can be funded by issuing debt and that
only the remaining 80 per cent have to be funded by raising equity capital.
Moreover, by assuming an effective company rate of taxation of 35 per
cent over all jurisdictions, the estimated cost of debt is in practise outweighed
by the adjustments for tax relief on interest payments made to
service the debt. As a result the Cost-of-Capital rate equals only approximately
80 per cent of the estimated cost of equity rate.
3.100. Contrary to this, CEIOPS finds it more reasonable to assume that the
capital base33 used when calculating the risk margin under a Cost-of-
33 In the remainder of the present sub-section it is referred to “the capital base” and not “the
eligible own funds” since the first concept is closest to the terminology used in CRO Forum's report.
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Capital methodology is funded solely with equity capital.34 As the capital
base is defined as the solvency capital requirement in an adverse
situation, i.e. as the amount of capital that is substantially at risk, it would
be inconsistent to assume at the same time that this requirement can be
funded by debt investors at costs substantially below the equity costs.
Accordingly, this approach has been used in the assessments summarised
below.35
(c) The three-step procedure for assessing the Cost-of-Capital rate
(c1) Shareholder return models
3.101. The research carrried out by both CRO Forum and GNAIE has been
analysed. As the most commonly used models in the market seem to be
the Capital Asset Pricing Model (CAPM) and versions of the Fama-French
multi Factor Model (FFmF), CEIOPS’ analysis has been confined to the
results given for these models.
• The Frictional Cost-of-Capital approach
3.102. In CRO Forum’s research the rate of return above the risk free rate that
shareholders of insurance undertakings demand in order to assume
broadly diversified insurance risks, are estimated using different methods
and assumptions. CRO Forum deems that the so-called Frictional Cost of
Capital approach is the most appropriate to capture the rate of return an
insurance company requires on the capital it deploys to support nonhedgeable
risk over a given year. This is likely the reason why they rely so
heavily on the results from this method when drawing their conclusions.
3.103. However, CEIOPS has strong reservations regarding the results based on
this approach36 as reproduced in the CRO Forum’ report. Firstly, the
results of the method are very dependent on a number of key assumptions
– effective tax rate, loss carry forward period and risk free rate – for which
it is difficult to assess reasonable parameter estimates in an EU context.
Secondly, of the main components of the frictional costs – double taxation
costs, financial distress costs37 and agency costs38 – only the two first
have been modelled.
3.104. Moreover, the CRO Forum has drawn e.g. the following conclusions after
having modelled double taxation and financial distress costs:39
34 This is seen as a more appropriate assumption also by GNAIE, cf. their report.
35 It may also be questionable whether an insurance undertaking being in a stressed situation will
be in a position to benefit from further tax credits.
36 Under this approach, the total return required by shareholders may be thought of consisting of
the base cost of capital, the frictional costs and the expected economic profit. Only the frictional
costs are taken into account in determining the Cost of Capital rate.
37 These are direct and indirect costs which arise when an insurer has difficulties meeting its
financial obligations to policyholders or debt holders.
38 Agency costs are associated with the misalignment of the interest between management and
shareholders or between policyholders and shareholders. The lack of transparency and informational
asymmetry are also deemed to be part of agency costs.
39 Cf. CRO Forum's report, page 36.
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For highly capitalized companies, the cost of capital rate is
determined mainly by the cost of double taxation and the cost of
financial distress is negligible. […]
The cost of capital rate depends linearly on a jurisdiction’s tax rate for
all confidence levels. This means that the cost of capital rate (and
therefore the MVM) in a jurisdiction with a tax rate of 10% is only half
of that in a jurisdiction with a tax rate of 20%.
In CEIOPS’ opinion the result implied by these conclusions seems
unreasonable for Member States in which the effective tax rate is low.
Furthermore, CEIOPS also questions the assertion that financial distress
costs are negligible for well capitalized companies.
• The CAPM and the FF2F-method
3.105. In CRO Forum’s research related to the CAPM and the FF2F method, the
cost of equity rate above the risk-free rate has been estimated for three
markets: the European, the Asian and the US market. From these estimated
rates a “Global World” rate has been derived for both methods. The
Global World rates are in general lower than the European rates, cf. table
2 below.40 When concluding on an appropriate level of the Cost-of-Capital
rate, CRO Forum has taken into account only the lower Global World rates
without giving any explicit rationale for this choice.
3.106. CEIOPS finds it more reasonable to base the assessment of the Cost-of-
Capital rate on CRO Forum’s results for the CAPM and the FF2F method for
European insurance undertakings. In this context it may also be noted that
the FF2F-results for the European non-life insurers are in line with the
results referred to in GNAIE’s report for US non-life insurers (an equity risk
premium of 14.2 per cent).
Table 2. Equity Risk Premiums as assessed in the CRO Forum’s report.41
CAPM FF2F
European Global European Global
market market market market
Life 10.0 pct 5.1 pct 11.8 pct 9.4 pct
Non-life 7.4 pct 4.2 pct 12.5 pct 9.6 pct
3.107. Taking into account only the results from the shareholder return models a
Cost-of-Capital rate of at least 7 ½-10 per cent seems to be adequate.
40 In the CAPM-case the reported Global rates are lower than the reported rates for all three
markets – a result that could have been better explained in the report.
41 Cf. CRO Forum's report, page 58, 60 and 61.
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(c2) Adjustment of shareholder return
3.108. To the output from the shareholder return models both upward and downward
adjustments are needed when assessing the cost of capital rate in a
solvency context.
3.109. Downward adjustments: In order to account for the fact that a key source
of return that exists for going concerns (the so called franchise value
related to expected profit from new business) may not be demanded by
capital providers in a transfer context, a downward adjustment is needed.
No reliable quantitative results are available concerning the size of this
adjustment.
3.110. Upward adjustments: Additional costs, i.e. costs beyond those required to
compensate investors for the risk they are assuming, make an upward
adjustment necessary. These additional costs may stem from:
• Frictional costs of carrying capital. These are additional costs42 which
reflect a variety of indirect costs, as frictional costs related to managers’
incentives, information asymmetries, and so on. Again, these
costs are very difficult, if not impossible, to quantify.
• Initial costs of raising capital. These are fees for underwriting, listing
and regulation, which in most jurisdictions are not negligible43.
• Corporate income taxes on the risk margin in some tax jurisdictions.
This is the case if the risk margin is considered as taxable profit at
inception and not as taxable income only over the time of its release
from the risk margin.
3.111. As already indicated, the aggregate effect of both upward and downward
adjustments is difficult to quantify in a reliable manner. However, as it is
unlikely that the downward adjustment outweighs the upward adjustments
by a large margin, a range for the Cost-of-Capital rate after these adjustments
of 6-8 per cent is deemed as reasonable.
(c3) Calibration to market prices
3.112. The output for the cost of capital rate has to be calibrated further to give
final risk margins consistent with observable prices in the marketplace.
The risk margin together with the best estimate shall be “equivalent to the
amount insurance and reinsurance undertakings would be expected to
require in order to take over and meet the insurance and reinsurance
obligations” (Article 76(3)).
3.113. In the Solvency II context an allowance may be necessary for the methodologies
applied when calculating the capital base (i.e. the future SCRs).
42 Cf. the GNAIE-report, page 30.
43 Underwriting fees, which generally constitute at least half of the direct IPO costs, amount to
about 3.5% of the raised equity in the UK, Germany or France, and to more than 6.5% in the USA.
Source: Oxera report (2006), “The Cost of Capital: An International Comparison”. Available at
www.oxera.com.
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This is especially the case for any simplifying methods allowed.44 All other
assumptions equal, especially for unchanged best estimate, the cost of
capital rate has to be set higher if methods used in the solvency context
give systematically lower capital bases than the capital bases assessed
through the markets in real insurance portfolio transfers. Otherwise the
technical provisions will be insufficient.
3.114. As long as the method used in assessing the capital base does not
systematically underestimate the needed amount, a Cost-of-Capital rate of
at least 6 per cent could be seen as adequate. In order to avoid procyclical
effects, the Cost-of-Capital rate should not be adjusted to follow market
cycles.
(d) A final comment
3.115. It should be noted that some recent academic work45 suggests that the
proportional method46, as used as a simplification for calculating the future
SCRs (e.g. as in QIS3 and QIS4), systematically understates the capital
base needed. If this proves true – and a proportional method is still to be
allowed as a simplification in the Solvency II context – a Cost-of-Capital
rate higher than the rate of 6 per cent could be necessary in order to compensate
for this bias.
44 In QIS4 a majority of undertakings (independently of their size) used simplifications when
making SCR-projections for the risk margin calculations.
45 Cf. Gareth Haslip: “Risk assessment”, The Actuary (December 2008). See also the example
given on page 27 in the GNAIE-report.
46 I.e. a method where the ratio of the SCR to the best estimate technical provisions (or another
exposure measure reflecting the underlying risks) is assumed to be constant throughout the whole
run-off period of the (re)insurance obligations.
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3.1.3.3 Calculation of the risk margin
The general approach
3.116. Based on the assumptions laid down for the reference undertaking and
the assessment regarding the Cost-of-Capital rate referred to in sections
above, a general approach for the risk margin calculations according to the
Cost-of-Capital methodology can be summarised as shown in paragraphs
below.
3.117. It follows from assumption 8 regarding the reference undertaking that the
risk margin should be calculated per line of business and that no diversification
effects should be taken into account. This means that
CoCM = ΣlobCoCMlob,
where
CoCM = the overall risk margin for the portfolio; and
CoCMlob = the risk margin for an individual line of business (lob).
3.118. According to assumption 2 and 3 laid down for the reference undertaking,
this undertaking is empty before a transfer of (re)insurance obligations
takes place, whereas it after the transfer has eligible own funds corresponding
exactly to the SCR that is necessary to support the transferred
(re)insurance obligations. This means 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.
EOFRU(0) = ΣlobSCRRU,lob(0),
where
EOFRU(0) = the eligible own funds raised by the reference undertaking
at time t = 0 (when the transfer takes place); and
SCRRU,lob(0) = the SCR for a given line of business (lob) at time t = 0
as calculated for the reference undertaking.
The cost of providing this amount of eligible own funds equals the Cost-of-
Capital rate times the amount.
3.119. An assessment as sketched in the previous paragraph applies to the
eligible own funds that the reference undertaking needs to provide in all
future years, in order “to support the insurance and reinsurance obligations
over the lifetime thereof” (Article 76(5)).
3.120. As the transfer of (re)insurance obligations is assumed to take place
immediately (cf. Article 76(3)), the method for calculating the overall risk
margin can in general terms be expressed in the following manner:
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CoCM = CoC·Σt≥0EOFRU(t)/(1+rt+1)t+1 = CoC·Σt≥0ΣlobSCRRU,lob(t)/(1+rt+1)t+1
= Σlob{CoC·Σt≥0SCRRU,lob(t)/(1+rt+1)t+1} = ΣlobCoCMlob,
where
SCRRU,lob(t) = the SCR for a given line of business (lob) for year t as
calculated for the reference undertaking,
rt = the risk-free rate for maturity t; and
CoC = the Cost-of-Capital rate.
3.121. The Cost-of-Capital rate “shall be the same for all insurance and reinsurance
undertakings” (Article 76(5)). According to CEIOPS’ view this rate
should be fixed to at least 6 per cent (i.e. CoC ≥ 0.06), cf. the assessment
made in the previous sub-section. However, a reservation should be made
with respect to the outcome of the periodic reviews to be carried out.
3.122. The general rules for calculating the risk margin as laid down in the
previous paragraphs should 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.
Calculations based on the standard formula
3.123.If the SCR of the (original) undertaking is calculated using the standard
formula, all SCRs (for t ≥ 0) for a given line of business should be calculated
as follows:
SCRRU,lob(t) = BSCRRU,lob(t) + SCRRU,lob,op(t) – AdjRU,lob(t),
where
BSCRRU,lob(t) = the Basic SCR for the given line of business (lob) and
year t as calculated for the reference undertaking,
SCRRU,lob,op(t) = the partial SCR regarding operational risk for the
given line of business (lob) and year t as calculated
for the reference undertaking; and
AdjRU,lob(t) = the adjustment for the loss absorbing capacity of
technical provisions for the given line of business
(lob) and year t as calculated for the reference undertaking.
3.124. It should be ensured that the assumptions made regarding loss absorbing
capacity of technical provisions that need 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).
3.125. The Basic SCRs for a given line of business (i.e. BSCRRU,lob(t) for all t≥0)
should be calculated by using the relevant SCR-modules and sub-modules
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per line of business (meaning that the input to be used in the relevant
modules should be restricted to the line of business in question).
3.126. Moreover, the calculation of the Basic SCRs (as referred to in para. 3.123)
should be based on the correlation assumptions laid down in Annex IV of
the Level 1 text although only the unavoidable market risk and the
counterparty default risk with respect to ceded reinsurance is taken into
consideration.
3.127. It should be noted that to the extent that market risk can be considered
avoidable for a line of business (either from the very beginning (i.e. from
t = 0) or after some years (i.e. from t ≥ t*)), the calculation of the Basic
SCR would be simplified. Further simplifications may arise if the
underwriting risk of a given line of business is confined to only one of the
three modules for this risk.
The risk margin for lines of business within non-life insurance
3.128. With respect to the lines of business within non-life insurance the risk
margin (as calculated per line of business) should be attached to the
overall best estimate (i.e. no split between risk margins for premiums
provisions and for provisions for claims outstanding).
Simplifications
3.129.General issues regarding simplifications for the risk margin calculations,
including principles and criteria for using such simplifications, are
addressed in CEIOPS’ advice on Article 85(h). Specific simplifications will
be consulted upon in the third set of advice.
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3.2 CEIOPS’ advice
The reference undertaking
3.130. The reference undertaking assumed to take over and meet the insurance
and reinsurance obligations of an insurance or reinsurance undertaking
shall fulfil the following assumptions:
1. The reference undertaking is not the undertaking itself (the original undertaking),
but another undertaking.
2. The reference undertaking is an empty undertaking in the sense that it
does not have any insurance or reinsurance obligations and any own funds
before the transfer takes place.
3. After the transfer the reference undertaking has eligible own funds corresponding
exactly to the amount of SCR that is necessary to support the
transferred obligations.
4. After transfer of the insurance obligations, the reference undertaking has
assets to cover the Best Estimate net of reinsurance and SPVs, the Risk
Margin and the SCR. These assets should be considered to minimize the
market risk of the undertaking. The reference undertaking should only be
subject to market risk that is unavoidable in practice.
5. SCR of the reference undertaking consists of
(a) underwriting risk with respect to the existing business,
(b) counterparty default risk with respect to ceded reinsurance and SPVs,
(c) operational risk; and
(d) unavoidable market risk.
6. The loss absorbing capacity of technical provisions in the reference undertaking
corresponds to those of the original undertaking.
7. There is no loss absorbing capacity of deferred taxes for (related to) the
reference undertaking
8. The insurance and reinsurance obligations of each line of business (as
defined in Article 85(e)) are transferred to the empty reference undertaking
in isolation. Hence, there does not arise any diversification benefits
between lines of business.
For the purpose of the calculation of the risk margin, the calculation of the
SCR of the reference undertaking (using a standard formula or internal
model) should be done at least by line of business, based on the segmentation
laid down by the implementing measures referred to in Article
85(e).
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If the SCR of the original undertaking is calculated by using an internal
model, the segmentation may differ from the one laid down by the implementing
measures referred to in Article 85(e). However, the risk margin
shall always be valued at least at the level of lines of business laid down
by those implementing measures.
9. The internal models of the original undertaking (partial or full) can be
used to measure the SCR of the reference undertaking to the extent that
these models cover at least the risks referred to in no. 5 (assumption 5
regarding the reference undertaking) as defined by the standard formula.
10.The Cost-of-Capital risk margin is defined net of reinsurance only.
The Cost-of-Capital rate
3.131. The Cost-of-Capital rate should be calibrated in a manner that is
consistent with the assumptions made for the reference undertaking. In
practise 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). Especially, the
Cost-of-Capital rate should be independent of the actual solvency position
of the original undertaking.
3.132. The risk margin should 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.
3.133. In order to stipulate an adequate placeholder for the Cost-of-Capital rate
in the Solvency II regulatory context, the following procedure should be
applied:
• Shareholder return models should be used to provide the initial input.
• Some objective criteria for upward and downward adjustments of the
provided initial input should be established.
• A final calibration of the Cost-of-Capital rate should be carried out in order
to obtain risk margins consistent with observable prices in the marketplace.
3.134. Based on available information a Cost-of-Capital rate of at least 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.
Calculation of the risk margin
3.135. In general, the overall risk margin according to the Cost-of-Capital methodology
(CoCM) should be calculated as follows:
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CoCM = Σlob{CoC·Σt≥0SCRRU,lob(t)/(1+rt+1)t+1} = ΣlobCoCMlob,
where
SCRRU,lob(t) = the SCR for a given line of business (lob) for year t as
calculated for the reference undertaking,
rt = the risk-free rate for maturity t; and
CoC = the Cost-of-Capital rate.
3.136. If the SCR of the (original) undertaking is calculated using the standard
formula all SCRs (for t ≥ 0) for a given line of business should be calculated
as follows:
SCRRU,lob(t) = BSCRRU,lob(t) + SCRRU,lob,op(t) – AdjRU,lob(t),
where
BSCRRU,lob(t) = the Basic SCR for the given line of business (lob) and
year t as calculated for the reference undertaking,
SCRRU,lob,op(t) = the partial SCR regarding operational risk for the given
line of business (lob) and year t as calculated for the
reference undertaking; and
AdjRU,lob(t) = the adjustment for the loss absorbing capacity of
technical provisions for the given line of business (lob)
and year t as calculated for the reference undertaking.
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, is consistent with the assumptions made for the
overall portfolio (of the original undertaking).
The Basic SCRs for a given line of business (BSCRRU,lob(t) for all t≥0) should
be calculated by using the relevant SCR-modules and sub-modules per line
of business (i.e. by restricting the input to be used in the relevant modules
to the line of business in question).
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 although only the unavoidable market risk and
the counterparty default risk with respect to ceded reinsurance is taken into
consideration.
3.137.With respect to non-life insurance the risk margin as calculated per line of
business should be attached to the overall best estimate (i.e. no split
between risk margins for premiums provisions and for provisions for claims
outstanding).
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Annex A Impact assessment on the cost-of-capital rate for
the risk margin
In its Call for Advice of 1 April 2009, the Commission has asked CEIOPS to
contribute to the Commission’s impact assessment of the Level 2 implementing
measures.47 To this end, a list of issues has been set up by the Commission and
CEIOPS, identifying the Level 2 implementing measures that should be
accompanied by an impact assessment. The objectives of the issues have been
selected among the list of objectives used by the Commission in its Level 1
impact assessment.48 On 12 June 2009, the Commission has issued an updated
list of policy issues and options, to which reference is being made.49 This impact
assessment covers issue 2 (sub-issue A) of the list of policy issues and options.
Two summary tables accompanying the impact assessment are published in a
separate excel document.
1. Description of the policy issue
A.1. The Level 1 text states that technical provisions shall correspond to the
current amount (re)insurance undertakings would have to pay if they were
to transfer their (re)insurance obligations immediately to another
undertaking. They are calculated in a “prudent, reliable and objective
manner”. Their value is equal to the sum of a best estimate and a risk
margin where the best estimate corresponds to the probability-weighted
average of future cash-flows taking into account the time value of money.
If future cash flows associated with insurance or reinsurance obligations
can be reliably replicated using financial instruments for which a reliable
market is observable, the separate calculation of best estimate and risk
margin shall not be required.
A.2. This impact assessment only concerns those insurance or reinsurance
obligations for which a separate calculation of the risk margin is required.
A.3. The valuation of technical provisions should be based on sound economic
principles. This means that the technical provisions should be consistent
with the valuation of assets and other liabilities, they should be market
consistent and in line with international developments in accounting and
supervision.
A.4. The Level 1 text further defines the amount of technical provisions as the
value which correspond to the amount an insurer would have to pay if it
transferred its contractual rights and obligations immediately to another
undertaking and the amount that another undertaking would be expected
47 http://www.ceiops.eu/media/files/requestsforadvice/EC-april-09-CfA/EC-call-for-advice-Solvency-II-Level-
2.pdf.
48 http://ec.europa.eu/internal_market/insurance/docs/solvency/impactassess/final-report_en.pdf.
49 http://www.ceiops.eu/media/files/requestsforadvice/EC-June-09-CfA/Updated-List-of-policy-issues-andoptions-
for-IA.pdf.
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to require to take over and meet the underlying (re)insurance obligations.
Due to the nature and uncertainty embedded in the best estimate, the
value of the best estimate should be adjusted by increasing the best
estimate with a risk margin to achieve a market consistent valuation of
technical provisions. The risk margin represents the cost of providing the
amount of eligible own funds to cover the Solvency Capital Requirement
necessary to support the obligations over the lifetime thereof. The Level 1
text in Article 76(5) further requires that the rate used to determine the
cost of providing the amount of eligible own funds should be the same for
all (re)insurance companies and be reviewed periodically. The annual rate
used, which is called cost-of-capital rate, should be equal to the additional
rate above the relevant-risk-free interest rate, that a (re)insurance
undertaking would incur to hold the necessary eligible own funds.
A.5. The issue at hand concerns the appropriate level of the cost-of-capital rate
and, if necessary, the modalities for its periodic review.
2. Detailed description of policy options and assessment of the relative
impacts on the different affected parties
Detailed description of policy options
A.6. Option 1: Cost-of-capital rate equal to 6%, as specified in QIS4
Under this option, the level of the cost-of-capital rate should be equal to
6%, as specified in QIS4. The QIS4 calibration of the cost-of-capital rate
was based on the Swiss Solvency Test. However, as described further in
this document, the level of 6% is also consistent with the results of models
such as the Capital Assets Pricing Model (CAPM) and the Fama-French
multi Factor Model (FFmF).
A.7. Option 2: Cost-of-capital rate lower than 6%
Under this option, the level of the cost-of-capital rate should be lower than
6%. This would mean that the cost-of-capital rate could be determined
based on models such as the Capital Assets Pricing Model (CAPM) and
versions of the Fama-French multi Factor Model (FFmF) which are
commonly used in the market.
If the cost-of-capital rate were to be calibrated based on current data, its
calibration should be periodically reviewed based on the selected model.
A.8. Option 3: Cost-of-capital rate higher than 6%
Under this option, the level of the cost-of-capital rate should be higher
than 6%. Similarly to Option 2, its calibration should consider the selection
of the model and the periodic review of the cost-of-capital rate.
A.9. Specific questions that were addressed in the discussion of the policy
options include:
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What would be an appropriate level?
A.10. CEIOPS believes that (at least) 6% is an appropriate level for the cost-ofcapital
rate.
How should it be calibrated / updated?
A.11. The cost-of-capital rate should be calibrated according to the three-step
procedure laid out in annex 1.
A.12. CEIOPS believes that the cost-of-capital rate should not be updated too
frequently. An annually updated cost-of-capital rate would be seen as too
frequent as it may increase the volatility of the balance sheet since
different cost-of-capital rates will be applied at the end of each financial
period. This may have an effect on the sustainability of the value of
technical provisions as well as on risk management and consistency
because it would be more difficult to predict the cost-of-capital rate.
Should it be the same for both life and non-life business?
A.13. The cost-of-capital rate should be the same for life and non-life business.
There seems to be no evidence that the cost of providing the amount of
eligible own funds necessary to support the (re)insurance obligations
would be substantially different for life and non-life insurance
undertakings.
Impact on industry, policyholders and beneficiaries and supervisory
authorities
A.14. CEIOPS believes that the level of 6% (option 1) most closely represents
the market cost of capital. This is based on the analysis summarised in
Annexes 1 and 2 in this paper and the calibration from the Swiss Solvency
Test. The impact assessment is therefore based on this assumption.
However, CEIOPS notes that the assumption that a single cost-of-capital
rate is applicable for the whole European Union is a significant
simplification as the cost-of-capital varies across markets. Furthermore,
the market cost-of-capital evolves over time. There is some scope in the
Level 1 text for periodic reviews of the cost-of-capital rate. However this
has not been addressed in the impact assessment (i.e. the impact
assessment is based on the assumption that the cost-of-capital rate will
not be reviewed).
Likely industry response
A.15. Considering the CRO Forum study50 which concluded that the annual costof-
capital rate should be between 2.5% and 4.5%, CEIOPS expects that
some members of the industry are likely to disagree with options 1 and 3.
50 http://www.croforum.org/publications.ecp (Market Value of Liabilities for Insurance Firms – Implementing
elements for Solvency II).
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A.16. QIS4 results show that for 75% of undertakings, the risk margin in
proportion to the best estimate was less than 5% for life insurance and
less than 10% for non-life insurance.
A.17. The ratio of the risk margin (RM) to the best estimate (BE) for some
alternative choices of the cost-of-capital rate is illustrated in Table 1.
Table 1.
Cost-of-capital Ratio of RM to BE
rate Life insurance Non-life insurance
6 % 5 % 10 %
4.5 % 3.8 % 7.5 %
2.5 % 2.1 % 4.2 %
7.5 % 6.3 % 12.5 %
A.18. It seems reasonable to believe that a change of the cost-of-capital rate in
the order of +/- 1 to 1,5 percentage point (e.g. from 6 % to a value in the
interval 4.5% – 7.5%) would not lead to significant changes in the
industry behaviour.
Costs and Benefits
• Policyholders and beneficiaries
A.19. Policyholders and beneficiaries can be affected in two different ways, one
minor and one major. A minor effect is that a higher cost-of-capital rate
means a higher risk margin and consequently higher premiums to pay if
premiums were to fund the risk margin. However, a higher risk margin
would also mean higher technical provisions and better protection of the
policyholders and beneficiaries.
A.20. The cost-of-capital parameter impacts the amount a (re)insurance
undertaking would require to accept a transfer of insurance and
reinsurance obligations. There is considerable uncertainty with regard to
the calibration of this parameter. As stated above, CEIOPS believes that
option 1 is most consistent with the market cost-of-capital. Therefore
option 2 will have a permanent negative effect compared to options 1 and
3 as technical provisions will not be sufficient to effect a transfer leading to
lower protection of the policyholders. On the other hand, option 3 may
lead to technical provisions which are higher than necessary without any
additional benefit.
• Insurance and reinsurance undertakings
A.21. Regarding the impact on the (re)insurance undertaking, option 2 results in
lower technical provisions compared to the other two options. Option 3 will
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generate the highest technical provisions compared to the other two
options.
A.22. However, as already indicated, it is unlikely that the alternative choices of
cost-of-capital rates within a reasonably bounded interval (e.g. from 4.5%
to 7.5%) will lead to significantly different industry behaviour.
• Supervisory authorities
A.23. The determination of the option which will have a neutral effect depends
on which cost-of-capital rate is consistent with the market “cost of
capital”. There is a risk that the value of technical provisions will not be
sufficient to transfer the portfolio to another undertaking.
A.24. From the perspective of the supervisory authority, the option which in
most cases results in technical provisions which are consistent with the
current transfer value is also the most acceptable. As stated above,
CEIOPS believes that option 1 is most consistent with the market cost of
capital. Also option 3 results in an amount of technical provisions which
would be enough for a transfer of the portfolio to another undertaking.
However option 3 may lead to undertakings holding unnecessarily high
technical provisions. On the other hand, option 2 results in technical
provisions which are not sufficient to enable the portfolio transfer.
A.25. In general, there is also a potential risk that it would not be possible to
transfer the portfolio of a distressed insurer to a third party insurer if the
cost-of-capital rate is expected to increase from one year to the next.
3. Relevant objectives
A.26. The calibration of the cost-of-capital rate falls under the scope of the
following general and operational objectives:
A.27. The general objective relevant for this policy option is to “enhance the
protection of the policyholders and beneficiaries”.
A.28. The relevant operational objectives are to “harmonise the calculation of
technical provisions”, “introduce risk-sensitive harmonised solvency
standard”, “introduce proportionate requirements for small undertakings”
and to “promote comparability of valuation and reporting rules with the
international accounting standards elaborated by the IASB”.
4. Comparison between the different options based on the efficiency and
effectiveness in reaching the relevant operational objectives
A.29. The comparison and ranking of the policy options is based on the
effectiveness and efficiency of each option in reaching the relevant
objectives. Effectiveness is defined as the extent to which options achieve
the objectives of the proposal. Efficiency is defined as the extent to which
options can be achieved at the lowest cost (cost-effectiveness).
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A.30. The sources of evidence available to CEIOPS are the research
commissioned by the CRO Forum51 and the research commissioned by
GNAIE52 (see Annex 1).
A.31. It is expected that all options achieve harmonisation of the calculation of
technical provisions as all insurance and reinsurance companies will use
the same cost-of-capital rate to calculate the risk margin.
A.32. It is impossible to determine which option better promotes compatibility of
valuation rules with international accounting standards elaborated by IASB
because this could only be checked when the portfolio will be transferred
to another undertaking. A fixed cost-of-capital rate does not introduce
risk-sensitive harmonised solvency standard but introduces proportionate
requirements for small undertakings.
A.33. Option 1 is most likely to facilitate the transfer of liabilities in practice
since this is closest to the market cost-of-capital and therefore meets the
objective of policyholder protection.
A.34. Option 2 will not meet the objective of policyholder protection as the risk
margin will be low and hence the technical provisions will not be sufficient
to transfer the liabilities.
A.35. Option 3 also meets the objective of policyholder protection as it is
expected that the technical provisions will be more than sufficient to
facilitate a transfer. However there may be unintended costs to
policyholders if technical provisions are unnecessarily high.
A.36. Finally there is also a potential risk that it would not be possible to transfer
the portfolio of a distressed insurer to a third party insurer if the cost-ofcapital
rate increases from one year to the next.
A.37. In conclusion, taking into account the potential cost and benefits for
policyholders and beneficiaries, insurance and reinsurance undertakings
and supervisory authorities, the effectiveness and efficiency level to meet
the relevant objectives, and its sustainability and comparability levels,
CEIOPS recommends in its advice that the cost-of-capital should be fixed
to at least 6 per cent.
51 http://www.croforum.org/publications.ecp (Market Value of Liabilities for Insurance Firms –
Implementing elements for Solvency II).
52 Study prepared by Ernst & Young: ”Market Value Margins for Insurance Liabilities in Financial
Reporting and Solvency Applications“, dated October 2007, commissioned by GNAIE – Group of
North American Insurance Enterprises.
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Annex 1 CEIOPS' assessment of the cost-of-capital rate
1. Introductory remarks
A.38. 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.
A.39. The risk margin shall guarantee that sufficient technical provisions for a
transfer are available even in a stressed scenario. Hence, the cost-ofcapital
rate has to be a long-term average rate, reflecting both periods of
stability and periods of stress.
– A rate of at least 6% has been assessed to be an adequate placeholder
for the cost-of-capital rate in QIS2, QIS3 and QIS4. 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.
A.40. In addition, one needs to reflect on the assumptions that would be
reasonable to make regarding the funding of the capital requirement in a
stressed scenario.
2. Funding of the capital requirement
A.41. In the CRO Forum’s report, the cost-of-capital rate is calculated as a
weighted average of the cost of equity and the cost of debt. It is assumed
that 20% of the capital requirement can be funded by issuing debt and
that only the remaining 80% have to be funded by raising equity capital.
Moreover, by assuming an effective company rate of taxation of 35% over
all jurisdictions, the estimated cost of debt is in practise outweighed by the
adjustments for tax relief on interest payments made to service the debt.
As a result the cost-of-capital rate equals only approximately 80% of the
estimated cost of equity rate.
A.42. Contrary to this, CEIOPS finds it more reasonable to assume that the
capital base used when calculating the risk margin under a cost-of-capital
methodology is funded solely with equity capital.53 As the capital base is
defined as the Solvency Capital Requirement in an adverse situation, i.e.
as the amount of capital that is substantially at risk, it would be
inconsistent to assume at the same time that this requirement can be
funded by debt investors at costs substantially below the equity costs.
53 This is seen as a more appropriate assumption also by GNAIE, cf. their report.
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Accordingly, this approach has been used in the assessments summarised
below.54
3. The three-step procedure for assessing the cost-of-capital rate
3.1 Shareholder return models
A.43. The research carried out by both CRO Forum and GNAIE has been
analysed. As the most commonly used models in the market seem to be
the Capital Asset Pricing Model (CAPM) and versions of the Fama-French
multi Factor Model (FFmF), CEIOPS’ analysis has limited itself to the
results given by these models.
(a) The frictional cost-of-capital approach
A.44. In the CRO Forum’s research the rate of return above the risk-free rate
that shareholders of insurance undertakings require in order to assume
broadly diversified insurance risks, are estimated using different methods
and assumptions. CRO Forum deems that the so-called frictional cost-ofcapital
approach is the most appropriate to capture the rate of return an
insurance company requires on the capital it deploys to support nonhedgeable
risk over a given year.
A.45. However, CEIOPS has strong reservations regarding the results based on
this approach55 as set out in the CRO Forum’ report. Firstly, the results of
the method are very dependent on a number of key assumptions –
effective tax rate, loss carry forward period and risk-free rate – for which
it is difficult to assess reasonable parameter estimates in an EU context.
Secondly, of the main components of the frictional costs – double taxation
costs, financial distress costs56 and agency costs57 - only the two first have
been modelled.
A.46. Moreover, the CRO Forum has drawn e.g. the following conclusions after
having modelled double taxation and financial distress costs:58
For highly capitalized companies, the cost-of-capital rate is determined
mainly by the cost of double taxation and the cost of financial distress
is negligible. […]
The cost-of-capital rate depends linearly on a jurisdiction’s tax rate for
all confidence levels. This means that the cost-of-capital rate (and
therefore the MVM) in a jurisdiction with a tax rate of 10% is only half
of that in a jurisdiction with a tax rate of 20%.
54 It may also be questionable whether an insurance undertaking being in a stressed situation will
be in a position to benefit from further tax credits.
55 Under this approach, the total return required by shareholders may be thought of consisting of
the base cost of capital, the frictional costs and the expected economic profit. Only the frictional
costs are taken into account in determining the cost-of-capital rate.
56 These are direct and indirect costs which arise when an insurer has difficulties meeting its
financial obligations to policyholders or debt holders.
57 Agency costs are associated with the misalignment of the interest between management and
shareholders or between policyholders and shareholders. The lack of transparency and
informational asymmetry are also deemed to be part of agency costs.
58 Cf. CRO Forum's report, page 36.
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A.47. In CEIOPS’ opinion the result implied by this conclusion seems
unreasonable for Member States in which the effective tax rate is low.
Furthermore, CEIOPS also questions the assertion that financial distress
costs are negligible for well capitalized companies.
(b) The CAPM and the FF2F-method
A.48. In CRO Forum’s research related to the CAPM and the FF2F method, the
cost of equity rate above the risk-free rate has been estimated for three
markets: Europe, Asia and the US. From these estimated rates a “Global
World” rate has been derived for both methods. The Global World rates
are in general lower than the European rates, cf. table 2 below.59 When
concluding on an appropriate level of the cost-of-capital rate, CRO Forum
has taken into account only the lower Global World rates without giving
any explicit rationale for this choice.
A.49. CEIOPS finds it more reasonable to base the assessment of the cost-ofcapital
rate on CRO Forum’s results for the CAPM and the FF2F method for
European insurance undertakings. In this context it may also be noted that
the FF2F-results for the European non-life insurers are in line with the
results referred to in GNAIE’s report for US non-life insurers (an equity risk
premium of 14.2%).
Table 2. Equity Risk Premiums as assessed in the CRO Forum’s report.60
CAPM FF2F
European Global European Global
market market market market
Life 10.0 % 5.1 % 11.8 % 9.4 %
Non-life 7.4 % 4.2 % 12.5 % 9.6 %
A.50. Taking into account only the results from the shareholder return models a
cost-of-capital rate of at least 7.5% - 10% seems to be adequate.
3.2 Adjustment of shareholder return
A.51. To the output from the shareholder return models, both upward and
downward adjustments are needed when assessing the cost-of-capital rate
in a solvency context.
A.52. Downward adjustments: In order to account for the fact that a key source
of return that exists for going concerns (the so-called franchise value
related to expected profit from new business) may not be demanded by
59 In the CAPM case, the reported Global rates are lower than the reported rates for all three markets, a result that
could have benefited from a more thorough explanation in the report.
60 Cf. CRO Forum's report, page 58, 60 and 61.
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capital providers in a transfer context, a downward adjustment is needed.
No reliable quantitative results are available concerning the size of this
adjustment.
A.53. Upward adjustments: Additional costs, i.e. costs beyond those required to
compensate investors for the risk they are assuming, make an upward
adjustment necessary. These additional costs may stem from:
– Frictional costs of carrying capital. These are additional costs61 which
reflect a variety of indirect costs, as frictional costs related to
managers’ incentives, information asymmetries, and so on. Again,
these costs are very difficult, if not impossible, to quantify.
– Initial costs of raising capital. These are fees for underwriting, listing
and regulation, which in most jurisdictions are not negligible.62
– Corporate income taxes on the risk margin in some tax jurisdictions.
This is the case if the risk margin is considered as taxable profit at
inception and not as taxable income only over the time of its release
from the risk margin.
A.54. As already indicated, the aggregate effect of both upward and downward
adjustments is difficult to quantify in a reliable manner. However, as it is
unlikely that the downward adjustment outweighs the upward adjustments
by a large margin, a reasonable range for the cost-of-capital rate taking
into account these necessary adjustments would be 6% to 8%.
3.3. Calibration to market prices
A.55. The output for the cost-of-capital rate has to be calibrated further to give
final risk margins consistent with observable prices in the marketplace.
The risk margin together with the best estimate shall be “equivalent to the
amount insurance and reinsurance undertakings would be expected to
require in order to take over and meet the insurance and reinsurance
obligations” (Article 76(3)).
A.56. In the Solvency II context an allowance may be necessary for the methodologies
applied when calculating the capital base (i.e. the future SCRs).
This is especially the case for any simplifying methods allowed.63 All other
assumptions equal, especially for unchanged best estimate, the cost-ofcapital
rate has to be set higher if methods used in the solvency context
give systematically lower capital bases than the capital bases assessed
through the markets in real insurance portfolio transfers. Otherwise the
technical provisions will be insufficient.
61 Cf. the GNAIE-report, page 30.
62 Underwriting fees, which generally constitute at least half of the direct IPO costs, amount to about 3.5% of the
raised equity in the UK, Germany or France, and to more than 6.5% in the USA. Source: Oxera report (2006),
“The Cost of Capital: An International Comparison”. Available at www.oxera.com.
63 In QIS4 a majority of undertakings (independently of their size) used simplifications when making SCRprojections
for the risk margin calculations.
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A.57. As long as the method used in assessing the capital base does not
systematically underestimate the needed amount, a cost-of-capital rate of
at least 6% could be seen as adequate. In order to avoid procyclical
effects, the cost-of-capital rate should not be adjusted to follow market
cycles.
Annex 2 On CAPM and FFMF Models
1. Quantification using the Capital Asset Pricing Model
A.58. The CAPM is a traditional model from financial theory. It is the most
popular method used to estimate the cost of equity capital among large
publicly traded companies.
A.59. The expected cost of equity for a firm “j”, written E(Rj), can be derived
from the risk-free rate Rf, the expected price E(Rm) of the market portfolio
Rm and the firms beta, which reflects the correlation of the firm’s returns
with those of the equity market overall:
( ) * ( )
( , )
with j ( * ),where j ( ), m ( ) and jm
( ) * ( ( ) ),
R j Rm
Cov R j Rm
R j Rm
m
j
jm
j f j m f E R R E R R
σ σ
σ σ σ σ ρ
σ
σ
β ρ
β
= = = =
= + −
This gives the cost of equity above risk-free return (equity risk premium
ERP) for a firm “j”, as beta of this firm times market returns over risk-free:
( ) *( ( ) ) j j f j m f ERP = E R − R = β E R − R .
A.60. In the research commissioned by the CFO Forum equity risk premium
rates for the European market were estimated64 to be 10.03% for Life and
7.35% for Non–life.
A.61. In the above calculation the average over the estimated betas for
European insurance companies from 1998 – 2006 was used: 0.94 for Non-
Life insurance companies and 1.28 for Life companies. The expected
excess market risk premium used was 7.81%, assessed on US-data from
years 1926 to 2006.
2. Quantification using a Fama-French Multi Factor Model
A.62. The Fama-French multi factor-asset pricing model was developed because
the systematic risk factor in the CAPM model alone does not adequately
explain stock returns. Fama and French have shown that adding a second
or third factor significantly increases the explanatory power of the model.
A.63. In the research commissioned by the CRO Forum, the equity risk premium
rates from the Fama-French 2-factor model (the second factor is related to
the ratio of the book value of equity relative to the market value) were
64 CRO Forum Research, “Table 4: Full Information Beta CAPM Dollar Denominated Cost of Equity
Capital Estimates for the U.S., European, Asian and Global Insurance Industry: 1998 – 2006”, on
page 58.
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estimated for the European market to be 12.54% for Life and 11.76% for
Non-life.65
A.64. In the research commissioned by the GNAIE the equity risk premium rates
for US-based non life insurers was estimated to be 14.17%. Thereby a
market risk premium of 8.4%, a risk free rate of 4% and the parameters
for the Fama-French 3 Factor model resulting from an exhaustive analysis
of US-based P&C insurers by Cummins and Phillips66, were used.
65 CRO Forum Research, “Table 5: Full Information Beta International Fama-French Two Factor
Dollar Denominated Cost of Equity Capital Estimates for the U.S., European, Asian and Global Non-
Life Insurance Industry: 1998 – 2006”, on page 60 for non life and Table 6 on page 61 for life
companies.
66 J. D. Cummins and R. D: Phillips, Estimating the Cost of Equity Capital for Property-Liability
Insurers, The journal of Risk and Insurance, 2005, Vol. 72, No 3.
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Annex B Impact assessment on diversification benefits in
the risk margin
In its Call for Advice of 1 April 2009, the Commission has asked CEIOPS to
contribute to the Commission’s impact assessment of the Level 2 implementing
measures.67 To this end, a list of issues has been set up by the Commission and
CEIOPS, identifying the Level 2 implementing measures that should be
accompanied by an impact assessment. The objectives of the issues have been
selected among the list of objectives used by the Commission in its Level 1
impact assessment.68 On 12 June 2009, the Commission has issued an updated
list of policy issues and options, to which reference is being made.69 This impact
assessment covers issue 2 (sub-issue B) of the list of policy issues and options.
Two summary tables accompany the impact assessment, published in a separate
excel document.70
1. Description of the policy issue
B.1. The Level 1 text states that the technical provisions correspond to the
current amount (re)insurance undertakings would have to pay if they were
to transfer their (re)insurance obligations immediately to another
undertaking. The calculation of technical provisions should make use and
be consistent with information provided by the financial markets and
generally available data on underwriting risk. They are calculated in a
“prudent, reliable and objective manner”. The technical provisions are
equal to the sum of a best estimate and a risk margin (unless the criteria
for calculating the technical provisions as a whole are fulfilled). The risk
margin shall be such as to ensure that the value of technical provisions is
equivalent to the amount another (re)insurance undertaking (a reference
undertaking) would be expected to require in order to take over and meet
the insurance and reinsurance obligations.
B.2. In other words, the risk margin shall be calculated by determining the cost
of providing an amount of eligible own funds equal to the Solvency Capital
Requirement necessary to support the insurance and reinsurance
obligations over the lifetime thereof. The amount of technical provisions
should reflect the characteristics of the underlying insurance portfolio.
Undertaking-specific information should only be used in the calculation
67 http://www.ceiops.eu/media/files/requestsforadvice/EC-april-09-CfA/EC-call-for-advice-
Solvency-II-Level-2.pdf
68 http://ec.europa.eu/internal_market/insurance/docs/solvency/impactassess/final-report_en.pdf
69 http://www.ceiops.eu/media/files/requestsforadvice/EC-June-09-CfA/Updated-List-of-policyissues-
and-options-for-IA.pdf.
70 http://www.ceiops.eu/media/files/consultations/consultationpapers/CP42/CEIOPS-CP-42-09-
Annex-IA-Risk-Margin-CoC-rate.xls
http://www.ceiops.eu/media/files/consultations/consultationpapers/CP42/CEIOPS-CP-42-09-
Annex-IA-Risk-Margin-Diversification.xls
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insofar as that information enables insurance and reinsurance
undertakings to better reflect the characteristics of the underlying
insurance portfolio.
B.3. In order to harmonise the calculation of the risk margin throughout the
European Union the assumptions to be fulfilled by the reference
undertaking should be determined. In particular, whether or not
diversification effects should be taken into account in the calculation of the
risk margin, should be analysed as part of the impact assessment of
implementing measures.
B.4. Recognising diversification benefits leads to lower financial requirements.
Diversification benefits are explicitly allowed for in the calculation of the
Solvency Capital Requirement between different risks and risk modules.
The issue to be analysed is to what extent diversification effects should
also be taken into account in technical provisions, more specifically in the
risk margin. The outcome of this analysis will depend on the assumptions
made regarding the reference undertaking assumed to take over and meet
the underlying insurance and reinsurance obligations for each line of
business.
2. Detailed description of policy options and assessment of the relative
impacts on the different affected parties
Detailed description of policy options
B.5. Option 1: The reference undertaking is a well-diversified undertaking.
If the reference undertaking is assumed to be well-diversified, then this
would imply that market-wide diversification effects are recognised by all
undertakings, even if they are not diversified themselves.
B.6. Option 2: After the transfer has taken place, the reference undertaking is
a mirror image of the undertaking transferring the risk.
If the reference undertaking – after the transfer of insurance and
reinsurance obligations has taken place – is assumed to be a mirror image
of the insurer transferring the risk, then the insurer could take into
account the diversification effects assumed to be present in its own
business.
B.7. Option 3: Before the transfer takes place the reference undertaking is an
empty undertaking.
If the reference undertaking is assumed to be empty before the transfer of
insurance and reinsurance obligations take place, then it is also reasonable
to assume that no diversification effects across lines of business could be
taken into account in the risk margin.
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Impact on industry, policyholders and beneficiaries and supervisory
authorities
Likely industry response
B.8. Option 3, which leads to no recognition of diversification benefits will
generate the highest technical provisions compared to the two other
options.
B.9. An integral part of the risk management is to reduce risk through the
diversification of insurance and reinsurance obligations. In the case of
options 1 and 3 the management of undertakings would not be
incentivized to minimise the insurance risk through diversification of the
insurance portfolio across different lines of business. Both options may
therefore affect risk mitigation through the diversification of risks.
Costs and Benefits
• Policyholders and Beneficiaries
B.10. Policyholder protection stems in part from the possibility to transfer
liabilities. However, a transfer of the liabilities is only achievable in practice
if the ensuing increase in the technical provisions of the transferee
(accepting undertaking) is not bigger than the amount of the technical
provisions transferred. Otherwise the risk margin of the transferee would
be insufficient to support the cost of providing an amount of eligible own
funds equal to the Solvency Capital Requirement necessary to support the
(re)insurance obligations over the lifetime thereof.
B.11. Option 1 may lead to inappropriate policyholder protection as the majority
of undertakings would not be as well diversified as the reference
undertaking. Therefore, the risk margin based on a well diversified
reference undertaking would not be adequate for the undertaking to
provide the eligible own funds needed to run- off its own insurance and
reinsurance obligations.
B.12. More generally, from a policyholder perspective, because recognising
diversification benefits leads to lower financial requirements, the
protection against the risk of the insurer not meeting its commitments, is
higher.
B.13. Policyholder protection could also be threatened under option 2 as it would
only be possible to transfer liabilities to (re)insurance undertakings which
after that transfer are at least as well diversified as the undertaking which
is transferring the liabilities. Furthermore, if the undertaking would
transfer (re)insurance obligations of only a part of its lines of business, the
technical provisions for the lines of business that remain at the
undertaking, would not be adequate.
B.14. Option 3 ensures the highest level of policyholder protection since it
assumes the lowest level of diversification of the reference undertaking. It
is therefore possible in practice to transfer the liabilities to any
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(re)insurance undertaking. There would also be no need to increase the
value of the remaining liabilities if the undertaking transferred only part of
its obligations.
• Insurance and Reinsurance Undertakings
B.15. Options 1 and 3 enable comparing the amount of technical provisions for
similar (re)insurance obligations. However, with respect to option 1 on
would have to agree on the assumptions to be fulfilled by the welldiversified
undertaking and especially the criteria to be applied when
allocating the overall risk margin among the individual lines of business. A
comparison of the amount of technical provisions would not be possible
under option 2.
B.16. Under option 3 transfers of obligations would not be limited by the size
and portfolio diversification of the accepting undertaking, which is
necessarily not the case with options 1 and 2. Under options 1 and 2 the
amount of technical provisions of the (re)insurance company that transfers
the obligations would need to be increased if only the (re)insurance
obligations related to some of the lines of business are transferred to
another undertaking. Under option 1 the technical provisions would be
insufficient also in cases where the undertaking has to run-off its own
obligations.
B.17. Under option 2 the value of the risk margin would be volatile, following
changes of the portfolio mix over time, which is not the case for options 1
and 3.
B.18. Based on the determination of the risk profile of well-diversified
undertakings (option 1), the valuation of the risk margin may not be
harmonised between big and small (re)insurance undertakings with similar
portfolio mix, due to the bigger relative impact of diversification effects on
risk margin for smaller portfolios.
• Supervisory authorities
B.19. As explained above, there is a risk that under option 1 and to some extent
under option 2 technical provisions for a given line of business would not
be sufficient to be transferrable to another undertaking.
B.20. Furthermore, options 1 and 2 could be workable for a (re)insurance
undertaking only if the risk margin would be calculated as a whole and
there would be no requirement to distribute the risk margin between the
lines of business. Options 1 and 2 are therefore in conflict with Article 79
of the Level 1 text, which requires segmentation of technical provisions –
i.e. both the best estimate and the risk margin – into homogenous risk
groups and as a minimum by lines of business.
B.21. Option 1 is also problematic in terms of how to determine the risk profile
of the well-diversified undertaking. This definition is crucial as it would
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have a direct impact on the amount of technical provisions in every
insurance and reinsurance undertaking within the European Union.
B.22. If this artificial, well-diversified reference undertaking should reflect the
amount of diversification observed in the market, it has to be decided
whether it should be constructed based on national markets or if it should
represent the whole European market. If the reference undertaking
depends on the national market then the criterion that the assumptions
regarding the reference undertakings should be harmonised throughout
the European Union is not satisfied. Furthermore, a decision would need to
be made on how to determine the reference undertaking in those Member
States where old composites, new composites, pure life and pure non-life
insurance undertakings co-exist, as well as where both pure reinsurers and
direct insurers underwrite reinsurance business. Since not only the
diversification but also the absolute size of the reference undertaking has
an impact on the amount of the risk margin, there are great difficulties
also with the definition of a European Union-wide reference undertaking. It
could easily be criticized that whatever the choice, it would not be market
consistent.
B.23. Under option 2, even if the technical provisions are sufficient to transfer
the whole portfolio to another undertaking, the technical provisions would
not be sufficient to transfer selected lines of business separately. This is
problematic from a supervisory point of view since transfers of portfolios
are an important tool in the supervisory toolkit when the interests of
policyholders and beneficiaries are in jeopardy. From a supervisory point
of view the same portfolio of obligations should result in the same amount
of technical provisions (except consideration of expenses which could be
differently integrated in the assessment). This is not the case with option
2.
B.24. From a supervisory perspective, option 3 is the most acceptable since it
results in the highest likelihood of achieving a transfer of the full portfolio
in practice and also facilitates the transfer of selected lines of business to
another undertaking. The undertaking would also be able to run-off its
obligations. The same insurance portfolio would result in the same amount
of technical provisions for each line of business independent of the other
lines of business in the undertaking. This would mean that undertakingspecific
information is only used to better reflect the characteristics of the
underlying insurance portfolio. Moreover, this option will not raise
questions with regard to the determination of the well-diversified portfolio
for the reference undertaking.
3. Relevant objectives
B.25. The assumptions made about the reference undertaking that is assumed
to take over and meet the underlying insurance and reinsurance
obligations fall under the scope of the following general, specific and
operational objectives.
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B.26. First, the general objective relevant for this policy option is the “enhanced
protection of the policyholders and beneficiaries”.
B.27. Secondly, the specific objectives relevant for this policy are to “improve
the risk management of the EU (re)insurer” and to “increase
transparency”.
B.28. Finally, the relevant operational objective is “harmonise the calculation of
technical provisions” “introduce risk-sensitive harmonised solvency
standards”, “introduce proportionate requirements for small undertakings”
and “promote compatibility of valuation and reporting rules with the
international accounting standards elaborated by the IASB”.
4. Comparison between the different options based on the efficiency
effectiveness in reaching the relevant operational objectives
B.29. The comparison and ranking of the policy options will be based on the
effectiveness and efficiency of each of them in reaching the relevant
objectives. Effectiveness is defined as the extent to which options achieve
the objectives of the proposal. Efficiency is defined as the extent to which
objectives can be achieved at the lowest cost (cost-effectiveness).
B.30. Taking into account the discussion in section 2 of this paper on the
difficulty of achieving a transfer in practice, option 1 does not fulfil the
general requirement of enhancing the protection of the policyholders and
beneficiaries. Allowing all undertakings to take into account a welldiversified
portfolio will not encourage management to improve the risk
management of the (re)insurers. Depending on the choice of the reference
undertaking, option 1 could meet the operational objective to harmonise
the calculation of technical provisions but it will not increase transparency
because it does not take into account the insurance or reinsurance specific
risk profile. Option 1 does not introduce a risk-sensitive harmonized
solvency standard. Simplified methods will most probably be necessary for
small undertakings under option 1. This option also does not promote
comparability of valuation and it goes against the objective of convergence
with the work of the IASB on international accounting standards as well as
that of the IAIS .
B.31. Option 2 encourages undertakings to improve risk management through
diversification across lines of business, but it will only partly meet the
objective of enhancing the protection of the policyholders and
beneficiaries. This option is unlikely to contribute to the specific objective
to increase transparency and the operational objective to harmonise the
calculation of technical provisions. Option 2 introduces a risk-sensitive
harmonized solvency standard. Under Option 2 simplified methods should
probably be determined for small undertakings. Option 2 might not
promote comparability of valuation nor convergence with the work of the
IASB on international accounting standards nor that of the IAIS.
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B.32. Option 3 fully meets the general objective to enhance the protection of
policyholders and beneficiaries. This option also fulfils the specific
objective to increase transparency and the operational objective to
harmonise the calculation of the technical provisions. The specific objective
to improve the risk management of the EU (re)insurers would probably not
be harmed although undertakings will not be rewarded for diversification
between lines of business. To some extent option 3 introduces a risksensitive
harmonized solvency standard. Under option 3 no simplified
methods will be needed specifically for small undertakings. Not including
diversification effects goes towards comparability of valuation and
convergence with the work of the IASB on international accounting
standards and that of the IAIS.
B.33. In conclusion, taking into account potential costs and benefits for
policyholders and beneficiaries, insurance and reinsurance undertakings
and supervisory authorities, the effectiveness and efficiency level to meet
the relevant objectives, CEIOPS recommends option 3 in its advice.