Market risk

1.3. The equity risk sub-module and the correlations between the market risk
sub-modules and between the market risk module and other modules are
not covered in this draft advice as they will be addressed in a separate
consultation paper due to be published in a third set of advice in
November 2009. In addition, advice on simplifications to the standard
formula will also be published at this stage.
1.4. The objective of this Paper is to give draft advice on the structure and
design of interest rate risk, spread risk, currency risk, property risk and
concentration risk sub-modules. With the exception of concentration risk,
the calibration of the market risk module is not covered by this paper.
CEIOPS will be producing a further consultation paper, covering the
calibration of the market risk module as part of third set of advice.
2. Extract from Level 1 Text
2.1 The legal basis for the advice presented in this paper is primarily found in
Article 109 of the Level 1 text which states:
“1. In order to ensure that the same treatment is applied to all insurance
and reinsurance undertakings calculating the Solvency Capital
Requirement on the basis of the standard formula, or to take account of
market developments, the Commission shall adopt implementing measures
laying down the following:
[…]
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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(c) the methods, assumptions and standard parameters to be used, when
calculating each of the risk modules or sub-modules of the Basic Solvency
Capital Requirement laid down in Articles 104, 105…
[…]
2. The Commission may adopt implementing measures laying down
quantitative limits and asset eligibility criteria in order to address risks
which are not adequately covered by a sub-module. Such implementing
measures shall apply to assets covering technical provisions, excluding
assets held in respect of life insurance contracts where the investment risk
is borne by the policyholders. Those measures shall be reviewed by the
Commission in the light of developments in the standard formula and
financial markets.
[…]”
2.2 Article 104 states the design of the Basic Solvency Capital Requirement:
“1. The Basic Solvency Capital Requirement shall comprise individual risk
modules, which are aggregated in accordance with point 1 of Annex IV.
It shall consist of at least the following risk modules:
[…]
(d) market risk
[…]
5. The same design and specifications for the risk modules shall be used
for all insurance and reinsurance undertakings, both with respect to the
Basic Solvency Capital Requirement and to any simplified calculations as
laid down in Article 108.
[…]
It should be noted that there is no possibility based on the Level 1 text
(art. 104 7) for the use of undertaking-specific parameters in the market
risk module.”
2.3 Article 105 requires that:
“[…]
5. The market risk module shall reflect the risk arising from the level or
volatility of market prices of financial instruments which have an impact
upon the value of assets and liabilities of the undertaking. It shall properly
reflect the structural mismatch between assets and liabilities, in particular
with respect to the duration thereof.
It shall be calculated, in accordance with point 5 of Annex IV, as a
combination of the capital requirements for at least the following submodules:
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(a) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the term structure of interest rates, or in the
volatility of interest rates (interest rate risk);
(b) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or in the volatility of market prices of
equities (equity risk);
(c) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or in the volatility of market prices of
real estate (property risk);
(d) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or volatility of credit spreads over the
risk-free interest rate term structure (spread risk);
(e) the sensitivity of the values of assets, liabilities and financial
instruments to changes in the level or in the volatility of currency
exchange rates (currency risk);
(f) additional risks to an insurance or reinsurance undertaking stemming,
either from lack of diversification in the asset portfolio, or from large
exposure to default risk by a single issuer of securities or a group of
related issuers (market risk concentrations).
[…]”
2.4 On simplifications in the standard formula, Article 108 states:
“Insurance and reinsurance undertakings may use a simplified calculation
for a specific sub-module or risk module where the nature, scale and
complexity of the risk they face justifies it and where it would be
disproportionate to require all insurance and reinsurance undertakings to
apply the standardised calculation.”
2.5 The Level 1 text also mentions concentration risk in the following
provisions:
“Article 13 – Definitions
29) concentration risk means all risk exposures with a loss potential which
is large enough to threaten the solvency or the financial position of
insurance and reinsurance undertakings; “
“Article 130 – ‘Prudent person’ principle
4. (last alinea) Investments in assets issued by the same issuer, or by
issuers belonging to the same group, shall not expose the insurance
undertakings to excessive risk concentration. “
2.6 Title III of the Level 1 text, dealing with group supervision, also refers to
to concentration risk (eg. Article 248, which specifically relates to the
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supervision of risk concentration in a group)3. There are also some
references to concentration risk in the provisions referred to risk
management (Pillar II)4. The treatment of concentration risk in this paper
is limited to the solo standard formula SCR, since the treatment of this risk
in the context of groups and for internal models is being dealt with in other
draft Level 2 CEIOPS advice.
2.7 From a legal perspective, it is relevant to point out that Article 13(29)
defines concentration risk in the widest and most comprehensive manner.
This interpretation shall apply when referring to concentration risk in the
Level 1 text (eg. in the context of risk management, capital requirements,
investments and group supervision...).
3. QIS4 outputs and industry feedback
3.1 Market risk (except concentration risk)
3.1 From April to July 2008, CEIOPS carried out the fourth Quantitative Impact
Study on Solvency II (QIS4). This included testing each of the submodules
of the market risk module, according to the structure set out in
Article 105.
3.2 For both life and non-life undertakings, as well as for composites, the
quantitative results indicated that market risk represented one of the most
significant modules for the standard formula SCR.
3.3 The largest components of the market risk charge were interest rate and
equity risk (though equity risk is not considered in this paper), with each
of these typically contributing around 40-50% of the total market risk
requirement. Property risk and spread risk contributed less: property
contributed between 8% and 15% of the total market risk, and spread risk
contributed 11-21%. Currency risk contributed less than 7% of the total
market risk. These statistics are useful to bear in mind when considering
the design and structure of the market risk module and when assessing
the merits of any simplifications.
3.4 In general, feedback from the QIS4 exercise indicated few difficulties with
the design and structure of the market risk module and its sub-modules.
The main comments were as follows:
Structure
- For the interest rate module, there were suggestions that sensitivity to
changes in the shape of the yield curve could be introduced.
3 See CEIOPS-CP-61-09, http://www.ceiops.eu/content/view/14/18/
4 See CEIOPS-CP-33-09, http://www.ceiops.eu/media/files/consultations/consultationpapers/CP33/CEIOPS-CP-
33-09-Draft-L2-Advice-on-Governance.pdf .
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- Volatility of interest rates was not modelled in the QIS4 approach.
-Some undertakings suggested use of a correlation matrix for the
treatment of currency risk.
- The QIS4 specifications did not address the treatment of inflation-linked
bonds.
- For the property risk sub-module, some undertakings felt that the
situation where buildings are used for the insurer’s own activities
rather than as an investment was not adequately reflected in the QIS4
approach.
- Some undertakings suggested that property risks could be split into sublines
(residential, commercial, offices, etc.)
- In the spread risk sub-module, it was suggested that a distinction should
be drawn between losses due to migration risk and default risk, and
those due to a general change in the market price of credit risk.
-Some undertakings felt that the approach taken for spread risk in QIS4
did not allow for risk mitigation instruments.
- There were confusions as to which sub-modules should be used to assess
the market risk in mortgage-backed securities with one country stating
a preference for treating these instruments via the spread and interest
rate sub-modules rather than using the counterparty default risk
module.
Practical issues
- It was suggested that the use of a delta-NAV (i.e. change in net asset
value) approach is overly complex and would require sophisticated
modelling techniques
- Many insurers found the application of the look-through approach for
investment funds impractical.
- The approach to currency risk was viewed as problematical for
undertakings writing international business, particularly if this were to
be applied to the currency of the free assets relative to the Euro rather
than to the currency in which the liabilities are denominated (or the
currency of the local regulator).
3.5 This paper takes into account the results and comments from the QIS4
exercise with the aim of refining the design and structure of the market
risk module further.
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3.2 Concentration risk
3.6 According to the QIS4 report, the concentration risk sub-module presented
on average 7.2 % (life), 17.9 % (non-life) and 9.5 % (composite) of the
market risk SCR (before diversification benefits).5
3.7 The QIS4 report also contains quantitative references to the impact of
concentration risk on each Member State and market segment (non-life,
life and composite).
3.8 The issues commented on by the industry with regard to concentration risk
in the solo SCR in QIS4 report can be summarized as follows:
3.9 Treatment of participations. The inclusion of participations into the
concentration risk sub-module was rejected by some undertakings as
double counting. Some undertakings were concerned that intra-group
operations are faced with a too high capital charge.6
CEIOPS will produce an advice on participations and their treatment in the
solvency assessment of an undertaking at the end of October. Therefore,
this advice does not consider the treatment of participations.
3.10 Treatment of properties. The QIS4 report mentions the need for
clarification of concentration risk on properties.7
3.11 First of all, it is worth clarifying that concentration risk on properties does
not refer to having a high percentage of properties in respect of equities,
bonds, or the total balance sheet. This lack of diversification is captured
with the use of a correlation matrix to add the SCRs derived in each of the
market risk sub-modules.
3.12 When dealing with concentration on properties, the difficulty arises from
the fact that the core drivers of diversification are both the type of
property (office premises, residential property, grounds, etc) and mainly
the geographical spread.
3.13 Regarding the first criterion (the type of use of the property) a huge
percentage of properties held by undertakings corresponds to office
premises and commercial non-residential properties, and therefore this is
considered in the calibration of the ‘property risk’ sub-module. Outliers in
respect of this assumption may be better treated via internal models.
3.14 The second criterion (geographical diversification) has revealed to be
extremely difficult to model in an appropriate manner. Experience from the
recent crisis shows that in case of a severe stress, geographical
diversification has no significant effect, since property prices tend to
contract almost worldwide.
5 See CEIOPS' Report on its Fourth Quantitative Impact Study, November 2008,
http://www.ceiops.eu/media/files/consultations/QIS/CEIOPS-SEC-82-08%20QIS4%20Report.pdf, p. 176.
(hereafter: QIS4 report).
6 QIS4 report, p. 179,186..
7 QIS4 report, p. 179, 186.
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3.15 At the same time, it is generally agreed that an undertaking with a
significant percentage of its assets invested in a single property, in
principle would have a higher exposure to market risk than an undertaking
with a diversified portfolio of properties.
3.16 Having this in mind, this advice only contains a specific provision regarding
concentration risk in a single property, considering that the market risk
associated to this type of assets is not geographically diversifiable in case
of severe crisis, and this feature has been considered in the calibration of
property risk sub-module within the standard calculation of the SCR.
3.17 Assets to include in the denominator. Undertakings asked for a clearer
description and rationale of the treatment. In order to solve this point, this
advice contains a better definition of the amount to include in the
denominator.
3.18 Treatment of bank deposits. Undertakings in one country criticized the
concentration risk sub-module with respect to bank deposits from financial
entities under Basel II and investment funds harmonized at a European
level. In their view, these elements should be excluded from the module,
as their issuers are subject to anti-concentration regulation.
3.19 The recent crisis has shown several practical examples demonstrating the
inappropriateness of the proposed exemption. Nevertheless, this empirical
evidence does not preclude the possibility of taking into account
government guarantees provided for bank deposits and cash-accounts. In
fact, this allowance seems aligned with the economic assessment
underlying Solvency 2.
3.20 Risks derived from concentration in cash held at a bank are captured in
the counterparty default risk module, while risks corresponding to
concentration in other bank assets are reflected in the concentration risk
sub-module (no-hole, no-overlap).
3.21 Geographical and sectoral diversification. Although not reflected
explicitly in QIS4 report, it seems relevant to comment on geographical
and sectoral diversification referring to financial investments. An
undertaking concentrating its investments in the same geographical area
or in the same economic sector is bearing higher risks than in case of a
geographically/sectorally diversified portfolio. The difficult point here is
how to measure these types of concentration.
3.22 In the case of geographical concentration, most large groups are present
worldwide and it is difficult to find a reliable and publicly disclosed
measure of their geographical investments. Management of geographical
exposures requires an in-depth insight of each investment and a rather
complex monitoring process. Furthermore, the calibration of different
parameters according to each geographical area is not immediate. In fact,
such differentiation may be not meaningful in an increasingly globalised
context. The crisis has shown that diversification benefits (among lines of
business, asset classes, geographical, etc.) tend to diminish or not be
realizable in stressed times. CEIOPS recognizes the existence of
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diversification effects (both benefits and risks), but notices that they don’t
operate in the same way in normal and crisis times. 8
3.23 A similar statement is applicable to sectoral concentration, perhaps with a
slightly different intensity and some nuances. Examples of tobacco groups
with huge dietary business or utilities groups moving towards the service
sector are sufficiently illustrative of the blurred frontiers that sectoral limits
have in the modern economy. Furthermore, contagion risks and 'domino'
effects have increased the inter-sectoral correlations in times of crisis, in
such a manner that in some cases the correlation among entities of
different sectors closely related is significant, even similar to the
correlation of one entity with its sectoral competitors.
3.24 Summing up and for all the reasons described above, the present advice
does not contain any formula to quantify capital requirements regarding
geographical and sectoral concentrations of financial investments.
Therefore these risks shall be primarily considered as part of Pillar 2
activities (risk management, ORSA, etc.) and via internal models when it
be necessary to ensure that the SCR appropriately reflects the risk profile
of each undertaking.
4. Advice
4.1 General structure of the market risk module
4.1 For the purposes of this quantitative advice and from a technical point of
view, one issue to consider is which types of concentration can be taken
into account a manner that would be compatible with the degree of
simplicity desirable for the standard calculation of the SCR.
4.2 In general, undertakings and supervisors should verify that the SCR
provides an appropriate reflection of the risk profile of the insurance or
reinsurance undertaking. Should this not be the case with respect to the
concentration of assets or liabilities, necessary action will need to be
adopted in a relevant manner, i.e. via internal models or through capital
add-ons.
4.3 There were no major difficulties arising as a result of the structure of the
market risk module and its sub-modules as tested in QIS4 and as set out
in the Level 1 text quoted above.
4.4 However a number of (re)insurance undertakings highlighted that volatility
of interest rates was not captured by the standard formula. In that regard
this advice considers the impact of interest rate volatility on the shape
(i.e., slope and curvature) of the term structure of interest rates.
8 See CEIOPS Lessons learned from the crisis (SII and beyond), March 2009
http://www.ceiops.eu/media/files/publications/reports/CEIOPS-SEC-107-08-Lessons-learned-from-the-crisis-
SII-and-beyond.pdf, section 1.1.4.
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4.5 With the exception of interest rate volatility, we propose no changes to be
made to the module/sub-module structure. Instead, effort will be focused
on refining the design of the sub-modules and (later) on reassessing the
calibration of the modules.
4.6 One suggestion arising from QIS4 has been that liquidity risk could be
included in the market risk module. However, this has been discussed as
part of the development of the Level 1 text and it has been concluded that
this risk is better captured in Pillars 2 and 3.
4.2 General considerations where a delta-NAV approach is used
4.2.1. Explanatory text
4.7 A number of the market risk stresses are based on a delta-NAV (change in
value of assets minus liabilities) approach. The change in net asset value
should be based on a balance sheet that does not include the risk margin
of the technical provisions. This approach is based on the assumption that
the risk margin does not change materially under the scenario stress. This
simplification is made to avoid a circular definition of the SCR since the
size of the risk margin depends on the SCR.
4.8 Where a delta-NAV approach is used, the impact of hedging instruments
shall be allowed for as part of the sub-module: use of the delta-NAV
calculation ensures the impact of the stress scenario on the hedging
instrument is captured alongside the impact on all other assets and
liabilities. (Re)insurance undertakings shall have regard to CEIOPS-CP-31-
09 in determining whether a financial risk mitigation instrument may be
taken into account.9
4.9 Furthermore, where a delta-NAV approach is used, the revaluation of
technical provisions should allow for any relevant adverse changes in
option take-up behaviour of policyholders in this scenario.
4.2.2. CEIOPS’ advice
Delta-NAV Approach
4.10 The change in net asset value shall be based on a balance sheet that does
not include the risk margin of the technical provisions.
4.11 The impact of interest rate hedging instruments shall be allowed for as
part of the scenarios. (Re)insurance undertakings shall have regard to
CEIOPS-CP-31-09 in determining whether a financial risk mitigation
instrument may be taken into account.
4.12 The revaluation of technical provisions should allow for any relevant
adverse changes in option take-up behaviour of policyholders in this
scenario.
9 See CEIOPS-CP-31-09, http://www.ceiops.eu/index.php?option=content&task=view&id=549
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4.3 Interest rate risk
4.3.1. Explanatory text
4.13 As set out in TS.IX.B.1 of the QIS4 Technical Specification, interest rate
risk exists for all assets and liabilities for which the net asset value is
sensitive to changes in the term structure of interest rates or interest rate
volatility.
4.14 Assets sensitive to interest rate movements will include fixed-income
investments, insurance liabilities, financing instruments (for example loan
capital), policy loans and interest rate derivatives.
4.15 Liability cash-flows received in the future will be sensitive to a change in
the rate at which those cash-flows are discounted.
4.16 The values of assets and liabilities that are sensitive to changes in interest
rates can be determined using the term structure of interest rates – which
can change over time.
4.17 QIS4 describes a methodology that derives a capital charge for interest
rate risk based on a delta-NAV (change in value of assets minus liabilities)
approach. Some respondents suggested that this approach is overly
complex. However, the quantitative QIS4 results demonstrated the
significance of interest rate risk not only within the market risk module but
also within the total SCR. As a result, CEIOPS considers the delta-NAV
approach should be retained in order to capture as effectively as possible
this important risk.
4.18 Accordingly, the input information required for this module will the net
asset value (i.e., NAV) calculated as the value of assets minus liabilities.
4.19 The capital charge arising from this sub-module will be Mktint and will be
calculated based on two pre-defined scenarios: one scenario will consider
an upward shock to interest rates and will deliver Mktint
Up; the other
scenario will consider a downward shock and will deliver Mktint
Down. The
capital charge Mktint will then be determined as the maximum of the capital
charges Mktint
Up and Mktint
Down, subject to a minimum of zero.
4.20 The capital charges Mktint
Up and Mktint
Down will be calculated as
Mktint
Up = ΔNAV|upwardshock and Mktint
Down = ΔNAV|downwardshock
where, ΔNAV|upwardshock and ΔNAV|downwardshock are the changes in net values
of assets and liabilities due to revaluation of all interest rate sensitive
assets and liabilities based on:
1. Specified alterations to the interest rate term structures
combined with:
2. Specified alterations to interest rate volatility.
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4.21 The altered term structures used in calculating the capital charge for this
sub-module will be composed of several factors, although there will only
be one upward shock and one downward shock to be applied at each
maturity.
4.22 The intention will be to provide a decomposition of the shocks so that the
assumptions underlying the calibration are transparent: the factors will
capture changes in level, slope and curvature of the term structure.
4.23 The slope and curvature of the term structure of interest rates may be
materially affected by the volatility of interest rates. Interest rate volatility
has further material impact on the assets and/or liabilities of (re)insurance
undertakings that have embedded guarantees in their business.
4.24 The proposed increase in interest rate volatility is therefore likely to affect
traditional participating business, certain types of annuity business and
other investment contracts.
4.25 The calibration of the upward and downward interest rate stresses will be
considered further in the forthcoming consultation paper on calibration of
the market risk module.
4.3.2. CEIOPS’ advice
Interest rate risk
4.26 The input information required for this module is the net asset value (NAV)
calculated as the value of assets minus liabilities.
4.27 The capital charge arising from this sub-module will be Mktint and will be
calculated based on two pre-defined scenarios: one scenario will consider
an upward shock to interest rates and will deliver Mktint_Up; the other
scenario will consider a downward shock and will deliver Mktint_Down. The
capital charge Mktint will then be determined as the maximum of the
capital charges Mktint_Up and Mktint_Down, subject to a minimum of zero.
4.28 The capital charges Mktint_Up and Mktint_Down will be calculated as
Mktint_Up = ΔNAV|upwardshock and Mktint_Down = ΔNAV|downwardshock
where, ΔNAV|upwardshock and ΔNAV|downwardshock are the changes in
net values of assets and liabilities due to revaluation of all interest rate
sensitive assets and liabilities based on:
1. Specified alterations to the interest rate term structures
combined with:
2. Specified alterations to interest rate volatility.
4.29 The calibration of the interest rate shock will capture changes in level,
slope and curvature of the term structure.
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4.4 Currency risk
4.41. Explanatory text
4.30 Currency risk arises from changes in the level or volatility of currency
exchange rates.
4.31 Undertakings may be exposed to currency risk arising from various
sources, including their investment portfolios, as well as assets, liabilities
and investments in related undertakings. The design of the currency risk
sub-module is intended to take into account currency risk for an
undertaking arising from all possible sources.
4.32 Respondents to QIS4, however, highlighted the situation where an
undertaking’s liabilities and local currency are not denominated in euros.
In such a case, the undertaking should consider currency risks relative to
that local currency. Conversion of the components of undertaking’s overall
solvency position (including SCR, MCR, technical provisions and other) into
euros for reporting will not incur currency risk.
4.33 A scenario-based approach was used for the assessment of the currency
risk capital charge in QIS4. Although this can be considered more complex
than a factor-based approach, it is likely that for smaller undertakings the
extent of any cross-currency holdings may be sufficiently limited as to
make a scenario-based approach relatively simple in practice. Moreover, a
scenario-based approach allows currency hedging programmes to be
captured appropriately.
4.34 We propose therefore to retain a scenario-based approach, but to make
some refinements to better capture more complex scenarios without
adding excessive complexity to the standard formula methodology:
4.35 The QIS4 approach considered the effect of two scenarios (a rise and a fall
in exchange rates) on the net value of assets minus liabilities. The
scenarios implicitly assumed that all currencies experience the same rise
or fall in reference to a local currency, whilst ignoring the interdependencies
between currencies other than the local currency.
4.36 As an example, consider the case of an insurer with regulatory accounts
denominated in EUR who has US$ denominated liabilities of value EUR 1
million and assets in £ sterling of value EUR 1 million at the 2007 year
end. In addition, suppose that all other balance sheet items are
denominated in EUR. In this case, the scenarios fx upward and fx
downward do not lead to a change in basic own funds, because pound and
dollar both are assumed to rise or fall in relation to euro. According to the
scenarios, the insurer seems to be perfectly hedged against currency risk.
During the year 2008, the value of the US dollar liabilities have risen to
EUR 1.05 million and the value of the pound sterling assets have fallen to
EUR 0.77 million. Consequently, there is a loss of basic own funds of EUR
0.28 million, more than a quarter of the initial exposure.
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4.37 The example shows that significant currency risks may not be detected if
the QIS4 approach is applied. The two currency scenarios imply that the
exchange rate between pound and dollar is fixed. This is not a realistic
assumption. Moreover, the current approach incentives a currency risk
mis-management as illustrated in the above example: If no appropriate
assets in US dollar are available to cover the dollar liabilities, then the
undertaking can reduce its capital requirement by covering the liabilities
with another foreign currency. However, if the dollar liabilities are covered
with euro assets then the resulting capital charge will be 20% of the
liabilities.
4.38 This issue can be addressed by refining the QIS4 approach to consider
each currency separately.
4.39 Under the refined approach, the local currency is the currency in which the
undertaking prepares its local regulatory accounts. All other currencies are
referred to as foreign currencies. A foreign currency is relevant for the
scenario calculations if the amount of basic own funds depends on the
exchange rate between the foreign currency and the local currency.
4.40 The capital charge arising from this sub-module will be Mktfx and will be
calculated based on two pre-defined scenarios: for each currency C, one
scenario will consider a rise in the value of the foreign currency against the
local currency and will deliver Mktfx,C
Up; the other scenario will consider a
fall in the value of the foreign currency against the local currency and will
deliver Mktf,Cx
Down. All of the participant's individual currency positions and
its investment policy (e.g. hedging arrangements, gearing etc.) should be
taken into account. For each currency, the contribution to the capital
charge Mktfx,C will then be determined as the maximum of the results
Mktfx,C
Up and Mktfx,C
Down. The total capital charge Mktfx will be the sum over
all currencies of Mktfx,C.
4.41 For each relevant foreign currency C, the capital charges Mktfx,C
Up and
Mktfx,C
Down will be calculated as:
max(0, | upward_ ) , Mkt up NAV C shock fx C = Δ
max(0, | downward_ ) , Mkt downward NAV C shock fx C = Δ
where ΔNAV| C upward shock and ΔNAV| C downward shock are the changes
in net values of assets and liabilities due to the rise and fall respectively in
value of the foreign currency against the local currency.
4.42 Note that for each relevant foreign currency C, the currency position
should include any investment in foreign equities where the currency risk
is not hedged. This is because the currency risk is not captured by the
equity stress which is calibrated based on currency hedged time series.
4.43 For the example presented in 4.366 above, the modification would require
the analysis of a dollar shock and a pound shock. The dollar shock would
be an increase of the dollar value compared to the euro by 20%. The
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pound shock would be a loss in value of the pound of 20%. The resulting
capital charge would be Mktfx = 0.2 million + 0.2 million = 0.4 million.
4.44 In situations where two foreign currencies are matched as in the example,
the proposed approach leads to the assumption that - compared to the
local currency - one exchange rate moves up and the other one down.
Consequently, the exchange rate between the two foreign currencies
moves more strongly than the assumed 20%. This could be considered to
be a drawback of the proposed approach. The effect could be avoided by
allowing for diversification between the shocks on different currencies. For
example the results of the different currency shocks could be aggregated
with a correlation matrix. However, there are three arguments against
such an amendment: Firstly, it would be difficult to quantify the
diversification between two exchange rates, even if the simple approach is
taken that the correlation factor for each pair of foreign currencies is the
same. Secondly, the amendment would increase the complexity of the
calculation. And thirdly, situations as illustrated in the example can usually
be avoided in practice.
4.45 The calibration of the upward and downward currency stresses will be
considered further in the forthcoming consultation paper on calibration of
the market risk module.
4.4.2. CEIOPS’ advice
Currency risk
4.46 A scenario-based approach shall be used for the assessment of the
currency risk capital charge.
4.47 The local currency is the currency in which the undertaking prepares its
local regulatory accounts. All other currencies are referred to as foreign
currencies. A foreign currency is relevant for the scenario calculations if
the amount of basic own funds depends on the exchange rate between the
foreign currency and the local currency.
4.48 The capital charge arising from this sub-module will be Mktfx and will be
calculated based on two pre-defined scenarios: for each currency C, one
scenario will consider a rise in the value of the foreign currency against the
local currency and will deliver Mktfx,C
Up; the other scenario will consider a
fall in the value of the foreign currency against the local currency and will
deliver Mktfx,C
Down. All of the participant's individual currency positions and
its investment policy (e.g. hedging arrangements, gearing etc.) should be
taken into account. For each currency, the capital charge Mktfx,C will then
be determined as the maximum of the results Mktfx,C
Up and Mktfx,C
Down. The
total capital charge Mktfx will be the sum over all currencies of Mktfx,C.
4.49 For each relevant foreign currency C, the capital charges Mktfx,C
Up and
Mktfx,C
Down will be calculated as:,
max(0, | upward_ ) , Mkt up NAV C shock fx C = Δ
max(0, | downward_ ) , Mkt downward NAV C shock fx C = Δ
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where ΔNAV| C upward shock and ΔNAV| C downward shock are the
changes in net values of assets and liabilities due to the rise and fall
respectively in value of the foreign currency against the local currency.
4.50 For each relevant foreign currency C, the currency position should include
any investment in foreign equities. This is because the currency risk is not
captured by the equity stress which is calibrated based on currency
hedged time series.
4.5 Spread risk
4.5.1. Explanatory text
4.51 Spread risk is the part of risk that reflects the change in value of net
assets due to a move in the yield on an asset relative to the risk-free term
structure. The spread risk sub-module should address changes in both
level and volatility of spreads.
4.52 QIS4 respondents suggested it would be helpful to have greater clarity on
the scope of the spread risk sub-module. There are two particular areas of
concern: first, the interaction between this sub-module and the
counterparty default module, and second, the way in which certain
financial instruments would be treated under this sub-module.
4.53 The interaction between the spread risk sub-module and the counterparty
default risk module is also addressed in the draft advice relating to the
counterparty default risk module. The Level 1 text relating to the
counterparty default risk module is the starting point for this analysis:
Article 105(6) states:
The counterparty default risk module shall reflect possible losses due to
unexpected default, or deterioration in the credit standing, of the
counterparties and debtors of insurance and reinsurance undertakings over
the next twelve months. The counterparty default risk module shall cover
risk-mitigating contracts, such as reinsurance arrangements,
securitisations and derivatives, and receivables from intermediaries, as
well as any other credit exposures which are not covered in the spread risk
sub-module.
For each counterparty, the counterparty default risk module shall take
account of the overall counterparty risk exposure of the insurance or
reinsurance undertaking concerned to that counterparty, irrespective of
the legal form of its contractual obligations to that undertaking.
4.54 The definition of spread risk in the Level 1 text allows a certain amount of
freedom in setting the boundary between the spread risk sub-module and
the counterparty default risk module However, wherever the dividing line
between these two modules is drawn, the principle should be that no risk
is left unaddressed and no risk is double-counted.
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4.55 The QIS4 Technical Specifications identified three areas of application for
the spread risk sub-module:
• bonds
• asset-backed securities
• collateralised debt obligations
• credit derivatives (e.g. credit default swaps (CDS), total return swaps
(TRS), credit linked notes (CLN)) where:
- The (re) insurance undertaking does not hold the underlying
instrument or another exposure where the basis risk between that
exposure and the underlying instrument is immaterial in all possible
scenarios; or
- The credit derivative is not part of the undertaking's risk mitigation
policy
In QIS4, credit derivatives were only covered in the spread risk submodule
in relation to the credit risk transferred by the derivative: the
credit risk of the counterparty to the derivative treaty was not covered,
being addressed instead in the counterparty default risk module.
4.56 In general the QIS4 approach seemed to be accepted by the stakeholders.
We therefore propose to clarify the scope of the spread risk sub-module as
follows:
4.57 The spread risk sub-module should cover the credit risk of:
• investments for the benefit of life-insurance policyholders who bear the
investment risk
• credit derivatives
• other credit risky investments including in particular:
- participating interests
- debt securities issued by, and loans to, affiliated undertakings and
undertakings with which an insurance undertaking is linked by virtue
of a participating interest
- debt securities and other fixed-income securities
- participation in investment pools
- loans guaranteed by mortgages
- deposits with credit institutions
In relation to credit derivatives, only the credit risk which is transferred by
the derivative is covered in the spread risk sub-module.
4.58 Following the methodology tested in QIS4, we propose that no capital
charge applies for the purposes of this module to borrowings by or
guaranteed by national government of an OECD or EEA state, issued in the
currency of the government
4.59 The spread risk module therefore applies to at least the following classes
of bonds:
• Investment grade corporate bonds
• High yields corporate bonds
• Subordinated debt
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• Hybrid debt
4.60 Furthermore, the spread risk module is applicable to all types of assetbacked
securities as well as to all the tranches of structured credit
products such collateralised debt obligations. This class of securities
includes transactions of schemes whereby the credit risk associated with
an exposure or pool of exposures is tranched, having the following
characteristics:
(a) payments in the transaction or scheme are dependent upon the
performance of the exposure or pool of exposures; and
(b) the subordination of tranches determines the distribution of losses
during the ongoing life of the transaction or scheme.
4.61 The spread risk sub-module will further cover in particular credit
derivatives, for example (but not limited to) credit default swaps, total
return swaps and credit linked notes that are not held as part of a
recognised risk mitigation policy. As indicated in paragraph 4.57 above,
the spread risk sub-module will also applicable to all tranches of structured
credit products like collateralised debt obligations. In addition, traditional
forms of asset backed securities, that is commercial and residential
mortgage backed securities, home equity loans, credit card receivables,
auto loans, student loans as well as whole-business securitisations,
infrastructure finance notes and other covered bonds are also addressed
by this sub-module.
4.62 Instruments sensitive to changes in credit spreads may also give rise to
other risks, which should be treated accordingly in the appropriate
modules. For example, the counterparty default risk associated with the
counterparty should be addressed in the counterparty default risk module,
rather than in the spread risk sub-module.
4.63 The QIS4 approach to the spread risk sub-module relied on a factor-based
methodology. In general, QIS4 participants seemed broadly happy with
this approach.
4.64 The proposed design for the sub-module implies that credit spread risk
hedging programmes can still be taken into account when calculating the
capital charge for this risk type. This enables undertakings to gain
appropriate recognition of, and allowance for, their hedging instruments –
subject to proper treatment of the risks inherent in the hedging
programmes.
4.65 The capital charge for spread risk will be determined by assessing the
results of a factor-based calculation which considers a rise in credit
spreads. Empirically, spreads tend to move in the same direction in a
stressed scenario, and therefore the assumption is made that spreads on
all instruments increase. This also helps to avoid excessive complexity.
4.66 The spread risk sub-module will not explicitly model migration and default
risks. Instead, these risks will be addressed implicitly, both in the
calibration of the factors and in movements in credit spreads. For
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example, the impact of intra-month changes in rating will be reflected in
any indices used to inform the calibration of the factors. The factors will
also implicitly address not only change in the level of credit spreads but
also term structure for the level of spreads. The sensitivity of the
underlying portfolio to changes in level of volatility of credit spreads is also
indirectly considered in this sub-module.
4.67 In that regard, CEIOPS is considering developing risk factors that vary by
spread duration to take into account the non-linearity of spread risk across
duration and credit rating.
4.68 The factor-based approach will be built from the market value of the
instrument in question, and will take into account the credit rating of the
instrument and its duration.
4.69 The approach to be taken for collective investment vehicles is set out in
section 4.8 below. Similarly, a look-through approach should be applied to
assets representing reinsurers' funds withheld by counterparty.
4.70 For collateralised debt obligations it will be important to take into account
the nature of the risks associated with the collateral assets. For example,
in the case of a CDO-squared, the rating should take into account the risks
associated with the CDO tranches held as collateral, i.e. the extent of their
leveraging and the risks associated with the collateral assets of these CDO
tranches.
4.71 For credit derivatives, the capital charge will be scenario-based. The
scenario will consider both a rise and fall in credit spreads. The capital
charge is determined by the more onerous of the two scenarios.
4.5.2. CEIOPS’ advice
Spread risk
4.72 The spread risk sub-module shall cover the credit risk of
• investments for the benefit of life-insurance policyholders who bear
the investment risk
• credit derivatives
• Other credit risky investments including in particular:
- participating interests
- debt securities issued by, and loans to, affiliated undertakings
and undertakings with which an insurance undertaking is
linked by virtue of a participating interest
- debt securities and other fixed-income securities
- participation in investment pools
- loans guaranteed by mortgages
- deposits with credit institutions
In relation to credit derivatives, only the credit risk which is
transferred by the derivative is covered in the spread risk sub-module.
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4.73 No capital charge shall apply for the purposes of this module to borrowings
by or guaranteed by national government of an OECD or EEA state, issued
in the currency of the government
4.74 The spread risk module applies to at least the following classes of bonds:
• Investment grade corporate bonds
• High yields corporate bonds
• Subordinated debt
• Hybrid debt
4.75 Furthermore, the spread risk module is applicable to all types of assetbacked
securities as well as to all the tranches of structured credit
products such collateralised debt obligations. This class of securities
includes transactions of schemes whereby the credit risk associated with
an exposure or pool of exposures is tranched, having the following
characteristics:
(a) payments in the transaction or scheme are dependent upon the
performance of the exposure or pool of exposures; and
(b) the subordination of tranches determines the distribution of losses
during the ongoing life of the transaction or scheme.
4.76 The spread risk sub-module will further cover in particular credit
derivatives. , for example (but not limited to) credit default swaps, total
return swaps and credit linked notes that are not held as part of a
recognised risk mitigation policy. The spread risk sub-module will also
address spread risk sensitivities of both mortgages and mortgage
derivatives.
4.77 The sensitivity of the underlying security to changes in level of volatility of
credit spreads should also be considered in this sub-module;
notwithstanding that such instruments may also give rise to other risks
(which should be treated accordingly in the appropriate modules).
4.78 The capital charge for spread risk shall be determined by assessing the
results of two factor-based calculations: the first of these considers a rise
in credit spreads and the second considers a fall in credit spreads. The
capital charge is determined by the more onerous of these two scenarios.
4.79 The spread risk sub-module will not explicitly model migration and default
risks. Instead, these risks will be addressed implicitly, both in the
calibration of the factors and in movements in credit spreads. The factors
will also implicitly address not only change in the level of credit spreads
but also term structure for the level of spreads as well as features of the
volatility surface.
4.80 The factor-based approach will be built from the market value of the
instrument in question, and will take into account the credit rating of the
instrument and its duration.
4.81 For credit derivatives, the capital charge will be scenario-based.
4.82 The proposed design for the sub-module shall take account of credit
spread risk hedging programmes.
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4.6 Property risk
4.6.1. Explanatory text
4.83 Property risk arises as a result of sensitivity of assets, liabilities and
financial investments to the level or volatility of market prices of property.
4.84 The capital charge for property risk is calculated based on the impact of a
shock scenario on the net value of assets and liabilities. Although feedback
from QIS4 indicated that some undertakings found a delta-NAV approach
complicated, a shock to net asset value is less complex for property risk,
as properties are only likely to be included in the undertaking’s assets,
making application of the stress scenario more straightforward.
Furthermore, property risk can be a significant component of the market
risk capital charge, as evidenced by QIS4.
4.85 In QIS4, a single stress (a 20% fall in real estate benchmarks) was applied
to the net value of assets less liabilities. However, some respondents to
QIS4 noted that this does not take account of the differences between
different types of properties.
4.86 The capital charge for property risk Mktprop will be calculated as the result
of a pre-defined scenario(s),
shock
prope
rty
ΔNAV
Mk
tprop=
.
4.87 The property shock is the immediate effect on the net asset value of a fall
in real estate benchmarks taking account of all the participant’s individual
direct and indirect exposures to property prices. The calibration of the
shocks will be considered in the forthcoming draft advice on calibration of
the market risk module.
4.88 As part of the calibration exercise, CEIOPS will investigate whether
distinctions between commercial, retail and other types of property is
possible. If this is the case it is possible that more than one scenario will
be defined for property risk. CEIOPS believes that there may be merit in
this approach, as there are structural market differences between the
different types of property.
4.89 Participations in real estate companies shall be treated as property, if they
only give rise to property risk. Usually, this is only the case if the business
of the real estate company is restricted to the direct or indirect holding of
property. Otherwise, if the company engages also in real estate
management, project development or similar activities, the participation
shall be treated as equity. Further, if the real estate company takes out
loans in order to leverage its investments in properties, the participation
should be treated as equity.
4.90 Investment in collective investment vehicles where the underlying includes
property will be considered in the section on investment funds below.
4.91 It would not be proportionate to explicitly test changes in the volatility of
property prices as part of the standard formula approach. However, these
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factors will be implicitly taken into account when considering the
calibration of the shock scenarios.
4.92 Where undertakings have property investments that consist of properties
for their own use, these would be regarded as office properties.
4.6.2. CEIOPS’ advice
Property risk
4.93 The capital charge for property risk Mktprop will be calculated as the result
of a pre-defined scenario(s).
4.94 The property shock is the immediate effect on the net asset value of a fall
in real estate benchmarks taking account of all the participant’s individual
direct and indirect exposures to property prices. The calibration of the
shocks will be considered in the forthcoming draft advice on calibration of
the market risk module.
4.95 As part of the calibration exercise, CEIOPS will investigate whether
distinctions between commercial, retail and other types of property is
possible. If this is the case it is possible that more than one scenario will
be defined for property risk.
4.96 Participations in real estate companies shall be treated as property, if they
only give rise to property risk. In any other case participations shall be
treated as equities and their risks considered accordingly in the equity risk
sub-module.
4.7 Concentration risk
4.7.1. Explanatory text
4.7.1.1 Scope of the module
4.97 The scope of the concentration risk sub-module extends to assets
considered in equity, interest rate, spread risk and property risk submodules
within the market risk module, and excludes assets covered by
the counterparty default risk module in order to avoid any overlap
between both elements of the standard calculation of the SCR.
4.98 An appropriate assessment of concentration risks needs to consider both
the direct and indirect exposures derived from the investments included in
the scope of this sub-module.
4.99 Regarding direct exposures, it is relevant to discriminate between at least
two cases:
a) those investments where the failure or default of the issuer is borne,
totally or partially, by the holder of the investment. This is the case of
equities and a large number of bonds. (Independent of the fact that
the risk described in this paragraph could be appropriately hedged);
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b) those investments where the failure or default of the issuer does not
imply any economic loss for the holder of the investment under any
scenario. This might be the case of some bonds or securitizations
(Mitigating tools are not relevant in this case, since the direct
exposure risk simply does not exist).
4.100 Regarding indirect exposures, two cases can be distinguished:
a) those investments where it is sensible and workable to apply a lookthrough
approach, or where there is no evidence that the indirect
exposures are reasonably well-diversified, and therefore for the sake
of prudence it is relevant to require a look-through approach. This
may be the case of instrumental holdings or hedge funds.
b) those investments where there is an evidence or legal guarantee that
indirect exposures are reasonably well-diversified, in such a manner
that it is possible to reach a certainty on the lack of materiality of
each individual indirect exposure.
4.101 Government bonds are exempted from the application of this module. The
exemption concerns borrowings by the national government, or
guaranteed by the national government, of an OECD or EEA state, issued
in the currency of the government.
4.102 Due to its frequent presence in undertakings’ investment portfolios, it may
be worthwhile to clarify the treatment of UCITs.
4.103 The UCITS Directive 85/611/EEC includes diversification requirements
regarding the issuers of the assets held by the UCITS. Article 22(1) of the
UCITS Directive stipulates that a UCITS may invest no more than: [...]
- 5% of its assets in transferable securities or money market
instruments issued by the same body, and
- 20% of its assets in deposits made with the same body.
4.104 There are several Member State options to relax these limits. For example,
the 5% limit may be raised to: [...]
- 10% (without further conditions);
- 35% for bodies which are states, local authorities and
certain public international bodies;
- 25% for credit institutions which are supervised in a certain
way;
- 35% if the UCITS tries to replicate an index and certain
conditions are fulfilled;
- 100% for bodies which are states, local authorities and
certain public international bodies if additional requirements
are met.
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4.105 Obviously, the diversification requirements in the UCITS Directive are not
sufficiently strict to exempt all UCITS from the concentration risk submodule.
However, for most UCITS the degree of concentration is known,
for example measured with the relative share of the largest exposure. This
allows setting up an exemption rule as contained in this advice.
4.106 The method proposed in this advice may be illustrated with a simple
example, where we assume the concentration threshold to be equal to
2%. The reference magnitude Assetsxl in the example is equal to 100. The
undertaking holds a UCITS investment with a market value of 20 (i.e.
quite a relevant investment). The UCITS is exempted from the
concentration sub-module if the share of no single investment of the
UCITS exceeds 2% · 100 / 20 = 10%.
4.107 This approach ensures that no single counterparty exposure of an
exempted UCITS exceeds the concentration threshold (CT). Compared to
applying a look-through approach to all UCITS, concentrations may be
missed if they are spread over several UCITS or spread over UCITS and
the remaining assets of the undertaking. Moreover, the definition of a
body in the UCITS Directive and the definition of the independent
counterparty in the concentration module may differ. It is difficult to
capture in a simple manner within the standard SCR calculation all these
more sophisticated or complex to identify types of concentration. In these
circumstances, the approach proposed below seems acceptable and
workable in order to maintain the balance between simplicity and
accuracy.
4.108 Considering its practical importance in some markets, this advice also
contains specific rules regarding mortgage covered bonds and public
sector covered bonds.
4.109 CEIOPS would like to hear stakeholders’ views on a preferred option for
the concentration threshold for mortgage covered bonds and public sector
covered bonds:
4.110 Threshold applicable shall be a 10 per cent (Option A) or 20 per cent
(Option B)10 when (under option A as well as under option B) all the
following requirements are met:
• the asset has a AAA credit quality
• the portfolio of mortgages backing the asset is diversified into a
sufficiently high number of borrowers
• there is no evidence of high correlation or connection among the
default of one or few borrowers
• the covered bond meets the requirements defined in Article 22(4) of
the UCITS directive 85/611/EEC
4.111 While QIS4 specifications considered some national exemptions, this
advice proposes specific thresholds for the assets referred in the previous
paragraph, thereby removing any national reference.
10 CEIOPS majority supports option A, i.e a concentration threshold of 10 per cent.
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4.112 Specific thresholds are considered to be a more economically consistent
solution than exemptions, since it cannot be ascertained that the
aforementioned assets are fully riskless, both from a default perspective,
from a look-through approach and from a managerial consideration.
Obviously the application of specific thresholds is subject to adequate
requirements, taking into account which categories of these instruments
have demonstrated to provide sufficient safety during the current crisis.
4.113 Another feature to consider in this advice refers to the treatment of assets
which are allocated to policies where the policyholders bear the investment
risk. To the extent that the risk in these assets is passed on to
policyholders, it lacks economic sense to consider those assets in the
calculations of this sub-module.
4.114 Financial derivatives on equity and defaultable bonds should be properly
attributed to the net exposure, i.e. an equity put option reduces the equity
exposure to the underlying ‘name’ and a single-name CDS (‘protection
bought’) reduces the fixed-income exposure to the underlying ‘name’. The
exposure to the default of the counterparty of the option or the CDS is not
treated in this module, but in the counterparty default risk module. Also,
collaterals securitising bonds should be taken into account. Similarly, a
look-through approach should be applied to assets representing
undertakings' funds withheld by counterparty.
4.115 Exposures via investment funds or such entities whose activity is mainly
the holding and management of an undertaking’s own investment need to
be considered on a look-through basis unless otherwise stated in this
advice. The same holds for CDO tranches and similar investments
embedded in ‘structured products’.
4.7.1.2 Design of the module
4.116 Market risk concentration in financial investments presents an additional
risk to an insurance or reinsurance undertaking because of:
• additional volatility that exists in concentrated asset portfolios; and
• the additional risk of partial or total permanent losses of value due
to the default of an issuer.
4.117 In the case of properties, the second bullet point above is not applicable.
Since for the sake of simplicity the calculations of this sub-module for
properties are those applicable to financial investments, the lack of
relevance of the second bullet point is reflected in the parameters
proposed for properties.
4.118 The model approach included in this advice is the same used in QIS3 and
QIS4, since it is simple to understand and captures the targeted risk in a
rather straightforward manner, which was confirmed in QIS4.
4.119 The approach is based on the setting of certain thresholds depending on
the credit quality of the exposure. For those exposures that are kept below
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the threshold there is no capital charge, while above it a capital
requirement is triggered.
4.120 All exposures to the same party are cumulated. Exposures of different
entities within the same group considered in the calculation of own funds
are taken jointly, in order to provide a fair reflection of the group risks,
whose importance has been demonstrated in the current crisis.
4.121 In particular, entities (regulated or not) which belong to the same group
as defined in Article 210 of the Level 1 text11 or to the same financial
conglomerate as defined in Article 2(14) of the Financial Conglomerate
Directive (2002/87/EC) should be treated as dependent exposures.
Consequently, the different legal entities of the group or financial
conglomerate considered in the calculation of own funds should be treated
as one exposure in the sub-module calculations and no diversification
effects between the entities are taken into account in the capital
requirement. Cross-sectoral developments on the treatment of intra-group
relations may be taken into account for further developing the notion of
dependency.
4.122 The process of calculation is simple. The bulk of the analysis lies in the
identification of all the exposures borne, directly or indirectly, explicit or
hidden, by the undertaking. Since this analysis and identification of the
exposures is necessary to achieve an appropriate risk management and to
allow for a risk-oriented SCR, the concentration risk sub-module uses as
input the results of other existing risk management actions.
4.123 As one of the lessons learnt from the crisis and as a reflection derived
from some comments of the industry on QIS4, the present advice
proposes a reduction of the thresholds of this sub-module. The crisis has
demonstrated that should QIS4 thresholds be used, the impact of failures
(such as for example Lehman Brothers), or downfalls of equities prices
(such as for example Fortis or AIG), would have had devastating
consequences.
4.124 Considering that on average own funds represent around 25 per cent of
total assets, setting a 5 per cent threshold referring to total assets, would
mean that an undertaking would be allowed to risk about 20 per cent of its
own funds with a single exposure, without imposing any capital
requirement for such concentration. The crisis has demonstrated the
inappropriateness of this allowance, not only with respect the worst credit
quality exposures, but even with respect to the best ones.
4.125 Therefore, this advice proposes using thresholds of 2 per cent in respect
AAA-AA-A rated exposures, which means on average not to require capital
up to 8 per cent of total own funds. For other rated and all non-rated
exposures, the proposed threshold is 1 per cent of total assets.
Furthermore, it is likely that the equity risk stress and the credit spread
risk factors will be calibrated based on well diversified indices. For
11 "Group" means a group of undertakings, which consists of a participating undertaking, its subsidiaries and the
entities in which the participating undertaking or its subsidiaries hold a participation, as well as undertakings
linked to each other by a relationship as set out in Article 12(1) of Directive 83/349/EEC.
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example, the MSCI World Index that was used to calibrate the equity
stress of the previous QIS exercises comprises about 1600 titles and the
largest constituent contributes about 2% to the total market capitalisation
of the index. Since the concentration risk charge is the mechanism for
correcting the assumption underlying the equity stress that the insurer
holds an equally well diversified portfolio, CEIOPS believes that the
proposed reduction in the thresholds is reasonable.
4.126 The calibration process and methodology have been adapted to give
appropriate allowance to this reduction.
4.127 In the case of properties, the thresholds proposed are higher in order to
take into account the different features mentioned at the beginning of this
section.
4.7.1.2 Calibration
4.128 The calibration of this sub-module is based on quite simple evidence: the
risk (volatility - VaR) of a badly diversified portfolio is higher than in the
case of a well-diversified basket of investments.
4.129 The calibration process, detailed in annex A to this advice, is based on the
comparison of the historical VaR of a well-diversified portfolio and the VaR
of a set of portfolios where the representativeness of a concrete exposure
is increased step by step by 1 per cent. In other words, the initially welldiversified
portfolio is progressively being transformed in a more and more
badly diversified portfolio, by increasing successively the importance of a
single concrete exposure.
4.130 In each step the initial VaR (well-diversified portfolio) is compared to the
VaRs of the progressively worsened portfolios, deriving a raw line charting
the 2-dimensional link between the increase in the level of concentration
of investments and the increase of VaR. Fitting a straightforward function
is the final step to deliver the parameters reflected in this advice.
4.131 The aforementioned process is repeated for each of the exposures of the
initially well- diversified portfolio, in order to derive specific parameters for
exposures with different credit quality.
4.132 This calibration process was applied in QIS3 and QIS4 without receiving
substantial comments. The current calibration has included the experience
of the current crisis till 30 April 2009.
4.7.2. CEIOPS’ advice
A. Assets covered by concentration risk sub-module
4.133 The concentration risk sub-module covers assets considered in equity,
interest rate, spread risk and property risk sub-modules within the market
risk module, to the extent that those assets are not covered by the
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elements of the standard calculation of the SCR.
4.134 The assessment of concentration risk needs to consider both the direct
exposures and the indirect exposures derived from the investments
considered in this sub-module.
4.135 Assets which are allocated to policies where the policyholders bear the
investment risk should be excluded from this risk module. However, as
these policies may have embedded options and guarantees, an adjustment
(calculated using a scenario-based approach) is added to the formula to
take into account the part of the risk effectively borne by the undertaking.
4.136 For the sake of simplicity and consistency, the definition of market risk
concentrations regarding financial investments is restricted to the risk
regarding the accumulation of exposures with the same counterparty. It
does not include other types of concentrations (e.g. geographical area,
industry sector, etc.).
4.137 Undertakings and supervisors shall verify that the SCR provides an
appropriate reflection of the risk profile of the undertaking. Should this not
be the case with respect to any type of concentration of assets or liabilities,
necessary actions shall be adopted in a relevant manner, i.e. via internal
models or through a capital add-on.
4.138 According to an economic approach, exposures which belong to the same
group as defined in Article 210 of the Level 1 text or to the same financial
conglomerate as defined in Article 2(14) of the Financial Conglomerate
Directive (2002/87/EC) should not be treated as independent exposures.
The legal entities of the group or the conglomerate considered in the
calculation of own funds should be treated as one exposure in the
calculation of the capital requirement.
4.139 Government bonds are exempted from the application of this module. The
exemption concerns borrowings by the national government, or guaranteed
by the national government, of an OECD or EEA state, issued in the
currency of the government.
4.140 Risks derived from concentration in cash held at a bank are captured in the
counterparty default risk module, while risks corresponding to
concentration in other bank assets shall be reflected in the concentration
risk sub-module (no-hole, no-overlap).
4.141 Furthermore, bank deposits considered in the concentration risk submodule
can be exempted to the extent their value is covered by a
government guarantee scheme in the EEA area, the guarantee is applicable
unconditionally to the undertaking and provided there is no double-counting
of such guarantee with any other element of the SCR calculation.
4.142 CEIOPS will produce an advice on participations and their treatment in the
solvency assessment of an undertaking at the end of October. Therefore,
this advice does not refer to participations. This exclusion does not mean
any position in advance regarding the treatment of participations in
concentration risk sub-module.
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4.143 In general, undertakings and supervisors should verify that the SCR
provides an appropriate reflection of the risk profile of the insurance or
reinsurance undertaking. Should this not be the case with respect to the
concentration of assets or liabilities, necessary action will need to be
adopted in a relevant manner, i.e. via internal models or through capital
add-ons.
B. Inputs required for financial concentration risk
4.144 Risk exposures in assets need to be grouped according to the
counterparties involved.
Ei = Net exposure at default to counterparty i
Assetsxl = Amount of total assets considered in this sub-module
according the paragraphs contained in this advice in the
item 'Assets covered by concentration risk sub-module'.
Government bonds should be included in this amount,
notwithstanding the exemption specified in 4.139.
ratingi = External rating of the counterparty i
4.145 Where an undertaking has more than one exposure to a counterparty then
Ei is the aggregate of those exposures at default. Ratingi should be a
weighted rating determined as the rating corresponding to a weighted
average credit quality step, calculated as:
Weighted average
credit quality step
= round (average of the credit quality steps
of the individual exposures to that
counterparty, weighted by the net exposure
at default in respect of that exposure to
that counterparty)
4.146 The net exposure at default to an individual counterparty i shall comprise
all assets contained in Section A of this advice (Assets covered by
concentration risk sub-module), including hybrid instruments, e.g. junior
debt, mezzanine CDO tranches ….
4.147 When calculating the net exposures, financial mitigation techniques shall be
considered in this sub-module except to the extent that they have already
been taken into account in other modules or sub-modules. They shall be
considered only when they meet the requirements set out for financial
mitigation techniques (see CEIOPS-CP-31-09,
http://www.ceiops.eu/media/files/consultations/consultationpapers/CP31/C
EIOPS-CP-31-09-Draft-L2-Advice-on-SCR-Standard-Formula-Allowance-of-
Financial-mitigation-techniques.pdf).
4.148 Financial derivatives on equity and defaultable bonds should be properly
attributed to the net exposure, i.e. an equity put option reduces the equity
exposure to the underlying ‘name’ and a single-name CDS (‘protection
bought’) reduces the fixed-income exposure to the underlying ‘name’. The
exposure to the default of the counterparty of the option or the CDS is not
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collaterals securitising bonds should be taken into account. Similarly, a
look-through approach should be applied to assets representing
undertakings' funds withheld by a counterparty.
4.149 Exposures via investment funds or such entities whose activity is mainly
the holding and management of an undertaking’s own investment need to
be considered on a look-through basis unless otherwise stated in this
advice. The same holds for CDO tranches and similar investments
embedded in ‘structured products’.
C. Output
4.150 The module delivers the following outputs:
Mktconc = Total capital charge concentration risk sub-module
Mktconc_financial = Capital charge for financial concentration risk
Mktconc_properties = Capital charge for properties concentration risk
D. Calculation
4.151 The calculation is performed in three steps: (a) excess exposure, (b) risk
concentration charge per ‘name’, (c) aggregation.
4.152 The excess exposure is calculated as:
⎭ ⎬ ⎫
⎩ ⎨ ⎧
= − CT
Assets
E
XS
xl
i
i max 0; ,
where the concentration threshold CT, depending on the rating of
counterparty i, is set as follows:
ratingi Concentration
threshold (CT)
AA-AAA 2%
A 2%
BBB 1%
BB or lower 1%
4.153 The risk concentration charge per ‘name’ i is calculated as:
Conci = Assetsxl • XSi • gi + ΔLiabul
where XSi is expressed with reference to the unit (i.e. an excess of exposure i
above the threshold of 8%, delivers XSi = 0.08) and the parameter g ,
depending on the credit rating of the counterparty, is determined as follows:
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ratingi Credit Quality Step gi
AAA
AA
1 0.12
A 2 0.21
BBB 3 0.27
BB or lower,
unrated
4 – 6, - 0.73
and where
4.154 ΔLiabul means the overall impact on the liability side for policies where the
policyholders bear the investment risk with embedded options and
guarantees of the stressed scenario, with a minimum value of 0 (sign
convention: positive sign means losses). The stressed scenario is defined as
a drop in value on the assets for counterparty i used as the reference to the
valuation of the liabilities by XSi * gi.
For “names” which can only be found on the assets used as the reference to
the valuation of the liabilities, the risk concentration charge per name ‘i’ is
calculated as follows: Conci = ΔLiabul,i
4.155 The financial concentration risk capital requirement is calculated as
Mktconc = Mktconc - ΔLiabfuture profits
4.156 ΔLiabfuture profits = the overall impact on technical provisions with future profit
features of this sub-module, provided the undertaking is able to assess
such impact with the same requirements applied to the calculation of best
estimate values, and preventing that double counting of this effect is
allowed with other sub-modules or modules.
4.157 This capital charge is calculated for financial concentration risk under the
condition that the assumptions on future bonus rates (reflected in the
valuation of future discretionary benefits in technical provisions) remain
unchanged before and after a presumed change in volatility and/or default
level of concentrated assets.
4.158 Additionally, the result of the calculation should be determined under the
condition that the participant is able to vary its assumptions in future bonus
rates in response to the shock being tested. If this calculation is not feasible
in a reliable manner, the capital requirement for financial concentration risk
shall be the obtained according the previous paragraph.
4.159 The capital requirement for financial concentration risk is determined
assuming a correlation of 0.25 among the requirements for each
counterparty i.
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Mkt Conc Conc Conc for j i
i j
conc i i j ≠ ⎟
⎟⎠
⎞
⎜ ⎜⎝
⎛
= Σ 2 +Σ0.25∗ ∗ ,
E. Special reference to UCITS
4.160 Investments in a single UCITS i are exempted from the concentration risk
sub-module if the maximum share of the UCITS assets which are invested
in a single body does not exceed
UCITS i
xl
UCITS i MW
Assets
CT CT
,
, = ⋅ ,
where
CTUCITS,i = concentration threshold for UCITS i
MWUCITS,i = market value of the undertaking’s investment in UCITS i
CT = concentration threshold of the sub-module
Assetsxl = comparative measure of the sub-module
4.161 Whether the UCITS is sufficiently diversified to meet this criterion, may for
example be determined
• from the composition of the UCITS’ assets at the valuation date (e.g
from list of top holdings),
• if the UCITS’ investment policy is to replicate a certain index, from the
composition of the index or
• from the diversification requirements for UCITS of the Member State
that the UCITS is situated in.
4.162 A look-through approach should be applied to all UCITS which are not
exempted from the sub-module.
F. Special reference to mortgage covered bonds and public sector covered
bonds
4.163 In order to provide mortgage covered bonds and public sector covered
bonds with a treatment in concentration risk sub-module according their
specific risk features, the threshold applicable shall be a 10 per cent
(Option A) or 20 per cent (Option B).12
when (under option A as well as under option B) all the following
requirements are met:
• the asset has a AAA credit quality
• the portfolio of mortgages backing the asset is diversified into a
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sufficiently high number of borrowers
• there is no evidence of high correlation or connection among the
default of one or few borrowers
• the covered bond meets the requirements defined in Article 22(4) of
the UCITS directive 85/611/EEC
G. Concentration risk capital in case of properties
4.164 Undertakings shall identify the exposures in a single property higher than
10 per cent of ‘total assets’ considered in this sub-module according to
contained in Section A of this advice (Assets covered by concentration risk
sub-module). Government bonds should be included in this amount,
notwithstanding the exemption specified in 4.139.
4.165 For this purpose the undertaking shall take into account both properties
directly owned and those indirectly owned (i.e. funds of properties), and
both ownership and any other real exposure (mortgages or any other legal
right regarding properties).
4.166 Properties located in the same building or sufficiently nearby shall be
considered a single property.
4.167 This capital charge is calculated for properties concentration risk under the
condition that the assumptions on future bonus rates (reflected in the
valuation of future discretionary benefits in technical provisions) remain
unchanged before and after a presumed change in volatility and/or default
level of concentrated assets.
4.168 Additionally, the result of the calculation should be determined under the
condition that the participant is able to vary its assumptions in future bonus
rates in response to the shock being tested. If this calculation is not feasible
in a reliable manner, the capital requirement for financial concentration risk
shall be the obtained according the previous paragraph.
4.169 Exposures exceeding the threshold shall deliver a capital requirement
calculated applying the formula reflected in this sub-module for financial
investments rated as AA. Capital requirements for different properties shall
be aggregated assuming a correlation factor 0 between the requirements
for each property.
= Σ
i
conc i Mkt Conc2 .
H. Aggregation of capital requirements reflecting financial and properties
concentration risks
4.170 Capital requirements for financial investments and properties shall be
added using the same correlation applied to sub-modules regarding
properties and equity risk.
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4.8 Treatment of investment funds
4.8.1. Explanatory text
4.171 Respondents to the QIS4 exercise suggested it would be helpful to have
greater clarity as to the treatment of collective investment vehicles, and
other investments packaged as funds, in the market risk module.
4.172 In order to properly assess the market risk inherent in these instruments,
it will be necessary to examine their economic substance. Wherever
possible, this should be achieved by applying a look-through approach in
order to assess the risks applying to the assets underlying the investment
vehicle. Each of the underlying assets would then be subjected to the
relevant sub-module stresses and capital charges calculated accordingly.
4.173 The same look-through approach shall also be applied for other indirect
exposures.
4.174 Where a number of iterations of the look-through approach is required
(e.g. where an investment fund is invested in other investment funds), the
number of iterations shall be sufficient to ensure that all material market
risk is captured.
4.175 Other case where it is impractical or disproportionate to apply a full lookthrough
approach shall be considered in CEIOPS’ advice on simplifications
(CEIOPS-CP-45-09, http://www.ceiops.eu/content/view/14/18/).
4.176 The above recommendations can be applied to both passive and actively
managed funds.
4.8.2. CEIOPS’ advice