Standard formula

Insurers must calculate the amount of their Solvency Capital Requirement (SCR), i.e., their own funds needs, themselves. If they do not use an individually developed internal model for such calculation, they must use the standard formula. This formula accounts for both insurance-specific risks as well as operational risks.

EIOPA examined whether the capital requirements for the following investments are adequate:

• small and medium-sized enterprises (SMEs) financing through debt and equity;
• infrastructure financing through debt and equity;
• sustainable and responsible investments (SRIs) and social business financing through debt and equity; and
• securitisations of debt serving the above mentioned purposes.

In nearly every case, the EIOPA report comes to the conclusion that the capital requirements for the investments under review are adequate, or that no data is available that would justify changing them. However, EIOPA did propose a complete recalibration of the spread risk charge for securitisations. For lower-risk products, EIOPA proposed a lower spread risk charge than previously required.

Not too much or too little capital

Under Solvency II, EIOPA will first and foremost have to ensure that the capital requirements are not set too low because the overriding objective of regulation and supervision of the insurance industry is the adequate protection of policyholders and beneficiaries. Therefore, the primary purpose of regulatory capital is to guarantee these groups that benefits will be paid when due. The Solvency II Directive stipulates that the requirements under the standard formula must be set such that an insurer will have no more than a 0.5% probability of becoming insolvent in the course of the following year. Changes in the standard formula must not result in a reduction in this safety margin. Therefore, when it comes to capital requirements under Solvency II, individual investments should not receive preferential treatment for reasons of economic policy without a sound justification in risk theory.

On the other hand, excessively cautious capital requirements would be inappropriate – not only as far as individual insurers are concerned, but also for the economy as a whole. With an investment volume of more than €5 trillion, the EU insurance industry represents an important investor. When deciding whether or not to make a certain investment, insurers also factor in the amount of own funds it has to furnish. Excessively high capital requirements for insurers could make it unnecessarily difficult to make investments which would benefit the economy as a whole.

Before capital requirements can be changed, reliable data is needed so that the risk can be determined. EIOPA therefore examined whether the data relevant for changing the standard formula is even available.

The options for altering the standard formula are also limited inasmuch as the formula should not become any more complicated than it already is. Many SMEs had considered the calculations too complex even with Quantitative Impact Study 5 (QIS 5; only available in German).

Determining risk

Under Solvency II, the risk of an investment is understood as the risk of a reduction in market value. Determining such risk requires data that allow the change in market value to be identified. In the case of listed securities, time series market price data are available for this purpose.

However, most of the investments examined by EIOPA are not traded on an exchange, which makes it significantly more difficult to determine their market values. In order to obtain as much information as possible about the relevant investments, EIOPA therefore consulted numerous industry and academic experts, including representatives of the European Central Bank, institutions, associations and ratings agencies.

Insufficient data

In early April 2013, EIOPA published a detailed Discussion Paper with preliminary findings for consultation. The Discussion Paper also included numerous questions on potential data sources for individual investments, since the lack of data for the aforementioned reasons impaired the examination of most of the asset classes.

Some entries to the Discussion Paper contained suggestions for solving the problem. For example, it was suggested that the capital requirements for equity investments in unlisted companies could be determined by referring to changes in the net asset values of these companies.

However, EIOPA assessed all the suggestions as unworkable, primarily because the change in market values would not be reproduced precisely enough. For example, net asset values were supposedly subject to fluctuations that were usually not as readily observable as those in market values. Therefore, the actual risk of change in market value, which the standard formula is supposed to account for, would be underestimated if net asset values alone were used to measure risk.

Infrastructure projects

With investments in unrated infrastructure project debt, where repayments to the project company are contingent solely on whether the infrastructure is provided and not on the extent to which that infrastructure is used, no market data is available from which one could derive the spread risk, i.e., the risk that risk discounts in the price of an investment increase. However, there are qualitative studies on this. For example, a study by the ratings agency Moody's¹⁾ comes to the conclusion that such investments have a similar credit risk as corporate bonds with a Baa rating, which most likely corresponds to the credit quality step 3 within the meaning of Solvency II. This suggests that such investments may be treated as corporate debt with the same rating. The result would then be, for example, that the spread risk for an investment with a ten-year term²⁾ would be reduced from 23.4% to 20%.

EIOPA did consider the possibility of minimally changing the capital requirements for this asset class. However, it elected not to recommend this to the Commission because the cost of doing so would outweigh the benefit: a minimally more precise capital requirement for such a small asset class would require a more complicated standard formula calibration and additional assessments by insurers and supervisory authorities as to whether an investment meets the criteria for classification as low-risk.

Securitisations

With respect to securitisations, EIOPA comes to the conclusion that the capital requirements should be lowered for a portion of these investments. Thanks to better data, it was significantly easier to examine the regulatory capital required. EIOPA examined the capital requirements for all securitisations, i.e., not just those types specified by the Commission.

Previously, regulatory capital had been determined solely depending on the rating and the term of a securitisation. The starting point of the examination was the question of whether or not this was adequate. For instance, residential mortgage-backed securities (RMBS) demonstrated substantial differences in terms of risk, such as between US subprime RMBS, some of which lost a substantial amount of their value during the subprime crisis, and European RMBS with the same rating, the value of which remained comparatively stable. This example also shows that differentiating among the types of secured claims is not enough because in both cases private mortgage-backed loans were involved.

In order to identify riskier securitisations, EIOPA has developed a list of 15 criteria which according to EIOPA's proposal would have to be met following a transitional period so that the tranche of a securitisation will be deemed high-quality within the meaning of the standard formula provisions for regulatory capital. EIOPA relied largely on criteria employed by the European Central Bank to decide whether it would accept the tranche of a securitisation as security. In addition to this, there are criteria developed by rating agencies and market participants. In selecting the criteria, emphasis was placed primarily on being able to effectively distinguish high-quality securitisations from other securitisations, and on insurers as well as supervisory authorities being able to assess them without excessive effort. As far as possible, determining whether or not a given criterion has been met must not be open to interpretation.

The figures for securitisations that meet the criteria are substantially lower compared to the regulatory capital previously required. They are higher than originally planned for the remaining securitisations with very good ratings.

Footnotes

1) Moody’s Investors Service (2013): Default and Recovery Rates for Project Finance Bank Loans,
1983-2011.

2) Modified duration.