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Erscheinung:31.07.2018 | Topic Solvency Solvency II: Reviewing the standard formula

Dynamic developments on the financial and insurance markets mean regular reviews of the Solvency II framework are required. BaFin therefore welcomes the fact that the European Commission has launched the first reassessment of the standard formula only shortly after Solvency II came into force. The Solvency II review will examine a number of elements of the relevant Delegated Regulation in the period up to the end of 2018.

In February, the European Insurance and Occupational Pensions Authority (EIOPA) issued technical advice on this subject. The focus was on various assumptions and methods associated with the standard formula for calculating the supervisory Solvency Capital Requirement (SCR).

EIOPA’s review of the standard formula was based on the insights gained by insurance undertakings and supervisors during the preparatory phase for Solvency II and the first years of its application. A number of topics that are particularly important for the German insurance market were analysed, especially:

  • interest rate risk
  • simplification of the standard formula
  • non-life premium and reserve risk
  • deferred taxes and the risk margin

BaFin’s position

In particular, BaFin had called for a reduction in the complexity of the standard formula and the elimination of technical inconsistencies. It encouraged German insurers to take part in the consultations on the review of the standard formula, as well as in the surveys designed to collect data.

Both the undertakings involved and BaFin considered it important to draw attention once again to the special features of the German insurance business. All parties involved explicitly underscored this in the European discussions, in keeping with the features’ importance for the German market.

At a glance:How the SCR is calculated

The fundamental premise of the SCR calculation is that undertakings must have, at a minimum, sufficient own funds to withstand a loss that statistically would only occur at most once every two hundred years. When calculating the SCR, undertakings can use either a (partial) internal model that has been approved by the competent supervisory authority or the standard formula. In contrast to an internal model, the standard formula – as its name suggests – only permits a standardised calculation of the SCR and does not include all the specific details relating to the undertaking concerned.

The standard formula adopts a modular structure to do this. In a first step, a capital requirement is calculated for every individual risk. Care must be taken during the process to ensure that the Solvency II prudential requirements are met in all cases. The Delegated Regulation specifies standardised stress factors and parameters for this that have been derived from market and insurance company data, and from other analyses. In a second step, the individual risks are then aggregated to produce an overall capital requirement after adjustment for diversification effects and for loss-reducing effects resulting from profit participations and deferred taxes. This overall requirement is lower than the aggregate of the capital requirements for the individual risks.

Interest rate risk

The most important issue for the German insurance market is the reassessment of interest rate risk. This especially affects the German life insurance sector with its long-term interest guarantees, which result in correspondingly high interest rate sensitivities.

The way in which the interest rate risk module in the standard formula is currently designed provides for a relative increase/decrease in the basic interest rate term structure for the two interest rate scenarios covered, a rise in interest rates and a reduction in interest rates (“relative stress approach”). However, no further decrease in interest rates is assumed in the case of negative interest rates. This is due to the fact that the relative stress approach was calibrated in 2009. At the time, interest rates were considerably higher and an environment in which they were persistently low was hardly imaginable. Nevertheless, rates have fallen significantly since then and in some cases negative rates have been observed for some time now. EIOPA’s comprehensive analyses of interest rate trends in recent years has shown that the relative stress approach significantly underestimates interest rate risk in the current interest rate environment.

Therefore, in its technical advice to the European Commission, EIOPA is therefore proposing the shifted approach as the new method of quantifying interest rate risk. This is designed to adequately measure interest rate risk in a variety of interest rate environments, and especially in a low-interest rate environment with negative interest rates. Since a survey by EIOPA of European life insurers revealed that this would have a substantial impact, it is recommending that the new methodology should be introduced gradually over a three-year transitional period.

In BaFin’s opinion, the interest rate risk must be revised as a matter of urgency for technical reasons. The current methodology significantly underestimates interest rate risk in low interest rate periods and cannot accommodate negative rates. In addition, the standard formula for interest rate risk lags well behind both the reality and practice of internal models, which already take negative interest rates adequately into account. In BaFin’s view, EIOPA’s proposal offers a technically sound methodology for adequately measuring interest rate risk in a variety of interest rate environments.

However, following criticism from across the political spectrum in the European Parliament, the European Commission has announced that, contrary to EIOPA’s recommendation, it will not review interest rate risk until its comprehensive Solvency II review in 2020. In BaFin’s view, the interest rate risk defects in the standard formula still need addressing. BaFin will therefore continue to play an active role in the reassessment of the interest risk, which is an extremely important topic for the German insurance market in the 2020 review.

Simplifications to the standard formula

The standard formula as a whole is too complex, both from a supervisory perspective and from the undertakings’ point of view. This means that simplifications are required for the insurers – and in particular for small and medium-sized undertakings – and for effective supervision.

BaFin has therefore called for a reduction in the complexity of the standard formula. EIOPA’s technical advice makes concrete suggestions on how to simplify the standard formula, especially for counterparty credit risk and catastrophe risk, lapse risk in the case of non-life insurance and the look-through approach (i.e. market risk) for investment funds.

These suggestions largely take the form of optional simplifications. This means that undertakings can apply these conservatively calibrated simplifications in order to reduce the effort and complexity involved in calculating the SCR. Equally, though, they can decide not to apply a simplification if they want to benefit from the more risk-sensitive SCR.

It is important to note that the standard formula as a whole is not being simplified. In fact, the complexity of some elements will actually increase due to the enhanced risk sensitivity of the modelling. For example, in future lower-risk bonds and loans that are not externally rated can be allocated lower risk factors in the spread risk module than in the past, provided that they meet certain criteria.

Non-life premium and reserve risk

When reviewing the factor-based premium and reserve risk module for non-life insurers, EIOPA recalibrated both the risk factors for selected lines of business and the volume measure for premium risk.

German market data played a decisive role in helping ensure that certain risk factors could be calibrated more accurately. This applies in particular to the reserve risk factor for legal expenses insurance, which now better reflects the risk profile of the insurers concerned.

In the case of the volume measure for premium risk, EIOPA suggests making a distinction between one- and multi-year contracts. In EIOPA’s opinion, the volume measure for one-year contracts, which comprise the bulk of the German non-life business, need not be changed. In the case of multi-year contracts, EIOPA aims to close the current gap for future premiums from new business. However, these premium components will be corrected at the same time using an adjustment factor.

Overall, the adjustments to premium and reserve risk will probably tend to reduce the SCR of the undertakings affected.

Deferred taxes and risk margin

As regards how to deal with the loss-absorbing effects of deferred taxes, EIOPA suggests several key principles that should be applied primarily during impairment testing of deferred tax assets. The key principles set out requirements that need to be applied when projecting future taxable profits after the 200-year loss during impairment testing.

In the case of the risk margin, the review was limited to the cost of capital. EIOPA examined a number of different ways of calculating the cost of capital, all of which ultimately confirm the current figure of 6 per cent.

Please note

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