Solvency II: Its Influence Is Coming Our Way

 

As EU & Bermuda adopt framework, U.S. must anticipate it as well

By Stewart J. Foley


Mr. Foley, CFA is the Head of U.S. Insurance Advisory for P-Solve Meridian, a consulting firm formed last year by London-based P-Solve Asset Solutions after its acquisition of Meridian, a leading advisor in the UK insurance market established in 1984. Contact him at [email protected] or visit http://www.psolvemeridian.com

Solvency II, the new insurance industry risk capital framework being adopted in Europe, has broad implications, including substantial changes to the way capital charges are calculated on invested assets.  While the regulations are not yet finalized, the draft rules have caused many to re-think how they view, measure, and govern their investment risks within a framework such as Solvency II.  While Solvency II does not directly impact most US insurers today, it surely will in the future as regulators in the U.S. need to keep pace with their counterparts in the EU and Bermuda, who are adopting a Solvency II-equivalent framework.  This article provides a brief overview of Solvency II and compares some of the capital adequacy methods to the NAIC risk-based capital (RBC) framework.

What is Solvency II?
Solvency II is a comprehensive evaluation of the European insurance industry’s risk management and capital adequacy provisions.  Solvency II combines a principle-led approach with the following objectives:
– To improve policyholder protection, in particular through better management of mismatches between assets and liabilities
– To promote greater consistency in the management of risk across the European insurance industry
– To ensure that effective risk management practices are embedded in governance structures
– To improve the competitiveness of EU insurers vis-a-vis non-EU insurers How will it work?

Solvency II is based on the incorporation of the so-called ‘three pillars.’  These are briefly summarized below:

Pillar 1:  Primarily based on quantitative inputs, Pillar 1 considers a firm’s assets and its liabilities.  In doing so it outlines a firm’s ability to withstand unanticipated shocks.

Pillar 2:  Pillar 2 focuses on risk detection and management through the Own Risk and Solvency Assessment (ORSA) Supervisory Review.

Pillar 3:  Aims to improve market discipline through increased transparency (a secondary aim has been to eliminate the discount historically applied to listed insurers).  Disclosure culminates in, but is not limited to, a solvency and financial condition report.

The focus of the remainder of this article will be a comparison of the capital charge related to invested assets under Pillar 1.

NAIC RBC versus Solvency II – A comparison

Both the NAIC’s Risk-Based Capital (RBC) and the AM Best’s Capital Adequacy Ratio (BCAR), use a similar methodology.  Simply put, both apply a static capital charge to investments based on the rating and asset class.  The charge is fixed for equity investments with no credit given for hedging or the benefits of diversification.  For fixed income securities, the capital charge is based on the credit rating, the lower the credit rating on the bond, the higher the capital charge. There is no explicit credit or charge for the relationship between the assets and liabilities. Similarly, there is no consideration given to interest rate shocks, spread widening or other sources of investment volatility.

Both the NAIC's Risk-Based Capital (RBC) and the AM Best's Capital Adequacy Ratio (BCAR), use a similar methodology. Simply put, both apply a static capital charge to investments based on the rating and asset class.

Solvency II takes a very different approach.  The Solvency Capital Requirement (SCR) is the amount of capital to be held by an insurer to meet the Pillar I requirements under the Solvency II regime.[i]  According to European Commission Article 250, ‘the SCR corresponds to the economic capital a (re) insurance undertaking [company] needs to hold in order to limit the probability of ruin to 0.5%, i.e. ruin would occur once every 200 years.’  Thus the SCR Is calculated using Value-at-Risk (VaR) to a confidence level of 99.5% over a one year period.

The SCR can be calculated in one of two ways, either via the standard formula or through the use of an internal model.  We think that most insurers will want to use an internal model in order to tailor it to their specific business needs.  However, for the purposes of this example, we used the standard formula.[ii]

For fixed income, the standard formula breaks down the capital charges into three buckets:  1) interest rate risk, 2) credit risk and 3) sub-category of bond.  For interest rate risk, the capital charge is based on the net interest rate exposure of the assets minus the liabilities.  While for credit risk, the capital charge is based on the impact of widening of yield spreads and further differentiates those charges by sub-category of bonds.  With respect to equity and other non-fixed income investments, the capital charge is based on the total exposure, with credit given for some types of hedging activities.  In addition, there is some capital relief provided for the benefits of diversification through the correlation between asset classes.  Companies using an internal model might have lower capital requirements as natural hedges and other correlation benefits of diversification can be modelled and accounted for.

We compare the capital charge on a hypothetical U.S.-based P&C insurance company with an asset allocation of 90% in a high-quality, intermediate duration core bond portfolio and 10% in return-seeking asset classes (a diversified portfolio of assets such as domestic and international equities, high-yield bonds and other asset classes).

The core bond portfolio the following characteristics:

Duration of 3.5, average credit quality of AA-

Sovereign bonds                                                     9%

Credit (Corporate and Municipal)                          48%

Structured securities (MBS/CMBS/ABS)             33%

90%

Return-seeking assets[iii]                                       10%

Total Investment Portfolio                                    100%

 

 

We see how the required capital charge under both the Solvency II and RBC frameworks.  In our simplified example, the capital charge is approximately twice as high using the Solvency II methodology.  While that difference is stark, some capital relief is given for the interaction between asset classes as shown by light grey bar below the line.  That concept, along with the credit given for aligning assets with liabilities, isn’t part of the current RBC or BCAR frameworks.

While Solvency II isn’t on U.S. insurers’ doorsteps today, we believe it will influence regulator and rating agency thinking going forward.  In addition, we believe that many aspects of this approach have merit including decomposing fixed income risks and giving credit for hedging and diversification.  In time, we expect that the ‘Cost of Capital’ approach suggested under Solvency II will lead to a re-evaluation of current asset allocations techniques.

[i] CEA, Solvency II Glossary, 2007

[ii] Example based on the European Commission QIS 5 Technical Specifications, 2010

[iii] The return-seeking portfolio is assumed to have a Beta to the U.S. equity markets of 0.70.