Odomirok.25-Solv2

This chapter, Solvency II, is a principles-based insurance regulatory system to determine the required capital levels of insurance companies in the European Union.

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Study Tips

This reading is tested about once out every 3 exams. The memory items are straightforward but they are very detailed. There is also a calculation problem that will take a solid effort to learn.

Estimate study time: 3 hours (not including subsequent review time)

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• pillar 1 (quantification) - calculating components, regulator action, internal models
• ORSA - requirements under Solvency II

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Fall #20)	pillar 1 (quantification): - calculate components	ORSA: - under Solvency 2
E (2018.Spring #17)	pillar 2 (governance): - functional areas
E (2017.Spring #20)	pillar 1 (quantification): - internal model approval	pillar 1 (quantification): - calculate components
E (2015.Fall #19)	see Odomirok.19-RBC	pillar 1 (quantification): - calc + regulator action	RBC vs Solvency 2: - regulator action 1
E (2013.Fall #23)	3 pillars (Solvency 2): - identify & describe	pillar 1 (quantification): - solvency cap. req.	ORSA: - under Solvency 2

¹ Part of the examiners' report solution is now outdated because RBC has been expanded to include certain risks that were not previously included. See Context for Solvency II further down.

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In Plain English!

The 3 Pillars of Solvency II

These are the main things you have to know about Solvency II.

item 1: what is Solvency II

Solvency II is a principles-based insurance regulatory system for capital levels of insurance companies in the European Union.

item 2: what are the 3 pillars of Solvency 2 [Hint: QGT]

1. Quantitative: sets SCR & MCR (Solvency Capital Requirement & Minimum Capital Requirement)
   • uses a total balance sheet approach
   • SCR corresponds to 99.5% VaR (Value at Risk) meaning that the probability of ruin is < 0.5%
2. Governance: supervisory activities - requires adequate governance for
   • internal audit (should report failure to follow company policies and/or deficiencies in internal controls)
   • actuarial (ensure reasonability of DAM when calculating technical provisions - Data, Assumptions, Methods)
   • risk management (perform ORSA to identify unique risks of company)
   • compliance (report failure to comply with regulations to board of directors)
3. Transparency: supervisory reporting & public disclosure
   • information from pillars 1 & 2 are given to the supervisor & financial markets
   • purpose is to increase market discipline because companies know their decisions are public
   • this should reduce intervention by regulators

The quiz covers the above material plus a couple of other more minor factoids.

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Regulator Action Under Solvency II

There is a colorful diagram on the first page of chapter 25 in Odomirok. It's an elegant representation of the quantitative pillar. Here's the link:

Solvency II Quantitative Pillar Diagram

The gold rectangle on the left side of the diagram represents IFRS assets available. The right side of the diagram shows 4 separate colored rectangles stacked, representing IFRS assets required and a 5th rectangle at the top representing Free Surplus (if any). Note that SCR is Solvency Capital Requirement and MCR is Minimum Capital Requirement:

quantity	example
Free Surplus (if any)	?
SCR - MCR	50
MCR	250
risk margin	53.07
Best Est. of Liabilities	150

It's odd that the blue rectangle was not labeled in Odomirok, but you can deduce that it must equal SCR - MCR because Odomirok does tell us that:

• SCR    =    aqua + blue
• MCR    =    aqua

Therefore

• SCR - MCR    =    blue

Odomirok also tells us that:

• total technical provisions    =    (Best Est. of Liabilities) + margin    =    red + purple

Now, here's a very simple question:

Question: if IFRS assets available = 850, what action would the regulator take under Solvency II quantitative capital requirements Some Helpful Information: The terms [1] Solvency Capital Requirement (SCR) and [2] Solvency Capital Requirement Assets Required might seem similar, but they refer to different concepts within the context of the Solvency II framework: Solvency Capital Requirement (SCR): This is the amount of capital that an insurance company must hold to ensure it can withstand significant unforeseen shocks. It's calculated based on various risk modules, including market risk, credit risk, underwriting risk, and operational risk. The SCR is a critical regulatory threshold, and insurers are required to manage their capital to ensure they stay above this level. Solvency Capital Requirement Assets Required: This refers to the actual assets that an insurance company must have on hand to meet the SCR. It includes the mix of bonds, stocks, real estate, and other investments that the insurer uses to back its SCR. The type and quality of these assets are usually subject to regulatory guidelines to ensure they can be readily converted into cash if needed. So, in simple terms, the SCR is the target level of capital required, and the Solvency Capital Requirement Assets Required are the specific assets used to meet that target. The former is a regulatory measure, while the latter pertains to the insurer's actual investment strategy and asset allocation.

• To answer this you need to know:

→    SCR assets required    =    (Best Est. of Liabilities) + margin + SCR    =    150 + 53.07 + 300    =    503.07

→    MCR assets required   =    (Best Est. of Liabilities) + margin + MCR    =    150 + 53.07 + 250    =    453.07

• Also:

SCR assets required    ≤    IFRS assets available    → no action

MCR assets required    ≤    IFRS assets available    <    SCR assets required    → regulator will intervene

IFRS assets available    <    MCR assets required    → company is no longer permitted to operate

• It's easy to see we are in the first case:

SCR assets required    =    503.07    ≤    850    =    IFRS assets available    → no action

• And it's trivial to calculate that Free Surplus = 850 - 503.07 = 346.93

2017.Spring #20

The numbers from the example in the previous section are from the following exam problem:

E (2017.Spring #20)

This problem is easy except that you aren't given the risk margin - you have to calculate it, and it's a confusing calculation. :-(

Alice has a few comments about this problem: (Some of these will make more sense after you've done the problem)

• She thinks it's an unfair problem. If the CAS wants you to know how to do the Solvency II calculation, the source reading should have a clearly explained example. In Odomirok, the explanation is buried in the text under the colorful diagram on the first page. And it's a poor explanation. I don't think Odomirok expected you to be able to do the calculation from their brief description.

• Let's glance back at a discussion from Odomirok.22-23, involving E (2016.Fall #18):

cost-of-capital = 9%

risk-free rate = 2%

illiquidity premium = 1%

→ cost-of-capital above risk-free rate    =    (R - i)    =    9% - (2% + 1%)    =    6%

→ but this labeling is sloppy because it's really the cost-of-capital above the risk-free rate + illiquidity premium

→ none of this matters in this chapter's problems because they give you (R - i) directly

• You would think the risk margin would be based on the best estimate of liabilities, something like 10% extra, but that isn't how it works. The risk margin has nothing directly to do with the best estimate. You'll see in the solution to the problem that the risk margin is based on the SCR value and the cost of capital.

• The actual calculation in the examiner's report is well laid out and you can learn the steps without fully understanding the rationale for each step. There is a practice template for this problem and if you do it enough times, the reason for the steps should sink in, at least somewhat.

• The discounting of capital is done using integer exponents because you're told the capital is held until the end of the year. (The assumption about loss payments being made mid-year is irrelevant because you aren't discounting loss payments. See the exam problem in the next bullet point below for more on that.)

• Here's a pdf with my solution:   (shout-out to PA!)

Solution to 2017.Spring #20

• Part (b) of the problem below is similar except in addition to calculating the risk margin, they make you calculate the best estimate also. It's here that you use the assumption that loss payments are done mid-year. That means the exponents used in discounting the losses are 0.5, 1.5, 2.5. Once you understand to above problem, see if you can do this one.

E (2015.Fall #19)

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Context for Solvency II

Note the connection between Solvency 2 and Odomirok.19-RBC. Both are implementations of a capital adequacy framework:

• Odomirok.19-RBC is for the U.S.
• Solvency 2 is for the European Union.

Here's an old exam question, part (c), about the differences between these frameworks:

E (2015.Fall #19)

This is an absolutely straightforward memory question. You only had to provide 2 differences, but the examiner's report listed 8. I've rearranged them and organized them to make them easier to remember. And again, you probably don't have to know all 8, but learn at least 1 difference related to each pillar.

relevant pillar	category	solvency 2	RBC
pillar 1 (quantitative)	method	principle-based	rule-based
pillar 1 (quantitative)	method	can be tailored with ORSA	same formulas for all insurers
pillar 1 (quantitative)	risks	more comprehehsive 1	omits important risks
pillar 1 (quantitative)	reserves	discounted + margin	not discounted
pillar 1 (quantitative)	assets available	use IFRS assets 2	use SAP assets
pillar 1 (quantitative)	assets required	based on 99.5 percentile on loss distribution	not based on modeled results
pillar 2 (governance)	action levels	2 action levels (SCR, MCR)	4 action levels [Hint: CRAM]
pillar 3 (transparency)	disclosures	required more info to be made public 3	results are public but calculations aren't

¹ The RBC methodology has been updated since this exam question appeared in 2015. None of the listed answers regarding differences in risk factors for Solvency II versus RBC is valid anymore. (Interest rate risk, catastrophe risk, and operational risk are now included in the updated version of RBC.)

² IFRS has different standards for testing risk transfer and this may result in different balance sheet values.

³ If the market can see the details, insurers will be more disciplined and this will reduce the need for intervention.

The quiz covers the above material and a couple of other factoids from prior exam questions.

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