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Solvency II: On the right track

The publication by the European Insurance CFO Forum of the Market Consistent Embedded Value (MCEV) principles in June 2008 was a significant step forward for financial reporting. Many firms embraced MCEV and set about implementing the requirements as part of their reporting processes, although the pace of adoption was slowed by the financial crisis.

From a process perspective, MCEV sometimes became another bolt-on to existing reporting processes, which are again set to change under Solvency II. In the sprint to the Solvency II finish line, we wonder if firms have adequately considered potential alignment of reporting processes to maximise the efficiency of their reporting functions?

This article looks at Solvency II and MCEV, and outlines the potential for convergence as well as the challenges faced by firms in this area.

Distributable earnings vs economic balance sheet
Most MCEV models are designed to project shareholder cashflows based on current statutory technical provisions. Indeed, this is a specific requirement of the MCEV principles, which refers to the “...present value of shareholders’ interests in the earnings distributable from assets”. Under this approach, the MCEV calculation starts from a net asset position; free surplus allocated to covered business and required capital, based on a valuation of assets and liabilities. The present value of future profits (PVFP) is then calculated, ensuring that the liabilities projected are consistent with those used in the valuation of the net assets. Allowance is also made for the time value of financial options and guarantees (TVOG), the cost of residual non-hedgeable risks (CRNHR) and frictional costs of required capital.

The current reserving requirements, which drive distributable earnings, will no longer be used from 2013 onwards. However, most MCEV models cannot be easily converted to move to the Solvency II basis for calculating technical provisions, and so cannot be readily adapted for use from 2013 onwards. In addition, most models project current Pillar 1 capital requirements, or use them as a proxy for projecting an economic capital requirement.

At the same time, many insurers are in the process of developing models capable of reporting and projecting Solvency II metrics, best estimate liabilities (BEL), risk margin, minimum capital requirement (MCR) and solvency capital requirement (SCR). These will be needed for internal model approval and to support the own risk and solvency assessment (ORSA) process. There is therefore a major opportunity to combine market-consistent reporting processes, at least for MCEV, and Solvency II. In our experience, nearly all of the focus has been on the requirements of Solvency II, rather than MCEV, for new models. But there are a number of areas where firms will have to take key decisions quickly if they are to achieve integration and efficiencies in the reporting process.

Fundamentally, MCEV focuses on the valuation of the shareholder interest in distributable earnings, whereas Solvency II focuses on the direct valuation of the liabilities. If a shareholder view of liabilities is taken, these approaches can be equivalent, but this is not always the case. There is therefore an opportunity to move MCEV to an ‘economic balance sheet’ approach (analogous to Solvency II) from the current ‘distributable earnings’ approach, subject to ensuring that the approach is equivalent to the projection of distributable earnings.

The Solvency II balance sheet can be used as a starting point, but adjustments will certainly be needed. Solvency II own funds, free surplus plus required capital, for instance MCR and SCR, will be based on a market-consistent valuation of assets, and a market-consistent view of the liabilities calculated allowing for best estimate cashflows.

Note, however, that Solvency II is designed from the point of view of policyholder protection. Own funds can therefore include the value of eligible debt instruments, which will be excluded from MCEV, and may not provide a shareholder view of the value of with-profits business. For liabilities, the shareholder view on with-profits business is quite different, for instance valuation of shareholder transfers and the treatment of burn-through cost on with-profits funds. Challenges also arise in relation to some of the components of the MCEV calculation, especially taxation, frictional cost of required capital, TVOG and the CRNHR to maintain compliance with the MCEV principles.

Although in theory Solvency II uses the same risk subdivision basis as MCEV, hedgeable and non-hedgeable, the ‘charge for uncertainty’ (CRNHR) and risk margin are not the same. MCEV requires only consideration of a charge for uncertainty where asymmetry of risk arises, whereas Solvency II requires an explicit charge for the remuneration of an acquirer to transfer the risk. Under Solvency II the requirement is very high at a 6% charge per annum on non-hedgeable risk capital; this allowance for uncertainty is much greater than typically allowed for under MCEV.

Other key issues that need to be addressed under the economic balance sheet approach include:
>> Differences in the definition and valuation of future premiums
>> Definition of ‘covered business’ under the different reporting bases
>> Valuation of items that depend on the timing and quantum of future profits (such as tax losses)
>> Analysis of change in MCEV, as expected surplus over the reporting period is no longer projected n Disclosure and presentation, in the format prescribed by the MCEV principles. Figure 1 (below) provides a high-level comparison of MCEV and Solvency II and illustrates a possible approach.

This is not just an issue in the UK, but in all European markets. One difference is that current UK approaches to statutory valuation will completely disappear in 2013, whereas statutory reserving will be retained in some European countries such as Germany and France. This is because the statutory reserves will still be needed to determine the profit-sharing, and so will continue to be relevant to the projection of future profits.

Other changes
There are other changes that need to be considered. As noted earlier, MCEV reporting often reflects the cost of statutory capital based upon Solvency I Pillar 1 metrics. Until Solvency II goes live at the end of 2012, MCEV will continue using Solvency I metrics; however, with these set to quickly disappear, the move to report on an economic balance sheet approach may mean we are likely to see a step change. We think it is unlikely that companies will anticipate any changes to capital requirements before 2013, although they will be significant for some companies. Life company taxation will also be changing in the Solvency II world, and will need to be reflected in the new models.

Benefits of aligning MCEV and Solvency II processes
In many respects, a key challenge firms will likely face is a logistical one, for example, how much of the work can realistically be carried out on top of core Solvency II development within the time available. The priority this is given will depend upon the extent to which management can foresee the clear benefits of alignment, and how companies’ Solvency II programmes progress. For those companies that can afford to dedicate resource and/ or budget, the benefits of convergence are clear:
>> Convergence of reporting measures will create obvious efficiencies to reporting processes and resource synergies
>> To the extent that the initial MCEV implementation built on existing cumbersome or unwieldy processes, Solvency II implementation provides firms with an opportunity to get their processes in order and to avoid more manual intervention and spreadsheet-based processes to reflect the new reserving and capital requirements
>> Producing MCEV from the Solvency II balance sheet will allow greater comparability of the two metrics, and reconciliation, providing improved transparency and comparability that will inevitably be demanded by analysts
>> There is an opportunity to align pricing and risk management decisions with performance reporting, which in turn will support the use test for companies adopting an internal model
>>
The quality of MCEV will be improved as Solvency II raised the bar in terms of data requirements, review and documentation.

Conclusion
Embedded value reporting was originally developed because the reserving approaches were seen as uneconomic and, therefore, a poor basis for measuring performance. The MCEV principles then attempted to develop a comparable standard for the insurance industry, with enhanced approaches to providing for risk in the valuation.

There is a clear opportunity to align reporting processes, but there still remains significant uncertainty regarding the scope of MCEV under Solvency II. Firms will need to develop the detailed methodology required for the MCEV economic balance sheet approach, but the industry can support this by developing its thinking further. It is clearly not desirable to maintain dual processes to report MCEV as well as available and required capital under Solvency II. Therefore we wonder if MCEV will survive after 2013?

As we noted earlier, the Solvency II balance sheet is not appropriate for measuring shareholder value and business performance. Companies urgently need to assess how they will report meaningfully to shareholders and analysts in the Solvency II world. IFRS Phase 2 may be a possible solution, but we doubt whether it will be implemented in time.

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Roger Houlihan is principal adviser focusing on financial transformation at KPMG. Ferdia Byrne is a partner leading on Europe at KPMG