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The Actuary The magazine of the Institute & Faculty of Actuaries
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Solvency II: Something in reserve

Among the multitude of things that will have to be done differently under Solvency II, it might be easy to miss the changes to the way reserves are calculated. However, to do so would be dangerous since the way in which non-life insurers will be required to calculate their technical provisions under Solvency II is significantly different to the way they calculate them today.

The differences arise from the Solvency II Directive itself and, in particular, Article 77. This states that “the value of technical provisions shall be equal to the sum of a best estimate and a risk margin” and “the best estimate shall correspond to the probability-weighted average of future cash flows, taking account of the time value of money”.

But what are the key changes that actuaries will need to make in their reserving processes?

Segmentation into Solvency II classes
Under Solvency II, insurers will be required to segment their reserves between a prescribed set of classes. Although the reserving analysis can be undertaken using whatever segmentation of business is considered appropriate, the insurer must be able to allocate the results between the Solvency II classes.

In many cases, it will be essential to undertake the analysis at a more detailed level since a number of the prescribed classes are very wide ranging. These include one class for the whole of marine, aviation and transport, only three classes for non-proportional reinsurance, and a miscellaneous class that may end up containing some very diverse books of business.

One area that will create difficulties for many UK insurers is the required segmentation of motor risks between liability and other. This is straightforward in most of Europe where these are sold via separate policies; however, in the UK and Ireland they are sold together and splitting the premiums is likely to prove challenging.

Solvency II will also require separate reserves to be calculated for different currencies. However, the proportionality principle underlying Solvency II will mean that currencies that are immaterial to an insurer will not need to be considered in isolation.

A new recipe for technical provisions
Currently, insurers often include elements of prudence in their reserves, either explicitly or implicitly. Under Solvency II such an approach will not be acceptable. As indicated in Article 77, insurers will have to estimate their reserves on a strict best-estimate basis and will hold an explicit risk margin in addition.

In fact, under Solvency II the technical provisions are derived as the sum of three components: the claims provisions, the premium provisions and the aforementioned risk margin.

We will return to the risk margin later in this article but what of the other two ingredients? The claims provision is the best estimate of the reserve in respect of claims that have occurred prior to the valuation date (irrespective of whether or not they have been reported), together with the corresponding claims-handling expenses.

Meanwhile, the premium provision is the best estimate of the total cash flows in respect of claims occurring after the valuation date together with the corresponding claims-handling expenses, premiums received after the valuation date and the expenses of administering the business. It follows from this definition that it is entirely possible for the premium provision to be negative.

Legal obligations basis
Currently, insurers reserve for all policies that have incepted up to the valuation date. For example, at 31 December 2010, insurers held reserves in respect of all policies incepted up to that date but did not allow for any policies incepting afterwards.

Under Solvency II, this will no longer be sufficient — insurers will also be required to allow for policies that they were legally obliged to write at the valuation date, even if they had not incepted. For example, by 31 December 2011, insurers will have agreed policies incepting on 1 January 2012. Under current reserving approaches, the technical provisions make no allowance for such policies but, under Solvency II, an allowance must be included.

This is known as a legal obligations basis and is a major deviation from the way reserving is currently done. The collection of the necessary data is likely to be a challenge for many insurers. Interestingly, because insurers will be able to take credit for the expected profits arising from this unincepted business, allowing for these policies will actually reduce the reserves of an insurer who is writing business profitably.

Binary events
Article 77 makes it clear that reserves under Solvency II should take account of all possible future cash flows. It follows that it is necessary to make provision for the sort of very low probability but very high severity events that tend to be ignored under current reserving approaches. These have become known as binary events. By definition, they are very unlikely to occur but, if they do, they could significantly impact an insurer’s results.

Examples of binary events include a meteor strike on a populated area, substantial claims arising from nanotechnology and a tsunami hitting Florida. Selecting an appropriate provision for such events will be extremely challenging. Any such provision will be highly subjective, require significant judgment, and be very sensitive to the assumptions made. Deciding on this provision will probably be one of the most significant difficulties facing actuaries reserving under Solvency II.

Expenses
As indicated above, under Solvency II technical provisions are required to include claims-handling expenses (both allocated and unallocated) and other expenses incurred in running the business.

Currently, most reserves estimated by actuaries would implicitly include allocated claims-handling expenses. Additionally, in some cases, actuaries would consider unallocated claims-handling expenses (for example, when providing Statements of Actuarial Opinion to syndicates at Lloyd’s of London). However, it is far less common for actuaries to analyse other expenses. Consequently, the new regime will require many actuaries to develop a deeper understanding of the expense elements of the balance sheet than they have now.

The need to discount
Currently, the vast majority of non-life insurance reserves are not discounted for the time value of money. However, as laid down in Article 77, under Solvency II they will have to be discounted. This is a major change and will mean that cash-flow projections will be required for all of the elements making up the technical provisions, including outstanding claims, incurred but not reported, claims on unincepted policies, reinsurance recoveries, future premiums (including those in respect of unincepted policies) claims-handling expenses and other expenses.

It will no longer be sufficient merely to develop a best estimate of each of these items — the actuary will also need to estimate how that amount will be paid or received over time.

Back to the risk margin
This risk margin represents another big change. While some insurers may have held such margins before, the requirement under Solvency II is very different since the risk margin has to be calculated in a prescribed manner.

Under Solvency II, the technical provisions are intended to equal the amount that another insurer would require in order to take over the insurance obligations. Clearly, any insurer taking over responsibility for a book of insurance liabilities would require more than the best estimate of those liabilities, and the risk margin is designed to represent the additional amount that would be required.

The risk margin is calculated as the cost of providing the capital required in respect of the liabilities over their lifetime; in other words, the cost of providing the required solvency capital requirement (SCR) over the lifetime of the liabilities.

The theoretically correct way to calculate this is by determining the SCR in each future year, multiplying each SCR by the cost of capital and discounting them to the valuation date. Although this sounds fine if you say it quickly enough, a moment’s thought will lead to the conclusion that calculating the SCR in each future year will be a very difficult and onerous task. For this reason, a number of simplifications have been proposed and we expect the vast majority of insurers to make use of these.

You have been warned
In this brief article, we have been able to touch on only a few of the joys awaiting actuaries reserving on a Solvency II basis. Each of the areas discussed above requires far greater consideration than we have had space for, and there are a number of additional differences from current reserving practices that we have not even been able to mention.

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Simon Sheaf leads Grant Thornton’s general insurance actuarial practice