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The Actuary The magazine of the Institute & Faculty of Actuaries

Solvency II: A point of consistency

The introduction of Solvency II in 2012 aims to raise the standard of insurance company risk and financial management. Although the formal implementation of Solvency II is still over two years away, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) has already issued a large number of consultation papers (CPs) containing detailed proposals for implementation measures. The CPs give a strong indication of the issues that insurers will face in implementing Solvency II. At the time of writing, CEIOPS has recently issued a series of CPs covering, among other things, the calculation of technical provisions.

This calculation is central to the Solvency II process and CPs 39 to 42 cover much of the detail, the core of the proposals being a market-consistent valuation of liabilities. A market-consistent valuation embraces the goal of putting a mark-to-market value on insurance liabilities while recognising that these liabilities will often have features (ultra-long-term, path-dependency, and so on) that are not readily replicated by observable market prices. As a result, market-consistent valuation of insurance liabilities will inevitably involve a significant amount of judgment. The detailed proposals in the CPs aim to provide guidance on how these areas of judgment should be implemented in the calculation of the technical provisions, and they introduce some new and complex issues in doing so.

Risk-free rates, extrapolation and liquidity premia
CP40 considers the important issue of establishing how the risk-free term structure used for discounting liability cash flows is derived. There are three key questions that need to be addressed when defining this methodology:
1 What risk-free assets should be used to derive the risk-free term structure — for instance, government bond yields or swap rates?
2 Insurance liabilities will often have cash flows that will arise beyond the longest maturity of observable risk-free assets. How should the risk-free yield curve that is derived from observable market prices be extrapolated in order to value these liability cash flows?
3 Some insurance liabilities are highly illiquid, much more so than the above risk-free assets, the obvious example being fixed annuity business where no surrender option is available to the policyholder. There is a widely-held belief that a financial instrument with such illiquidity would have a market value that incorporates a discount for this illiquidity. Should an allowance be made for the illiquidity of (some) insurance liabilities in defining the risk-free yields that are used to discount the cash flows?

CP40 states that government bond yields should be used as the starting point for deriving the risk-free yield curve. This differs from established practice in some other areas of market-consistent insurance liability valuation. For example, Market Consistent Embedded Value (MCEV) uses swaps as its reference risk-free assets. Swaps will usually yield more than government bonds, so the decision to use government bond yields may result in higher values for the technical provisions than are produced under MCEV.

CP40 recognises that extrapolation of the yield curve will be necessary, but does not give any specific methodology for how this should be done. This will have a major impact on the technical provisions calculation of long-term liabilities.

Finally, CP40 also states that no allowance for the illiquidity of insurance liabilities should be incorporated into the risk-free yield curve. While it is accepted by many that a liquidity premium exists, its quantification and the circumstances in which it can be used in valuing liabilities remain contentious. CEIOPS recognises this, stating that a best-practice method is still to emerge in this area. While this is undoubtedly true, it is a topic that will see much research in the coming months and recent practice in MCEV assessments has seen extensive use of liquidity premiums in the market-consistent valuation of insurance liabilities.

Market risk and the Solvency II risk margin
The technical provisions are made up of a best estimate and a risk margin. The risk margin in the technical provisions has to be calculated wherever the liability cash flows cannot be reproduced by values derived from marketable assets. Currently, marketable assets are not available that reproduce cash flows affected by certain liability risks such as mortality risk, so there is ‘unavoidable’ uncertainty and a risk margin is required in the technical provisions.

CPs 39 to 42 introduce guidance on when values derived from market prices are ‘reliable’ and can be used without a risk margin calculation. As currently drafted, many markets generally understood to produce ‘reliable’ market prices, such as over-the-counter (OTC) derivatives, may not meet the CP definition of ‘reliable’. This means that there is ‘unavoidable’ market risk and a risk margin is required in calculating the technical provisions. This is a change from the QIS4 specification, where ‘unavoidable’ market risk was not recognised in the calculation.

Unavoidable market risk in the risk margin calculation
This raises many interesting issues:
>> Rules to define markets that produce ‘reliable’ prices will have to be developed. Is this really a binary decision? For example, even for the most ‘reliable’ asset prices, it is highly unlikely that a large block of insurance liabilities could be matched at that price. The size of major insurance liability blocks means that some market price impact is inevitable in the event of trying to switch to the matching or replicating portfolio.
>> For markets that do not meet the ‘reliable’ test, then on what basis will the best-estimate calculation be done? Extrapolating the implied volatility values of ‘reliable’ prices would introduce a market risk margin that would duplicate the Solvency II risk margin. There is a similar issue with yield curve extrapolation formulae, again potentially resulting in a double-counting of the risk margin.
>> A process must be created by insurers to calculate the risk margin. The CPs suggest that the risk margin is calculated using a cost-of-capital approach. This requires a valuation of the cost of future capital requirements for the asset whose risk margin is being calculated. Calculating the risk margins in option prices would be an extremely demanding modelling exercise, likely requiring a calibration to the market prices of ‘unreliable’ assets, and so would produce results that are very similar to simply using ‘unreliable’ market prices to derive a market-implied risk margin.

Another approach
The International Accounting Standards Board (IASB) has recently published an exposure draft on fair values. This proposes a three-level hierarchy for inputs to the fair value calculation:
Level 1 — quoted prices in active markets.
Level 2 — inputs, other than quoted prices included within Level 1, that are observable, either directly or indirectly.
Level 3 — inputs that are not based on observable market data but which reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. The CEIOPS proposal stops at Level 1 and appears not to use the information on how the market prices risk for Level 2 or Level 3. This is an area where some consistency of approach between IASB and CEIOPS could produce an efficient outcome.

What does this all mean?
Although there is a long way still to go in the Solvency II process, the foundations are now being set. CEIOPS’ initial proposals suggest there will be some significant inconsistency with other reporting standards, necessitating some highly complicated calculations that are not required by the other market-consistent reporting standards.

We believe this is the right time to take a step back and recall that the fundamental objective of Solvency II is to better align firms’ market risk exposures with their regulatory capital assessment, so as to give incentive for better economic risk management behaviour and avoid regulatory arbitrage. Such an aim is best served by a methodology that is pragmatic and transparent, that makes the most use of available market prices, and which is coherently aligned with the emerging practice of other major reporting standards.


Andy Frepp is a director at Barrie & Hibbert Ltd and leads its corporate development and product proposition team, Craig Turnbull is Barrie & Hibbert’s regional head of North America and Sandy Sharp is a consultant