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The Actuary The magazine of the Institute & Faculty of Actuaries

QIS3 implications for general insurers

Solvency II will form the basis of insurance regulation throughout the European Economic Association (EEA) after 2010. However, many of the key decisions that will shape it are being taken over the next few months. QIS3, the third quantitative impact study, is in essence a survey of market participants throughout the EEA in which the latest proposals for the solvency standard are to be tested. QIS3 runs from April to June 2007.
The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS the UK is represented by the FSA) has been preparing advice to assist the European Commission in the implementation of Solvency II. CEIOPS conducts quantitative impact studies to assess the effect of the proposed new solvency standards.
Two studies (QIS1 and QIS2) have already been carried out. QIS1 focused on technical provisions. QIS2 added solo-entity capital requirements to the technical provisions. QIS2 also asked for feedback on the structure and design of the standard formulae for solvency capital. QIS3 covers the same elements as QIS2 but there is greater emphasis on calibration and, in addition, data are requested on the categorisation of eligible elements of capital and group diversification effects.
Capital requirements under Solvency II
Capital requirements under Solvency II fall under a two-tier structure. The minimum capital requirement (MCR) is the threshold below which an insurer cannot continue to trade. The solvency capital requirement (SCR) is a target level of capital which is defined as giving a 0.5% probability of ruin over a one-year time horizon. The capital is determined relative to a modified balance sheet under which the claim provisions may be discounted and a risk margin added.
The SCR may be determined by standard formulae or from an internal model; an internal model alternative is not available for the MCR. The requirements for the approval of internal models are not yet clarified. However, insurers should expect that the standard formulae will form a benchmark against which the results of internal models will need to be compared and explained. QIS3 tests proposals for the standard formulae and its calibration for both the SCR and the MCR.

QIS3 overview
Figure 1 outlines the structure of the calculations for the SCR. For completeness life business is also included. Separate capital calculations for each risk module are required. These are aggregated into the basic SCR (BSCR) using specified correlation matrices. An operational risk loading is added to the BSCR to derive the SCR. The non-life specific risks are modelled as premium, reserve and catastrophe risk elements.
The responses to QIS3 will be used by CEIOPS to inform the calibration of the standard formulae that will be used to determine regulatory capital requirements. This is in the context of assets at realisable values and liabilities at market-consistent amounts. Feedback is also elicited from participants on the suitability and practicality of the proposals.

General insurance issues
Risk margins
Generally for non-hedgeable risks (technical provisions for general insurers), a cost-of-capital methodology has been prescribed for the calculation of risk margins. The risk margin should be calculated for the prescribed lines of business and aggregated without allowance for diversification. This approach is consistent with a line-by-line notional transfer of liabilities to third parties. It is also consistent with the views of the International Accounting Standards Board (IASB).
For the longer-tailed lines of business, unspecified alternative approaches to calculating risk margins may be used instead of the cost-of-capital approach. However, the use of alternative approaches could undermine the coherence of the overall methodology for calculating technical provisions.
Elements of the cost-of-capital methodology worthy of investigation include:
– the basis for including market risk in the first year following the notional transfer of liabilities within the cost-of-capital calculation; and
– the calibration of the cost-of-capital charge, which is taken as 6% in QIS3.

Following QIS2, the main concerns expressed by the industry related to the calibration of the non-life premium and reserve risk factors, which were regarded as over-prudent. Smaller companies were penalised because of size factors that loaded the capital charges for small lines of business. In QIS3, size factors have been removed, leading to reduced capital requirements for smaller insurers. However, apart from this there are no significant changes. We therefore expect continuing concern over the calibration.

Removal of expected profits or losses
Under QIS2, companies were required to incorporate expected profitability into the calculation of the SCR and the MCR. There were problems in the way this adjustment was calculated as it was based retrospectively on past profitability.
Under QIS3 this aspect has been removed. This will make the SCR and MCR unresponsive to the underwriting cycle. We will continue, as under Solvency I, to have a situation in which falling premium rates will lead to lower capital requirements and rising premium rates will lead to higher requirements. To overcome this situation, it would be necessary to include a prospective assessment of expected profitability in the standard formulae.

Use of company-specific experience
For reserve risk, the capital charge factors are fixed. In contrast, company-specific data can be used in determining premium risk charges. Given the importance of reserve risk this seems odd. However, we note that there are difficulties with incorporating company-specific data as the methods used in the assessment of the premium risk charge are mechanical and do not reflect changes to the company.

Catastrophe risk
Non-life insurers are asked to assess the impact on their financial position under several prescribed catastrophe scenarios. Several scenarios have been prescribed by CEIOPS. Examples are the impact of a flood of the Thames in the London area with a total gross loss of £15bn and a windstorm in the Gulf of Mexico with a total gross loss of $100bn.
Although companies will need to assess the impact of the scenarios using their own models, we believe that many companies will have some practical difficulties. For example, it will be non-trivial to determine the market shares of individual companies. How should companies determine their market share of insured property around the Thames in the London area? Which areas will be affected by the windstorm in the Gulf of Mexico? Further guidance will be needed from CEIOPS to enable companies to make risk assessments on a consistent basis.

Based on the feedback during QIS2, CEIOPS expanded the number of classes in QIS3 from 11 to 15. The full list of classes is:
– Accident & Health workers’ compensation
– Accident & Health health insurance
– Accident & Health others/default
– Motor third-party liability
– Motor other classes
– Marine, aviation, and transport
– Fire and other property damage
– Third-party liability
– Credit and suretyship
– Legal expenses
– Assistance
– Miscellaneous non-life insurance
– Non-proportional reinsurance Property
– Non-proportional reinsurance Casualty
– Non-proportional reinsurance Marine, aviation, and transport
Facultative and proportional reinsurance should be treated as direct insurance. Although the segmentation is an improvement, it may still not provide sufficient granularity to avoid anomalous results because the classes are not homogeneous. However, there is necessarily a balance to be struck between simplicity of reporting and the homogeneity of the classes.

Treatment of operational risk
Under the standard formulae approach it is difficult for operational risk capital requirements to be determined in a way that truly reflects the underlying risk. The capital charge is set equal to the maximum of 2% of the gross premiums and 2% of the technical provisions. This amount is capped to 30% of the BSCR. It remains to be seen whether these parameters yield reasonable results. UK companies will have the advantage of being able to use ICA (individual capital assessment) operational risk assessments as a benchmark.

Relationship between MCR and SCR
Two alternative calculation bases for the MCR are tested in QIS3:
– The first is a modular factor-based calculation for the different risk modules. However, the structure differs from that underlying the SCR calculation. It excludes operational risk and catastrophe risk. There is also a simplified approach for calculating the capital requirement for market risk.
– Under the second approach the MCR is calculated as a percentage of the SCR.
The results of QIS2 showed that a modular approach had several practical disadvantages. In particular, in some cases it produced an MCR that was very close to, or even above, the SCR. It remains to be seen whether revised calibration of the MCR will remove this problem entirely.

Capital requirements for groups
QIS3 specifies the application of the standard solvency formulae for insurance groups. It appears that the specification falls short of applying an economic approach to groups. However, CEIOPS recognises that further refinement of the framework is necessary.
Insurance groups are given the opportunity to benchmark the results of QIS3 against their own group-wide internal models and it is expected that they will make use of this option, given the importance of group issues such as group diversification and the treatment of non-EEA entities. The feedback provided by insurance groups is therefore of particular importance.

Market risk
The correlation matrix for the aggregation of the market risk elements suggests that there is no correlation between equity risk and interest rate risk. This seems counter-intuitive as rapidly rising interest rates would be expected to affect equity market values negatively.

QIS3 tests the calculation of regulatory capital requirements on a standard formulae basis. Participants need to re-estimate their liabilities on a discounted basis and calculate risk margins in order to complete QIS3. The standard approach to calculating risk margins is one using a cost of capital method, but long-tail liabilities may be derived using alternative unspecified methods.
We recommend that companies participate on a best efforts basis to understand the implications of the proposals on their business and to take what could be their last opportunity to influence the shape of Solvency II.
Although companies can use internal models in the Solvency II regime to determine capital requirements, the standard approach will be important for all companies. The results from internal models will be benchmarked against those of the standard approach. In addition, the approval criteria for internal models are expected to be relatively demanding. This implies that many companies could be faced with initial capital requirements based on the standard approach, especially in the early years of the new regime.