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10

A fundamental flaw in Solvency II

Open-access content Monday 3rd October 2016 — updated 5.50pm, Wednesday 29th April 2020

Brian Woods says the EIOPA formula for the risk margin should take into account the current low interest rate environment

2


In his submission to the Committee of European Insurance and Occupational Pensions (CEIOPS), now known as the European Insurance and Occupational Pensions Authority (EIOPA) consultation of 2009, on the Level 2 implementation of the risk margin, Dutch actuary Hans Waszink drew attention to a fundamental flaw in the proposed formula. In particular, he pointed out that, in certain conditions, the risk margin could be even higher than the solvency capital requirement (SCR) itself. 

This incongruity had been of little practical significance in most situations, but in the current low interest rate environment and for long-duration obligations such as longevity it can, and does, produce very anomalous outcomes.

Central to the issue is the economic status of the risk margin. Is the risk margin itself capital, requiring an economic return in excess of the risk-free rate? Companies may indeed regard it as simply another form of capital, but it is quite clear that the directive does not regard it so. 

According to the directive, the SCR is the capital and the risk margin is there to ensure that it, the SCR, earns an economic return. There is no equivalent requirement for the risk margin itself to enjoy an economic return in excess of risk free. 

The fact that the directive does not regard it as capital needing its own economic return has inexorable implications. For example, the risk margin is in these terms 'certain' to be released over time, by which I mean its risk of not being so released is deemed to be below the threshold that would require an economic return in excess of risk free. 

In other words, the cost of capital on the SCR, which will be funded by the unwind of the risk margin, is in this sense economically certain to be enjoyed. 

Just to labour the point, the SCR itself may be at risk of being fully consumed, but its cost of capital is, in the sense described, effectively certain to be realised and, as we shall see below, this could actually be substantially higher in present value terms than the SCR itself. I contend that it would not be reasonable for market participants to require this level of certainty of achieving the cost of capital.

As a further illustration, and one which points in the direction of the correct formula, the premise of the directive is that the risk margin itself does not need an economic return in excess of risk free and so, by that logic, it could in principle be financed at the risk-free rate. This leads to the conclusion that it is the difference between the SCR and the risk margin that needs to be remunerated, with a cost of capital in excess of risk free.

The thrust of the EIOPA formula is as follows. The projected release of the SCR over time is determined using current best estimates. For each year that an amount of SCR is still required on the balance sheet, the cost of holding this capital is calculated as 6% of its amount. 

The risk margin is then calculated as the value of these projected costs of capital discounted using current risk-free rates. 

It is not hard to see that for very long durations the discounting of a 6% requirement at current low risk-free rates could be higher than the capital itself. For example, for an SCR that is required for 20 years, the risk margin using a long-term discount rate of 2% a year is 98% of the SCR and for 40 years it is 164%.

I contend, and this follows Waszink's original submission to CEIOPS, that the correct approach is to calculate the risk margin using a formula that is based on requiring the difference between the risk margin and the SCR to earn a cost of capital of 6% a year.

In the same example, over 20 years, the risk margin would be 68% of the SCR, and, for 40 years, it would be 90%. It would always be less than 100%, as there is always a residual value in the possibility that some SCR capital will be ultimately released.

There have been various rumblings of late about the volatility of the risk margin formula, but most comments seem directed at the level of the cost of capital rate - 6%. This, in my view, is missing the key flaw, which is in the underlying formula.


Brian Woods is non-executive director,  AXA Life Europe and AXA Reinsurance Ireland, SMI (Pearl Group)

This article appeared in our October 2016 issue of The Actuary .
Click here to view this issue

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