In an opinion piece for The Actuary magazine in October 2016 (bit.ly/fundamentalFLAW) I highlighted a fundamental flaw in the EIOPA formula for calculating the risk margin.
In an opinion piece for The Actuary magazine in October 2016 I highlighted a fundamental flaw in the EIOPA formula for calculating the risk margin.
I drew attention to the most stark manifestation of the flaw as being the possibility of situations where the risk margin could exceed the solvency capital requirement (SCR). But the flaw was more structural than that and derived from the prescribed method for calculating the risk margin, which was to discount future 6% annual costs of capital at the risk-free rate. This was highlighted as far back as the first (CEIOPS) consultation in 2009 by Dutch actuary Hans Waszink.
It was therefore most disappointing and surprising that in the latest EIOPA consultation paper (6 November 2017) these points are dismissed somewhat summarily with the observation that (paraphrasing) "there is no conceptual reason why the risk margin cannot exceed the SCR". As a stand-alone statement this is unobjectionable but it completely misses the point.
The point, though not the central one that I made in the opinion piece, was that it is economically absurd for the present value of the cost of capital to exceed the maximum amount of that capital which is projected to be required. Solvency II defines the required capital as being the SCR and it defines the risk margin as being the upfront cost of providing that capital. Ergo, the risk margin should not in any circumstances exceed the SCR. Hans Waszink, in his 2009 submission to CEIOPS, gave the theoretically correct formula. To have ignored that advice once was careless, but to ignore it twice well, we know what Lady Bracknell would have thought.
By contrast to this 'one liner' dismissal of the logical flaw in the formula, the consultation paper devoted many pages to supporting a rejection of the call for a reduction in the CoC rate of 6%.
Brian Woods FSAI
16 November 2017
