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The Actuary The magazine of the Institute & Faculty of Actuaries

Real-world risk


In the April issue, the IFoA Risk Margin working party responded to my letter of December 2017. In that letter, I had pointed out that, in my opinion, the risk discount approach of Hans Waszink was more appropriate than the EIOPA risk-free approach for calculating the cost of capital. I had given more detailed arguments in my opinion piece in The Actuary in October 2016.

I think we can all agree that if the owners of the reference portfolio could ‘pocket’ the risk margin, then there is no possible way in which this could be greater than the capital or SCR that has to be injected, no matter how many times that capital could subsequently be lost as is argued by the working party. On this premise, the risk discount approach of Waszink seems eminently sensible.

But the risk margin cannot be pocketed. It must be left in the company. Thus in the real world, the risk margin would itself be regarded as a form of capital – although the Solvency II text would seem to be clear that the SCR alone is the capital requirement.

The following text appears in the delegated acts: “After the transfer, the reference undertaking raises eligible own funds equal to the SCR necessary to support the (re)insurance obligations over the lifetime thereof.”

Thus on this premise, the risk margin can be seen to itself not be economically at risk over the lifetime of the obligations. In theory, then, the new owners could borrow the risk margin at risk-free rate, and so the capital that they actually have to provide is the SCR less the risk margin. Put another way, the risk margin in this sense guarantees the providers of the capital the CoC of 6% a year on that amount. I know of no financial model whereby the providers of capital, while prepared to lose that capital, require an effective guarantee that they should enjoy their required cost of capital. It seems particularly farcical when this ‘guarantee’ could itself exceed the original capital, or even the original capital rolled up at current low risk free rates.

The Waszink approach is appropriate where the risk margin does not have to be reinvested in the company. The use of the EIOPA approach might be seen as a way of compensating for the real-world situation where the risk margin would itself be regarded as a form of capital, but it is a crude and ad hoc way of achieving this.

Brian Woods FSAI 

27 April 2018