In the April 2018 edition of The Actuary, the Risk Margin Working Party (WP) of the Institute and Faculty of Actuaries commented on the Risk Margin under Solvency II (bit.ly/2l7uAst).
In the April 2018 edition of The Actuary, the Risk Margin Working Party (WP) of the Institute and Faculty of Actuaries commented on the Risk Margin under Solvency II (bit.ly/2l7uAst). In the article, the WP responded to Brian Woods' previous letter of opinion, and commented on recent EIOPA consultations and my earlier comments on the subject referred to in Woods' letter.
It is good to see that this matter is receiving renewed attention from the Institute and Faculty of Actuaries in the UK, and that a Risk Margin working party has now been established. Moreover, I welcome the reaction of the WP to my comments made to CEIOPS in 2009 (in response to CP42), to which I would hereby like to respond as follows:
The WP states that the Reference Undertaking (RU) must hold a risk margin itself as the capital it is holding may be lost more than once during run-off. This invokes the question of what the function of the SCR is, as well as the Risk Margin.
On the former, the Level I legislative text states (62):
The Solvency Capital Requirement should reflect a level of eligible own funds that enables insurance and reinsurance undertakings to absorb significant losses and gives reasonable assurance to policy holders and beneficiaries that payments will be made as they fall due.
The same requirement is echoed in article 77 paragraph 5 on the risk margin:
[...] the risk margin shall be calculated by determining the cost of providing an amount of eligible own funds equal to the SCR necessary to support the insurance and reinsurance obligations over the lifetime thereof.
and also in the Delegated Acts (art. 38f):
[...] after the transfer, the reference undertaking raises eligible own funds equal to the Solvency Capital Requirement necessary to support the insurance and reinsurance obligations over the lifetime thereof.
Hence the SCR raised at inception by the RU is considered to be sufficient to meet obligations to policyholders over the entire period of run-off held by the RU. As a consequence, the possibility that the capital of the RU may be lost more than once is deemed to have no material impact on the value at present.
Note that, as with any other valuation model, the model for the risk margin is an approximation of reality based on assumptions. It is obvious that not all these assumptions hold true in reality, or that they only hold true by approximation. By accepting the valuation model nonetheless, it must be assumed that these deviations from reality do not materially affect the value of liabilities at the present time.
Furthermore, note that article 101 of the Solvency II, level I legislative text, requires the SCR be calculated at the 99.5% confidence level over a one-year time horizon, or (art.122) at a different confidence level and time horizon deemed to provide equivalent protection to policyholders.
Article 101 thus merely specifies the way in which the SCR is to be calculated, but does not state its purpose. Therefore, article 101 does not contradict the assumption that the SCR at inception is sufficient to support liabilities over the lifetime thereof.
Similarly, paragraph 5 of article 77 mentioned above only describes the way in which the Risk Margin is to be calculated. Its purpose is stated in paragraph 3 of the same article:
The risk margin shall be such as to ensure that the value of the technical provisions is equivalent to the amount that insurance and reinsurance undertakings would be expected to require in order to take over and meet the insurance obligations.
More generally, assets and liabilities must be valued at 'market value', as stipulated in paragraph 75 of the level I text. Furthermore, paragraph 4 of article 77 states that in case liabilities can be replicated with financial instruments for which a reliable market value is observable, a risk margin does not need to be identified separately.
It can be concluded that the function of the Risk Margin is not to fully restore Own Funds to the amount of the SCR in case of a severe loss, but only to reflect the Market Value of the insurance obligations at the present time. For other assets and liabilities which are valued as a whole, there is no requirement that additional funds be attracted to restore Own Funds to the level of the SCR following a severe loss.
If one assumed that the Reference Undertaking were able to fully restore Own Funds to the level of the SCR after a loss in the same amount, then the RU could suffer such a loss an almost unlimited number of times. The only limitation would be that a new valuation be performed and capital be attracted in an arm's length transaction.
As a result, the level of assurance given to the policyholders would be far in excess of Solvency II requirements. This, however, also comes at excessive cost to the same policyholders, as many stakeholders in the industry have now witnessed.
15 May 2018