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Consultation Paper
No 47
Draft CEIOPS Advice for Level 2 Implementing Measures on Solvency
II:
SCR Standard
Formula. Article 109 - Structure and Design of Market Risk Module
1. Introduction
1.1. In its letter of 19 July 2007, the European Commission
requested CEIOPS to provide final, fully consulted advice on Level
2 implementing measures by October 2009 and recommended CEIOPS to
develop Level 3 guidance on certain areas to foster supervisory
convergence.
On 12 June 2009 the European Commission sent a letter with further
guidance regarding the Solvency II project, including the list of
implementing measures and timetable until implementation.
1.2. This Paper aims at providing advice
with regard to the design and structure of the market risk module
of the SCR standard formula, as required by Article 109 of the
Solvency II Level 1 text.
1.3. The equity risk sub-module and the correlations between the
market risk sub-modules and between the market risk module and
other modules are not covered in this draft advice as they will be
addressed in a separate consultation paper due to be published in
a third set of advice in November 2009.
In addition, advice on simplifications to the standard formula
will also be published at this stage.
1.4. The objective of this Paper is to give draft advice on the
structure and design of interest rate risk, spread risk, currency
risk, property risk and concentration risk sub-modules.
With the exception of concentration risk, the calibration of the
market risk module is not covered by this paper.
CEIOPS will be producing a further consultation paper, covering
the calibration of the market risk module as part of third set of
advice.
2. Extract from Level 1 Text
2.1 The legal basis for the advice presented in this paper is
primarily found in Article 109 of the Level 1 text which states:
“1. In order to ensure that the same
treatment is applied to all insurance and reinsurance undertakings
calculating the Solvency Capital Requirement on the basis of the
standard formula, or to take account of market developments, the
Commission shall adopt implementing measures laying down the
following:
[…](c) the methods, assumptions and standard parameters to be
used, when calculating each of the risk modules or sub-modules of
the Basic Solvency Capital Requirement laid down in Articles 104,
105…
[…]
2. The Commission may adopt implementing measures laying down
quantitative limits and asset eligibility criteria in order to
address risks which are not adequately covered by a sub-module.
Such implementing measures shall apply to
assets covering technical provisions, excluding assets held in
respect of life insurance contracts where the investment risk is
borne by the policyholders.
Those measures shall be reviewed by the Commission in the light of
developments in the standard formula and financial markets.
[…]”
2.2 Article 104 states the design of the
Basic Solvency Capital Requirement:
“1. The Basic Solvency Capital Requirement shall comprise
individual risk modules, which are aggregated in accordance with
point 1 of Annex IV.
It shall consist of at least the following risk modules:
[…]
(d) market risk
[…]
5. The same design and specifications for the risk modules shall
be used for all insurance and reinsurance undertakings, both with
respect to the Basic Solvency Capital Requirement and to any
simplified calculations as laid down in Article 108.
[…]
It should be noted that there is no possibility based on the Level
1 text (art. 104 7) for the use of undertaking-specific parameters
in the market risk module.”
2.3 Article 105 requires that:
“[…]
5.
The market risk module shall reflect the risk arising from the
level or volatility of market prices of financial instruments
which have an impact upon the value of assets and liabilities of
the undertaking.
It shall properly reflect the structural mismatch between assets
and liabilities, in particular with respect to the duration
thereof.
It shall be calculated, in accordance with
point 5 of Annex IV, as a combination of the capital requirements
for at least the following submodules:
(a) the sensitivity of the values of assets, liabilities and
financial instruments to changes in the term structure of interest
rates, or in the volatility of interest rates (interest rate
risk);
(b) the sensitivity of the values of assets, liabilities and
financial instruments to changes in the level or in the volatility
of market prices of equities (equity risk);
(c) the sensitivity of the values of assets, liabilities and
financial instruments to changes in the level or in the volatility
of market prices of real estate (property risk);
(d) the sensitivity of the values of assets, liabilities and
financial instruments to changes in the level or volatility of
credit spreads over the risk-free interest rate term structure
(spread risk);
(e) the sensitivity of the values of assets, liabilities and
financial instruments to changes in the level or in the volatility
of currency exchange rates (currency risk);
(f) additional risks to an insurance or reinsurance undertaking
stemming, either from lack of diversification in the asset
portfolio, or from large exposure to default risk by a single
issuer of securities or a group of related issuers (market risk
concentrations).
[…]”
2.4 On simplifications in the standard formula, Article 108
states:
“Insurance and reinsurance undertakings may use a simplified
calculation for a specific sub-module or risk module where the
nature, scale and complexity of the risk they face justifies it
and where it would be disproportionate to require all insurance
and reinsurance undertakings to apply the standardised
calculation.”
2.5 The Level 1 text also mentions concentration risk in the
following provisions:
“Article 13 – Definitions
29) concentration risk means all risk exposures with a loss
potential which is large enough to threaten the solvency or the
financial position of insurance and reinsurance undertakings; “
“Article 130 – ‘Prudent person’ principle
4. Investments in assets issued by the same issuer, or by issuers
belonging to the same group, shall not expose the insurance
undertakings to excessive risk concentration. “
2.6 Title III of the Level 1 text, dealing with group supervision,
also refers to to concentration risk (eg. Article 248, which
specifically relates to the supervision of risk concentration in a
group).
There are also some references to concentration risk in the
provisions referred to risk management (Pillar II).
The treatment of concentration risk in this paper is limited to
the solo standard formula SCR, since the treatment of this risk in
the context of groups and for internal models is being dealt with
in other draft Level 2 CEIOPS advice.
2.7 From a legal perspective, it is relevant
to point out that Article 13(29) defines concentration risk in the
widest and most comprehensive manner.
This interpretation shall apply when referring to concentration
risk in the Level 1 text (eg. in the context of risk management,
capital requirements, investments and group supervision...).
3. QIS4 outputs and industry feedback
3.1 Market risk (except concentration risk)
3.1 From April to July 2008, CEIOPS carried out the fourth
Quantitative Impact Study on Solvency II (QIS4). This included
testing each of the submodules of the market risk module,
according to the structure set out in Article 105.
3.2 For both life and non-life undertakings, as well as for
composites, the quantitative results indicated that market risk
represented one of the most significant modules for the standard
formula SCR.
3.3 The largest components of the market risk charge were interest
rate and equity risk (though equity risk is not considered in this
paper), with each of these typically contributing around 40-50% of
the total market risk requirement.
Property risk and spread risk contributed less: property
contributed between 8% and 15% of the total market risk, and
spread risk contributed 11-21%.
Currency risk contributed less than 7% of
the total market risk.
These statistics are useful to bear in mind when considering the
design and structure of the market risk module and when assessing
the merits of any simplifications.
3.4 In general, feedback from the QIS4 exercise indicated few
difficulties with the design and structure of the market risk
module and its sub-modules.
The main comments were as follows:
Structure
- For the interest rate module, there were suggestions that
sensitivity to changes in the shape of the yield curve could be
introduced.
- Volatility of interest rates was not modelled in the QIS4
approach.
- Some undertakings suggested use of a correlation matrix for the
treatment of currency risk.
- The QIS4 specifications did not address the treatment of
inflation-linked bonds.
- For the property risk sub-module, some undertakings felt that
the situation where buildings are used for the insurer’s own
activities rather than as an investment was not adequately
reflected in the QIS4
approach.
- Some undertakings suggested that property risks could be split
into sublines (residential, commercial, offices, etc.)
- In the spread risk sub-module, it was suggested that a
distinction should be drawn between losses due to migration risk
and default risk, and those due to a general change in the market
price of credit risk.
- Some undertakings felt that the approach taken for spread risk
in QIS4 did not allow for risk mitigation instruments.
- There were confusions as to which sub-modules should be used to
assess the market risk in mortgage-backed securities with one
country stating a preference for treating these instruments via
the spread and interest rate sub-modules rather than using the
counterparty default risk module.
Practical issues
- It was suggested that the use of a delta-NAV (i.e. change in net
asset value) approach is overly complex and would require
sophisticated modelling techniques
- Many insurers found the application of the look-through approach
for investment funds impractical.
- The approach to currency risk was viewed as problematical for
undertakings writing international business, particularly if this
were to be applied to the currency of the free assets relative to
the Euro rather than to the currency in which the liabilities are
denominated (or the currency of the local regulator).
3.5 This paper takes into account the results and comments from
the QIS4 exercise with the aim of refining the design and
structure of the market risk module further.
3.2 Concentration risk
3.6 According to the QIS4 report, the concentration risk
sub-module presented on average 7.2 % (life), 17.9 % (non-life)
and 9.5 % (composite) of the market risk SCR (before
diversification benefits).
3.7 The QIS4 report also contains quantitative references to the
impact of concentration risk on each Member State and market
segment (non-life, life and composite).
3.8 The issues commented on by the industry with regard to
concentration risk in the solo SCR in QIS4 report can be
summarized as follows:
3.9 Treatment of participations. The inclusion of participations
into the concentration risk sub-module was rejected by some
undertakings as double counting.
Some undertakings were concerned that intra-group operations are
faced with a too high capital charge.
CEIOPS will produce an advice on participations and their
treatment in the solvency assessment of an undertaking at the end
of October.
Therefore, this advice does not consider the treatment of
participations.
3.10 Treatment of properties. The QIS4 report mentions the need
for clarification of concentration risk on properties.
3.11 First of all, it is worth clarifying that concentration risk
on properties does not refer to having a high percentage of
properties in respect of equities, bonds, or the total balance
sheet.
This lack of diversification is captured with the use of a
correlation matrix to add the SCRs derived in each of the market
risk sub-modules.
3.12 When dealing with concentration on properties, the difficulty
arises from the fact that the core drivers of diversification are
both the type of property (office premises, residential property,
grounds, etc) and mainly the geographical spread.
3.13 Regarding
the first criterion (the type of use of the property)
a huge percentage of properties held by undertakings corresponds
to office premises and commercial non-residential properties, and
therefore this is considered in the calibration of the ‘property
risk’ sub-module.
Outliers in respect of this assumption may be better treated via
internal models.
3.14
The second
criterion (geographical diversification)
has revealed to be extremely difficult to model in an appropriate
manner.
Experience from the recent crisis shows that in case of a severe
stress, geographical diversification has no significant effect,
since property prices tend to contract almost worldwide.
3.15 At the same time, it is generally agreed that an undertaking
with a significant percentage of its assets invested in a single
property, in principle would have a higher exposure to market risk
than an undertaking with a diversified portfolio of properties.
3.16 Having this in mind, this advice only contains a specific
provision regarding concentration risk in a single property,
considering that the market risk associated to this type of assets
is not geographically diversifiable in case of severe crisis, and
this feature has been considered in the calibration of property
risk sub-module within the standard calculation of the SCR.
3.17 Assets to include in the denominator. Undertakings asked for
a clearer description and rationale of the treatment. In order to
solve this point, this advice contains a better definition of the
amount to include in the denominator.
3.18 Treatment of bank deposits. Undertakings in one country
criticized the concentration risk sub-module with respect to bank
deposits from financial entities under Basel II and investment
funds harmonized at a European level.
In their view, these elements should be excluded from the module,
as their issuers are subject to anti-concentration regulation.
3.19 The recent crisis has shown several practical examples
demonstrating the inappropriateness of the proposed exemption.
Nevertheless, this empirical evidence does not preclude the
possibility of taking into account government guarantees provided
for bank deposits and cash-accounts.
In fact, this allowance seems aligned with the economic assessment
underlying Solvency 2.
3.20 Risks derived from concentration in cash held at a bank are
captured in the counterparty default risk module, while risks
corresponding to concentration in other bank assets are reflected
in the concentration risk sub-module (no-hole, no-overlap).
3.21 Geographical and sectoral diversification. Although not
reflected explicitly in QIS4 report, it seems relevant to comment
on geographical and sectoral diversification referring to
financial investments.
An undertaking concentrating its investments in the same
geographical area or in the same economic sector is bearing higher
risks than in case of a geographically/sectorally diversified
portfolio.
The difficult point here is how to measure these types of
concentration.
3.22 In the case of geographical concentration, most large groups
are present worldwide and it is difficult to find a reliable and
publicly disclosed measure of their geographical investments.
Management of geographical exposures requires an in-depth insight
of each investment and a rather
complex monitoring process.
Furthermore, the calibration of different parameters according to
each geographical area is not immediate.
In fact, such differentiation may be not meaningful in an
increasingly globalised context.
The crisis has shown that diversification benefits (among lines of
business, asset classes, geographical, etc.) tend to diminish or
not be realizable in stressed times.
CEIOPS recognizes the existence of diversification effects (both
benefits and risks), but notices that they don’t operate in the
same way in normal and crisis times.
3.23 A similar statement is applicable to sectoral concentration,
perhaps with a slightly different intensity and some nuances.
Examples of tobacco groups with huge dietary business or utilities
groups moving towards the service sector are sufficiently
illustrative of the blurred frontiers that sectoral limits have in
the modern economy.
Furthermore, contagion risks and 'domino' effects have increased
the inter-sectoral correlations in times of crisis, in such a
manner that in some cases the correlation among entities of
different sectors closely related is significant, even similar to
the correlation of one entity with its sectoral competitors.
3.24 Summing up and for all the reasons described above, the
present advice does not contain any formula to quantify capital
requirements regarding geographical and sectoral concentrations of
financial investments.
Therefore these risks shall be primarily considered as part of
Pillar 2 activities (risk management, ORSA, etc.) and via internal
models when it be necessary to ensure that the SCR appropriately
reflects the risk profile of each undertaking.
4. Advice
4.1 General structure of the market risk module
4.1 For the purposes of this quantitative advice and from a
technical point of view, one issue to consider is
which types of concentration can be taken into account a manner
that would be compatible with the degree of simplicity desirable
for the standard calculation of the SCR.
4.2 In general, undertakings and supervisors should verify that
the SCR provides an appropriate reflection of the risk profile of
the insurance or reinsurance undertaking.
Should this not be the case with respect to the concentration of
assets or liabilities, necessary action will need to be adopted in
a relevant manner, i.e. via internal models or through capital
add-ons.
4.3 There were no major difficulties arising as a result of the
structure of the market risk module and its sub-modules as tested
in QIS4 and as set out in the Level 1 text quoted above.
4.4 However a number of (re)insurance undertakings
highlighted that volatility of interest
rates was not captured by the standard formula. In that regard
this advice considers the impact of interest rate volatility on
the shape (i.e., slope and curvature) of the term structure of
interest rates.
4.5 With the exception of interest rate volatility, we propose no
changes to be made to the module/sub-module structure. Instead,
effort will be focused on refining the design of the sub-modules
and (later) on reassessing the calibration of the modules.
4.6 One suggestion arising from QIS4 has been that liquidity risk
could be included in the market risk module. However, this has
been discussed as part of the development of the Level 1 text and
it has been concluded that this risk is better captured in Pillars
2 and 3.
4.2 General considerations where a delta-NAV approach is used
4.2.1. Explanatory text
4.7 A number of the market risk stresses are based on a delta-NAV
(change in value of assets minus liabilities) approach.
The change in net asset value should be based on a balance sheet
that does not include the risk margin of the technical provisions.
This approach is based on the assumption that the risk margin does
not change materially under the scenario stress.
This simplification is made to avoid a circular definition of the
SCR since the size of the risk margin depends on the SCR.
4.8 Where a delta-NAV approach is used, the impact of hedging
instruments shall be allowed for as part of the sub-module: use of
the delta-NAV calculation ensures the impact of the stress
scenario on the hedging instrument is captured alongside the
impact on all other assets and liabilities.
(Re)insurance undertakings shall have regard to CEIOPS-CP-31-09 in
determining whether a financial risk mitigation instrument may be
taken into account.
4.9 Furthermore, where a delta-NAV approach is used, the
revaluation of technical provisions should allow for any relevant
adverse changes in option take-up behaviour of policyholders in
this scenario.
4.2.2. CEIOPS’ advice
Delta-NAV Approach
4.10 The change in net asset value shall be based on a balance
sheet that does not include the risk margin of the technical
provisions.
4.11 The impact of interest rate hedging instruments shall be
allowed for as part of the scenarios. (Re)insurance undertakings
shall have regard to CEIOPS-CP-31-09 in determining whether a
financial risk mitigation instrument may be taken into account.
4.12 The revaluation of technical provisions should allow for any
relevant adverse changes in option take-up behaviour of
policyholders in this scenario.
4.8 Treatment of
investment funds
4.8.1. Explanatory text
4.171 Respondents to the QIS4 exercise suggested it would be
helpful to have greater clarity as to the treatment of collective
investment vehicles, and other investments packaged as funds, in
the market risk module.
4.172 In order to properly assess the market risk inherent in
these instruments, it will be necessary to examine their economic
substance.
Wherever possible, this should be achieved by applying a
look-through approach in order to assess the risks applying to the
assets underlying the investment vehicle.
Each of the underlying assets would then be subjected to the
relevant sub-module stresses and capital charges calculated
accordingly.
4.173 The same look-through approach shall also be applied for
other indirect exposures.
4.174 Where a number of iterations of the look-through approach is
required (e.g. where an investment fund is invested in other
investment funds), the number of iterations shall be sufficient to
ensure that all material market risk is captured.
4.175 Other case where it is impractical or disproportionate to
apply a full look through approach shall be considered in CEIOPS’
advice on simplifications
4.176 The above recommendations can be applied to both passive and
actively managed funds.
4.8.2. CEIOPS’ advice
Investment funds
4.177 In order to properly assess the market risk inherent in
collective investment vehicles, and other investments packaged as
funds, it shall be necessary to examine their economic substance.
Wherever possible, this shall be achieved by applying a
look-through approach in order to assess the risks applying to the
assets underlying the investment vehicle.
Each of the underlying assets would then be subjected to the
relevant sub-module stresses and capital charges calculated
accordingly.
4.178 The look through approach shall also be applied for
other indirect exposures.
4.179 Where a number of iterations of the look-through approach is
required (e.g. where an investment fund is invested in other
investment funds), the number of iterations shall be sufficient to
ensure that all material market risk is captured.
4.180 Other case where it is impractical or disproportionate to
apply a full lookthrough approach shall be considered in CEIOPS
advice on simplifications.
4.181 The above recommendations can be applied to both passive and
actively managed funds.
  
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