The September 2009 edition of the
Solvency ii Association newsletter
Dear Members,
Today we will discuss the frequency and the details of the
calculation of the Minimum Capital Requirement (MCR) and the
Solvency Capital Requirement (SCR), as I have witnessed that there
is some confusion in major firms.
To make
a long story short: We will calculate both, the MCR and the SCR
every three months.
What? You have read in the Level 1 text
that the SCR will be calculated every year? Yes... It is correct,
but we have an interesting Level 2 interpretation (every 3
months!!!).
We must
learn some interesting words, and we must start using them:
A "linear formula" (a
simple factor-based combination of basic volume measures) ...
... a cap (of 45%) ...
... a floor (of 25%) ...
... a corridor (the cap
and the floor together are referred to as the "corridor") ...
...
and an "absolute floor".
Enjoy!
Article
127 - Calculation of the Minimum Capital Requirement
(1) The Minimum Capital Requirement shall be calculated in
accordance with the following principles:
(a) it shall be calculated in a clear and simple manner, and in
such a way as to ensure that the calculation can be audited;
(b) it shall correspond to an amount of eligible basic own funds
below which policyholders and beneficiaries are exposed to an
unacceptable level of risk if insurance and reinsurance
undertakings were allowed to continue their operations;
(c) the linear function referred to in paragraph 2 used to
calculate the Minimum Capital Requirement shall be calibrated to
the Value-at-Risk of the basic own funds of an insurance or
reinsurance undertaking subject to a confidence level of 85% over
a one-year period;
(d) it shall have an absolute floor of:
(i) 2.200.000 EUR for non-life insurance undertakings, including
captive insurance undertakings, except in the case where all or
some of the risks included in one of the classes 10 to 15 listed
in point A of Annex 1 are covered, in which case it shall not be
less than 3.200.000 EUR,
(ii) 3.200.000 EUR for life insurance undertakings, including
captive insurance undertakings,
(iii) 3.200.000 EUR for reinsurance undertakings, except in the
case of captive reinsurance undertakings, in which case the
Minimum Capital Requirement shall not be less than a minimum of
1.000.000 EUR,
(iv) the sum of the amounts set out in points (i) and (ii) for
insurance undertakings as referred to in Article 72(5).
(2) Subject to paragraph 3 the Minimum Capital Requirement shall
be calculated as a linear function of a set or sub-set of the
following variables: the undertaking's technical provisions,
written premiums, capital-at-risk, deferred tax and administrative
expenses.
The variables used shall be measured net of reinsurance.
(3) Without prejudice to point (d) of paragraph 1, the Minimum
Capital Requirement shall not fall below 25% nor exceed 45%, of
the undertaking's Solvency Capital Requirement, calculated in
accordance with Chapter VI, Section 4, Sub-sections 2 or 3, and
including any capital addon imposed in accordance with Article 37.
Member States shall allow their supervisory authorities, for a
period not exceeding two years after the date referred to in
Article 310(1), to require an insurance or reinsurance undertaking
to apply the percentages referred to in the previous subparagraph
exclusively to the undertaking's Solvency Capital Requirement
calculated in accordance with Chapter VI, Section 4, Sub-section
2.
(4) Insurance and reinsurance undertakings shall calculate the
Minimum Capital Requirement at least quarterly and report the
results of that calculation to supervisory authorities.
If either of the limits referred to in paragraph 3 determines an
undertaking's Minimum Capital Requirement, the undertaking shall
provide to the supervisory authority information allowing a proper
understanding of the reasons for this.
Advice
3.1 Explanatory text
3.1.1. Previous advice
3.1.3. The overall structure of the MCR in the combined approach
3.5. Article 127 of the Level 1 text sets out a combined approach
for calculating the MCR.
This combined approach consists of
� A "linear formula", i.e. a simple factor-based combination of
basic volume measures (written premiums, technical provisions,
capital-at risk, deferred taxes and administrative expenses),
combined with
� A cap of 45% and a floor of 25% of the SCR (calculated using
either the standard formula or an internal model) to ensure a
proper ladder of supervisory intervention.
The cap and the floor together are
hereafter referred to as the "corridor".
In the final step, an absolute floor is applied to the result of
the above calculation.
The values of the absolute floor for different types of
undertakings are set out in Article 127(1)d.
3.6. The general rule is that if an undertaking has an approved
internal model, then the corridor used for calculating its MCR is
determined by the internal model SCR result.
However, for no longer than two years after the entry into force
of Solvency II, the supervisory authority has the power to require
that the corridor is calculated from the SCR standard formula.
3.7. The definition of the corridor
includes capital add-ons imposed on the undertaking's SCR in
accordance with Article 37.
3.1.4. Structure and segmentation of the linear formula
3.8. This section describes the structure of the linear formula as
recommended by CEIOPS, including the segmentation of the volume
measures used in the linear formula.
The linear formula structure suggested below is based on the
formula tested in QIS4, however some changes to the segmentation
are suggested.
3.9. Following the separation of life and non-life insurance
management required in Article 73(1) of the Level 1 text, the MCR
linear formula is divided between life and non-life activities.
When the word "activities" is used in this paper, the distinction
between "life activities" and "non-life activities" reflects the
legal classification for administrative authorisation.
3.10. In addition to the split reflecting the legal distinction
between life and non life activities, a second split is made
according to the technical nature of insurance obligations
(whether they are technically similar to life or non life).
The combination of these two splits
defines the following four components of the linear formula:
A. Non-life activities practised on a non-life technical basis
B. Non-life
activities technically similar to life
C. Life activities practised on a life technical basis
D. Life activities - supplementary obligations practised on a
non-life technical basis
For the purposes of determining the MCR, health obligations are
divided between the above life and non-life categories A to D
according to the nature of the contracts and their underwriting,
in line with the criteria set out below.
3.11. The volume measures referred to in the linear formula, in
particular technical provisions, written premiums and
capital-at-risk, should be allocated between the above four
components without double counting.
It is also suggested that all volume measures in the linear
formula are subject to a floor of zero.
3.12. For the purpose of the calculation of the linear formula,
the technical provision net of reinsurance is the difference
between the gross technical provision and the reinsurance
recoverables, where the recoverables should not include
recoverables from finite reinsurance.
3.13. For the purpose of the calculation of the linear formula,
the premiums net of reinsurance are the premiums received from the
policyholders less the reinsurance premiums paid for reinsurance
contracts which correspond to these policyholder premiums.
The reinsurance premiums should not include payments of
reinsurance premiums for finite reinsurance.
3.14. For consistency with the volume measures used in the SCR
standard formula, it is suggested that the technical provision
volume measures in the linear formula are understood without the
risk margin.
3.15. The volume measures prescribed in Article 127(2) of the
Level 1 text do not allow to explicitly reflect in the linear
formula all risks that an undertaking is exposed to.
Such risks as e.g. market risk are reflected implicitly in the
calibration of the factors.
A.
Non-life activities practised on a non-life technical basis
3.16. This component of the linear formula should be calculated as
the sum over all lines of business of the higher of the following
two results:
� A fixed percentage (αlob) of net technical provisions,
reflecting underwriting risk for long-term business;
� a fixed percentage (βlob) of net written premiums, reflecting
underwriting risk for short-term business.
3.17. It is suggested that the segmentation of lines of business
for the purposes of this linear formula component should be
consistent with the segmentation of non-life technical provisions,
and with the segmentation of non-life and health lines of business
used in the SCR standard formula (CP 272, CP48 and CP50).
The following segments are suggested:
A.1 Motor vehicle liability
A.2 Motor, other classes
A.3 Marine, aviation, transport
A.4 Fire and other property damage
A.5 Third party liability
A.6 Credit and suretyship
A.7 Legal expenses
A.8 Assistance
A.9 Miscellaneous non-life insurance
A.10 Non-proportional reinsurance - property
A.11 Non-proportional reinsurance - casualty
A.12 Non-proportional reinsurance - marine, aviation, transport
A.13 Accident and health (segmentation pending)
3.18. The segments A.1 to A.9 and A.13 include both insurance and
proportional reinsurance accepted.
Other reinsurance accepted than proportional reinsurance should be
allocated to the segments A.10 to A.12.
3.19. The segmentation of Accident and health lines of business
(A.13) should follow the segmentation of lines of business in the
SCR standard formula non-SLT health underwriting risk submodule
(CP 50).
Regarding the segmentation of these lines, several options are
currently under consideration by CEIOPS.
B.
Non-life activities technically similar to life
3.20. The calculation of this linear formula component should be
the same as the calculation for life activities, with the same
segmentation and the same factors as described below in component
C.
3.21. Examples of non-life activities that are similar in nature
to life insurance include long-term health insurance and non-life
annuities.
3.22. The rationale for change relative to the QIS4 treatment of
this component is that the QIS4 approach may not cover all types
of non-life insurance which are similar to life insurance.
Furthermore, arbitrage opportunities should be avoided: the MCR
should not depend on whether an activity is done by a life or by a
non-life insurer.
C. Life activities practised on a
life technical basis
3.23. This component of the linear formula should be calculated as
the sum of the following results:
� A fixed percentage (αi) of net technical provisions excluding
non-retail unit linked business, at an appropriate granularity, to
reflect long-term risks relating to life business; and
� A fixed percentage of net capital-at-risk (βj), at an
appropriate granularity, depending on the outstanding term of the
contract.
3.24. For the purposes of the MCR linear formula, CEIOPS suggests
a segmentation that is somewhat different from the life segments
suggested in CEIOPS' draft Level 2 advice on the segmentation of
technical provisions (CEIOPS-CP-27/09).
The changes mainly affect the second level of the segmentation.
Some second-level segments have been introduced to capture major
differences in risk profiles.
However, because of the need for simplicity and comparability, the
granularity of second-level segments is kept at the minimum in the
suggested segmentation, which is described below:
3.25. Technical provisions - with-profit segment:
Technical provisions relating to contracts with profit
participation clauses are split between the following two
sub-segments:
C.1.1 provisions for guaranteed benefits
C.1.2 provisions for future discretionary benefits
3.26. As the linear formula charge for the discretionary
sub-segment is negative, it is suggested to include a with-profit
floor (expressed as a percentage of the technical provisions for
guaranteed benefits) in the linear formula charge of the overall
with-profit segment to prevent it from falling too low.
3.27. Technical provisions - unit-linked segment: Technical
provisions relating to contracts where the policyholder bears the
investment risk (not including non-retail unit-linked business
which is defined below) are split between the following
sub-segments:
C.2.1 provisions for unit-linked contracts without guarantees
C.2.2 provisions for unit-linked contracts with guarantees
3.28. Technical provisions - non-profit segment: Technical
provisions relating to contracts without profit participation
clauses are treated as a single segment:
C.3 provisions for contracts without profit participation clauses
3.29. Technical provisions - life reinsurance:
Reinsurance accepted is not treated as a separate segment in the
linear formula but should be apportioned according to the
segmentation of direct business, using the same factors as for
direct business.
The technical provisions of reinsurance accepted of with-profit
business should be completely assigned to segment
C.1.1.
3.30. Capital-at-risk is defined as the
sum of financial strains for each policy on immediate death or
disability where it is positive.
The financial strain on immediate death or disability is the
amount currently payable on death or disability of the insured and
the present value of annuities payable on death or disability of
the insured less the net technical provisions (not including the
risk margin) and less the increase in reinsurance recoverables
which is directly caused by death or disability of the insured.
3.31. Capital-at-risk is split between
the following segments, depending on the duration:
C.4.1 capital-at-risk for contracts with an outstanding term of 5
years or more
C.4.2 capital-at-risk for contracts with an outstanding term of 3
to 5 years
C.4.3 capital-at-risk for contracts with an outstanding term less
than 3 years
D. Life activities - supplementary
obligations practised on a non-life technical basis
3.32. The calculation of this linear formula component is the same
as the calculation for non-life activities practised on a non-life
technical basis, with the same segmentation and the same factors
(although some classes are unlikely as supplementary insurance, it
is not in the scope of this advice to decide which supplementary
classes should be possible).
Deferred taxes
3.33. According to Article 127 of the Level 1 text, deferred tax
liabilities can be used as a variable in the calculation of the
linear MCR.
The objective of the inclusion of the deferred tax liability in
the calculation would be to capture the loss-absorbing capacity of
this balance sheet item: in case an undertaking incurs losses, the
deferred tax liabilities potentially decrease and thereby offset a
part of the losses.
The SCR calculation allows for this effect by an adjustment to the
Basic SCR.
3.34. An allowance for deferred taxes in the linear MCR could
increase the risk sensitivity of the formula.
On the other hand, there are strong arguments not to allow for
deferred taxes in the linear MCR as follows:
� When the MCR becomes relevant, i.e. when the own funds of an
undertaking are close to the MCR, it has usually incurred losses
in the past that made the deferred tax liabilities vanish.
Therefore, deferred tax liabilities are likely only to have a
significant effect on the linear MCR in case the MCR itself is not
relevant for the undertaking.
� The loss-absorbing characteristics of deferred taxes depend on
the tax regulation of the state that the undertaking is situated
in. It is unclear whether the characteristics of different
(probably complex) tax regimes can be reflected in one risk
factor. Moreover, there seems to be no database yet for an
analysis of this question. The QIS4 results do not appear to be a
reliable basis as the participants' approach to deferred taxes
differed significantly.
3.35. For these reasons, CEIOPS considers that the inclusion of
deferred tax liabilities in the MCR linear formula would not lead
to any significant regulatory benefit.
3.1.5. Notional non-life and life MCR for composite undertakings
3.36. For composite undertakings, the notional non-life and life
MCR (NMCRNL and NMCRLife) are capital requirements that must be
covered by eligible basic own funds with respect to the non-life
and life activity.
3.37. While the Level 1 text explicitly requests separate notional
life and non-life MCR calculations for composite undertakings,
this is not the case for the SCR.
This raises the question of how to calculate the cap and the floor
as a percentage of the SCR for composites.
CEIOPS considers that the corridor needs to be calculated
separately for non-life and life activities, and applied to the
non-life and life linear formula respectively.
Without applying the separate corridors, the supervisory ladder
properties of the overall combined approach cannot be retained.
In QIS4, the separate corridors in respect of non-life and life
were not yet defined: their calculation is a new element in this
preparatory advice.
3.38. For determining the separate non-life and life corridors, in
turn, a notional non-life SCR and a notional life SCR (NSCRNL and
NSCRLife) need to be calculated.
It is noted that the notional non-life and life SCR results do not
constitute a capital requirement on their own: they are regarded
as interim results of the notional non-life and life MCR
calculations.
3.39. While splitting the linear formula between non-life and life
components is self-explanatory, calculating notional non-life and
life SCR results is not straightforward.
3.40. CEIOPS recommends that, when the two notional SCRs are
calculated, the overall SCR of an undertaking is split in such a
way that NSCRNL + NSCRLife = SCR.
This means that CEIOPS recognises the diversification benefits
that arise between the non-life and life activities of a composite
undertaking.
3.41. More precisely, NSCRNL and NSCRLife are calculated directly
by splitting the overall SCR charge according to the ratio of the
non-life and life MCR linear formula results.
The advantages of this method are that:
� it is very simple to calculate;
� it avoids the burden of calculating the full SCR separately for
non life and life;
� it is directly applicable regardless of whether the corridor is
derived from the standard formula or from an internal model;
� given that the linear formula and the corridor are split
according to the same ratio, the sum of the notional non-life MCR
and the notional life MCR is always equal to the overall MCR.
3.42. Furthermore, the notional non-life MCR should not be lower
than the non life absolute floor defined in point (i) of Article
127(1)d, and the notional life MCR should not be lower than the
life absolute floor defined in point (ii) of Article 127(1)d of
the Level 1 text.
3.43. If capital add-ons are taken into account in the definition
of the corridor, then an add-on imposed on a composite undertaking
should also be allocated between non-life and life activities for
the purposes of calculating the MCR split between life and
non-life.
The split should be declared by the supervisor imposing the add-on
for that particular undertaking.
3.1.3.
Quarterly calculation of the corridor
Frequency of calculation
3.44. According to the Level 1 text Member States shall require
that insurance and reinsurance undertakings hold eligible basic
own-funds to cover the MCR, that the calculation of the MCR shall
be carried out at least quarterly and that the results should be
reported to supervisory authorities.
3.45. By way of the corridor, the calculation of the MCR is linked
to the calculation of the SCR.
Regarding the frequency of the SCR calculations, the Level 1 text
in Article 102(1), requires that an undertaking shall calculate
its SCR at least once a year.
In addition, extraordinary SCR calculations are required whenever
there is a significant change in the risk profile.
3.46. Therefore, for the purpose of the MCR calculation, the SCR
shall be calculated on a quarterly basis.
3.47. Since the objective of the quarterly MCR calculation is to
ascertain whether or not the MCR has been breached, the own funds
eligible to cover the MCR should also be calculated in parallel on
a quarterly basis.
Simplification for the quarterly calculation of the SCR for the
purpose of MCR calculation
3.48. When the SCR is calculated using the standard formula, for
the quarterly calculation that is not at year end, undertakings
are allowed to use a simplification.
3.49. The simplification consists of a partial recalculation of
the last reported SCR.
A partial recalculation means that only those (sub)modules of the
SCR whose main risk drivers have changed significantly since the
last calculation are recalculated.
3.50. A minority of CEIOPS' members suggested that a simple carry
forward of the last reported SCR should be used as a
simplification.
3.51. However, no simplifications are allowed in the following
cases:
a. (significant change in risk profile:) if there has been a
significant change in the risk profile of an undertaking since the
last reported SCR,
b. (proximity of intervention point:) if the undertaking falls
below the following capital thresholds, indicating that there is
an increased probability of MCR level intervention in the
forthcoming period:
i. the undertaking has breached the SCR,
ii. the undertaking has breached the MCR, or
iii. the undertaking does not hold eligible Tier 1 and Tier 2
basic own funds covering at least 200% of the MCR, without taking
into account the absolute floor.
3.52. Under the principle of proportionality (see CEIOPS advice on
proportionality), undertakings using undertaking-specific
parameters, a partial internal model or a full internal model,
shall apply a quarterly calculation that is sufficiently
sophisticated.
3.53. Regarding the thresholds in point b, to avoid circularity,
if the last full MCR/SCR calculation indicated that any of the
thresholds i.-iii. has been breached, then the simplification
should not be used.
If the simplification has been used but it indicates a breach of
any of the thresholds i.-iii., then the undertaking shall not use
the simplification.
3.54. The reason for not taking into account the absolute floor in
iii. of point b. above is to avoid demanding extraordinary full
SCR recalculations in those cases where the capital requirements
are dominated by the absolute floor.
Dear members,
The Solvency ii Association
develops and maintains a compendium of Solvency ii related risk and
compliance topics. Subject matter experts review and update this
body of knowledge.
The Solvency
ii Association offers two Solvency ii certification
programs:
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countries
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Association will provide Solvency II Training classes worldwide only
in cooperation with Solvency II Training Ltd.
Next European open Solvency II Training
Course:
Date: Sept 23-25,
2009
Location: Canary Wharf, London, UK
As Corporate
Affiliates of The Institute of Continuing Professional Development
(CPD) our three-day Solvency II training courses offer delegates a
total of 24 (CPD) hours.
Contact: Ross Fenwick, Managing
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Best Regards,
George
Lekatis
President of the Solvency ii Association
General
Manager, Compliance LLC
1200 G Street NW Suite 800, Washington DC
20005, USA
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