Flashcards in 15 Solvency II (2) Deck (18):

1

## What are the three components of assets in the Solvency 2 balance sheet?

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1. Investments (equities, bonds, property).

2. Reinsurance recoveries.

3. Participations (companies in which the insurance company owns at least 20% of the voting rights).

2

## What are the factors to consider when valuing assets under Solvency 2?

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1. Where possible, assets should be valued using market values.

2. If market values are not available, mark-to-model techniques can be used provided they follow a market consistent approach.

3. Reinsurance recoveries are shown as an asset on the balance sheet rather than a reduction in gross liabilities.

4. Reinsurance recoveries should be adjusted to allow for the best estimate of expected losses due to default of the reinsurer.

5. A market consistent approach should be used when valuing participations in other companies within a group.

3

## What are the factors to consider when calculating technical provisions?

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1. Technical provisions consist of a best estimate liability and a risk margin.

2. They should represent the amount that the insurance company would have to pay to transfer the liability to another insurance company.

3. The calculations should be segmented by homogeneous product type.

4

## What are the factors to consider regarding the calculation method for best estimate liabilities?

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1. The best estimate liability is the present value of expected future cashflows discounted using a risk-free yield curve.

2. Cashflow projections would ideally be made on a policy by policy basis, but grouped model points may be used if these can be validated for accuracy.

3. For unit linked business, the BEL must be calculated separately for the unit and non-unit components.

4. Options and guarantees should be valued using a stochastic model, unless a deterministic "closed form" approach is deemed appropriate on the grounds of materiality.

5

## What are the factors to consider regarding the assumptions used (other than the yield curve) for calculating for best estimate liabilities?

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1. All assumptions should be best estimate, with no prudential margins.

2. Allowance should be made for all expected decrements and policyholder actions, including lapses.

3. All relevant available data must be used when arriving at assumptions specific to the liabilities being valued.

4. Future premiums can be taken into account up to the "contract boundary" which is defined as the point at which the company can unilaterally terminate the contract or change the premiums or benefits in such a way that fully reflects the risks. This normally means the maturity date.

5. Future expenses must be allowed for - both overheads and direct costs.

6. Inflation must be allowed for in the expense basis.

7. No closure reserve is required.

8. For with-profits business, discretionary benefits must be allowed for.

9. The calculations must reflect realistic management actions and policyholder behaviour.

6

## What are the factors to consider regarding determination of the yield curve to be used for calculating for best estimate liabilities?

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1. The risk-free yield curve should be based on swap rates, or on government bond yields where swap rates are not available.

2. Methods used to determine the yield curve must be consistent between different countries, including those without an active government bond or swap market.

3. A matching adjustment in line with the spread movements in the assets is allowed where the insurer has long term predictable liabilities and can hold matching assets to maturity.

4. Any matching adjustment must be approved by the regulator and there are strict requirements on the eligibility of the assets and liabilities.

5. A volatility adjustment is allowed for liabilities not eligible for a matching adjustment.

6. The purpose of of the volatility adjustment is to prevent forced sales of assets in the event of extreme bond spread movements.

7. The volatility adjustment is based on the spreads on a representative portfolio of assets for each relevant currency.

8. Use of a volatility adjustment is subject to certain risk management requirements, such as a liquidity plan and sensitivity analysis.

7

## What are the factors to consider when calculating the risk margin for Solvency 2 technical provisions?

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1. The risk margin is intended to increase the technical provision to the amount that would have to be paid to another insurance company in for them to take on the best estimate liability.

2. The risk margin therefore represents the theoretical compensation for the risk of future experience being worse than the best estimate assumptions and for the cost of holding regulatory capital against this.

3. The risk margin is calculated using the "cost of capital" method, based on the cost of holding capital to support the risks that cannot be hedged. These include insurance risk, reinsurance risk, operational risk and residual market risk.

4. The cost of capital method involves projecting forward the required capital (SCR) to the end of each projection period during run-off of the existing business. These amounts are then multiplied by a cost of capital rate representing the cost of raising incremental capital in excess of the risk free rate. The amounts are then discounted using the risk-free rate to give the risk margin.

5. Since the projection of the SCR is potentially complex, various simplified approaches can be used that involve the selection of risk drivers that are correlated in some way with the required capital.

6. Although the risk margin must be disclosed separately for each line of business, the overall risk margin can be reduced to allow for diversification between lines of business up to legal entity level.

7. The allocation of diversification benefit can be approximated by apportioning the total diversified risk margin across lines of business in proportion to the SCR calculated on a stand-alone basis for each line.

8

## What are the factors to consider when calculating the Solvency Capital Requirement (SCR) for Solvency 2?

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1. The SCR is a value-at-risk measure based on a 99.5% confidence interval of the variation over one year of the amount of "basic own funds".

2. There is a prescribed list of risk groups that the SCR has to cover.

3. A Standard Formula or Internal Model approach may be used.

4. The Standard Formula approach uses prescribed stress tests which are aggregated using prescribed correlation matrices.

5. Use of an Internal Model must be approved by the regulatory authority and must meet a number of standards, including the "Use Test" which requires that the internal model is widely used within the company and plays an important role in its decision making and governance processes.

6. A combination of the Standard Formula and Internal Model approaches may be used, referred to as a Partial Internal Model.

7. Simplifications can be applied, provided they are proportionate to the nature, scale and complexity of the risks.

8. For some parts of the Standard Formula, insurance companies may apply for the use of "undertaking specific parameters" instead of the prescribed parameters.

9. Dynamic hedging is not permitted under the Standard Formula approach, but may be used in an Internal Model.

9

## What are the risk groups that the SCR must cover?

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1. Non-life underwriting risk.

2. Life underwriting risk.

3. Health underwriting risk.

4. Market risk.

5. Counter-party default risk.

6. Operational risk.

10

## What are the factors to consider when using a Standard Formula approach to calculating the SCR?

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1. The basic SCR is calculated by considering different modules of risk.

11

## List the modules of risk to be considered when using a Standard Formula approach to calculate the SCR.

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1. Market Risk (equity, property, interest rate, credit spread, currency, concentration).

2. Counterparty default.

3. Insurance (separately for life, health and non-life).

4. Intangible assets.

12

## What are the Standard Formula risk sub-modules for life assurance business?

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1. Mortality risk

2. Longevity risk

3. Disability / Morbidity risk

4. Lapse risk

5. Expense risk

6. Revision risk

7. Catastrophe risk (e.g. pandemic)

13

## Describe the Standard Formula calculation of the SCR.

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1. The first step is to calculate an SCR separately for each sub-module and module separately.

2. The calibration and application of each stress is specified within the standard formula.

3. The SCR for each stress is calculated as the difference between the net asset value in the unstressed balance sheet and the net asset value in the stressed balance sheet.

4. The SCRs are then aggregated across the various risks using a specified correlation matrix.

5. For the counterparty risk module, differentiation must be made between:

- Type 1 exposures where the counterparty is rated and the risk may not be diversified and

- Type 2 exposures where the risk is usually diversified and the counterparty is not rated.

6. The SCRs for each risk module are then combined to give the basic SCR (BSCR).

7. The BSCR is then adjusted by an allowance for operational risk and an allowance for the loss absorbing capacity of technical provisions and deferred taxes.

8. The operational risk module is based on simple percentages of premiums and technical provisions.

9. The loss absorbing capacity of technical provisions could include the ability to reduce discretionary benefits under stressed conditions.

10. The loss absorbing capacity of deferred taxes could include a reduction in any base balance sheet deferred tax liability as this would no longer be fully payable in a stressed scenario.

14

## What are the tests that an internal model must pass before it can gain approval?

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1. The "Use Test" that the model is widely used throughout the business and plays an important role in risk management and governance.

2. Statistical Quality Standards relating to assumptions and data.

3. Calibration Standards which aim to assess whether the SCR derived from the internal model has a calibration equivalent to the 99.% value at risk confidence internal.

4. Profit and Loss Attribution to demonstrate how the risk categorisation is used to explain sources of profit and loss.

5. Validation Standards to show that the model has been fully validated and subject to regular control cycle review.

6. Documentation Standards for the design and operational aspects of the internal model.

15

## Discuss the Minimum Capital Requirement (MCR).

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1. The MCR is defined as a simple factor-based linear formula targeted at a Value-at-Risk over one year with 85% confidence.

2. The MCR has a floor of 25% and a cap of 45% of the SCR.

3. If a company's eligible capital falls below the MCR or a breach is likely within the next three months, the regulator must be informed.

4. Within one month of a breach, the insurance company must submit a short-term finance scheme for approval by the regulator.

5. The company must rectify the breach within three months of it occurring.

6. If the short term financing scheme does not work, the regulator would remove the company's authorisation to sell new business.

16

## Explain what "Own Funds" means.

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1. Own Funds refers to assets in excess of technical provisions and subordinated liabilities.

2. Own Funds are split into basic and ancillary own funds and then tiered within those categories based on loss absorbency and permanence.

3. Basic Own Funds is broadly capital that exists within the insurer.

4. Ancillary Own Funds is capital that may be called upon in certain adverse circumstances, but which does not currently exist within the insurer.

17

## What restrictions are placed on the quality of capital that can be used to cover the Solvency 2 MCR and SCR?

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1. The SCR must be backed by at least 50% Tier 1 capital and less than 15% Tier 3.

2. The MCR must be backed by at least 80% Tier 1 capital and non Tier 3 capital.

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