How to Estimate Risk Margins Under Solvency II
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1 How to Estimate Risk Margins Under Solvency II Arthur J. Zaremba, FCAS, MAAA Manager, PwC May 22, 2012
2 Today s Agenda Introduction (Risk Margin, Solvency II) Overview of Risk Margin Calculation SCR Overview Methods to Calculate Risk Margins Example Wrap-Up PwC 2
3 Definition of Risk Margin Industry descriptions of risk margin under Solvency II: PwC 3
4 Definition of Risk Margin Industry descriptions of risk margin under Solvency II: Along with best estimate makes up technical provisions, Ensures that value of technical provisions is equivalent to the amount that an insurer would be expected to require in order to take over and meet the insurance obligations. PwC 4
5 Definition of Risk Margin Industry descriptions of risk margin under Solvency II: Along with best estimate makes up technical provisions, Ensures that value of technical provisions is equivalent to the amount that an insurer would be expected to require in order to take over and meet the insurance obligations. OR... Increases the technical provisions from the best estimate up to an amount equivalent to a theoretical level needed to transfer obligations to another insurer. PwC 5
6 Solvency II Balance Sheet Quantitative Capital Requirements Assets at Market Value PwC 6
7 Solvency II Balance Sheet Quantitative Capital Requirements Risk Margin Assets covering technical provisions Assets at Market Value Best Estimate Technical Provisions PwC 7
8 Solvency II Balance Sheet Quantitative Capital Requirements BE = (Provision for Claims Outstanding) + (Premium Provision) Risk Margin Assets covering technical provisions Assets at Market Value Best Estimate Technical Provisions PwC 8
9 Solvency II Balance Sheet Quantitative Capital Requirements Assets available for SCR SCR Risk Margin Assets covering technical provisions Assets at Market Value Best Estimate Technical Provisions PwC 9
10 Solvency II Balance Sheet Quantitative Capital Requirements Assets available for SCR Excess Capital SCR (MCR) Risk Margin Assets covering technical provisions Assets at Market Value Best Estimate Technical Provisions PwC 10
11 Solvency II Balance Sheet Quantitative Capital Requirements Assets available for SCR Excess Capital SCR Focus of our Discussion! i (MCR) Risk Margin Assets covering technical provisions Assets at Market Value Best Estimate Technical Provisions PwC 11
12 Risk Margin Calculation - Overview Risk Margin is calculated by: Determining cost of providing amount of own funds equal to SCR needed to support runoff of your (re)insurance obligations; PwC 12
13 Risk Margin Calculation - Overview Risk Margin is calculated by: Determining cost of providing amount of own funds equal to SCR needed to support runoff of your (re)insurance obligations; The rate used in determining this cost is called Cost-of-Capital rate; PwC 13
14 Risk Margin Calculation - Overview Risk Margin is calculated by: Determining cost of providing amount of own funds equal to SCR needed to support runoff of your (re)insurance obligations; The rate used in determining this cost is called Cost-of-Capital rate; CoC = 6% = spread above risk-free rate. PwC 14
15 Risk Margin Calculation - Overview Risk Margin is calculated by: Determining cost of providing amount of own funds equal to SCR needed to support runoff of your (re)insurance obligations; The rate used in determining this cost is called Cost-of-Capital rate; CoC = 6% = spread above risk-free rate. PwC 15
16 Risk Margin Calculation - Overview Risk Margin is calculated by: Determining cost of providing amount of own funds equal to SCR needed to support runoff of your (re)insurance obligations; The rate used in determining this cost is called Cost-of-Capital rate; CoC = 6% = spread above risk-free rate. Memorize for Later! PwC 16
17 Risk Margin Calculation - Overview Risk Margin is calculated by: Determining cost of providing amount of own funds equal to SCR needed to support runoff of your (re)insurance obligations; The rate used in determining this cost is called Cost-of-Capital rate; CoC = 6% = spread above risk-free rate. Memorize for Later! PwC 17
18 SCR Overview SCR Adi BSCR Operational SCR SCR Market Health Default health Life Non-Life Intang Interest rate SLT Health CAT Non SLT Health Mortality Premium Reserve Equity Mortality Premium Reserve Longevity Lapse Property Longevity Lapse Disability Mortality CAT Spread Currency Concentration Disability Morbidity Lapse Expenses Lapse Expenses Revision Included in the adjustment for the loss absorbing bi capacity of technical provisions under the modular approach Illiquidity Revision CAT PwC 18
19 SCR Overview SCR needed to support runoff of your (re)insurance obligations captures the following: PwC 19
20 SCR Overview SCR needed to support runoff of your (re)insurance obligations captures the following: Underwriting Risk with respect to transferred business PwC 20
21 SCR Overview SCR needed to support runoff of your (re)insurance obligations captures the following: Underwriting Risk with respect to transferred business Some confusion during QIS 5 Newer guidance adding clarity PwC 21
22 SCR Overview SCR BSCR SCR Health health Non SLT Health Non-Life Premium Reserve Premium Reserve Lapse Lapse CAT Underwriting Risks PwC 22
23 SCR Overview SCR needed to support runoff of your (re)insurance obligations captures the following: Underwriting Risk with respect to transferred business; Credit Risk (aka Counterparty Default Risk) with respect to reinsurance contracts PwC 23
24 SCR Overview SCR needed to support runoff of your (re)insurance obligations captures the following: Underwriting Risk with respect to transferred business Credit Risk (aka Counterparty Default Risk) with respect to reinsurance contracts Make sure to exclude unrelated credit risks that are factored into SCR calculation (cash at bank, etc.) PwC 24
25 SCR Overview SCR BSCR SCR health Default Credit Risk PwC 25
26 SCR Overview SCR needed to support runoff of your (re)insurance obligations captures the following: Underwriting Risk with respect to transferred business; Credit Risk (aka Counterparty Default risk) with respect to reinsurance contracts; Operational Risk PwC 26
27 SCR Overview SCR BSCR Operational SCR Operational Risk PwC 27
28 SCR Overview SCR needed to support runoff of your (re)insurance obligations captures the following: Underwriting Risk with respect to transferred business; Credit Risk (aka Counterparty Default risk) with respect to reinsurance contracts; Operational Risk; Unavoidable Market Risk expected to be zero for P&C companies PwC 28
29 SCR Overview SCR BSCR Operational SCR Health Default health Non SLT Health Non-Life Premium Reserve Premium Reserve Lapse Lapse CAT All Risks relevant to Risk Margin calculation PwC 29
30 Risk Margin Calculation - Methods Recall Formula: PwC 30
31 Risk Margin Calculation - Methods Recall Formula: CoC Cis given = 6% r f is risk-free rate for t+1 years maturity SCR in future years is the unknown and where bulk of calculation lies PwC 31
32 Risk Margin Calculation - Methods Hierarchy of Simplifications used for projecting SCRs: 5) % of Best Estimate PwC 32
33 Risk Margin Calculation - Methods Hierarchy of Simplifications used for projecting SCRs: 4) Duration Approach 5) % of Best Estimate PwC 33
34 Risk Margin Calculation - Methods Hierarchy of Simplifications used for projecting SCRs: 3) Approximate whole SCR in future years (Proportional Approach) 4) Duration Approach 5) % of Best Estimate PwC 34
35 Risk Margin Calculation - Methods Hierarchy of Simplifications used for projecting SCRs: 2) Approximate individual (sub)risks used for SCR calculation 3) Approximate whole SCR in future years (Proportional Approach) 4) Duration Approach 5) % of Best Estimate PwC 35
36 Risk Margin Calculation - Methods Hierarchy of Simplifications used for projecting SCRs: 1) Full Calculation 2) Approximate individual (sub)risks used for SCR calculation 3) Approximate whole SCR in future years (Proportional Approach) 4) Duration Approach 5) % of Best Estimate PwC 36
37 Risk Margin Calculation - Methods Hierarchy of Simplifications used for projecting SCRs: 1) Full Calculation 2) Approximate individual (sub)risks used for SCR calculation 3) Approximate whole SCR in future years (Proportional Approach) 4) Duration Approach 5) % of Best Estimate PwC 37
38 Risk Margin Calculation - Methods Method 3 - Proportional Approach Most commonly used; Formula is: Method essentially runs-off SCR in proportion to Best Estimate (reserves); Recall SCR 0 only includes underwriting risk, credit risk, operational risk. Hence is NOT your company s full SCR PwC 38
39 Risk Margin Calculation - Example Example of Method 3 - Proportional Approach BE 0 = $300M; SCR 0 = $80M Pay m ent t = time Pattern (Ratio-to-Ult) BE t SCR t 0 0% $300 $ % $180 $ % $120 $ % $60 $ % $0 $0 Where, PwC 39
40 Risk Margin Calculation - Example Example of Method 3 - Proportional Approach Next, calculate Risk Margin using: t = time SCR t t+1 years r f for 0 $80 1.0% $79 1 $48 1.0% $47 2 $32 1.5% $31 3 $16 1.5% $15 4 $0 2.0% $0 $172 = Risk Margin = (6%) x ($172M) = $10.3M Ratio of RM to BE = 3.4% 34 PwC 40
41 Risk Margin Calculation - Methods Hierarchy of Simplifications used for projecting SCRs: 1) Full Calculation 2) Approximate individual (sub)risks used for SCR calculation 3) Approximate whole SCR in future years (Proportional Approach) 4) Duration Approach 5) % of Best Estimate PwC 41
42 Risk Margin Calculation - Methods Method 2 Approximate (sub)risks Approach Expected to gain popularity; User should approximate future SCRs based on underwriting risk, credit risk, and operational risk separately: PwC 42
43 Risk Margin Calculation - Methods Method 2 Approximate (sub)risks Approach Expected to gain popularity; User should approximate future SCRs based on underwriting risk, credit risk, and operational risk separately: Credit Risk future SCRs run-off in line with ceded best estimates PwC 43
44 Risk Margin Calculation - Methods Method 2 Approximate (sub)risks Approach Expected to gain popularity; User should approximate future SCRs based on underwriting risk, credit risk, and operational risk separately: Credit Risk future SCRs run-off in line with ceded best estimates Underwriting Risk calculate SCRs in future years based on expected Best Estimates in future evaluations PwC 44
45 Risk Margin Calculation - Methods Method 2 Approximate (sub)risks Approach Expected to gain popularity; User should approximate future SCRs based on underwriting risk, credit risk, and operational risk separately: Credit Risk future SCRs run-off in line with ceded best estimates Underwriting Risk calculate SCRs in future years based on expected Best Estimates in future evaluations Operational Risk standard formula approach PwC 45
46 Wrap-Up Additional items to consider include: Solvency II requires Risk Margin allocated by LOB; Consideration of Standard Formula vs Internal model Calculating a unique Cost of Capital rate PwC 46
47 Wrap-Up Questions/Comments Thank You PwC 47
48 com/us/insurance This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. Solicitation 2012 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers LLP which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.
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