9.5 Risk margins and solvency capital requirements
13 min read•august 20, 2024
Insurance companies need to be prepared for unexpected events. Risk margins provide a safety buffer, ensuring insurers can meet obligations even in tough times. They're added to the best estimate of liabilities, forming part of technical provisions.
Solvency Capital Requirements (SCR) are another key safeguard. They represent the minimum capital insurers must hold to withstand a 1-in-200-year event. SCR calculations involve assessing various risk types, from market fluctuations to underwriting challenges.
Definition of risk margins
- Risk margins are an essential component of solvency assessment in the insurance industry, providing a buffer against uncertainty in the valuation of insurance liabilities
- They represent an additional amount, over and above the best estimate of liabilities, that an insurer should hold to ensure it can meet its obligations with a high degree of confidence
- Risk margins are closely related to technical provisions, which are the total amount an insurer sets aside to cover future claims and expenses
Role in solvency assessment
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- Risk margins play a crucial role in assessing an insurer's solvency position, as they help to ensure that the insurer has sufficient financial resources to withstand adverse events and fulfill its obligations to policyholders
- By including risk margins in the valuation of liabilities, insurers can demonstrate their ability to absorb potential losses and maintain financial stability
- Solvency assessment frameworks, such as in the European Union, require insurers to calculate and hold adequate risk margins as part of their overall capital requirements
Relationship to technical provisions
- Technical provisions consist of two main components: the best estimate of liabilities and the
- The best estimate represents the expected present value of future cash flows related to insurance obligations, based on realistic assumptions about factors such as mortality, morbidity, and expenses
- Risk margins are added to the best estimate to account for the uncertainty inherent in these assumptions and to provide an extra layer of protection against adverse deviations
- The combination of the best estimate and risk margin forms the total technical provisions, which are a key element of an insurer's balance sheet and solvency assessment
Calculation of risk margins
- The calculation of risk margins involves various methods and assumptions, with the aim of quantifying the additional capital required to cover the uncertainty in the valuation of insurance liabilities
- Actuaries and risk managers must carefully consider the appropriate approach and parameters to use in determining risk margins, taking into account the specific characteristics of the insurer's business and risk profile
Cost-of-capital approach
- The cost-of-capital approach is a widely used method for calculating risk margins, particularly under solvency regimes like Solvency II
- This approach is based on the principle that an insurer should hold enough capital to cover the cost of transferring its liabilities to another insurer, in the event that it is unable to meet its obligations
- The cost of capital is typically determined using a risk-free rate plus a risk premium, which reflects the return that investors would require to take on the insurer's liabilities
Assumptions and parameters
- The calculation of risk margins involves various assumptions and parameters, which can have a significant impact on the final result
- Key assumptions include the risk-free rate, the cost of capital rate, and the projection period over which future cash flows are considered
- Other important parameters include the level of granularity at which risk margins are calculated (e.g., by line of business or by product) and the treatment of diversification effects between different risk sources
Projection of future SCRs
- To calculate risk margins using the cost-of-capital approach, insurers must project their future Solvency Capital Requirements (SCRs) over the lifetime of their liabilities
- This involves estimating the capital required to cover the risks associated with the insurer's business at each future point in time, taking into account factors such as expected growth, changes in the risk profile, and the runoff of existing liabilities
- The projection of future SCRs is a complex process that requires sophisticated modeling techniques and expert judgment to ensure that the resulting risk margins are appropriate and robust
Solvency capital requirements (SCR)
- Solvency Capital Requirements (SCR) are a key component of modern solvency frameworks, such as Solvency II in the European Union
- The SCR represents the amount of capital that an insurer must hold to ensure that it can meet its obligations to policyholders over the next 12 months, with a confidence level of 99.5%
- This high level of confidence is designed to provide a strong level of protection for policyholders and to ensure the financial stability of the insurance sector
Definition and purpose
- The SCR is defined as the (VaR) of an insurer's basic own funds, subject to a confidence level of 99.5% over a one-year period
- In other words, it represents the amount of capital required to ensure that the insurer can withstand a 1-in-200-year event without defaulting on its obligations
- The purpose of the SCR is to ensure that insurers have sufficient financial resources to absorb significant losses and to continue operating as a going concern, even in adverse circumstances
Regulatory framework
- The calculation of SCRs is governed by regulatory frameworks, such as Solvency II in the European Union
- These frameworks set out the principles, rules, and guidelines for determining capital requirements, as well as the reporting and disclosure obligations for insurers
- Regulatory authorities, such as the European Insurance and Occupational Pensions Authority (EIOPA), are responsible for overseeing the implementation and enforcement of these frameworks, and for ensuring that insurers comply with the relevant requirements
Standard formula vs internal models
- Under Solvency II, insurers have the option to calculate their SCR using either the standard formula or an internal model
- The standard formula is a prescribed set of rules and parameters that insurers can use to determine their capital requirements, based on their specific risk profile and business mix
- Internal models, on the other hand, are developed by insurers themselves, subject to approval by the regulatory authorities
- Internal models allow insurers to more accurately reflect their specific risk characteristics and to potentially benefit from lower capital requirements, but they also require significant investment in data, systems, and expertise
SCR calculation
- The calculation of the (SCR) is a complex process that involves assessing an insurer's exposure to various types of risks and determining the capital required to cover those risks
- Under Solvency II, the SCR is calculated using a modular approach, which breaks down the overall risk into several sub-components, each focusing on a specific risk category
Structure of standard formula
- The standard formula for calculating the SCR follows a modular structure, consisting of several risk modules and sub-modules
- The main risk modules include , counterparty default risk, life underwriting risk, non-life underwriting risk, health underwriting risk, and operational risk
- Each risk module is further divided into sub-modules, which capture more specific risk factors within that category (interest rate risk, equity risk, mortality risk, premium and reserve risk)
- The capital requirements for each sub-module are calculated separately and then aggregated using correlation matrices to arrive at the overall SCR
Risk modules and sub-modules
- Market risk: Captures the risk of losses arising from fluctuations in financial markets, including interest rates, equity prices, property values, and exchange rates
- Counterparty default risk: Reflects the potential losses from the default or deterioration in the credit quality of counterparties, such as reinsurers, derivatives counterparties, and intermediaries
- Life underwriting risk: Covers the risks associated with life insurance contracts, including mortality, longevity, disability, lapse, and expense risks
- Non-life underwriting risk: Encompasses the risks related to non-life insurance policies, such as premium and reserve risk, lapse risk, and catastrophe risk
- Health underwriting risk: Addresses the risks stemming from health insurance obligations, both similar to life techniques (SLT) and non-SLT
- Operational risk: Captures the risk of losses resulting from inadequate or failed internal processes, people, and systems, or from external events
Correlation matrices
- Correlation matrices are used to aggregate the capital requirements from the various risk modules and sub-modules into the overall SCR
- These matrices reflect the dependencies between different risk factors and allow for diversification benefits, as not all risks are expected to materialize simultaneously
- The correlation coefficients used in these matrices are prescribed by the regulatory authorities and are based on extensive research and consultation with the insurance industry
Diversification benefits
- One of the key features of the SCR calculation is the recognition of diversification benefits, which arise from the fact that not all risks are perfectly correlated
- By holding a diversified portfolio of risks, insurers can potentially reduce their overall capital requirements, as losses in one area may be offset by gains in another
- The standard formula explicitly accounts for diversification benefits through the use of correlation matrices, which allow for some degree of risk offsetting between different modules and sub-modules
- However, the recognition of diversification benefits is subject to certain limits and restrictions, to ensure that insurers do not rely too heavily on risk diversification and maintain a prudent level of capital
Market risk module
- The market risk module is one of the main components of the Solvency Capital Requirement (SCR) calculation, focusing on the risks arising from fluctuations in financial markets
- This module captures the potential losses that an insurer may face due to changes in interest rates, equity prices, property values, credit spreads, and exchange rates
- The capital requirements for market risk are calculated using a set of standardized stress scenarios, which simulate the impact of adverse market movements on the insurer's assets and liabilities
Interest rate risk
- Interest rate risk arises from the sensitivity of an insurer's assets and liabilities to changes in the level and volatility of interest rates
- The standard formula assesses interest rate risk by applying upward and downward shocks to the yield curve, based on prescribed stress factors
- Insurers must calculate the impact of these shocks on the value of their interest-rate sensitive assets (bonds) and liabilities (insurance contracts with guaranteed returns)
- The capital requirement for interest rate risk is determined as the maximum loss resulting from the upward and downward stress scenarios
Equity risk
- Equity risk refers to the potential losses arising from changes in the level or volatility of equity prices
- The standard formula distinguishes between two types of equity exposures: type 1 (listed equities in developed markets) and type 2 (unlisted equities, private equity, hedge funds, and other alternative investments)
- The stress scenarios for equity risk involve a 39% downward shock for type 1 equities and a 49% downward shock for type 2 equities
- Insurers must calculate the impact of these shocks on the value of their equity holdings and determine the resulting capital requirement
Property risk
- Property risk captures the potential losses from changes in the level or volatility of real estate prices
- The standard formula applies a 25% downward shock to the value of an insurer's property investments
- Insurers must assess the impact of this shock on their property portfolio and calculate the corresponding capital requirement
Spread risk
- Spread risk arises from the sensitivity of the value of assets, liabilities, and financial instruments to changes in the level or volatility of credit spreads over the risk-free interest rate term structure
- The standard formula assesses spread risk by applying a set of risk factors to the market value of an insurer's fixed-income investments, based on their credit quality and duration
- The capital requirement for spread risk is calculated as the impact of the prescribed stress scenarios on the value of the insurer's assets
Currency risk
- Currency risk refers to the potential losses arising from changes in exchange rates
- The standard formula assesses currency risk by applying a 25% upward or downward shock to the value of an insurer's net assets denominated in foreign currencies
- Insurers must calculate the impact of these shocks on their foreign currency exposures and determine the resulting capital requirement
Concentration risk
- Concentration risk captures the additional risks stemming from a lack of diversification in an insurer's asset portfolio or from large exposures to individual counterparties
- The standard formula assesses concentration risk by comparing an insurer's exposure to each counterparty or group of connected counterparties against a set of threshold values
- Capital charges are applied to exposures exceeding these thresholds, with the charges increasing as the concentration level rises
- Insurers must aggregate the capital charges for all exposures to determine the overall capital requirement for concentration risk
Life underwriting risk module
- The life underwriting risk module is another key component of the Solvency Capital Requirement (SCR) calculation, focusing on the risks associated with life insurance contracts
- This module captures the potential losses that an insurer may face due to deviations in the assumptions used to price and reserve for life insurance policies, such as mortality rates, longevity, disability, lapses, and expenses
- The capital requirements for life underwriting risk are calculated using a set of standardized stress scenarios, which simulate the impact of adverse developments on the insurer's life insurance obligations
Mortality risk
- Mortality risk arises from the potential for actual mortality rates to be higher than assumed in the pricing and reserving of life insurance contracts
- The standard formula assesses mortality risk by applying a permanent 15% increase to the best estimate mortality rates used by the insurer
- Insurers must calculate the impact of this stress on their life insurance liabilities and determine the resulting capital requirement
Longevity risk
- Longevity risk refers to the potential losses arising from policyholders living longer than expected, leading to higher than anticipated annuity payments
- The standard formula assesses longevity risk by applying a permanent 20% decrease to the best estimate mortality rates used for annuity contracts
- Insurers must evaluate the impact of this stress on their annuity obligations and calculate the corresponding capital requirement
Disability-morbidity risk
- Disability-morbidity risk captures the potential losses from higher than expected rates of disability or morbidity among policyholders
- The standard formula assesses this risk by applying a combination of stresses to the best estimate assumptions for disability and morbidity rates, as well as to the recovery rates and termination rates
- Insurers must determine the impact of these stresses on their disability and health insurance liabilities and calculate the resulting capital requirement
Lapse risk
- Lapse risk arises from the potential for policyholders to surrender or lapse their insurance contracts at rates that deviate from the assumptions used in pricing and reserving
- The standard formula assesses lapse risk by applying both permanent increases and decreases to the best estimate lapse rates, as well as a mass lapse event
- Insurers must calculate the impact of these stresses on their life insurance liabilities and determine the capital requirement as the maximum loss across the scenarios
Expense risk
- Expense risk refers to the potential losses arising from higher than expected expenses associated with administering and servicing life insurance contracts
- The standard formula assesses expense risk by applying a permanent 10% increase to the best estimate expense assumptions, along with an increase of 1 percentage point to the expense inflation rate
- Insurers must evaluate the impact of these stresses on their life insurance liabilities and calculate the corresponding capital requirement
Revision risk
- Revision risk captures the potential losses from unfavorable changes in the level, trend, or volatility of revision rates for annuities exposed to revision risk
- The standard formula assesses revision risk by applying a permanent 3% increase to the best estimate revision rates
- Insurers must determine the impact of this stress on their relevant annuity obligations and calculate the resulting capital requirement
Catastrophe risk
- Life catastrophe risk arises from extreme or irregular events that are not adequately captured by the other life underwriting risk sub-modules, such as pandemics or terrorist attacks
- The standard formula assesses life catastrophe risk by applying a prescribed set of stress scenarios, which vary depending on the geographical location and the type of insurance contracts
- Insurers must evaluate the impact of these stress scenarios on their life insurance liabilities and determine the capital requirement as the maximum loss across the scenarios
Non-life underwriting risk module
- The non-life underwriting risk module is a crucial component of the Solvency Capital Requirement (SCR) calculation, addressing the risks associated with non-life insurance contracts
- This module captures the potential losses that an insurer may face due to deviations in the assumptions used to price and reserve for non-life insurance policies, such as claims frequency, severity, and expenses
- The capital requirements for non-life underwriting risk are calculated using a set of standardized stress scenarios, which simulate the impact of adverse developments on the insurer's non-life insurance obligations
Premium and reserve risk
- Premium risk refers to the potential losses arising from the inadequacy of premiums charged for non-life insurance contracts, relative to the actual claims and expenses incurred
- Reserve risk arises from the potential for actual claims payments to exceed the reserves set aside for outstanding claims
- The standard formula assesses premium and reserve risk by applying a set of prescribed factors to the insurer's premium and reserve volumes, based on the specific line of business and geographical location
- Insurers must calculate the capital requirement for premium and reserve risk as the sum of the charges for each line of business and geographical segment
Lapse risk
- Lapse risk in the non-life context refers to the potential losses arising from the discontinuance or surrender of non-life insurance contracts by policyholders
- The standard formula assesses non-life lapse risk by applying a prescribed stress scenario, which assumes a combination of a permanent increase in lapse rates and a mass lapse event
- Insurers must evaluate the impact of this stress scenario on their non-life insurance liabilities and calculate the corresponding capital requirement
Catastrophe risk
- Non-life catastrophe risk arises from extreme or irregular events that are not adequately captured by the premium and reserve risk sub-module, such as natural disasters or man-made catastrophes
- The standard formula assesses non-life catastrophe risk using a set of standardized scenarios, which vary depending on the type of catastrophe and the geographical location
- The scenarios cover risks such as windstorms, earthquakes, floods, hail, and industrial accidents, among others
- Insurers must calculate the capital requirement for each relevant catastrophe scenario and aggregate them to determine the overall non-life catastrophe risk charge
Health underwriting risk module
- The health underwriting risk module is a component of the Solvency Capital Requirement (SCR) calculation that focuses on the risks associated with health insurance contracts
- This module captures the potential losses that an insurer may face due to deviations in the assumptions used to price and reserve for health insurance policies, such as morbidity rates, claim frequency,
Key Terms to Review (18)
Best estimate liability: Best estimate liability refers to the actuarial calculation that reflects the expected present value of future cash flows required to meet policyholder obligations, taking into account the probabilities of different outcomes. This concept plays a crucial role in assessing an insurer's financial health, as it informs the risk margins and solvency capital requirements necessary to ensure that an insurer can meet its obligations to policyholders under various scenarios.
Capital Adequacy: Capital adequacy refers to the minimum amount of capital that financial institutions must hold in relation to their risk-weighted assets. This concept ensures that institutions have enough buffer to absorb potential losses and meet obligations, promoting stability in the financial system. Adequate capital helps protect policyholders and maintain confidence in the insurance and banking sectors, especially under stress scenarios.
Capital Buffer: A capital buffer is an additional layer of capital held by financial institutions to absorb potential losses beyond the minimum capital requirements set by regulators. This buffer serves as a safety net, enhancing the institution's resilience against financial shocks, thereby contributing to overall stability in the financial system.
Coverage ratio: The coverage ratio is a financial metric used to assess an entity's ability to meet its financial obligations, particularly in relation to insurance and risk management. It measures the extent to which an insurer's capital and reserves can cover its liabilities, helping to ensure solvency and stability in operations. A higher coverage ratio indicates a stronger capacity to absorb losses, making it essential for evaluating the financial health and risk profile of insurers.
Credit Risk: Credit risk refers to the potential that a borrower or counterparty will fail to meet their obligations in accordance with agreed terms. This risk is crucial in financial markets and affects various aspects, including the pricing of bonds, determination of yield curves, and the evaluation of investment strategies. Understanding credit risk helps assess solvency, develop risk-based capital requirements, and establish appropriate risk margins necessary for maintaining financial stability.
Discounting: Discounting is the financial process of determining the present value of future cash flows by applying a specific interest rate. This concept is crucial in evaluating the worth of future obligations or returns in today's terms, which helps assess the financial stability of entities and their ability to meet future liabilities.
Excess capital: Excess capital refers to the amount of capital that an insurer holds above the minimum requirements set by regulatory authorities, which is meant to ensure that the insurer can meet its obligations and absorb potential losses. This surplus acts as a buffer against unforeseen risks and helps maintain solvency in times of financial stress, ultimately contributing to the stability of the insurance market and protecting policyholders.
Liquidity Coverage Ratio: The liquidity coverage ratio (LCR) is a financial metric that measures a bank's ability to meet its short-term obligations using its most liquid assets. This ratio is critical in assessing a bank's liquidity risk, ensuring that it holds enough high-quality liquid assets (HQLA) to survive a significant stress scenario for at least 30 days. By maintaining an adequate LCR, financial institutions can enhance their resilience against potential liquidity crises, thereby supporting overall financial stability.
Market Risk: Market risk refers to the potential for losses in financial investments due to fluctuations in market prices or interest rates. It affects various assets and is an essential consideration for institutions that hold securities, as it can lead to significant financial instability if not properly managed. Understanding market risk is crucial when determining risk margins and ensuring solvency capital requirements, as it impacts the overall financial health and resilience of an organization.
NAIC Risk-Based Capital: NAIC Risk-Based Capital (RBC) is a framework established by the National Association of Insurance Commissioners to assess the minimum capital required for insurance companies based on their risk profiles. This system helps regulators ensure that insurers maintain sufficient capital to protect policyholders from financial instability and insolvency, considering various risks like underwriting, investments, and operational risks.
Reinsurance: Reinsurance is a financial arrangement where an insurance company transfers a portion of its risk to another insurance company, known as the reinsurer, to reduce the likelihood of a catastrophic loss. This practice helps insurers stabilize their finances by protecting against unexpected high claims and allows them to maintain solvency while providing coverage to policyholders. Through reinsurance, insurers can manage their capital requirements and improve their overall risk management strategy.
Risk margin: Risk margin refers to the additional capital that an insurer holds above its best estimate liabilities to ensure that it can meet its obligations under adverse conditions. This margin acts as a buffer against uncertainty in insurance claims and serves to protect policyholders and stakeholders from potential financial distress. It is a critical component in the calculation of solvency capital requirements, ensuring that an insurer remains financially stable even during periods of unexpected losses.
Risk transfer: Risk transfer is the process of shifting the financial burden of risk from one party to another, typically through mechanisms such as insurance or reinsurance. This allows the original party to mitigate potential losses and manage their overall exposure to uncertain events. By employing risk transfer strategies, organizations can ensure greater stability and predictability in their financial planning, while also enhancing their capacity to absorb unexpected shocks.
Solvency Capital Requirement: The Solvency Capital Requirement (SCR) is the minimum amount of capital that an insurance or reinsurance company must hold to ensure it can meet its obligations over a specified time horizon, even in adverse conditions. This requirement aims to protect policyholders and maintain the stability of the financial system by ensuring insurers have enough capital to cover potential losses.
Solvency II: Solvency II is a comprehensive regulatory framework for insurance companies in the European Union, designed to ensure that insurers maintain adequate capital to meet their liabilities. This framework emphasizes risk-based capital requirements, promoting a more holistic approach to risk management, aligning capital with the risks that insurers face.
Solvency ratio: The solvency ratio is a key financial metric used to measure an organization's ability to meet its long-term debt obligations. It compares an entity's total assets to its total liabilities, helping assess financial health and stability. A higher solvency ratio indicates a stronger financial position, as it shows that the entity has more assets than liabilities, which is essential in determining risk and ensuring compliance with capital requirements.
Stress Testing: Stress testing is a risk management tool used to evaluate the resilience of financial systems and institutions under extreme conditions. It involves simulating adverse scenarios to assess potential impacts on capital, liquidity, and overall financial stability. This technique is crucial for understanding vulnerabilities and ensuring that organizations can withstand severe economic shocks.
Value-at-Risk: Value-at-Risk (VaR) is a financial metric used to quantify the level of financial risk within a firm or investment portfolio over a specific time frame. It provides an estimate of the potential loss in value of an asset or portfolio, given normal market conditions, within a set confidence interval. VaR is essential for understanding the risk margins needed for solvency capital requirements, helping firms manage their capital and ensure they have enough resources to cover potential losses.