PROBABILITY OF SUFFICIENCY OF SOLVENCY II RESERVE RISK MARGINS: PRACTICAL APPROXIMATIONS

2017 ◽  
Vol 47 (3) ◽  
pp. 737-785 ◽  
Author(s):  
Eric Dal Moro ◽  
Yuriy Krvavych
Keyword(s):  
Life Insurance ◽  
Confidence Level ◽  
Cost Of Capital ◽  
Cash Flows ◽  
Solvency Ii ◽  
Risk Profile ◽  
List Type ◽  
Risk Margin ◽  
Insurance Contracts ◽  
The Cost

AbstractThe new Solvency II Directive and the upcoming IFRS 17 regime bring significant changes to current reporting of insurance entities, and particularly in relation to valuation of insurance liabilities. Insurers will be required to valuate their insurance liabilities on a risk-adjusted basis to allow for uncertainty inherent in cash flows that arise from the liability of insurance contracts. Whilst most European-based insurers are expected to adopt the Cost of Capital approach to calculate reserve risk margin — the risk adjustment method commonly agreed under Solvency II and IFRS 17, there is one additional requirement of IFRS 17 to also disclose confidence level of the risk margin.Given there is no specific guidance on the calculation of confidence level, the purpose of this paper is to explore and examine practical ways of estimating the risk margin confidence level measured by Probability of Sufficiency (PoS). The paper provides some practical approximation formulae that would allow one to quickly estimate the implied PoS of Solvency II risk margin for a given non-life insurance liability, the risk profile of which is specified by the type and characteristics of the liability (e.g. type/nature of business, liability duration and convexity, etc.), which, in turn, are associated with•the level of variability measured by Coefficient of Variation (CoV);•the degree of Skewness per unit of CoV; and•the degree of Kurtosis per unit of CoV2.The approximation formulae of PoS are derived for both the standalone class risk margin and the diversified risk margin at the portfolio level.

scholarly journals Issues of risk margin computation under Solvency II regulatory regime

2021 ◽  
Vol 37 (1) ◽  
pp. 7-40
Author(s):  
Jelena Kočović ◽  
Marija Koprivica
Keyword(s):  
Interest Rates ◽  
Life Insurance ◽  
Solvency Ii ◽  
Capital Cost ◽  
Insurance Companies ◽  
Regulatory Regime ◽  
Risk Margin ◽  
Low Interest Rates

The paper deals with the issues of risk margin computation as an element of technical provisions of Insurers under the Solvency II regulatory regime. Due to a lack of regulatory method for the capital cost, in combination with the low interest rates, the risk margin is set too high and variable, which primarily affects life insurance companies. The paper includes particular proposals for overcoming or mitigating the problem of too high and rate-sensitive risk margin. The proposed solutions include both modifications to the existing capital cost method and abandonment and the replacement of this method by other risk margin computation methods.

scholarly journals A Case for using a Real Asset Transaction Approach for Estimating the Cost of Capital from Rural Telephone Company Data

2018 ◽  
pp. 5-16
Author(s):  
Victor Glass ◽  
Keyword(s):  
Risk Premium ◽  
Cost Of Capital ◽  
Traditional Approach ◽  
Weighted Average ◽  
Cash Flows ◽  
Financial Assets ◽  
Publicly Traded ◽  
Local Exchange ◽  
Telephone Companies ◽  
The Cost

This paper develops a real asset transaction approach for estimating the cost of capital for rural telephone companies whose financial assets are not publicly traded. The transaction approach uses the actual purchase prices of rural local exchange carriers (RLECs)’ properties and cash flows for estimating the rate of return required by buyers and sellers of RLEC properties. The transaction approach produces higher cost of capital estimates than a traditional approach using a weighted average of debt and equity costs of proxy companies traded on organized exchanges. The estimated difference is in line with the risk premium estimated for small non-traded companies estimated by Duff and Phelps Ibbotson.

scholarly journals Loss portfolio transfer treaties within Solvency II capital system: a reinsurer’s point of view

2020 ◽  
Vol 11 (1) ◽  
pp. 1-10
Author(s):  
Nicolino Ettore D’Ortona ◽  
Gabriella Marcarelli ◽  
Giuseppe Melisi
Keyword(s):  
Cost Of Capital ◽  
Solvency Ii ◽  
Capital Requirements ◽  
Point Of View ◽  
Insurance Company ◽  
Specific Level ◽  
Collective Risk ◽  
Risk Appetite ◽  
Reinsurance Treaty ◽  
The Cost

Loss portfolio transfer (LPT) is a reinsurance treaty in which an insurer cedes the policies that have already incurred losses to a reinsurer. This operation can be carried out by an insurance company in order to reduce reserving risk and consequently reduce its capital requirement calculated, according to Solvency II. From the viewpoint of the reinsurance company, being a very complex operation, importance must be given to the methodology used to determine the price of the treaty.Following the collective risk approach, the paper examines the risk profiles and the reinsurance pricing of LPT treaties, taking into account the insurance capital requirements established by European law. For this purpose, it is essential to calculate the capital need for the risk deriving from the LPT transaction. In the case analyzed, this requirement is calculated under Solvency II legislation, considering the measure of variability determined via simulation. This quantification was also carried out for different levels of the cost of capital rate, providing a range of possible loadings to be applied to the premium. In the case of the Cost of Capital (CoC) approach, the results obtained provide a lower level of premium compared to the percentile-based method with a range between 2.69% and 1.88%. Besides, the CoC approach also provides the advantage of having an explicit parameter, the CoC rate whose specific level can be chosen by the reinsurance company based on the risk appetite.

The Characteristics, Valuation Methods, and Information Use of Valuation Specialists

2020 ◽  
Vol 34 (3) ◽  
pp. 23-38 ◽  
Author(s):  
Kristian D. Allee ◽  
Devon Erickson ◽  
Adam M. Esplin ◽  
Teri Lombardi Yohn
Keyword(s):  
Cost Of Capital ◽  
Information Use ◽  
Cash Flows ◽  
Jel Classification ◽  
Professional Judgment ◽  
Discounted Cash Flow ◽  
Future Earnings ◽  
Valuation Model ◽  
Risk Free Rate ◽  
The Cost

SYNOPSIS We provide insights into the inputs and valuation models used by valuation specialists. We survey 172 valuation specialists and conduct several follow-up interviews covering various topics, including the valuation inputs, models, and industry information that they use, as well as how they estimate long-term growth and the cost of capital. We find that valuation specialists rely on their professional judgment to select a valuation model but prefer the discounted cash flow (DCF) model. They primarily rely on the firm's historical performance when forecasting the financial statements, but communication with management is particularly relevant for forecasting future earnings or cash flows. When estimating the cost of capital, they most commonly use the risk-free rate with subjective adjustments. The results of our study provide insights on the information use of valuation specialists that are relevant to other valuation specialists, managers, academic researchers, and regulators. JEL classification: M41; G12; G17; G32.

scholarly journals A review of the risk margin – Solvency II and beyond

2020 ◽  
Vol 25 ◽  
Author(s):  
A. J. Pelkiewicz ◽  
S. W. Ahmed ◽  
P. Fulcher ◽  
K. L. Johnson ◽  
S. M. Reynolds ◽  
...  
Keyword(s):  
Cost Of Capital ◽  
Working Party ◽  
Solvency Ii ◽  
Risk Margin ◽  
Life Insurers ◽  
Wide Range ◽  
The Difference ◽  
Set Up ◽  
The Uk ◽  
The Impact

Abstract For life insurers in the United Kingdom (UK), the risk margin is one of the most controversial aspects of the Solvency II regime which came into force in 2016. The risk margin is the difference between the technical provisions and the best estimate liabilities. The technical provisions are intended to be market-consistent, and so are defined as the amount required to be paid to transfer the business to another undertaking. In practice, the technical provisions cannot be directly calculated, and so the risk margin must be determined using a proxy method; the method chosen for Solvency II is known as the cost-of-capital method. Following the implementation of Solvency II, the risk margin came under considerable criticism for being too large and too sensitive to interest rate movements. These criticisms are particularly valid for annuity business in the UK – such business is of great significance to the system for retirement provision. A further criticism is that mitigation of the impact of the risk margin has led to an increase in reinsurance of longevity risks, particularly to overseas reinsurers. This criticism has led to political interest, and the risk margin was a major element of the Treasury Committee inquiry into EU Insurance Regulation. The working party was set up in response to this criticism. Our brief is to consider both the overall purpose of the risk margin for life insurers and solutions to the current problems, having regard to the possibility of post-Brexit flexibility. We have concluded that a risk margin in some form is necessary, although its size depends on the level of security desired, and so is primarily a political question. We have reviewed possible alternatives to the current risk margin, both within the existing cost-of-capital methodology and considering a wide range of alternatives. We believe that requirements for the risk margin will depend on future circumstances, in particular relating to Brexit, and we have identified a number of possible changes to methodology which should be considered, depending on circumstances.

scholarly journals The Cost of Financial Frictions for Life Insurers

2015 ◽  
Vol 105 (1) ◽  
pp. 445-475 ◽  
Author(s):  
Ralph S. J. Koijen ◽  
Motohiro Yogo
Keyword(s):  
Financial Crisis ◽  
Life Insurance ◽  
Cost Of Capital ◽  
Financial Frictions ◽  
Life Insurers ◽  
Pricing Behavior ◽  
Different Types ◽  
Shadow Cost ◽  
The Cost

During the financial crisis, life insurers sold long-term policies at deep discounts relative to actuarial value. The average markup was as low as −19 percent for annuities and −57 percent for life insurance. This extraordinary pricing behavior was due to financial and product market frictions, interacting with statutory reserve regulation that allowed life insurers to record far less than a dollar of reserve per dollar of future insurance liability. We identify the shadow cost of capital through exogenous variation in required reserves across different types of policies. The shadow cost was $0.96 per dollar of statutory capital for the average company in November 2008. (JEL G01, G22, G28, G32)

scholarly journals A Bridge between Local GAAP and Solvency II Frameworks to Quantify Capital Requirement for Demographic Risk

Risks ◽  
2021 ◽  
Vol 9 (10) ◽  
pp. 175
Author(s):  
Gian Paolo Clemente ◽  
Francesco Della Corte ◽  
Nino Savelli
Keyword(s):  
Life Insurance ◽  
Random Variable ◽  
Mortality Rates ◽  
Solvency Ii ◽  
Capital Requirement ◽  
Insurance Contracts ◽  
Financial Conditions ◽  
Accounting Principles ◽  
Demographic Risk

The aim of this paper is to provide a stochastic model useful for assessing the capital requirement for demographic risk in a framework coherent with the Solvency II Directive. The model extends to the market consistent context classical methodologies developed in a local accounting framework. The random variable demographic profit, defined in literatue under local accounting principles, is indeed analysed in a Solvency II framework. We provide a unique formulation for different non-participating life insurance contracts and we prove analytically that the valuation of demographic profit can be significantly affected by the financial conditions in the market. Regarding this topic, we implement the Vašíček model to add randomness to risk-free rates. A case study has also been developed considering a portfolio of life insurance contracts. Results prove the effectiveness of the model in highlighting the main drivers of capital requirement evaluation (e.g., the volatility of both mortality rates and risk-free rates), also compared to the local GAAP framework.

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