EIOPA’s second set of advice to the European Commission on specific items in the Solvency II Delegated Regulation

Background

In July 2016, the European Commission requested a review of the standard formula calculation of the Solvency Capital Requirement (SCR). EIOPA was then asked to provide technical advice relating to the methods, assumptions and parameters used to calculate the standard formula SCR. The aim of the review was to ensure a proportional and simplified application of the requirements and to remove unintended inconsistencies.

In November 2017, EIOPA published a consultation paper which set out its proposed advice on a number of changes to the calculation of the SCR using the standard formula. This set out feedback it received on discussion papers released between December 2016 and March 2017, the analysis carried out by EIOPA and the proposed technical advice for a number of risk categories.

A summary of the key proposed changes is set out below. The final technical advice will be sent to the European Commission by the end of February 2018 when work can commence on assessing the potential impact on firms’ solvency position.

Consultation Paper Proposed Changes

1 Recalibration of standard parameters of non-life underwriting premium and reserve risks

The lines of business impacted are medical expenses, credit and suretyship, assistance, legal expenses and worker compensation.

2 Volume measure for non-life underwriting premium risk

EIOPA reviewed the definition of the volume measure for non-life underwriting premium risk to ensure that is continues to be appropriate.

EIOPA has recognised that the current calculation methodology is not ideal for policies with a term greater than 12 months but has not decided on its preferred approach.
The consultation paper is seeking feedback on two options to calculate the volume measure after the initial 12 months for future business.

The two options are either to continue to use the current calculation, or to adjust the current calculation to ensure that no gap occurs in the volume measure after the initial 12 months for future business and introduce an adjustment factor of 30%.

This change will only apply to non-life insurance business with terms greater than 12 months.

3 Recalibration of mortality and longevity risks for life underwriting risks

EIOPA has reviewed the appropriateness of the current mortality and longevity stresses and has proposed that the current 20% stress for longevity stress continues to be appropriate, and that the mortality stress factor should be increased to 25%.

EIOPA considered whether an improvement in the granularity of the mortality and longevity stress should be introduced and has decided against this as it would lead to added complexity.

4 Health catastrophe risk

Due to the difficulty firms have had in estimating the benefits payable under the prescribed mass accident and accident concentration scenarios, EIOPA is recommending the removal of one of the scenarios. The proposal is to remove the scenario for temporary disability lasting ten years caused by an accident and to allocate policies that were previously allocated to this scenario to either the scenario for temporary disability that lasts 1 year or the permanent disability scenario.

5 Man-made catastrophe risk

EIOPA is proposing the following changes to the calculation of marine, fire and aviation catastrophe risk.

Marine Risk:

  • Replace the “tanker” scenario with “vessel” to allow for a non-zero SCR for all firms writing marine business without adding any complexity to the formula.
  • Introduce a threshold (so that no catastrophe risk SCR is calculated where the maximum hull value insured is less than EUR 100,000).

Marine, Fire and Aviation Risk:

  • The largest risk exposure within the marine, fire and aviation sub-modules should be assessed net of reinsurance if the reinsurance cover alters the relative ranking of the exposure within the undertaking’s portfolio, based on the size of the exposure.
  • The undertaking must continue to use gross sum insured as the basis for the calculation if allowance for the reinsurance program would lead to a distortion of the relative exposure.

For fire catastrophe risk, EIOPA continues to believe that the existing methodology is an appropriate approach and recommends that this remains the default calculation. In recognition of the difficulties with the current methodology, EIOPA has recommended a simplified approach to the calculation of the largest fire risk concentration with a 200m
radius around the exposure address. The proposed simplified approach is to restrict the number of buildings considered in the calculation to the top five exposures per risk type (residential, commercial, industrial).

6 Natural catastrophe risk

EIOPA has proposed that all exposures which cannot be mapped to a risk zone must be considered to fall within the risk zone with the highest risk factor.

EIOPA has proposed some new provisional calibrations but has stated that these are highly likely to change and are still subject to validation.

The recalibrated/new factors are listed below:

  • Windstorm risk factors for Germany, Finland, Hungary, Slovenia, Sweden;
  • Earthquake risk factors for Greece, Italy and Slovak Republic;
  • Flood risk factors for Germany and Hungary;
  • Hail risk factors for Czech Republic and Slovenia;
  • Updated windstorm aggregation matrix for Finland, Hungary and Slovenia;
  • Updated hail aggregation matrix for Czech Republic and Slovenia;
  • Recalibrated windstorm risk zone weights for Finland, Hungary, Slovenia, Sweden;
  • Recalibrated earthquake risk zone weights for Greece and Slovak Republic;
  • Recalibrated flood risk zone weights for Hungary; and
  • Recalibrated hail risk zone weights for Czech Republic and Slovenia.

In order to allow for individual risk profiles, EIOPA has proposed the introduction of an adjustment to the calculation of the loss for each region.

The loss for each region of each country is calculated as the lower of the undertaking specific calculation of the gross exposure and the country average percentage of the risk weighted sum insured.

7 Interest rate risk

EIOPA is proposing a change in the methodology used to calculate interest rate risk, as the current methodology is not appropriate in a low yield environment with negative interest rates.

EIOPA has made two proposals, one based on a symmetric 200 basis point minimum shock with a static interest rate floor (Proposal A) and the other a combined approach (Proposal B).

Proposal A applies a percentage adjustment based on term to maturity, similar to the current approach, with a linearly calculated minimum shock depending on term. The minimum
shock is increased from 1% to 2% for terms less than 20 years. A minimum shock is now also included in the interest rate downwards scenario.

Proposal B is a combined approach which uses Proposal A in a moderate and high interest rate environment but introduces a more appropriate calculation in a low yield environment.

The calculation of the interest rate stresses under both proposals follow similar calculation methodologies to those in current use. The main changes are to the parameters.

The final proposal will be communicated in the final technical advice to the European Commission.

8 Market risk concentration

EIOPA has reviewed the assumptions underlying the current calculation of the market risk concentration sub-module and is proposing that a change should be made to the derivation of the risk factor for ‘mixed’ exposures, i.e. those which do not exclusively consist of exposures to a single solo insurer.

EIOPA has suggested two alternative proposals. No decision has yet been made, although EIOPA currently favours the second option which uses an average risk factor.

9 Currency risk at group level

EIOPA has decided to give groups with exposure to multiple currencies the flexibility to select a ‘local’ currency other than the one used for their consolidated accounts, for the purpose of the calculation of the currency risk sub-module.

10 Unrated debt

EIOPA has been asked to provide clear and conclusive criteria which can be used to determine whether bonds and loans, for which no credit assessment is available, would then be allowed to receive the calibration associated with credit quality step (CQS) 2 (or alternatively CQS 1 or 3).

EIOPA has identified two possible approaches for identifying unrated debt with a credit risk comparable with rated debt assigned to CQS 2. The first is the “internal assessment approach” and the second approach makes use of results from approved internal models for banks or insurance companies.

Under the ‘internal assessment approach’, in order to qualify for the same spread risk charge as rated debt assigned to CQS 2, an unrated debt has to meet conditions based on all of the following:

  1. The financial ratios of the borrower must meet the required thresholds which are yet to be determined;
  2. The yield on the debt of the borrower should not exceed the defined threshold;
  3. Additional conditions relating to the borrower including the fact that it has been incorporated in the European Economic Area (EEA) with limited liability for at least 10 years without a credit event and can provide financial data to the lender;
  4. Additional conditions relating to the debt including the fact that the debt is senior to all other claims except for statutory claims, trustees and derivatives counterparties; and
  5. The internal process of the insurer to identify all factors with a material effect on the credit risk associated with the debt which will require validation.

EIOPA will make a final recommendation by the end of February 2018.

11 Unlisted equity

Currently unlisted equities are treated as type 2 equities. As part of the consultation process, EIOPA was asked to provide clear and conclusive criteria which could be applied to EEA unlisted equities, in order to identify those instruments which could benefit from the same risk factor as listed equity.

EIOPA’s proposal is that investments in the unlisted equity of companies in the EU/EEA either direct or through a private equity fund or private equity fund of funds where the conditions set out below are met should be considered as type 1 equities.

In addition to the criteria above, EIOPA will also set out the look-through criteria which must apply at the end of February.

For companies from industry sectors which are not covered in the look-through criterion the type 2 equity risk charge should be applied.

12 Strategic equity investments

The consultation paper sets out information on how the criteria set out in the Delegated Regulation for the identification of strategic equity investments has been applied by insurance companies. No changes to the current approach are proposed by EIOPA.

13 Simplification of the counterparty default risk

Currently derivatives are defined as either type 1 or type 2 based on their purpose. EIOPA is proposing that all derivatives are defined as type 1.

EIOPA recommends that Article 196 (allowing for risk mitigation effect of derivatives) recognises contractual netting arrangements if the arrangement complies with Article 214 (on collateral arrangements). This would mean that all derivatives with a counterparty could be allowed for in this calculation, provided they were covered by such an arrangement, but with the minimum effect being set to zero (ie no negative effect allowed for). This has the potential to increase the calculated risk-mitigation effect and therefore reduce capital requirements. It also avoids artificial division of collateral to allow the calculation.

Following on from allowing for contractual netting arrangements in the risk-mitigating effect of derivatives, EIOPA recommends that the economic effect of such an arrangement is recognised by performing loss-given-default calculations on a counterparty level rather than separately for each derivative. Therefore, the value of derivatives, the risk-mitigating effect of derivatives and the collateral relating to the derivative should all be considered at a counterparty level.

EIOPA has proposed two additional optional simplifications, one to use when calculating the loss given default for reinsurance and the second to avoid the step change which currently occurs when the standard deviation of the loss distribution moves across the 20% trigger point.

EIOPA proposes an additional optional simplification for calculating the risk-mitigating effect of reinsurance arrangements where that reinsurance only affects one line of business.

EIOPA proposes only allowing the simplification of the calculation for reinsurance counterparties if the reinsurance recoverables are non-negative, as the simplifications do not currently produce sensible results for negative cases.

14 Treatment of exposure to CCPs and changes resulting from EMIR

A CCP is a central counterparty, i.e. central clearing house to help facilitate trades in derivatives and equities, and the use of a CCP should reduce counterparty risk. EMIR is the European Market Infrastructure Regulation on derivatives and its main aim is to reduce risk. The Solvency II regulations do not make any explicit allowance for the existence of CCPs or EMIR. EIOPA understands that no European insurer is currently a clearing member of a CCP but insurers may use a clearing member.

EIOPA has highlighted two possible options in relation to CCPs and will make a decision before the final advice is communicated.

For option 2, a change to the LGD formula in Article 192(3) would also be proposed.

EIOPA concludes that no changes should be made in relation to EMIR as the effects of EMIR are too unpredictable.

15 Simplification of the look-through approach

Article 84(1) of the Delegated Act requires a look-through approach. Article 84(3) states that if a look-through approach is not possible for collectives, the SCR can be calculated on the basis of the target asset allocation of the collective, provided this applies to a maximum of 20% of total assets by value. Article 168 states that if neither look-through nor target asset allocation approach is used, the assets must be assumed to have the same risk as type 2 equities.

EIOPA is proposing the following changes:

  1. Removal of unit-linked and index-linked products from the20% limit if they do not significantly contribute to the SCR (eg they have no significant guarantees) or where a change in value of the underlying assets does not affect the available own funds, thereby allowing wider use of target asset allocation methods
  2. Alternative, where look-through cannot be applied, of using the last reported asset allocation provided that the underlying assets are and will be managed strictly according to the reported asset allocation
  3. Allowing grouping of exposures, if applied prudently, when target asset allocation not available at necessary granularity
  4. Additional qualitative condition for applying the simplified look through based on assessment of nature, scale and complexity of risks

16 Look-through approach at group level

Currently there are diverging approaches to the application of look-through at a group level across Europe.

EIOPA has identified and consulted on two options:

a) Keeping the current look-through regulations and providing more guidance to supervisors; and

b) Treating undertaking at a group level in the same way as they are treated at solo level.

17 Loss-absorbing capacity of deferred taxes

EIOPA is looking to achieve convergence in the calculation of the loss-absorbing capacity of deferred taxes. The consultation paper sets out a number of
principles relating to the projection of future profits and will make a final decision following its review of the feedback received.

18 Risk Margin

EIOPA has undertaken a review of the appropriateness of the Cost of Capital rate used to in the calculation of the risk margin and has recommended that the rate should remain at 6%.

Senior Consultant Actuary & Client Manager
Tel: 01372 847582
Email: kathryn.moore@sda-llp.co.uk
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