Final EIOPA proposals for changes to the standard formula SCR

1. Background

The European Commission asked EIOPA to review the standard formula used to calculate the Solvency Capital Requirement (“SCR”), focussing on simplifications, removal of technical inconsistencies and removal of unjustified financing constraints. EIOPA has now finalised its Advice to the Commission. We produced a newsletter in February 2018 setting out the proposals (see this post) and we set out below a summary of the final proposals. Whilst the changes are largely around the formula itself, proposals are also made in respect of governance and reporting of certain aspects.

The European Commission will consider the Advice and is expected to finalise its review during 2018, with a later implementation date, possibly 31 December 2019.

2. What do firms need to do now?

Firms that calculate the SCR using the standard formula should consider:

  • which of the proposed changes will affect them,
  • what changes may need to be made to calculations,
  • data requirements or processes, and
  • whether there is likely to be any significant effect on the level of the SCR.

3. Will these changes affect you?

Many of the proposals will only affect certain insurers and may not be significant even for those affected and we consider the different groups below.

Most InsurersInterest Rate Risk
Non-life InsurersPremium Risk for some lines of business
Premium risk for terms greater than 12 months
Man-Made catastrophe for marine
Simplification of fire catastrophe
Change to Natural Catastrophe
Health InsurersHealth Catastrophe Risk calculation
Insurers holding certain assetsChanges for single name exposures
Classification of unrated debt
Classification of unlisted equity
Simplifications for derivatives
Simplification for reinsurance
Allowance for investment in central counterparties
Simplification of look-through approach
Insurers with multi-currency exposureAbility to choose the local currency for use in the calculation
Insurers allowing for Loss Absorbing Capacity of Deferred TaxesRestrictions on the assumptions which can be made in the calculation together with greater governance requirements

Most insurers

Interest Rate Risk
EIOPA is proposing changes to make the calculation more appropriate in a low interest rate environment and where there are negative interest rates.  The proposal is for a relative shift approach to the stress parameters, which is likely to increase the interest rate risk SCR.  It proposes a three year transition period for the change, indicating that it expects the effect to be potentially significant – average solvency ratios are estimated to reduce from 216% to 202%.

Non-life insurers

Non-life underwriting risk
Changes are proposed to the factors used for calculating premium and reserve risk for certain non-life underwriting lines of business: medical expenses, credit and suretyship, assistance, legal expenses, and worker compensation.  As some have increased and others decreased, the effects will depend on the mix of business.  Note that there have been some changes from the original proposals.

Changes to the volume measure used to calculate premium risk for non-life underwriting risk are proposed that will only affect insurance with terms greater than twelve months.

Catastrophe risk
Changes are proposed to the calculation for man-made catastrophe risk.  These will ensure a non-zero SCR for all firms writing marine business unless the value insured is less than €250k and provide a simplification for fire catastrophe risk.  The changes will also clarify the need to assess the largest exposures net of reinsurance.

Changes are proposed to the factors used to calculate the natural catastrophe risk SCR for the property line of business, including the use of the highest risk factor if the risk zone cannot be identified.

Health insurers

Health catastrophe risk
Changes to the factors used to calculate health catastrophe risk are proposed in line with the original proposal.  As some have increased and others decreased, the effects will depend on the mix of business.

Insurers holding certain assets

Market concentration risk and counterparty default risk
Changes are proposed to the calculation of the risk factors for single name exposures that consist of both exposure to a single solo insurer or a credit or financial institution and other exposure.

Changes are proposed to enable classification of some unrated debt and unlisted equities to specific credit ratings based on meeting certain conditions and internal assessments.  This will enable reductions in the SCR for some insurers.

Simplifications are proposed for insurers holding derivatives or reinsurance.  They are only likely to affect those holding derivatives currently defined as type 2, derivatives held under contractual netting arrangements and reinsurance that only affects one line of business.

Changes are proposed to allow for the risk-mitigating effect of central counterparties for those insurers using central clearing houses for derivatives, thus reducing SCR.

Look-through approach
Where look-through is not possible, EIOPA proposes expanding the possible simplifications:

  • not including unit-linked and index-linked products in the 20% limit for use of target asset allocation method
  • allowing use of the last reported asset allocation provided certain conditions are met
  • allowing prudent grouping of exposures

In our experience, some insurers have already been using the last two simplifications in the absence of information enabling use of other method.

EIOPA also proposes adding an extra qualitative condition for using look-through simplifications, based on the nature, scale and complexity of risks.  This may mean that some insurers currently using simplifications may not be able to in future.

Insurers with multiple currency exposure

Groups with multiple currency exposure will be able to choose their local currency for this calculation.  Groups with significant exposure to one particular currency but using a different currency to prepare consolidated financial statements who use this option will see a reduced currency SCR.

Insurers allowing for the Loss Absorbing Capacity of Deferred Taxes (“LAC DT”)

LAC DT normally relates to net deferred tax liabilities or expected future profits.  EIOPA is proposing changes to regulations on the use of the latter. In particular, it proposes restrictions on the assumptions used to take account of the financial and solvency position after the shock loss and the increased uncertainty around the projection of future profits.  Assumptions should not be more favourable than those used in the best estimate or allow for new business sales beyond the business planning period.

EIOPA is also proposing greater governance around the projection assumptions through the risk management or actuarial function and the Board and related additional disclosure through the SFCR and RSR.

For those firms allowing for LAC DT, the proposals may well lead to a lower LAC DT amount and therefore higher capital requirements, due to the additional restrictions on the future profits projections, and to additional oversight requirements.

4. What has not changed?

No change is proposed in the calculation of the risk margin, so the Cost of Capital rate remains at 6% pa.

The original proposal for changes to mortality stresses for life underwriting risk is no longer advised.