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,