Some grave incoherencies remain in the Solvency II framework despite significant improvements in the most recent quantitative impact study.

Dr Philippe Foulquier provides some suggestions on how it can be improved ahead of the next quantitative impact study.

EDHEC has just released its response to CP20 (Foulquier and Sender, January 2007). CP20 is the current consultation paper initiated by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) on the "Advice to the European Commission in the framework of the Solvency II project on Pillar I issues". The current consultation is a very important stage as it aims to prepare for the Quantitative Impact Study 3, due in spring, and also because the European Commission is due to release the Solvency II Directive in 2007. This directive shall be applied to national regulations and implemented in 2010.

There has been significant progress since the framework proposed in the Quantitative Impact Study 2 (QIS2), which lays out the main proposals for the basis of the standard solvency formula. In a previous study (Amenc, Foulquier, Martellini and Sender, November 2006) and also a position paper (Foulquier and Sender, November 2006), EDHEC focused on certain aspects of the modelling suggested by CEIOPS in QIS2, demonstrating that the choice of certain concepts, measures and calibrations were sometimes hazardous and in contradiction with the goals of the evolution in the solvency framework. More precisely:

  • Concerning market risks, it was argued that factor-based methods should not be used;
  • For credit risks, the difference in risk capital between an AA-rated bond and an A-rated bond was said to be disproportionate with their relative default probabilities;
  • The authors totally disagreed with the approach suggested in QIS2 for non-life reserve risk because of the use of standard market volatilities. The measure of premium risk through the historical volatility of the net combined ratio was at odds with the nature of the non-life business;
  • In terms of calibration, they proved the importance of having realistic scenarios in the case of hedgeable risk factors by showing that inadequate calibration, as was the case in QIS2 - and still is in CP20 for equity risk - creates incentives for opportunistic regulatory capital arbitrage rather than efficient risk management; and
  • The importance of recognising the tools available to mitigate risks was underlined, especially where CEIOPS had failed to do so.
  • Since then, there has been a significant improvement in the framework proposed in CP20. For instance, the use of factor-based methods to calculate market risks has been suppressed and replaced by scenario analysis. Equally important is the fact that CEIOPS has abandoned the reference to the net combined ratio as the sole indicator of the profitability of non-life business. This is because the original methodology proposed in QIS2 was backward looking and ignored the important fact that profit also emerges from financial revenues.
  • Lingering flaws in the framework
  • EDHEC's response to CP20 focuses on the flaws that remain in the proposed structure, and more particularly on four points:
  • Cost of capital and financial risk - The current proposal on the cost of capital does not allow a reflection of the risk at the level of the lines of business, because required capital is proposed to be proportional to the technical provisions and not to the risk. They suggest a definition of the required capital per line of business as a function of the liability risk of each line of business. Secondly, they demonstrate that the lack of guidelines in the CEIOPS' proposal may lead to lack of comparability because of diverging interpretations. CEIOPS must define the classes of risks that are to be hedgeable and non-hedgeable. Thirdly, they propose that the component of financial risk that cannot be hedged be accounted for in asset liability management (ALM) risk.
  • For the 75th percentile method, the lack of guidelines in this approach may lead to financial risk being added to insurance risk. More precisely, it is argued that it leads to an overestimation of the desired market value margin, because "hedgeable" financial risk may be added to the calculation of "non-hedgeable" insurance risk. Secondly, because CEIOPS currently fails to recognise inflation risk as hedgeable or to separate it from non-hedgeable insurance risk, it generates both an additional capital requirement (solvency capital requirement through asset liability management risk) and additional technical provisions (market value margin). Thirdly, it does not favour comparability between companies because market value margin may reflect insurance risk only in some companies, but insurance risk and financial risk together in other companies. Guidance must be given so that only the non-hedgeable risks are valued with a margin. Finally, when computing the available capital in the balance sheet, risk margins should be aggregated in the same way as risk capital charges so as to avoid any situation where the risk margins could be larger than the economic capital.
  • Market consistency - The second analysis insists on the importance of being market-consistent in the calibration of the scenarios used as a proxy to measure risk. Dynamic strategies must be recognised in order to avoid opportunistic capital arbitrage taking place instead of healthy risk management. This lack is a real hindrance to the use of ALM techniques. Lastly, the bond market is not correctly described in terms of risk factors (choosing only one factor leads to an inability to explain a large part of the source of volatility).
  • Structure of the standard approach - In some cases, the buffer component of the profit sharing can be used against non-market losses, and therefore the reduction should apply at a higher level than CEIOPS has proposed (market risks only). Moreover, in the current system there is a risk of double counting the catastrophe risk, which should be avoided. In order to protect policyholders and the industry as a whole, CEIOPS must provide clear incentives for using financial protection to cover catastrophe losses.
  • Internal model recommendations - Some guidelines must be given as early as possible to avoid cherry picking in internal models.
  • The standard formula represents a short-term view on the solvency of insurance companies, just as Basel II does for banks. This is despite the fact that the nature of the insurance business is more long term. The long-term nature of this business and its risks would ideally plead for an ALM-based regulation where solvency requirements are calculated from internal models, provided these reflect management actions and vice versa.
  • Nevertheless, there has been significant progress since the framework proposed in QIS2. In particular, most of the concepts appear to be clear, as should be the case in an economic framework. However, the very nature of the insurance business, where risks from different sources are combined, in particular hedgeable and non-hedgeable risks, makes it necessary to give precise guidelines. the road ahead
  • CEIOPS must now focus on improving the guidelines to be applied when calculating the solvency capital requirements. Guidelines are necessary to avoid the temptation of cherrypicking, but also to avoid diverging interpretations of the concepts and methods to apply, which would make the comparability of the balance sheets illusory. Most dangerously, the lack of guidelines may lead on the one hand to double counting of risks and hence an excessive market value margin (such as with catastrophe risk or where financial risk may be mixed with insurance risk) and, on the other, to excessive capital requirements or arbitrage strategies.
  • More generally, as far as calibration is concerned, the principle should be calibration to market prices where these are available, as well as a symmetrical treatment of assets and liabilities. Where, as is the case today in the formula proposed by CEIOPS, risk is calculated by taking all actions from management into account on the liability side but none on the asset side, the relevance of the results can legitimately be questioned.
  • Dr Philippe Foulquier is professor of finance and accounting and director of the EDHEC Financial Analysis and Accounting Research Centre.
  • Solvency II What is ALM?
  • Asset liability management (ALM) is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. ALM can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies relating to assets and liabilities to achieve an organisation's financial objectives, given the organisation's risk tolerances and other constraints. ALM is critical for the sound management of the finances of any organisation that invests to meet its future cash flow needs and capital requirements. ALM is also a vital element within an enterprise risk management framework.