Solvency II: Forecasting liabilities

Traditionally products were priced such that they would turn in a profit while prudent assumptions in the reserving aimed at ensuring that there was enough in the kitty to pay the policyholders what they were owed.

This was not just the case in the UK but across Europe. The Solvency I directive essentially asked firms to reserve using prudent assumptions and then add 4 per cent of this as capital. This broad brush technique developed in the 1970s for the EEC members at the time was not risk sensitive and left a good deal of subjective choice over what was considered a “prudent” assumption.

Solvency II is an attempt to make the reserving more transparent, ensuring that reserves are calculated on a market consistent / best estimate basis and that all prudence is captured in an additional capital requirement. That capital requirement is intended to enable the insurer to still have more assets than reserves after an extreme shock. The politicians have even quantified how severe the shock should be as one in 200 over one year.

But Solvency II goes much further, allowing companies to use their own capital models (internal models) to calculate the amount of capital they need to hold. So firms taking this internal model route are asking the regulators to trust that their internal model will correctly calculate the capital requirement.

That is quite a change in the insurer-regulator relationship, so why would a regulator want to do this? It is simply because for many firms (especially the large firms) their business is so complex that even a relatively sophisticated risk-based capital formula (as developed for Solvency II) cannot capture the complexity of these firms.

In return for this trust the firms asking to use internal models are required to jump through a lot of hoops (tests) to justify their models to the regulators. One of the most important tests is called the ‘use test’. This holds the insurer to task over how they use the model. The regulators want to see that the model is used for making real business decisions. There is some flexibility of how this is demonstrated but using the internal model in product design is certainly fair game and so many insurers are having to more tightly connect the products they sell with the capital those products consume.

Solvency II is increasing the charges for insurers holding credit and equity. This is making traditional long-term participating products with guarantees more expensive in capital terms and therefore less attractive. This is not just the case in the UK where equity-backed guarantees have been popular but also in many European countries where guarantees backed by credit are popular savings vehicles. The issue also arises for similar products in US subsidiaries of European insurers. Perhaps you were wondering why those internal models could not just use a lower charge for equity or credit? The regulators have a hoop called the ‘statistical quality test’ too, which ensures that the capital held is maintained at those high levels. If insurers want to lower the capital charges they need to provide a lot of evidence and regulators still have the right to say no.