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Give a summary of what the Solvency II framework requires of insurance companies in terms of capital.

FRM® Part II · Operational Risk and Resilience · Capital Regulation Before the Global Financial Crisis · FRM2.ORR.21.h

The idea

Solvency II is the risk-based capital framework for insurers and reinsurers in the European Union, in force from 2016, and it also has three pillars. Pillar 1 sets quantitative requirements on a market-consistent balance sheet. The Solvency Capital Requirement (SCR) is calibrated to a 99.5 percent one-year value at risk, a one-in-200-year loss. The lower Minimum Capital Requirement (MCR) is the level below which supervisory action becomes severe. The SCR can be found with the standard formula or an approved internal model. In the standard formula the risk modules are market, counterparty default, life, health and non-life underwriting. They are combined with a correlation matrix, where ρij is the correlation between modules i and j, as follows: SCR = √(Σ ρij × SCRi × SCRj). Then operational risk is added and a loss-absorbency adjustment deducted. Pillar 2 covers governance and the own risk and solvency assessment. Pillar 3 covers reporting and disclosure.

Formulas

Solvency II aggregated module requirement

BSCR = √(Σ Σ ρij × SCRi × SCRj)

ρij
the correlation between risk modules i and j, with ρii equal to 1
SCRi, SCRj
the capital requirements of modules i and j

The standard formula. The SCR then adds operational risk and deducts the loss-absorbency adjustment.

Solvency II capital requirement

SCR = BSCR + Op + Adj

BSCR
the basic SCR aggregated across risk modules
Op
the operational risk requirement
Adj
the adjustment for loss-absorbing capacity, a negative amount

Calibrated to a 99.5 percent one-year VaR. The adjustment reduces the total, so add it with its sign.

A practice question

From the question bank, with the reason each wrong option is wrong.

To which institutions does the Solvency II framework apply?

  1. Banks and investment firms in the European Union, under CRD and CRRWhy not: Bank capital in the EU follows the Basel-based capital requirements framework, not Solvency II.
  2. Insurance companies and banks in all Basel Committee member countriesWhy not: Solvency II is a European Union framework for insurers, not a global bank standard.
  3. Pension funds and mutual funds in the European Union onlyWhy not: Solvency II targets insurers and reinsurers; funds are regulated separately.
  4. Insurance and reinsurance companies in the European Union - correct

Solvency II is the EU risk-based capital regime for insurers and reinsurers, in force since 2016, and is often called the insurance counterpart of Basel II.

A harder one

Under Solvency II, which pillar covers governance, risk management systems and the insurer's own risk and solvency assessment (ORSA)?

  1. Pillar 2, the qualitative supervisory review requirements - correct
  2. Pillar 1, the quantitative capital requirements for the balance sheetWhy not: Pillar 1 covers valuation of assets and liabilities and the SCR and MCR, not governance.
  3. Pillar 3, supervisory reporting and public disclosureWhy not: Pillar 3 covers supervisory reporting and public disclosure.
  4. The Solvency I premium-based marginWhy not: Solvency I was the earlier factor-based regime that Solvency II replaced; it has no ORSA.

As in Basel II, Pillar 1 is quantitative, Pillar 2 is governance and supervisory review (including the ORSA) and Pillar 3 is disclosure.

The hardest tier

An insurer has standard formula modules of market 100, counterparty default 40 and non-life underwriting 80 (USD million). Correlations are 0.25 (market and default), 0.25 (market and non-life) and 0.50 (default and non-life). Operational risk capital is 15, and the adjustment for the loss-absorbing capacity of deferred taxes is -20. The SCR, with SCR = BSCR + operational risk + adjustment, is closest to:

  1. USD 164.9 millionWhy not: Stops at the basic SCR; it omits operational risk and the loss-absorbency adjustment.
  2. USD 179.9 millionWhy not: Adds operational risk but omits the negative loss-absorbency adjustment.
  3. USD 215.0 millionWhy not: Adds the three modules without correlation, losing the diversification benefit.
  4. USD 159.9 million - correct

BSCR² = 100² + 40² + 80² + 2 x (0.25x4000 + 0.25x8000 + 0.5x3200) = 18000 + 9200 = 27200, so BSCR = 164.9. SCR = 164.9 + 15 - 20 = 159.9.

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