Continuing the “The Standard Formula” Back to Basics series, host Rob Chaplin, with colleague William Adams, take an in-depth look at one of Solvency II’s most complex and crucial provisions: the solvency capital requirement. They discuss how it’s calculated, how it works with the minimum capital requirement, and many more features.
Episode Summary
“The Solvency Capital Requirement, or SCR, is designed to protect policyholders by helping to make sure that insurers can survive difficult periods and pay claims as they fall due.”
In this episode of "The Standard Formula" podcast, Rob Chaplin, host and head of Skadden’s Europe Financial Institutions Group, is joined by colleague Will Adams as they take an in-depth look at the Solvency Capital Requirement, one of Solvency II’s most important and complex provisions. The discussion covers the SCR’s key features, risk modules, how it’s calculated and its relationship with the Minimum Capital Requirement (MCR). They also discuss the standard formula (for an in-depth discussion of technical provisions, listen to the previous episode).
Key Points
- Understanding the Solvency Capital Requirement (SCR): SCR is a critical provision of Solvency II, designed to ensure that insurers can weather difficult periods and pay claims as they become due. The SCR sets a specific capital level an insurer must hold and must be calculated and reported annually.
- How the Standard Formula Applies: The standard formula provides a risk-sensitive approach to the calculation of the SCR, taking into account underwriting risk, market risk of the assets held by the insurer, counterparty default risk and operational risk.
- Overview of the Minimum Capital Requirement (MCR): The SCR works in tandem with the MCR, which acts as a lower, absolute minimum threshold. Like the SCR, the MCR is calculated to a “value-at-risk” of its capital, but unlike the SCR it is at a confidence level of 85% rather than 99.5%.
Voiceover (00:01):
From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner Robert Chaplin leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome back to the Standard Formula Podcast. Today I’m joined by my colleague, Will Adams. Together in this episode of our Solvency II Back to Basics series, we’ll be discussing one of Solvency II’s most important and complex provisions, the Solvency Capital Requirement. We’ll discuss its key features, how it’s calculated with a particular focus on our namesake, the standard formula, and how it works together with the minimum capital requirement. Well, let’s kick things off with an overview of the Solvency Capital Requirement.
William Adams (00:57):
Thanks, Rob. The Solvency Capital Requirement or SCR is designed to protect policyholders by helping to make sure that insurers can survive difficult periods and pay claims as they fall due. It prescribes a specific level of capital that an insurer is expected to hold calculated after taking into account a diverse range of risks. Solvency II requires that the SCR is calculated at a value-at-risk.
(01:24):
That’s subject to a 99.5% confidence level. In other words, the SCR should allow the insurer to be able to withstand all but the most extreme risks that occur less than once every 200 years. The SCR operates alongside the Minimal Capital Requirement or MCR, which is a significantly lower threshold than the SCR. If an insurer’s capital falls below the SCR, the PRA is able to intervene in the running of the insurer.
(01:54):
If the level of capital falls below the MCR, the PRA has the right to withdraw authorization and close the insurer to new business. The SCR must be calculated annually and the result must be reported to the PRA. Insurers must continue to monitor their amount of capital and their SCR on an ongoing basis.
(02:15):
If there’s a significant change in an insurer’s risk profile, it must recalculate its SCR as soon as possible and report the new result to the PRA. The SCR can be calculated by either using the standard formula prescribed by the PRA rule book and Solvency II, or by using a PRA-approved internal model bespoke to the company concerned. Regardless of the method used, there are certain features of the SCR that always apply. Over to Rob to discuss these in more detail.
Rob Chaplin (02:45):
Thanks, Will. As you rightly pointed out, there are a number of features of the SCR that apply regardless of whether an insurer uses the standard formula or their own approved internal model.
(02:58):
These are that the SCR must be calculated on the presumption that the insurer will pursue its business as a going concern, be calibrated so as to ensure that all quantifiable risks to which an insurer is exposed are taken into account, cover existing business, as well as new business expected to be written over the coming 12 months, correspond to a value at risk subject to a confidence level of 99.5% over a one-year period, cover at least the following risks, non-life underwriting risk, life underwriting risk, market risk, credit risk and operational risk, and take into account the effective risk mitigation techniques provided that credit risk and other risks arising from the use of such techniques are properly reflected.
(03:54):
The use of an approved internal model is a complex topic worthy of its own podcast episode. So stay tuned for that in the future. In the meantime, Will, why don’t you start delving into how the standard formula operates?
William Adams (04:10):
Thanks, Rob. The standard formula provides a risk sensitive approach to the calculation of the SCR taking into account underwriting risk, market risk of the assets held by the insurer, counterparty default risk and operational risk. It has four key components, the basic Solvency Capital Requirement, or basic SCR, the capital requirement for operational risk, an adjustment for the loss absorbing capacity of technical provisions.
(04:40):
For a deeper dive into technical provisions, please listen to our previous episode. And a capital requirement for intangible asset risk, which is included within the basic SCR calculation. The basic SCR is the largest component which must comprise of at a minimum six prescribed risk modules. The basic SCR figure is calculated by aggregating the capital charges arising from each of the risk modules in accordance with the prescribed formula and correlation matrix.
(05:12):
The correlation matrix factors in circumstances where an insurer has diversified its risks or holds a diversified portfolio of assets. The five key risk modules are non-life underwriting risk, which is the risk arising from non-life insurance obligations. These include non-life premium and reserve risk, and non-life catastrophe risk.
(05:35):
Life underwriting risk, which is the risk arising from life insurance obligations including mortality, longevity, disability morbidity, life expense, revision, lapse, and life catastrophe risks. Health underwriting risk, which is the risk arising from the underwriting of health insurance obligations. Market risk, which is divided into six risk sub-modules, and is the risk arising from the level of volatility of market prices of financial instruments, which have an impact on the value of the assets and liabilities of the insurer.
(06:12):
And counterparty default risk, which is the risk of possible losses due to the unexpected default or deterioration in the credit standing of counterparties and debtors over the coming 12 months. There’s an additional risk module included in the basic SCR known as the intangible asset risk module, which sets a capital charge for any amount of intangible assets valued in the Solvency II balance sheet.
(06:38):
Intangible assets are generally valued at zero and goodwill is always valued at zero, but intangible assets can be given a value if they can be sold separately and the firm can demonstrate that there’s a market value for the same or similar assets. I’ll hand back over to Rob who will go into more detail on the basic SCR’s underwriting risk modules.
Rob Chaplin (07:00):
Thanks, Will. The role of the underwriting risk modules in the basic SCR is to reflect the risk that an insurer’s insurance liabilities are higher than anticipated, such as where the technical provisions calculated in respect of such liabilities are inadequate. The non-life underwriting risk module must include at least the following risk sub-modules, non-life premium and reserve risk, which results from changes in the timing, frequency and severity of insured events, and in the timing and amount of claim settlements.
(07:35):
Non-life catastrophe risk, which is broken up into two parts, natural catastrophe and man-made catastrophe, and is the risk resulting from the significant uncertainty of pricing and provisioning assumptions related to extreme or exceptional events. And non-life lapse risk, which is the risk of the discontinuance of insurance policies.
(08:00):
The life underwriting risk module must include the following seven risk sub-modules. Mortality risk, which is the risk resulting from changes in mortality rates where an increase in the mortality rate leads to an increase in the value of insurance liabilities. Longevity risk, which is the risk resulting from changes in mortality rates where a decrease in the mortality rate leads to an increase in the value of insurance liabilities.
(08:29):
Disability morbidity risk, which is the risk resulting from changes in disability, sickness and morbidity rates. Life expense risk, which is the risk resulting from changes in the expenses incurred in servicing life insurance and reinsurance contracts. Revision risk, which is the risk resulting from changes in the revision rates applied to annuities. Lapse risk, which is the risk resulting from changes in the rates of policy lapses, terminations, renewals, and surrenders.
(09:03):
And life catastrophe risk, which is the risk resulting from the uncertainty of pricing and provisioning assumptions related to extreme or irregular events. The health underwriting risk module is designed to reflect the risk arising from the underwriting of health insurance obligations and applies to health insurance written by non-life insurers and life insurers. It must cover the following risks.
(09:30):
Risks resulting from changes in the expenses incurred in servicing insurance and reinsurance contracts, risks resulting from changes in the timing, frequency and severity of insured events, and the timing and amount of claim settlements and risks resulting from the uncertainty of pricing and provisioning assumptions relating to major epidemics as well as the accumulation of risks under such circumstances. I’ll take a breather now and hand back over to Will to discuss the remaining parts of the basic SCR, the market risk module and the counterparty default risk module.
William Adams (10:09):
Thanks, Rob. The market risk module in the basic SCR is designed to capture the risk of the value of an insurer’s assets decreasing and the value of such insurers non-insurance liabilities increasing. It’s broken down into six sub-modules that each address a different market factor. A risk charge is calculated for each sub-module that contributes to the overall capital charge for market risk.
(10:36):
The six sub-modules are as follows. First, interest rate risk, which is the risk associated with an increase or decrease in the term structure of interest rates. Second, equity risk, which is the risk associated with the fall in the value of equities. It’s worth noting that equities for this purpose has a meaning wider than merely the holdings of shares in other companies.
(11:00):
In certain circumstances, insurers must look through their equity holdings to calculate the market risk on the underlying assets held by the entity in which the equity is held. Third, property risk, which is the risk of a decrease in the value of immovable property, covering an insurer’s direct investments in land, buildings and other immovable property rights.
(11:26):
As with equity risk, in certain circumstances, an insurer must apply a look through approach, which would capture indirect investments in real estate held through funds. Fourth, market risk concentrations, which is the risk arising from an insurer having large exposures to a single counterparty or to a number of counterparties within the same corporate group covering the assets discussed the previous sub-modules.
(11:55):
Fifth, currency risk, which is the risk arising from changes in currency exchange rates, which an insurer can be exposed to from various sources, including assets denominated in currencies other than their national currency and investments located in a different currency area. Sixth, spread risk, which is the risk arising from changes in the level of volatility of credit spreads, including the risk from an insurer holding assets subject to a spread risk.
(12:27):
Certain types of instruments which would otherwise attract a capital charge under the market risk module are treated differently under the spread risk sub-module. That is attracting a 0% capital charge for spread risk exposures from highly rated covered bonds, credit derivatives where the underlying bond or loan is issued by the European Central Bank or the central government or central bank of an EU member state or the UK.
(12:56):
Exposures, which relate to qualifying infrastructure investments subject to certain conditions. And bonds or loans issued by the European Central Bank, central governments and central banks. In particular, those from EU member states in the UK, multilateral development banks, and certain international organizations, insurance or reinsurance undertakings or a third country insurance or reinsurance undertaking in an equivalent jurisdiction and certain credit and financial institutions.
(13:32):
The counterparty default risk module in the basic SCR captures the risk of losses due to the unexpected default or deterioration in the credit standing of counterparties and debtors. It’s split into type one exposures, which includes risk mitigation contracts, cash, and certain types of deposits, commitments and guarantees and type two exposures, which acts as a catchall. That covers all the parts of the basic SCR. I’ll now hand back over to Rob to discuss the remaining aspects of the standard formula, the operational risk module, and the loss absorbency, credit ratings and correlation matrices.
Rob Chaplin (14:14):
Thanks, Will. Operational risk is not clearly defined within Solvency II, but the SCR whether calculated using the standard formula or an approved internal model must cover it. The operational risk module should include legal and reputational risks and exclude risks arising from strategic decisions. The capital requirement for operational risk should reflect the operational risks that are not already included in the other risk modules capped at 30% of the basic SCR say for unit linked businesses where different rules apply.
(14:53):
Under the standard formula, the calculation is based on the level of earned premiums over a specific period and the amount of technical provisions excluding the risk margin, and deductions of recoverables from reinsurance contracts are special purpose vehicles. As Will mentioned, the standard formula contains an adjustment for the loss absorbing ability of technical provisions and deferred taxes.
(15:19):
It also provides for different risk considerations depending on whether an external credit rating is available and what rating is assigned. Insurers must assess the appropriateness of such ratings as part of their risk management and may only use an external rating whether it has been issued or approved.
(15:39):
The idea behind the loss absorbing adjustment is to cover the fact that in some circumstances, while unexpected losses arise, the insurer can compensate for these, for reducing the benefits payable on policies involving future discretionary benefits or reducing future deferred tax liabilities. That covers all the aspects of the standard formula. Since we have some time left, Will, why don’t you finish by giving the listeners an overview of the MCR?
William Adams (16:09):
Thanks, Rob. As we discussed at the start of this episode, the SCR works in tandem with the MCR, which acts as a lower absolute minimum threshold. Insurers must calculate the MCR and report the result of the PRA quarterly. Like the SCR, the MCR is calculated to a value at risk of its capital. Unlike the SCR, it is at a confidence level of 85% rather than 99.5%. It is calculated as a function of a set of technical provisions, written premiums, capital at risk, and deferred tax and administrative expenses.
(16:47):
The MCR should always be significantly lower than the SCR to allow for tiered intervention by the PRA before withdrawal of authorization is threatened, which occurs if an insurer drops below the MCR. To that end, the MCR must not exceed 40% or be less than 25% of the insurer’s SCR, including any capital add-ons and has an absolute minimum that’s different for general insurers, long-term insurers, pure reinsurers and composite insurers.
Rob Chaplin (17:22):
So that just about wraps up this episode on the Solvency Capital Requirement. One of the most important aspects of Solvency II. Do stay tuned for more episodes in particular on the use of approved internal models. If you have any questions at all on the topics discussed today, please don’t hesitate to get in touch. We look forward to welcoming you next time.
Voiceover (17:46):
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(18:03):
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