Institutional Investment - June 20, 2007

New EDHEC study indicates the ground that needs to be covered for successful implementation of Solvency II

A new EDHEC position paper entitled "QIS3: meaningful progress towards the implementation of Solvency II, but ground remains to be covered", by Samuel Sender, Research Associate with the EDHEC Risk and Asset Management Research Centre, and Philippe Foulquier, Director of the EDHEC Financial Analysis and Accounting Research Centre, contains EDHEC's views on the third Quantitative Impact Study carried out by CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors) at the request of the European Commission within the framework of the Solvency II project.

This position paper follows a series of EDHEC publications on the new solvency and supervisory standard for European insurance undertakings. “CP20: Significant improvements in the Solvency II framework but grave incoherencies remain” contained EDHEC's answer to CP20, a consultation process initiated by CEIOPS. In “QIS 2: Modelling that is at odds with the prudential objectives of Solvency II”, EDHEC focused on certain aspects of the modelling suggested by CEIOPS in the QIS 2, 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. Finally, in a major report entitled “The Impact of IFRS and Solvency II on Asset-Liability Management and Asset Management in Insurance Companies”, EDHEC revealed the contradictions inherent in the Solvency II and IFRS provisions for insurance companies. The report showed notably that the numerous provisions proposed by the IFRS were at odds with the good risk management practices put forward by Solvency II.

This new document outlines EDHEC's position on the third quantitative impact survey on the standard formula for the calculation of capital requirements for insurance companies under Solvency II. Before reviewing the principles that underlie the standard formula, the authors give a brief introduction to Solvency II. In light of this introduction, they then review the changes that QIS3 has brought about in the design of Solvency II; they also point out major improvements as well as changes that are inconsistent with the very principles of this body of regulations.

The authors then focus on the proposed calibration, as calibration is one of the main objectives of QIS3. They argue that the third quantitative impact survey (QIS3) has brought substantial improvements to the standard formula for the calculation of solvency capital requirements. In particular, the guidelines, the structure of the calculations, as well as calibration have been the beneficiaries of these improvements.

In the preceding works cited above, EDHEC had underlined the importance of giving clear guidelines for the use of the standard formula and internal models, by showing that diverging interpretations of the necessary calculations could lead to significant differences in capital requirements as well as to an inability to compare results across insurance companies and countries. With the support of the European Commission, the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS) has markedly improved the practical definition of concepts and given far more accurate guidelines for calculations; for instance, it gives a clearer definition of the scope within which a market-value margin shall be applied.

The structure of the standard formula has also been improved since Solvency II:

  • The reduction for profit-sharing states that profit-sharing can be reduced in the event of a shock. In most savings contracts, with the notable exception of unit-linked products, risk and return are shared between the policyholder and the shareholder, hence the so-called profit-sharing contracts. Significant progress has been made by eliminating the arbitrary “K-factor” approach, which sometimes led to negative capital requirements. The ability to use profit-sharing as a buffer against risk is now examined in a manner consistent with the rest of the standard formula. What we now expect from CEIOPS is to propose a more realistic way of testing for the maximum ability to use profit-sharing to reduce risk.
  • Credit risk has been split into default risk and spread risk, the latter a sub-component of market risk.
  • Concentration risk has been calculated separately, a method of calculation that permits a clear distinction between systematic risk and idiosyncratic risk.
  • A special status has been given to operational risk, as must be the case in any economic framework. Operational risk is the only risk that brings no reward; no one is in charge of producing it. It is therefore treated separately, especially since strategic planning is involved. For EDHEC, the prudential regulations taking shape in Solvency II are a significant step forward for the insurance industry, insofar as they will reflect risk profiles more clearly and provide incentives for improved risk identification and management. However, despite the significant improvements in the SolvencyII framework, EDHEC finds that grave inconsistencies remain at the very heart of the standard formula: i) asset-liability management is not well captured by CEIOPS, which has failed to account for interaction between the different risks; ii) as far as non-life insurance is concerned, even though modern valuation methodologies such as those promoted by CEIOPS are based on the discounting of cash flows, CEIOPS measures risk on an undiscounted basis.

However practical it may be to use traditional key performance indicators as the basis for the new regulatory standards, this usage may be a conceptual error. The CEIOPS choice currently penalises companies such as Berkshire Hathaway that price their products according to market-consistent principles whereas it favours those that do not discount cash flows, thus subverting the very principles of market consistency that underlie Solvency II and modern regulation in general.

As far as calibration is concerned, the industry has generally focused on the reduction of the value at risk of equities from 40% to 32%. In addition, the methodology for estimating parameter values has been fine tuned and communicated to those concerned. However, EDHEC argues that:

  • Calibration for risk parameters should be made to market values where the information is available.
  • As the Solvency horizon is one year, the resulting fall in market value shall be observed in one year’s time rather than immediately. The recognition that risk accrues progressively within the Solvency time-horizon shall lead to the recognition of dynamic hedging strategies (CPPI or other risk mitigation techniques where documented). The current lack of recognition is unfortunately more of an incentive to regulatory arbitrage than to good risk management practices.
  • The “alternative” approach to equity and property risk that reduces the implied volatility of equities (from 36% for short-tail businesses to 13% for long-tail businesses) has no theoretical foundation. The main reason long-tailed businesses have more equities in their books is that there are more expected future profits as well as more expected profit-sharing as a buffer to risk.

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Hyperlinks in this document:
(1) http://www.edhec-risk.com/site_edhecrisk/public/latest_news/Business%20_Strategy_Issues/RISKArticle.2007-01-26.2246
(2) http://www.edhec-risk.com/latest_news/Business%20_Strategy_Issues/RISKArticle.2006-11-15.4510
(3) http://www.edhec-risk.com/ALM/ifrs_solvency_II