08 January 2013

Risk.net: Insurers grapple with Solvency II economic capital projections

Solvency II's requirement for insurers to project capital calculations forward over a number of years is a significant challenge for insurers that are still grappling with modelling their year-one requirements.

One of the major distinctions between Pillar I and Pillar II of Solvency II is that the first takes a snapshot of the here and now, while the latter looks more towards the future. The quantification requirements of Pillar I are based on a ‘time-zero’ balance sheet, with own funds and capital calculated to meet obligations over the next 12 months, whereas the Own Risk and Solvency Assessment (ORSA) of Pillar II is forward-looking and covers the business planning period.

With many insurers still struggling to calculate their capital one year out properly under the new rules as well as perform the stress tests that the ORSA requires, the prospect of modelling a forward-looking balance sheet and the associated capital for the full business planning period can present a significant challenge. Yet it is early days, and insurers are still getting the measure of the task and exploring ways of making the problem more manageable.

For products with significant options and guarantees, such projections can be particularly challenging. Issues can also arise when projecting the impact of stresses and [other] scenarios.  In addition, the modelling of appropriate levels of future new business and allowing for future strategic decisions adds complexity.

Solvency II does not prescribe how far forward insurers must project their balance sheet and acknowledges that firms operate different business planning periods. However, the European Insurance and Occupational Pension Authority (EIOPA) says in its ORSA guidelines that “any regularly developed business plan or changes to an existing business plan need to be reflected in the ORSA process taking into account the new risk profile, business volume and mix as expected at the end of the projection period at least annually”.

Because of the challenges of a full stochastic-on-stochastic approach or rolling models forward, insurers have been experimenting with other simplification methods. One of the most widely used at the moment is risk drivers. This is where elements of capital requirements are projected through the use of a proxy that is easier to determine, rather than directly calculating the projected capital requirements. “Such methods make the modelling of forward-looking balance sheets significantly easier, in terms of the complexity of models, reducing production timescales, and aiding understanding of the results”, says Black of Friends Life. 

Insurers are only beginning to get to grips with the ORSA, as much of the focus to date has been on stress testing the solvency capital requirement based on the time-zero balance sheet. It is still early days in terms of modelling forward-looking balance sheets and best practice has yet to emerge.

There is significant variation between insurers on how to model forward-looking balance sheets, with most insurers still developing their approach in this area. Companies are experimenting with a variety of approaches, from the use of risk drivers and other simplification methods to full stochastic analysis, and various combinations in between. No single best-practice approach has yet to emerge and it is expected that significant variation will remain due to the differing size and complexity of different businesses.

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