‘Simple solutions’ exist to resolve SII risk margin issues

Written by Adam Cadle

11/02/2022

“Simple solutions” could be adopted for the Solvency II risk margin to better align it with the specific features of the UK insurance market, PwC has argued.

The risk margin has come under continuous criticism since the implementation of Solvency II for being too large and too sensitive to movements in underlying interest rates. In its latest research paper, PwC has published proposals to modify the PRA’s QIS approaches or the current cost of capital approach to make them more representative of the UK insurance and, specifically, annuity market.

Firstly, the consultant has outlined a margin over current estimate (MOCE) approach.

“The percentile MOCE approach is different to the current cost of capital approach in that it relies on statistical theory rather than finance theory to determine the market price of liabilities,” it stated. “The MOCE can either be based on a cost of capital approach or a percentile approach. For purposes of the Solvency II review, the percentile approach is being considered since the cost of capital approach is very similar to the current risk margin methodology. The MOCE represents a provision for the inherent uncertainty in the best estimate liabilities (BEL) and is calculated with reference to a specified percentile of a given loss distribution. The main premise of the MOCE approach is that losses are normally distributed with a mean equal to the BEL and the 99.5th percentile equal to the solvency capital requirement (SCR) for non-hedgeable risks. The MOCE for any pth percentile is then derived from the cumulative distribution function.”

Secondly, PwC has proposed a risk tapering (lambda) approach.

“The risk tapering (lambda) approach allows for a time-varying cost of capital within the current cost of capital framework. This is achieved by applying a tapering adjustment to the projected SCRs. In the current cost of capital approach, the SCR projected in each period is independent of events that may have occurred in prior periods. The risk margin calculation effectively assumes that the third party reference entity is recapitalised at the end of each period and that capital is only held for the next year, ensuring it is independent of prior periods. In reality, the risks and projected SCR in each period may not be independent. An alternative way of saying this is if losses were incurred in one period, the SCR in the following period may be expected to be lower. The main premise of the risk tapering (lambda) approach is that the SCR in each future period is not independent from prior periods. To reflect this, the projected SCRs include a time scaling factor, lambda, which can take on a value between 0 and 1.”

Another approach being explored is the cost of capital. PwC said the cost of capital should respond to market conditions if it is to represent the current cost of transfer to a third party (i.e. it should be dynamic so it does not introduce unintended volatility and sensitivity of the risk margin to changes in underlying interest rates).

“This suggests the cost of capital can be expressed as a proportion of the risk-free rate plus a constant addition. The calibration of Beta could be set by considering the riskiness of a typical annuity portfolio. Assuming the capital is always funded through equity is a simplifying assumption and a possible weakness of this approach. This approach could be applied as an adjustment to the lamda approach considered in the QIS.”

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