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March 27, 2015updated 13 Apr 2017 8:31am

How standard is the standard formula?

Emma Gerrard and Wolfgang Hoffmann from the life insurance consultancy practice at Towers Watson explain why, for the vast majority of insurers across Europe, the use of the standard formula to calculate the Solvency Capital Requirement (SCR) under Solvency II is the natural choice

By Verdict Staff

Emma Gerrard and Wolfgang Hoffmann from the life insurance consultancy practice at Towers Watson explain why, for the vast majority of insurers across Europe, the use of the standard formula to calculate the Solvency Capital Requirement (SCR) under Solvency II is the natural choice

With less than a year until the imple¬mentation of Solvency II, many life insurers around Europe may face an unwelcome addition to their already full workload.

Across the continent, a large majority of insurers, perhaps 90% or more, plan to cal¬culate their SCR using the standard formula developed for the directive, for the simple reason that the potential capital disadvan¬tages of following a prescribed approach far outweigh the time, resource requirements and cost associated with developing their own risk models.

Firms choosing the standard formula knew that from 2016 onwards they would have to justify this approach in their Own Risk Sol¬vency Assessment (ORSA) submission, dem¬onstrating how it is representative of their risk profile.

Furthermore, the European Insurance and Occupational Pensions Authority (EIOPA) had indicated that firms above a certain size threshold would have to provide evidence of its appropriateness in the 2015 buildup to implementation.

Widening net

In practice, national supervisors seem to be widening the net. Cases of companies that fall below the EIOPA threshold, but that have nonetheless been requested to assess standard formula appropriateness during the prepara¬tory phase, are starting to come to light.

Speculation is rife on why this is happening, but the most plausible reason is that, recognising that supervisory resources are themselves typically very stretched, the attention being paid to standard formula appropriateness now is as much about determining whether they will be required to carry out capital add-on assessments and further internal model reviews after 2015, as it is to do with immediate concerns about appropriateness.

This is because capital add-ons, the use of undertaking specific parameters or the development of partial or full internal mod¬els are the natural outcomes for firms failing to demonstrate the standard formula is right for their business.

So the stakes are high, and firms that previ¬ously had justifying their use of the standard formula on their 2016 regulatory agenda may need to have an approach in place soon¬er than that. But, just what may be involved?

Evaluating appropriateness

The explanatory text to the EIOPA guidelines on standard formula appropriateness specifi¬cally asks firms to consider differences due to risks that are not considered in the standard formula, and differences due to risks that are either under- or over-estimated by the stand¬ard formula compared to the risk profile of the company.

Common examples of insurer risks not captured by the standard formula include equity or property volatility risk, benefit inflation risk and emerging risks. Equally, the quantitative nature of the standard formula means that other risks, such as reputational risk, are also excluded.

In other cases, risks may be under- or over-estimated by the standard formula – opera¬tional risk, for example, particularly where firms outsource their policy services.

For firms that do find themselves having to justify their use of the standard formula sooner than expected, a logical starting point is a qualitative analysis of all risks to which the firm is exposed. From there they can pro¬gress to quantitative analysis, where this is deemed proportional, for the following: The most material risk exposures, for which a ranking of risks will be useful The areas where there are most significant deviations from the assumptions underly¬ing the standard formula Importantly, risks which fall into both categories

While there is no specific guidance in the regulations, a reasonable interpretation seems to be that a 10% difference from the standard formula SCR would potentially lead to a capital add-on, while a deviation greater than 15% would almost certainly result in one.

Another area of potential scrutiny is where the total company SCR is less than or equal to the total standard formula SCR, but where there are significant deviations within the individual modules or sub-modules that can¬cel one another out at an aggregate level. An approach that demonstrates that the standard formula remains appropriate over time, using sensitivity testing, may be useful in this case.

Mortality risk

By way of illustration, a key potential area of discrepancy for life insurers is mortality risk.

Within the standard formula,the level, trend and volatility components of the mortality risk factor assume an instantaneous permanent increase of 15% in mortality rates. The calibration also assumes a well-diversified portfolio and that companies have adequate underwriting of risks to restrict adverse selection.

Therefore, a company framework for reviewing mortality risk might include: 1. A comparison of each category such as age and gender to relevant available benchmarks, and to identify whether there are any significant concentrations in the portfolio 2. Splitting the portfolio into age bands and looking at the diversity by inspection 3. Comparing the portfolio to available statistical data on age 4. Reviewing whether there are certain lines of business that are written without underwriting, or with very limited under¬writing, that might need further examination 5. Where mortality is a significant risk, examining the level, trend and volatility of mortality rates in more detail

Being prepared

With regulator interest in the use of the standard formula increasing in many parts of Europe, there is a strong case for insurers to demonstrate that they believe the standard formula is appropriate for them before Solvency II goes live.

Even if firms do not get a call from super¬visors in 2015, such justification will form part of the ORSA submission from 2016, so the sooner firms perform this assessment, the better prepared they will be to defend their approach.

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