Solvency
ii - Best Estimate
from the Solvency ii
Association, the largest Association of
Solvency ii Professionals in the world
Consultation Paper No. 41
Draft CEIOPS’
Advice for Level 2 Implementing Measures on Solvency II: Technical
Provisions - Article 85 c, Circumstances in which technical
provisions shall be calculated as a whole
1. Introduction
1.1. In its letter of 19 July 2007, the European Commission
requested CEIOPS to provide final, fully consulted advice on
Level 2 implementing measures by
October 2009 and recommended CEIOPS to develop
Level 3 guidance on certain areas to foster supervisory
convergence.
On 12 June 2009 the
European Commission sent a letter with further guidance regarding
the Solvency II project, including the list of implementing measures
and timetable until implementation.
1.2. This Paper aims at providing advice with regard to the
circumstances in which
technical provisions shall be calculated as a whole, as required in Article
85c of the Solvency II Level 1 text (herein “Level 1 text”).
1.3. References in this advice to ‘undertakings’ embrace both
insurance and reinsurance undertakings, unless otherwise explicitly
mentioned.
2. Extract from Level 1 Text
2.1 Legal basis for
implementing measure
2.1. According to the guiding principles referred to in the
Commission’s letter, the legal basis for the advice presented in
this paper is primarily found in Article 85(c)
of the Level 1 text, which states:
Article 85 –
Implementing measures
The Commission shall adopt implementing measures laying down the
following:
[..]
c) The circumstances in which technical
provisions shall be calculated as a whole, or as a sum of a best
estimate and a risk
margin, and the methods to be used in the case where technical
provisions are calculated as a whole;
2.2 Other relevant Articles for
providing background to the advice
2.2. Article 76(4) of the Level 1 text is the provision the
aforementioned implementing measure refers to:
Article 76 – Calculation
of technical provisions
4. Insurance and reinsurance undertakings
shall value the best estimate and the risk margin separately.
Nevertheless,
where future cash-flows
associated with insurance or reinsurance obligations can be
replicated reliably using financial instruments for which a reliable
market value is observable, the value of technical provisions
associated with those future cash-flows shall be determined on the
basis of the market value of those financial instruments.
In
this case, separate calculations of the best estimate and the risk
margin shall not be required.
3. QIS4 outputs and
industry feedback
3.1. In the QIS4 technical specifications, there is no reference to
the exact terminology used in the Level 1 text, but to the concept
of ‘hedgeable cash-flows’ and ‘hedgeable risks’.
3.2. The QIS4 Technical Specifications include the following
definition of
'hedgeable cash-flows':
TS.A.II.22. Future cash-flows from obligations towards policyholders
and beneficiaries of insurance contracts are hedgeable if
they can be replicated using financial instruments for which a
market value is directly observable
on a deep,
liquid and transparent market.
TS.A.II.23. The financial instruments shall completely replicate all
possible payments corresponding to the liability cash-flow, taking
into account the uncertainty in amount and timing of these payments
(theoretical perfect hedge).
TS.A.II.24.
A perfect hedge or replication is
one that completely eliminates all risks associated with the
liability.
In practise perfect
hedges are expected to be relatively rare.
If in practice the hedge
is not perfect but the remaining basis risk is
immaterial, in the interest of proportionality the
undertaking may consider the risks as hedgeable.
TS.A.II.25.
Circumstances where
cash-flows are hedgeable could include, for example, some options
and guarantees embedded in life insurance contracts, some
unit-linked (equity-indexed for instance) life insurance contracts,
cash-flows where there is no uncertainty in the amount and timing,
etc.
TS.A.II.26. For a hedged portfolio or replication, the
non-arbitrage principle implies that the market
consistent value of the hedgeable cash-flow should be acceptably
close to the market value of the relevant hedge or replicating
portfolio.
TS.A.II.27.
A market is defined to be deep,
liquid and transparent if it meets the following requirements:
(a) market participants can rapidly execute
large-volume transactions with little impact on prices;
(b) current trade and quote information is readily available to the
public;
(c) the properties specified in a. and b. are expected to be
permanent.
TS.A.II.28. Basis risk originates from
differences between the exposure in an undertakings
liabilities and the contract terms of what may be purchased from the
market.
3.3. QIS4 Technical
specifications also refer to 'hedgeable risks' in the context of the
risk margin:
TS.II.A.29. Where the cash-flows associated with the (re)insurance
obligations contain non-hedgeable financial
(due to incomplete markets) or non-financial risks (due to options
and guarantees on mortality and expenses for instance) that, when
combined in a single insurance contract, cannot be hedged or
replicated using instruments on a deep, liquid and transparent
market, the obligations may be valued by inter/extrapolating from
directly observable market prices.
Market consistent valuation techniques may be used to
set the assumptions for, say, financial
risks within a non-hedgeable contract and, for the remaining risks
(the non-financial risks in this example), valued using best
estimate assumptions.
The risk margin should
then be determined according to a cost-of-capital (CoC) approach.
The cost of capital
calculation excludes market risk as this would otherwise
double-count margins which are implicitly included in market prices.
TS.II.A.30.
Not all financial risks can be
hedged or replicated using instruments traded on a deep, liquid and
transparent market.
For instance, different
kinds of embedded financial options and guarantees in life insurance
contracts may include risks where there is a non traded underlying,
or risks where the duration exceeds a reasonable extrapolation from
durations traded on the financial market, or risks relating to
traded financial instruments that are not available in sufficient
quantities, etc.
Where this is the case
and if the remaining risk is considered material, alternative
methods to find a “hedgeable cost” may be used to adjust market
information and capture an additional market-consistent risk margin.
Please see TS.II.D.60 on
the calibration of stochastic models.
TS.II.A.31.
Even if it would be desirable, the
values of hedgeable and non-hedgeable risks might not be separable
under all
circumstances (for instance, because a market consistent valuation
has been used).
3.4. Feedback from QIS4 did not contain substantial remarks to the
conceptual framework described, although there was some confusion
over the treatment of unit-linked business that shows the need for
some clarification:
For
unit-linked business, different approaches
have been observed:
- technical provisions were set equal to the
unit fund (i.e. applying a surrender value floor);
- or the unit fund less present value of future profits emerging
from unit-linked business.
“Unit-linked products were mostly defined as hedgeable obligations”
“One supervisor observed that the risk margin has not been always
calculated on unit-linked business independently of its
classification as hedgeable or non hedgeable contract”
“Non-life provisions are largely considered non-hedgeable... on
average the share of hedgeable elements is about 1.5%.'
3.5. The present advice has a twofold goal: on the one hand it is
necessary to adapt the terminology and conceptual framework used in
QIS4 to those used in the Level 1 text, and on the other hand it is
necessary to provide sufficient clarifications to ascertain that
there will be a harmonized application at EU level of the
calculation of technical provisions as a whole.
3.6. Harmonization is a core goal in this issue, since different
practices will likely lead to different valuations of technical
provisions, especially of the risk margin considered, explicitly or
implicitly, in the different calculations.
4. Advice
4.1 Explanatory text
4.1.1. Legal conceptual
framework
4.1. From a legal perspective, CEIOPS considers that the general
rule set out in the Level 1 text is that the technical provisions
should be calculated as the sum of two
explicit components which are being
the
best estimate plus an appropriate risk margin.
Both components should
be valued separately.
4.2. The calculation of technical provisions 'as a whole' (Article
85c) is
only admissible under three sine qua non circumstances, that should be assessed
in a strict manner:
• The
future cash-flows associated with
insurance or reinsurance obligations can be replicated reliably;
• This replication shall be
provided by
financial instruments;
• Those financial
instruments shall have reliable market values
which are observable.
4.3. Within this legal framework
it is
necessary to define
• what is meant by 'to
replicate reliably the future cash-flows associated with insurance
or reinsurance obligations'; and
• when a market value is 'observable' and 'reliable'
4.4. According to the Level 1 text, for the purpose of calculating
technical provisions as a whole the replication can only be referred
to ‘cash-flows associated with insurance or
reinsurance obligations'.
Therefore, from now on,
CEIOPS will refer in this advice neither to ‘hedgeable cash-flows’
(or risks or insurance obligations) nor to replicate obligations (or
risks).
This
requires some amendments on the wording and
concept used in QIS4.
4.5. CEIOPS considers that the definitions mentioned in paragraph
4.3. should be developed according to the legal context of Articles
75 and 76 of the Level 1 text.
This requires to take
into account the role of the calculation of technical provisions in
the solvency assessment of an undertaking and the interplay of such
calculation with other elements of the solvency assessment.
Two
features may be identified in this respect:
• Dynamic perspective
• Market consistency
4.6. Dynamic perspective.
In the Solvency II
framework, the calculation of technical provisions plays a wider
role than in the previous legal system.
The calculation of technical provisions is required not only to
aggregate the total of insurance liabilities, and then to derive the
total of basic own funds of the undertaking,
but it is also a core element to assess the solvency capital
requirement, as a consequence of the
use of scenario-approaches on the prudential balance sheet in
a good number of modules and
submodules (in the case of life insurance, almost all the modules
and submodules require the recalculation of technical provisions).
4.7. As a consequence of this dynamic approach the calculation of
technical provisions shall be done under different sets of
assumptions, so as to provide legal and technical consistency.
CEIOPS considers that
this needs to be taken into account in the definition of 'reliable
replication of cashflows'.
4.8. The conclusion is that 'to replicate
reliably the future cash-flows associated with insurance or
reinsurance obligations' means that the
cash-flows of the financial instruments need to perform as all risks
underlying the cash-flows associated with the insurance and
reinsurance obligations in the different scenarios considered in the
calculation of the solvency position of an
undertaking (including the uncertainty in amount and timing of these
payments).
This means that
the cash-flows of the financial instruments
must provide not only the same expected amount as the cash-flows
associated with insurance or reinsurance obligations, but also the
same degree of variability.
4.9. In order to respect the requirement set out in Article 76(2),
first subparagraph, of the Level 1 text, for the purposes of the
replication, the future cash-flows of the financial instruments
shall be risk adjusted to derive the risk-free
cash-flow.
4.10. Market consistency.
From a legal point of
view, Article 76(4) sets out a strict framework to allow financial
instruments to replicate future cash flows associated with the
insurance and reinsurance obligations.
This is explicit in the
requirement to use 'reliable market values'
and to restrict that values to those that are 'observable'.
4.11. In this context, CEIOPS considers that
the criteria used in QIS4 remains fully consistent with the Level 1
text.
Therefore, the
expression 'financial instruments for which a
reliable market value is observable' should be understood as
financial instruments quoted in 'deep, liquid
and transparent markets', which requires to meet all the following
requirements:
• Market participants can rapidly execute
large-volume transactions with little impact on the prices of the
financial instruments used in the replications;
• Current trade and quote information of those prices is readily
available to the public;
• The properties specified above are expected to be permanent.
4.12. CEIOPS notes the
importance of drawing
lessons from the current crisis.
One of the main lessons is the lack of
reliability of the valuations of OTC financial instruments,
and the lack of transparency when financial
investments are not actively traded in deep, liquid and transparent
markets.
In fact, a main
conclusion commonly repeated in the various reports dealing with the
crisis, is the necessity of
limiting the scope of
mark-to-model practices and non-actively traded assets, as one of
the main sources of the current situation.
4.13. In this context, the fact that Article
76(4) refers twice in the same sentence to reliability is a
clear signal of the sensitiveness to this issue.
Therefore CEIOPS considers that the proposals developed in this
advice are essential in order to prevent in the future crisis like
the current one.
4.14. In the light of these considerations and the strict approach
adopted by the Level 1 text in Article 76(4), 'future cash-flows
associated with insurance or reinsurance obligations' shall be
considered
non-replicable when:
i. one or several features of the future
cash-flow (its expected value, its volatility or any other feature)
depend on any type of biometric development or on the behaviour of
the policyholder;
ii. one or several features of the future cash-flow depend to any
extent on the development of magnitudes internal to the
undertakings, such as expenses or acquisition costs; or
iii. one or several features of the future cash-flow depend to any
extent on the development of magnitudes external to the undertaking
for which there are no financial instruments for which reliable
market values are observable.
4.15. Where under the same contract a number of future cash-flows
exist, which meet all the conditions mentioned before in order to
calculate the technical provision as a whole and other future
cash-flows which do not meet some of those conditions, both sets of
cash-flows should be unbundled.
For the first set of
cash-flows, no separate calculation of the best estimate and the
risk margin shall be required but a separate calculation shall be
required for the second set of cash-flows.
If the proposed
unbundling is not feasible, separate calculations of the best
estimate and the risk margin shall be required for the whole
contract.
4.16. The main case where Article 76(4), second paragraph, of the
Level 1 text is met is when the insurance or reinsurance obligation,
according to the clauses of the contract,
consists in the delivery of a portfolio of financial instruments for
which a reliable market value is observable or in the portfolio's
price at the moment of the payment of the benefit.
Residually there could
be very limited cases of cash-flows that can be replicated reliably,
such as a future fixed benefit in an insurance contract where the
policyholder cannot lapse the contract.
Elements of actuarial and statistical methodologies for
the calculation of the best estimate
Solvency
ii Best Estimate - CEIOPS Consultation Paper No.
26
CEIOPS Consultation Paper No. 41 - Level 2, Circumstances in which
technical provisions shall be calculated as a whole
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