There is need for an appropriate balance between controlling risk, ensuring practicability for issuers of these products and also respecting the principle of “freedom of investment” (priority: medium) The advice in this paper should be balanced between 2 important Principles in the Directive: “Prudent Person” (Art 132) and also “Freedom of Investment” (Art 133).
This document is a follow-up to our position paper published last May: ‘Calibration Principles for the Solvency II Standard Formula”. The paper provides our recommendation on the methodology to calibrate market risk correlation factors as well as a counterproposal for the correlation matrix as suggested by CEIOPS in its Consultation Paper n°74. The final chapter of this document also briefly addresses the correlations for non-market risk.
The CRO Forum's views on the consequences for Enterprise Risk Management and regulation in the insurance industry.
For a long time, many (re)insurance companies have realized the need for risk-based valuations and solvency capital measurement and have started developing internal economic capital models which suit their needs. This is without prompting from regulators and rating agencies. Why? Such models provide a common measurement basis across all risks (e.g. same methodology, time horizon, risk measure, level of confidence, etc.) and are a powerful tool for strategic decision-making, for example in capital allocation and pricing.
Under Solvency II, (re)insurance companies have the option to elect the Standard Model as defined under Solvency II or apply for approval to use Internal Models. Regulatory authorities have spent a lot of time and attention on the admissibility requirements for granting Internal Model approval.
The Forum strongly believes the directive represents an important step toward implementing an advanced supervisory and solvency framework which will help strengthen the European insurance industry. The Forum now urges the European Commission to introduce clear and effective implementing measures that will deliver the directive's basic principles.
Internal models should reflect the nature, scale and complexity of the underlying businesses; they should be proportional in sophistication to the materiality of the risks they cover. Materiality levels should be determined by stakeholders based on the model's purpose. Practical considerations for models include usability, reliability, timeliness, process effectiveness, systems and cost efficiency. There should be an acceptable tradeoff between accuracy and the various practical constraints.
Further, European supervisors considered the causes of failures (and near-failures) of a number of insurers and their analysis showed that the causes were mostly associated with inappropriate risk decisions resulting from underlying internal failures rather than inadequate capitalisation per se.
The Solvency II standard formula to calculate a company's Solvency Capital Requirement should present a balancing act between various targets such as simplicity, risk sensitivity and robustness. The CRO Forum believes the main principles of the current standard formula, namely to asses the sensitivity with respect to all material risk factors and to aggregate capital requirements allowing for diversification, are appropriate for this purpose and moreover set incentives towards risk mitigation strategies.