UK: Facing The Challenge Of Solvency II - Latest CEIOPS Consultation Papers - Part 2

Last Updated: 22 December 2009
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017
This article is part of a series: Click Facing The Challenge Of Solvency II - Latest CEIOPS Consultation Papers - Part 1 for the previous article.

CP 79 – SCR STANDARD FORMULA – SIMPLIFICATIONS/ SPECIFICATIONS FOR CAPTIVES

Purpose – This paper provides advice with regard to simplified calculations for the Solvency Capital Requirement for captives due to their specific business model as requested in Article 109.

The simplification proposed is split into two categories.

  1. Simplifications only applicable to captives based on their specific business model.
  2. Simplifications only applicable to the ceding undertakings of captive reinsurance undertakings.

Key Messages

Following concerns from the local supervisors over some of the QIS4 approaches and calibrations on a number of risk modules, a number of simplifications have been proposed in CP79 relating to captives. The application of these simplifications are limited to captives meeting certain criteria.

Detailed Summary

Simplifications only applicable to captives based on their specific business model

Non-Life Premium And Reserve Risk

National guidance of certain EU member states provided a simplified calculation of the non-life Premium and Reserve risk sub-module.

The simplified approach included:

  • Choosing uniform parameters. These are in relation to:
    • Using a uniform parameter to extrapolate reserves.
    • Applying uniform standard deviations to all LOBs (30%).
    • Applying a uniform correlation of 35% between all lines of business.
    • Based on the uniform parameters a simplified formula for the capital charge for premium and reserve risk can be used.
  • Taking into account the risks mitigation effect of aggregate limits. This was done by modifying the volume measure for premium risk of a LOB. The aggregate limit represents the net retention per LOB, after reinsurance and increased by reinstatement premiums.
  • Removal of simplifications relating to expected profit and losses stemming from business written during next year.

Non-Life CAT Risks

The simplification relates to captives using separate CAT charges based on the factor method given in CP71.

These factors are different and much higher than the standard factors applicable to other insurance and reinsurance undertakings. These increases were expected as local supervisors identified the QIS4 calibration as being inappropriate for captives.

Concentration Risk

This simplification proposes that captives may be exempt from the concentration risk sub-module due to intra-group pooling arrangements. This is because there may exist legally effective provisions whereby liabilities can transfer to other parts of the group to suit needs. Since the owner will have an interest in saving the solvency of the group as a whole the risk is reduced.

Other simplifications in relation to concentration risk include the following:

  1. Increasing the concentration threshold for captives to 15%.
  2. Term deposits less than or equal to 3m EUROS and less than 3 months term at a AA rated bank may be exempt from the concentration risk module.
  3. Cash held in a bank is subject to counterparty risk capital charges and not concentration risk capital charges.
  4. Bank deposits can be exempt if their value is covered by a government guarantee scheme in the EEA area.

Interest Rate Risk

CP79 discusses a simplified approach to determining the change in market value following an interest rate shock separately for assets and liabilities.

To determine the impact of an interest rate shock on assets, a simplified approach would involve grouping the assets by intervals of maturities and deducting a separate (upward and downward) interest rate shock percentage to the market value of the assets. The simplified calculation is expected to be done by currency.

To determine the impact of an interest rate shock on liabilities, the average duration of the undiscounted liabilities must be estimated followed by an assessment of the change in the value of the best estimate using an appropriate term structure. This assessment should be carried out by LOB and currency.

Market Spread Risk

In QIS4, captives argued that it would be too burdensome to adopt the maturity approach based on the rating of each bond. Therefore a simplified approach was suggested whereby all bond holdings that are submitted to the spread risk module are considered BBB. This simplification excludes structured bonds and bonds with a rating of less than BBB and credit derivatives.

Simplifications Only Applicable To The Ceding Undertakings Of Captive Reinsurance Undertakings

SCR Counterparty Risk/Recoverables Towards A Captive

This simplification relates to an undertaking ceding its liabilities to a reinsurance captive. If there is an explicit and legally effective guarantee by the captive owner for the liabilities of the captive, the credit rating of the captive owner instead of the captive may be used:

  • in the calculation of the counterparty risk capital charge; and
  • in the calculation of the adjustment for expected losses owing to counterparty default for the recoveries towards the captive.

Cut-Through Liability Clauses

Reinsurance cut-through mitigates captive risk where there is a retrocession arrangement. Assuming all parties are willing to sign-up, this allows the fronting insurer to access (or cut-through to) the retrocessionaires directly. This arrangement is not very popular as there are dangers for the retrocession that they could be faced with double payments. In addition, as a matter of English law whilst it may be enforceable it runs a risk of being struck down as a preference in the event of a captive's insolvency. So if the cut through liability clause exists then this allows the captive's ceding undertaking to make an adjustment in its counterparty default risk capital charge by cutting through the captive to the retrocessional reinsurers.

CONCLUSION

These latest CPs have clarified CEIOPS's thinking in a number of areas particularly relating to using simplified calculations in the SCR standard formula and how it will be critical to demonstrate to the relevant supervisor why this option can be used. Other CPs deal with how groups will be supervised when they have Centralised Risk Management and also how Ring Fenced Funds will be identified and treated. Many of the new CPs deal with enhancements to the calibrations required when using the standard formula and these will result in increasing the capital requirements of (re)insurers. In this particular area responding to QIS 5 will be critical to (re)insurers as it will be important to demonstrate to CEIOPS the impact of the proposed changes. Firms should respond to the consultation process articulating their views on the impacts of this proposed Level 2 guidance addressing the practicalities of implementation and the impact on their business models.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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This article is part of a series: Click Facing The Challenge Of Solvency II - Latest CEIOPS Consultation Papers - Part 1 for the previous article.
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