Solvency II - Lesson learned? E-Book

Michael Gutsche

• Herausgeber: GRIN Verlag
• Sprache: Englisch

Veröffentlichungsjahr: 2011

Beschreibung

Diploma Thesis from the year 2011 in the subject Engineering - Industrial Engineering and Management, grade: 1,0, University of Kassel, language: English, abstract: It may appear somewhat hasty, asking for a lesson learned for a framework which has not yet been implemented. Taking another perspective, it even sounds implausible, to force an industry which has been very successful with managing risks for their customers in the past to use a new regulatory risk framework. Nevertheless, to question whether the lesson has been learned or the usefulness of the introduction of a new risk based regulatory framework, seems to be more up-to-date than it has ever been. The pace of our time is getting faster. “Nothing is as consistent as change” - these wise words uttered by Greek philosopher Pythagoras over 2500 years ago adequately describe today’s world in which change is rather the rule than the exception. The supervisory system for EU insurers which was proofed to be sufficient in 1997 was considered to be insufficient only five years later. Recently, the latest financial crisis has shown that the strength of companies is not a matter of balance sheet size anymore; it is rather the result of understanding the risk a company takes. The cutting-edge Solvency II framework is now going to replace the current existing supervisory system, adopting the latest developments for measuring risk in financial markets. However, with the recent financial crisis in mind, modern financial theories, investment strategies or risk measurement techniques look again like a fancy part of academia without any connection to the real financial world. Basel II, the EU wide regulatory framework for banks which has failed to protect the banking industry from the risk arising in the financial markets, can be quoted as a good example for the necessity of a new framework. As a consequence, Basel III is being developed at the moment. One might be led to believe, that these issues do not concern the insurance industry. Insurers are long-term investors and usually follow a rather conservative investment policy. This did not protect them from losses but they were still able to sit out the last crisis, except for AIG which gambled in markets far off from their core business. Financial markets and their volatile behavior have not affected them directly but now Solvency II is going to introduce a market consistent valuation for their assets and liabilities. The value of both sides of their balance sheet, of every insurer in the EU will be linked directly to the financial markets. Changed market conditions will impact on all EU insurers at once [...]

Leseprobe

Table of Content

List of abbreviations

1. Introduction

1.1 Subject and background of the study

1.2 Objectives of this thesis

1.3 Course of the analysis

1.4 Scope and limitations

2. Solvency II - A major European regulatory initiative

2.1 The development of Solvency II

2.2 The three pillar approach

2.3 The current second phase

2.4 Quantitative impact studies

2.5 A risk based economic system

2.5.1 The economic balance sheet

2.5.2 Overall structure of the standard formula

2.5.3 Measurement and assessment of risk.

3. Treatment of investment risk under the standard formula

3.1 Interest rate risk.

3.1.1 The discount rate

3.1.2 The illiquidity premium

3.2 Equity risk

3.2.1 Symmetric adjustment mechanism

3.2.2 Duration based equity dampener

3.3 Spread risk

3.3.1 Spread risk on bonds

3.3.2 Spread risk on structured credits

3.3.3 Spread risk on credit derivatives

3.4 Illiquidity premium risk

3.5 Property risk

3.6 Currency risk

3.7 Concentration risk

3.8 Counterparty default risk

3.9 Aggregation of risk modules

4. Potential implications caused by Solvency II

4.1 The beginning of an EU wide asset reallocation

4.1.1 Summary of capital requirements of major asset classes

4.1.2 The driver for solvency capital requirements

4.1.3 The changing investment behavior

4.2 The possibility of new risk due to changed market conditions

4.2.1 Negative feedbacks as a consequence of market consistent valuation

4.2.2 A new interesting investment market

4.2.3 Multiple additional threats for the insurers and the market

5. Conceptual drawbacks of Solvency II

5.1 Theory, reality and the model

5.1.1 The independence of price changes

5.1.2 Price changes adhere to a probability distribution

5.2 False confidence in Value at Risk

5.2.1 Underestimation of tail risk

5.2.2 Sub-additive

5.2.3 Different methodology leads to a different Value at Risk

5.3 Black Swans and the Big Bang

5.4 Reliance on credit rating agencies

5.4.1 The non transparent business model

5.4.2 No liability or regulation

5.4.3 Mistakes in the past

6. Conclusion

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"It is better to be roughly right than precisely wrong"

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List of abbreviations

ABS Asset Backed Security AIG American International Group BaFin German Federal Financial Supervisory Authority(Bundesanstalt für Finanzdienstleistungsaufsicht)BSCR Basic Solvency Capital Requirements CDO Collateralized Debt Obligations CEA European Insurance and Reinsurance Federation(Comité Européen des Assurances)CEIOPS Committee of European Insurance and Occupational Pensions Supervisors CLN Credit Linked Notes CLT Central Limit Theorem CRA Credit Rating Agency DAX German Stock Index(Deutscher Aktien Index)ECB European Central Bank EEA European Economic Area EIOPA European Insurance and Occupational Pensions Authority EIOPC European Insurance and Occupational Pensions Committee EMH Efficient Market Hypothesis ES Expected Shortfall EU European Union IAIS International Association of Insurance Supervisors IASB International Accounting Standard Board IOSCO International Organization of Security Commissions KfW Reconstruction Credit Institute(Kreditanstalt für Wiederaufbau)KPMG Klynveld, Peat, Marwick and Goerdeler LGD Loss Given Default LIBOR London Interbank Offered Rate LP Liquidity premium MCR Minimum Capital Requirements MSCI Morgan Stanley Capital International NAV Net Asset Value OECD Organization for Economic Co-operation and Development P&C Property and Causality

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PD Probability of Default PIIGS Portugal, Italy, Ireland, Greece and Spain PV Present Value QIS1 First Quantitative Impact Study QIS2 Second Quantitative Impact Study QIS3 Third Quantitative Impact Study QIS4 Fourth Quantitative Impact Study QIS5 Fifth Quantitative Impact Study RWH Random Walk Hypothesis S&P Standard & Poor's SCR Solvency Capital Requirements SPV Special Purpose Vehicle SST Swiss Solvency Test TRS Total Return Swaps UFR Ultimate Forward Rate VaR Value-at-Risk

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1. Introduction

1.1 Subject and background of the study

It may appear somewhat hasty, asking for a lesson learned for a framework which has not yet been implemented. Taking another perspective, it even sounds implausible, to force an industry which has been very successful with managing risks for their customers in the past to use a new regulatory risk framework.1Nevertheless, to question whether the lesson has been learned or the usefulness of the introduction of a new risk based regulatory framework, seems to be more up-to-date than it has ever been.

The pace of our time is getting faster.“Nothing is as consistent as change”- these wise words uttered by Greek philosopher Pythagoras over 2500 years ago adequately describe today’s world in which change is rather the rule than the exception. The supervisory system for EU insurers which was proofed to be sufficient in 1997 was considered to be insufficient only five years later.2Recently, the latest financial crisis has shown that the strength of companies is not a matter of balance sheet size anymore; it is rather the result of understanding the risk a company takes.3The cutting-edge Solvency II framework is now going to replace the current existing supervisory system, adopting the latest developments for measuring risk in financial markets. However, with the recent financial crisis in mind, modern financial theories, investment strategies or risk measurement techniques look again like a fancy part of academia without any connection to the real financial world. Basel II, the EU wide regulatory framework for banks which has failed to protect the banking industry from the risk arising in the financial markets, can be quoted as a good example for the necessity of a new framework. As a consequence, Basel III is being developed at the moment. One might be led to believe, that these issues do not concern the insurance industry. Insurers are long-term investors and usually follow a rather conservative investment policy. This did not protect them from losses but they were still able to sit out the last crisis, except for AIG which gambled in markets far off from their core business. Financial markets and their volatile behavior have not affected them directly but now Solvency II is going to introduce a market consistent valuation for their assets and liabilities. The value of both sides of their balance sheet, of every insurer in the EU will be linked directly to the financial markets. Changed market conditions will impact on all EU insurers at once. It almost seems

1Cf. Lang (2008), p. 388.

2Cf. Buchholz/Sielaff/Wiegard (2008), p. 414.

3Cf. Institutional Investment Advisors (2010), p. 11.

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unnecessary to mention that a correct measurement of risk arising from the financial markets is therefore of prime concern.

1.2 Objectives of this thesis

In the light of the increased importance of correct risk measurement, the analysis of the new Solvency II framework might provide useful insights on how to obtain greater effectiveness in the handling of risk for insurance companies. Solvency II is still in its development phase and literature is scarce in comparison to a framework like Basel II/III. This thesis will explore the basic principles behind the framework and the overall complex assessment of risk in financial markets within the framework’s context. This is done by shedding some light on how risk is measured within Solvency II and why insurers or investment markets might face certain specific types of risk due this new framework. Furthermore, the impact on investment decisions and financial markets will be analyzed and whether a framework of this size might be able to create new risks by altering the market. The final goal is to figure out whether the way Solvency II measures risk is reliable and useful or if it needs further adaptations.

1.3 Course of the analysis

This thesis is structured in six chapters. The second chapter seeks to establish the foundations for understanding the reasons behind the introduction of Solvency II, the current state of affairs and the development process. Furthermore, it outlines the principles underlying the framework and its general design. The aim is to provide the reader with the necessary background knowledge to keep track with the several aspects of the further analysis. Chapter three provides a deeper insight into the standard formula of Solvency II and its assessment of financial risk. This is done by analyzing all the risk factors which are covered and, if necessary, their calibration, the reasons for their integration and the associated current discussion. The analysis highlights what has been introduced due to latest experiences, which parameters have changed over time and which are the critical risk factors. Chapter four describes how these rules might affect investment decisions and, since they will apply to all EU insurers, the overall impact on the European financial market. This is done by analyzing different opinions, statistics and studies in order to find evidence for a possible change in investment behavior due to Solvency II. Furthermore, the potential of the framework itself to change market conditions or investment behavior and create new risk sources will be discussed. Chapter five discusses the general theory of risk measurement, more specifically

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the underlying theory and the statistical and the mathematical concepts behind it. Finally, it covers how the risk associated with certain investments is determined by the opinion of external institutions. This reliance and its drawbacks will be discussed as well.

1.4 Scope and limitations

Solvency II aims to measure all the quantifiable risks of an insurance undertaking. Apart from financial risk, it also takes the risk of the underlying business into account. The focus in this thesis is mainly set on risk arising from the financial markets and how it affects the asset side or liability side of the balance sheet. The methods for calculating the technical provision4of the liability side will not be treated. Only how its cash flows are discounted will be taken into consideration since this depends on data from the financial markets. Life insurer usually have larger investments in the financial markets which is why examples are mostly given and explained in regard to life insurers. If necessary, some scenarios are also explained by taking property and causality (P&C) insurers into account.

4The current value of all payments and claims which are expected to be made to the policyholders in the future.

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2. Solvency II - A major European regulatory initiative

2.1 The development of Solvency II

Solvency margin requirements have been in place in Europe since 1973 for non-life and since 1979 for life insurance companies and belong to the first European directives meant to establish a homogeneous insurance industry.5“The solvency margin is the amount of regulatory capital an insurance undertaking is obliged to hold against unforeseen events.”6The drawbacks of the so far existing rules were that they made no attempt to reflect on the development of risk theory and did only focus on the underwriting risk of an insurance company. To modernize the existing rules a work group under the direction of Dr. Helmut Müller, former vice president of the Federal Insurance Commission, was established in 1994.7The results of this workgroup have come to be known as the “Müller Report” which was published in 1997. It came to the conclusion that overall the current solvency rules are still sufficient and contained only some suggestions to adopt the changed market conditions into the established system.8The result of this report were two EU directives which were adopted under the heading of Solvency I in 2002 but it was only a temporary solution since the drawbacks of the established system had still not been solved.9Major changes were only the improvement for calculating the solvency margin, a better intervention for the regulator and the requirement that insurance companies now had to guarantee their solvency at any time during the year.

Solvency I had been implemented in many different ways around Europe and during this process it had finally come apart that those regulations did not satisfy the complex requirements of the European insurance business.10The actual risk position of the insurer just did not correlate with the required solvency margin.11The regulations did not account sufficiently for important risk factors like the risk arising from investment in the financial market.12A more fundamental evaluation of the capital adequacy regime for the European insurance industry was needed. It shall harmonize the EU-wide supervisory legislation and

5Cf. Sandström (2006), pp. 23 ff.; Straßburger (2006), p. 5.

6Bourdeau (2009), p. 193.

7Cf. Straßburger (2006), p. 6.

8Cf. Buchholz/Sielaff/Wiegard (2008), p. 414; Straßburger (2006), p. 6; Graf (2008), p.11.

9Cf. Graf (2008), pp. 11-12.

10Cf. Bourdeau (2009), p. 193; Straßburger (2006), p. 6; Buchholz/Sielaff/Wiegard (2008), p. 414.

11Cf. European Commission (2002), p. 14.

12Cf. Graf (2008), p. 12.

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bring it into accordance with those for credit institutions. Thus, at the beginning of 2000 the EU Commission decided to fundamentally reform Solvency I.

The result of this reform will be the Solvency II framework which is meant to “facilitate the development of a single market for insurance in the EU […].”13While Solvency II is one more plank in building a single market platform for the EU insurance industry, its aims are also to ensure capital adequacy, to strengthen risk management and to protect policyholders. The main objective is to mirror more strongly the actual risk taken by the entire insurance company. Solvency II therefore considers five risk categories:14Theoperational risks(system failures, fraud, etc.), thecredit risks(shortfall of reinsurers or debtors), theasset liability mismatch risks(e.g. due to wrong matching of assets to liabilities), themarket risks(volatility of the values of investments), and theunderwriting risks(calculation of premiums, reinsurance and reservation). Whereby the attempt is being made to design the rules and the new regulatory framework as simple as possible.15