An EDHEC Financial Analysis and Accounting Research Centre Publication

Solvency II: An Internal

Opportunity to Manage the
Performance of Insurance
Companies
July 2009

with the support of

Table of Contents

Introduction..................................................................................................................................5

Executive Summary....................................................................................................................9

1. Value Creation in Insurance Companies................................................................19

2. Solvency II: From a Constraint to an Opportunity

for Sophisticated Internal Management........................................................................ 35

3. Underwriting Risks and the Economic Capital Model

under the Solvency II Constraint...................................................................................... 49

4. Market and Counterparty Risks in the Economic Capital Model

under Solvency II Constraints............................................................................................... 69

5. Economic Capital Model versus Solvency II Regulatory Capital.....................87

Conclusion................................................................................................................................ 119

Appendix...................................................................................................................................121

References...................................................................................................................................154

Acronyms.....................................................................................................................................157

About the EDHEC Financial Analysis and Accounting Research Centre ............. 160

EDHEC Position Papers and Publications from the last four years.....................161

About Swiss Re..........................................................................................................................167

Printed in France, May 2009. Copyright EDHEC 2009.

The opinions expressed in this survey are those of the authors and do not necessarily reflect those of EDHEC Business School and
Swiss Re.
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Foreword
The study it is our pleasure to present to
you here was done by the EDHEC Financial
Analysis and Accounting Research Centre
and is sponsored by Swiss Re. This study
is an integral part of our innovative
approach to research, an approach in
which research is done for business, and
this in an attempt to favour a dynamic
that puts business at the heart of the
researcher’s work.
Since its founding the EDHEC Financial
Analysis and Accounting Research
Centre has, for two essential reasons,
stressed work on Solvency II and IFRS in
the insurance industry. First, we believe
that the implementation of this new
accounting and prudential framework
will have a great impact on the perception
of risks, not just by insurance companies
but also by the financial markets. So, by
taking into account this new regulatory
framework, valuation methods should
also undergo a profound shift. The second
reason for this emphasis is that the
financial industry is the industry in which
the measurement and management of
value creation in a risky environment are
at their most sophisticated.
This study shows that it may be in the
interest of the company to capitalise
on the investments required for purely
regulatory ends to pursue its own
objectives, in particular to perfect or
create an economic dashboard, which can
be used to improve management of the
company. The leading European insurers,
forerunners in this domain, show that
their economic capital models make it
possible to guide their choices, for the
company as a whole or for individual lines
of business.
An EDHEC Financial Analysis and Accounting Research Centre Publication
By elaborating a management tool for
an insurance company under Solvency II
constraints, we show the advantages of
putting in place such an economic capital
model and the degree of complexity needed
to create it with the data and simulations
required by Solvency II. So this study is
of relevance to all insurers, as they are
ultimately all compelled to comply with the
new Solvency II prudential regulations and
their common objective is the satisfaction
of their shareholders or members. We also
hope that this study will contribute to the
debate involving insurance companies,
institutional investors, financial analysts,
and supervisory authorities.
I would like to thank Liliana Arias Arellano,
an intern in our research centre, for her
contribution and her great availability.
Finally, this study would not have been
possible without the support of our
partner Swiss Re, to which we would
like to express our warmest gratitude.
Swiss Re, the world’s leading reinsurer, is
at the forefront in the development and
use of economic capital models, and our
discussions on the subject made it possible
to enrich this publication. The success of
this partnership demonstrates yet again
the advantages of close cooperation
between the business and academic
worlds.
Philippe Foulquier, PhD,
Director of the EDHEC Financial
Analysis and Accounting Research Centre
3
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

About the Author

Philippe Foulquier, PhD, is Professor of Finance and Accounting and

Director of EDHEC’s Financial Analysis and Accounting Research Centre.
He has a PhD in economic science and is a member of the SFAF (the French
Financial Analysts’ Society). He began his career in 1990 in the scientific
department of the French insurer UAP, as an internal consultant, notably in asset
liability management. He left UAP in 1996 and spent ten years as a sell-side
financial analyst in brokerage firms. He was head of the Pan-European insurance
sector at Credit Lyonnais Securities Europe, at Enskilda in 2000 and at Exane BNP
Paribas in 2003. During this time, he carried out several IPO and international
M&A operations. He has been ranked top insurance sector financial analyst in
the Extel/Thomson Financial and Agefi international surveys. He joined EDHEC
in 2005 to teach financial analysis and accounting and to head the EDHEC
Financial Analysis and Accounting Research Centre. He is also actively involved
in consulting in both IFRS-Solvency II and corporate valuation issues.

4 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Introduction

A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 5
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Introduction
Since the turn of the millennium, a profound
shift in the management of insurance
companies has been underway. The main
catalysts of this shift are the growing
complexity of risks, the sophistication of the
means of measuring them, and the demands
made by investors for greater transparency
and for higher-quality management. In
this environment, prudential (Solvency II)
and accounting (IFRS) requirements must
also adapt to create new frameworks
offering a better view of the risks borne
by companies.
All insurers, regardless of their characteristics
(public companies, mutual insurers,
provident societies) will be subject to
the new prudential rules and will thus
have to make heavy investments in the
data collection, risk measurement, and
simulations required by the supervisor.
The objective of our study is to show how,
by having these investments respond to
objectives more inherent to the company,
these Solvency II constraints can be
capitalised on. With a fictitious company, we
build a management tool for an insurance
company subject to Solvency II constraints.
We then highlight the contributions this
tool makes to the perfecting of the strategy
of the company, in particular for the
definition of policy for asset allocation,
management of capital, asset/liability
management, hedging of risks, and the
launch of new products. At the heart of this
model is value creation for shareholders or
mutual members.
To show how to transform Solvency II
constraints into an opportunity to perfect
company management, we first survey
the changes in the ways of measuring
performance. So, keeping in mind the major
6 An EDHEC Financial Analysis and Accounting Research Centre Publication
work done over the last three centuries,
we present in the first chapter the genesis
of value creation. We show how it is an
integral part of the management of an
insurance company and responds to the
goals of the industry as a whole, including
the member-centred mutual insurers. These
analyses make it possible to understand the
shift from a study of margins to the more
complete and relevant market-consistent
embedded value and the economic capital
models put in place by the leading European
insurers.
Chapter II focuses on the differing objectives
of regulatory and economic capital, but it
also shows the degree to which the Solvency
II prudential framework could become
an industry benchmark for the creation
of economic capital models and thus
contribute to the perfecting of insurance
company management. This chapter also
shows how, by building an economic capital
model subject to Solvency II constraints,
these constraints can be turned into a
management opportunity.
Chapters III and IV present the elaboration
of such a management model, and they
do so by simulating—based on data from
a fictitious insurance company active in
six lines of life, property and casualty, and
business—the underwriting, market, and
counterparty risk modules elaborated by the
international supervisor. The construction
of this model makes it possible to gauge
the complexity required and to determine
the feasibility of this construction for
all insurers, regardless of their particular
features.
Chapter V puts in place an economic capital
model subject to Solvency II constraints,
a model based on the work done in the
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Introduction

preceding chapters. We highlight the

contributions made by the model not just
to the definition of the strategic objectives
of the company but also to the tracking,
control, and measure of strategy and
management.

An EDHEC Financial Analysis and Accounting Research Centre Publication 7

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Introduction

8 An EDHEC Financial Analysis and Accounting Research Centre Publication

Executive Summary

9
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Solvency II has created a
prudential framework likely
to give a boost to the trends
taking shape…
…in managerial practices:
integration of risks,
consideration of the cost
of capital, value creation
for shareholders or mutual
members.
The aim of this study is
to show that it may be
opportune for a company to
capitalise on the investments
it has had to make for purely
regulatory ends …
…to achieve goals more
intrinsic to the company, in
particular by perfecting its
management tools.
10 An EDHEC Financial Analysis and Accounting Research Centre Publication
Executive Summary
In the last two decades, changes in risks
(distribution, extreme risks, correlation),
investor culture, managerial practices and
regulation have led to profound shifts in
corporate management. Value creation,
now at the heart of corporate strategy,
has gradually become an indispensable
approach to evaluating performance.
As a result of the nature of its business,
founded on uncertainty and bound by
new accounting rules (IFRS) and new
prudential rules (Basel II, Solvency II),
it is in the financial world that the measure
and management of value creation in a
risky environment are at their most
sophisticated; in many non-financial
industries profound management changes
are underway as well.
Solvency II is expected to come into effect
in 2010: it will introduce a new era for
insurance companies. Unlike Solvency I,
Solvency II seeks to create a prudential
framework that would converge with that
used in insurance companies’ internal
models, in particular with economic capital
models. The trend in managerial practices
observed in the past few years is likely to
gain momentum; the aim is to improve
the integration of risks (identification,
measurement and management), consider
the cost of capital and create value for
shareholders or mutual members. However,
data collection and simulations required
by the regulator in the new prudential
framework will, in view of the quantitative
impact studies (QIS) that have already been
done, call for heavy investment.
The objective of this study is to show
that it is perhaps advisable to capitalise
on these investments made for regulatory
ends alone to meet goals more intrinsic to
the company, in particular by perfecting
or devising an economic dashboard,
a management tool to improve the
company’s strategy. The leading European
insurers, which are forerunners in this
domain, have shown that their economic
capital model makes it possible to guide
their strategic global and/or local choices
for their lines of business, in terms of
asset allocation, management of capital,
underwriting, asset/liability management
and risk hedging.
We use data from a fictitious insurance
company to devise a means of managing
an insurance company subject to Solvency
II constraints. The objective is to show
the advantages of having an economic
capital model in place and the degree
of complexity involved in creating it
with the required data and simulations.
We then underscore the contributions
this management model makes in several
domains, such as the allocation of
risk-adjusted capital (RAC), the definition
of policies for investment, underwriting,
launch of new products, provisions,
reinsurance, asset/liability management,
allocation to lines of business and risk
management (definition of accepted
bounds, concentration, diversification), as
well as communication with the financial
markets, rating agencies and the prudential
regulator. At the heart of this model lies
value creation for shareholders or mutual
members.
The study is of relevance to all companies
in the insurance industry, regardless
of their features, because they are all
compelled to adhere to the new Solvency
II standards and they all strive to
provide shareholder or mutual member
satisfaction.

Making the cost of capital an
integral part of performance
measurement is likely to
impose a certain capital
discipline on both executive
and operational managers,
as the use of capital does not
come without a cost.
Economic capital models
are thus likely to become
indispensable in the world of
mutual insurance as well.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Executive Summary
Value creation and the cost of
capital: a managerial change at
the heart of the company…
Since the industrial revolution, the measure
of company performance has been the
subject of wide-ranging studies. Value
creation became one of the cornerstones of
economic thought in the early nineteenth
century and was gradually taken up in the
business world over the second half of
the twentieth century. Unlike the classic
measures of value—measures based on
turnover, net income or operating margins—
the measure of value creation assumes that
the resources of the company (capital and/or
debt) have a cost. This approach is applicable
to all companies in all industries.
For example, some insurers believe that
the third-party liability business performs
satisfactorily because it generates a net
margin (net income/turnover) as much as
three times that generated by the motor
own damage business. Yet when the net
margin is viewed in the light of allocated
economic capital it often turns out that
the motor own damage business is more
profitable.
Therefore, making allowances for the cost
of capital in measuring performance is
likely to impose a certain capital discipline
on executives and operational managers
throughout the operating cycle, as the
use of capital does not come without a
cost. This notion of a residual profit (the
profit generated in excess of the cost of
capital) was mentioned by General Motors
in the 1920s and first used a few years
later by General Electric. But it was not
until the 1990s that, as a result of the EVA
(economic value added) concept promoted
by the firm Stern & Stewart, this measure
of performance came into its own.
An EDHEC Financial Analysis and Accounting Research Centre Publication
…even for mutual insurers
It would be reductive to think that value
creation consists solely of optimising the
profitability of a company. For a mutual
undertaking, in the broad definition of the
term, and unlike public corporations, the
insured and the insurer are one and the
same (mutual members), so the profitability
of the company is not an end in itself. For
a mutual undertaking, value creation is
founded on satisfying members by providing
insurance products relevant to the features
of the affinity group (coverage, services), the
prices of which are not very volatile and the
margins on which reflect its particularities
as defined by the price/service ratio.
With the increasing globalisation of the
insurance market, the attempt to strike
a balance between competitive pricing,
coverage, premium refunds, and solvency
requires more efficient management.
Economic capital models devised around
the notion of value creation are thus likely
to become indispensable in the world of
mutual insurance as well.
Economic capital models
founded on value creation: a
growing trend…
In the early 1990s, the performance of
a company in any sector was measured
largely by its operating margin, net margin,
and the health of its balance sheet.
In the insurance business, the development
of asset/liability management models
in the mid 1990s and the measure of
performance in life insurance through
embedded value gradually encouraged
the leading insurers to create dashboards
to steer the creation of value. In view of
the investment necessary, only the largest
companies have had the means to come
up with such dashboards.
11
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
The mobilisation of capital
required by Solvency II
is a cost that is likely to
encourage companies to
optimise the way they
allocate their resources and
manage their risks...
…this is the main point
of convergence with the
economic capital model, the
strategic management tool.
12 An EDHEC Financial Analysis and Accounting Research Centre Publication
Executive Summary
The objective of the economic capital
models involves departing from the single
net margin standard to make allowances
for the cost of capital. These economic
capital models have become genuine tools
for strategic decisions.
... that should grow even
faster as a result of Solvency II
requirements
As the insurance business is subject to many
extreme exogenous variables, financial as
well as insurance related, the regulator
defines a minimum amount of capital
required to do business, so that the insurer
will be able to deal with these extreme risks.
The current regulatory solvency margin
(Solvency I) has never been included by
internal models, as it takes a proportional
approach to calculating the minimum
capital requirement, an approach to the
minimum capital requirement founded
on historic administrative and accounting
data—with variations depending on the
country where the company or subsidiary is
located—and calculated in standard fashion
in proportion to the volumes of business
(premiums, claims, or provisions) without
explicitly taking into account the notion of
risk. Economic capital models, by contrast,
take into account the correlation of risks
(technical, financial, operational), hedging
arrangements (reinsurance, derivatives,
securitisation) and the concentration and
diversification of risks.
The European Commission, with the
backing of CEIOPS (Committee of European
Insurance and Occupational Pensions
Supervisors), created a new regulatory
framework for solvency (CEIOPS, 2007), a
framework founded on economic principles
of valuation, risk management and internal
risk control. The Solvency II directive is
meant to give insurance companies
incentives to measure, manage, and control
their risks through a cost that translates
into the mobilisation of capital. This cost
will inevitably encourage companies to
optimise their resource allocation and risk
management. This is the main point of
convergence with the economic capital
model, the strategic management tool.
Nonetheless, despite the converging
conceptualisation and modelling of risks,
regulatory and economic capital are not
meant to be equal, as they have different
objectives. Regulatory capital is meant
above all to ensure a company’s solvency
for clients and to avoid any systemic risk; it
may have policy designs. Indeed, depending
on the calibration of the formula, some
activities or risks may be preferred to others.
The objective of economic capital is to
optimise the profitability of capital, directly
for shareholders or indirectly by improving
the price/service ratio for mutual members.
In this respect, the economic capital model
can easily meet regulatory requirements,
but first of all it is a strategic management
tool based on performance through the
measure of value creation.
In practice, the companies that have
(or would like to have) internal economic
capital models could use much of their
information and many of their tests for
regulatory purposes. Conversely, the
companies that do not have such models
could use the information required by
the regulator and with possible internal
management tools (risk analysis model,
reserves, pricing, asset/liability management
and so on) devise a dashboard or decision
tool in the spirit of the leading companies’
economic capital models. The degree of

Companies with economic
capital models will be in
a position to perfect their
internal management and to
gain a genuine competitive
advantage from it.
Solvency II could become a
new standard for defining
the amount of allocated
economic capital.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Executive Summary
sophistication of such a tool will depend
on the means available. As we have
noted, regardless of their size, legal form,
values, and objectives (value creation for
shareholders or mutual members), all
insurance companies are affected by this
prudential reform and thus by its impact
on the management of each firm.
The design and sophistication of Solvency
II should boost the fundamental trend in
managerial practices that has been observed
over the last decade. Companies with
economic capital models will be in a position
to perfect their internal management and
to gain a genuine competitive advantage
from it.
How management tools can
contribute under Solvency II
constraints
The standard formula spelled out in the
Solvency II prudential framework can be
seen as a simplified internal model that
each company can tailor (and is even
encouraged to use) to its own particularities,
especially in view of its exposure to risks
and its ability to manage them. With
the standard formula, we have devised a
simplified economic capital model subject
to Solvency II constraints.
The objective of this economic capital
model is to provide every company with a
management tool, the foundation of which
is the investment necessary to comply
with the requirements of the prudential
regulator, in terms of both data collection
and simulations. This decision tool makes it
possible to manage the amount of available
capital (the capital structure), allocation
to lines of business (in accordance with
profitability and the cost and consumption
An EDHEC Financial Analysis and Accounting Research Centre Publication
of capital), exposure to risks (which has an
impact on capital requirements), financial
autonomy, and solvency. The tool also
makes it possible to reallocate surplus
capital destructive of value to optimise
the profitability of existing activities or
to new developments or new business.
As capital has a cost, it is indispensable
to manage it. The Solvency II prudential
framework could become a new standard
and constraint for defining the amount of
allocated risk-adjusted capital (RAC).
Hitherto, the companies with economic
capital models have calculated RAC in
keeping with their own perception of risks
and the sophistication of their internal
models. For example, each company has
its own range of weights, although the
publication of these weights ultimately
attests to a certain heterogeneity.
Solvency II is meant to encourage an
operational approach to risk exposure,
that is, an approach consistent with
internal management and/or economic
capital models in an attempt to foster the
development of these models and to give
companies incentives to improve their risk
management. The calculation of allocated
risk-adjusted capital (RAC) in economic
capital models could, as a result of the
new solvency requirements, evolve toward
greater standardisation.
With a fictitious insurance company whose
characteristics are described in appendix 7,
we calculated the capital requirement for
each line of business (RAC), the company’s
profitability per line of business (return
on risk-adjusted capital RoRAC) and
surplus capital (the difference between
available capital and required capital). These
three components are at the heart of the
economic capital model described below and
13
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Executive Summary

1 - RAC in % = RAC/technical
provisions life or RAC/premiums
of our demonstration of the contributions In view of its turnover (% premiums),
in non life of such models to the management of a non-life insurance accounts for two-thirds
RoRAC = Net profit/RAC
RAC x = (RoRAC – g)/(CoC – g)
company. of this company’s business. A large share
where g is the perpetual growth
rate of value creation flows, CoC Economic capital model1
the cost of capital.
Life Non-life
RAC % of total = RAC/sum of RAC
A company’s value is based on a Activity Unit Euro Motor Property Third-party Health Sum Surplus TOTAL
combination of a cash flow-asset linked denominated own damage liability
mixed approach (called goodwill) damage
and a sum-of-the-parts
approach. Premiums
V = net asset value – accounting
Premiums EURm 250 1000 1000 1000 250 200 3700
goodwill + economic goodwill
V (RACj) = Premiums % 7% 27% 27% 27% 7% 5% 100%
Σt=1,.., ∞ RACj (RoRACj – CoCj)/
Capital
(1+ CoCj)t
= RAC (RoRACj – gj)/(CoC – gj) RAC in % (Solvency) 0.4% 3.1% 7.1% 10.8% 34.4% 9.9% 12.8%
where RACj is the economic
capital allocated to line of RAC EURm 5 185 71 108 86 20 474 615
business j. RAC % of total 1% 39% 15% 23% 18% 4% 100%
V(RAC) % = V(RAC)/Sum of
V(RACj) Profitability
Net margin 0.8% 4.0% 2.3% 3.0% 6.1% 2.9% 3.1%
Net profit EURm 2 40 23 30 15 6 116
RoRAC 35% 21% 33% 28% 18% 29% 24% 5%
Valuation
RAC x 4.7 2.8 3.6 3.1 2.0 3.2 2.9 0.5 1.2
V(RAC) EURm 25 513 256 336 169 64 1364 308 1671
V(RAC) % 2% 38% 19% 25% 12% 5% 100%
Source: EDHEC Business School

The economic capital model makes it of the business is exposed to frequency

possible not only to look at each strategic
decision from the perspective of the
relevant business unit(s) (line of business,
country, region, and so on) but also to gauge
the impact on the company as a whole.
Indeed, what is best locally is not necessarily
appropriate globally: for example, the best
acquisition from a strategic and financial
point of view in a particular country may
not be appropriate, in terms of management
priorities, profitability, financing, capital
allocation, and so on, for the company as
a whole. An analysis of the table above
makes it possible not just to see the risk
profile and profitability of the company
but also to propose strategic management
improvements.
risks; it thus has a low risk profile. The line
of business with the highest risk profile is
third-party liability, but it accounts for only
7% of premiums and, at first glance, enjoys
a net margin (net earnings/premiums)
significantly greater than that enjoyed
by the company’s other non-life lines
of business (6.1%, as opposed to 3% for
property damage, 2.9% for health and 2.3%
for motor own damage). Many insurance
companies still analyse risk profiles based on
net margin and the weight of the turnover
or the balance sheet items of individual
lines of business in the company as a whole.
The ROE (return on equity) of the company—
here 11.3%—is calculated to refine this
analysis. This calculation is based on
published book equity that in no way
reflects the economic dimension (under-

14 An EDHEC Financial Analysis and Accounting Research Centre Publication


2 - Allocated economic
capital was calculated with
the Solvency II standard
formula, which is an initial
phase in the improvement
in the analysis of risks and
of economic performance,
but which, as we note above,
could be made much more
sophisticated with a partial or
total internal model.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Executive Summary
or over-capitalisation, goodwill, in force,
and so on) and as such it is a poor strategic
indicator and does not serve as a solid basis
for the comparison of the performance of
the company and that of other companies
in the industry.
If during the analysis the capital required
for each line of business is kept in mind,
the conclusions are quite different:
the riskiest business and the highest
margin business—third-party liability—
has a greater weight than its share of
premiums (7%) would first suggest. Indeed,
it consumes 18.3% of total allocated RAC,
2.6 times more than its share of premiums.
So the profile of the company is riskier than
was suggested by the conventional analysis
described in the preceding paragraph. If
allocated economic capital2 rather than
net margins, ROE or Solvency I (net
profit/16% of turnover) is used to measure
the performance of third-party liability,
one sees that it requires five times more
allocated capital given its intrinsic risks
(RAC in %, 34.4% vs. 7.1%), and profitability
of allocated economic capital (RoRAC) is
18%, as opposed to 33% for motor own
damage, 28% for property damage and
29% for health. This results in an implicit
valuation of two times allocated capital in
third-party liability as opposed to 3.6 times
in motor own damage insurance (see RAC
x in the table above).
Motor own damage, the business that
generates the lowest net margin (2.3%),
turns out to be the company’s second most
profitable line of business (RORAC of 33%
as opposed to 35% for unit-linked business),
and this as a result of its modest risk profile
(measured here with the Solvency II standard
formula, though this measurement could be
perfected with an internal model).
An EDHEC Financial Analysis and Accounting Research Centre Publication
With respect to strategic decisions, what
main conclusions can be drawn from this
dashboard? We will list only two, as each
number naturally provides key information
for the management of the company.
In terms of RoRAC, the least profitable
lines of business are third-party liability
and euro-denominated policies; they
account for 57% of the total RAC of the
company ((185+86)/474). The first means
of improving this situation could be to
reduce RAC by analysing each of the risk
sub-modules. By identifying the greatest
consumers of capital, it is possible to
identify the actions that can be taken to
reduce this consumption. It may be possible
to analyse possible risk transfer policies to
reduce the capital allocated (RAC) to third-
party liability. The numerator in RoRAC may
be looked at as well; that is, it is possible
to study ways to improve the standardised
economic results of these two lines of
business (fees, rates offered to the insured,
asset allocation, underwriting and financial
hedging policy, administrative, management
and acquisition costs, portfolio selection,
fraud, claims management costs and so
on).
Other types of strategic decisions could be
considered as well. Has the company’s third-
party liability business reached critical mass?
If operational and financial management
are already optimised and there is no room
to improve RoRAC (by steering RAC and
net earnings), is it strategically appropriate
to maintain this business? If so, might
it not need to expand (to attain critical
mass)? Such an analysis should naturally
be done for each line of business in an
attempt to identify possible improvements
to RAC as well as to net earnings and risk
management.
15
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
The measure and calibration
of the formula are decisive,
and some reworking is still
necessary…
…if the supervisor does not
want to cause distortions
that are at odds with the
objective to create incentives
for insurance companies to
improve the management of
their risks.
16 An EDHEC Financial Analysis and Accounting Research Centre Publication
Executive Summary
Another strategic point is the management
of capital surpluses. We see that on the
basis of RAC the company is valued at an
implicit multiple of 2.9 (RAC x line), but
that taken as a whole this multiple changes
to 1.2. This value destruction stems from
the capital surplus: only 43.5% of the
company’s available capital is allocated to
the insurance business, so 56.5% destroys
value. The company should think of ways
to improve the allocation of this “dormant”
capital, by reinvesting it in existing lines of
business to make them more profitable or
by moving forward with acquisitions that
would make the company bigger or more
diversified or, as a last resort, by returning
capital to shareholders (dividends, share
buybacks) or mutual members (premium
refunds).
It would of course be possible to fine
tune the strategies resulting from closer
analysis.
Risk transfer policy is likely to
undergo profound changes
It is our view—and to bring about this
change is also one of the objectives of
the regulators—that the universe of risk
transfers will undergo profound changes.
The catalysts of these changes in the
culture of the ceding companies and thus
in the supply of risk transfers are found
in the incentives provided to view these
transfers not just by business unit but
also from the perspective of the overall
company strategy (optimisation of required
capital, reallocation of paid-up capital)
and in the quantitative and qualitative
standardisation brought about by pillars 1
and 2 of Solvency II. We have shown that
the treatment and calibration of reinsurance
by the European regulator will have a great
impact on the risk transfer policies of the
ceding companies, on the rate of coverage
as well as on the way insurers divide up
the risks they transfer to reinsurers, on the
number of reinsurers as well as on their
rating and prices.
Nonetheless, the part of the model of
underwriting risk based on net premiums
leads to calibration errors (as a result of
the non-linearity of net premiums and risk
transfers) that in turn lead to errors in the
capital requirement, errors that are likely
to favour policies that do not manage risk
optimally over others that do. In this way,
the measure and calibration of the formula
are decisive, and some reworking is still
necessary if the supervisor does not want to
cause distortions that are at odds with the
objective to create incentives for insurance
companies to improve the management of
their risks.
Conclusion
In the last ten years, the managerial
practices of the leading insurers have
undergone profound changes, in particular
by making value creation an integral part
of their strategic choices. The development
of asset/liability management models,
embedded value models, and then economic
capital models has increased executive and
operational management awareness that
decisions should be made in the knowledge
that capital is not a free resource and that
it must be managed accordingly.
At the same time, with the growing
complexity of risks, the prudential regulator
sought to put in place regulation more
consistent with the economic reality
and practices of insurers. The transition
from Solvency I to Solvency II leads to a
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Executive Summary
determination to calculate the solvency
of an insurance company on the basis of
a standard formula (or of a partial or full
internal model) that converges with that used
in economic capital models. In addition to
the measure of solvency itself, the regulator
seeks to foster the development of internal
models likely to improve identification,
calibration and management of company
risks; it is thus necessary to be consistent
with the economic approach taken by the
insurance companies.
As for the quantitative impact study (QIS4),
the data collection and simulations required
by the regulator are a heavy investment for
many companies. In our opinion, it would
be wise to capitalise on this investment
made for purely regulatory ends to pursue
goals more intrinsic to the company itself:
to perfect or put in place a decision tool,
with a view to improving the management
of the company and boosting its creation
of value. These decision tools make
numerous contributions: management of
risk-adjusted capital, definition of policy
for investment, underwriting, launch of
new products, reserves, reinsurance, asset/
liability management, allocation of capital
to individual lines of business, risk
management (definition of accepted
limits, concentration, diversification),
and communication with the financial
markets, rating agencies, and the prudential
regulator.
Just as we were concluding this study,
representatives of the European Commission
and the European Parliament finally came
to an informal agreement, on 26 March
2009, on the Solvency II directive proposal,
a consensus reached after a major effort:
it involved dropping the notion of “group
support”. Group support would have meant
An EDHEC Financial Analysis and Accounting Research Centre Publication
that pan-European companies could have
consolidated their capital more heavily
at the parent company, by including the
benefits of diversification of the subsidiaries
active in other European countries, a
practice that would have exempted these
groups from having to comply with capital
requirements in each country. Nonetheless,
the notion of group support may be looked
at again in three years, after the entry into
force of Solvency II.
In addition, CEIOPS is relying on analyses
of the results of QIS4 and of the current
financial crisis to come up with an improved
measurement and calibration of the model.
Called into question are the approaches
to measuring liquidity, concentration and
counterparty risks, the loss given default
for financial derivatives, and the correlation
of market risks.
We believe that these choices are decisive,
all the more so in view of the current financial
and economic crisis, as they will have a
major impact not just on the effectiveness
of the protection of the insured but also on
the incentives created to improve insurance
company management.
17
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Executive Summary

18 An EDHEC Financial Analysis and Accounting Research Centre Publication

 1. Value Creation in
Insurance Companies

19
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
In recent years the insurance industry has
undergone profound change: competition
has grown stiffer, companies have
consolidated and expanded overseas,
insurance and financial risks have become
increasingly complex. To adapt to these
changes, modelling has become more and
more sophisticated (premiums, reserves,
asset/liability management, embedded
value).
Since the late 1990s, some leading
European insurers have put in place real
strategic decision-making tools, tools
known as economic capital models. They
have several functions: they may serve
to define policies for investment, for
underwriting, for creation of new products,
for reserves, for reinsurance, for asset/
liability management, for capital allocation,
for capital arbitrage, for risk management
(definition of accepted limits, concentration,
diversification) or as a means of
communication with the financial markets,
rating agencies, and the prudential
regulator. At the core of these models is
value creation.
The primary objective of this chapter
is to do an analysis of the academic
foundations of value and of its
development in the business world
(section I) and show the relevance
of this notion for the management
of a company. Section II analyses the
extent of the domain in which it can
be applied, in particular in the mutual
insurance business, and it will do so even
though the objectives and values of this
business are centred on the members of
the mutual.
The second objective is to show how
Solvency II should, as a result of its
20 An EDHEC Financial Analysis and Accounting Research Centre Publication
nature and sophistication, accelerate the
trend in managerial practices that has
been observed over the last decade: the
inclusion of risk management and the cost
of capital in the process of performance
measurement and value creation. This
trend is a true departure (section III) from
traditional approaches focusing on sales
and on operating and net margins.
Although not all insurance companies may
have the means to create elaborate internal
economic capital models, we will show in
section IV and in the following chapters
that with the data and simulations
required by Solvency II it is possible to
transform these investments to improve
management.
I. Value Creation, at the Heart of
Corporate Management
Value creation is one of the cornerstones of
economics. This section looks at the origins
of value creation as well as at its accepted
academic meanings. The objective is to show
how value creation has, over the twentieth
century, gradually made its presence felt in
business. Unlike traditional indicators of
value, indicators based on sales, net profit,
or margins, value creation incorporates
the notion of performance while taking
into account the cost of resources. Taking
into account the cost of resources is likely
to require that both executive managers
and operational managers draw on
capital, throughout the business cycle,
with a certain discipline, as the use of this
capital does not come without costs.
We will show in particular that the
objective of creating shareholder
value is not at odds with satisfying
other stakeholders in the company

1 - Initially, discounting
made allowances only for
the temporal value of money.
There is a time preference or
impatience for immediate
consumption (Fisher 1930)
measured by the risk-free
interest rate. It is not until
Markowitz’s (1952) work
on the measure of risk and
Sharpe’s (1964) and Lintner’s
(1965) formalisation of
this work with the famous
capital asset pricing model
(CAPM) that the discount
rate incorporates a risk
component. Since this work,
the discounting of future
cash flows has been
grounded on a rate that
incorporates the opportunity
cost of a risk-free investment
as well as the risk premium
demanded by an investor.
2 - The share of the profits
generated by a company
that goes to the shareholder
(variable) is that which
remains after the other
stakeholders of the company
(employees, suppliers, banks,
the state) have been paid,
in keeping with the terms
of a contract that clearly
spells out their remuneration
(fixed).
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
(clients, employees, suppliers, banks,
governments). So the managerial
revolution underway in the leading
insurance companies, a revolution
sparked by economic capital models,
is affecting all those involved in the
industry, including mutual insurance
companies, whose primary concern is
member satisfaction.
I.1. The accepted meanings of
value creation: the cornerstone of
economics
For the origins of value creation, it
is necessary to go back to the classic
economists, who, in fact, make it one of
the cornerstones of economics. At the
outset, the notion of value was associated
with that of labour: the value of a good
is represented by the cost of the labour
that went into the production of the good.
This notion, pioneered by Smith (1904)
and further developed by Ricardo (1817),
was taken to its political apogee by Marx
(1867). At the same time, another school
of thought was taking shape: Say (1803),
who disagrees with this notion of value,
believes instead that the value of a good
is the result of its utility to the person who
uses it.
Finally, grounded on these two schools
of thought, value can be defined on
the basis of a transaction (exchange or
market value), a function of the cost of
production to the seller and on the basis
of utility to the buyer (utility value).
So it is possible to define an objective value
made up of an unchangeable social sense
(cost of labour and resources used, observed
exchange value) and a subjective value made
up of the individual perceptions of those
involved (the utility value or the individual
and occasional value an economic agent
An EDHEC Financial Analysis and Accounting Research Centre Publication
ascribes to a good or service, depending on
its ability to meet a particular need).
The reconciliation of market value and utility
was achieved by corporate finance theory
(Caby and Hirigoyen 2001). Taking into
consideration the existence of a risk-free
(or fixed-income) asset and its opportunity
cost for any investor, in equilibrium, the
exchange value (market value) of a risky
asset should converge toward its utility
value, as measured by the discounted value
of the cash flows it will generate.1 Since
the work relying on institutional theories
of the firm (theory of ownership rights, of
transaction costs, and of agency costs—see
Coriat and Weinstein for a review), lenders
of equity have been viewed as holders of
residual rights2 and as such they bear the
totality of the risks. In exchange, they
require a utility value (and thus a market
value) of their investments (contributors
of capital) greater than the opportunity
cost, increased by the specific risk of the
firm. As a consequence, the maximisation
of the market value of capital, that is, of
the utility value for the shareholders with
respect to the risks they bear, should be the
main objective of any financial decision
(Albouy 2006).
All the same, in practice, as the manager
of the company is privy to information on
each stakeholder in the company (clients,
employees, suppliers, banks, the state), it
is often he who decides how to allocate
any surplus to these stakeholders. In an
uncertain environment characterised by
the incompleteness of contracts, each
stakeholder runs a risk in the relationship
of information asymmetry that binds him
to the manager (Garvey and Swan 1994;
Zingales 2000). So now the objective of
the firm is to create value not just for
21
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
3 - ROI or ROIC (return on
invested capital) is the net
profit divided by the invested
capital.
4 - Stern Stewart & Co. has
trademarked EVA.
5 - Capital invested/employed
is the net assets invested
throughout the business
and investment cycles. It is
financed by equity and debt.
It is equal to the sum of
fixed assets and the need for
working capital.
6 - Return on capital
employed (ROCE) is the
operating profit after taxes
divided by capital employed.
Although it measures the
efficiency of a company’s
business from a financial
point of view, it is an
accounting indicator that
fails to make allowances for
the notion of risk.
7 - WACC is the overall
financing costs for a
company, that is, the
rate of return required by
the suppliers of capital
(shareholders and creditors).
22 An EDHEC Financial Analysis and Accounting Research Centre Publication
1. Value Creation in Insurance
Companies
shareholders but for all stakeholders.
Charreaux and Desbrières (1998) note that
all stakeholders are affected each time a
strategic decision is made in the company.
So these authors speak of stakeholder value.
It can be measured at each link in the chain,
by taking into consideration the difference
between the price paid by the recipient of
the value and the minimum price required
(opportunity cost) by the contributor of
this value.
In this respect, the work of Rappaport
(1987) and Slywotzky (1998) shows
that the companies that focus on
creating value for clients end up
creating more shareholder value than
do those that focus exclusively on
financial indicators of shareholder
value. In particular, innovative products
and services offered clients make it possible
to build a lasting competitive advantage,
a source of additional shareholder value.
In short, creating shareholder value is not
incompatible with the satisfaction of other
stakeholders in the company (Denglos
2008). The value created for the shareholder
is the final link in a chain whose strength
rests on the earlier satisfaction of the other
stakeholders. It is nonetheless the ultimate
objective.
I.2. Value creation (and measuring
value creation) in the corporate world
Pinpointing the origin of value creation
in the corporate world is not easy, but the
notion seems to have been current, in large
conglomerates with several businesses,
since the start of the twentieth century
(Johnson and Kaplan 1987). In classic
economic theory, value for the holders of
residual rights was initially measured with
net income (and/or earnings per share). It is
for this reason that in spite of subsequent
developments the price-earnings ratio
(P/E), which has several drawbacks (static,
dependent on the financial structure), is
still so heavily relied on.
Large companies have gradually refined their
measure of value creation by incorporating
the capital invested by each profit and
investment centre. Return on investment
(ROI)3 was essential to strategic decision
making until the late 1980s. In the 1960s,
however, ROI will be called into question
(Dearden 1969) and a notion founded on
the concept of residual income, a notion
that is today standard, will take its place.
All the same, it was not until the 1990s,
when the consulting firm Stern & Stewart
promoted EVA (economic value added),4
that the measure of performance adjusted
for cost of capital really came into its
own.
In this approach, value creation corresponds
to the firm’s profits in excess of the
rate of return required by the suppliers
of capital (shareholders and creditors).
According to Solomons (1965), cited by
Bromwoch and Walker (1998), the term
residual income was first used by General
Electric, even though the president of
General Motors in 1923 (A. Sloan) refers
to an indicator of this type in the early
1920s. EVA is the capital employed5
multiplied by the difference between
return on capital employed (after taxes)6
and the weighted average cost of capital
(WACC).7 As the first tool for decentralised
financial management, capable of gauging
the performance of a unit by applying an
embedded required rate of return, EVA is
often considered the forerunner of the
dashboards and value management (also
known as economic capital models) put in
place by companies.
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

1. Value Creation in Insurance

Companies

8 - CFROI is a variation
on ROI that measures the
EVA will be widely taken up outside So then, unlike the traditional indicators of
difference between the consulting firms. Some academic studies value that are based on sales, net income,
internal rate of return (IRR)
on capital employed and the
(Anctil 1996; Reichelstein 1997; Rogerson or margins, these indicators are closer to
weighted average cost of 1997) have demonstrated analytically the the notion of performance, as they include
capital (WACC) multiplied
by the amount of capital ability of EVA and of residual income in optimisation of the use of resources. This
employed. The idea is to
determine the IRR that leads
general to coordinate company objectives feature is likely to force managers to use
to a match between the in the context of an agency relationship. capital with a certain discipline throughout
gross value of investments
before amortisation and the Many variations have been created: cash the business cycle, as the use of capital has
future after-tax operating flow return on investment (CFROI),8 its monetary costs.
cash flows generated over
the estimated life of the total shareholder return (TSR),9 the
investments. A simplified
version of CFROI involves
Strategic Planning Associates model,10 The success of these indicators of value
dividing earnings before the McKinsey and LEK Consulting model for creation lies also in the ease with which they
interest, taxes, depreciation,
and amortisation by capital discounting future cash flows, the Marris can be explained to operational managers
employed and comparing this Q index (price/book value of equity), the and with which they can be made aware
ratio to WACC.
9 - TSR is the internal rate Marakon Associates model, the Fruhan of the cost of financial resources. So it is
of return on an investment
made up of the purchase of
and McKinsey model. The interested little wonder that some companies have
a share of a company and reader can find a description of these used them to force responsibility on their
whose revenue flows are the
sum of the dividends and the models in appendix 1 (Appendix 1: Value managers, by putting in place, for example,
share price at the end of the
period, discounted for the
Creation Models) and in the work of Hoarau a system of variable pay indexed to a value
cost of capital. The indicator and Teller (2001) or Caby and Hirigoyen creation indicator. Stern, the co-founder
of the Boston Consulting
Group compares a forecasted
(2001). of Stern Stewart, goes so far as to speak
TSR and a TSR founded on of employee capitalism (Ehrbar 1999). The
realised results.
10 - The Strategic Planning Although these indicators of value creation value created, as it happens, is shared by
Associates model relies on the
value curve approach, which
differ, they ultimately have the same shareholders, who see the prices of their
involves comparing the price/ conceptual framework: shares rise, and managers, who receive
book ratio (the ratio of the
market value of a company • Operationally, the firm creates value with bonuses.
to its book value possibly the resources it has available, that is, the
adjusted for intangible
assets) and the ratio of the capital employed We believe that reliance on economic
return on capital (Rc) to the
minimum expected return on
• Financially, value creation is discounted capital models founded on these notions
capital (Ra). When the price/ at the cost of capital (that is, that of of value creation, currently the province
book ratio is greater than the
return on capital/minimum resources) of only a few leading firms, will, in
expected return on capital • The organisational dimension (organisation tandem with an increase in management
ratio the performance of the
firm will, in all likelihood, of a corporation into profit centres) is control and risk management, increase
improve, thus creating value.
associated with a certain allocation of in the near future. These models make
resources and has an impact on the cost it possible not just to offer management
of capital a broad view of the performance of the
• Managerially, the pursuit of the efficient company and to optimise the allocation
use of resources results in a need for each of capital to each operational unit in view
investment to generate a return greater of its profitability but also to provide a
than the cost of capital. So investment point of reference for investors, financial
and financing are closely bound up with analysts, and rating agencies.
each other, a message that should also be
understood at the operational level. The object of this study is to show that in
the insurance industry the implementation

An EDHEC Financial Analysis and Accounting Research Centre Publication 23

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
of Solvency II forces companies to build
internal models or at the very least to make
significant investments in the gathering
of data that could then be used for other
purposes: to refine strategy, to improve
management, and thus to increase the
profitability of insurance companies. In
other words, these data could serve as the
foundation of a dashboard for managing
the company or even of economic capital
models such as those used by the leading
European firms.
With our examination of the original
notion of value creation, we have
shown that this managerial revolution
is of relevance to both leading insurers
and smaller insurers, and that this is
so whatever their legal form (mutual
insurance company, public company,
provident society, and so on) or end
objectives (satisfaction of the mutual
member on the premium charged/service
provided criterion or of the shareholder
on the risk/return criterion).
II. The Concept of Value Creation
in Mutual Insurance Companies
What with the widely differing views held
by the different groups of mutual insurance
societies (as opposed to incorporated or
public companies), it seemed worth taking
a look in this section at the ways in which
these groups are also affected by this
managerial revolution, the momentum
of which is growing with the work on
Solvency II.
As it happens, a reductive version of value
creation consists of optimising a company’s
profitability. Now, for a mutual insurance
company, optimising profitability cannot
be an end in itself, as the insured party
24 An EDHEC Financial Analysis and Accounting Research Centre Publication
and the insurer are one: the mutual
member. Is it then necessary to reject
the notion of value creation for the
mutual insurance universe? Does the
economic capital model make no sense for
mutual insurance societies? We will show
that the answer to these two questions is
no, and that Solvency II has been at the
origin of much thought in mutual insurance
companies (in the rest of the survey we will
use the term mutual to differentiate these
organisations from incorporated companies
or public companies).
Value creation is interpreted one way in a
mutual and another way in an incorporated
company. First of all, the mutual member
(both the insured party and the insuring
party) participates in the life of the mutual
undertaking with his vote at general
meetings (he may even be elected to the
board). The board determines the policies
of the mutual undertaking, including
the budget for overhead and changes in
premiums. When the mutual undertaking
makes a profit, the members may be given
a premium refund (for example Mutuelle
de Poitiers refunded €6.3 million to
its members in 2005; Ethias refunded
€9 million in 2006). On the other hand,
in the event of heavier-than-expected
claims, mutual undertakings charging
variable premiums may adjust those
premiums upwards (for example, in 2000,
after the storms Lothar and Martin, MAIF
adjusted total premiums upwards by €53.4
million).
So for a mutual undertaking value creation
relies on member satisfaction: insurance
products well suited to the characteristics of
the affinity group (coverage and services),
stable premiums, and margins consistent
with member needs. According to Facts

11 - Such a scheme is not
unique to the insurance
industry: rival carmakers, for
example, may develop motors
jointly.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
and Figures (2008), the combined ratios
of mutual undertakings are less volatile
than those of public companies and, in
an attempt to maintain a price/service
ratio satisfactory to their members, their
profitability seems deliberately to be kept
to less than 10% (as measured by return
on equity). Finally, the solvency margin of
mutual undertakings is usually greater than
that of public companies. Unlike public
companies, mutual undertakings have not
usually optimised their equity financing.
Note, however, that, so as not to distort
the analysis, mutuals cannot reduce the
accumulated shareholders’ equity and that
the bulk of the business for some mutual
undertakings is insuring against long-term
risks.
In a public insurance company, by contrast,
it is a tripartite arrangement: the insured
party, the insurer, and the shareholder.
The relationship between the insured
party and the insurer is a purely commercial
one. The insured party is not involved in the
insurer’s policy decisions, premium setting
or product development. If the insurer
is profitable, it can pay dividends to its
shareholders. If it loses money, it cannot
resort to premium adjustments and must
instead appeal to the shareholder (new
equity issues). Value creation is done mainly
with shareholders (and often management)
in mind.
So the mutual and corporate worlds’
contrasting views of the ties between
value creation and profit are founded
on the fact that profit is merely a tool
for the mutual undertaking but an end
in itself for the public company. All the
same, this difference is not likely to call
into question the trend that, for more
than a decade now, has been underway in
An EDHEC Financial Analysis and Accounting Research Centre Publication
the management of insurance companies
and that will gather momentum with the
entry into force of Solvency II.
For one thing, the insurance industry is
globalising, and it is become increasingly
complex for mutual undertakings to strike
a balance among competitive premiums,
refunds, and solvency. For another,
the Solvency II Quantitative Impact Studies
result, for some small or specialised mutuals,
in solvency requirements as much as ten
times greater than those of Solvency I.
And the ability of these insurers to turn to
the financial markets is often limited.
To survive in this new environment, some
mutuals have advocated more efficient
management (some even mention the
use of dashboards or decision tools
reminiscent of economic capital models)
and, failing that, consolidation of those
involved in the business. According to
Jean-Claude Seys (2006), this consolidation
would enable the new entities to benefit
from the size effect, from diversification
of risk, and perhaps even from
internationalisation and access to the
capital markets through issues of
subordinated debt. Consolidation could
take place through mergers when the
undertakings are involved in similar
lines of business, offer similar products,
and have similar distribution networks
(see the merger of MMA and Azur,
for example); or a common controlling
entity could also be created (cooperation
among mutual undertakings that continue
to have a legal existence, as in the case
of Covea, an undertaking in a group of
mutuals undertakings—SGAM—that is
without capital of its own but has a social
fund whose members are exclusively
mutual insurance undertakings).11
25
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
12 - With its commitments
to those it insures, an
insurance company must
have own funds sufficient
to withstand a multitude
of external shocks. At the
time, the measure was
relatively unsophisticated, as
asset/liability management
models were, for the most
part, used only by British or
North American insurance
companies.
13 - It is the difference
between the return on the
assets of the company and
the payments made to
policyholders.
26 An EDHEC Financial Analysis and Accounting Research Centre Publication
1. Value Creation in Insurance
Companies
We will examine in greater detail the
managerial evolution and the suitability
of resorting to an economic capital model
in section IV.
III. Value Creation and
Performance Measurement in
Insurance Companies
For a closer look at the origins of dashboards
or economic capital models and at the
suitability of using them, we propose in this
section to put in perspective the change in
the measure of performance and of value
creation in insurance companies. We will
show that these decision-making tools have
very naturally become standard in certain
companies.
III.1. From net asset value to
embedded value
In the early 1990s, as in the manufacturing
sector, value creation and the performance
in general of an insurance company were
measured by operating margins (before and
after financial profit, given the weight of
the latter in the business), net margin, and
the good health of the balance sheet.12
Turnover (insurance premiums), the
combined ratio in property and casualty
insurance and the financial margin in
life insurance13 were the main means of
evaluating the strategy of a company.
When it came to assessing the health of
the balance sheet and pricing an insurance
company, the main indicator was net asset
value: the book value of shareholders’
equity adjusted for the unrealised capital
gains or losses, net of policyholders’ share
and net of taxes, and possibly adjusted
for other on and off balance sheet items
(mainly analysis of the ratio of technical
provisions and goodwill). In the literature,
there is much talk of wealth valuation
methods that rely on an instant snapshot
of the balance sheets and thus on past
events alone.
When, in the mid 1990s, the stock market
capitalisations of European insurance
companies began substantially to exceed
their net asset value, methods for the
evaluation and measurement of value
creation were refined. It turned out that
the net asset value multiple (market
capitalisation/net asset value) could be
greater than one, given the profits generated
by the company. Like M. Jourdain, who spoke
in prose without realising it, most financial
analysts took value creation approaches
without knowing they were doing so.
Indeed, this net asset value multiple was
nothing but the simplification of the ratio
of the profitability of insurance companies
to the cost of capital.
It can be argued that an insurance
company creates value when the net
asset value multiple is greater than one.
As it happens, the value of an insurance
company is the sum of its net asset value
and its goodwill. Goodwill is made up of
intangible assets, that is, of the value of
those prospects of the company that are not
included in the balance sheet (for example,
the profits that will be generated by a
savings insurance contract are often absent
from the balance sheet but are nonetheless
a source of wealth for the company). So
economic goodwill (future cash flows
generated by the firm) replaces the book
value of goodwill taken from the balance
sheet. Unlike the traditional approach,
goodwill (GW) makes it possible to view
the company as a going concern and to
make allowances for future profitability.
This goodwill can thus be analysed in
terms of the value created by the company,

14 - Economic goodwill can be
expressed as the discounted
sum of superprofit (as the
Anglo-Saxons call it), that is, of
net profit NPt less the cost of
capital (NAV*rE where rE is the
cost of capital):
GW = Σt=1,n(NPt - [NAVt * rE ])/
(1+ rE)t
15 - In the context of
embedded value, the cost
of capital is the cost of the
capital assets required to
ensure the solvency of the
insurance company in the
event of different scenarios
(including extreme shocks).
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
that is, in terms of the profitability of the
company with respect to its net asset value
(RoNAV and the cost of this capital (rE)).
So the valuation (V) of an insurance company
can, by making certain assumptions that
simplify prospects for cash flow growth,
be expressed as a multiple of net asset
value:14
V = NAV + GW = NAV * RoNAV/rE
If RoNAV > rE the company creates value and
the investor agrees to price it above the net
asset value so as to include the future value
creation cash flows that it will generate.
Conversely, if RoNAV < rE the company
destroys value and it is priced at less than
its net asset value.
With this dual determination to refine
in-house the tracking and management
of risks and to improve valuation
techniques (in a world where the
consolidation of the industry, in and
outside the European Union, is gathering
momentum) came the development of the
notion of embedded value.
Embedded value (EV) can be seen as
the value of a life insurance company
that stops writing new business. It is
often associated with scrap value. It is
the sum of net asset value (after deduction
of accounting goodwill in life insurance)
and of the value of in-force business (VIF),
the present value of future profits from
existing insurance contracts, less deduction
of the implied costs of the risks (cost of
capital15). It is calculated net of taxes and
of the share owed to policyholders.
Deterministic at the outset, measures of
embedded value are gradually becoming
uniform. Its sophistication (stochastic
An EDHEC Financial Analysis and Accounting Research Centre Publication
calculation, integration of contract options
and guarantees) has led to the creation
of European embedded value (EEV) and
market-consistent embedded value (MCEV)
(CFO Forum 2004; 2005; 2008).
Calculation of embedded value (EV, EEV,
MCEV) relies on modelling policyholder
behaviour (mortality table, surrender
and cancellation rates, average up-front
fees, amount of average premium, and
so on), on the quality of management
(the gap between financial statements
and the estimates, commissions,
matching of assets and liabilities,
hedging policy, profit-sharing policy),
and on macroeconomic scenarios
(financial markets, inflation, taxation, and
so on).
Embedded value, then, has gradually
become the standard measure of the
creation of value by life insurance: externally
(investors, mergers and acquisitions) as well
as internally (standard tool for business
and risk management). Some insurance
companies (AXA and Allianz, for example)
have recently modified the features of
their products before launch (premiums
and guarantees) as a result of the MCEV
readings of value creation.
III.2. From the sum of the parts to the
economic capital model
In view of the great differences (risks,
profitability, capital requirements) from
one branch of insurance to another, it was
necessary to refine the approach to value
creation, a refinement that began in the
late 1990s.
So called sum-of-the-parts valuation
methods were thus gradually developed
while, at the same time, some leading
27
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
insurers were creating in-house models
per business unit, the forerunners of today’s
economic capital models.
Sum-of-the-parts valuation involves
replacing net asset value (NAV), as defined
in the preceding section, with the sum
of risk adjusted capital for each activity
j (RACj, determined by the economic
solvency requirement for each company as
shown by its experience and its exposure
to risk) and the surplus or deficit of
capital (non-allocated capital). For the
capital allocated to each activity RACj
it is possible to calculate a return on risk
adjusted capital (RoRAC), a cost of capital
CoC, possibly a perpetual growth rate gj
and thus to determine the value of the
company (V) and its creation of value:
V = NAV + GW = NAV + Σj=1,m Σt=0,n
[RACjt[RoRACj - CoC)]]/(1+CoC)t
V = (NAV - Σj=1,mRACj) + Σj=1,m RACj *
(RoRACj - gj)/(CoC - gj)
The first term is the surplus capital.
By design, risk adjusted capital (RAC)
includes a margin of safety to cover any
possible risk, so the surplus capital is likely to
destroy value and should thus be managed
actively (share buyback, extraordinary
dividends, or acquisitions)
Dashboard for steering and valuation of an insurance company
Activity j RACj RoRACj CoC
1 V(RAC1)
2 V(RAC2)
…
…
M V(RACm)
Surplus
Source: EDHEC Business School
28 An EDHEC Financial Analysis and Accounting Research Centre Publication
The second term measures value creation.
One finds that the risk adjusted capital
multiple is greater than or less than one,
depending on whether the company creates
value (RoRAC >CoC) or destroys it.
With the results for each element of the
sum of the parts, it is possible to create
the following dashboard, a dashboard
widely used by those who value insurance
companies.
When the activity under consideration is
life insurance, value creation is measured
using market consistent embedded value.
When it is property and casualty insurance,
value creation depends on premiums,
shareholders’ equity, reserves, the return on
financial assets, and the combined ratio.
Concomitantly, some insurance companies,
have, since the start of the new millennium,
created economic capital models that rely
on an analysis broadly similar to that which,
described just above, is used for valuation.
To measure the break in the appreciation
of the strategy caused by this approach,
consider a company active in five lines of
business (1: general third-party liability,
2: corporate risk, 3: property damage, 4:
assistance, 5: motor insurance).
g RoRACj - CoC %RACj V(RACj)
V(Surplus)
V(NAV)
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

1. Value Creation in Insurance

Companies

Illustration: Comparison of traditional analysis and analysis founded on economic capital 16

Activity Premiums Premiums RAC in % RAC Net Net profit RoRAC g RAC V(RAC) V(RAC)
EURm % of EURm margin EURm x EURm %
premiums
General third-party
1456 10.4% 80% 1165 6.5% 95 8.1% 2.0% 0.94 1098 20.5%
liability
Corporate risk 897 6.4% 40% 359 4.0% 36 10.0% 1.5% 1.21 436 8.2%
Property damage 4951 35.3% 30% 1485 3.0% 149 10.0% 1.0% 1.20 1782 33.4%
Assistance 745 5.3% 25% 186 3.5% 26 14.0% 1.0% 1.73 323 6.0%
Motor insurance 5963 42.6% 12% 716 2.5% 149 20.8% 1.0% 2.64 1892 35.4%
Sum 14012 100.0% 3911 454 11.6% 1.37 5344 100.0%
Surplus 1000 4.5% 45 4.5% 0.53 529.41
TOTAL 14012 4911 499 1.20 5873
Source: EDHEC Business School

16 - RAC in % = RAC/
technical provision life or
RAC/premiums in non life
RoRAC = Net profit/RAC
RAC x = (RoRAC – g)/(cost of
capital – g)
The valuation of the company
is founded on a mixed cash
flow—asset mix approach
(called goodwill) combined
with a sum of the parts:
V = net asset value
- accounting goodwill
+ economic goodwill
V (RACj) = Σt=1,.., ∞ RACj
(RoRACj – CoCj)/(1+ CoCj)t
= RAC (RoRACj - gj)/(CoC - gj)
where RACj is the economic
capital allocated to line
of business i, CoC the cost
of capital, g the perpetual
growth rate of value creation
flows.
V(RAC) % = V(RAC)/Sum of
V(RACj)
This table shows the profile of the company:
premiums (in EURm), distribution of
premiums (Premiums %), economic solvency
margin per line of business (that is, RAC
as a percentage of premiums), net margin,
return on risk adjusted capital of each line
of business (RORAC defined by ratio of
standardised net profit to RAC).
With the return on risk adjusted capital
(RoRAC) and a perpetual growth rate of
cash flows (g), it is possible to determine the
value created by the company with respect
to its cost of capital. Discounting at a risky
rate seems inappropriate to us, as the risk is
in the flows to be discounted (Amenc and
Foulquier 2006), but the financial markets
(most financial analysts, investors, and
insurance companies) discount at the risky
rate (out of prudence, in case insufficient
allowance is made for risk). The valuation
ratios are thus shown in keeping with this
approach, more familiar to the reader. We
have chosen a cost of capital of 8.5%.
When RoRAC is greater than the cost of
capital to the company, the company creates
value and the implicit valuation multiple
in terms of RAC (column RAC x) is greater
than one. It is important to notice that this
multiple is the result of the RAC valuation
(xRAC= V(RAC)/RAC) as opposed to the
result of an a priori assessment performed
by certain evaluators. As the table shows,
general third-party liability destroys value:
the RAC multiple is 0.94. The valuation
of the capital allocated to general third-
party liability (€1,165m) is thus affected
by a coefficient of 0.94 (leading to value
destruction) and is thus valued at only
€1,098m (V((RAC)). So general third-party
liability accounts for only 20.5% of total
value but consumes 30% (1,165/3,911) of
risk-adjusted capital.
With this dashboard thus defined, what
can a manager do to refine or reorient his
strategy? In the traditional approach, still
taken by most managers (in all industries,
including insurance), assessment of strategy
relies on analysis of sales and margins.
So, at first glance, this company has a
low-risk profile, as a large share of the
business is exposed to frequent risks.
General third-party liability, by contrast,
the most volatile in terms of net profit,
accounts for only 10% of total premiums.
In addition, it delivers margins 2.6
times greater than those of motor
insurance (6.5% as opposed to 2.5%).
Many insurers can fit this profile, and
the composition of the premiums of this

An EDHEC Financial Analysis and Accounting Research Centre Publication 29

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
company seems appropriate, in terms of
both risks and margins.
All the same, the development of the notion
of value creation in a risky environment
and economic capital models are turning
this view on its head (much as Basel II has
just done in the banking industry). Indeed,
if capital has a cost and capital (RAC) is
allocated to activities in accordance with
their risks (for example, 80% in liability,
12% in motor insurance—figures taken
from the internal model of a European
insurer), the assessment of this strategy is
altogether different.
As it happens, this more economic approach
makes it possible to verify not only that
third-party liability accounts for a greater
share of the business (nearly one-third of
risk-adjusted capital—1,165/3,911) than
that suggested by the more traditional
analysis but also that the high net
margin (6.5%) is insufficient to offset
the large amount of capital required:
this line of business destroys value.
Third-party liability is valued at 94% of
its allocated capital. By contrast, motor
insurance, despite its low margins,
creates more value than any other line
of business. As it uses little capital, it is
valued at 2.64 times its allocated capital.
This sort of information is likely to lead to
changes in strategy along several axes, none
of them mutually exclusive: reallocation
of capital to lines of business, transfer or
expansion of the third-party liability line
to attain critical mass, modification of the
reinsurance or third-party liability hedging
policy in an attempt to reduce the risk and
thus the capital allocated to it).
How then can the traditional approach, still
the standard for many companies, lead to
30 An EDHEC Financial Analysis and Accounting Research Centre Publication
a conclusion so different from that drawn
from the economic model? As we saw in
section I, the difference lies in the notion
that capital is a resource that has a cost.
For public companies, this notion is not new
and their shareholders go over it regularly.
For other companies (especially mutual
undertakings), in light of the analysis in
section II, we see that even if they do not
always have problems with capital it is in
their interest to put in place an economic
capital model. This model can be used as
a decision tool to gauge the impact on
member satisfaction (through the previously
defined price/service ratio) of operational
decisions (setting of premiums, launch of a
new product or line of business, evaluation
of the impact of the offer of an option,
new claim management processes, pooling
of resources with a mutual undertaking,
and so on).
The change in bank acquisition policy
in favour of retail banks after the entry
into force of Basel II is also worth noting
(concomitantly with the refinement of the
capital allocation coefficients in favour
of this activity). With the weightings of
Solvency II, we expect similar changes
of strategy in the insurance industry. In
fact, some leading European insurers have
already modified their strategies in view
of their internal economic model (AXA and
Allianz, for example).
IV. The Contributions of an
Economic Capital Model in a
Solvency II Environment
The objective of this section is to analyse in
greater detail the foundations of economic
capital models, to assess their contributions
to company management, and to look at the
ways Solvency II fits into this environment
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
and should accelerate the development of
these models.
Since the late 1990s, some insurers have
been using economic capital models that
they have been perfecting over the years.
This decision-making tool enables
them to refine in-house their strategic
choices and the tracking of these
choices and to disclose to the markets
information on their performance.
In its 2000 annual report, AGF said of its
economic capital model: “this approach does
not supplant the information transmitted
by the financial statements; instead,
it sheds relevant economic light on the
quality and durability of the results and
facilitates the search for and implementation
of practical means of creating shareholder
value”.
Economic capital can be viewed as the
amount of capital a company believes it
needs to cover its risks. So it may be viewed
as a safety net intended to absorb any
extreme losses beyond technical provisions,
that is, those resulting from any great failure
to meet expectations for average expected
cash flow. So, unlike regulatory capital,
imposed by the regulator, it is intrinsic to
each company.
In particular, an economic capital model
addresses two issues:
• Capital is not a free resource and it is
necessary to include the cost of capital
in the measure of the value created by
the company.
• Return on equity (ROE), the classic
measure of profitability, indicates only
overall performance and does not make
it possible to identify profitability or
risk per business unit.
An EDHEC Financial Analysis and Accounting Research Centre Publication
So the economic capital model is built on
an allocation of the capital available to
the business or reporting units in keeping
with their contribution to the total risk of
the company (RAC) and on determination
of the standardised profit or loss of each
unit. Doing the latter involves reposting
the accounting profit or loss in such a way
as to reflect more accurately the economic
performance of the unit, independently of
the accounting framework (for example,
reposting of provisions for profit sharing),
of policy for net profit management, and
of the volatility of financial markets. The
capital allocated is determined by the
insurer, which considers that these capital
expenditures must be sufficient to absorb
these risks.
The current regulatory solvency margin
(Solvency I) was swiftly discarded, as it
creates a standard minimum capital
requirement proportional to the
volume of business (premiums, claims,
or provisions) without explicitly making
allowances for the notion of risk. Economic
capital models, by contrast, include the
correlation of risks (technical, financial,
operational), hedges (reinsurance,
derivatives, securitisation), and the
concentration and diversification of risks.
In this way, these models enable the
company to ward off certain risks (extreme
risks, in particular), measure the effects
of these risks, and suggest optimal
management of them. By calculating the
ratio of this economic profit to economic
capital, it is thus possible to determine the
return on risk adjusted capital per activity
j (RoRACj).
So economic capital makes it possible to
strengthen the analysis of the profitability
of a company by taking into account both
31
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1. Value Creation in Insurance
Companies
overall company risks and those of each
business unit, in keeping with the principles
and objectives of value creation. The
advantage of the economic capital model
is as much in its operational dimension
and thus its capacity to aid in company
management as in its measure of risks
strictly speaking.
Economic capital also meets an objective
for the internal management of allocated
capital and of risks, in keeping with
the often contradictory demands of
shareholders and rating agencies:
optimisation of capital allocation and of
the profitability of the invested capital
supplied by shareholders and high
capital requirements and appropriate
management (diversification of risks,
growth prospects, and so on) to obtain a
satisfactory rating from rating agencies
and bond investors.
Finally, for chief executives, financiers,
and managers, the economic capital
model provides a common language and
a single measure proportional to risk.
Its role is to guide the strategic choices
made by each unit, and to serve as the
foundation of the outside financial
communication of some insurance
companies, and as such it is a dynamic
tool that makes it possible to gauge the
efficiency of strategy.
V. Conclusion
A profound shift in the management of
insurance companies has been underway
for the last decade. The major catalysts
are the growing complexity of risk, the
sophistication of the means of measuring
it, the increasing internationalisation
and competition in the industry, the
32 An EDHEC Financial Analysis and Accounting Research Centre Publication
awareness that capital comes with a cost,
and accounting and prudential regulatory
changes.
In the late 1990s, this new environment
encouraged some leading insurers to put in
place economic capital models to optimise
the management of their businesses. Value
creation naturally established itself as a
performance measurement standard; it was
thus possible to integrate all the issues a
company had to deal with.
For the insurers on the crest of the wave,
as it were, these economic capital models
have become veritable tools for strategic
decisions: investment policy, underwriting,
launch of new products, reserves, asset/
liability management, reinsurance,
allocation of capital to individual lines of
business, and risk management (definition
of accepted limits, concentration,
diversification). They are also the
foundation of the communication of certain
corporations to the financial markets, rating
agencies, and the prudential regulator.
In this context, then, the primary objective
of our study is to show that Solvency II
and its corollary (compelling insurance
companies to read and manage their risks
better) should, by design, lead to widespread
changes in managerial practices revolving
around value creation.
Starting with an analysis of the foundations
of value creation (in both the academic
and business worlds), we have attempted
to underscore in this chapter the relevance
of the notion of value creation in the
management of a company as well as the
breadth of the domain in which this notion
is, so to speak, legal tender: manufacturing
firms, insurers and mutual undertakings (in
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

1. Value Creation in Insurance

Companies

spite of their objectives and values focused So Solvency II is likely to provide a boost
on the mutual member). to a trend that was already taking shape
before this reform to the rules for the
The second objective of this study is to solvency and capital of insurance companies:
show that the Solvency II constraint, which a profound shift in managerial practices
involves significant costs for data collection characterised by the inclusion of risks and
and simulation, can be transformed into the cost of resources (capital) in an attempt
an opportunity to rethink the culture to measure the performance of and the
and fine tune the management of each value generated by the company.
insurance company (the management
of risk, in particular). Indeed, much as
with what the banking industry has
recently undergone, the measure of
regulatory capital as defined by Solvency II
has become so sophisticated that it
now resembles the measure used in
economic capital models: the tools
and the underlying measurement
concepts are gradually converging.
As we will see in chapter II, regulatory
capital and economic capital are naturally
not meant to be equal amounts, as they
do not pursue the same objectives:
regulatory capital has to do with ensuring
solvency, while economic capital has to
do with optimising internal management
to achieve satisfactory profitability. In any
case, the objective of the internal models
favoured by the regulator is to provide
information necessary to the determination
of Solvency II required capital.

Not all insurance companies have the

means to put in place sophisticated
internal models, but in the following
chapters we will show that with the
data and the simulations required by
Solvency II it is possible to convert
these investments for the purpose of
improved management: they should
serve as foundations to improve
existing management tools in insurance
companies (reserves, premiums, asset/
liability management).

An EDHEC Financial Analysis and Accounting Research Centre Publication 33

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

1. Value Creation in Insurance

Companies

34 An EDHEC Financial Analysis and Accounting Research Centre Publication

 2. Solvency II: From
Constraint to an Opportunity
for Sophisticated Internal
Management

Une publication de l'EDHEC Financial Analysis and Accounting Research Centre 35

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
In chapter I we show that value creation
is capable of encompassing the entirety
of the issues dealt with by insurers,
and that this is so whatever their legal
form (mutual undertaking, incorporated
company, provident society, and so on)
or objectives (member satisfaction on
the quality/price criterion or shareholder
satisfaction on the risk/return criterion).
In this chapter, we will show that as
a result of its contents Solvency I is
altogether unable to provide the means
of elaborating an economic capital model;
Solvency II, by contrast, may further
hasten the managerial changes that
have been underway in the insurance
industry in the last decade: improved
readings of risks (identification,
measurement, and management),
of the cost of resources (capital), and thus
of the value created for the shareholder or
mutual member. In addition, the investment
in data collection and the simulations
required by the European regulator have
turned out to be particularly costly.
This chapter uses these two observations
as a starting point; its objective is to
show that it is possible to turn the
constraints brought about by Solvency
II into opportunities to improve
existing tools for internal management
(reserves, premiums, asset/liability
management, reinsurance, embedded value).
After all, however sophisticated the
insurance company is, it should be capable
of calculating the risk-adjusted capital
(RAC), a function of underwriting, financial
market, counterparty, and operational
risks, for each business or reporting unit.
These calculations may be products of
existing internal or economic capital
models, possibly adjusted so as to be
36 An EDHEC Financial Analysis and Accounting Research Centre Publication
recognised by the regulator as acceptable
substitutes for the Solvency II standard
formula, or they may be products of the
standard formula itself.
Today, then, economic solvency margins
defining RAC are the product only of
subjective calibrations, specific to the culture
and experience of each insurance company
and to the sophistication of its models.
This subjectivity, all the same, is relative,
because the publication of RAC leads
to a certain homogeneity per business
unit from one corporation to another.
With the entry into force of Solvency II,
the calculation of RAC could, as a result of
new solvency requirements, become more
standardised.
As the data and simulations compulsorily
provided to the prudential regulator to
determine the solvency margin can be used
to put in place economic capital models, the
use of these models should become more
common, in versions of varying degrees of
sophistication, depending on the culture
and the means of the companies using
them. This greater use of these models is,
as it happens, one of the objectives of the
regulator.
With this chapter, the keystone of the study,
it will be possible to show that—as a result
of improved management of risk, of the
amount of capital allocated to each line
of business and of the capital available
and required—this decision tool is likely to
improve the management of companies and
to increase the creation of shareholder or
mutual member value.

17 - For a company with
VaR of €1bn at a one-year
horizon and at a 99.5%
confidence interval, the
chances of suffering a loss
greater than €1bn over a
year are, assuming trading is
normal, 0.5%; that is, such a
fall in value will occur once
every two hundred years.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
I. From the Measure of Economic
Capital Models to Changes to
Solvency II
As we mention in the introduction, not
all insurance companies have the means
to put in place sophisticated internal
models. All the same, the new prudential
framework should act as an accelerator and
provide an opportunity to improve internal
management. In particular, Solvency II is
leading to a sophistication of solvency
rules, the underlying bases of which are
gradually converging toward those used in
economic capital models. On the other hand,
the calculation of the capital required by the
regulator requires a substantial investment
in data collection and simulations. In view
of these changes, it seems opportune
for each insurance company to use
this investment to improve its existing
internal management tools (reserves,
premiums, asset/liability management,
embedded value) and move toward
economic capital models of degrees of
complexity in keeping with the company’s
means.
The preceding chapter examined the
foundations of the economic capital
model, an examination that enables us to
underscore the existence of the current break
from the traditional means of performance
measurement. The objective of this section
is to focus on the measure used in economic
capital models in an attempt to examine the
ways in which the appearance of Solvency
II dovetails with the development of these
models. Economic capital addresses
the objective of strategic steering of
business, steering that relies on the
management of risks and the allocation
of capital to lines of business in keeping
with their economic performance. The
ultimate objective is to measure the value
An EDHEC Financial Analysis and Accounting Research Centre Publication
created either directly for the shareholder
or indirectly for the mutual, through the
member’s increased satisfaction with the
price/service ratio.
So it is necessary to determine the economic
profitability of each line of business (return
on risk-adjusted capital—RoRAC). The types
of risks considered and the measure of the
capital employed must be defined so as to
quantify the minimum amount of capital
corresponding to the risk of ruin that the
insurer deems acceptable. In other words, the
probability distribution of economic capital
at a given time horizon should be modelled
and the economic capital for the degree of
risk deemed acceptable by the company
should be defined. The measures usually
used to evaluate these risks are Value at Risk
(VaR), stress tests, or perhaps a combination
of the two. These measures, which are the
heart of economic capital models, are also,
as we will see in the coming chapters, the
measures that have been chosen for Solvency
II. We will thus proceed with a brief analysis
that will, among other things, underscore
the limitations of these measures.
VaR is a probability measure of the risk of
the loss that will be borne by a company as
a result of future changes in risk factors. It is
equal to the maximum potential loss suffered
by a company given a particular horizon
(often one year) and a confidence interval
α (99.97%, for example, is associated with
an AA rating).17 It is expressed VaRα (X) =
− inf{x: FX (x) ≥α}. The distribution of losses
can be estimated with a historic method
(observation of past behaviour), a parametric
method (probability distribution of the risk
factors), or the Monte Carlo method (several
thousand random draws in an attempt to
ascertain the likelihood of the occurrence
of each of the states of nature).
37
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
18 - TailVaRα (X) = TCEα (X)
= E[X/X≥VaRα (X)]
19 - Stress testing involves
analysing the changes in
the valuation (often net
asset value) resulting from
changes in risk factors that
reflect extreme events (crisis
scenarios).
38 An EDHEC Financial Analysis and Accounting Research Centre Publication
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
VaR may be a simple concept, easy to
compute and interpret, but it is often
criticised, as it is not sub-additive and it
does not take into account the severity
of the loss. Because it is not sub-additive,
the overall VaR of a company is not
necessarily less than sum of the figures
for VaR or each of its components (VaR(X1,
…, Xn) > VaR(X1) +…+ VaR(Xn)); now,
economic capital is built precisely on a
sum of figures for VaR. As a result, highly
debatable correlation matrices must be put
in place; otherwise, no allowances would
be made for diversification. In addition,
the correlation of the risk factors is often
variable over time and, as we are seeing now,
it generally increases in periods of turmoil.
Yet most economic capital models assume
constant correlation over time. Finally,
VaR reduces the view of the risk profile
of the company to a single point on the
loss distribution and fails to indicate the
severity of the fall in value (fatness of the
tail distribution).
So a measure of risk derived from VaR,
but sub-additive, is attracting growing
attention. This measure is tail VaR (also
known as expected shortfall, conditional
tail expectation, or conditional VaR). Tail
VaR18 of confidence interval α is the
conditional expectation of the random
variable of an amount less than VaR of
confidence interval α. Its advantage is
that it is more sensitive to the distribution
tails and that it is a coherent measure of
risk—coherence as defined by Artzner et
al. (1999). One of the drawbacks of VaR
and of tail VaR, highlighted by the banking
and insurance regulators, is that in general
these measures rely on the assumption of
normal events. Yet rare events are of greater
magnitude than the law of normality would
have it (fat distribution tails).
The advantage of stress testing19 is that,
by offering the opportunity to choose the
magnitude of the event, whatever the
odds of its occurring, it makes it possible
to get around resorting to laws of fat tail
distributions. Insurance companies (like
Solvency II, as it happens) thus combine
stress testing and VaR.
Of course, in a more general manner, it is
worth recalling the limitations intrinsic to
any method of risk evaluation, limitations
that are the result of the quality of data,
of the occurrence of rare events that are
not present in the simulations, of tested
asset and liability valuation problems, and
of model risks.
The regulatory reaction to the industry
changes described above was tardier.
Solvency I should remain in force until at
least 2012 and it is much too simplistic
(and unrealistic) to serve as a point of
reference for the management of insurance
companies.
Indeed, the foundations of the current
solvency system date to the 1970s. They
were updated in 2002, though without
really changing the substance, to increase
the power of the Commission de contrôle
des assurances. Yet in view of the small
number of bankruptcies its effectiveness
should be underscored. In France, for
example, the failure rate of insurance
companies is less than 0.25% (less than
one company a year), much lower than the
failure rate, an estimated 2%, for the rest
of the economy.
Solvency I has several drawbacks that
make it an inappropriate managerial
benchmark for insurance companies
(see appendix 2: Solvency I: An Efficient
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

2. Solvency II: From a Constraint to an

Opportunity for Sophisticated Internal
Management
20 - By contrast, there is a
list of assets and authorised
System with Numerous Drawbacks). It does and encourage them to improve their
proportions, but it is so not take into account: i) the risks of poor measurement and monitoring of risks”.
crude that it is possible, in
theory, for unlisted corporate
operational (costs) and/or financial (assets) So it is not the aim of the new solvency
Colombian debt to back 100% management, a major cause of bankruptcy system to lay down new rules for provisions
of a company’s insurance
commitments. But if an asset according to the European Commission, or for capital but to encourage companies
is not on the list it cannot be
used in calculating the solvency
ii) investment risks (stock market to use their existing models (models for
margin. volatility, exchange rates, interest rates, asset allocation models, for asset/liability
21 - Not explicitly included in
the calculation of the solvency risks linked to derivatives, to liquidity, to management, for embedded value, or for
margin are hidden options, floors, matching, or to credit),20 iii) the risks in reserves) to develop more sophisticated
and guaranteed rates, major
causes of earlier bankruptcies. the calculation of technical provisions,21 models to analyse, manage, and control
22 - Today, under Solvency I,
the calculation of the solvency
iv) the characteristics of reinsurance risks. To meet these objectives, Solvency II
margin does not take into programmes,22 and v) risk correlation, requires a view of risk broader than that of
account the specific features
of a reinsurance programme. In dispersion and diversification. Solvency I and closer and more Draconian
life insurance, for example, the evaluation (distribution of risks, correlation,
solvency margin is the sum of
two values: There are several paradoxes that can diversification, extreme risks, and so on). So
i) 4%* gross mathematical
reserves GMR * R), where
also be highlighted. As required capital it also seeks to lead to the determination
R=(GMR - reinsurance transfers)/ is a percentage of technical provisions in of a minimum capital requirement and
GMR cannot be less than 85%.
So Solvency I recognises at most life insurance, the less well provisioned a of economic capital that depends on the
15% of reinsurance transfers
with respect to GMR;
company is, the less capital the regulator ability of the company to control its risks
ii) (0.3% * risk capital charged requires. There is also the asymmetric (see appendix 3: Solvency II: An Extension
to the life insurer gross of
reinsurance RCG * K), where
treatment of bond capital gains and of the Notion of Risks).
K=(RCG - reinsurance transfers)/ losses23 and the total decorrelation of the
RCG and cannot be less than
50%. So Solvency I recognises solvency margin and business prospects As with IFRS, the philosophy of Solvency II
at most 50% of reinsurance
transfers with respect to RCG.
(the calculation is done a posteriori, is to create principles rather than to lay
These R and K ratios are those of using past financial statements). So it is down strict rules; the aim is for each
the latest financial year.
In non-life insurance, the clear that the current body of rules for company to put in place or adapt its own
solvency margin (we simplify) insurance capital (Solvency I) cannot serve model of risk evaluation, a model that should
corresponds to the higher of the
two values below: as a benchmark for the elaboration of an then of course be validated by the regulator.
i) (16% * gross premiums * C),
where C=(gross claims GC -
insurance company decision tool. So it seems that with this particular
claims transferred to reinsurers)/ philosophy prudential constraints may
GC and cannot be less than 50%.
ii) (23% * GC * C), where C=(gross In the last several years, the complexity of have a great impact on the managerial
claims GC - claims transferred to risks has led to a determination to change decisions in insurance companies. They
reinsurers)/GC and cannot be less
than 50%.GC is the average over prudential rules so that they will offer are likely to become the standard for
the last three financial years.
The standard reduction of 15%
an improved view of every company, in economic capital models, and ultimately,
in life insurance and of 50% in particular with respects to the risks taken for companies that do not yet boast
property and casualty insurance
in the event of reinsurance on. The finalities may differ, but IFRS, economic capital models, they will
seems devoid of any grounding Solvency II, Basel II, new rules for financial serve as an incentive to expand current
in economics. It is often labelled
standard because, whatever conglomerates, and market-consistent decision tools.
the type of reinsurance (simple
proportional reinsurance
embedded value (MCEV) were implemented
with a BB rated reinsurer or or are being implemented with the objective A new issue is raised then: Are economic
sophisticated non-proportional
reinsurance, indexed on indices of an improved view in mind. With capital and regulatory capital compatible?
and/or excluding extreme risks,
with an AAA rated reinsurer), the
Solvency II, the European Union intends To what extent can regulatory capital
15% and 50% coefficients are “better to match solvency requirements serve as a point of reference for economic
applied uniformly.
to the risks insurance companies face capital?

An EDHEC Financial Analysis and Accounting Research Centre Publication 39

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
23 - Capital gains are
added to available capital,
while capital losses are not
deducted in the calculation
of the solvency margin.
So, when rates are falling,
solvency margins are
overestimated and include a
latent wealth very susceptible
to a rise in rates. In addition,
this wealth creation is not
offset as it should be, with a
corresponding revaluation of
the liabilities.
40 An EDHEC Financial Analysis and Accounting Research Centre Publication
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
II. Economic Capital versus
Regulatory Capital
The main objective of Solvency II, like that
of Solvency I, is to protect the interests of
the insured and those of the beneficiaries
of insurance contracts. Solvency I takes a
standard approach, founded on historic
administrative and accounting data, to
determining regulatory capital; there are
variations that depend on the country
in which the company or subsidiary is
located. Solvency II, by contrast, takes a
forward-looking and economic approach
that is uniform throughout Europe.
With the support of CEIOPS (Committee
of European Insurance and Occupation
Pensions Supervisors), the European
Commission created a new framework
of solvency rules (Solvency II), published
in July 2007, a framework built on
economic principles of internal evaluation,
management, and control of risks.
The aim of the Directive is thus to
encourage insurance companies to
measure, manage, and control their risks
through the implementation of a cost
that results in a mobilisation of capital.
This cost will inevitably compel companies
to optimise their allocation of resources
and their management of risk, optimisation
that is a major point of convergence with
the economic capital model, a strategic
decision tool. In spite of the limitations
of this convergence (section II.1), we
will show that it is possible to devise an
economic capital model for the Solvency
II environment, as long as estimates
are made at market value and technical
reserves are defined with a best estimate
and a market value margin (section II.2).
II.1. The conceptual approach of
Solvency II favours convergence with
economic capital.
The aim of the reform of prudential rules
led by the supervisor and the European
Commission is to encourage insurance
companies to measure and control their
risks better. To do so, it seems natural
for the calculation of regulatory capital
to be perceived not as a constraint for
insurers but as an incentive for them to
develop internal management tools. So the
calculation should be similar to those used
in economic capital models.
But in spite of converging conceptions
and models of risk, regulatory capital
and economic capital are not meant
to be equal, as they pursue different
objectives. The objective of regulatory
capital is to keep companies solvent (for
their clients and to prevent systemic risk)
and it may have policy designs (depending
on the calibration of the formulas, some
risks or lines of business may be preferred to
others). The aim of economic capital is above
all to optimise the return on capital (directly
by creating shareholding value or indirectly
by meeting mutual member demands for
a satisfactory price/service ratio). In this
respect, the economic capital model can
easily satisfy regulatory requirements,
but above all it is a performance-based
decision tool for companies. So, even
though a convergence of the two measures
is already underway in the banking industry
and is desirable in the insurance industry, it
seems unlikely, given the differing ends of
regulatory and economic capital, that the
amounts will ever be strictly equal.
In practice, the companies that have
internal models (or that wish to have
one) can convert much of their data and

24 - Proposal for a Directive
of the European Parliament
and of the Council for the
taking-up and pursuit of the
business of the business of
insurance and reinsurance.
Solvency II. Art. 73.
10/07/2007. In its appendices
TS.III.A. and TS.III.B., QIS4
provides the instructions
necessary to determine if
IFRS is a satisfactory indicator
of economic value in the
context of Solvency II.
25 - MCR: Minimum capital
requirement and SCR:
solvency capital requirement.
26 - CEIOPS’s analysis of the
data supplied by insurers
during QIS4 draws on the
participation of 1,412
insurers (“solo” entities)
from thirty countries in
the European Economic
Area (EEA), approximately a
third of European insurance
undertakings. The responses
represent 75% of total
life business (in terms of
technical provisions), 69%
of non-life (in terms of
premiums), and 50% of
health (in terms of technical
provisions). It is worth
pointing out that slightly
more than a third of the
participants are mutual
undertakings, that 667
respondents are considered
small (less than €100m gross
non-life premiums written
or than €1bn gross life
technical provisions) and 220
large (more than €1bn gross
non-life premiums written
or than €10bn gross life
technical provisions).
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
their tests for regulatory requirements.
Conversely, the companies that do not
have internal models will be able to
use the data submitted to the regulator
and drawn from any existing internal
decision tools (risk analysis model, reserves,
premiums, asset/liability management, and
so on) to create a dashboard or decision
model inspired by the economic capital
models in use in the leading insurance
companies. These models will naturally
be of varying degrees of sophistication,
depending on the means available for the
construction. As we note in the introduction,
all insurance companies, whatever their
size, legal form, or objectives (creation of
shareholder or mutual member value), are
affected by this prudential reform.
II.2 Pricing of assets and liabilities
other than technical provisions of the
economic capital models in keeping
with the tenets of Solvency II
In spite of the incomplete convergence
of economic and regulatory capital that
we have just mentioned, it is nonetheless
preferable for economic capital models
or other existing internal decision tools
to be elaborated or modified in keeping
with the tenets of Solvency II, in particular
with respect to the implementation of an
economic balance sheet. Naturally, this
presupposes that the rules Solvency II lays
out to draw up this statement are entirely
relevant and compatible with the principles
of management of an insurance company.
Such seems to be the case. Otherwise,
Solvency II would have been nothing but an
administrative and regulatory constraint.
The determination of economic capital and
regulatory capital relies on an economic
valuation, in keeping with market value,
of the assets and liabilities. One of the
An EDHEC Financial Analysis and Accounting Research Centre Publication
regulator’s proposals is to value the
elements on the balance sheet (other
than technical provisions) at fair value as
defined by IFRS; that is, at the amount for
which they could be exchanged between
knowledgeable willing parties in an arm’s
length transaction;24 three approaches
(from mark to market to mark to model),
depending on the information available for
completing this evaluation, can be taken.
For Solvency II, as a result of their near
illiquidity, the economic value of intangible
assets is considered nil.
To test the quantitative aspects and the
feasibility of the new solvency rules, the
European Commission asked CEIOPS to
perform quantitative impact studies (QIS).
The latest study (QIS4) was done between
April and July 2008; its aim was to test the
calibration of the formulas intended to
determine the MCR and SCR,25 the elements
eligible for capital, and the “group” effects.
With the data and simulations done by
insurers26 in response to QIS4, CEIOPS
(2008) was able to compare the balance-
sheet structure according to Solvency I
and the current Solvency II proposals as
formulated in QIS4.
41
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
27 - If a component of a
contract such as a guarantee
or an option is entirely
separable and hedgeable,
then it is considered a
hedgeable component.
42 An EDHEC Financial Analysis and Accounting Research Centre Publication
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
Comparison of a QIS4 and Solvency I balance sheet
Source: CEIOPS 2008, p40
In addition to the interesting information
offered by this figure, completeness requires
that it be recalled that it was an optional
impact study, that it had no effect on the
participants, and that it was sometimes
carried out by an intermediary (brokers,
consultants). As a result, the quality of
the information of some insurers could be
wanting (for example, some participants
used the accounting balance sheet as a
substitute for market value) and could
thus lead to biased results. In addition,
the insufficient precision of the treatment
of certain data (deferred taxes, reinsurance
receivables, intra-group transfers, and so
on) provided by CEIOPS often left things
open to interpretation, so there again
there may be some biases. All the same,
these data provide an interesting idea of
the conversion of these balance sheets to
market value.
II.3. Best estimate and market
value margin valuation of technical
provisions
The approach taken by Solvency II to
determining the economic value of technical
provisions is that of the current exit value.
It is the amount a company would have to
pay to another entity if it transferred all its
contractual obligations, in normal conditions
of competition, to an informed and willing
party. It is the sum of two components:
the best estimate and the margin of risk
(market value margin). Each must be the
subject of a separate valuation, unless the
insurance and reinsurance commitments
are hedgeable, that is, if future cash flows
associated with these commitments can be
replicated with financial instruments whose
market value is observable directly.27
The best estimate “is equal to the probability-
weighted average of future cash-flows,
taking account of the time value of money,
using the relevant risk-free interest rate
term structure”. It is calculated gross,
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
without deduction of amounts recoverable
from reinsurance and securitisation and
must include all flows required to settle
obligations over their lifetime on the
hypothesis of their liquidation (future
fees, inflation, guarantees, options, the
insured party’s behaviour, management
decisions), discounted at the risk-free
interest rate corresponding to each maturity.
Reinsurance and securitisation are taken
into account in the balance sheet assets
adjusted for counterparty risk and later in
the calculation of the capital requirement
of the company. The calculation of the best
estimate can be done with deterministic or
stochastic methods. An example of a QIS4
best estimate in life insurance can be found
in appendix 8 (Simplified Best Estimate
Example Drawn from QIS4).
The risk margin plays the role of adjustment
variable to take into account the potential
gap between the average and reality to
ensure that the insurer will be able to meet
its obligations. It is calculated by determining
the cost of providing an amount of eligible
own funds equal to the solvency capital
requirements (cost of capital method). The
risk margin is determined for each line of
business, net of reinsurance and according to
the following method: i) calculation of the
annual capital required per line of business
(except for market risks already included
in the best estimate), ii) calculation of the
cost of providing capital by multiplying the
annual required by capital by a 6% cost of
capital, and iii) discounting of cash flows
at the risk-free rate.
With these elements, it is thus possible to
define a balance sheet in the Solvency II
format:
• On the asset side are investments and
reinsurance receivables
An EDHEC Financial Analysis and Accounting Research Centre Publication
• On the liability side are own funds used
to cover the solvency margins (SCR and
MCR), technical provisions calculated with
the risk margin and the best estimate, and
other debts.
Solvency II balance sheet
ASSET LIABILITIES
Surpluses
SCR Own funds
MCR
Investments Risk margin
and other assets (MVM) Technical
provisions
Best
estimate
Reinsurance
receivables Other debts
Again, it is interesting to compare the QIS4
and Solvency I amounts for life and non-life
technical provisions.
In the figures below, CEIOPS compares
the net technical provisions calculated in
keeping with QIS4 and those calculated in
keeping with Solvency I for each European
country that participated in QIS4 (each
bar is a country, but CEIOPS chose to keep
contributions anonymous). So, for the first
country represented in the figure on the
left, in weighted average, the net QIS4
provisions are half those of Solvency I
(♦ weighted average = 50%). For all of this
country’s contributions to QIS4, this ratio
ranges from 50% to 95%, and 50% of the
life insurance companies in this country
have a ratio between 58% and 82% (25th
and 75th percentile).
If this figure dealing with life business is
looked at Europe-wide, it is clear that, with
a few exceptions, this ratio is less than
100%. Much as in France, as we will see in
the ACAM figure below, this ratio is very
near 100%.
43
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

2. Solvency II: From a Constraint to an

Opportunity for Sophisticated Internal
Management
Ratio of net QIS4 life (left) and non-life (right) technical Ratio of net life QIS4 technical provisions to Solvency I technical
provisions (including the risk margin) to those for Solvency I provisions for the French insurers that participated in QIS4
for each European country 120
3.0%
0.9% 1.0%
100 104.2%
101.0% 0.9%
99.7%
95.8%
80 4.7%
78.3%

60

0
With profit Without profit Total
Unit linked Reinsurance

BE/TP (S1) Coc / TP (S1)

Source: ACAM, La Conférence du Contrôle, 6 October 2008

Here again, these figures may by biased

by the somewhat ill-assorted data and the
lack of instructions from the supervisor on
certain calculations, thus giving insurers
Source: CEIOPS 2008, p118 and 123 plenty of room for interpretation. ACAM
points out in particular a great disparity
The Autorité de Contrôle des Assurances in the calculation of the risk margin and
et des Mutuelles (ACAM) did an analysis of the best estimate (given the large
of French insurers similar to similar to that number of methods used and the technical
done by CEIOPS (ACAM 2008). specifications that provide few details for

Ratio of net non-life QIS4 technical provisions to Solvency I technical provisions for the French insurers that participated in QIS4

100
5% 4%
6% 93% 4%
2% 3%
80 82% 4% 11% 82% 85% 11%
81% 79% 8%
74% 74% 73%
71%
60
10%
51%
40 3%
33%
20

0
ilit
y ses MA
T ge ilit
y
ysh
ip ses an
ce eo
us ert
y
alt
y
MA
T
liab las ma liab en rop asu
ty erc r da ty suret l exp
Assist ellan s p s c reins
ar th e r a sc n rei
n NP
dp r, o oth rd-pa an
d
Leg Mi rei
thir oto and T hi edit NP NP
, M e r
tor Fir C
Mo
BE/TP (S1) Coc / TP (S1) Average 82.7%

Source: ACAM, La Conférence du Contrôle, 6 October 2008

44 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
contracts with discretionary profit sharing
and for the treatment of future premiums).
In addition to these biases, QIS4 technical
provisions are slightly lower than those
currently published, given the discounting
of cash flows and the nature of the best
estimate (shift of implicit prudence toward
own funds).
III. Method of Elaborating an
Economic Capital Model in a
Solvency II Environment
This section is the keystone of our study.
Indeed, as we note above, the changes
in the rules from Solvency I to Solvency
II have led to the implementation of a
prudential framework that is converging
with that used in economic capital models.
This is likely to hasten the trend that was
taking shape in managerial practices:
improved assessment of risks (identification,
measurement, and management), of the
cost of resources (capital), and, finally, of
value creation for shareholders or mutual
members.
In addition, investments in data collection
and simulations to be supplied to the
supervisor in Solvency II are very costly
(see appendix 5: Data Collection and
Simulations for QIS4: Major Investments).
It would be advisable to capitalise on
this investment made for regulatory
reasons alone to serve ambitions more
intrinsic to the company: to perfect or
put in place a management decision
tool, in an attempt to improve the
management of the company and have
it create more value. The leading European
insurers, pioneers in this domain, show that
their economic capital models have many
roles (orientation of global strategy choices
as well as those for each line of business,
An EDHEC Financial Analysis and Accounting Research Centre Publication
for asset allocation, for management of
capital, for underwriting, for asset/liability
management, and for hedging of risks).
The degree of sophistication of internal
management tools (reserves, premiums,
asset/liability management, reinsurance,
embedded value, economic capital)
naturally varies greatly depending on the
culture of the undertaking, the means it
has at hand, its size, its strategy, and so on.
So we believe that the smallest common
denominator for all the insurance industry
will be the requirements for disclosure
of information made by the prudential
regulator.
Let it be recalled that the objective of this
study is to underscore the advantages
of using the elements provided to the
supervisor to develop an economic capital
model that will improve the management
of the company, in particular as a result
of improvements in the management
of risks and the allocation of capital.
These data could be relatively “simple”
information meant for the Solvency II
standard formulas or the product of
sophisticated internal models (validated and
accepted by the regulator). So the approach
that follows concerns all entities in the
insurance industry, whatever their degree
of sophistication, as ultimately they are
all compelled to comply with the new
Solvency II prudential standards.
The link between the economic capital
model and Solvency II lies in the
calculation of risk-adjusted capital.
Until now, risk-adjusted capital has been
calculated depending on the company’s
own perception of its risks and on the
sophistication of its model. Indeed, we
have seen that Solvency I could in no
45
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
2. Solvency II: From a Constraint to an
Opportunity for Sophisticated Internal
Management
way serve as a benchmark and that the
standard formulas of Solvency II were
hitherto not definitive. In practice, each
company has its own weighting range, even
if, ultimately, publications attest to certain
homogeneity.
We have emphasised the determination of
Solvency II to take an operational approach
to risk exposure, that is, an approach in
keeping with internal management or
economic capital models so as to favour
their development and give companies
an incentive to improve management of
their risks. In particular, Solvency II has
defined two levels of required capital. The
first, the minimum capital requirement
(MCR), is the minimum beneath which
supervisory intervention is systematic.
The second is the solvency capital
requirement (SCR), which is a capital target
sufficiently high to absorb any unusual
shock. The means of calculating the SCR
could set standards for improving existing
internal management tools or for putting
in place an economic capital model of a
greater or lesser degree of sophistication.
The calculation of the SCR is done to
reflect a VaR (with a confidence level of
99.5%) at a time horizon of one year; the
six risk modules (themselves broken into
sub-modules—see appendix 4: Modular
Organisation, Identification and Calibration
of Risks) are aggregated.
In short, the calculation of risk-adjusted
capital in economic capital models
could, under the solvency constraints,
move toward more standardised
approaches. If the calibration and the
modelling of the risks chosen for the
prudential framework are consistent (in
particular with respect to the perception
of the economic reality of insurers),
46 An EDHEC Financial Analysis and Accounting Research Centre Publication
it is likely that the companies that have
an economic capital model or a partial
internal model (modelling of certain
risks or lines of business) will need only
to make a few adjustments for the
regulator to approve these models as a
substitute for the standard formula defined
by Solvency II. The less highly advanced
insurers can use the data and simulations
supplied to the regulator, data and
simulations possibly adjusted to better
respond to the needs of the company,
to elaborate an economic capital model.
The capital required by Solvency II is the
sum of the capital required for operational
risk, adjustments (future profit sharing,
deferred taxes), and the basic solvency
capital requirement (BSCR) derived from
the aggregation of the five other risks using
a correlation matrix. The risks considered
by Solvency II are the following (for a more
detailed analysis, see appendix 4):
• operational risk “arising from inadequate
or failed internal processes, or from
personnel and systems, or from external
events” (QIS4 2008)
• life underwriting risk
• non-life underwriting risk (risk having
to do with the amount and time at which
claims must be settled, with the volume of
business, and with pricing rates)
• health underwriting risk (health coverage
and workers’ compensation)
• market risk (stemming from the volatility
of the market value of financial
instruments
• counterparty default risk (the risk
of losses arising from the unexpected
default or lowering of the credit rating of
counterparties, of issuers of risk-mitigating
contracts, or of receivables from
intermediaries).
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

2. Solvency II: From a Constraint to an

Opportunity for Sophisticated Internal
Management
SCR mkt SCR def SCR life SCR health SCR nl
SCR mkt 1
SCR def 0.25 1
SCR life 0.25 0.25 1
SCR health 0.25 0.25 0.25 1
SCR nl 0.25 0.5 0 0.25 1
Source: QIS4

So, however sophisticated the insurer may
be, it is possible to determine for each line
of business j (or reporting unit j) an amount
of risk-adjusted capital RACj, a function of
the underwriting risks of line of business j,
of market risk, of counterparty risk, and of
the operational risks of line of business j.
This function may be derived from internal
models (partial or total), from regulatory-
approved economic capital models for the
calculation of the Solvency II solvency
capital requirement, or from the standard
formula defined by the regulator.
If it is derived from the standard formula,
reallocations (sometimes non-linear) will be
necessary, since the regulator aggregates
certain risk modules for the company as a
whole. For example, market risk is calculated
not for each line of business but for the
entire company, whereas the input for
the economic capital model (defined in
chapter I, section III.2 and looked at again
below) requires assessment of the risks for
each line of business. We will come back
to these technical points in the following
chapters.
So this approach, illustrated in the table
below, makes the prudential dimension a
constraint in the economic capital model
defined in the previous chapter (section
III.2.):

RACj = F(SCRj) = F(SCRj underwriting line of business j, SCRj market, SCRj counterparty, SCRj operational)

RAC in Net
Premiums Premiums RAC Net RAC V(RAC) V(RAC)
Activity % of profit RoRAC g
EURm % EURm margin x EURm %
premiums EURm
1

Sum

Surplus

TOTAL
Source: EDHEC Business School

An EDHEC Financial Analysis and Accounting Research Centre Publication 47

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

2. Solvency II: From a Constraint to an

Opportunity for Sophisticated Internal
Management
The creation of this dashboard is not
the ultimate aim of this study. The aim
is to show that with this decision tool
that enables improved management
of risks, of the allocation of capital to
lines of business, and of available and
required capital it is possible to improve
strategic decision making in a company
and boost value creation.

Given the sophistication of the coming

rules for insurance capital, in the
following chapters we construct an
economic capital model under Solvency
II constraints for a fictitious company.
This procedure should enable the reader
to perceive the advantages of putting
in place an economic capital model
and the relatively low complexity of
elaborating it with data and simulations
required (probably after 2012) by
Solvency II. With this tool, we will be
able in the last chapter of the study to
analyse the role it plays in strategic
decision making: improved consideration
of risks (identification, measurement, and
management), of the cost of resources
(capital), and, finally, of the creation of
shareholder or mutual member value.

48 An EDHEC Financial Analysis and Accounting Research Centre Publication

 3. Underwriting Risks and the
Economic Capital Model under
the Solvency II Constraint

A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 49
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
As we saw in chapter II, the development
of internal models and, more broadly, of
economic capital models, is likely to gain
momentum with the implementation
of Solvency II. This shift is grounded on
reasons at once conceptual (convergence
of the approaches to the economic
capital model and regulatory capital)
and operational (exploitation of the
investments in data collection and
simulation made at the behest of the
regulator for company-specific risk
management purposes). In the final
chapter of this study we will highlight the
contributions made by these models to
the management of risk, of risk-adjusted
capital, of available economic capital and
required capital, and, more broadly, to the
optimisation of shareholder or mutual
member value.
To elaborate the economic capital model
described in section III of the preceding
chapter, and given the sophistication
of prudential rules, we propose to do
simulations for a fictitious company
(section I) to analyse the measurement of
risks and their associated capital needs.
Underwriting risks in life insurance, property,
and health are analysed in sections II
to IV.
According to the calibration offered
by Solvency II and the results analysed
by the ACAM (2008), in France these
underwriting risks account for 17% of
required capital (before diversification
effects, operational risks, and adjustments
for future profit sharing and deferred
taxes) for life insurers and approximately
50% for property and casualty insurers
and mixed insurers. Appendix 6 (Weighting
of Risk Types in the Composition of the
Solvency Capital Requirement in France
and in Europe) shows that there are
nonetheless great differences from one
European country to another (CEIOPS
2008).
I. Features of the Model Company
The contribution of our study lies more
in the demonstration of the potential
of economic capital models to improve
risk management and, more broadly,
the governance of the company, than
in the results of the simulation itself.
All the same, for the needs of our
demonstration, we have postulated
the existence of a fictitious insurance
company (which throughout our study we
call the model company) and calculated
the capital requirements for each risk
type so as to create an economic capital
model.
This fictitious company has five lines of
business:
• life (euro-denominated and unit-linked
contracts)
• motor own damage
• property damage
• third-party liability
• health
Turnover is broken down as follows:

Turnover of the model insurance company by line of business

Life
Life Motor own Property Third-party
Lines of business euro Health Total
unit linked damage damage liability
denominated
Gross premiums in EUR million 250 1 000 1 000 1 000 250 200 3 700
% of total premiums 6,8% 27,0% 27,0% 27,0% 6,8% 5,4% 100,0%
Source: EDHEC Business School

50 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
The characteristics of the balance sheet
are synthesised in the table below. The
entirety of the data necessary for the
components of the risks can be found in
appendix 7.
II. Capital Required for Life
Underwriting Risk
First, it is important to note that Solvency
II calculates life underwriting risk in an
aggregate fashion for all euro-denominated
life insurance and unit-linked (UL) policies.
All the same, as a life insurer’s exposure
to risk depends greatly on the type of
policies under consideration (risks borne
by the insurer or not), we differentiate
these two types of business (after the
fashion of insurer practices in the context
of internal models of the embedded value
or economic capital type) in our elaboration
of the economic capital model. So, as a

Characteristics of the model company

Euro Motor own Property Third-party
(EURm) Unit linked Health Total
denominated damage damage liability
Stocks 838 959 105 330 318 5 2554
Bonds 685 4920 392 924 636 99 7657
Property 0 511 26 66 106 0 709
Reinsurance 2 6 3 10 35 1 56
Total assets 1525 6396 525 1330 1095 105 10976

Own funds 23 360 250 300 200 50 1183

Technical provisions 1500 6000 250 1000 875 50 9675
Debt 2 36 25 30 20 5 118
Total liabilities 1525 6396 525 1330 1095 105 10976

Premiums per activity

250 1000 1000 1000 250 200 3700
(gross)
Source: EDHEC Business School

Assumptions
Unit Euro Motor own Property Third-party
Health Total
linked denominated damage damage liability
Asset components %
Stocks 55% 15% 20% 25% 30% 5% 23%
Bonds 45% 77% 75% 70% 60% 95% 70%
Property 0% 8% 5% 5% 10% 0% 6%
Total 100% 100% 100% 100% 100% 100% 100%

Reinsurance assets/technical
0.1% 0.1% 1.0% 1.0% 4.0% 1.0% 0.6%
provisions

Technical provisions/premiums 600% 600% 25% 100% 350% 25% 261%

Own funds/technical provisions 1.5% 6% 12%
Own funds/premiums 9% 36% 25% 30% 80% 25% 32%
Debt/own funds 10% 10% 10% 10% 10% 10% 10%
Source: EDHEC Business School

An EDHEC Financial Analysis and Accounting Research Centre Publication 51

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
result of this disaggregation, calculating This sub-module does not benefit from
the risk-adjusted capital will require the risk-absorbing effect of future profit
making allowances for possible non-linear sharing (SCR rev = nSCR rev)
effects. • catastrophe risks (SCR cat)

The life underwriting module is defined by The calculation of the capital required
the risks covered and by the risks involved in for life risk (SCR Life) makes it possible
the management of the business. Solvency to use the process below to define one
II thus spells out seven risk sub-modules of the components necessary for the
for life underwriting (k), for which seven calculation of risk-adjusted capital (RAC)
capital charges are calculated before (SCRk) for euro-denominated life business and in
and after (nSCRk) allowances are made for unit-linked policies.
the risk-absorbing effects of future profit
sharing. The risks considered are:
• biometric risks (mortality, longevity,
disability-morbidity-illness) for which we
calculate required capital SCR mort, SCR
long, SCR dis
• lapse risks (SCR lapse)
• expense risks (SCR exp)
• revision risks having to do with non-life
claims settled as annuities (SCR rev).

Calculation of the components of life RAC

RAC in net
Premiums Premiums RAC Net RAC V(RAC) V(RAC)
Activity % of profit RoRAC g
EURm % EURm margin x EURm %
premiums EURm

Life euro denominated

Life unit linked

Motor own damage

Property damage

Third-party liability

Health

Sum

Surplus

TOTAL

RAC euro denominated = F(SCR euro denominated) (RAC UL is calculated with the same approach)
= F(SCR Life euro denominated, SCR market euro denominated, SCR counterparty euro denominated, SCR operational euro denominated)

SCR Life euro denominated = √∑r,c Corr SCR life rxc * SCRr*SCRc
where Corr SCR life rxc are the cells of the correlation matrix of the seven sub-modules (SCRk) of life underwriting.

52 An EDHEC Financial Analysis and Accounting Research Centre Publication


1 - For the totality of the
risk modules, the regulator
considers that a loss of
value caused by a shock was
reposted by a positive change
in NAV.
2 - For mixed insurance
policies, that is, for those
providing benefits in the
event of death and in the
event of survival, QIS4
offers two options: apply
the mortality shock scenario
while making allowances
for the natural offsetting
of the survival and death
components or unbundle the
policies into two separate
components (survival and
death) and apply the survival
and death shocks on the
corresponding component.
3 - Article 107, simplification
of the standard formula:
“Insurance and reinsurance
undertakings may use a
simplified calculation for a
specific sub-module or risk
module where the nature,
scale and complexity of
the risks they face justifies
it and where it would be
disproportionate to require
all insurance reinsurance
undertakings to apply the
standardized calculation.”
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
3. Underwriting Risks and the Economic
Capital Model under the Solvency II
Constraint
The correlation matrix supplied by QIS4
(QIS4 2008) is:
Corr SCR life SCR mort SCR long SCR dis
SCR mort 1 -0,25 0,5
SCR long -0,25 1 0
SCR dis 0,5 0 1
SCR lapse 0 0,25 0 1
SCR exp 0,25 0,25 0,5
SCR rev 0 0,25 0 0
SCR cat 0 0 0 0
The capital allocated for each of the seven
sub-modules (SCRk) is equal to the change
in net asset value (NAV)1 following an
upwards and/or downwards shock. The
two cases should be differentiated:
• for the mortality, longevity, disability, and
lapse sub-modules, the capital allocated
to risk i (SCR risk i) is calculated from the
sum of the changes in NAV of each of the
policies n following a given shock:
SCR risk i = ∑n (ΔNAV | shock)
• by contrast, for expense, revision, and
catastrophe risks, the calculation of SCR
risk j is not done by policy, but directly on
the insurer’s net asset values NAV:
SCR risk j =ΔNAV | shock
In the following sections (II.1 to II.7),
we present the risk sub-modules for life
underwriting. This presentation makes
it possible to analyse the risks under
consideration, the calibration of these risks
with the standard formula and the possible
effects of non-linearity in order to proceed
with the retreatment necessary (chapter V)
to determine risk-adjusted capital. As we
have mentioned, for each branch these
calculations could, in practice, be fine
tuned by and/or tailored to each insurer so
that exposure to risks in greater keeping
with the characteristics of its portfolio
can be determined (supervisor-approved
internal model).
An EDHEC Financial Analysis and Accounting Research Centre Publication
SCR lapse SCR exp SCR rev SCR cat
0 0,25 0 0
0,25 0,25 0,25 0
0 0,5 0 0
0,5 0 0
0,5 1 0,25 0
0,25 1 0
0 0 1
II.1. Capital required for mortality risk
The policies for which the amounts to
pay out in the event of death are greater
than those of technical provisions involve
mortality risk.2 The capital charge for
mortality risk is equal to the change in
the net value of assets as a result of a
permanent 10% increase in mortality rates
for each age. This charge is calculated
before (SCR mort) and after (nSCR mort)
allowances are made for the risk-absorbing
effect of future profit sharing.
When the risk capital is not subject to
significant changes over the life of the
policy and when the general simplification
criteria are met (article 107, p. 107 of the
European directive of July 2007)3, the
simulation can be done with the following
simplified formula (which we have taken):
SCR mort = (total capital at risk)* q *n*
0.10*1.1((n-1)/2)
where q is the expected average death rate
over the next year weighted by the sum
insured (specific to each company), n the
modified duration of liability cash flows,
and 1.1((n-1)/2) the projected mortality
increase.
53
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
4 - For mixed insurance
policies, that is, for those
Simulation with the model company insured (specific to each company), n the
providing benefits in the Assumptions modified duration of liability cash flows,
event of death and in the
event of survival, QIS4
Contracts Unit Euro and 1.1((n-1)/2) the projected mortality
linked denominated
offers two options: apply increase.
the mortality shock scenario Gross technical provisions (EURm) 1425 6000
while making allowances
for the natural offsetting Share reinsured 5% 1% Simulation with the model company
of the survival and death
Share of life insurance contracts 35% 5%
components or unbundle the
contingent on mortality risk
Assumptions
policies into two separate
Contracts Unit Euro
components (survival and Capital at risk/technical provisions 0.10 4.00
death) and apply the survival
linked denominated
for death benefit contracts
and death shocks on the Gross technical provisions (EURm) 1425 6000
corresponding component. Expected average death rate over 0.3% 0.3%
the next year weighted by the Share reinsured 5% 1%
sum insured q Share of life insurance contracts 5% 5%
Modified duration of liability cash 7.64 7.64 contingent on longevity risk
flows n Expected average death rate over 0.3% 0.3%
Net asset value (NAV) before the 47 360 the next year weighted by the
shock (EURm) sum insured q
Source: EDHEC Business School Modified duration of liability cash 7.64 7.64
flows n

Results Net asset value (NAV) before the 47 360

Contracts Unit linked Euro denominated
SCR mort (EURm) 0.15
nSCR mort (EURm) 0.15
Source: EDHEC Business School
II.2 Capital required for longevity risk
Longevity risk is a feature of policies that
offer no benefits in the event of death
or policies for which a drop in mortality
rates would lead to a risk of a rise in
technical provisions.4 The capital charge
for longevity risk is equal to the change
in the value of net assets as a result of
a permanent fall of 25% in the mortality
rates for each age.
When the average age of the policyholder
is sixty years and the general criteria for
simplification are met, the simulation can
be done with the following simplified
formula (which we have taken):
SCR long = TP long * q *n* 0.25 *
1.1((n-1)/2)
where TP long is the technical provisions
subject to longevity risk, q the expected
average death rate weighted by the sum
shock (EURm)
Source: EDHEC Business School
3.74
0.00 Results
Contracts Unit linked Euro denominated
SCR mort (EURm) 0.53 2.34
nSCR mort
(EURm)
0.53 0.00
Source: EDHEC Business School
II.3 Capital required for disability risk
Disability risk is a feature of insurance
policies for which the payment of benefits
(lump sum or annuities) is contingent
on some definition of disability or
sickness. The capital charge for disability-
morbidity-sickness risk (SCR dis) is equal
to the change in the net value of assets
following a 35% increase in the disability
rate for the next year, together with
a permanent 25% increase (over best
estimate) in the disability rates for each
age in the following years.
When there is no significant change in
the capital at risk over the term of the
policies and when the general criteria
for simplification are met, the simulation
can be done with the following simplified

54 An EDHEC Financial Analysis and Accounting Research Centre Publication


5 - The surrender cost is net
of any amounts recoverable
from policyholders or agents
(for example, net of any
surrender charge that may
apply under the terms of the
contract). As such, it may be
positive or negative.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
3. Underwriting Risks and the Economic
Capital Model under the Solvency II
Constraint
formula (which we have taken):
SCR dis = (total disability sum at risk)
* i *n* 0.35*1.1((n-1)/2)
where i is specific to each company and
is the expected number of movements
from health to sickness for the coming
year weighted by the amount insured/
annual payment, n the modified duration
of liability cash flows, and 1.1((n-1)/2) the
projected disability increase.
Simulation with the model company
Assumptions
Contracts Unit
linked
Gross technical provisions (EURm) 1425
Share reinsured 5%
Share of life insurance contracts 0.1%
contingent on disability risk
Capital at risk/technical provisions 0.10
for contracts contingent on
disability risk
Expected average disability rate 0.3%
over the next year weighted by
the sum insured i
Modified duration of liability cash 7.6
flows n
Net asset value (NAV) before the 47
shock (EURm)
Source: EDHEC Business School
Results
Contracts Unit linked Euro denominated
SCR mort (EURm) 0.00
nSCR mort (EURm) 0.00
Source: EDHEC Business School
II.4 Capital required for lapse risk
Lapse risk relates to the loss, or adverse
change in the value of insurance liabilities,
losses resulting from changes in the
level or volatility of the rates of policy
lapses, terminations, changes to paid-up
status (cessation of premium payment)
and surrenders. The capital required for
lapse risk is calculated based on a net
surrender cost,5 that is, on the difference
between the amount currently payable on
surrender and the best estimate provision
in the books reprocessed in the Solvency
II format.
Three shocks are tested:
• Reduction of 50% in the assumed rates
of lapsation in all future years for policies
where the surrender strain is expected
to be negative. The associated required
capital is noted Lapsedown.
• Increase by 50% in the assumed rates
of lapsation in all future years for policies
Euro where the surrender value is expected to
denominated be positive. The associated required capital
6000 is noted Lapseup.
1% • Mass lapses equal to 30% of the sum
2.0% of surrender strains of the policies for
which the surrender strain is positive.
0.10
The associated required capital is noted
Lapsemass.
0.3%
The capital required for lapse risk is the
7.6 greatest of the amounts generated by
these three shocks.
360
SCR lapse = max (lapsedown; lapseup;
lapsemass)
If the simplification reflects the nature,
scale, and complexity of the risk, if the
0.13 company is small, or if in the simplified
0.00 calculation the capital charge for lapse
risk is less than 5% of the total SCR before
adjustment for the loss-absorbing capacity
of technical provisions, the simulation
can be done with the following simplified
formula (which we have taken):
Lapsedown = 0.5 * ldown * ndown * Sdown
Lapseup = 1.5 * lup * nup * Sup
where ldown, lup are the estimates of
average lapsation rates for policies with
An EDHEC Financial Analysis and Accounting Research Centre Publication 55
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
6 - If the scenario that
produces the largest net
negative/positive surrender strain, ndown, (over best estimate) in future expenses
amount is not the one that nup the average period (in years), weighted and of an expense inflation rate higher
produces the largest gross
amount, the gross amount
by positive/negative surrender strain, and than expected by 1% a year.7
that is taken is that which Sdown, Sup the sum of negative/positive
produces the largest net
amount. surrender strains. If the general simplification criteria are
7 - For policies with
adjustable loadings (policies
met:
in which expense loadings Simulation with the model company6 SCR exp = (renewal expenses in the
or charges may be adjusted
within the next twelve Assumptions twelve months prior to valuation date)
months), 75% of these Contracts Unit Euro * n(exp) *(0.1 + 0.005*n(exp))
additional expenses can linked denominated
be recovered by increasing where n(exp) is the average period (in
the charges payable by Gross technical provisions (EURm) 1425 6000
policyholders.
years), weighted by renewal expenses,
Share reinsured 5% 1%
8 - Annuities whose amount over which risk runs off.
is linked to earnings or Average rate of lapsation for the 0.5% 0.5%
another index such as prices policies with a negative surrender
or that vary in deterministic strain Simulation with the model company
value on change of status
(a standard annuity that Surrender strain/technical -2.0% -2.0% Assumptions
becomes a two-way annuity, provisions for policies with negative
Contracts Unit Euro
for example) should not surrender strain
be classified as genuinely linked denominated
reviewable for these Average rate of lapsation for the 3.5% 3.5%
Gross technical provisions (EURm) 1425 6000
attributes. Annuities subject policies with a positive surrender
to legal or other admissibility strain Share reinsured 5% 1%
restrictions are excluded. Expense rate 0.2% 0.2%
Surrender strain/technical 10.0% 17.0%
provisions for policies with positive Average period over which risk 5 5
surrender strain runs off, weighted by renewal
Average period, weighted by 1.5 1.5 expenses n(exp)
surrender strains, over which the Net asset value (NAV) before the 47 360
policy with a negative surrender shock (EURm)
strain runs off ndown
Source: EDHEC Business School
Average period, weighted by 6 6
surrender strains, over which the
policy with a positive surrender
Results
strain runs off nup Contracts Unit linked Euro denominated
Net asset value (NAV) before the 47 360 SCR exp (EURm) 1.27 5.57
shock (EURm)
nSCR exp (EURm) 1.27 0.00
Source: EDHEC Business School
Source: EDHEC Business School

Results
Contracts Unit linked Euro denominated
SCR lapse (EURm) 1.49
nSCR lapse (EURm) 1.49
Source: EDHEC Business School
II.5 Capital required for expense risk
Expense risk arises from the changes in the
expenses incurred in servicing insurance or
reinsurance contracts. If the amount of an
expense is already fixed at the valuation
date, however, it is not included in the
scenario. The capital charge for expense
risk is equal to the change in the net value
of assets as a result of a 10% increase
II.6 Capital required for revision risk
11.13
Revision risk is the risk of adverse
0.00
variation of the amount of an annuity
as a result of an unexpected revision of
the process of the settlement of claims
(for legal reasons, for example).8 This
risk is applicable only to annuities that
are genuinely reviewable and to those
benefits that can be approximated by a
life annuity arising from non-life claims.
The capital charge for revision risk is equal
to the change in the net value of assets as
a result of an increase of 3% in the annual
amount payable for annuities exposed

56 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
to revision risk. The impact should be If the general simplification criteria are
assessed considering only the remaining met:
run-off period. This sub-module does not SCR Cat = = ∑i 0.0015*Capital at riski
benefit from the risk-absorbing effect of Capital at riski = SAi + ABi
future profit sharing. * Annuity _factor - TPi
where i is each policy for which the payment
If the general simplification criteria are
of benefits (in the form of an annuity or
met:
in multiple payments) is contingent on
SCR rev = 3% * net technical provisions mortality or disability; where for each
for annuities exposed to revision risk policy i SAi is the insured sum, net of
reinsurance, on death or disability when
Simulation with the model company
the benefits are payable as a lump sum
Assumptions
(otherwise zero); ABi is the annual amount
Contracts Unit Euro
linked denominated of benefit, net of reinsurance, payable on
Gross technical provisions (EURm) 1425 6000 death or disability when benefits are not
Share reinsured 5% 1% payable in lump sums (otherwise zero);
Percentage of annuities elegible 0% 0% Annuity _factor is the average annuity
for revision risk factor for the expected duration over
Net asset value (NAV) before the 47 360
which benefits may be payable in the event
shock (EURm)
Source: EDHEC Business School
of a claim; and TPi is technical provisions
net of reinsurance for each policy i.
Results
Contracts Unit linked Euro denominated
Simulations with the model company
SCR rev (EURm) 0.00 0.00
Assumptions
Contracts Unit Euro
nSCR rev (EURm) 0.00 0.00
linked denominated
Source: EDHEC Business School
Gross technical provisions (EURm) 1425 6000
% of technical provisions for policies 95% 90%
II.7 Capital required for catastrophe risk contingent on mortality risk whose
Catastrophe risk in life insurance stems benefits payable as a lump sum

from extreme events (a pandemic, for Share reinsured of technical provisions 0% 0%

for policies contingent on mortality risk
instance) that as a result of their nature
% technical provisions for policies 90% 90%
are not sufficiently well integrated in whose benefits are payable on disability
the capital charges of the other sub- definition and as a lump sum

modules of life underwriting risk. Share reinsured of technical provisions 0% 0%

for policies whose benefits are payable
The capital charge for catastrophe risk on disability risk
is equal to the change in the net value Multiple of the amount insured when 1.1 5
of assets as a result of a combination of the benefit is paid as a lump sum as a
function of TP
two simultaneous events: an absolute
Multiple annualised amount when 1.1 5
1.5 per mille increase in the rate of benefits are paid on death or disability
policyholders dying over the following year as annuities (net of reins.)

(e.g., from 1.0 per mille to 2.5 per mille) Average annuity factor for the 20 20
expected duration over which benefits
and an absolute 1.5 per mille increase may be payable in the event of a claim
in the rate of policyholders experiencing Net asset value (NAV) before the shock 47 360
morbidity over the following year. (EURm)
Source: EDHEC Business School

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
Results
Contracts Unit linked Euro denominated
SCR cat (EURm) 0.08 2.52
nSCR cat (EURm) 0.08 0.00
Source: EDHEC Business School
II.8. Total capital required for life
underwriting risk
In the preceding sections (II.1 to II.7) we
calculated the capital required for the
seven life underwriting risk sub-modules
as spelled out by Solvency II. As we have
noted, these calculations could be fined
tuned for and/or tailored to each insurer
in order to calculate an exposure to risk
in greater keeping with its portfolio
(supervisor-approved internal model).
Given our intention to elaborate an
economic capital model, we have
distinguished between euro-denominated
and unit-linked policies. We thus
determine two capital requirements
for life underwriting risk, one for euro-
denominated business (SCR Life euro
denominated) and another for unit-
linked business (SCR Life UL). As we have
mentioned, a life insurer’s exposure to
risk is heavily dependent on the type of
policy (euro-denominated or unit-linked),
so our approach seems more consistent
with insurance industry practices in
the context of internal models of the
embedded value or economic capital
type). As a basis for comparison, we have
also decided to run a simulation with
our model company using the Solvency
II approach (aggregated presentation
of euro-denominated and unit-linked
policies) to highlight possible non-linear
effects (see simulation below).
The amounts of capital required for
life underwriting risk (SCR Life euro
denominated and SCR Life UL) make it
possible, with the process described in the
introduction to this section II, to determine
one of the components necessary to
the calculation of risk-adjusted capital
for euro-denominated and unit-linked
policies. The method for euro-denominated
business is shown below (the method for
unit-linked business is identical).
RAC euro denominated
= F(SCR euro denominated)
= F(SCR Life euro denominated, SCR market
euro denominated, SCR counterparty
euro denominated, SCR operational euro
denominated)
where SCR Life euro denominated = √∑r,c
Corr SCR Liferxc * SCRr*SCRc with the
following correlation matrix:

Corr SCR life Life mort Life long Life dis Life lapse Life exp Life rev Life cat
Life mort 1 -0.25 0.5 0 0.25 0 0
Life long -0.25 1 0 0.25 0.25 0.25 0
Life dis 0.5 0 1 0 0.5 0 0
Life lapse 0 0.25 0 1 0.5 0 0
Life exp 0.25 0.25 0.5 0.5 1 0.25 0
Life rev 0 0.25 0 0 0.25 1 0
Life cat 0 0 0 0 0 0 1

58 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
9 - The commercial premium Simulation with the model company
payable by the policyholder Synthesis and comparison of QIS4 and “disaggregated” approaches (UL + euro denominated)
is composed of the pure
(or technical) premium and SCR (EURm) Euro Unit linked Euro denominated Life QIS 4 Life QIS4/Euro
loadings. This pure premium denominated + unit linked den. + Unit linked
is equal to the premium rate
times the capital insured. The Mortality 3.74 0.15 3.89 3.89 100%
premium rate is a function of Longevity 2.34 0.53 2.87 2.87 100%
the frequency of claims and
the average cost of claims for Disability 0.13 0.00 0.13 0.13 100%
a given risk. Lapse 11.13 1.49 12.63 12.59 100%
10 - 1) Motor, third-party
liability; 2) Motor, other Expense 5.57 1.27 6.84 6.84 100%
classes; 3) Marine, aviation,
Revision 0.00 0.00 0.00 0.00 -
transport (MAT); 4) Fire and
other damage; 5) Third- Catastrophe 2.52 0.08 2.60 2.60 100%
party liability; 6) Credit and
suretyship; 7) Legal expenses; SCR life 16.42 2.61 19.03 18.93 99%
8) Assistance; 9) Miscellaneous; Source: EDHEC Business School
10) Non-proportional
reinsurance—property;
11) Non-proportional Of the seven sub-modules for life the premium rates that will be necessary
reinsurance—casualty; underwriting risk, only the lapse to cover the liabilities generated by the
12) Non-proportional
reinsurance—MAT. underwriting risk sub-module, for which business written.
11 - 1) Each country of the
EEA; 2) Switzerland;
the greatest of three scenarios determines
3) The rest of Europe; 4) Asia the required capital, is non-linear. Non-life underwriting risk—SCR NL—is
(excluding Japan and China);
5) Japan; 6) China; 7) Oceania All the same, in our simulation, the measured with:
(excluding Australia); calculation based on a distinction between • two risk sub-modules (premium and
8) Australia; 9) North America
(excluding Canada and the unit-linked and euro-denominated reserve risk, SCR NL pr, and catastrophe
United States); 10) Canada;
11) United States; 12) Each
business and the aggregate calculation risk, SCR NL cat)
country of South America; as in QIS4 leads to the same result. • segmentation of non-life business into
13) Central America; 14) Africa.
This segmentation was done The second absence of linearity lies in twelve lines of business10
for QIS4 and could change
as a result of work currently
the correlation matrix. In our simulation • segmentation into fourteen geographic
underway to heighten (economic approach), we do one areas.11
sensitivity to the risks inherent
to geographic regions. In correlation calculation of the seven risk
addition, an overall threshold sub-modules of life underwriting risk This breakdown of premiums and of
of materiality of 5% must
be observed for geographic for unit-linked policies and another for technical provisions by area and by line
diversification to apply.
euro-denominated policies. In the QIS4 of business makes it possible to take
approach, a single correlation calculation into account geographic diversification
is done for all life insurance policies. In and the correlation of the risks of these
our simulation the difference (1%) is businesses.
nonetheless slight.
The calculation of the capital required for
non-life underwriting risk (SCR NL) makes it
III. Capital Required for Non-Life possible to use the process below to define
Underwriting Risk one of the components necessary to the
The non-life underwriting risk module calculation of the risk-adjusted capital for
is made up of the risk linked to the non-life business (three lines of business
uncertainty of underwriting results. This for our model company):
uncertainty has to do the with the amount
and timing of the settlement of claims,
the volume of business, and the premium
rates at which it will be written,9 and

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
Calculation of one of the components of property and casualty RAC
RAC in
Premiums Premiums RAC Net Net profit RAC V(RAC) V(RAC)
Activity % of RoRAC g
EURm % EURm margin EURm x EURm %
premiums

Life euro
denominated
Life unit linked

Motor own damage

Property damage

Third-party liability

Health

Sum

Surplus

TOTAL

RAC motor own damage = F(SCR motor own damage)

= F(SCR NL motor own damage, SCR market motor own damage, SCR counterparty motor own
damage, SCR operational motor own damage)
The property and casualty RAC and the third-party liability RAC are calculated with the same approach

SCR NL motor own damage = √∑r,c Corr SCR NL rxc * SCR NLr*SCR NLc
où Corr SCR NLrxc are the cells of the correlation matrix of the two sub-modules (SCR NLk) of non-life underwiting
(k=pr or cat depending on the sub-module).

The correlation matrix of the two non-life determine its exposure to risks in greater
underwriting risk sub-modules supplied by keeping with the characteristics of its
QIS4 (2008) assumes that the sub-modules portfolio (a supervisor-approved internal
are not correlated: model).

Corr SCR NL SCR NL pr SCR NL cat
SCR NL pr 1 0
SCR NL cat 0 1
In the following sections (III.1 and III.2),
we present the two sub-modules for
non-life underwriting risk. This presentation
makes it possible to analyse the risks
considered, the calibration of these risks
with the standard formula, and the
possible effects of non-linearity to proceed
with the retreatment necessary to the
calculation of RAC. As we have noted,
these calculations could be fine tuned by
and/or tailored to each insurer in order to
III.1. Capital required for non-life
premium and reserve risk
Premium risk is the risk that expenses
and claims will be greater than premiums
received. This risk is present as soon as the
policy is issued, as well as before, given the
uncertainty as to the premium rates charged
and the volume of business underwritten.
Reserve risk stems from the possible
underestimate of provisions for claims and
from the random nature of future claims
payouts.

60 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
12 - The log-normal law for
parameters μ and σ has a
The capital required for premium and derive an overall volume measure V and an
density function: reserve risk (SCR NL pr) is determined overall standard deviation σ.
with a three-step process, calibrated in
μ and σ are the mean and such a way that, assuming a lognormal Simulation with the model company
the standard deviation of the
logarithm of the variable. distribution of the underlying risk, a Assumptions
The logarithm of the variable
is normally distributed with
risk capital charge consistent with the Activity
Motor own Property Third-party
damage damage liability
a mean μ and standard VaR 99.5% standard is produced.12 To show
deviation σ. Gross written
the overall principles, we provide below premiums (EURm)
1000 1000 250
a brief look at the three steps; for more Share reinsured 3% 10% 15%
information, see appendix 9 (Major Steps Gross written premiums by geographic area
in the Calculation of the Premium and Area 1 60% 60% 100%
Reserve Risk Sub-Module of the Non-Life Area 2 24% 24% 0%
Underwriting Risk Module). Area 3 16% 16% 0%
Ratio written premiums/earned premiums
The first step involves using the standard Area 1 105% 103% 105%
deviations of the premium sub-risk σ(prem, lob) Area 2 104% 105% 0%
and of the reserve sub-risk σ(res, lob) and Area 3 103% 104% 0%
a correlation coefficient of 0.5 to determine Net written premiums growth rate %
the standard deviation for aggregate Area 1 1% 3% 5%
premium and reserve risk (σlob) for each line Area 2 -1% -2% 0%
of business (LoB). The standard deviation Area 3 1% 5% 0%
σ(prem, lob) is a function of the firm-specific Gross technical
205 740 647,5
provisions (EURm)
standard deviation σ(U,prem, lob), itself a
Share reinsured 2% 15% 20%
function of the historic volatility ratios of
Net written premiums by geographic area
the firm, of the standard deviation of the
Area 1 60% 60% 100%
market σ(M, prem, lob), and of a credibility
Area 2 24% 24% 0%
factor clob defined by QIS4 for each line
Area 3 16% 16% 0%
of business.
Number of
historic years 5 5 10
In the second step, the effects of geographic considered

diversification are calculated for each Premium

risk standard 10% 11% 11%
line of business. To do so a measure of deviation
the geographic volume of premium risk Net asset value
V(prem, lob), a function of the turnover (NAV) before the 265 387 276
shock (EURm)
of the insurer, as well as of reserve risk
Source: EDHEC Business School
V(res, lob), a function of the best estimate
and of the Herfindahl indeed DIVpr, lob Results
(see appendix 9). Activity Motor own Property Third-party
damage damage liability

In the third step, the standard deviations SCR NL pr 262 350 276
(EURm)
and volume measures for the premium
Source: EDHEC Business School
risk and the reserve risk in the individual
LoBs are aggregated (using a matrix of
the correlation of the lines of business) to

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
III.2. Capital required for non-life cost of the most severe scenario (defined
catastrophe risk as the impact on net asset values).
The aim of the non-life catastrophe risk
sub-module is to make allowances for The capital charge for the scenario method
extreme or irregular events that are not is:
NL = ∑CATi
2
sufficiently captured by the charges for CAT
premium and reserve risk. To determine i

the capital required for catastrophe

risks (SCR NL cat), the regulator offers a Method 3: personalised scenarios
choice of three possible methods: Personalised scenarios make it possible for
companies to improve the integration of
Method 1: standard formula specific features of their business (risks
If no regional scenarios are provided, a underwritten, geographic concentration),
standard method is used. The capital especially when the insurer considers
charge for non-life catastrophe risk (SCR that the calibration obtained under
NL cat) is a function of the estimate of the methods 1 or 2 is not representative of
net written premiums to be issued in the its exposure to the risk of man-made or
coming year for each line of business (Plob) natural catastrophes. The scenarios to be
and of a regulator-supplied catastrophe selected are those that the firm considers
factor particular to each line of business will exceed the materiality threshold (as
ct (t=lob=1,...,12). defined above). The costs of the scenarios
are net of reinsurance to assess the effect
of reinsurance treaties and any exceptional
costs incurred by the firm in post-event
where: management.
LoB t ct LoB t ct LoB t ct There are two options for the calculation:
Motor. third-party 0.15 Third-party liability 0.15 Miscellaneous 0.25 • one on the basis of the occurrence of a
liability single event (storm, flood, earthquake, fire,
Motor. other 0.075 Credit and 0.60 Reins. (property) 1.50 single explosion) and
suretyship
• another on an annual basis (occurrence
MAT 0.50 Legal expenses 0.02 Reins. (casualty) 0.50
of several catastrophic events over the
Fire 0.75 Assistance 0.02 Reins. (MAT) 1.50
Source: QIS4
twelve coming months in line with the
calibration of the SCR at a 99.5% confidence
Method 2: scenarios interval over a one-year horizon)
The second method integrates regional
scenarios supplied by the local supervisor
(annex SCR3 TS.XVII.E. QIS4 2008).
For the moment, no inter-regional scenario
has been supplied. The capital charge for
non-life catastrophe risk (SCR NL cat)
is a function of the sum of the costs,
net of reinsurance, of each specified
catastrophe CATi in excess of the materiality
threshold, a threshold set at 25% of the

62 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
13 - Annex SCR3 TS.XVII.E of
QIS4 provides information
Simulation with the model company With the matrix of correlation (Corr SCR
on the choice of risks Given the very specific features taken in NL) of the risk sub-modules SCR NL pr and
(certain types of natural
disasters are envisaged: for
the scenario methods 2 and 3,13 we have SCR NL cat described in the introduction to
example, floods, hail, storms, taken method 1 for the simulation with section III, it is possible to determine the
earthquakes, man-made
disasters), the treatment of our model company. capital required for non-life underwriting
which differs from country to
country (seventeen countries
risk (SCR NL).
considered: Austria, Belgium, Assumptions
Czech Republic, Denmark,
France, Germany, Italy, Activity Motor own Property Third-party Simulation with the model company
Iceland, Lithuania, Malta, damage Damage liability
Activity Motor own Property Third-party
Norway, Poland, Portugal, Gross written pre- 1000 1000 250 damage damage liability
Slovakia, Slovenia, Sweden,
miums (EURm)
Great Britain). SCR NL (EURm) 272 357 277
Share reinsured 3% 10% 15% Source: EDHEC Business School
Risk factor ct 0.075 0.075 0.15
Net asset value 265 387 276 At this point, the economic capital
(NAV) before the
shock (EURm)
model and the Solvency II approach to
Source: EDHEC Business School calculating the capital charge for the risks
of underwriting each of the non-life lines
Results of business are identical and thus raise no
Activity Motor own Property Third-party problems of linearity.
damage Damage liability
SCR NL cat
(EURm)
73 68 32 All the same, in the introduction to this
Source: EDHEC Business School section III, we saw that the supervisor
considered an economic capital requirement
for the non-life underwriting risk module
III.3. Total capital required for (SCR NL) to make allowances for the effects
non-life underwriting risk (SCR NL) of diversified lines of non-life business. We
In the preceding sections (III.1 and III.2), will do this reposting in determining the
we calculated the capital required for the overall SCR for each line of business in
two non-life risk sub-modules considered chapter V. We now provide the Solvency
by Solvency II. As we note earlier, these II results:
calculations could be fine tuned by and/or SCR NL = √∑r,c Corr SCR NLr,c * NLr*NLc
tailored to each insurer in order to calculate
a risk exposure in greater keeping with the The matrix of the correlation of the three
characteristics of its portfolio (supervisor- lines of business of the model company is
approved internal model). given by QIS4:
Corr SCR NL Motor own Property Third-party
The capital charges for non-life underwriting damage damage liability
risk (SCR NL motor own damage, SCR NL Motor own 1 0.25 0.25
damage
property damage, and SCR NL third-party
Property 0.25 1 0.25
liability) make it possible, with the process damage
described in the introduction to this section Third-party 0.25 0.25 1
III, to determine one of the components liability
necessary to the calculation of risk-adjusted
capital (RAC) for the three non-life lines
of business.

An EDHEC Financial Analysis and Accounting Research Centre Publication 63

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
Diversification benefit (lines of business) for non-life underwriting risk
SCR (EURm) Motor Property Third-party Sum of Sum of Capital saving related to
own damage liability activities before activities after diversification of non-life
damage diversification diversification business
benefits benefits
Premium and
262 350 276 888 236 73%
reserve
Catastrophe 73 68 32 172 104 39%
SCR NL 272 357 277 906 258 72%
Source: EDHEC Business School

IV. Capital Required for Health where Healthr and Heatlthc are the
Underwriting Risk capital charges for individual health
The health underwriting risk module underwriting sub-modules according to
covers the risks for all health and workers’ the rows and columns of correlation matrix
compensation guarantees. Health CorrHealth:
underwriting risk (SCR health) is split CorrHealth Health LT Accident and Health WC
into three sub-modules: long-term health Health ST

(Health LT), practised on a technical basis Health LT 1 0 0

similar to that of life assurance (it exists Accident and

0 1 0,5
Health ST
only in Austria and Germany), short-term Health WC 0 0,5 1
health (Accident and Health ST), and
Source: QIS4
workers’ compensation (Health WC). Like
life and non-life underwriting risks, health The determination of the capital required
underwriting risk is calculated based on the for health underwriting risk (SCR Health)
capital charges of the sub-modules and by makes it possible, with the process described
integrating the correlation of these risk below, to define one of the components
sub-modules: necessary to the calculation of the
SCR health = √∑r, c CorrHealthr, risk-adjusted capital for health lines of
c*Healthr *Heatlthc business.

Calculation of one of the components of health RAC

Premiums Premiums RAC in % RAC Net Net profit RAC V(RAC) V(RAC)
Activity RoRAC g
EURm % of premiums EURm margin EURm x EURm %

Life euro denominated

Life unit linked

Motor own damage

Property damage

Third-party liability

Health

Sum

Surplus

TOTAL

RAC health = F(SCR health) = F(SCR health, SCR market health, SCR counterparty health, SCR operational health)

64 An EDHEC Financial Analysis and Accounting Research Centre Publication


14 - The expense ratio is the
ratio of expenses to gross
earned premiums. Volatility
is calculated with “the gross
earned premium weighted
standard deviation of the
expense result in relation to
the gross premium over the
previous ten-year period.”
15 - The previous ten-year
period is used to determine
volatility. Here again, if the
expense history is too short, a
standard formula can be used
instead (QIS4 p. 180).
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
3. Underwriting Risks and the Economic
Capital Model under the Solvency II
Constraint
In the following sections (IV.1 to IV.3), we
present the three health underwriting risk
sub-modules. This presentation makes it
possible to analyse the risks considered, the
calibration of these risks with the standard
formula, and the possible non-linearity
effects in order to proceed with the reposting
necessary to the determination of RAC.
As we mention above, these calculations
can be fined tuned and/or tailored by each
insurer to calculate its exposure to risks in
greater keeping with the characteristics
of its portfolio (the supervisor-approved
internal model).
IV.1. Capital required for long-term
health
Health long-term underwriting risk is split
into three components that benefit from
the risk-absorbing effects of future profit
sharing: expense risk, claim/mortality/
cancellation risk and epidemic/accumulation
risk.
i) Expense risk in long-term health arises
from the difference in expenses estimated
during prices and the expenses actually
incurred. The Health exp capital charge is a
function of gross earned premium (Pay), of
the volatility of the expense ratio (σ h exp)14,
and of a risk factor (λexp = 2.58) calibrated
to produce a capital charge consistent with
a VaR of 99.5%:
Health exp =λexp * σ h exp * Pay
ii) Claim risk (or per capital loss risk) is
the risk of a difference between the
losses assumed in technical provisions
when products are priced for mortality or
cancellation risk and the losses actually
incurred. The capital charge Health cl
is a function of gross earned premium
(Pay), of the volatility of the claims ratio
(σh cl),15 and of a risk factor (λcl = 2.58) set
An EDHEC Financial Analysis and Accounting Research Centre Publication
to generate a capital charge consistent with
a VaR 99.5% standard.
Health cl = λcl * σ h cl * Pay
iii) Epidemic risk measures the impact on
the insurer’s balance sheet of possible
outbreaks of epidemics. Accumulation
risk is grounded on the assumption that
persons are interdependent. The capital
charge Health ac is a function of gross
premium earned (Pay) by the firm and in the
health insurance market (MPay), of claims
expenditure for the accounting year in the
health insurance market (claimsay), and of a
risk factor (λac = 6.5) calibrated to generate
a capital charge consistent with a 99.5%
VaR standard and it takes into account the
correlation with the other health insurance
sub-modules:
Health ac = λ ac * claims ay* (Pay / MPay)
Simulation with the model company
As the long-term health business exists only
in Germany and Austria, we have decided
that our model company is not in this
business; it is involved only in short-term
health and accidents (section IV.3.).
IV.2. Capital required for workers’
compensation risk
Underwriting risk in workers’ compensation
has to do with the risks of the liabilities
resulting from short- or long-term sick
leave: medical treatment and payment of
lump-sum indemnities, annuities payable
to injured workers and beneficiaries,
regular and recurrent payments over
a long-term horizon to cover the costs
of assistance of a third party. The
calculation of the capital required for
workers’ compensation underwriting risk is
grounded on three risk sub-modules, each
them benefiting from the risk-absorbing
65
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
16 - The shocks whose impact
on net asset value is tested
effect of future profit sharing: IV.3. Capital required for accident and
are: i) premium and reserve (WCompgeneral), short-term health risk
• for longevity risk, a
permanent fall of 25% in the
ii) underwriting (WCompannuities), and The accident and short-term health risk
mortality rate for each age iii) catastrophe (WCompcat). sub-module does not benefit from the
• for disability risk, a 35%
increase in the disability rate risk-absorbing effect of future profit
for the coming year together
with a permanent increase
The regulatory approach to calculating sharing. It is made up of two lines of business
of 25% in the disability rate the capital required for the first and third (short-term health and accident) with a
in the following years for
each age components of risk is similar (although the correlation of 0.5 and of two independent
• for revision risk, a 2% volatility parameters are different) to that risk components (premium and reserve risk
annual increase in the
amounts payable in the described for the non-life underwriting and catastrophe risk).
form of annuities and a 5%
increase in the amounts
module: a three-step approach (appendix
payable annually in the form 9) for premium and reserve risk and the The approach taken by the regulator to
of payments for assistance
• for expense risk, future standard method or scenario methods calculate the capital required for each
expenses 10% greater than for catastrophe risk. Underwriting risk in of these two risk components is similar
estimated and an inflation
rate higher than estimated by workers’ compensation refers to benefits (although the volatility parameters are
1 percentage point.
The correlation of these four
paid in the form of annuities or assistance different) to that described for the non-life
shocks is defined by the as a result of workplace accidents. The underwriting module: a three-step approach
matrix:
risk is split into four categories (longevity, (appendix 9) for premium and reserve risk
disability, revision, and expense) and is and a standard method or scenario methods
Longevity
Annuities

Disability

Revision

Expense
Corr

measured with the same approach as for catastrophe risk.

Longevity 1 0 0 0.25 that taken in life insurance (the impact of
Disability 0 1 0 0.5
correlated shocks on the change in the net The standard formula for catastrophe risk
Revision 0 0 1 0.25
value of assets).16 is:
Expense 0.25 0.5 0.25 1

Source: QIS4
Accident and health ST CAT = √ [(C1*P1)²
So the capital charge for the workers’ + (C2*P2)²],
compensation sub-module is defined by:
Wcomp = √∑Corr Wcomp r,c * where P1 and P2 are the estimates of the net
Wcomp r * Wcomp c written premium in the individual lines of
business short-term health and accident and
where the correlation matrix of the three other for the coming year. The catastrophe
risk sub-modules is given by QIS4: factors C1 and C2 are equal to 0.1.
Corr W Comp W comp W comp W comp
general annuities cat
Simulation with the model company
W comp general 1 0.5 0
We assume that the model company is
W comp annuities 0.5 1 0
present in the two lines of health business
W comp cat 0 0 1
described by the regulator: short-term
health and accident and other. In addition,
we assume that its business is done in a
Simulation with the model company single geographic area (for example, the
We have chosen not to have our model regulator’s area 1, that is, the European
company be present in this line of business; Economic Area).
instead it is present in the accident
and short-term health business (section
IV.3).

66 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
Premium and reserve risk IV.4 Total capital required for health
Assumptions underwriting risk
Activity Short-term Accident In the previous sections (IV.1 to IV.3),
health & others
we calculated the capital requirements
Gross written premiums (EURm) 168 32
for the three health underwriting risk
Share reinsured 2% 10%
sub-modules described by Solvency II.
Ratio written premiums/earned 102% 102%
premiums
As we note above, these calculations
Net written premiums growth 3% 3% could be fine tuned by and/or tailored to
rate % each insurer, in order for it to calculate
Gross technical provisions 35.7 6.8 its exposure to risks in greater keeping
(EURm)
with the characteristics of its portfolio (a
Share reinsured 1% 8%
supervisor-approved internal model).
Number of historic years 7 5
considered
Premium risk standard 3% 5% The amounts of capital required for health
deviation underwriting risk (SCR Health) make it
Net asset value (NAV) before
52 possible, with the process described in
the shock (EURm)
the introduction to this section IV,
Source: EDHEC Business School
to determine one of the components
Results : necessary to the calculation of risk-adjusted
Activity Short-term health and
capital for health.
accident & others
SCR health ST pr (EURm) 21 Simulation with the model company
Source: EDHEC Business School SCR Health
Activity Health
Catastrophe risk SCR health (EURm) 27
Assumptions Source: EDHEC Business School
Activity Short-term Accident
health & others
The economic capital model and the
Gross written premiums 168 32
(EURm)
Solvency II approach to calculating the
Share reinsured 2% 10%
capital charge for the risks of underwriting
Risk factor C 0.1 0.1 health business are identical and thus raise
Net asset value (NAV) before no problems of linearity.
52
the shock (EURm)
Source: EDHEC Business School By running simulations on a fictitious
company, chapter III has made it possible
Results to study the measurement of the
Activity Short-term health and
accident & others
underwriting risks of life, non-life, and
SCR health ST cat (EURm) 17
health insurance, as well as the capital
Source: EDHEC Business School charges associated with these risks. So we
have shown the possible conceptual
Capital required for accident and short- convergence of the economic and
term health: regulatory capital approaches and the
Activity Short-term health and accident
& others
operational requirement for heavy
SCR health ST (EURm) 27
investment in data collection simulation
Source: EDHEC Business School for the regulator.

An EDHEC Financial Analysis and Accounting Research Centre Publication 67

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

3. Underwriting Risks and the Economic

Capital Model under the Solvency II
Constraint
In light of these two analyses, the
development of internal models and,
more broadly, of economic capital models,
should pick up speed with the
implementation of Solvency II, and
this for firm-specific risk-management
improvements as well as for more general
management improvements.

This chapter has described the prerequisites

for elaborating an economic capital
model and analysing its contributions to
risk management, to the determination
of risk-adjusted capital, to available
and required capital, and, more broadly,
to the optimal creation of shareholder
or mutual member value. With the same
objective, the following chapter will deal
with market and counterparty risks.

68 An EDHEC Financial Analysis and Accounting Research Centre Publication

 4. Market and Counterparty
Risks in the Economic Capital
Model under Solvency II
Constraints

A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 69
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
Before proceeding in the final chapter of for each line of business before (SCR
this study (chapter V) to the contributions Mktk) and after (nSCR Mktk) allowances
of economic capital model to risk are made for the risk-absorbing effect of
management and to value creation for future profit sharing, that is, a total of
shareholders or mutual members, we will seventy-two capital charges for market risks
look in chapter IV at market (section I) and (six lines of business x six risk sub-modules
counterparty (section II) risks, prerequisites x two depending on whether there is a
for determining risk-adjusted capital risk-absorbing effect). The risks considered
(RAC). are:
• interest rate risk, for which we determine
In the calibration suggested by Solvency II a capital charge SCR Mkt int
and the results analysed by the ACAM • equity risk (SCR Mkt eq)
(2008), market risks are the greatest • property risk (SCR Mkt prop)
consumers of capital. In France, they • currency risk (SCR Mkt fx)
account for 82% of the capital required • spread risk (SCR Mkt sp)
of life insurers (before the diversification • risk concentrations (SCR Mkt conc).
effect, operational risk, and adjustments
for profit sharing and deferred taxation), The calculation of the capital required for
nearly 46% for property insurers, and more market risk (SCR Mkt) makes it possible
than 50% for mixed insurers. to determine one of the components
necessary to the calculation of RAC for
each of the model company’s six lines of
I. Capital Required for Market business:
Risk
First, in Solvency II the calculation of market
risk is done in an aggregate fashion for the
entire insurance company, that is, without
making distinctions for lines of business.
Nonetheless, for the needs of the economic
capital model we identify the market risks
for each of the six lines of business of
our model company. To determine the
capital allocated to each line of business
it will then be necessary, as a result of this
disaggregation, to make allowances for
possible non-linear effects.

Market risk arises from the level or volatility

of market prices of financial instruments.
It is measured by the impact of movements
in financial variables (stock prices, interest
rates, real estate prices and exchange
rates). There are six risk sub-modules (see
below). There are thus six capital charges

70 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
Calculation of one of the components of RAC
Premiums Premiums RAC in % RAC Net Net profit RAC V(RAC) V(RAC)
Activity RoRAC g
EURm % of premiums EURm margin EURm x EURm %

Life euro denominated

Life unit linked

Motor own damage

Property damage

Third-party liability

Health

Sum

Surplus

TOTAL

RAC euro denominated = F(SCR euro denominated) = F(SCR Life euro denominated, SCR Mkt euro denominated,
SCR counterparty euro denominated, SCR operational euro denominated)
Similar approach for RAC UL, RAC motor own damage, RAC property damage RAC third-party liability and RAC health)

SCR Mkt = √∑r,c CorrSCR market rxc * Mktr* Mktc

where SCR market rxc are the cells of the matrix of the correlation of the six market risk sub-modules (Mktk).

The correlation matrix provided by QIS4 In addition, QIS4 mentions several

(2008) is: methodological points having to do
Corr SCR market Mkt interest Mkt equity Mkt property Mkt fx Mkt spread Mkt conc
Mkt interest 1 0 0.5 0.25 0.25 0
Mkt equity 0 1 0.75 0.25 0.25 0
Mkt property 0.5 0.75 1 0.25 0.25 0
Mkt fx 0.25 0.25 0.25 1 0.25 0
Mkt spread 0.25 0.25 0.25 0.25 1 0
Mkt conc 0 0 0 0 0 1

This correlation matrix was highly
controversial and, as CEIOPS (2009)
mentioned in its document on the lessons
of the crisis, it is likely to be modified.
The capital required for each of the six
sub-modules is equal to the change in the
net asset value (NAV) following upwards
and/or downwards shocks:
SCR risk i =ΔNAV | shock
with policies in accumulation units, with
derivatives, and with collective investment
schemes. For unit-linked policies, market
risk must be studied when the charges on
the policies depend on fund performance.
If there are embedded options or
guarantees in the policies, exposure to
market risk must be analysed. The effect of
risk-reduction techniques on the asset side
(financial hedging, for example) and on
the liability side (hedging instruments,
reinsurance) must be taken into account

An EDHEC Financial Analysis and Accounting Research Centre Publication 71

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
1 - As in QIS4, positive values
of ΔNAV signify losses.
2 - When a company is
exposed to interest rate risk
in more than one currency,
the capital charge for
interest rate risk should
be calculated on the basis
of an identical relative
variation on all relevant yield
curves. The term structure is
communicated by QIS4.
72 An EDHEC Financial Analysis and Accounting Research Centre Publication
4. Market and Counterparty Risks in the
Economic Capital Model under Solvency II
Constraints
in the evaluation of the risk sub-modules.
By contrast, the counterparty risks taken on
as a result are dealt with in the counterparty
risk module. In chapter V we go over in
greater detail the conditions on which
risk-reduction techniques are taken into
account.
For collective investment schemes, the
look-through principle must be applied:
risk exposures are allocated to each
sub-module. If the collective investment
scheme is not sufficiently transparent,
the investment mandate of the scheme
should be referred to (authorised limits,
authorised investment types, and so on)
and the share of assets in each risk category
chosen in such a way as to maximise the
overall charge. The final option is to assume
that if the majority of the assets of the
collective investment scheme are listed,
the collective investment scheme is an
equity investment and that if they are not
listed it is another risk type.
In the following sections (I.1 to I.6), we
present the market risk sub-modules.
This presentation makes it possible to
analyse the risks considered, the calibration
of these risks with the standard formula,
and the possible non-linearity effects to
proceed with the reposting necessary to
the calculation of RAC. As we mention
above, these calculations could be fined
tuned by and/or tailored to each insurer
so that it can calculate its exposure to
risks in greater keeping with the
characteristics of its portfolio (supervisor-
approved internal model).
I.1 Capital required for interest rate risk
Interest rate risk is measured by the impact
on net asset value (ΔNAV)1 of changes
in the term structure of interest rates or
by the impact on the balance sheet of
the company (investments in fixed-rate
instruments, interest rate derivatives,
insurance liabilities, and debts) and on
future liability flows (in a manner correlated
to the change in the rate at which they
are discounted) of interest rate volatility.
The upwards (upwardshock) or downwards
(downwardshock) interest rate shock that
leads to the highest charge is used to
determine the capital charge, and this for
each year over a twenty-year period (see
appendix 10).2
SCR Mkt int = ΔNAV | shock
When the cash flows of the relevant balance
sheet item are not sensitive to interest
rates (in particular, when it does not
have an embedded option or guarantee),
the simplified calculation suggested by
the regulator involves multiplying the
modified duration for each asset or
liability by the change in the yield curve.
For all durations, the downwards shock is
-40% and the upwards shock is +50%. This
simplification should not be use for life
technical provisions.
It should be underscored that the regulator
wants embedded options and guarantees
to be priced, all the more so when the bulk
of the risk of the policy is borne by the
policyholder, as in unit-linked policies.
The main embedded options and guarantees
in a life insurance portfolio can, of course,
be of very different natures: guaranteed
minimum rates, profit sharing, annuity
conversion options, guaranteed floors
for unit-linked policies, guaranteed
surrender values, and surrender options.
The pricing of these options and guarantees
is generally done in accordance with the
standards set by the CFO Forum (2008;
2005; 2004), in particular with the so-called
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
market-consistent approach. The idea is It is interesting to compare this line-of-
to take a risk-neutral approach, which business approach (economic capital
involves using expected stochastic cash approach) and aggregate approach taken by
flows (as determined by several thousand Solvency II (regulatory capital approach).
scenario simulations that make it possible
to take in the cost of negative changes)
discounted at the risk-free rate to calculate
the price of these options and guarantees.
Models usually simulate the movements
of market indices, the dividend rate,
inflation, real and nominal rate curves
for maturities of between one and thirty
years, credit spreads, credit default
risks, exchange rates, and so on. In
addition, these simulations should reflect
policyholder behaviour: (surrenders, and
so on), management policies (dynamic
investment strategies, hedging, and so
on), implicit market-consistent volatilities,
the correlation of asset classes, and the
correlation of economies.

Simulation with the model company

Assumptions
Activity Unit linked Euro Motor own Property Third-party Health
denominated damage damage liability
Bonds (EURm) 663 4920 370 804 550 95
Bond duration 8 8 4 4 9 3
Gross technical provisions (EURm) 1425 6000 205 740 647.5 42.5
Share reinsured 5% 1% 2% 15% 20% 2%
Reinsurance assets (EURm) 1 6 2 7 26 0
Technical provisions duration 8 8 2 2 9 1
Debt (EURm) 2.25 36 25 30 20 5
Debt duration 6 6 6 6 8 4
Net asset value (NAV) before 47 360 265 387 276 52
the shock (EURm)
Source: EDHEC Business School

Results
Activity Unit linked Euro Motor own Property Third-party Health
denominated damage damage liability
SCR int (EURm) 4.00 371.24 27.84 39.83 0.00 4.82
nSCR int (EURm) 4.00 349.23 27.84 39.83 0.00 4.82
Source: EDHEC Business School

An EDHEC Financial Analysis and Accounting Research Centre Publication 73

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
QIS4 assumptions
Total balance sheet
Bonds(EURm) 7403
Bond duration 7
Life gross technical provisions (EURm) 7425
Non life and health gross technical provisions (EURm) 1592.5
Reinsurance assets/technical provisions 1%
Reinsurance assets (EURm) 43
Life technical provisions duration 8
Non life and health technical provisions duration 5
Debt (EURm) 118
Debt duration 6
Net asset value (NAV) before the shock (EURm) 1387
Source: EDHEC Business School

Results
Total balance sheet
SCR int (EURm) 420
nSCR int (EURm) 398
Source: EDHEC Business School

Activity Unit Euro Motor own Property Third-party Health Sum of Interest Interest rate
linked denominated damage damage liability activities rate QIS4 QIS4/sum of
activities
SCR int
4 371 28 40 0 5 448 420 94%
(EURm)
nSCR int
4 349 28 40 0 5 426 398 94%
(EURm)
Source: EDHEC Business School

We see that the QIS4 approach leads to a
capital requirement lower than that of the
sum of the amounts required for each line
of business. This difference is the result of
the non-linearity of the interest rate risk
module. As it happens, Solvency II tests a
downwards shock and an upwards shock
and takes the greater of the two on an
integrated basis of the lines of business.
In our economic capital approach, we
consider an upwards and a downwards
shock for each of the lines of business. In
our simulation, the upwards shock is usually
more demanding of capital, although this
is not the case, for example, for third-party
liability. It is the only non-linearity bias
observed and, to calculate the economic
capital for each line of business, we will
take another look at it in the following
chapter.
I.2 Capital required for equity risk
As in financial theory, two components
serve as a basis on which the regulator can
measure equity risk:
i) idiosyncratic risk, the result of insufficient
diversification, a risk dealt with in the
concentrations risk sub-module, and
ii) systemic (or market) risk, which cannot
be reduced by diversification and is thus
market correlated. It is sensitive to overall
economic changes, taxation, interest rates,
inflation, and so on.

74 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
3 - Hedging instruments are
allowed only when average
The regulator puts equities into one of two this value is high and that it is high when
protection is afforded over indices: Global (for equities listed in EEA and this value is low. The dampener option was
the next year. For example,
where an equity option
OECD countries) and Others (for equities tested in QIS4, but only for the market value
provides protection for listed only in emerging markets, unlisted of equity portfolios (MVEP)4 drawn from the
the next six months, the
determination of the capital equities, hedge funds, and other alternative Global index associated with the share (α)
requirement should be done
assuming that the option
investments). In QIS4 it is assumed that the of technical provisions for commitments
covers only half of the beta of the equity portfolio of the insurance of more than three years (duration k ≥ 3).5
current exposure. In addition,
hedging programmes other companies is identical to that of the indices The value of the Global6 equity index is
than those in force at the (Beta = 1). split into a trend component and a cyclical
balance sheet date, rolling
hedging programmes, for component ct.7 In the dampener approach
example, are not included.
4 - Excluding equity positions
Two shocks (a 32% drop in the Global index to the Global index (SCRGlobal index), the
in which a parent has an and a 45% drop in the Others index), net capital charge for equity risk is defined
interest in a subsidiary (see
TS.VI.E QIS4). of hedging and risk transfers, are used to by:
5 - For the share for which determine the capital charge SCR Mkt SCR Global index = MVEP * ([α*(F(k)
the duration is less than three
years, the shock (-32%) to the Equity:3 + (G(k) * ct))] + [(1- α) * 32%])
Global equity index is taken.
6 - For the dampener SCR Mkt Equity = √∑r,c CorrIndexr,c
option, QIS4 takes the MSCI
Developed Markets index as
* Mktr * Mktc
the equity index. where F(k) and G(k) are coefficients defined
7 - Ct is the difference
between the mean of the
where Mktr, Mktc are the capital charges for in the table below:
ten trading days (Ybar 10) equity risk per individual index as shown Duration of the F(k) G(k)
before the day when the SCR
is calculated and the mean in the lines and columns of the correlation liabilities k
of the last year (around 250 matrix CorrIndex. QIS4 sets the correlation 3 to 5 years 29% 0.20
trading days—Ybar 261) that
precedes the calculation of coefficient at 0.75. 5 to 10 years 26% 0.11
the SCR.
10 to15 years 23% 0.08
In addition, there is an optional method More than 15 years 22% 0.07
that is currently the subject of debate. This Source: QIS4
so-called dampener method rests on the
theory that the likelihood of an increase in
the value of an equity index is low when

Simulation with the model company

Assumptions
Activity Unit linked Euro Motor own Property Third-party Health
denominated damage damage liability
Global index equities 94.0% 95.0% 95.0% 92.0% 90.0% 95.0%
Global index hedging rate 10.0% 5.0% 0.0% 0.0% 0.0% 0.0%
Other index hedging rate 5.0% 1.0% 0.0% 0.0% 0.0% 0.0%
Efficiency of Global index hedge 90.0% 90.0% 90.0% 90.0% 90.0% 90.0%
Efficiency of Others index hedge 80.0% 80.0% 80.0% 80.0% 80.0% 80.0%
Value of hedge/value of asset 4.0% 1.0% 1.0% 1.0% 1.0% 1.0%
hedge (Global)
Value of hedge/value of asset 4.0% 1.0% 1.0% 1.0% 1.0% 1.0%
hedge (Other)
Net asset value (NAV) before the 47 360 265 387 276 52
shock (EURm)
Source: EDHEC Business School

An EDHEC Financial Analysis and Accounting Research Centre Publication 75

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
Results The equity risk sub-module of the market
risk module is perfectly linear and the QIS4

denominated

Third-party
Motor own
Unit linked

Property
damage

damage
and economic capital approaches lead to

liability

Health
Euro
Activity
identical results.

SCR Mkt 4.0 48.8 31.7 92.6 88.9 1.6

eq (EURm)
nSCR Mkt 4.0 26.8
eq (EURm)
Source: EDHEC Business School
It is interesting to compare the line-of-
business approach (economic capital
approach) and the aggregate approach
taken by Solvency II (regulatory capital
approach)
Comparison of regulatory capital required
by the QIS4 approach (global approach)
I.3. Capital required for property risk
31.7 92.6 88.9 1.6 Property risk makes it possible to calculate
the capital charge (SCR Mkt prop) for the
changes in market prices for property. It
is measured by the change in net assets
(ΔNAV) following a 20% fall in the “real
estate benchmarks” after allowances are
made for investment policy (hedging
arrangements, leverage, and so on).
Simulation with the model company
Assumptions

denominated

Third-party
Motor own
Unit linked
and economic capital (line-of-business

Property
damage

damage

liability

Health
Euro
Activity
approach in keeping with the objective
of capital allocation)
Actifs
immobiliers 0 511 25 57 92 0
QIS4 assumptions (EURm)
Bilan Total
Actif net
Global index equities 62.5% (NAV) avant le 47 360 265 387 276 52
Global index hedging rate 3.0% choc (EURm)

Other index hedging rate 0.5% Source: EDHEC Business School

Efficiency of Global index hedge 90.0%
Results
Efficiency of Other index hedge 80.0%
denominated

Third-party
Motor own
Unit linked

Value of hedge/value of asset hedge 1.0%

Property
damage

damage

liability

Health
Euro

(Global) Activity
Value of hedge/value of asset hedge (Other) 1.0%
Net asset value (NAV) before the shock 1387 SCR Mkt prop
(EURm) 0 21 5 11 18 0
(EURm)
Source: EDHEC Business School nSCR Mkt
0 0 5 11 18 0
prop (EURm)
Results Source: EDHEC Business School
Bilan Total
SCR Mkt eq (EURm) 267
nSCR Mkt eq (EURm) 245
Source: EDHEC Business School

Activity Unit Euro Motor Property Third-party Health Sum of Interest Interest
linked denominated own damage liability activities rate QIS4 rate QIS4/
damage sum of
activities
SCR Mkt eq (EURm) 4,0 48,8 31,7 92,6 88,9 1,6 268 267 100%
nSCR Mkt eq (EURm) 4,0 26,8 31,7 92,6 88,9 1,6 246 245 100%
Source: EDHEC Business School

76 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

8 - The magnitude of the
shocks for the currency of an
ERM II (European exchange
rate mechanism) member
state with respect to the euro
must respect the limits set
by the ERM II (for example,
2.25% for the Danish crown).
9 - QIS4 excludes sovereign
bonds as well as assets
allocated to policies in
which policyholders bear
the investment risks. If these
policies have embedded
options or guarantees, the
share of the risk in fact
borne by the insurer is taken
into account with the term
ΔLiabul. The capital charge for
bond spread risk is calculated
as follows: Mkt sp bonds =
∑i MVi * m(duri)*F (ratingi) +
Δ Liab ul.
F (and G—see the sub-module
for the risk of structured
credit products) is calibrated
to deliver a shock consistent
with a 99.5% VaR:
Note F(Ratingi)
Economic Capital Model under Solvency II
Constraints
It is interesting to compare the line-of-
business approach (economic capital
approach) and the aggregate approach
taken by Solvency II (regulatory capital
approach)
Comparison of regulatory capital required
by the QIS4 approach (global approach)
and economic capital (line-of-business
approach in keeping with the objective
of capital allocation)
QIS4 assumptions
Total balance sheet
Real estate assets (EURm)
Net asset value (NAV) before shock
(EURm)
Source: EDHEC Business School
G(Ratingi)
in the value of other currencies against the
local currency (taking into account hedging
arrangements, gearing, and other aspects
of investment policy).8
Simulation with the model company
Assumptions and results
We assume that the model insurance company
has no currency risk as a result of its asset/
liability management, coherent investments,
and, failing that, a totally efficient hedge
against exchange rate risk.
1.5. Capital required for spread risk
685 The SCR Mkt spread capital charge for the
1387 volatility of spreads (the movement of the
yield curve) over the risk-free interest rate
term structure is measured by the change

AAA 0.25 % 2.13 % Total balance sheet

in net asset value (ΔNAV) following the
AA 0.25 % 2.55 % SCR Mkt prop (EURm) 55
more adverse of a rise and fall in credit
A 1.03 % 2.91 %
nSCR Mkt prop (EURm) 35 spreads for each of the relevant assets:
BBB 1.25 % 4.11 %
Source: EDHEC Business School bonds, structured credit products, and
BB 3.39 % 8.42 %

B 5.60 % 13.35 %
Activity Unit Euro Motor own Property Third-party Health Sum of Interest rate Interest rate
CCC or lower 11.20 % 29.71 %
linked denominated damage damage liability activities QIS4 QIS4/Sum of
Unrated 2.00 % 100.00 % activities
Source: QIS 4 SCR Mkt
For example, the loss caused by a shock 0 21 5 11 18 0 55 55 100%
to the spread for a BBB-rated asset with prop (EURm)
a term of four years is 5% (1.25*4).
nSCR Mkt
0 0 5 11 18 0 35 35 100%
prop (EURm)
Source: EDHEC Business School

The property risk sub-module of the credit derivatives such as credit-default

market risk module is perfectly linear and
the QIS4 and economic capital approaches
lead to identical results.
1.4. Capital required for currency risk
(volatility of exchange rates)
The currency risk sub-module makes it
possible to calculate the SCR Mkt fx capital
charge for changes in exchange rates. It is
measured with the change in net assets
(ΔNAV) following the greater of the capital
demands resulting from an 20% rise or fall
swaps. In particular, the SCR Mkt spread
capital charge is the sum of the three shocks
below:
• a shock to the market value (MV) of
bonds exposed to default risk. This shock
is a function of the modified duration of
the bonds (mdur), the credit risk rating
(F(rating)), and the impact on the liability
side for unit-linked policies with embedded
options and guarantees (ΔLiabul).9
The capital charge for spread risk of bonds
is given by Mktspbonds.

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4. Market and Counterparty Risks in the

10 - ABS (asset-backed
security); CDO (collateralised
debt obligation); CDS (credit
default swap); TRS (total
return swap); CLN (credit-
linked note).
11 - Mkt sp struct = ∑i MVi *
n(duri)*G (ratingi)
Economic Capital Model under Solvency II
Constraints
• a shock to structured credit products It is interesting to compare the line-of-
(ABSs, CDOs, and so on10). This shock is business approach (economic capital
a function of the modified duration of approach) and the aggregate approach
these products (ndur) and of the credit risk taken by Solvency II (regulatory capital
rating (G(rating)). The capital charge for approach).
the spread risk of structured products is
Mktspstruct.11
• a shock to credit derivatives (CDSs, TRSs,
CLNs) not held as part of a risk-reduction
programme. The capital charge for the
spread risk of credit derivative products
is noted Mktspcd. It is calculated as the
more adverse of the changes in the value
of the derivative following a widening of
300% or a narrowing of 75% in the credit
spreads.
SCR Mkt spread =
Mktsp bonds+ Mktspstruct + Mktspcd

Simulation with the model company

Assumptions
Activity Unit Euro Motor own Property Third-party Health
linked denominated damage damage liability
Bonds (EURm) 663 4920 370 804 550 95
% of bonds 99% 99% 99% 99% 99%
% of structured credits 1% 1% 1% 1% 1%
% of credit derivatives (investment 0% 0% 0% 0% 0%
not hedging
% non-governement bonds 60% 50% 60% 75% 40%
Non-governement bond portfolio cf. appendix
components 7
Structured credit portfolio cf. appendix
components 7
Net asset value (NAV) before the 47 360 265 387 276 52
shock (EURm)
Source: EDHEC Business School

Results
denominated

Third-party
Motor own
Unit linked

Property
damage

damage

liability

Health
Euro

Activity

SCR Mkt
0 26 3 10 20 0
spread (EURm)
nSCR Mkt
0 4 3 10 20 0
spread (EURm)
Source: EDHEC Business School

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4. Market and Counterparty Risks in the

12 - As in the spread risk
sub-module, contracts in
which the policyholder
bears the risk are excluded
from the calculation of risk
concentrations, but the
capital charge is adjusted for
the share of the risk borne by
the insurer in that event that
the policies have embedded
options and guarantees
(ΔLiabul).
13 - For this sub-module
of market risk, all the
entities in a conglomerate
should be treated as a
single counterparty. The
asset classes considered are
stocks and bonds (including
bonds held as collateral) and
such hybrid instruments as
the junior and mezzanine
tranches of CDOs. The
exposure should be assumed
net, that is, it should be
assumed, for example, that
a put option on a stock or a
credit default swap (single
name) reduce stock or bond
exposure, but the exposure
to the risk of option or CDS
counterparty default is dealt
with in the counterparty
risk sub-module (chapter IV,
section II).
Economic Capital Model under Solvency II
Constraints
Comparison of regulatory capital required
by the QIS4 approach (global approach)
and economic capital (line-of-business
approach in keeping with the objective
of capital allocation)
QIS4 assumptions
Activity
Bonds (EURm)
% of bonds
% of structured credits
% of credit derivatives (investment not
hedging
% non-government bonds
Non-government bond portfolio
components
Structured credit portfolio components
Net asset value (NAV) before the shock
(EURm)
Source: EDHEC Business School
Results
SCR Mkt spread (EURm)
nSCR Mkt spread (EURm)
Source: EDHEC Business School
inherent to concentrated asset portfolios
and of losses of value resulting from
the default of an issuer. For the sake of
simplicity, QIS4 limited the bounds of this
parameter to the risk of the accumulation
of exposures to the same counterparty.
Other types of concentrations (geographic
Total balance area, industry sector, and so on) are thus
sheet
out of bounds.
7403
99%
It is assumed that risk concentrations are
1%
present only when the net exposure to a
0.10%
counterparty with a rating higher than
60% or equal to A is greater than 5% (or, for
cf. appendix 7 counterparties with ratings lower than A,
when this exposure is greater than 3%).
cf. appendix 7 This exposure does not count policies
1387 where the policyholder bears the
investment risk,12 not including sovereign
bonds, holdings of more than 20% of the
shares of an insurance or financial services
company (see treatment of subsidiaries—
Bilan Total
QIS4, annex SCR 1, TS.XVII.C), or bank
59
deposits of a term of less than three months
37
and a ceiling of €3 million in a bank rated
at least AA.

Activity Unit Euro Motor own Property Third-party Health Sum of Interest Interest rate
linked denominated damage damage liability activities rate QIS4 QIS4/sum of
activities
SCR Mkt
0 26 3 10 20 0 60 59 99%
spread (EURm)
nSCR Mkt
0 4 3 10 20 0 38 37 98%
spread (EURm)
Source: EDHEC Business School

The spread risk sub-module of the market
risk module is perfectly linear, the QIS4
and economic capital approaches lead to
identical results.
I.6. Capital required for risk of
concentration of market risks
The supervisor deemed it advisable to
incorporate market risk concentrations
to reflect the risks of additional volatility
Three steps are taken to calculate the SCR
Mkt conc capital charge:
• based on total asset (Assetsxl)13 and
net exposure of assets at default (Ei),
determination of excess exposure (XSi)
to counterparty i depending on its rating
(the concentration threshold CT is at
5% for a rating of A or higher and at 3%
otherwise): XSi = max{0 ; (Ei/Assetsxl) – CT}.

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4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
• calculation of the capital charge per issuer It is interesting to compare the approach by
(Conci) on the basis of a shock (gi) depending line of business (economic capital approach)
on the credit rating of the counterparty (gi to the aggregated approach from Solvency
is equal to 0.15, 0.18, 0.30, and 0.73 for II (regulatory capital approach).
ratings of AA-AAA, A, BBB, and lower than
BB or unrated respectively): Conci = (Assetsxl QIS4 assumptions
* XSi * gi ) + ΔLiabul Activity Total balance
sheet
• calculation of the capital charge for
Total assets excluding unit-linked,
aggregate market concentrations risk government bonds and reinsurance 5764
SCR Mkt conc assuming independence of (EURm)
the capital required for each counterparty: Net exposure 4%
SCR Mkt conc = √∑ Conci². Counterparty rating BBB
Net asset value (NAV) before the
1387
shock (EURm)
Simulation with the model company
Source: EDHEC Business School
For the sake of simplicity, we assume that
for each line of business there is a single net
4% exposure to a BBB-rated counterparty. QIS4 results
Since it is assumed that the percentage and Activity Total balance
sheet
the counterparty are the same for each
SCR Mkt conc (EURm) 17
line of business, the sum of the exposures
nSCR Mkt conc (EURm) 5
for each of the lines of business leads to a
Source: EDHEC Business School
single net exposure of 4% to a BBB-rated
counterparty. Unit-linked business in life
insurance, of course, is excluded from
this module, as spelled out in the method
defined in QIS4:
Assumptions:
Activity Euro Motor own Property Third-party Health
denominated damage damage liability
Total assets excluding unit-linked, government 3965 288 774 694 44
bonds and reinsurance (EURm)
Net exposure 4% 4% 4% 4% 4%
Counterparty rating BBB BBB BBB BBB BBB
Net asset value (NAV) before the shock (EURm) 360 265 387 276 52
Source: EDHEC Business School

Results
Activity
denominated

Third-party
Unit linked

Motor own

Property
damage

damage

liability

Health
Euro

SCR Mkt
0 12 1 2 2 0.13
conc (EURm)
nSCR Mkt
0 0 1 2 2 0.13
conc (EURm)
Source: EDHEC Business School

80 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
Comparison of the regulatory capital To determine the total capital required
required according to QIS4 (global approach) for market risk (SCR Mkt), the regulator
to the economic capital (line of business assumes a correlation of the risk sub-modules
approach with the goal of capital allocation but looks at the insurer as a whole.
to line of business)

Activity Unit Euro Motor own Property Third-party Health Sum of Interest rate Interest rate
linked denominated damage damage liability activities QIS4 QIS4/sum of
activities
SCR Mkt
0 12 1 2 2 0.13 17 17 100%
conc (EURm)
nSCR Mkt
0 0 1 2 2 0.13 5 5 100%
conc (EURm)
Source: EDHEC Business School

The market concentrations risk sub-module
is not linear because the capital requirement
is the square root of the squared
concentrations sum (per counterparty).
Nevertheless, in our simulation we
assumed that the exposure to counterparty
risk was identical for each line of business;
as a result, global exposure to the
counterparty is linear.
I.7. Total capital required for market
risk module (SCR Mkt)
In the preceding sections (I.1 to 1.6), we
calculated the capital required for the
six Solvency II market risk sub-modules.
As we have noted previously, these
calculations could be fined tuned by
and/or tailored to each insurer, so that
an exposure to risks in greater keeping
with the features of its portfolios can be
calculated (the supervisor-approved internal
model).
For the purposes of allocating economic
capital to each line of business, we will
determine a SCR Mktj for each of the
six lines of business j. The problems of
non-linearity will be dealt with in detail
in the following chapter.
SCR Mkt j = √∑r,c CorrSCR Market rxc, j*
Mktr j* Mktc j
where CorrSCR Marketrxc are the cells
of the matrix of the correlation of the
six market risk sub-modules (Mktk) for
each line of business j (unit-linked, euro
denominated, motor own damage, property
damage, third-party liability, and health).
We take the correlation matrix provided by
QIS4 (2008) for the company as a whole
and for each of its lines of business.

Corr SCR market Mkt interest Mkt equity Mkt property Mkt fx Mkt spread Mkt conc
Mkt interest 1 0 0.5 0.25 0.25 0
Mkt equity 0 1 0.75 0.25 0.25 0
Mkt property 0.5 0.75 1 0.25 0.25 0
Mkt fx 0.25 0.25 0.25 1 0.25 0
Mkt spread 0.25 0.25 0.25 0.25 1 0
Mkt conc 0 0 0 0 0 1

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4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
14 - Simulation with the model company The definition of the capital required
Ratingi PDi Ratingi PDi Ratingi PDi
Market risk sub-module capital charges per for counterparty default risk (SCR def)
AAA 0,002 % BBB 0,24 % CCC or 30,41 %
lower,
unrated
line of business makes it possible to calculate one of the
AA 0,01 % BB 1,20 %

A 0,05 % B 6,04 % SCR (EURm) Euro Unit Motor own Property Third-party Health Sum of Interest Interest rate
Source : QIS 4 denominated linked damage damage liability activities rate QIS4/sum of
QIS4 activities
An unrated insurer subject to
Solvency II is considered BBB; Interest rate 371 4 28 40 0 5 448 420 94%
if it is not subject to Solvency
Equity 49 4 32 93 89 2 268 267 100%
II it is considered CCC.
Property 21 0 5 11 18 0 55 55 100%
Fx 0 0 0 0 0 0 0 0 -
Spread 26 0 3 10 20 0 60 59 99%
Concentration 12 0 1 2 2 0 17 17 100%
SCR Market 395 6 48 115 111 5 679 568 84%
nSCR Market 351 6 48 115 111 5 635 511 80%
Net asset value
(NAV) before the 360 47 265 387 276 52 1387 1387
shock (EURm)
Source: EDHEC Business School

II. Capital Required for components necessary to the calculation of

Counterparty Risk
Like the market risk module, the counterparty
risk module is an aggregate (the company
is taken as a whole). All the same, for the
purposes of the economic capital model,
we will single out the counterparty risks
for each of our model insurer’s six lines of
business. To determine capital allocated
to each line of business, it will then be
necessary, as a result of this disaggregation,
to make allowances for possible non-linear
effects.
The counterparty default risk module is
defined by QIS4 (2008) as “the risk of
possible losses due to unexpected default,
or deterioration in the credit standing of
the counterparties or debtors in relation
to risk mitigating contracts, such as
reinsurance arrangements, securitisations
and derivatives, and receivables from
intermediaries, as well as any other credit
exposures which are not covered in the
spread risk sub-module.”
risk-adjusted capital for each of the model
company’s six lines of business.
The capital charge for counterparty
default risk is the aggregation of losses
given default (LGDi) of each counterparty i
depending on its type (reinsurance or SPV,
financial derivatives, intermediaries, and
other credit exposures) and its probability
of default (PDi) as indicated by outside
credit ratings:14
• The loss given default on a reinsurance
contract or SPV is: LGD = 50% * max
(recoverables + gross SCRu/w - net SCRu/w
- collateral; 0), where gross/net SCRu/w is
underwriting risk gross/net of reinsurance
and recoverables are the best estimate
of recoverables from the reinsurance
contract or SPV. Any collateral held by the
counterparty itself should not be taken
into account in the calculation. If the
collateral bears any default risk, it should
be included in the module calculation like
receivables from intermediaries and other

82 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
15 - Hre, Hfd, Hint, Hoce Calculation of one of the components of RAC
are indices of the Premiums Premiums RAC in % RAC Net Net profit RAC V(RAC) V(RAC)
concentration of exposure Activity RoRAC g
EURm % of premiums EURm margin EURm x EURm %
to reinsurers or SPVs (re),
to financial derivatives Life euro denominated
(fd), to recoverables from
intermediaries (int), and to Life unit linked
other credit exposures (oce).
16 - Herfindahl index = Σ Motor own damage
(LDG)²/(Σ LDG)²
et R = 0.5+0.5H. Property damage
For an implicit correlation R
less than 1, the determination Third-party liability
of Defi is based on the
Health
Vasicek distribution:
Defi = LGDi * N
Sum
[(1-R)-0.5*G(PDi) + √(R/
(1-R)* G(0.995)] where N is Surplus
the cumulative distribution
function for the standard TOTAL
normal random variable
and G is the inverse of this
function. For an implicit
correlation R greater than 1, RAC euro denominated = F(SCR euro denominated) = F(SCR Life euro denominated, SCR Mkt euro denominated, SCR def euro
Defi = LGDi * min(100*PDi; 1).
denominated (counterparty), SCR operational euro denominated)
(same approach for RAC UL, RAC motor own damage, RAC property damage, RAC third-party liability et RAC health)

credit exposures (see above). The benefits of
the risk-mitigating effects of future profit
sharing are left out.
• Loss given default on a financial derivative
is: LGD = 50%* max (market value + gross
SCRmkt - net SCRmkt - collateral; 0), where
market value is the value of the financial
derivative as defined in article 74 of the
proposal for a framework directive.
• Loss given default on recoverables from
intermediaries and other credit exposures
is the best estimate of the credit to
intermediaries and any other credit
exposures.
required for counterparty default risk (SCR
Mkt def).
Simulation with the model company
Assumptions: we have assumed that for
each line of business the model insurer
had reinsurance arrangements with ten
reinsurers, the three largest of which
accounted for 61% of the total of the
business. Given the individual weights of the
seven other reinsurers, the capital required
for counterparty risk is nil. The tables below
therefore show the assumptions and results
only for the three largest reinsurers.

When each loss given default (LGDi) has

been calculated for each counterparty i, an
index of the concentration of the exposure
by counterparty type (Hre, Hfd, Hint, and
Hoce)15 and an implicit correlation R are
calculated via the Herfindahl index16 in
order to determine the capital charge Defi
for each type of counterparty. The sum of
these capital charges produces the capital

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4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
Assumptions
Activity Unit linked Euro Motor own Property Third-party Health
denominated damage damage liability
Percentage of concentration per
reinsurer
Reinsurer 1 27% 27% 27% 27% 27% 27%
Reinsurer 2 17% 17% 17% 17% 17% 17%
Reinsurer 3 17% 17% 17% 17% 17% 17%
Other reinsurers 39% 39% 39% 39% 39% 39%
Total 100% 100% 100% 100% 100% 100%
Net asset value (NAV) before the
47 360 265 387 276 52
shock (EURm)
Source: EDHEC Business School

Results (economic capital approach per line of business)

Activity Unit linked Euro Motor own Property Third-party Health
denominated damage damage liability
SCR Mkt def (EURm) 0.0035 0.0136 0.4558 0.6796 0.3062 0.0222
nSCR Mkt def (EURm) 0.0035 0.0000 0.4558 0.6796 0.3062 0.0222
Source: EDHEC Business School

It is interesting to compare the line-of- Assumptions

business approach (economic capital Total balance sheet
approach) and the aggregate approach Percentage of concentration per
reinsurer
taken by Solvency II (regulatory capital
Reinsurer 1 27%
approach)
Reinsurer 2 17%
Reinsurer 3 17%
Comparison of regulatory capital required
Other reinsurers 39%
by the QIS4 approach (global approach)
Total 100%
and economic capital (line-of-business
Net asset value (NAV) before the
approach in keeping with the objective of shock (EURm)
1387

capital allocation) Source: EDHEC Business School

QIS4 results
Total balance sheet
SCR Mkt def (EURm) 0.4
nSCR Mkt def (EURm) 0.4
Source: EDHEC Business School

Counterparty default risk synthesis

SCR Euro Unit Motor own Property Third-party Health Sum of Interest Interest
(EURm) denominated linked damage damage liability activities rate QIS4 rate QIS4/
sum of
activities
SCR def
0.0035 0.0136 0.4558 0.6796 0.3062 0.0222 1.4810 0.4267 29%
(EURm)
nSCR def
0.0035 0.0000 0.4558 0.6796 0.3062 0.0222 1.4673 0.4025 27%
(EURm)
Source: EDHEC Business School

84 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints
As the set of the preceding risk modules
(underwriting and market) and the Vasicek
distributions, themselves a function of the
Herfindahl index, are used to calculate the
counterparty default risk module, it has
very many non-linearities.

In conclusion, this chapter has made it

possible to calculate the capital charges
for market and counterparty risks, charges
whose calculation is necessary to the
determination of the regulatory capital and
to the economic capital required by each of
the lines of business of our model insurer,
under the constraint of Solvency II. With
these results, as well as those from chapter
III, and in light of chapters I and II, chapter
V will be able to show the contributions
that economic capital models can make
to risk management and, more broadly, to
the creation of value for shareholders or
mutual members.

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4. Market and Counterparty Risks in the

Economic Capital Model under Solvency II
Constraints

86 An EDHEC Financial Analysis and Accounting Research Centre Publication

 5. Economic Capital Model
versus Solvency II Regulatory
Capital

A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 87
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
In chapters III and IV, we calculated the
capital required for the risk types (life
underwriting, non-life, health, market
and counterparty risks) for each of the
six lines of business of the model insurer.
The final phase involves calculating
regulatory capital, in keeping with the
framework provided by the prudential
regulator, for the company as a whole and
putting in place, under the constraint of
Solvency II, the economic capital model.
This model is more sophisticated than
that put in place by the regulator, as it
defines allocation of capital not just for the
company as a whole but also for each of the
lines of business it is involved in, a definition
that makes possible a more sophisticated
dashboard, especially for managing
risks and, more broadly, value creation.
The complexity lies in the non-linear
treatment of some of the modules, and
the diversification of risks and lines of
business.
The aim of the first section is to calculate
regulatory capital. Section II defines the
economic capital model under a Solvency
II constraint. These two sections serve
as the bases for our demonstration of
the numerous contributions of this
decision model: it contributes to the
management of risk-adjusted capital (RAC),
to the definition of policies for investment,
underwriting, provisioning, reinsurance,
asset/liability management, allocation
of capital to lines of business, and risk
management (definition of accepted limits,
concentration, diversification) and to the
communication with the financial markets,
rating agencies, and the prudential
regulator. The heart of this model is the
creation of value for the shareholders or
mutual members.
88 An EDHEC Financial Analysis and Accounting Research Centre Publication
Finally, section III shows that Solvency
II will lead to a profound shift in
risk transfer policies, those involving
reinsurance in particular. As it now takes
risk transfer policy and the underlying
counterparty risks more closely into account,
Solvency II favours the management and
hedging of risks. We will see, nonetheless,
that the measurement and calibration
of the formula are decisive, and that a
few modifications still need to be made
if the regulator wants to avoid causing
certain biases that would be at odds with
its objective of encouraging improved
management of insurance companies.
I. Calculation of Solvency II
Regulatory Capital
As we mentioned in sections II.2 and II.3 of
chapter II, there are two levels of capital
requirement in the Solvency II framework:
the minimum capital requirement (MCR)
and the solvency capital requirement (SCR).
The MCR is the indispensable minimum for
doing business. If this requirement is not
met, supervisory intervention is systematic.
The SCR is the target capital that every
insurance company should aim for, capital
that will enable it to absorb most unusual
shocks. As such, the SCR is a benchmark for
calculating RAC, in internal decision tools as
well as in economic capital models. The SCR,
with a VaR at 99.5% on a one-year horizon,
is the aggregate of the six risk modules
(themselves split into sub-modules—see
appendix 4).
SCR = BSCR + SCROp – Adj
where BSCR is the basic solvency capital
requirement, SCROp is the capital
charge for operational risk, and Adj the
adjustment for the risk-absorbing effect
of future profit sharing and deferred taxes.
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

5. Economic Capital Model versus

Solvency II Regulatory Capital

1 - The capital charge for

operational risk is thus capped at
The following sub-sections (I.1-I.6) deal with reduce by 50% the sum of capital required
0.3 times the BSCR (article 106(3) the calculation of each of these terms. when the lines of businesses are considered
of the proposed framework
directive).
individually ( in the table). We will go over
2 - OPln ul = max [0.03*(Earnlife- I.1. Calculation of the basic solvency these figures in greater detail in section I.4,
Earnlife-ul) + 0.02*Earnnon-life+
0.02*Earnhealth; 0.003*(TPlife- capital requirement (BSCR) in particular with reference to the CEIOPS
TPlife-ul) + 0.002*TPnon-life +
0.002*TPhealth] where:
The BSCR is the aggregate of the capital report (2008) that presents the QIS4 results
Earnlife and TPlife are the total charges for the five risk modules described obtained for European insurers.
earned life premiums and
technical provisions gross of in chapters III and IV (life underwriting,
reinsurance non-life, health, market, and counterparty) I.2. Calculation of the solvency capital
Earnlife-ul and TPlife-ul are the
total earned life premiums before operational risk is taken into requirement for operational risk
and technical provisions gross
of reinsurance for unit-linked
account and adjustments are made for (SCROp)
policies the risk-absorbing effects of future profit This risk module covers operational risks
Earnnon-life and TPnon-life are the
total earned non-life premiums sharing and deferred taxes. To include the not explicitly covered by the other risk
and technical provisions gross of benefits of diversification and the correlation modules (chapters III and IV), in particular
reinsurance, excluding the risk
related to annuities in the health of the five risk modules, the BSCR is defined the risk of loss arising from inadequate
and accident lines of business
Earnhealth and TPhealth are the
by Solvency II in the following way: or failed internal processes, people,
total earned non-life premiums
BSCR = √∑r, c Corr SCRr,c* SCRr *SCRc systems, or external events and legal
and technical provisions, gross of
reinsurance and not included in risks. Reputation risks and risks stemming
Earnnon-life and TPnon-life. where Corr SCRr,c are the cells of the from strategic decisions are not included.
correlation matrix.

Corr SCRr,c SCR Mkt SCR def SCR life SCR health SCR NL
SCR Mkt 1 0.25 0.25 0.25 0.25
SCR def 0.25 1 0.25 0.25 0.5
SCR life 0.25 0.25 1 0.25 0
SCR health 0.25 0.25 0.25 1 0.25
SCR NL 0.25 0.5 0 0.25 1
Source: QIS4

Simulation with the model company

Activity Unit Euro Motor own Property Third-party Health Sum of BSCR BSCR QIS4 /
linked denominated damage damage liability activities QIS4 sum of activities
BSCR 7 400 288 401 323 29 1448 693 48%
n BSCR 7 351 288 401 323 29 1400 636 45%
Source: EDHEC Business School

In this table, the BSCR per line of business
is the capital required before taking
into account operational risk and the
risk-absorbing effects of future profit
sharing and deferred taxation, but after
taking into account the correlation of the
five Solvency II risk modules. It is apparent
that the benefits from the diversification of
the lines of business (BSCR QIS4 in the table)
are substantial, as they make it possible to
The capital charge for operational risk
is a function of the BSCR,1 of annual
administrative expenses (gross of reinsurance
and not including acquisition expenses) for
unit-linked business (Expul), and of the basic
capital charge for the operational risk of
all business other than unit-linked business
(Opln ul):2
SCR Op = min (0.30 * BSCR; OPln ul)
+ (0.25* Expul)

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

5. Economic Capital Model versus

Solvency II Regulatory Capital

Simulation with the model company

Operational risk assumptions for the economic approach per line of business under QIS4
Unit Euro Motor own Property Third-party
Activity Health
linked denominated damage damage liability
Gross technical provisions (EURm) 1425 6000 205 740 648 43
Gross premiums earned (EURm) 255 1020 1044 1050 263 204
Annual expense rate 2%
Net asset value (NAV) before shock
47 360 265 387 276 52
(EURm)
Source: EDHEC Business School

Results per line of business (economic approach)

Activity Unit linked Euro Motor own Property Third-party Health
denominated damage damage liability
SCR Op (EURm) 3 31 21 21 5 4
Source: EDHEC Business School

It should be underscored that the QIS4 results

operational risk module is built gross of Total balance sheet
reinsurance and that it is still founded on SCR Op (EURm) 75
a very nearly standard approach. We will Source: EDHEC Business School

return in greater detail to the treatment

of risk transfers (of reinsurance as treated When the two approaches (by line of
by the standard formula of Solvency II, in business and global) are compared, the
particular in section III). As it turns out, for results are not identical, as the module is
each of the lines of business of the model not linear (it has minimum and maximum
company, the lower of 0.30 * BSCR and functions).
OPlnul is always the latter.
So, not including the risk-absorbing effects
QIS4 calculation of operational risk (global of future profit sharing and deferred
approach to the company) taxes, operational risk requires 11% more
Assumptions capital on top of the BSCR, a requirement
(EURm) Total balance sheet
somewhat above the European average
Gross technical provisions
(ACAM 2008; CEIOPS 2008).
Unit linked 1425
Euro denominated 6000
Non-life 1592.5
Health 42.5
Gross earned premiums
Unit linked 255
Euro denominated 1020
Non-life 2250
Health 204
Annual expense rate for 2%
unit-linked activity
Net asset value (NAV) before 1387
the shock (EURm)
Source: EDHEC Business School

90 An EDHEC Financial Analysis and Accounting Research Centre Publication

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5. Economic Capital Model versus

Solvency II Regulatory Capital

3 - The capital charge for Comparison of operational risk according to QIS4 and to an economic approach per line of business
the different risks given the
Activity Unit Euro Motor own Property Third-party Health Sum of BSCR BSCR QIS4 /
risk-absorbing effects of
future profit sharing. linked denominated damage damage liability activities QIS4 sum of activities
SCR Op
3 31 21 21 5 4 85 75 89%
(EURm)
Source: EDHEC Business School

I.3. Calculation of the adjustments for Given the profile of the model insurer (six
the risk-absorbing effect of future lines of business in which euro-denominated
profit sharing and deferred taxes life insurance accounts for only 27% of
The adjustment for the risk-absorbing total premiums), the diversification benefit
effect of future profit sharing (Adj is more modest than that of the European
FDB) is calculated based on the lower average, where country profiles are
of the technical provisions for future nonetheless highly dissimilar.
discretionary benefits (FDB) and the
difference between the BSCR and the In the context of calculating the
nBSCR:3 adjustment for the risk-absorbing effects
Adj FDB = min{(√∑r, c CorrSCRr, c* SCRr of deferred taxation (Adj DT), let us recall
*SCRc - √∑ r, c CorrSCRr, c* nSCRr * nSCRc) ; that the BSCR was calculated based on
FDB} a balance sheet without deferred tax
liabilities and without taking into
Simulation with the model company
Comparison of the risk-absorbing effects of future profit sharing according to QIS4 and to an economic approach per line of business
Activity Unit Euro Motor own Property Third-party Health Sum of FDB QIS4 after FDB QIS4/Sum of
linked denominated damage damage liability activities diversif. BSCR the activities
Adj FDB
0 44 0 0 0 0 44 57 130%
(EURm)
Source: EDHEC Business School

Naturally, for the model company, only account the tax savings in each risk
euro-denominated life insurance policies module (in particular, following changes
benefit from the risk-absorbing effect to net assets). AdjDT is the absolute value
of future profit sharing. When the line- of the reduction of deferred taxes (Δ
of-business (see sum of activities—total Deferred Taxes) following a scenario (SCR
in the table above) and Solvency II (FDB shock) corresponding to the immediate
QIS4 after diversif. BSCR) approaches loss of basic own funds of the amount
are compared, it is apparent that the BSCR- AdjFDB + SCROp.
risk-absorbing effects of diversification, Adj DT = Δ Deferred Taxes | SCR shock
especially on the market risk modules and
on the lines of business, as well as on the Simulation with the model company
five risk modules described in chapters IV We have assumed a corporate tax rate of
and V, are not linear. 33.33%
Comparison of the adjustments for deferred taxes according to QIS4 and to an economic approach per line of business
Activity Unit Euro Motor own Property Third-party Health Sum of Deferred Def. Taxes QIS4/
linked denominated damage damage liability activities taxes QIS4 Sum of activities
Adjustment
for deferred 3 92 35 54 43 10 237 237 100%
taxation (EURm)
Source: EDHEC Business School
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5. Economic Capital Model versus

Solvency II Regulatory Capital

The savings in the capital required for
deferred taxation is 33.33% for our
model insurer, which is higher than that
in the results published by CEIOPS (for
example, 20% for French companies,
according to the ACAM). This difference
may be accounted for by the average tax
rate in Europe or by the failure of many
of the respondents to QIS4 to make this
adjustment. In the end, the effects of
the adjustment (FDB and deferred taxes)
make it possible to reduce the capital
requirement by 42% (by 50% according
to the figures from ACAM and CEIOPS).
I.4. Calculation of the overall solvency
capital requirement
We have noted previously that the
calculation of the overall SCR is done on
a one-year horizon using a VaR of 99.5%,
based on the aggregation of six risk
modules (themselves broken down into
sub-modules—see appendix 4).
SCR = BSCR + SCROp - Adj
The weight of the diversification of business
in the Solvency II framework should be
underscored: the capital requirement in
the QIS4 method (after diversification)
is €470 million, whereas the sum of the
capital required for each of the lines
of business (that is, after geographic
diversification and diversification of
underwriting and market risks and
adjustments for risk-absorbing effects but
before the diversification of the lines of
business benefit) is €1.16 billion.
In addition to this substantial capital
savings made possible by the diversification
of the lines of business, it is interesting
to break down the components of the
capital required for each risk type. The
following table synthesises the entirety
of the calculations made in keeping with
the QIS4 risk-adjusted capital method
(economic capital).

Simulation with the model company

Calculation of overall SCR per line of business (economic approach) and QIS4 method
Activity Unit Euro Motor own Property Third-party Health Sum of BSCR BSCR QIS4 /
linked denominated damage damage liability activities QIS4 sum of activities
Global SCR (EURm)
8 267 238 352 284 25 1175 474 40%
sum of risk modules
Source: EDHEC Business School

Capital required before benefit for diversification of business

(EURm) Unit Euro Motor own Property Third-party Health Sum of
linked denominated damage damage liability activities
SCR u/w 3 16 272 357 277 27 952
n SCR u/w 3 0 272 357 277 27 936
SCR Mkt 6 395 48 115 111 5 679
n SCR Mkt 6 351 48 115 111 5 635
SCR Def 0 0 0 1 0 0 1
n SCR Def 0 0 0 1 0 0 1
BSCR 8 412 320 472 388 32 1633
Operational SCR 3 31 21 21 5 4 85
Adj DPF 0 48 0 0 0 0 48
Adj deferred taxes 3 127 103 141 110 11 495
GLOBAL SCR sum of risk modules 8 267 238 352 284 25 1175
Source: EDHEC Business School

92 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

5. Economic Capital Model versus

Solvency II Regulatory Capital

Breakdown of the QIS4 capital required per line of business

Activity Unit Euro Motor own Property Third-party Health Total
linked damage damage liability
Reinsurance ratios
Net/gross technical provisions 95% 99% 98% 85% 80% 98%
% premiums reinsured 3% 10% 15% 3%
Underwriting risk module (EURm)
Mortality/prem and reserve for 0.1 3.7 262 350 276 21
non-life
Longevity 0.5 2.3
Disability 0.0 0.1
Lapse 1.5 11.1
Expense 1.3 5.6
Revision 0.0 0.0
Catastrophe 0.1 2.5 73 68 32 17
Total underwriting SCR 2.6 16.4 78 102 79 27 304
Market risk module (EURm)
Interest rate 4 371 28 40 0 5
Equity 4 49 32 93 89 2
Property 0 21 5 11 18 0
Fx 0 0 0 0 0 0
Spread 0 26 3 10 20 0
Concentration 0 12 1 2 2 0
Total market SCR 5 330 40 96 92 4 568
Counterparty SCR before 0.003 0.014 0.456 0.680 0.306 0.022 1.481
diversification (EURm)
Counterparty SCR after 0.001 0.004 0.131 0.196 0.088 0.006 0.427
diversification (EURm)
BSCR u/w + mkt + def (EURm) 7 347 118 198 172 32 873
BSCR after diversification (EURm) 5 307 88 143 124 26 693
Operational SCR after diversification 3 27 19 19 5 4 75
(EURm)
Adj FDB (EURm) 0 57 0 0 0 0 57
Adj deferred taxes (EURm) 3 92 35 54 43 10 237
Global SCR after diversification 5 185 71 108 86 20 474
(EURm)
NAV (EURm) 47 360 265 387 276 52 1387
Source: EDHEC Business School

In life insurance, market risk accounts for the life capital charge.
98% of the aggregate SCR (sum of the
underwriting, market, and counterparty
capital requirements). Underwriting
risk is relatively modest, given the
weight of the savings component.
The adjustment factors are the key. They
make it possible to reduce substantially
(16% for FDB and 28% for deferred taxes)

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
Breakdown of the life and non-life SCR
Source: EDHEC Business School
The report on the European results
published by CEIOPS and ACAM shows
that capital requirements differ greatly
from one non-life insurer to another, a
difference that is the result of the duration
of liabilities. The insurers whose liabilities
unwind over the long term tend to have
capital requirements for underwriting risk
greater than those for market risk.
The simulation with a model company shows
a relative balance of capital requirements
for these two risks (50% for underwriting
risk and 45% for market risk). Third-party
liability, as it happens, accounts for only
11% of the insurer’s non-life business
(not including health) and 7% of its total
premiums.
As we have noted above, the capital savings
for diversification of risks and lines of
business, as well as the adjustments for
risk-absorbing effects, are very high. As
a result, the ACAM and CEIOPS reports
94 An EDHEC Financial Analysis and Accounting Research Centre Publication
underscore that ultimately QIS4 involves
capital requirements greater than those
of Solvency I, but that any increases are
largely offset by these diversification
effects, so much so that insurance company
surpluses are mostly unaffected, whatever
the prudential framework (Solvency I or
Solvency II).
If capital requirements are broken down
no longer by line of business but by risk
module, we see that the major component
of market risk in life insurance is interest
rate risk (77%, as opposed to 11% for equity
risk before the diversification benefit). In
non-life, equity risk (60%) is a much greater
component than interest rate risk (19%),
and this as a result of the structure of the
assets and the duration of the liabilities.
Overall, for the simulation of our model
company it is interest rate risk that is the
largest single component of the market
risk module (52%, as opposed to 32% for
equity risk).
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
Market SCR components per activity
Source: EDHEC Business School
Underwriting components per activity
Source: EDHEC Business School
For underwriting risk, in life insurance,
capital requirements are fairly
homogeneous. Lapse and longevity risks,
which each account for approximately
one-third of the total capital requirement
in the underwriting risk module, are the
largest consumers of capital. In non-life
insurance, requirements for premium and
reserve risks account for between 78% and
90% of capital required for underwriting
risk.
The entirety of these calculations thus
makes it possible to determine the economic
capital required for each line of business
under Solvency II. Before we describe
the means of going from Solvency II to
a dashboard, let us underscore that for
pillar II additional capital may be required:
these additional requirements are known
as capital add-ons.
An EDHEC Financial Analysis and Accounting Research Centre Publication
I.5. Evaluation of capital add-ons
According to the proposed directive of the
European Parliament and Council (2007), as
part of supervisory review, the supervisory
authorities must assess the adequacy of
the strategies and reporting procedures
used by insurers to identify, measure, and
control their risks. Article 37 stipulates
that the solvency capital requirement
is the starting point. Nonetheless, if the
supervisory authorities believe that risks
are inadequately taken into consideration,
that the standard formula or the insurer’s
internal models fail to reflect the company’s
real exposure to risk, or that governance
systems are faulty, they may require an
additional solvency margin, the so-called
capital add-ons.
For the simulation with our model company,
we assume that no capital add-on is
95
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
required. If it were, this capital add-on
would naturally be included in the economic
capital model and it would increase the
figures for risk-adjusted capital.
I.6. Definition of eligible capital and
breakdown into tiers
It seems likely that, with the coming into
force of Solvency and the changes it will
lead to, prudential regulation will have
a great impact on the management of
own funds, in particular on the choice of
capital type (“core” own funds, hybrid and/
or subordinate capital instruments) with
respect to the three tiers defined by the
supervisory authorities and to the SCR and
the MCR.
The proposed directive of the European
Parliament and Council (2007) defines own
funds as the sum of basic own funds (the
excess of assets over liabilities, not including
own shares directly held by the insurer or
subordinated liabilities) and ancillary own
funds, which are own funds that, after
prior supervisory approval, can be called
on to absorb possible losses (unpaid share
capital that has not been called up, letters
of credit, or, for mutual undertakings, calls
for supplementary contributions).
As in the banking world, own funds are
broken down into three tiers, on criteria
involving:
i) subordination
ii) loss-absorbency
iii) permanence
iv) perpetual nature
v) absence of mandatory servicing costs.
Basic own funds that meet the conditions
for subordination, loss-absorbency, and
permanence and to a large degree the
conditions for a perpetual nature and
96 An EDHEC Financial Analysis and Accounting Research Centre Publication
absence of servicing costs are eligible
for tier 1. Ancillary own funds that
meet the conditions for subordination,
loss-absorbency, and permanence and
to a large degree the conditions for a
perpetual nature and absence of servicing
costs are classified in tier 2. If basic own
funds fail to meet only the condition for
permanence (“the item is available, or can
be called up on demand, to absorb losses
on a going-concern basis, as well as in the
case of winding-up”) they are classified as
tier 2 funds. Basic or ancillary own funds
that do not have the characteristics that
would make them eligible for tiers 1 or 2
are classified in tier 3. For example, surplus
funds not made available for distribution
to policyholders and beneficiaries are
classified in tier 1 and letters of credit or
claims against members by way of calls for
supplementary contributions are in tier 2.
Finally, own funds are eligible for these tiers
within the following limits.
Eligibility of own funds and limits
SCR MCR
Tier 1 At least one-third At least 50%
Tier 2 The balance The balance
Tier 3 At most one-third
Source: Commission of the European Communities (art. 97, 2007)
Solvency II, of course, is principles-based
rather than rules-based. Indeed, so as not
to participate in domestic and European
debates on the difference between hybrid
capital instruments and subordinated
liabilities, QIS4 (2008) states: “what is
ultimately relevant is the extent to which
a particular instrument holds the qualitative
characteristics required for classification in
a particular tier”.
In addition, QIS4 emphasises the necessity
of determining the solvency of the company
by making allowances for the inability to
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

5. Economic Capital Model versus

Solvency II Regulatory Capital

4 - For example, there is

non-linearity in the lapse
transfer ring-fenced own funds. To simplify (by profitability, cost, and consumption
module of life underwriting our calculations, we assume that our model of capital), and exposure to risk (which
(the most adverse of three
scenarios); in the premium
insurer has no ring-fenced structures. has an impact on capital requirements),
and reserve module of financial autonomy and solvency and to
non-life underwriting (the
Herfindahl index measures It is thus very likely that, in an attempt to reallocate surplus capital destructive of
geographic diversification); in
the catastrophe sub-module
optimise the management of capital under value to optimise existing activities or to
of the non-life underwriting Solvency II, capital structure offerings, develop new business. Capital does not
module (the square root
of the standard charges perhaps through hybrid capital instruments come without a cost, so managing capital
calibrated per line of business or subordinated liabilities, will find takers. is indispensable.
multiplied by the net written
premiums for the coming
year). Market risk looks at
risk overall rather than by
The QIS4 standard formula, in its current
line of business. In this way, II. Calculation of Economic form, does not make possible a direct
there are necessarily biases
in the interest rate risk Capital under Solvency II calculation of the allocation of capital per
sub-module, where one takes
the greater of the capital
Constraints line of business, a calculation necessary
requirements following an Chapters I and II described the role of value to the creation of an economic capital
upwards or downwards shock
scenario. If the analysis is
creation in company strategy. Chapters III, model. Indeed, as it is not the domain
done per line of business, IV, and section I of chapter V calculated of Solvency II, some QIS4 risk modules
it is not necessarily the
same scenario (upwards regulatory capital in keeping with the (especially the market risk module) take
or downwards shock) that
leads to the greater capital
Solvency II prudential framework. With the company as a whole rather than
requirement. For example, all these elements, we can now build an each of its lines of business.
for third-party liability the
greater requirement follows
economic capital model under Solvency II
a downwards shock and for constraints. So some restatements are necessary, in
motor insurance it follows
an upwards shock. It is thus particular to make allowances for the
necessary to reallocate capital
in proportion to the relevant
II.1. Elaboration of the economic non-linear effects in certain modules
risk variable. capital model in the Solvency II and disaggregate the solvency capital
5 - For example, QIS4
provides a matrix of environment requirement (SCR) for each line of
the correlation of the The QIS4 standard formula can, of business (allocation of economic capital–
seven life underwriting
sub-modules (aggregate course, be viewed as an simplified risk-adjusted capital). In addition, these
unit-linked business and
euro-denominated business);
internal model that each insurer can adjustments must respect the following
of the sub-modules of (and is even encouraged to) perfect or constraint: the sum of the capital allocated
non-life underwriting risk for
each line of business (there fine tune so that it will be suited to to each activity (RAC) should be equal to
is a diversification benefit its own characteristics, in particular the Solvency II SCR (the standard formula
linked to the number of
non-life lines of business on its exposure to risks and its ability to or an internal model). In general, we choose
the volatility of claims in past
years); of the six market-risk
manage them. to isolate the non-linear effects4 or the
sub-modules (correlation of diversification and correlation benefits5
risks). On the other hand,
for the concentrations risk The objective of this economic capital defined by QIS4 through correlation matrices
sub-module, according to
our assumptions, this risk is
model is to provide every company with and to reallocate them proportionally to
nil for each line of business a steering tool, the foundation of which each line of business, depending on the
taken individually, but it is
positive when the company
is the investment—in both data collection variable linked to these benefits (capital
is viewed as a whole, a and simulations—required to meet the charge for a sub-module, best estimate, and
circumstance that requires
reallocation of this overall demands of the supervisory authority. This so on). So, with the framework provided
amount per line of business
in keeping with the amount
decision tool makes it possible to manage by Solvency II, we are able to determine
of its assets eligible for this available capital (the capital structure), risk-adjusted capital per line of business.
risk.
allocation of capital to lines of business

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5. Economic Capital Model versus

Solvency II Regulatory Capital

The Solvency II regulatory framework may
become the new standard and constraint
for the definition of RAC and is thus
harmonising European practices. The
insurance companies that already have
internal models may need to adjust them
to have them approved by the supervisory
authorities. Those that do not have them
will, as a result of Solvency II, have made
most of the investments required to
build them. As we have mentioned in the
preceding chapters, these investments
involve data collection and the running
of simulations to meet European regulatory
requirements.
The calculation of RoRAC (return on
risk-adjusted capital) and of capital
surpluses follows from the Solvency II
solvency capital requirements (see appendix
7 for more information).
The economic capital model presented in the
table above was built with the characteristics
of the model company (see appendix 7)
and under Solvency II constraints (RAC
is equivalent to the SCR). Analysis of this
table makes it possible not only to take in
the risk profile and the profitability of the
company but also, as we will see in the
following sections, to suggest some means
of improving the strategic management of
the company.
II.2. Analysis of the profile of the
company with the conventional
approach (turnover, net margin, and
return on equity)
The economic capital model is a steering
tool put in place by most leading European
insurers, the use of which is slowly
“trickling down” to rest of the insurance
industry (a partial or total model). It makes
it possible to assess the impact of each
strategic decision not just on the relevant
business unit(s) (line of business, country,
region, and so on) but also on the company
as a whole. After all, not every local
optimum is necessarily a global optimum
(for example, the best acquisition from a

Economic capital model

Life Non-life
Activity Unit Euro Motor own Property Third-party
Health Sum Excess TOTAL
linked denominated damage damage liability
Premiums
Premiums EURm 250 1000 1000 1000 250 200 3700
Premiums % 7% 27% 27% 27% 7% 5% 100%
Capital
RAC in % (Solvency) 0.4% 3.1% 7.1% 10.8% 34.4% 9.9% 12.8%
RAC EURm 5 185 71 108 86 20 474 615
RAC % of total 1% 39% 15% 23% 18% 4% 100%
Profitability
Net margin 0.8% 4.0% 2.3% 3.0% 6.1% 2.9% 3.1%
Net profit EURm 2 40 23 30 15 6 116
RoRAC 35% 21% 33% 28% 18% 29% 24% 5%
Valuation
RAC x 4.7 2.8 3.6 3.1 2.0 3.2 2.9 0.5 1.2
V(RAC) EURm 25 513 256 336 169 64 1364 308 1671
V(RAC) % 2% 38% 19% 25% 12% 5% 100%
Source: EDHEC Business School

98 An EDHEC Financial Analysis and Accounting Research Centre Publication


6 - The €615 million surplus
generates net earnings of
€18.54 million (on the basis
of a gross return of 4.5%
equal to the cost of the debt
and a tax rate of 33.33%). The
net earnings of the company
are thus €134.3 million. Book
value (see appendix 7 and
chapter III, section I) comes
to €1.183 billion.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
strategic and financial point of view in a Premium breakdown per activity
Property Third-party liability 7%
particular country is not necessarily ideal damage
Health
for the parent in terms of management 27% 5%
priorities, profitability, financing, capital Life unit
linked 7%
allocation, and so on).
Lines four and five of the table (Premiums
€m and Premiums %) show that the
risk profile of the model company is not
particularly risky:
• one-third (€1.25 billion) of total premiums
of €3.7 billion is written in life insurance Motor own Life euro
(with a large savings component, as we damage 27% denominated 27%
saw in chapter III); 20% of this life business
(€250 million) is in unit-linked policies Non life 66% Life 34%
• Non-life insurance (damage and health) Source: EDHEC Business School
is mainly formed by motor own damage
and property damage (€2 billion), each Net margin per activity
7
of them accounting for one-fourth of the
company; together they account for 82% 6
of non-life premiums 5
• Third-party liability and health account
4
for only 7% and 5% of the total premiums
of the company. 3
2
So, in view of its business (frequency
1
risks, for the most part), this company
does not seem to have an especially risky 0
Third-party Property Motor own
profile. The company’s riskiest business is liability damage damage
third-party liability, but it accounts for Life euro Health Life unit
denominated linked
only 7% of premiums and its 6.1% net Source: EDHEC Business School
margin (net earnings/premiums) is, at first
glance, substantially higher than that As we mentioned in chapter II, a great
of the other non-life businesses of the number of insurance companies still rely on
company (3% for property damage, 2.9% for net margins and the weight (as a proportion
health, and 2.3% for motor own of the total weight of the company) of
damage). turnover or balance sheet items of each
line of business to determine the risk
profile. This analysis is usually refined by
determining the return on equity (ROE) of
the company; here it is 11.3%.6 It should
be noted that this calculation is based on
published accounting own funds that in
no way reflect the economic dimension
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5. Economic Capital Model versus

Solvency II Regulatory Capital

(under- or over-capitalisation, goodwill, Lines of business as a share of total premiums and as a share
of total risk-adjusted capital
in force, and so on) and that as a result Health Life unit linked 7%
it is a poor strategic indicator and a poor 5%
basis for comparing the performance of Third-party Life euro
liability 7% denominated
the insurer and that of other insurers in 27%
the industry.

II.3. Economic capital approach

suggests a riskier profile than does
conventional analysis
In view of the limitations of the
conventional approach and the Solvency
Motor own
Property
II constraints that, as we have noted, require damage 27%
damage 27%
heavy investment in data collection and
simulations, we expect the development
of economic capital models to pick up
RAC per activity
speed. The economic capital model makes Health Life unit linked 1%
it possible to observe that the weight of 4%
our model insurer’s riskiest and highest Third-party Life euro
liability
margin business—third-party liability—is 18%
denominated
39%
ultimately greater than its share (7%) of
premiums would suggest.

Taking into consideration the Solvency II

constraint, we have allocated capital for
each activity (RACj) that, in view of its
intrinsic risks, ultimately corresponds to
an economic solvency margin or to the
capital necessary to run a line of business.
So, as the line for the RAC in % shows,
third-party liability requires a solvency
margin of 34.4% (of RAC), more than three
times that required by property damage
(10.8%) or health (9.9%) and nearly five
times more than that required by motor
own damage (7.1%). In other words, third-
party liability accounts for 7% of the
premiums of the company, but it consumes
18.1% of total RAC (86/474), 2.6 times
more (18.1/7) than its share of premiums.
The motor own damage business, by
contrast, accounts for 27% of the total
premiums of the company but consumes
only 15% (71/474) of RAC.
Property
damage 23% Motor own
damage 15%
Source: EDHEC Business School
So the company’s risk profile is riskier than
suggested by the conventional approach
described in the previous paragraph.
This increase in the perceived risk of the
company may nonetheless be offset by
the net margin substantially higher than
that of the other lines of business. In other
words, some might note that third-party
liability has a relatively modest weight and
that in return for its riskier profile it is the
best-performing line of business. What of
it? If the performance of the third-party

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5. Economic Capital Model versus

Solvency II Regulatory Capital

7 - The allocated capital

(or risk-adjusted capital,
RAC) was calculated in
keeping with the Solvency
II standard formula, which
is an initial improvement to
the analysis of risks and of
economic performance but
which, as we have noted,
could be made much more
sophisticated with a partial or
total internal model.
liability business is measured not from its net
margin (net earnings/turnover) or profitability
(net earnings/shareholders equity) or in
keeping with Solvency I (net earnings/(16%
of turnover)) but with allocated economic
capital7 what lessons can be imparted that will
improve the strategy and the management
of the company?
The net margin of the third-party liability
business (6.1%) is 2.6 times that of the
motor own damage business (2.3%) but takes
up five times more allocated capital (RAC
of 34.4% vs. 7.1%) as a result of its intrinsic
risks. So it turns out that profitability
measured as the return on risk-adjusted
capital (RoRAC) is 18% for third-party
liability, 33% for motor own damage, 28%
for property damage, and 29% for health.
In short, motor own damage insurance,
which has the company’s lowest profit
margin (2.3%), turns out to be its second
most profitable business (RoRAC of 33%,
as opposed to 35% for unit-linked
business), given its modest risk profile (measured
here with the Solvency II standard formula but
perfectible with an internal model).
Net margin and return on economic capital per activity (%)
400
350
300
250
200
150
100
50
II.4. The lessons for valuing lines of
business
Financial analysts and investors can use
figures for economic return on risk-adjusted
allocated capital to come up with valuation
models. Hitherto, these approaches had
depended excessively on the subjectivity
with which the company calculated
RoRAC for its lines of business. In addition,
companies do not always publish RoRAC
and analysts often had to estimate it.
If it turns out that the Solvency II calibration
is relevant from an economic perspective,
it is likely that companies and financial
analysts will make this prudential framework
the standard. As we have mentioned,
the solvency capital requirements for
each line of business could become
a harmonised calculation standard in
valuation methods, much as in the
approach taken in this study.
To determine the value of the company (V)
from that of each of its lines of business
(V(RAC)), we have shown in chapter II,
section II.2., that the approach taken by the
financial markets (net asset value NAV and
goodwill GW) is a function of risk-adjusted
capital per line of business (RACj), of RoRAC,
of the cost of capital CoC, of surplus capital
based on adjusted net assets, and possibly
a rate of growth towards infinity gj:
V = NAV + GW = NAV + Σj=1,m Σt=0,n
[RACjt[RoRACj - CoC)]]/(1+ CoC)t
V = (NAV - Σj=1,mRACj ) + Σj=1,m RACj *
(RoRACj - gj) / (CoC - gj)

0 Discounting at the risky rate does not seem

Life unit Motor own Third-party
linked damage liability relevant, because the risk is included in
Life euro Propety
damage
Health the flows to be discounted (Amenc and
denominated
Foulquier 2006), but the financial markets
Net Margin RoRAC
Source: Edhec Business School
(most financial analysts, investors, and

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5. Economic Capital Model versus

Solvency II Regulatory Capital

insurance companies) continue to discount % of premiums per activity

30
at the risky rate (as a precaution, in case risk
is insufficiently taken into account). So we 25
have shown the valuation ratios with this
approach, more familiar to the reader. We 20
assume a cost of capital of 8.5%.
15

When RoRAC is greater than the cost

10
of capital to the company, the company
creates value and the implicit valuation 5
multiple as a function of RAC (RAC x line)
is greater than one. This multiple is the 0
Life unit Motor own
result of the valuation (xRAC = V(RAC)/ linked damage
Third-party
liability
RAC) and not, contrary to the practices of Life euro Property Health
denominated damage
some analysts, of an a priori appreciation.
So the RAC multiple line (RACx) of the RAC per activity
40
dashboard of the economic capital model
shows that the lines of business as a whole 35
create value. 30

25
Of course, although the third-party liability
business generates the highest net margin, 20

it also creates the least value, what with 15

its great consumption of capital. The RAC 10
multiple for third-party liability is 2x,
5
so the valuation of allocated capital for
third-party liability (€86 million) comes 0
to €169 million (V(RAC) EURm line). In the Life unit
linked
Motor own
damage
Third-party
liability
end, third-party liability accounts for 7% or Life euro Property Health
denominated damage
premiums, takes up 18.1% of total allocated
capital and represents only 16% of the total Net margin per activity
value of RAC (V(RAC) in % line). 8

7
The motor own damage business, by
contrast, accounts for 27% of premiums, 6

takes up 15% of allocated capital, and 5

represents 19% of the value.
4

0
Life unit Motor own Third-party
linked damage liability
Life euro Property Health
denominated damage

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5. Economic Capital Model versus

Solvency II Regulatory Capital

RoRAC per activity For strategic decisions, then, what main

35
conclusions can be drawn from this
30 dashboard? We will list only two, as each
number on the dashboard is in fact a bearer
25
of important information for company
20 management.
15
II.5. The lessons for strategy (capital
10 allocation, management of surplus)
In terms of RoRAC, the least profitable lines
5
of business are third-party liability and
0 euro-denominated policies; they account
Life unit Motor own Third-party
linked damage liability for 56.5% of the total allocated capital of
Life euro Property
damage
Health the company ((185+86)/474). To improve
denominated
this situation the first thing would be
RAC multiple per activity to attempt to reduce RAC by analysing
5
each of the risk sub-modules of chapters
III, IV, and V (section I) to pinpoint the
4 greatest consumers of capital and to see
what can be done to reduce these capital
3 requirements.

2 In third-party liability, risk transfers to

reduce allocated capital RAC (see section
1 III of this chapter for examples of the
sensitivity to reinsurance arrangements) can
0 be studied. The RoRAC numerator should
Life unit Motor own
linked damage
Third-party
liability
also be looked at; in other words, how to
Life euro Property
damage
Health improve the normalised economic profit
denominated
on these two lines of business (fees, return
V(RAC) per activity
offered to policyholders, asset allocation,
40
underwriting and financial hedging
35 policy, administrative, management, and
30 acquisition costs, portfolio selection, fraud,
25
claims management costs, and so on.)

20
Other strategic decisions could be considered
15 as well. Has the company reached a critical
10 mass in third-party liability? If operational
and financial management is already
5
optimised and there is really no room to
0 improve RoRAC (by steering RAC and net
Life unit Motor own Third-party
linked damage liability earnings), is remaining in this business an
Life euro Property
damage
Health appropriate strategy? And if it is appropriate,
denominated

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5. Economic Capital Model versus
Solvency II Regulatory Capital
might it need to expand (to attain critical
mass)?
Such analyses should naturally be done for
each line of business, and this to identify
possible improvements to RAC, to net
earnings, and to risk management.
To avoid overloading this analysis, we will
focus on only one other strategic point. We
see that on the basis of economic capital
allocation (RAC) the company is valued at
an implicit multiple of 2.9 (RAC x line),
but that in the end (the company take
as a whole) this multiple changes to 1.2.
This value destruction stems from the
capital surplus (based on own funds
of €1.387 billion from the Solvency II
balance sheet, from which one deducts
capital allocation (RAC), the debt, and the
market-value margin [MVM]; see chapter II).
Only 43% of the company’s available capital
is allocated to the insurance business
(474/(474+615); 57% destroys value.
The company would do well to improve
allocation of this “dormant” capital, by
reinvesting it in existing businesses to
improve their profitability and/or making
opportune acquisitions that would make it
bigger or diversify it or, in the last resort, by
returning capital to shareholders (dividends,
share buybacks) or mutual members
(premium refunds).
It is of course possible to refine the
strategies that could be put in place
following more detailed analysis (definition
of policy for investment, underwriting,
new product launches, reserves,
reinsurance, asset/liability management,
allocation of capital to lines of business,
risk management [definition of accepted
bounds, concentration, diversification]),
but the objective of this section is simply to
104 An EDHEC Financial Analysis and Accounting Research Centre Publication
demonstrate the feasibility of an economic
capital model and to make the reader aware
of its contributions to the management of
the company.
As this section noted, one of the strategic
decisions that should be studied is the
policy for the transfer of risks. It is our
belief—and one of the regulatory objectives,
as it happens—that the culture of those who
transfer risks (and therefore the suppliers of
risk transfers) is likely to undergo a profound
change as a result of incentives to look at
these transfers not just locally (business
unit) but also globally (optimisation of
required capital, reallocation of freed-
up capital) and of the quantitative and
qualitative standardisation brought about
by pillars 1 and 2 of Solvency II. We look
at these aspects in greater detail in the
following section.
III. Management of Risks and
of Required Capital with an
Economic Capital Model under
Solvency II Constraints
As the supervisory authority defines the
principles for the attenuation of risk and
approves risk transfer instruments, Solvency
II should likewise guide the choices made
in the province of risk management and
required capital. Indeed, one of the great
improvements Solvency II makes on
Solvency I is that it takes into consideration
transfers of risk. Currently, they are dealt
with in a standard fashion under Solvency
I (see appendix 2—An Efficient System with
Numerous Drawbacks).
So, in this new environment, any
insurance company will be able to get
a read on a combination of instruments
(own funds, debt, financial and/or
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
reinsurance arrangements) from the
cost structure as well as the economic
and prudential efficiency of each of its
sources of financing and risk absorption.
In other words, the rationalisation of
capital management will involve the
rationalisation of risk transfers, on the
basis of quantitative evaluations that are
in keeping with prudential regulations.
After an introduction to the principles of
Solvency II recognition of risk reduction,
we analyse the impact of risk transfers
on the economic capital requirement.
We focus on reinsurance in particular,
as it is our belief that, as a result of the
change in their views of reinsurance, the
criteria guiding the choices of the ceding
companies are likely to undergo significant
change. Indeed, the companies that have
not yet created an overall decision tool in
the form of an economic capital model are
not currently capable of an exact evaluation
of the impact of risk transfers on their
available capital (freeing up of capital,
reallocation, management of surpluses,
holding/transfer arbitrage).
We will conclude by showing that
the choice of the treatment for and
calibration of reinsurance made by the
European supervisory authority will
have a great impact on the risk-transfer
policies of the ceding companies, and
this on the rate of coverage and the ways
reinsurance arrangements are assigned
to different reinsurers; the number of
reinsurers, their ratings, and, finally,
their pricing will also have an impact.
The regulation could thus be gamed; such
a development would be at odds with the
regulatory goal of improved perception and
management of risks.
An EDHEC Financial Analysis and Accounting Research Centre Publication
III.1. The economic capital model
and the principles of recognition of
risk mitigation in accordance with
Solvency II (risk management)
The preceding chapters have made it
possible to define the bounds of risk and
importance of managing it. One of the
main functions of the economic capital
model is to manage risk to optimise capital
management. So the Solvency II framework
and the economic capital models have a
major role in the development of coming
means of transferring risk, as they make
it possible to quantify the contribution of
each of these means.
The figure below shows the connections
between risk management policies under
Solvency II. Assets are priced at market value
or in keeping with the market-consistent
principles (see chapter II). Technical
provisions are reformatted on the basis of
a best estimate and by defining a market-
value margin (see chapter II) The Solvency
II standard formula (or any supervisor-
approved internal model) makes it possible
to calculate the capital requirements (SCR
and MCR) as well as free assets. For these
capital requirements, Solvency II, like Basel II,
created a three-tiered quality classification
and defined the proportions of capital that
are eligible for each of these three tiers (see
chapter V, section I.6.).
With this approach, the pursuit of
increased available capital and/or of
the reduction of required capital makes
it possible to improve the management
of a company. Risk transfers are one of
the preferred means of reducing capital
requirements. They make it possible to
free up capital that can then be allocated
to optimising the bounds of the existing
business (insurance and/or financial)
105
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5. Economic Capital Model versus

Solvency II Regulatory Capital

8 - QIS4 lays down two

principles concerning
and/or to new developments or lines requirements made of banks. Whether they
liquidity: the insurer should of business, and this in an attempt to are conventional or not, all transfers of asset
have written guidance on
the liquidity requirements
heighten value creation. Here again, in or liability risk are potentially recognised. But
that financial risk-mitigation view of the susceptibility of the capital to earn this recognition, they must respect
instruments should meet, in
keeping with the objectives of requirement to risk transfer policy, Solvency certain principles: the economic effect must
the insurer’s risk management
policy, and the risk-mitigating
II has provided a framework as well as take precedence over the legal form, they
instruments should meet Draconian rules that will inevitably have a must be legally effective and enforceable
these requirements.
The instruments should great influence on the definition of the risk in all relevant jurisdictions, they must be
also have a value over time transfer policies of insurance companies. liquid8 as well as of ascertainable value,
sufficiently reliable to provide
appropriate certainty as to
the risk mitigation achieved. Synthesis of the connections between risk-management policies

Balance sheet
At least 1/3 of tier 1
Balance in tier 2
A most 1/3 of tier 3
Free capital
Assets

MCR
SCR
} Own funds

At least 50% of tier 1

Balance in tier 2

}
At market value
or valued on a
"market-consisitent" Risk margin
basis

Market
consistent Technical provisions

Best estimate

Hedgeable Non-hedgeable

Increase available Decrease capital

capital requirement

Rating Probability of default Risk mitigation: financial protection and reinsurance

AAA 0.002% QIS4 in exchange
AA 0.01% for additional capital for default risk
A 0.05%
BBB 0.24%
BB 1.20%
B 6.40%
Others 30.41%

Source: EDHEC Business School

The supervisor treats separately risk explicit, irrevocable, and unconditional,

transfers that it takes into consideration in and they must be a direct receivable from
the evaluation of the risk modules and the the supplier. In addition, the mitigation of
counterparty risk thus created (for example, risks in the standard formula is restricted
for the risk of default of a reinsurer), to instruments alone and thus excludes
which is dealt with in a separate module processes and controls. So when the capital
(counterparty risk module—see chapter IV.). charge for an investment strategy such
In defining these principles, the supervisory as delta hedging or cash-flow matching
authorities took their inspiration from the is calculated the assumption is that the

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5. Economic Capital Model versus

Solvency II Regulatory Capital

9 - The calculation of the

solvency margin does not
company continues to hold its current coverage are not taken into account in the
currently make it possible, assets and suffers an instantaneous calculation of the company’s solvency.
in Solvency I, to take into
consideration the specific
shock.
features of a reinsurance In the Solvency II framework, by contrast,
programme). In life insurance,
the solvency margin is the To be more effective in a Solvency the role of reinsurance is essential to
sum of two values:
i) (4%* gross mathematical
II framework than those currently the calculation of the solvency capital
provisions GMP *R), where available, new means of transferring requirement (SCR), as the measure of it,
R=(GMP – reinsurance
transfers)/GMP and cannot be both financial and underwriting risk although partial, is quantitative, clearly
less than 85%. So Solvency are thus likely to see the light of day. defined, and done on several levels:
I recognises at most 15% of
reinsurance transfers with At the same time, the risk-transfer policies
respect to GMP;
ii) (0.3% * capital at risk
of insurance companies are likely to be i) In the estimate of reinsurance receivables
charged to the life insurer reworked or rationalised; they are likely in the balance sheet. In chapter II we
gross of reinsurance GCR * K),
where K = (GCR- reinsurance to be built on more objective and more saw that the best estimate should be
transfers/GCR) and cannot be quantitative bases, and this as a result of gross of reinsurance contracts and
less than 50%. So Solvency
I recognises at most 50% of the framework created by the supervisory special purpose vehicle arrangements.
reinsurance transfers with
respect to GCR. These R and
authorities and of the development of As a result, receivables from reinsurance
K ratios are those of the most economic capital models. contracts and from special purpose vehicles
recent financial year.
In non-life insurance, the are calculated separately (entered on the
solvency margin (we simplify)
is the greater of the two
Finally, as the impact of offerings for asset side of the balance sheet) including the
values below: transferring financial risk (market risk losses expected as a result of counterparty
i) (16% * gross premiums *
C), where C=(gross claims
modules) is usually calibrated beforehand risk,10 the duration of the reinsured
GC – claims transferred to by the suppliers of these offerings (banks, liabilities, the time gap between collection
reinsurers)/GC and cannot be
less than 50%. reinsurers, asset managers), we expect and payment, and the possible deposits of
ii) (23% * GC * C), where
C=(gross claims GC – claims
great cultural changes in the reinsurance the ceding companies. The risk of double
transferred to reinsurers)/GC landscape, where the global approach to counting with the counterparty risk module
and cannot be less than 50%.
GC is the average over the risk management and RAC is still being is often mentioned by insurers, concerns
three most recent financial developed. that could lead to modifications to QIS4.
years.
The standard reductions of The amount of the assets will be affected
15% in life insurance and
50% in non-life insurance
III.2. Using reinsurance in a Solvency depend on the reinsurance coverage, a
seem devoid of any II framework to mitigate underwriting circumstance that could have an impact
economic foundation. They
are often called standard risks on the calculation of the SCR, in particular
because regardless of the As we noted in appendix 2, the calculation through the market risk module.
type of coverage (simple
proportional from a BB rated of the solvency margin does not currently
insurer or sophisticated
non-proportional, indexed
make it possible, in Solvency I, to take into ii) In the calculation of the capital charge
to indices, and/or excluding consideration the specific features of a for the life underwriting risk module (see
extreme risks and from a
AAA insurer), the 15% and reinsurance programme. The 15% standard chapter III). The capital charge is equal to
50% coefficients are applied
uniformly.
deduction from the required solvency the change in the net asset value following
10 - Take, for instance, margin in life insurance and the 50% several scenarios.11 A simplified approach
the example given in QIS4
(2008, TS.II.B.25): if the
deduction in casualty insurance that are (which we have taken) involves calculating
insurer must pay 100 with allowed in the event of reinsurance seem the capital requirements for the mortality,
a probability of 99% and
10,000 with a probability devoid of any economic foundation.9 In longevity, disability, and catastrophe risk
of 1%, the best estimate of
the amount recoverable is
addition, the health of the balance sheets sub-modules with net best estimates
199. If one is sure that the of the reinsurers and the concentration or and capital at risk (insured amount net
insurer will be able to pay
diversification of a company’s reinsurance of technical provisions). For these risk

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5. Economic Capital Model versus

Solvency II Regulatory Capital

the amount of 100, but will

default (with a loss-given-
sub-modules, Solvency II is able to take tied-up management or commission costs.
default of 50%) if it has to into consideration most transfers of risk For the scenario-based methods, the capital
pay the amount of 10,000 the
expected loss is: 99%*100*0%
through proportional or non-proportional charge for non-life catastrophe risk is the
+ 1%*10,000*50% = 50. reinsurance. square root of the sum of the costs of each
The probability of default
is 1%, but for QIS4 it is catastrophe squared. For a catastrophe to
a weighted average of
probabilities: (99%*100*0%
iii) In the calculation of the capital charge be taken, its cost must exceed a threshold
+1%*10,000*50%)/199 ≈ for the non-life and health underwriting of materiality of 25% of the most adverse
50.25%. So the expected loss
is: 199*50.25%*50% ≈ 50. risk module (see chapter III). We have scenario.
11 - The scenarios tested are: shown that for these businesses Solvency II
• a permanent rise of 10%
in the mortality rates for considered two risk sub-modules: premium Naturally, the supervisory authorities
each age for mortality and
longevity risks, as well as a
and reserve risk and catastrophe risk. encourage the use of internal models
permanent fall of 25%. when the standard formula does not
• a rise of 35% in the
disability rate for the coming A risk measure of premium volume, adequately reflect the real risk exposures
year and of 25% for each age determined as a function of net written of the company, but this is not accessible to
in the following years
• a rise and fall of 50% in the and earned premiums, and its volatility are all companies. So discussions are underway
lapse rates
• an increase in future
used to assess premium risk. The volatility between insurance industry representatives
expenses 10% greater than is a function of the volatility of the loss and regulators to see to what extent
that of the best estimate,
and an increase in expense ratios of the company over the last five, improvements can be made to the Solvency
inflation rate of 1% per year
greater than that of the best
ten, of fifteen years, depending on the II standard formula.
estimate line of business (by net premiums earned
• an increase of 3% per year
in the amounts payable for
and loss ratios posted in the past) and of iv) In the allowances made for default risk.
annuities subject to revision the volatility of the market loss ratio.12 For Solvency II to recognise the impact of
risk (over the remaining
run-off period) So the transfer of risk through reinsurance the risk-mitigation techniques, the credit
• simultaneous absolute 1.5
per mille increases in the rate
is founded partly on transferred premiums, risk and other risks inherent to this reduction
of policyholders’ dying in the a circumstance that is likely to lead to a must be taken into consideration in the
coming year and experiencing
morbidity in the coming year. great underestimate of the efficiency of the calculation of the capital requirement. A
12 - The market standard coverage of non-proportional arrangements, capital charge in the counterparty risk
deviations taken by Solvency
II for premium risk of the especially when they have an effect on module integrates the risk of loss-given-
motor own damage, property
damage, third-party liability,
extreme risks. default. In chapter IV we saw that it is
and health lines of business equal to 50% of the recoverable amount
are 9%, 10%, 13%, and 3%
respectively. The market The volume of reserve risk, a function of and a function of ratings from rating
volatility taken for reserve the best estimate, and the market volatility agencies (two other sources of controversy
risk is 7%, 10%, 15%, and
7.5%. of reserve risk are used to assess reserve today), which determines the likelihood of
risk. default.

Solvency II offers three means of assessing
catastrophe risk: a standard formula
(used in our simulation) founded on a
standard basis of net written premiums
that, again, does not make it possible
to take into account in a suitable way
non-proportional reinsurance and two
scenario-based approaches; these two are
more demanding, but they accommodate
v) Finally, the operational risk module
takes into account the entirety of gross
pre-transfer risks, which may also seem
very conservative.
To evaluate the impact of transfers of risk
through reinsurance, we will run a test
on our model insurer. We compare three
reinsurance arrangements:

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5. Economic Capital Model versus

Solvency II Regulatory Capital

• total absence of reinsurance requirements. This reduction is achieved

• reinsurance taken for now to calculate in underwriting as well as market risk (the
the SCR for the model company presented weight of reinsurance assets in the balance
in chapter III, section I, and appendix 7 sheet). By contrast, when the number of
(we will call it benchmark reinsurance or reinsurers and their ratings (A or AA) are
benchmark coverage) satisfactory, they account for very little of
• doubling of the percentage of premiums the capital charge for counterparty risk.
transferred. We will take a close look at counterparty
risk and at shifts from one reinsurance
Simulation of reinsurance arrangements policy to another in the following section
with the model company (section III.3.).
Double
Total balance sheet Absence of Benchmark
benchmark
(EURm) reinsurance reinsurance
reinsurance
In addition, this simulation tends to
Underwriting SCR 338 304 271
underestimate the real benefits of
Market SCR 599 568 537 reinsurance in the Solvency II model,
Counterparty SCR 0 0.43 1 as we have not reduced catastrophe risk
BSCR 742 693 646 with coverage of peak risks or volatility of
Global SCR 507 474 442 claims with non-proportional protection
Reinsurance impact -6% -13% (and all the more so economically, as
Source: EDHEC Business School we have shown in section III.1., that the
supervisory authorities underestimate the
We see that in spite of our company’s very effects of reinsurance by neglecting certain
mixed profile (only a third of the model types of very widely used coverage).
company’s premiums really benefit from the
impact of the transfer of risks to a reinsurer, In the three tables below, we show the
as the tables below show), the transfer of detailed results (by risk sub-module and line
underwriting risk through reinsurance makes of business) of the impact of reinsurance
possible substantial reduction of capital coverage.

Calculation of economic capital RAC and SCR in the absence of reinsurance coverage
Unit Euro Motor own Property Third-party
Activity Health Total
linked denominated damage damage liability
Reinsurance ratios
Net/gross technical provisions 100% 100% 100% 100% 100% 100%
% premiums reinsured 0% 0% 0% 0%
Underwriting risk module (EURm)
Mortality/prem
0.2 3.8 270 397 341 22
and reserve for non-life
Longevity 0.6 2.4
Disability 0.0 0.1
Lapse 1.6 11.2
Expense 1.3 5.6
Revision 0.0 0.0
Catastrophe 0.1 2.5 75 75 38 17
Total underwriting SCR 2.8 16.6 79 114 97 28 338

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5. Economic Capital Model versus

Solvency II Regulatory Capital

Market risk module (EURm)

Interest rate 4 372 30 47 10 5
Equity 4 49 32 93 91 2
Property 0 21 5 12 19 0
Fx 0 0 0 0 0 0
Spread 0 26 3 10 21 0
Concentration 0 12 1 2 2 0
Total market SCR 5 344 43 103 100 5 599
Counterparty SCR before 0.000 0.000 0.000 0.000 0.000 0.000 0.000
diversification (EURm)
Counterparty SCR after 0.000 0.000 0.000 0.000 0.000 0.000 0.000
diversification (EURm)
BSCR u/w + mkt + def (EURm) 8 360 122 217 197 33 937
BSCR after diversification (EURm) 6 319 91 157 142 27 742
Operational SCR after 3 27 19 19 5 4 75
diversification (EURm)
Adj FDB (EURm) 0 56 0 0 0 0 56
Adj deferred taxes (EURm) 3 96 36 59 49 10 254
Global SCR after diversification 6 193 73 117 98 20 507
(EURm)
NAV (EURm) 47 360 265 387 276 52 1387
Source: EDHEC Business School

Calculation of RAC and SCR with benchmark reinsurance coverage

Unit Euro Motor own Property Third-party
Activity Health Total
linked denominated damage damage liability
Reinsurance ratios
Net/gross technical provisions 95% 99% 98% 85% 80% 98%
% premiums reinsured 3% 10% 15% 3%
Underwriting risk module (EURm)
Mortality/prem and reserve
0.1 3.7 262 350 276 21
for non-life
Longevity 0.5 2.3
Disability 0.0 0.1
Lapse 1.5 11.1
Expense 1.3 5.6
Revision 0.0 0.0
Catastrophe 0.1 2.5 73 68 32 17
Total underwriting SCR 2.6 16.4 78 102 79 27 304
Market risk module (EURm)
Interest rate 4 371 28 40 0 5
Equity 4 49 32 93 89 2
Property 0 21 5 11 18 0
Fx 0 0 0 0 0 0
Spread 0 26 3 10 20 0
Concentration 0 12 1 2 2 0
Total market SCR 5 330 40 96 92 4 568
Counterparty SCR before
0.003 0.014 0.456 0.680 0.306 0.022 1.481
diversification (EURm)

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5. Economic Capital Model versus

Solvency II Regulatory Capital

Counterparty SCR after

0.001 0.004 0.131 0.196 0.088 0.006 0.427
diversification (EURm)
BSCR u/w + mkt + def
7 347 118 198 172 32 873
(EURm)
BSCR after diversification
5 307 88 143 124 26 693
(EURm)
Operational SCR after
3 27 19 19 5 4 75
diversification (EURm)
Adj FDB (EURm) 0 57 0 0 0 0 57
Adj deferred taxes (EURm) 3 92 35 54 43 10 237
Global SCR after
5 185 71 108 86 20 474
diversification (EURm)
NAV (EURm) 47 360 265 387 276 52 1387
Source: EDHEC Business School

Calculation of RAC and SCR with double the benchmark coverage

Unit Euro Motor own Property Third-party
Activity Health Total
linked denominated damage damage liability
Reinsurance ratios
Net/gross technical provisions 90% 98% 96% 70% 60% 96%
% premiums reinsured 6% 20% 30% 7%
Underwriting risk module (EURm)
Mortality/prem and reserve for 0.1 3.7 254 304 210 21
non-life
Longevity 0.5 2.3
Disability 0.0 0.1
Lapse 1.4 11.0
Expense 1.2 5.5
Revision 0.0 0.0
Catastrophe 0.1 2.5 71 60 26 16
Total underwriting SCR 2.5 16.3 76 89 61 26 271
Market risk module (EURm)
Interest rate 4 370 26 32 0 4
Equity 4 49 32 92 86 2
Property 0 21 5 11 18 0
Fx 0 0 0 0 0 0
Spread 0 26 3 10 20 0
Concentration 0 12 1 2 2 0
Total market SCR 5 316 37 89 86 4 537
Counterparty SCR before 0.007 0.027 0.468 0.754 0.495 0.024 1.776
diversification (EURm)
Counterparty SCR after 0.002 0.009 0.151 0.244 0.160 0.008 0.575
diversification (EURm)
BSCR u/w + mkt + def (EURm) 7 332 113 178 147 30 809
BSCR after diversification (EURm) 5 294 85 129 108 25 646
Operational SCR after 3 27 19 19 5 4 75
diversification (EURm)
Adj FDB (EURm) 0 58 0 0 0 0 58

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5. Economic Capital Model versus

Solvency II Regulatory Capital

13 - We remind the reader

Adj defered taxes (EURm) 3 88 34 49 37 10 221
(see chapter IV) that
the capital required per Global SCR after diversification 5 175 69 99 75 19 442
counterparty in keeping with (EURm)
its weight in the exposure to
reinsurance or to financial NAV (EURm) 47 360 265 387 276 52 1387
derivatives is calculated Source: EDHEC Business School
with the Herfindahl index.
This index of concentration As expected, the gains from reinsurance are Fx 0 0 0
is the sum of the squares of
the market share of all the found primarily in the property damage and Spread 21 20 20
companies in the industry.
third-party liability lines of business. The Concentration 2 2 2
underwriting module makes it possible to Total market SCR 115 111 107
save slightly more capital than the market Counterparty SCR 0 0.31 0.49
module for all the lines of business benefiting BSCR 458 388 320
from slightly greater reinsurance coverage. Global SCR 332 284 237
For example, the savings in the market Reinsurance impact -15% -29%
module are greater for euro-denominated Source: EDHEC Business School
life business, health, and motor. The
savings from the underwriting module The transfer of risks is thus likely to lead
are nonetheless often underestimated, as to a substantial reduction in the capital
they do not take into account anything required in the Solvency II framework.
more than proportional improvement
of catastrophe risk or non-proportional In addition, with Solvency II, risks
reinsurance coverage. transferred as we have just shown are
naturally taken into account, as are the
To take yet a closer look at the impact of rating of the reinsurer and the weight of
reinsurance on required capital, we compare each reinsurer in the overall coverage of
the savings in the capital charge made by the company.13 In this way, ratings and
possible by reliance on the three reinsurance diversification have a significant impact
strategies detailed above; we look only at on the capital required for default risk and
third-party liability, that is, without applying thus on reinsurance policy.
the benefit for the diversification of lines
of business. Depending on the final calibrations,
an opportunity to arbitrage the cost
Third-party liability
of reinsurance and the rating of the
reinsurer could arise: by reducing the
Double benchmark

price of the reinsurance, a BBB-rated

reinsurance

reinsurance

reinsurance
Benchmark
Absence of

(EURm) reinsurer could offset the additional

capital charged to the company as a
result of the reinsurer’s rating. In an
Underwriting SCR efficient market, it is likely that prices
Premium and reserve 341 276 210 will even out and arbitrage opportunities
Catastrophe 38 32 26 will disappear. To remain consistent with
Total underwriting SCR 343 277 212 market practices and to avoid destabilising
Market SCR 0 0 the market, the standard Solvency II
Interest rate 10 0 0 calibration is primordial, as we will see in
Equity 91 89 86 the following section.
Property 19 18 18

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
III.3. The impact of credit quality and
of diversification of reinsurance on
the capital requirement
As we have just seen, reinsurance as a
means of transferring risks comes into
play largely in the underwriting and
counterparty modules. In this section, we
look at the problems of arbitrage (involving
the credit quality and diversification
of the reinsurers chosen) posed by
Solvency II.
To do so, we use several simple examples
to examine the ways the diversification
and ratings of reinsurers affect the capital
charge for counterparty risk. The examples
are deliberately somewhat exaggerated;
the idea is to highlight the perverse effect
Solvency II may have on the choice of
reinsurance policy.
First illustration: Combinations of one,
two, or three reinsurers
Take an insurance company that transfers
some of its risk through reinsurance
arrangements. It is assumed that in the
event of default of all of those who bear
these risks the loss (LGD or loss given
default) is €500 million. We will show that
the insurer’s choice to resort to one, two, or
three reinsurers, and above all the chosen
allocation (concentration or distribution of
risks) will have a great effect on the amount
of capital required for counterparty risk.
To isolate the effect of this diversification,
we assume that all the reinsurers have the
same credit rating.
An EDHEC Financial Analysis and Accounting Research Centre Publication
Measure of the total counterparty risk and capital charge
for default of one of the two reinsurers, in the context of
reinsurance coverage provided by two AA-rated reinsurers.
6
5
(EURm)
3
2
0
100%
99.99%
5%
0%
95%
80%
75%
70%
65%
60%
55%
50%
45%
40%
35%
30%
25%
20%
15%
10%
85%
90%
0.01%
% held by reinsurer 1
Def 1 SCR Def
If an insurance company resorted to but
a single AA-rated reinsurer, the capital
required for counterparty risk would be
€5 million. But if it opts for two AA-rated
reinsurers, it saves a substantial amount
of capital; and the more unevenly this
business is awarded, the more capital
the company saves. Coverage divided
50%-50% between two AA-rated
reinsurers will lead to a capital savings
of 85.4% (€0.73 million). This savings
amounts to 89.3% (€0.535 million) when
one reinsurer is allocated two-thirds of the
business and the other one-third, and at an
85%/15% breakdown the savings attains
98.8% (a requirement of €0.06 million).
The Solvency II formula based on a Vasicek
function is paradoxical, because, when it
resorts to a single reinsurer, the insurance
company will need €5 million, but when
it transfers 99.99% to one reinsurer and
0.01% to another, it will be subject to no
capital requirement for counterparty risk.
By splitting its risk fifty-fifty between two
reinsurers, its requirement will be reduced
by 85.4%.
Coverage provided in equal proportions
by three AA-rated reinsurers will result
in a capital requirement of €1.28m. The
savings on the €5m capital charge for the
coverage provided by a single AA-rated
reinsurer comes to 74.4% (less than the
85.4% savings for a fifty-fifty split).
113
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5. Economic Capital Model versus

Solvency II Regulatory Capital

Although it is appropriate for Solvency Third illustration: Combinations of two

II to encourage diversification of
reinsurance coverage in an attempt to
spread default risk more widely, the
suitability of the calibration, insofar
as the capital savings are high, does
perhaps raise eyebrows.
Second illustration: Choice of reinsurer
by credit rating
Take an insurance company that plans
to seek coverage from a single reinsurer.
This simulation makes it possible to
identify the effect of the reinsurer’s
credit rating on the capital required for
reinsurers of different credit ratings
(the two reinsurers constitute the entire
reinsurance coverage)
Take an insurance company whose
reinsurance coverage is split fifty/fifty
between two reinsurers and is seeking the
most advantageous split by credit rating.
To favour comparisons with the preceding
illustrations, we again assume that LGD is
€500 million.
The simulation leads to the following
results:

reinsurer 1 default

reinsurer 2 default
counterparty risk. To favour comparisons Reinsurer 1 rating

Reinsurer 2 rating

Capital charge for

Capital charge for

% covered by
reinsurer 1
with the preceding illustration, we again

Total
assume that LGD is €500 million.

The simulation leads to the following

result: AAA AAA 50% 0.02 0.02 0.04
Capital requirement for default risk by reinsurer rating AAA AA 50% 0.02 0.36 0.39
Reinsurer rating SCR AAA A 50% 0.02 4.26 4.28
PDi
counterparty
AAA BBB 50% 0.02 29.81 29.83
AAA 1 0.002%
AA AA 50% 0.36 0.36 0.73
AA 5 0.01%
AA A 50% 0.36 4.26 4.62
A 25 0.05%
BBB 120 0.24% AA BBB 50% 0.36 29.81 30.17

BB 500 1.20% A A 50% 4.26 4.26 8.51

B 500 6.04% A BBB 50% 4.26 29.81 34.06
CCC or below, unrated 500 30.41%
BBB BBB 50% 29.81 29.81 59.62
Source: EDHEC Business School
Source: EDHEC Business School

The capital required for default risk

increases by a multiple of approximately
five for every fall by one notch; they move
proportionally with the probability of
default. The counterparty SCR is naturally
capped by the LGD.
By contrast, when the ratings are analysed
in the presence of several reinsurers, the
effects of the ratings are cumulative and,
as the third illustration shows, they are no
longer proportional.
It is interesting to see the multiplicative
effect of the ratings. Reinsurance coverage
with AAA- and AA-rated reinsurers
requires nearly ten times more capital
(€0.39 million) than that required (€0.4
million) when the two reinsurers are rated
AAA, yet the risk of default of an AA-rated
reinsurer that provides 50% of reinsurance
coverage is only five times greater.

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5. Economic Capital Model versus

Solvency II Regulatory Capital

14 - In proportional reinsurance,
the reinsurer and the ceding
Likewise, for coverage provided by an III.4. The Solvency II measure of
company share the premiums AA-rated reinsurer and a BBB-rated the impact of non-proportional
and the losses of a portfolio at a
percentage set in advance. When
reinsurer, the capital requirement for reinsurance on the capital
reinsurance coverage kicks in the BBB reinsurer (€29.8 million) is 82.8 requirement is inadequate
from the first euro, it is known
as quota-share proportional times greater than that for the AA-rated
reinsurance. All policies thus
have a single underwriting limit.
reinsurer (€0.36 million); the capital After our look at the possible distortions to
When reinsurance coverage kicks requirement for the two reinsurers is reinsurance policy (combinations of credit
in only for policies exceeding a
certain amount (known as a line €30.2 million, forty-one times greater ratings and number of reinsurers) caused
or retention)—though it still kicks than requirement for coverage with two by Solvency II, we look in this section at
in from the first euro, it is known
as surplus-share reinsurance. This AA-rated reinsurers. The table above the impact of the Solvency II measures
enables the ceding company to
keep for itself a share of the risks
shows these combinations. and calibration of reinsurance on the
that it has the capacity to bear type of reinsurance chosen. In section
without resorting to reinsurance.
15 - In conventional By combining the three components of III.2 of this chapter, we saw that the
non-proportional reinsurance, the three illustrations above (number calculation of the capital required for life
reinsurance kicks in only at a
certain loss threshold (known as of reinsurers, rating, and breakdown of underwriting risk posed few conceptual
the attachment point or priority)
and to a certain limit (known as
coverage), it turns out to be relatively problems: the capital required is equal
the layer limit or guarantee) in easy to reduce counterparty risk. to the change in the value of net assets
exchange for a percentage of the
premiums earned by the ceding For example, with coverage evenly divided following different shocks. In spite of the
company. These arrangements
are known as excess of loss (XL)
between an AA- and an A-rated reinsurer, problems of evaluating these shocks in
and coverage per claim or per the capital requirement is €4.62 million. the mortality, longevity, disability, lapse
event is expressed in the amount
of claims. Another conventional
With four AA-rated reinsurers, the and expense risk sub-modules, Solvency
form of non-proportional capital requirement is €1.5 million. II can accommodate most transfers of
reinsurance is stop loss (SL),
which makes it possible to protect With two AA- and two A-rated reinsurers risk through proportional and non-
a share of the technical result
from frequency risk (catastrophe,
providing equal shares of coverage, the proportional reinsurance.
for example). It too relies on a capital requirement is €5.82 million.
threshold and on a reinsurance
intervention limit, but the annual By increasing the number of reinsurers, The capital required for non-life
coverage is a function of the total however, it is easy to reduce the capital underwriting is approached via premium
premiums earned by the ceding
company, which makes it possible requirement. risk, reserve risk, and catastrophe risk.
to protect a share of the technical
result from upwards drifts of
Premium risk is that risk that expenses
claims. This type of reinsurance As we stated in the introduction to this and claims may be greater than premiums
thus makes possible significant
reductions of the volatility of section, default risk should be sufficiently collected. Two measures are used to gauge
losses. More complex and often well calibrated to the number of this risk: one measure of volume and one
customised arrangements can
be made to meet the ceding counterparties, the share of coverage they of volatility. The volume measure is of net
company’s needs more exactly.
Such arrangements are often
provide, and their credit rating, and this written premiums over the past two years
known as unconventional to prevent reinsurance choices whose aim and net earned premiums over the past
non-proportional reinsurance.
These arrangements are naturally is simply to optimise Solvency II capital year.
not taken into consideration by
the Solvency II standard formula,
requirements without reflecting real
even though the capital they save exposure to risks. In proportional reinsurance, especially
is real. For example:
• standard deviation stop loss
of the quota share sort,14 the premiums
is a stop loss as defined above net of reinsurance can, in principle, serve
but focusing on the distribution
tails, which makes it possible to as an indicator of risk transfers. In non-
reduce volatility substantially and
keep the loss ratio within certain
proportional reinsurance,15 by contrast,
bounds. When claims are beneath a small percentage of premiums may
the lower bound, technical profits
are transferred to the reinsurer. be transferred to a reinsurer, all while

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
When, by contrast, they are
above the upper bound, the
reinsurer covers the losses.
• net quota share is a
combination of two forms:
a quota-share arrangement
(see proportional reinsurance)
from the first euro of
claims to an attachment
point and a conventional
non-proportional reinsurance
arrangement for the part
between this attachment
point and a layer limit.
• run-off involves
transferring the entirety
of the assets and technical
provisions of the ceding
company to the balance sheet
of the reinsurer (portfolio
transfer). A variation involves
reinsurance coverage that
makes possible the transfer
of the risk of upwards drift
of losses alone (adverse-
development cover or loss
portfolio transfer)
• risk swaps involve
improving the diversification
of risks (and thus reducing
the capital requirement)
by swapping with another
insurer portfolios of
uncorrelated risks (for
example, the risk of a storm
in a European country for
the risk of a storm in North
America)
• insurance-linked securities
involve structuring insurance
risks and placing them in the
financial markets.
16 - Reserve risk stems from
the underestimation of the
amount of reserves for claims
and from stochastic nature of
future settlement of claims.
116 An EDHEC Financial Analysis and Accounting Research Centre Publication
5. Economic Capital Model versus
Solvency II Regulatory Capital
transferring only extreme risks, and this
to reduce the impact of distribution tails.
This strategy makes possible a substantial
reduction of the volatility of risks and
thus of the consumption of capital.
All the same, the capital savings cannot
be reflected in an indicator of net
premiums. In other words, the amount
of net premiums with non-proportional
reinsurance coverage may be greater than
that obtained with proportional coverage,
all else being equal, and could nonetheless
lead to an economic capital requirement
lower than that of proportional coverage.
The company’s loss ratio (over the last five,
ten, or—at most—fifteen years, depending
on the line of business) and that of the
market are used to gauge the volatility
of premium risk. Net premiums earned
are used to determine these claims. Here
again, analysis of the transfer of risks
through reinsurance is thus founded
in part on ceded premiums, which is
likely to underestimate the efficiency of
coverage of non-proportional treaties,
especially when they have an effect on
the distribution tails (extreme shocks).
This approach also underscores a lack of
flexibility in the dynamic management
or restructuring of reinsurance policy: it
assumes a certain stability of reinsurance
arrangements over time. Indeed, the
volatility observed in the past may reflect
the unsuitability of past reinsurance
arrangements and is unable to make
allowances for any more efficient recent
restructuring of such arrangements.
Finally, premium (and reserve16) risk is
founded only on the volatility of loss ratios,
not on their magnitude, which can also lay
insurers open to criticism (volatility takes
precedence over the quality of pricing).
A lognormal distribution is used to
calculate the capital charge—consistent
with a 99.5% VaR—for the combined
premium and reserve risks. All the
same, it is appropriate to use this law
to model phenomena characterised by
a large number of small independent
factors. It is perfectly suitable for the
motor own damage line of business, for
example. The Poisson law is thus usually
used to model the number of losses per
contract, and a lognormal law is used
to model the average of the claims.
All the same, when the distribution tails
become fatter (that is, when extreme
events are more frequent), this law is no
longer relevant. For example, the Pareto
principle (or the 80/20 principle, that
is, 80% of any effects come from 20%
of the causes) is more commonly used
to measure the average cost of claims
in fire insurance; storm insurance may
be modelled with a Weibull law, a law
frequently used to model extreme values.
So, yet again, in this part of the non-
life underwriting module, Solvency II
fails to make appropriate allowances
for the real savings in the capital
required.
The final non-life underwriting risk is the
catastrophe sub-module. The standard
formula relies on a standard portion
of net business written. The use of net
premiums as an indicator of the transfer
of risk through reinsurance is, as we noted
for the measure of the volume of premium
risk, unsatisfactory. The scenario-based
approach is more demanding but makes
possible improved consideration of
reinsurance coverage, as the capital
charge for catastrophe risk is the square
root of the sum of the costs squared of
each catastrophe. For a catastrophe to

17 - This example is also
found in a note from Munich
Re: “Impact de la reassurance
sur le capital-risque : un
exemple pratique,” Solvency
Consulting Knowledge Series,
September 2008.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
5. Economic Capital Model versus
Solvency II Regulatory Capital
be taken, its cost must be higher than an
established threshold of materiality, 25%
of the cost of the most adverse scenario.
We have shown, then, that though, on
the whole, the Solvency II standard
formula makes appropriate allowances
for the savings in the capital
requirement generated by the transfer
of risks through proportional reinsure,
it fails to do so for non-proportional
reinsurance and should thus be
reworked.
We present, for example, simulations
representing five forms of reinsurance,
modelled with the QIS4 standard formula
as well as with a partial internal model.
This example is taken from a document
produced by Hannover Re, Munich Re,
and Swiss Re; the document is entitled
“Improving the Solvency II standard
approach—Toward a better recognition
of the risk mitigation effect of the
non-proportional reinsurance with the
standard approach.”17
As in the approach taken in chapters III
and IV, this approach takes a fictitious
insurance company and runs simulations
to assess the impact of QIS4 on the
strategy of the company. This company
has four businesses: motor (third-party
liability), motor own damage, property
damage, and general personal accidents.
Five reinsurance arrangements are tested:
• the absence of reinsurance (no reins. in
the figure)
• non-proportional coverage of peak risks
with relatively high attachment points in
all businesses (PeakRisk)
• non-proportional coverage with low
attachment points in all lines of business
(NP)
An EDHEC Financial Analysis and Accounting Research Centre Publication
• quota-share transfer (to diversify)
and non-proportional coverage of the
retention with low attachment points
for motor (third-party liability) and
non-proportional coverage with low
attachment points for the other lines of
business (MTP Auto50+NP)
• quota-share transfer in all lines of
business and non-proportional coverage
of the retention with a low attachment
point (All 50+NP)
The simulations of these arrangements
can be seen in the chart below:
Solvency capital requirement (SCR) after reinsurance
200
187
177
150
136
143
102
97
110
100
81
72
59
50
0
No reins. NP ALL50+NP
PeakRisk MTPL50+NP
QIS4 - standard approach
QIS4 - partial internal model
Source: Hannover Re, Munich Re, Swiss Re (op. cit.)
In each case, reinsurance naturally has a
favourable effect on the solvency capital
requirement as a result of the drop in the
premiums and the best estimate after
reinsurance and perhaps in historic loss
rates. When the Solvency II and internal
approaches are compared, however, one
sees that the standard formula recognises
but partially the positive effects of non-
proportional reinsurance. In addition,
whereas the internal model leads to capital
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5. Economic Capital Model versus

Solvency II Regulatory Capital

savings achieved by an NP arrangement

greater than the savings achieved by peak
risk coverage (97 vs. 102), the Solvency II
standard formula leads to the opposite
result (136 vs. 143).

The Solvency II standard formula is a

significant advance in the modelling
of risk transfers through reinsurance
arrangements. Nonetheless, the part
of the modelling of underwriting risk
founded on net premiums leads to
calibration mistakes (as a result of
the non-linearity of the net premiums
and the risk transfers) and these
mistakes lead to erroneous capital
requirements that are likely to favour
policies that provide less than optimal
risk management over other, more
appropriate policies.

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 Conclusion

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Conclusion

The Solvency I calculation of the capital
requirement is altogether outmoded and
arbitrary, insofar as its standard approach,
extremely simplistic, has no link to the real
economic exposure to the risks borne by
insurance companies. To remedy this failing,
the international supervisor sought to come
up with prudential rules that are in greater
keeping with the economic realities of the
companies. In addition to the measure of
solvency itself, the supervisor is seeking
to encourage the development of internal
models likely to improve identification,
calibration, and management of risk. This
objective will be reached only if rules put
in place by the supervisor dovetail with
the economic approach taken by insurers
in their everyday management.
As the quantitative impact studies (QIS)
show, the data collection and simulations
required by the supervisor are a heavy
investment for most companies. The
objective of this study was to show that these
investments, made for purely regulatory
ends, can be capitalised on to pursue
goals more intrinsic to the company. The
perfecting or elaboration of this managerial
tool is likely to improve the management of
the company and increase the creation of
value for the shareholder or mutual member.
We have shown that the contributions of
the models to the definition of the strategy,
its implementation, and the optimisation
of performance, especially with respect to
available capital, are many, and that they
are likely to encompass the entirety of the
issues dealt with by insurers.
agreement that implied the dropping of
the notion of group support. This notion
of group support will nonetheless come up
again three years after the entry into force
of Solvency II.
In addition, analysis of the results of QIS4
and of the current crisis is leading the
supervisor to adjust the standard formula,
and this in an attempt to gauge risks as
well as possible and to suit insurers, so
that they will have incentives to improve
their tools to control and manage risks.
The approaches to measuring liquidity risk,
risk concentrations, counterparty risk, loss
given default, and the correlation of market
risks, as well as the allowances made for
certain risk-mitigating tools are called into
question.
So we are at a critical juncture in the
elaboration of Solvency II, as the current
choices and modifications will determine
the effectiveness of the protection of
policyholders as well as the ability of the
regulator to encourage insurers to manage
better their risks and their companies.

As we were concluding this study, on 26

March 2009, representatives of the European
Commission and the European Parliament
finally reached an informal agreement
on the Solvency II project directive, an

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 Appendix

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
Appendix 1
Value Creation Models
The objective of this appendix is to discuss
very briefly some of the value creation models
we mention in chapter 1. We will present
cash flow return on investment (CFROI), total
shareholder return, the Strategic Planning
Associates model, the Marris Q ratio, the
Marakon Associates model, and the Fruhan
and McKinsey model.
1. CFROI (Cash Flow Return on
Investment)
CFROI was originally developed by Holt
consulting and then taken up by the
Boston Consulting Group. It looks at the
gap between the internal rate of return
(IRR) and weighted average cost of capital.
This positive difference multiplied by the
amount of capital employed provides an
estimate of the value created, while the
negative difference multiplied by this
capital provides an estimate of the value
destroyed. It is important to emphasise
that this model looks at the entirety of the
economic assets of the company, considered
a single investment.
The IRR is calculated by matching the gross
value of this investment (before depreciation
and adjusted for inflation) and the expected
future cash flows generated over the life
of the investment. A simplified version of
CFROI involves dividing EBITDA (earnings
before interest, taxes, depreciation, and
amortisation) by the capital invested and
comparing this ratio and weighted average
cost of capital.
II. Total Shareholder Return
Total shareholder return was developed
by the Boston Consulting Group and is
not observable for unlisted companies.
122 An EDHEC Financial Analysis and Accounting Research Centre Publication
It is the rate of return on a share over a
period, calculated including all dividends
received (all cash received as a recurrent or
exceptional dividend for a share buyback)
and the realised gain:
TSR = (share price end of period
– share price beginning of period)
+ dividends
share price beginning of period
It involves calculating the internal rate of
return (IRR) obtained by the shareholder on
the basis of dividends and the change in the
price of the shares he holds. Although it is
simplistic, the advantage of this model is
that it favours comparisons or companies
or of a company and a market, on the basis
of data external to and independent of the
size of the companies considered. Variations
on this model involve comparing other
fundamental indicators of the intrinsic
value of the company, indicators such as
the price/earnings ratio, free cash flows,
economic value added (EVA), and CFROI.
III. The Marris Q Ratio
The Marris Q ratio is not a direct measure of
value creation, but it does have to do with
it. It is the ratio of the market capitalisation
of invested equity to the book value of
equity. It is thus the inverse of the book
to equity ratio.
Q = market capitalisation
of invested equity
book value of equity
The Q ratio thus reveals the market’s view
of the future strategies of the company,
strategies that will lead to a rise or fall in
equity. A Q ratio greater than one indicates
creation of value: the expected return is
greater than the return required by the
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
suppliers of capital (as measured by the
average cost of capital). So it includes risk,
since it assumes a discounting of future
cash flows at the rate of return required
by investors.
IV. Strategic Planning Associates
Model
The Strategic Planning Associates model
measures value creation by comparing
the expected future performance of the
company, as measured by the market-to-
book-value ratio (M/B), and the results of
the strategic decisions made in the past,
as shown by the Rc/Ra ratio (where Rc is
the performance of the company and Ra
the cost of capital). When M/B is greater
than Ra/Rc, it is expected that company
performance will create value; when it
is less, it is expected that value will be
destroyed.
Source: Thiertart (1990)
V. The Marakon Associates Model
The Marakon Associates model relies on the
approach above to link the return on capital
(rc) and the cost of capital (ra) in such a way
as to identify four distinct performance
situations for a company.
An EDHEC Financial Analysis and Accounting Research Centre Publication
In the “excellence” quadrant the return
on equity capital is greater than the
cost of capital (rc > ra) and stock market
capitalisation is greater than equity
capital (M/B > 1). In this approach, the
company that is in this situation is likely
to repeat its past good performance.
In the “revitalisation” quadrant, the
market expects that future performance
will be better than past performance.
In the “rut” quadrant are companies whose
mediocre past performance is unlikely
to lead to future value creation (return
on equity capital lower than the cost of
capital). Finally, those in “decline” created
value in the past but are likely to destroy
it in the future.
Marakon Associates also developed a
profitability matrix linking company
performance (rc), the cost of capital (ra),
and the growth of the company (g)
compared to that of the market (G).
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Appendix

Marakon Associates pricing model

Source: Thiertart (1990)

Profitability matrix of Marakon Associates model

Source: Thiertart (1990)

124 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

The aim is to assess the value created by the

company and the company’s competitive
position. So, when the growth of a line of
business (g) is greater than its profitability
(rc), the resources produced by the line of
business will be unable to keep growth up,
even if in the very near term the company
is creating value.

VI. Fruhan and McKinsey Model

The Fruhan and McKinsey model looks at the
relationship between M/B and EV/B, where
EV is the future economic value of the
company estimated with historic cash flows
and B is the book value of equity capital.
When M/B > EV/B, value is created.
Model Fruhan - McKinsey

Source: Lai, L. K., cited by Hax et Majluf (1984)

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
Appendix 2
Solvency I: An Efficient System
with Numerous Drawbacks
The foundations of the current rules for
insurance capital date to the 1970s (in
particular directives 73/239 for property
and casualty insurance and 79/267 for
life insurance). As part of Solvency I,
work on which was kicked off in 1997
and published in 2002, they were
updated. Though they increased the power
of the insurance industry regulators,
they barely modified the contents of the
existing system.
European regulation requires that an
insurance company be solvent, that is,
that it be sufficiently sound financially
to meet its obligations toward its
policyholders and its other creditors.
Required are:
• Sufficient reserves, calculated prudently,
that is, providing a margin large enough
to absorb any unfavourable changes in
the variables making them up. The interest
rate is set in accordance with the rules
of the supervisory organ of the member
state.
• Safe, liquid, diversified, and profitable
assets. Each member state has drawn up
a list of admissible asset classes.
• A minimum amount of own funds in
excess of the RSM (required solvency
margin). In France, for example,
the RSM for euro-denominated life
insurance contracts is equal to 4% of
mathematical reserves and of reserves for
the management of policies involving an
investment risk, plus a percentage of the
capital at risk, a percentage that depends
on the term to maturity of the obligations
(0.3% for more than five years; 0.15% for
between three and five years; 0.1% for less
126 An EDHEC Financial Analysis and Accounting Research Centre Publication
than three years). Reinsurance contracts
can reduce the excess by at most 15%.
In the Solvency I environment, the
following count for the RSM:
• The paid-up capital or, for a mutual
undertaking, the paid-up amount of initial
funds, minus self-owned shares.
• The French “réserve de capitalisation”
or any free or regulatory provisions
not associated with obligations toward
policyholders.
• The carry-forward of the non-dividend
gain or loss from the last financial year
• Junior securities or borrowings of
25% of the amount of the RSM (or the
solvency margin if it is lower). If the debt
is of indefinite term, it is raised to 50%.
• Unrealised gains on assets when these
gains are not out of the ordinary.
• An amount equal to 50% of the
undertaking’s future profits (upon
application, with supporting evidence,
by the undertaking to the supervisory
authority of the member state in the
territory in which its head office is
located and with the agreement of that
authority); the amount of the future
profits is obtained by multiplying the
estimated annual profit by a factor that
represents the average period left to run
on policies.
• Provisions for guarantee funds (article
R423-16 of the Code des assurances) up to
and including the share of contributions
made by the company.
Before going on to the drawbacks of the
current system to demonstrate the need
for European reform, let us emphasise
that the existing rules have been
particularly effective in Europe. In spite
of the significant weakening of insurance
company balance sheets as a result of the
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
turmoil in the financial markets, in spite
of a significant slowdown in economic
growth and an often devastatingly high
claims rate, the number of insurance
companies going broke has remained very
low. In France, for example, the frequency
of bankruptcy is less than 0.25%
(approximately one company a year),
significantly lower than the 2% observed
for the rest of the economy.
All the same, Solvency I has several
drawbacks:
• Every member state has enacted its
own rules. Now, it is easy for an insurance
company to get around excessive
regulation in one country by setting up
another company in a country where
regulation is not as stringent. The lack
of harmonised rules for the solvency of
insurance companies can sometimes lead
to biases that distort competition. It seems
incongruous that the solvency margin of
a company in one country should depend
on domestic accounting standards rather
than on an economic reality shared by all
Europe.
• In spite of the bankruptcies in Japan
and the United States, the views of
prudential rules having to do with
provisions remains highly administrative
and accounting-centred. The calculation
of provisions does not always make
allowances for the general risks of doing
business (inadequate choice of markets or
products, ineffective prevention of fraud
or human error, legal, tax, or reputation
risks, internal risks linked to information
systems) and/or risks inherent to the
insurance business (mistaken choice or
modelling of the underwritten business,
changes in the competitive environment).
So it is surprising that hidden options
such as lower-limit benefits or guaranteed
An EDHEC Financial Analysis and Accounting Research Centre Publication
rates, a cause of earlier bankruptcies, are
not always explicitly taken into account
in the calculation of the solvency
margin. It is also worth noting that this
transformation is perhaps the result of
the supervisory focus on own funds rather
than on provisions. Own funds, of course,
are but a buffer in the event of insufficient
technical provisions. In other words, a
company with satisfactory provisions that
is already taking into account economic
and financial risks should by definition
be able to survive without own funds.
So the real issue is with the make-up of
provisions.
• As for the prudential rules for the
allocation of assets, it is surprising that
after the turmoil in the stock and credit
markets, the notion of risk remains so
simplistic. For example, the investment
risks that are the volatility of the stock
markets, or exchange rates, or interest
rates, the risks linked to the use of
derivatives, liquidity, matching, or credit
risks are not always included in the
calculation of the solvency margin. A list
of assets and the authorised proportions
has been defined, but in such a simplistic
way that in theory it is possible for 100%
of an insurer’s obligations to be backed by
debt issued by privately held Colombian
companies. But if an asset is not on this
list, it cannot be used in the determination
of the solvency margin.
• The minimum capital requirement
involves several paradoxes. As minimum
capital is calculated as a percentage of
technical provisions in life insurance, the
less well provisioned a company is, the less
the capital required of it will be. Another
paradox, and not one of the most minor, is
the asymmetry of the treatment of bond
gains and losses. Unrealised capital gains
are added to available capital, whereas
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Appendix
unrealised capital losses are not deducted
from the calculation of the solvency
margin. So, when rates fall, the solvency
margins are over-estimated and include
unrealised wealth that is very sensitive
to a new rise in rates. In addition, this
creation of wealth is not offset as it should
be, with a re-valuation of liabilities. But
except in the mid 1990s there has not
been a real bond crash, which perhaps
creates a distorted view of the robustness
of the current solvency system.
• The calculation of the solvency margin
does not make it possible to take into
account the specific features of a
reinsurance programme. The standard
reduction of 15% in life insurance and of
50% in property and casualty insurance in
the event of reinsurance seems devoid of
any economic foundation.
• According to the European Commission,
the primary cause of bankruptcy is poor
operational (costs) and/or financial (assets)
management. So it seems paradoxical that
the current solvency rules do not have the
flexibility to integrate this parameter.
• The objective of the solvency system is
early detection of any weakness or threat
to the insurer’s ability to meet its future
obligations toward its policyholders, in
particular as a result of a rise in claims
or a deterioration of the financial
markets. It may seem paradoxical that the
monitoring and the rules for calculation
are done on past financial statements
(total decorrelation of the solvency
margin and prospects). As it happens,
most European countries are putting in
place complementary forward-looking
prudential rules to mitigate the effects of
this paradox.
In France, for example, specific forward-
looking ratios for investments and
128 An EDHEC Financial Analysis and Accounting Research Centre Publication
reinsurance have been put in place, as have
“T3” quarterly asset/liability statements
(which introduce the notion of market
value), the C6 bis, C8, and C9 statements
that test the liquidity of assets in the
event of a mass lapses and the quality
of reinsurance coverage in the event of
great catastrophes (earthquake, epidemic,
and so on). With the same objective, in
the United Kingdom, the PSB (Prudential
Sourcebook) reinforces Solvency I by
broadening the notion of risks to include
market, credit, insurance, and liquidity
risks. Operational risk and the correlation
of branches are not yet integrated.
But there is still a broad debate: if it is
natural to take into account the risks
inherent to new business, should additional
mobilisation of capital be required for
business that is not yet in the portfolio?
Finally, the correlation and dispersion of
risks, which are also the subject of lively
debate, are still not directly taken into
account in phase I of IFRS or in Solvency I,
whereas most leading insurers have already
made them part of their internal models,
especially those that have economic
capital allocation and provision models.
It is evident that the current solvency
system is a set of rigid rules, corresponding
to an acceptable minimum, so much
so that, in general, when a company is
found to be in trouble it is often too late
for it to recover. So the current system is
an “off-the-rack” set of rules that destroys
any incentives for a company to monitor
its own risks.
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
Appendix 3
Solvency II: An Extension of the
Notion of Risk
In recent years, change in the complexity
of risks has led to a real determination to
adapt accounting and prudential rules,
with the objective of offering a better
vantage point on any company, especially
on the risks it is running. Although the
ends are different, the implementation
of IFRS, Solvency II, Basel II, new rules for
financial conglomerates, and European
embedded value (EEV) are converging
toward this objective. With Solvency II,
the European Union is seeking to draw up
solvency requirements more relevant to
the risks actually taken on by insurance
companies to encourage them to evaluate
and control their risks.
Analysis of IFRS and Solvency II reveals
a shared determination. IFRS attempts
to broaden the notion of risk taken into
consideration in the accounts, so as to
make insurance companies more aware of
their real risks and thus to encourage them
to understand them better. Solvency II is
attempting to encourage a move from an
“off-the-rack” system built on minimalist
rules to a “custom-made” system that,
by broadening the notion of risk and
transferring the analysis of their risks to
the companies themselves, is well suited to
the specific features of each firm. The aim
of the new solvency system is not to lay
down new rules for capital or provisions
but to give companies an incentive to
put in place more sophisticated internal
models for the analysis, management, and
control of risks.
So it is not necessary to revolutionise
existing models but to adapt models
An EDHEC Financial Analysis and Accounting Research Centre Publication
for asset allocation, asset/liability
management, and/or provisions to the
reality of risks.
I. The Foundations of Solvency II
To put in place Solvency II, the European
Commission proceeded in two phases:
• An initial phase focused on determining
the foundations of Solvency II. This phase
came to a close on 3 March 2003 after two
years of work, with the implementation of
an architecture for the prudential oversight
system built on three pillars, an architecture
similar to that used for Basel II.
• In the second phase, more technical, the
measures for the new solvency systems’
taking into account of risks are to be
spelled out. In 2004 the committee of
European insurance and occupational
pensions supervisors (CEIOPS) was created
to define these measures. The first directive
was put in place in July 2007 with the first
application planned for 2012. This phase is
particularly complex and it is easy to see
why the initial objective of a 2007 entry
into force was not met.
As with that of IFRS, the philosophy of
Solvency II is to foster principles rather
than to issue precise directives, so that
each company can put in place or adapt
its own risk-assessment model, which will
then of course have to win independent
approval.
The three pillars of the Solvency II
architecture are similar to those of Basel
II. In 1998, the objective of the Basel
Committee, made up of representatives of
the central banks and banking supervisory
authorities of twelve countries (the
body of rules has since been adopted by
more than one hundred countries) was
to increase the solidity and stability of
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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
the international banking system and to
reduce the number of competition
inequalities in the industry. The
contribution of Basel II lies in its
adaptation of the rules for bank capital to
changes in the risks prevalent in banking.
Work on Basel II began in 1998, the reform
was published in 2004, and it came into
force in 2008.
The prudential objective of Solvency
II is very different from that of Basel II.
Solvency II, after all, focuses not on
individual risks but on the entire set of
risks facing each company. In addition,
primary motivation for this body of rules
is the protection of policyholders from
the risk of bankruptcy of any insurance
company.
Nonetheless, Basel II provided certain
elements for the building of Solvency II:
architecture built on three types of rules
(known as pillars) and a three-tier ranking
of measurements of risk. The banking
reform spelled out:
• A standard method that classifies risks
by external rating
• An internal-rating method that relies
on the odds of default as identified by the
banks
• An advanced internal-rating method
in which risks are classified by statistical
series of the institution concerned.
So the calculation of the risks of bank
credit relies either on a standard method
founded on rating-agency ratings or
on the use of internal models. The
McDonough solvency ratio, which took
the place of the Cooke ratio, broadened
the notion of credit risks to include
market and operational risks. It is the ratio
of regulatory capital to the sum of credit,
130 An EDHEC Financial Analysis and Accounting Research Centre Publication
market, and operational risks. It should
be greater than 8%. The consequence
of Basel II is not an additional capital
requirement but a reallocation of capital
to each of the businesses, as a result of a
weighting of the risks that corresponds to
economic reality.
For insurance, the architecture and
definition of the measures of risk are
largely the result of:
• A KPMG report, commissioned by the
Internal Market and Services Directorate
General and published on 2 May 2002,
on risk modelling, technical provisions,
asset pricing, reinsurance, the transfer
of alternative risk and risk-reduction
techniques, the impact of changes to
accounting rules, the role of rating
agencies, and comparative analyses of
solvency systems. The main conclusions
of the report are that the three-pillar
approach taken by the Basel Committee
would be suitable for Solvency II and
that the formula for the calculation of
the solvency margin should integrate
technical, market, and credit risks. KPMG
remains circumspect about the integration
of operational and asset/liability mismatch
risk.
• The Sharma report, a report from the
conference of the insurance supervisory
services of the member states of the
European Union, published in November
2002 and grounded on making
the problems facing insurance companies
common knowledge. It advocates
prudential system intervention through
preventive or corrective regulatory tools
used at any stage of the appearance of
problems, from the earliest stage to the
final stage detrimental to policyholders.
This report also dealt with the definition
of good risk management (culture
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
and strategy of the company, decision
processes, risk-tracking and information
systems), with the principle of
prudent financial management, and
with reinsurance programmes. These
programmes should not just be tailored
to the underwriting policy of the insurer,
but their quality and liquidity should be
studied as well. The amount of capital
required should then integrate reinsurance
(no longer in a standard fashion) and, more
broadly, any means of transferring risk
(securitisation, for example). Reinsurance
could thus reduce second-pillar but not
first-pillar capital needs (see definitions
below).
The first phase of Solvency took a three-
pillar approach:
• The first pillar contains the quantitative
requirements and should define the
prudential rules for provisions, assets,
and capital. The calculation of life
technical provisions will be one of the
major changes in Solvency II. It should
integrate a forward-looking approach,
make allowances for the risk of a drift in
the factors used as assumptions in the
calculation, be founded on a discount rate
that depends on the kind of insurance
contract and the method of pricing the
assets and liabilities, and determine
the provisions for supplementary
guarantees (explicit valuation of options).
In property and casualty insurance, the
equalisation provision is being hotly
debated as treatment varies greatly
from one country to another, just like
the determination to set a quantitative
benchmark of the level of prudence for
provisions for claims. Asset risks are now
taken into account quantitatively in the
evaluation of the capital requirement (as
in the United States).
An EDHEC Financial Analysis and Accounting Research Centre Publication
• The second pillar has to do with
qualitative requirements. It is an
extension of the statement of the good
management practices of Solvency I
that the supervisory services would like
all insurers to put in place internally.
This pillar is grounded on the definition
of rules for internal analysis and
management of risks (assets and
liabilities) with ALM tools and reinsurance.
Although the Commission acknowledges
that asset/liability management should
be strengthened, for the moment it is
not planned to change explicitly the
capital requirement as a result of the
quality of ALM and of the management
of mismatches. For this pillar, discussion
revolves around the requirements made
of the means of tracking exposure to
investment risks, requirements founded
on an explicit definition of an investment
strategy (degree of risk accepted,
target composition of portfolio, use of
derivatives, liquidity of assets, correlation
with the risk profile of liabilities). The
insurance supervisory authorities would
like to increase their powers of inspection
and intervention (to demand capital add-
ons, for example), after the fashion of
the increase in this power provided for
by Solvency I, and this at each link in
the chain of the management of risks:
typology, analysis, valuation, acceptance,
transfer, or reduction and management of
risks.
• The third pillar has to do with market
discipline, with using rules reflecting
market demands that companies be more
transparent about their exposures and
their management of their risks.
This first phase also concluded that the
requirement for a regulatory solvency
margin is the basis of a prudential regime
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Appendix
suited to risks; the calculation method is
not yet defined. All the same, a capital
requirement may be created to define
both the level of capital that leads to
an acceptable likelihood of default and
the critical threshold beneath which the
company is at high risk of bankruptcy.
As with the American or Canadian RBC
(risk-based capital) systems, a degree of
intervention is planned that is a function
of the required solvency margin (RSM)
multiple depending on a lower limit and
a target. If the minimum compulsory
threshold is not reached by a company,
the supervisor must have the power
immediately to withdraw the company’s
accreditation to write insurance.
This threshold should be relatively low,
serve as a safety net, and be the result of
a relatively simple formula. Target capital
is the capital necessary to deal with the
risks of doing business and to converge
toward a nearly nil risk of bankruptcy.
The formula for calculating it should
integrate the particularities of the risk
profile of each company, including new
business. The idea is to give companies
an incentive to measure their own risks.
Internal models are perhaps the most
appropriate means of defining this target
capital.
So, Solvency II may well need to come
up with a more progressive solvency
control (modulated in keeping with the
financial health of the company) at an
explicit confidence interval, calculated
on the required solvency margin,
but the calculation formulas remain to be
finalised after the multiple quantitative
impact studies define their broad
principles.
132 An EDHEC Financial Analysis and Accounting Research Centre Publication
II. Constraints on the Elaboration of
the Solvency II Model and of Internal
Models
The choice of the formula to define
the solvency margin should take into
consideration the constraints and
objectives of Solvency II, constraints and
objectives characterised by:
• A determination to make the solvency
systems of each member state as uniform
as possible. The objective is not to take
the smallest common denominator. Unlike
those of Basel II, capital requirements
are likely to increase for most European
insurers (with the likely exception of
the large groups that benefit from
diversification).
• Solvency II is meant to be i)
homogeneous (although some countries
have already adopted complementary
systems of calculating the solvency
margin); ii) more complete, by broadening
the definition of risks (investment risk
and the reduction linked to derivatives
hedging are not taken into account in
most European countries) and by making
allowances for reinsurance and volatility
of claims (the risk depends more on the
change than on expectations, which alone
are taken into account in Solvency I).
Reinsurance, in fact, is completely
reworked. Risk-based capital (RBC), a
solvency model used in the United States,
does not integrate it, whereas in Europe it
is integrated in a standard fashion, which
fosters a search neither for high-quality
reinsurers nor for the coverage that would
be called for by underwriting policy.
• The new calculation rules must be
applicable to all companies. In this respect,
the Solvency II constraint is broader than
that which is initially applied in IFRS,
which affects only publicly traded
companies.
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
• The cost constraint is not insignificant.
Solvency II of course is meant to apply
as well to providential societies and
small mutual undertakings, which do
not have unlimited means of developing
sophisticated internal models.
• For obvious practical reasons Solvency
II is meant to be compatible with IFRS.
The problem is that the dates for IFRS II
and Solvency II are similar (and Solvency
II is even ahead in its decision to define
liabilities at market value). So Solvency
II has to lay down rules that anticipate
the decisions of the IASB, in particular
with respect to valuation of technical
provisions at market value. Solvency II
also relies on the financial conglomerates
directive (2002/87) and on the 2005
implementation of EEV (European
embedded value) born of the CFO Forum
(nineteen of the main European insurers
wanted to standardise the methods of
communicating embedded value).
• Solvency II must not lead to market
distortions or systemic risks. Indeed,
by underscoring the troubles of some
insurance companies, a crisis of confidence
among policyholders could lead to a
wave of surrenders and weaken these
companies while strengthening more
adequately capitalised ones. The gradual
implementation of tests, as in France (the
C6 bis test that is meant to assess the risk
of an asset/liability mismatch in different
scenarios, the C8 and C9 statements
having to do with reinsurance) thus seem
to be opportune means of smoothing the
transition. For its part, the United Kingdom
has put in place resilience tests for
insurance companies so that they can test
the impact on their technical provisions
of interest rate and stock price changes in
different scenarios. For reference only, and
to confirm this trend, the United States
An EDHEC Financial Analysis and Accounting Research Centre Publication
also put in place additional dynamic
stochastic tests to assess the resistance
of the financial solidity of a company to
interest rate fluctuations simulated in
the ALM model of the company under
consideration. The American RBC model is
currently being perfected (phase II of the
C3 project)
All solvency systems (in Europe, the
United States, Australia, Canada, Japan)
may require a solvency margin, but the
calculation of this margin varies greatly
from one continent to another. The two
main types of calculation rely on the
fixed-ratio and RBC concepts (Amenc et
al. 2006).
Finally, whether in Europe, the United
States, or Australia, recent work seems
to demonstrate the suitability of putting
in place internal models. As it happens,
recent developments outside Europe seem
to confirm the trend.
In Australia, for example, insurance will
have a choice of two models for the
calculation of the required solvency
margin:
• An internal model developed by each
insurance company, a model that reflects
most of the risks it has taken on, in
particular those inherent to its business
profile. These models are naturally subject
to regulatory approval.
• A model prescribed by law for companies
that do not have the means or the
intention to develop their own models.
This prescribed method is based on an
RBC model that integrates investment
and technical risks after the fashion of
the American model, in addition to the
concentration risk meant to integrate
catastrophic events.
133
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Appendix
Depending on the sophistication of
internal models, a combination of the two
methods is accepted.
The other example of a shift toward
internal models is the complementary
regulation of phase II of the American C3
project. It integrates cash-flow testing
for life insurance companies so that they
can directly test their own asset/liability
management model, the impact of
different interest rate scenarios (created
by the American Academy of Actuaries) on
capital adequacy, and the match of assets
and liabilities. It is projected over thirty
years and leads to an available surplus
or deficit, a surplus or deficit for which
allowances are made in the calculation
of the solvency margin. The aim of this
approach is to give insurance companies
an incentive to build their own risk-
management models; the incentive to
do so is made all the greater by the 50%
increase in the RBC coefficients for the
companies that do not have such models.
It seems that Solvency II intends to
foster the use of internal models for the
calculation of target capital. These models
could be total or partial, deterministic
(tests of different scenarios) or stochastic
(Monte Carlo simulation), models based
on the probability of bankruptcy or
default. With different scenarios, it is
possible to calculate both the likelihood
of the occurrence of the worst scenarios
and the capital necessary to keep the
likelihood of bankruptcy or default below
a certain limit. According to the European
Commission, the prudential rules could be
based on extensions of existing internal
models, such as asset allocation, ALM,
embedded value, dynamic financial
analysis (DFA), or the overall risk model.
134 An EDHEC Financial Analysis and Accounting Research Centre Publication
The latter model has drawn the attention
of both Solvency II task forces and large
insurance companies. It models the
probability distribution of real capital (or
economic capital), and its objective is to
calculate the need for economic capital
as a function of the overall risk deemed
acceptable by the company and to define
allocations of economic capital to lines of
business. This need for economic capital is
usually defined:
• Either with a Value-at-Risk approach in
which it corresponds to a quantile of the
distribution function of overall risk (as in
Australian regulation)
• Or with an expected-shortfall or tail
-VaR approach in which it corresponds
to the average of the losses occurring at
a frequency beneath a threshold. Some
insurance companies favour this approach,
as it offers a better view of the model of
the tail distributions.
The use of tools to measure risk and,
more broadly, of these internal models,
should also make it possible to fine tune
company strategy and the optimisation of
capital allocation, in particular to weigh
the advantages and disadvantages of
allocating capital to the different lines
of business (on the basis of RoRAC), the
taking on or transfer of risk, reinsurance
policy, asset allocation (measure of
volatility and performance), and liability
management.
The main advantage of these internal
models is that they take into account
the profile of the company and of its
risks. Putting them in place, by contrast,
is long and complex (information system
capabilities, development and robustness
of hypotheses, human resources).
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Appendix 4 We reproduce this modular structure

Solvency II: Modular to define the outline of the internal
Organisation, Identification and management models, with a closer look
Calibration of Risks per line of business (chapters III, IV, and V)
so as to be able to measure risk-adjusted
The calculation of the solvency capital capital (RAC).
requirement or the target capital required
by the regulator rests on a modular Solvency II rests on the following modular
structure of risks. Six risk modules, each approach:
Solvency II modular structure of risks
SCR

Adjustments Operational SCR

BSCR

SCR Life SCR Non Life SCR Health SCR Market SCR Counterparty

Premium reserve risk Accident and short

Mortality risk term health Interest rate risk

Longetivity risk Catastrophe risk Long-term health Equity risk

Disability risk Workers' compensation Property risk

Lapse risk Currency risk

Expense risk Spread risk

Revision risk Concentration risk

Catastrophe risk

Adjustment for risk-absorbing effect of future

discretionary benefits

Source: CEIOPS

made up of sub-modules, lead to the The calibration for each of these risk
calculation of required capital, usually modules and sub-modules is defined for
following a type of shock for each risk (see each type of risk and in accordance with
the typology of risks and measurement of its own framework. We review below the
risks below). Aggregation of these shocks, entire set of risks and their calibration
in keeping with correlation matrices that in keeping with the approach tested in
reveal the dependence of risks and the QIS4.
diversification of risks, leads to the final
regulatory capital requirement.

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Appendix

Typology, measure, and calibration of risks per line of business as defined by the Solvency II modular approach

LIFE
Mortality risk A permanent 10% increase in mortality rate for each age (for contracts where the
amount payable on death is greater than technical provisions held)
Longevity risk A permanent 25% decrease in mortality rate for each age (for contracts where the
amount payable on death is less than the technical provisions held)
Disability risk Increase of 35% in disability rates at each age for the next year together with a 25%
increase for the following years
Lapse risk Three shocks are tested. The maximum required capital is that which is the greatest
as a result of one of these three shocks:
• permanent reduction of 50% in the rates of lapsation for contracts for which the
surrender strain is expected to be negative
• increase of 50% in the rates of lapsation for contracts for which the surrender
value is expected to be positive
• 30% of the sum of surrender strains for the contracts for the surrender strain is
positive.
Expense risk Two simultaneous shocks are tested:
• increase of 10% in future expenses compared to best estimate
• increase of 1% per year in inflation rate.
Revision risk Increase of 3% in the annual amount payable for annuities exposed to revision risk
considering the remaining run-off period.
Catastrophe risk Two simultaneous shocks are tested:
• an absolute 1.5 per mille increase in the rate of policyholders dying over the
following year
• an absolute 1.5 per mille increase in the rate of policyholders experiencing
morbidity over the following year.

Non-Life
Premium and reserve risk The measure of premium and reserve risk is a function of the volumes underwritten
and the volatility of the combined historic ratios per line of business and it is calculated
in such a way that, assuming a lognormal distribution of the underlying risk, a risk
capital charge consistent with the VaR 99.5% standard is produced.
Catastrophe risk A choice of three approaches:
• percentage (catastrophe factor defined by the regulator depending on the line of
business specified) of estimated net premium written for the coming year
• sum of the costs of each scenario specified by the regulator (regional scenarios)
that exceeds a threshold of materiality set at 25% of the cost of the most severe
scenario
• impact of the change in NAV as a result of a personalised shock scenario: on the
basis of a single event or on an annual basis (occurrence of several catastrophic events
over the next twelve months in line with the SCR calibration at a 99.5% confidence
level at a one-year horizon).

HEALTH
Long-term health • health expense risk as a function of gross premiums earned, of the volatility of the
cost ratio, and of a risk factor such that a risk capital charge consistent with the VaR
99.5% standard is produced
• claim (mortality or cancellation) risk as a function of gross premiums earned, of
the volatility of the claims rate, and of a risk factor such that a risk capital charge
consistent with the VaR 99.5% standard is produced
• epidemic risk as a function of gross premiums earned (of the company and the
market), of claims expenditure in the accounting year for the health insurance
market, and of a risk factor calibrated by the regulator such that a risk capital charge
consistent with the VaR 99.5% standard is produced.

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Workers’ compensation
Short-term health, accidents, and other
• premiums and reserves: approach identical to that used in non-life insurance
(three-step approach—appendix 9)
• underwriting: four categories (longevity, disability, revision, and expense) of risk,
measured with the approach used in life insurance (impact of correlated shocks on
changes in NAV)
• catastrophe: approach identical to that used in non-life insurance (standard method
or scenario methods for catastrophe risk).
• premium and reserve risk as in the approach used in the underwriting risk in non-life
(in three phases—appendix 9)
• catastrophe risk as in the approach used in the underwriting risk in non-life (standard
method, regional scenarios, or personalised scenarios).

Market
Interest rate risk Changes in the interest rate term structure each year for a period of twenty years
with relative rise or fall (the greater of the two). Simplified approach (not authorised
for life technical provisions): upwards shock of 50% and a downwards shock of 40%
multiplied by the modified duration.
Equity risk Drop of 32% in the Global equity index and of 45% in the Others index (correlation
of the two risks of 0.75). Analysis net of hedging and risk transfers.
Property risk 20% fall in real estate benchmarks, taking into account all direct and indirect exposures
to property prices. The property shock takes into account specific investment policy,
including hedging arrangements.
Currency risk The greater of the capital charges in the event of a 20% change, rise or fall, in the
value of all other currencies against the local currency.
Spread risk Government bonds are exempted from an application of this module, as are assets
which are allocated to policies where the policyholders bear the investment risk (unless
they have embedded options or guarantees). The greater of the capital charges in the
event of a narrowing or widening of the spread with respect to the term structure of
the risk-free rate for bonds, structured credit products, and credit derivatives.
Concentration risk Evaluation for the company as a whole of the concentration with respect to each
counterparty. Shock depending on the credit rating of the counterparty under
consideration.

Counterparty
Counterparty risk Aggregation of loss-given-default of reinsurance, financial derivatives, intermediary,
or any other credit exposures if counterparty i defaults and probability of default
of counterparty i.

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Appendix

Appendix 5 accounts for some of the dispersion around

Data Collection and Simulations the average: larger companies devoted 4.4
for QIS4: Major Investments man months to it, as opposed to 2.2 for
smaller companies.
In its analysis of the results of QIS4 (2008),
CEIOPS (2008) commented on the resources The figures below show the investments
used by the participants to respond to the made by line of business and the breakdown
study. This impact study, of course, was of investment by task.
entirely optional and was meant only
Investment (man months) by participant profile
as an informative test; it had no effect 10
whatsoever on the participants. When
Solvency II comes into force, the issue will 8
be very different, since the two levels of
capital required by the regulator will have 6
to be officially defined. It is thus likely
that insurers will do much fine tuning and 4
make many adjustments, which will lead to
additional costs. 2

It is for this reason that this study seeks

0
to show that it is of interest to the insurer Life Composite Captive
to reorient the investments required by Non-Life Reinsurance

the regulator toward the insurer-specific

10th-90th percentile interval
ends of elaborating internal decision 25th-75th percentile interval
models. The leading European insurers, Median
Source: CEIOPS 2008
forerunners in this domain, are showing
that their economic capital model has
Investment (man months) by participant size and task type
several functions: definition of policy for
investment, underwriting, new product
undertakings

undertakings

undertakings

launches, provisions, reinsurance, asset/

Small
Large
All

liability management, allocation of

capital to the various lines of business,
Completing overall QIS4 3.2 4.4 2.6
risk management (definition of accepted
Getting acquainted with the
limits, concentration, diversification) and a technical specifications
1.0 1.1 0.9

means of communication with the financial Assessment of best estimate

0.9 1.1 0.8
markets, rating agencies, and the prudential provisions

regulator. These multiple functions are dealt Calculation of the risk margin 0.4 0.5 0.4

with in chapter V. The objective of this Valuation of assets and other

0.5 0.6 0.4
non-insurance liabilities
appendix is to illustrate with several figures
Calculation of the MCR 0.4 0.5 0.4
the cost of responding to QIS4.
Calculation of the SCR 1.0 1.6 0.8
Source: CEIOPS 2008
According to the CEIOPS study, the
participants invested on average 3.2 man
months to respond to QIS4. Size naturally

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
Appendix 6
Weighting of Risk Types in the
Composition of the Solvency
Capital Requirement in France
and in Europe
In its analysis of the results of QIS4
(2008), CEIOPS (2008) commented on the
composition of the basic solvency capital
requirement (BSCR), one of the components
of the solvency capital requirement (SCR),
in keeping with the modular structure
described in appendix 4 and the definition
in section I, chapter V.
For each country (although the names
of the countries were left off the X axis),
CEIOPS thus disclosed the breakdown of the
BSCR into the five risk modules it is made
up of (life, non-life, health underwriting
risk, market, and counterparty) and the
benefits of the diversification of these risks
(Diversification).
Depending on the participant’s profile
(life insurance company, non-life, mixed),
certain capital consumption trends
appear.
Composition of BSCR for life insurance companies by European country
Source: CEIOPS (2008)
An EDHEC Financial Analysis and Accounting Research Centre Publication
For life insurers, the market risk module
seems to require the most capital, as in
many countries it accounts for more than
half of the BSCR and in some for as much
as 80%. In most countries, nonetheless,
diversification enables life insurers to reduce
this BSCR anywhere from 10 to 30%.
If one focuses on data from the French
market drawn from the ACAM (2008)
presentation, life insurers stand apart
from the European average given the
characteristics of their products and their
allocation of assets (weights of equities
higher than the European average).
Even if the ACAM presentation differs from
that of CEIOPS, it is interesting to note the
82% weight of the market risk module in
the SCR before diversification, reducing to
14% the weight of underwriting risk.
The diversification benefit makes it possible
to reduce the BSCR by 11%. The adjustment
for the risk-absorbing effect of future profit
sharing is substantial, as it reduces the final
capital requirement (SCR) by 50% (to which
is added 8% for deferred taxation).
139
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
Composition of SCR for life insurance companies in France
Source: ACAM (2008)
Composition of the BSCR for non-life insurance companies in different European countries
Source: CEIOPS (2008)
For non-life insurance companies in
Europe, the non-life underwriting module
is the major component of the capital
charge; in many countries it accounts for
between 50 and 80% of the BSCR (even
though in some countries market risk and
non-life underwriting risk are not equally
weighted). The benefits of diversification
of the risk modules are, at between 15
and 30%, slightly greater than those in
life insurance.
If one focuses on data from the French
market drawn from the ACAM (2008)
presentation, non-life insurers too stand
apart from the European average, as the
140 An EDHEC Financial Analysis and Accounting Research Centre Publication
market risk and non-life underwriting risk
modules are equally weighted (46% and
44% of the BSCR before diversification).
This difference stems from a weight of
long-term business that is greater than
the European average. The diversification
benefit, at 20%, is double that of life
insurers in France.
Finally, for mixed insurers in Europe, it is
harder to identify a clear trend for the
community as a whole. Nonetheless, it
is clear that the market risk and non-life
underwriting risk modules consume a
large share of capital. The benefits of
diversification, which range from 15 to
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Composition of the SCR for non-life insurance companies in France

Source: ACAM (2008)

Composition of the BSCR for mixed insurance companies in Europe

Source CEIOPS (2008)

40%, are slightly greater than for life and

non-life insurers.

For mixed insurers in France, the market risk

module, accounting for approximately 50%
of capital needs (as measured by the BSCR)
,remains the greatest single contributor
to the capital charge. The diversification
benefit is relatively high, as it makes it
possible to reduce the capital requirement
by 25%. The weight of the life business for
the mixed French insurers seems relatively
high, as adjustments for the risk-absorbing
effect of future profit sharing and deferred
taxes make it possible to reduce the total
required by the regulator (SCR).

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Composition of the SCR for mixed insurers in France

Source: ACAM (2008)

142 An EDHEC Financial Analysis and Accounting Research Centre Publication

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Appendix

Appendix 7
Major Characteristics of the
Benchmark Company

Solvency I general hypotheses

Unit Euro Motor own Property Third-party
(EURm) Health Total
linked denominated damage damage liability
Stocks 838 959 105 330 318 5 2554
Bonds 685 4920 392 924 636 99 7657
Property 0 511 26 66 106 0 709
Reinsurance 2 6 3 10 35 1 56
Total assets 1525 6396 525 1330 1095 105 10976
Own funds 23 360 250 300 200 50 1183
Technical provisions 1500 6000 250 1000 875 50 9675
Debt 2 36 25 30 20 5 118
Total liabilities 1525 6396 525 1330 1095 105 10976
Premiums per
250 1000 1000 1000 250 200 3700
activity (gross)
Source: EDHEC Business School

Unit Euro Motor own Property Third-party

Health Total
linked denominated damage damage liability
Asset components %
Stocks 55% 15% 20% 25% 30% 5% 23%
Bonds 45% 77% 75% 70% 60% 95% 70%
Property 0% 8% 5% 5% 10% 0% 6%
Total 100% 100% 100% 100% 100% 100% 100%
Reinsurance assets/
0.1% 0.1% 1.0% 1.0% 4.0% 1.0% 0.6%
technical provisions
Technical provisions/
600% 600% 25% 100% 350% 25% 261%
premiums
Own funds/technical
1.5% 6% 12%
provisions
Own funds/premiums 9% 36% 25% 30% 80% 25% 32%
Debt/own funds 10% 10% 10% 10% 10% 10% 10%
ROE 11% 11% 9% 10% 8% 11% 10%
Source: EDHEC Business School

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Appendix

Solvency II general hypotheses

Unit Euro Motor own Property Third-party
(EURm) Health Total
linked denominated damage damage liability
Stocks 810 959 99 287 275 5 2435
Bonds 663 4920 370 804 550 95 7403
Property 0 511 25 57 92 0 685
Reinssurance 1 6 2 7 26 0 43
Total assets 1475 6396 495 1157 943 100 10566
Own funds 47 360 265 387 276 52 1387
Technical provisions 1425 6000 205 740 648 43 9060
Debt 2 36 25 30 20 5 118
Total liabilities 1475 6396 495 1157 943 100 10566
Premium per
250 1000 1000 1000 250 200 3700
activity (gross)
Source: EDHEC Business School

Unit Euro Motor own Property Third-party

Health
linked denominated damage damage liability
Gross premiums per activity 250 1000 1000 1000 250 200

Asset components %
Stocks 55% 15% 15% 15% 30% 5%
Bonds 45% 77% 80% 80% 60% 95%
Property 0% 8% 5% 5% 10% 0%
Total 100% 100% 100% 100% 100% 100%

Reinsurance assets/technical
0.1% 0.1% 1.0% 1.0% 4.0% 1.0%
provisions

Technical provisions/premiums 600% 600% 140% 160% 500% 110%

Own funds/technical provisions 2.0% 6%
Own funds/premiums 25% 40% 80% 25%
Debt/own funds 10% 10% 10% 10% 10% 10%
Duration
Bonds 8 8 4 4 9 3
Technical provisions 8 8 2 2 9 1
Debt 6 6 6 6 8 4
Interest rate used to calculate 4.65%
(8-year
modified duration
interest rate
term structure
proposed by
the CEIOPS)

Benefits distribution rate

Financial yield (%) 5.0%
Tax rate 35%
Discretionary benefits rate 96%
Source: EDHEC Business School

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Appendix

Hypotheses for life underwriting risk

Unit Euro
linked denominated
Net technical provisions/gross technical provisions 95% 99%
Mortality risk
Share of life insurance contracts contingent on mortality risk 35% 5%
Capital at risk/technical provisions for death benefit contracts 0.10 4.00
Expected average death rate over the next year weighted by the sum insured q 0.3% 0.3%
Longevity risk
Share of life insurance contracts contingent on longevity risk 5% 5%
Disability risk
Share of life insurance contracts contingent on disability risk 0.1% 2.0%
Capital at risk /technical provisions for contracts contingent on disability risk 0.10 0.10
Expected average disability rate over the next year weighted by the sum insured i 0.3% 0.3%
Lapse risk
Average lapse rate for policies with a negative surrender strain 0.5% 0.5%
Surrender strain/technical provisions for policies with negative surrender strain -2.0% -2.0%
Average rate of lapsation of the policies with a positive surrender strain 3.5% 3.5%
Surrender strain/technical provisions for policies with positive surrender strain 10.0% 17.0%
Average period, weighted by surrender strains, over which the policy with a negative
1.5 1.5
surrender strain runs off ndown
Average period, weighted by surrender strains, over which the policy with a positive surrender
6 6
strain runs off nup
Expense risk
Expense rate 0.2% 0.2%
Average period over which risk runs off, weighted by renewal expenses n(exp) 5 5
Revision risk
Percentage of annuities elegible for revision risk 0.0% 0.0%
Catastrophe risk
% of technical provisions for policies contingent on mortality risk with benefits payable as a
95% 90%
single lump sum
Share reinsured of technical provisions for policies contingent on mortality risk 0.0% 0%
% technical provisions for policies whose benefits are payable on disability definition and as a
90% 90.0%
single lump sum
Share reinsured of technical provisions for policies whose benefits are payable on disability
0.0% 0%
risk
Multiple of the amount insured when the benefit is paid as a lump sum as a function of TP 1.1 5
Multiple annualised amount when benefits are paid on death or disability as annuities (net
1.1 5
of reins.)
Average annuity factor for the expected duration over which benefits may be payable in the
20.0 20.0
event of a claim
Source: EDHEC Business School

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Appendix

Hypotheses for non-life and health risk

Motor own Property Third-party Short-term Accident &
damage damage liability health others
Share of premiums reinsured 3.0% 10.0% 15.0% 2.0% 10.0%
Net written premiums by geographic area
Area 1 59.9% 59.9% 100.0% 100.0% 100.0%
Area 2 24.0% 24.0% 0.0% 0.0% 0.0%
Area 3 16.2% 16.2% 0.0% 0.0% 0.0%
Ratio written premiums/earned premiums by geographic area
Area 1 105% 103% 105.00% 102.0% 102.0%
Area 2 104% 105%
Area 3 103% 104%
Net written premiums growth rate %
Area 1 1.0% 3.0% 5.00% 3.0% 3.0%
Area 2 -1.0% -2.0%
Area 3 1.0% 5.0%
Ratio net/gross best estimate 98.0% 85.0% 80.0% 99.0% 92.0%
Best estimate by geographic area
Area 1 59.9% 59.9% 100.0% 100.00% 100.00%
Area 2 24.0% 24.0% 0.0% 0.00% 0.00%
Area 3 16.2% 16.2% 0.0% 0.00% 0.00%
Source: EDHEC Business School

Market risk hypotheses

Motor
Unit Euro Property Third-party
Interest rate risk own Health Total
linked denominated damage liability
damage

Pre shock interest rate 4.65% 4.65% 4.65% 4.65% 4.65% 4.65% 4.65%
Equity risk
Global index equities 94.0% 95% 95% 92% 90% 95% 62%
Global index hedging rate 10% 5% 0% 0% 0% 0% 3%
Other index hedging rate 5% 1% 0% 0% 0% 0% 0%
Efficiency of Global index hedge 90% 90% 90% 90% 90% 90% 90%
Efficiency of Others index hedge 80% 80% 80% 80% 80% 80% 80%
Value of hedge/value of assets hedge
4% 1% 1% 1% 1% 1% 1%
(Global)
Value of hedge/value of assets hedge
4% 1% 1% 1% 1% 1% 1%
(Other)
Property risk
There are no hypotheses for this module; a 20% drop in the value of the property assets on the balance sheet is applied.
Currency risk
It is assumed that the company manages currency risk with the help of the congruence principle, efficient ALM and/or hedging for
currency fluctuations.
Source: EDHEC Business School

146 An EDHEC Financial Analysis and Accounting Research Centre Publication

 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Euro Motor own Property Third-party

Spread risk Health Total
denominated damage damage liability
Bonds 98.9% 98.9% 98.9% 98.9% 98.9% 98.9%
Structured credits 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%
Credit derivatives (investment and not
0.1% 0.1% 0.1% 0.1% 0.1% 0.1%
hedging)
% non-government bonds 60% 50% 60% 75% 40% 60.3%
Non-government bond portfolio
Rating
AAA 40% 50% 40% 25% 60% 39%
AA 30% 30% 30% 40% 30% 31%
A 24% 15% 20% 29% 9% 23%
BBB 5% 4% 9% 5% 0% 5%
BB 0% 0% 0% 0% 0% 0%
B 0% 0% 0% 0% 0% 0%
CCC or below 0% 0% 0% 0% 0% 0%
Unrated 1% 1% 1% 1% 1% 1%
Total 100% 100% 100% 100% 100% 100%
Structured credits portfolio
Rating
AAA 60% 40% 40% 40% 40% 55%
AA 20% 30% 30% 30% 30% 23%
A 20% 30% 30% 30% 30% 23%
BBB 0% 0% 0% 0% 0% 0%
BB 0% 0% 0% 0% 0% 0%
B 0% 0% 0% 0% 0% 0%
CCC or below 0% 0% 0% 0% 0% 0%
Unrated 0% 0% 0% 0% 0% 0%
Total 100% 100% 100% 100% 100% 100%
Source: EDHEC Business School

Euro Motor own Property Third-party

Activity Health
denominated damage damage liability
Total assets excluding unit-linked, government
3965 288 774 694 44
bonds and reinsurance (EURm)
Net exposure 4% 4% 4% 4% 4%
Counterparty rating BBB BBB BBB BBB BBB
Net asset value (NAV) before the shock (EURm) 360 265 387 276 52
Source: EDHEC Business School

Total balance sheet

Total assets excluding unit-linked, government bonds and reinsurance (EURm) 5764
Net exposure 4%
Counterparty rating BBB
Net asset value (NAV) before the shock (EURm) 1387
Source: EDHEC Business School

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Hypotheses for counterparty risk

Euro Motor own Property Third-party
Activity Unit linked Health
denominated damage damage liability
Percentage of concentration per reinsurer
Reinsurer 1 27% 27% 27% 27% 27% 27%
Reinsurer 2 17% 17% 17% 17% 17% 17%
Reinsurer 3 17% 17% 17% 17% 17% 17%
Other reinsurers 39% 39% 39% 39% 39% 39%
Total 100% 100% 100% 100% 100% 100%

Motor own Property Third-party Short-term Accident &

Activity
damage damage liability health others
Reinsurance gains applied to the loss ratio in basis points
Reinsurer 1 160 230 246 50 50
Reinsurer 2 160 230 246 50 50
Reinsurer 3 160 230 246 50 50

148 An EDHEC Financial Analysis and Accounting Research Centre Publication


1 - The financial aspect of
life insurance is founded
on financial capitalisation
characterised by the use
of a so-called technical
interest rate. It is used to
set premiums for policies
and to calculate the
insurer’s obligations to its
policyholders.
Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
Appendix
Appendix 8
Simplified Best Estimate Example
Drawn from QIS4
A simplified approach, proposed by QIS4,
can be taken to calculate the best estimate
of a life insurance policy with future
discretionary benefits. The steps are:
• calculation of the future value of
future cash flows at the rate offered
policyholders
• calculation of the guaranteed best
estimate
• and of the total best estimate.
We will look in detail at each of these
steps:
• Calculation of the future value of the cash
flow that the policyholder/beneficiary will
receive at term. This future value depends
on an interest rate offered by the insurer:
YT = S0 ∏ (1+ RT)
S0 is the amount insured at the moment
of the valuation, RT lthe interest rate paid
to the policyholder, and YT a benefit to be
paid at date T.
The interest rate paid to the policyholder
may be either a minimum guaranteed
rate (δ) or a minimum guaranteed rate
combined with a discretionary rate e (β*I),
set as a function of the return received
by the insurer on investment (I) adjusted
for the technical interest rate (r).1 In this
way, it is possible to establish the following
relationship :
RT = max [(β*I – r)/ (1+ r) ; δ]
• Calculation of the guaranteed best
estimate
The minimum guaranteed benefit is a
function of the discount rate of guaranteed
future cash flows:
An EDHEC Financial Analysis and Accounting Research Centre Publication
BE garantee = S 0 (1+ δ) T * VT
where VT is the risk-fee discount factor.
• Calculation of the total best estimate
The total best estimate corresponds to a
discounting of the benefit to be paid YT
which integrates the guaranteed minimum
rate and the discretionary rate. The return
on the insurer’s investments is a function
of a forward rate (m(f)), calculated from
the risk-free rate.
So the valuation of technical provisions
for life insurance policies is similar to that
of options. First, an intrinsic value, which
does not take into account the effect of
the time value of the future benefit, is
determined:
Intrinsic value =
S0 * ∏ (1+ m (f T) * VT
Then, to integrate the time value, the future
return on investments (f) is adjusted by
the volatility of the return on stocks and
bonds:
f*T = fT + [σB (1-WE) + σ E WE] / √ T
where, according to QIS4, σB = 2.5% et
σE = 15%. WE is the fraction of equity
investments.
The simplification for the total best estimate
(the guarantee plus a discretionary share)
is:
BE ≈ S0 Vt ∏ [1+m(f t*)]
The value of future discretionary benefits
is thus:
FDB = BE – BE garantee
149
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009
2 - The combined ratio is
based on technical provisions
discounted as in Solvency II,
not as in Solvency I.
150 An EDHEC Financial Analysis and Accounting Research Centre Publication
Appendix
Appendix 9
Major Steps in the Calculation
of the Premium and Reserve Risk
Sub-Module of the Non-Life
Underwriting Risk Module
The capital charge (SCR NL pr) for the
combined premium and reserve risk
in non-life business is a function of
the measures of volume (V) and the
volatility of the combined ratio of the overall
portfolio (σ):2
SCR NL pr =ρ (σ)*V
where ρ (σ) is a function of the volatility
of the combined ratio calculated in such a
way that assuming a lognormal distribution
of the underlying risk (approximately
ρ (σ) = 3σ)), a risk capital charge consistent
with the VaR 99.5% standard is produced.
ρ (σ) = exp (N0.995*√log(σ²+1)) _ 1
√σ²+1
To calculate the measures of volume (V) and
of the volatility of the combined ratio (σ), the
regulator suggests a three-step approach:
• Step 1: calculation of V and σ for each line
of business LOB
• Step 2: integration of the geographic
diversification benefit for each line of
business LOB
• Step 3: aggregation of measures of V and
σ to calculate overall measures.
Step I:
Calculation of volume measures and standard
deviations (for premium and reserve risk) per
line of business LOB and geographic zone j.
This step is broken down into five smaller
components. (i to v).
• The measure of the volume of premium
risk V(prem, j, lob) for the line of business LOB
in geographic zone j is a function of net
premiums written for the coming year Pj
lob
t, written, of those for the preceding year
Pj, lobt-1, written and of net premiums earned
during the forthcoming year Pj, lobt earned.
V (prem, j, lob) = max (Pj, lobt, written;
Pj, lobt earned; 1.05*Pj, lobt-1, written)
• The volume measure of reserve risk is equal
to the best estimate of claims outstanding
PCO j, lob for line of business LOB in geographic
area j.
V (res, j, lob) = POC j, lob
• The standard deviation σ(prem, lob) of
premium risk is a function of the standard
deviation σ(U, prem, lob), specific to the
insurance company under consideration,
of that σ(M, prem ,lob) of the market, and of a
credibility factor clob defined for the lines
of business:
σ ( prem , lob ) = c lob • σ (2U , prem , lob ) + (1 − c lob ) • σ (2M , prem , lob )
The estimate of the standard deviation
σ (U,prem,lob) specific to the company is a
function of the volatility of historic loss
ratios LR :
σ ( U , prem , lob ) =
1
• ∑ Plob
y ,e
( y
• LR lob − μ lob )
2
(n lob
−1 ) • V( prem , lob ) y
où :
nlob is the number of historic years (at most
five, ten or fifteen, depending on the LoB). The
number should not take into account the first
three years after start up of the line of business;
V( prem ,lob ) = ∑V( prem , j ,lob )
j
is the sum of the
volume measure of premium risk per line of
business (lob) in geographic area j ;
LRloby is the net loss ratio in each of the lines
of business and for historic years y=t-1, t-2,…,
t-n.
 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Py,elob = ∑ j ,lob
3 - On the basis of the QIS4 P y ,ea rned is the sum of earned Step II:
results for the credibility j
factor for premium risk, net premiums in each line of business for Integration of the geographic
CEIOPS is studying the
the period (y=forthcoming year -1). diversification benefit for each line of
suitability of putting in place
a credibility factor per line business.
of business for reserve risk
as well. μlob =
∑ P • LR
y
y ,e
lob
y
lob
is the premium-
4 - V(prem, lob) = ∑j V(prem, j, lob)
and V(res, lob) = ∑j V(res, j, lob).
∑P y
y ,e
lob
Diversification is not allowed for the
5 - The Herfindahl index weighted average of historic loss ratios. miscellaneous (line 9) and credit and
is calculated as DIVpr, lob = suretyship insurance (line 6) lines of
∑(V(prem, j, lob) + V(res, j, lob))²/
[∑(V(prem, j, lob) + V(res, j, lob))]². The market-wide estimate of the standard business.
deviation for premium risk in the individual
line of business is determined by QIS4 as The geographically diversified volume
follows: measure for premium and reserve risk
LOB = 1 2 3 4 5 6 7 8 9 10 11 12
σ (M,prem, lob) 9% 9% 12.5% 10% 12.5% 15% 5% 7.5% 11% 15% 15% 15%
Source: QIS4

The credibility factor is a function of the Vlob is a function of the volume measures
number of historic years for which data of premium risk V (prem, lob), of reserve risk
are available: V(res, lob)4 and of the Herfindahl index

clob Number of historic years of data available (excluding the first three years after the line of business was
first written

Maximum 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
value of 15 0 0 0 0 0 0 0.64 0.67 0.69 0.71 0.73 0.75 0.76 0.78 0.79
nlob
10 0 0 0 0 0.64 0.69 0.72 0.74 0.76 0.79 - - - - -
5 0 0 0.64 0.72 0.79 - - - - - - - - - -
Source: QIS 4

• The standard deviation σ(res, lob) ) for DIVpr, lob5 : Vlob = (V (prem, lob) + V (res, lob)) *
reserve risk in the individual line of business
(0.75+0.25*DIV pr,lob)
LOB is determined by QIS4 as follows:

LOB3 = 1 2 3 4 5 6 7 8 9 10 11 12
σ(res, lob) 12 % 7% 10 % 10 % 15 % 15 % 10 % 10 % 10 % 15 % 15 % 15 %
Source: QIS 4

• The standard deviation for the premium Step III:

and reserve risk σ(lob) for each line of Aggregation of volumes and standard
business LOB, is defined by aggregating deviation for each line of business.
the standard deviation of the two sub-
risks σ(res, lob) and σ(res, lob) under the • The overall volume measure V is
assumption of a correlation coefficient of determined as follows: (V = ∑lob Vlob).
α = 0.5 :

2 2
(σ ( prem ,lob )
V( prem ,lob ) ) (
+ 2ασ ( prem ,lob ) σ ( res .lob )V( prem ,lob )V( res .lob ) + σ ( res ,lob )V( res ,lob ) )
σ ( lob ) =
V( prem ,lob ) + V( res ,lob )

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Appendix

• The overall standard deviation is a

function of σ(lob) the standard deviation
of each line of business in the first step,
of volume measures Vlob for the lines of
business in the second step, of a matrix of
the correlation of the lines of business:

The correlation matrix CorrLob is specified

as follows:

CorrLob 1 2 3 4 5 6 7 8 9 10 11 12
1: Motor (third-party) 1
2: Motor (other) 0.5 1
3: MAT 0.5 0.25 1
4: Fire 0.25 0.25 0.25 1
5: Third-party liability 0.5 0.25 0.25 0.25 1
6: Credit 0.25 0.25 0.25 0.25 0.5 1
7: Legal exp. 0.5 0.5 0.25 0.25 0.5 0.5 1
8: Assistance 0.25 0.5 0.5 0.5 0.25 0.25 0.25 1
9: Misc. 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 1
10: Reins. (property) 0.25 0.25 0.25 0.5 0.25 0.25 0.25 0.5 0.25 1
11: Reins. (casualty) 0.25 0.25 0.25 0.25 0.5 0.5 0.5 0.25 0.25 0.25 1
12: Reins. (MAT) 0.25 0.25 0.5 0.5 0.25 0.25 0.25 0.25 0.5 0.25 0.25 1
Source: QIS4

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 Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies — July 2009

Appendix

Appendix 10
Information about the Market Risk
Module

I. Information on the change in the term

structure of interest rates
The interest rate term structure is provided
by the regulator. For the QIS4 tests, it was
the following:
Year 1 2 3 4 5 6 7 8 9 10
Rate 4.6960% 4.5262% 4.5097% 4.5330% 4.5529% 4.5797% 4.6137% 4.6529% 4.6975% 4.7417%

Year 11 12 13 14 15 16 17 18 19 20
Rate 4.7843% 4.8197% 4.8508% 4.8775% 4.9006% 4.9197% 4.9365% 4.9514% 4.9648% 4.9769%

The shocks that must be tested on the term

structure of interest rates to determine the
capital charge for interest rate risk are:
Maturity t (years) 1 2 3 4 5 6 7
Relative change sup(t) 0.94 0.77 0.69 0.62 0.56 0.52 0.49
Relative change sdown(t) -0.51 -0.47 -0.44 -0.42 -0.40 -0.38 -0.37

Maturity t (years) 8 9 10 11 12 13 14
Relative change sup(t) 0.46 0.44 0.42 0.42 0.42 0.42 0.42
Relative change sdown(t) -0.35 -0.34 -0.34 -0.34 -0.34 -0.34 -0.34

Maturity t (years) 15 16 17 18 19 20+

Relative change sup(t) 0.42 0.41 0.40 0.39 0.38 0.37
Relative change sdown(t) -0.34 -0.33 -0.33 -0.32 -0.31 -0.31
Source: QIS4

For example, the “stressed” ten-year

interest rate R1(10) in the upward
stress scenario is determined as:
R1 (10 ) = R0 (10 ) • (1 + 0,42)
These upwards and downwards shocks
make it possible to determine two new
interest rate structures with which changes
in the net value of assets and liabilities can
be analysed.
Modified term structure of interest rates
Year 1 2 3 4 5 6 7 8 9 10
Upwards shock curve 9.11% 8.01% 7.62% 7.34% 7.10% 6.96% 6.87% 6.79% 6.76% 6.73%
Downwards shock curve 2.30% 2.40% 2.53% 2.63% 2.73% 2.84% 2.91% 3.02% 3.10% 3.13%

Year 11 12 13 14 15 16 17 18 19 20
Upwards shock curve 6.79% 6.84% 6.89% 6.93% 6.96% 6.94% 6.91% 6.88% 6.85% 6.82%
Downwards shock curve 3.16% 3.18% 3.20% 3.22% 3.23% 3.30% 3.31% 3.37% 3.43% 3.43%
Source: EDHEC Business School
An EDHEC Financial Analysis and Accounting Research Centre Publication 153
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Acronyms

Acronym Expression
ACAM Autorité de Contrôle des Assurances et Mutuelles
Adj Adjustment for risk-absorbing properties of future profit sharing and deferred taxation
Adj DT Adjustment for risk-absorbing properties of deferred taxation
Adj FDB Adjustment for risk-absorbing properties of future discretionary benefits
ALM Asset/liability management
ANA Adjusted net assets
BE Best estimate
BSCR Basic solvency capital requirement
BV Book value
CAPM Capital asset pricing model
CAT Catastrophe
CEIOPS Committee of European Insurance and Ocupational Pensions Supervisors
CFROI Cash flow return on investment
Conci Risk concentration charge per counterparty
Defi Counterparty default risk requirement
DFA Dynamic financial analysis
DIV Herfindahl index used for geographic diversification
DPS Discretionary profit sharing
EBITDA Earnings before interest, taxes, depreciation and amortisation
EEA European Economic Area
EEV European embedded value
EV Embedded value
EVA Economic value added
Expul Amount of last year’s administrative expenses (gross of reinsurance) for unit-linked business
g Perpetual growth rate
Gross SCR u/w Capital requirement, gross of reinsurance, for underwriting risk
GW Goodwill
Health cl Capital charge for long-term health claims risk
Health exp Capital charge for long-term health expense risk
Health LT Capital charge for long-term health underwriting risk
Health WC Capital charge for workers' compensation underwriting risk
Heath ac Capital charge for long-term health accumulation risk
Hfd Concentration index for financial derivatives exposure
Hint Concentration index for receivables from intermediaries
Hoce Concentration index for other credit exposures
Hre Concentration index for reinsurance exposure
IFRS International financial reporting standards
LGDi Loss given default per counterparty i
LOB Line of business
MAT Marine, aviation, transport
MCEV Market-consistent embedded value
MCR Minimum capital requirement
Mkt sp bonds Capital charge for spread risk of bonds
Mkt sp cd Capital charge for credit derivatives

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Acronyms

Mkt spstruct Capital charge for spread risk of structured credit

MV Market value
MVEP Market value of equity portfolios drawn from Global index
MVM Market value margin
n BSCR Net basic solvency capital requirement
n SCR Net solvency capital requirement
n SCR Mkt k Net solvency capital requirement for equity risk per activity k
NAV Net asset value
Net SCR u/w Solvency capital requirement, net of reinsurance, for underwriting risk
NP Net profit
OECD Organisation for Economic Co-operation and Development
OPln ul Basic operational charge for all businesses except unit linked
Pay Company’s gross earned premiums
PBR Price book ratio
PDi Counterparty i default probability
PSB Prudential source book
TP Technical provisions
QIS Quantitative Impact Study
R Implicit correlation
RAC Risk-adjusted Capital
Rc Return on capital
RoNAV Return on net asset value
ROCE Return on capital employed
ROE Return on equity
ROI Return on investment
ROIC Return on invested capital
RoRAC Return on risk-adjusted capital
RSM Required solvency margin
SCR Solvency capital requirement
SCR cat Capital charge for catastrophe risk
SCR def Capital charge for default risk
SCR dis Capital charge for disability, morbidity and sickness
SCR exp Capital charge for expense risk
SCR health Capital charge for health underwriting risk
SCR lapse Capital charge for lapse risk
SCR life Capital charge for life underwriting risk
SCR long Capital charge for longevity risk
SCR Mkt Capital charge for market risk
SCR Mkt conc Capital charge for market concentration risk
SCR Mkt eq Capital charge for equity risk
SCR Mkt fx Capital charge for currency risk
SCR Mkt int Capital charge for interest rate risk
SCR Mkt k Capital charge for market risk per activity k
SCR Mkt prop Capital charge for property risk
SCR Mkt sp Capital charge for spread risk

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Acronyms

SCR mort Capital charge for mortality risk

SCR nl Capital charge for non-life underwriting risk
SCR NL cat Capital charge for non-life catastrophe risk
SCR NL pr Capital charge for non-life premium and reserve risk
SCR op Capital charge for operational risk
SCR rev Capital charge for revision risk
SPV Special purpose vehicle
TSR Total shareholder return
UL Unit linked
V(RAC) RAC valuation
V (prem, lob) Volume measure for premium risk
V (res, lob) Volume measure for reserve risk
VaR Value at risk
WACC Weighted average cost of capital
Wcomp annuities Capital charge for workers' compensation underwriting risk
Wcomp CAT Capital charge for workers compensation catastrophe risk
Wcomp general Capital charge for workers compensation premium and reserve risk
XSi Excess exposure to counterparty i

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About the EDHEC Financial Analysis

and Accounting Research Centre

The Financial Analysis and Accounting Research Centre was created in 2006 around
the theme of company valuation. Cultural and technological changes now make
it possible to use multiple dynamic analyses, the cornerstone of which is the discount
rate. There is an abundance of academic research into the determination of the
discount rate, but the gap between academe and business seems to be growing wider
by the day. In practice, those who do the valuations often oversimplify, invalidating
their reasoning; they may even ignore theory and transform the discount rate into a black
box to hide the absence of objective and academic foundations in the determination
of the risk premium and of beta.

The objective of the EDHEC Financial Analysis and Accounting Research Centre is
to call into question certain financial paradigms, in particular that which consists of
separating idiosyncratic risk—because it is diversifiable—from the risk premium and to
provide the financial markets (financial analysts, investors, companies, rating agencies,
auditors) with new light on the discount rate and to recommend new ways to
determine it.

The great diversity of backgrounds is one of the advantages of the Centre (specialists
in financial analysis, in accounting, in law, researchers from academe or from business),
and it allows the Centre to take a multi-disciplinary approach to financial analysis:
company valuation, the impact of IFRS and Solvency II on insurance companies,
the impact of IFRS on the valuation and pricing of risk, the growing use of fairness
opinions, the status of the outside expert, and the measurement of intangible assets.

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EDHEC Position Papers and Publications

from the last four years

EDHEC Risk and Asset Management Research Centre

2009 Position Papers

• Amenc, N. Quelques réflexions sur la régulation de la gestion d'actifs (June).
• Sender, S. The European pension fund industry again beset by deficits (May).
• Lioui, A. The undesirable effects of banning short sales (April).
• Gregoriou, G., and F.-S. Lhabitant. Madoff: A riot of red flags (January).

2009 Publications
• Amenc, N., F. Goltz, A. Grigoriu, and D. Schroeder. The EDHEC European ETF survey (May).
• Martellini, L., and V. Milhau. Measuring the benefits of dynamic asset allocation strategies
in the presence of liability constraints (March).
• Le Sourd, V. Hedge fund performance in 2008 (February).
• La gestion indicielle dans l'immobilier et l'indice EDHEC IEIF Immobilier d'Entreprise
France (February).
• Real estate indexing and the EDHEC IEIF Commercial Property (France) Index
(February).
• Amenc, N., L. Martellini, and S. Sender. Impact of regulations on the ALM of European
pension funds (January).
• Goltz, F. A long road ahead for portfolio construction: Practitioners' views of an EDHEC
survey. (January).

2008 Position Papers

• Amenc, N., and S. Sender. Assessing the European banking sector bailout plans
(December).
• Amenc, N., and S. Sender. Les mesures de recapitalisation et de soutien à la liquidité
du secteur bancaire européen (December).
• Amenc, N., F. Ducoulombier, and P. Foulquier. Reactions to an EDHEC study on the
fair value controversy (December). With the EDHEC Financial Analysis and Accounting
Research Centre.
• Amenc, N., F. Ducoulombier, and P. Foulquier. Réactions après l’étude. Juste valeur ou
non : un débat mal posé (December). With the EDHEC Financial Analysis and Accounting
Research Centre.
• Amenc, N., and V. Le Sourd. Les performances de l’investissement socialement responsable
en France (December).
• Amenc, N., and V. Le Sourd. Socially responsible investment performance in France
(December).

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EDHEC Position Papers and Publications

from the last four years

• Amenc, N., B. Maffei, and H. Till. Les causes structurelles du troisième choc pétrolier
(November).
• Amenc, N., B. Maffei, and H. Till. Oil prices: The true role of speculation (November).
• Sender, S. Banking: Why does regulation alone not suffice? Why must governments
intervene? (November).
• Till, H. The oil markets: Let the data speak for itself (October).
• Amenc, N., F. Goltz, and V. Le Sourd. A comparison of fundamentally weighted indices:
Overview and performance analysis (March).
• Sender, S. QIS4: Significant improvements, but the main risk for life insurance is not
taken into account in the standard formula (February). With the Financial Analysis and
Accounting Research Centre.

2008 Publications
• Amenc, N., L. Martellini, and V. Ziemann. Alternative investments for institutional
investors: Risk budgeting techniques in asset management and asset-liability management
(December).
• Goltz, F., and D. Schröder. Hedge fund reporting survey (November).
• D’Hondt, C., and J.-R. Giraud. Transaction cost analysis A-Z: A step towards best execution
in the post-MiFID landscape (November).
• Amenc, N., and D. Schröder. The pros and cons of passive hedge fund replication
(October).
• Amenc, N., F. Goltz, and D. Schröder. Reactions to an EDHEC study on asset-liability
management decisions in wealth management (September).
• Amenc, N., F. Goltz, A. Grigoriu, V. Le Sourd, and L. Martellini. The EDHEC European ETF
survey 2008 (June).
• Amenc, N., F. Goltz, and V. Le Sourd. Fundamental differences? Comparing alternative
index weighting mechanisms (April).
• Le Sourd, V. Hedge fund performance in 2007 (February).
• Amenc, N., F. Goltz, V. Le Sourd, and L. Martellini. The EDHEC European investment
practices survey 2008 (January).

2007 Position Papers

• Amenc, N. Trois premières leçons de la crise des crédits « subprime » (August).
• Amenc, N. Three early lessons from the subprime lending crisis (August).
• Amenc, N., W. Géhin, L. Martellini, and J.-C. Meyfredi. The myths and limits of passive
hedge fund replication (June).

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EDHEC Position Papers and Publications

from the last four years

• Sender, S., and P. Foulquier. QIS3: Meaningful progress towards the implementation of
Solvency II, but ground remains to be covered (June). With the EDHEC Financial Analysis
and Accounting Research Centre.
• D’Hondt, C., and J.-R. Giraud. MiFID: The (in)famous European directive (February).
• Hedge fund indices for the purpose of UCITS: Answers to the CESR issues paper
(January).
• Foulquier, P., and S. Sender. CP 20: Significant improvements in the Solvency II
framework but grave incoherencies remain. EDHEC response to consultation paper n°
20 (January).
• Géhin, W. The Challenge of hedge fund measurement: A toolbox rather than a Pandora's
box (January).
• Christory, C., S. Daul, and J.-R. Giraud. Quantification of hedge fund default risk
(January).

2007 Publications
• Ducoulombier, F. Etude EDHEC sur l'investissement et la gestion du risque immobiliers
en Europe (November/December).
• Ducoulombier, F. EDHEC European real estate investment and risk management survey
(November).
• Goltz, F., and G. Feng. Reactions to the EDHEC study "Assessing the quality of stock
market indices" (September).
• Le Sourd, V. Hedge fund performance in 2006: A vintage year for hedge funds?
(March).
• Amenc, N., L. Martellini, and V. Ziemann. Asset-liability management decisions in private
banking (February).
• Le Sourd, V. Performance measurement for traditional investment (literature survey)
(January).

2006 Position Papers

• Till, H. EDHEC Comments on the Amaranth case: Early lesson from the debacle
(September).
• Amenc, N., and F. Goltz. Disorderly exits from crowded trades? On the systemic risks
of hedge funds (June).
• Foulquier, P., and S. Sender. QIS 2: Modelling that is at odds with the prudential objectives
of Solvency II (November). With the EDHEC Financial Analysis and Accounting Research
Centre.
• Amenc, N., and F. Goltz. A reply to the CESR recommendations on the eligibility of
hedge fund indices for investment of UCITS (December).

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EDHEC Position Papers and Publications

from the last four years

2006 Publications
• Amenc, N., F. Goltz, and V. Le Sourd. Assessing the quality of stock market indices:
Requirements for asset allocation and performance measurement (September).
• Amenc, N., J.-R. Giraud, F. Goltz, V. Le Sourd, L. Martellini, and X. Ma. The EDHEC European
ETF survey 2006 (October).
• Amenc, N., P. Foulquier, L. Martellini, and S. Sender. The impact of IFRS and Solvency II on
asset-liability management and asset management in insurance companies (November).
With the EDHEC Financial Analysis and Accounting Research Centre.

EDHEC Financial Analysis and Accounting Research Centre

2009 Publications
• Foulquier, P. Solvabilité II : une opportunité de pilotage de la performance des
sociétés d’assurance (May).

2008 Position Papers

• Amenc, N., F. Ducoulombier, and P. Foulquier. Reactions to an EDHEC study on the fair
value controversy (December). With the EDHEC Risk and Asset Management Research
Centre.
• Amenc, N., F. Ducoulombier, and P. Foulquier. Réactions après l’étude. Juste valeur
ou non : un débat mal posé (December). With the EDHEC Risk and Asset Management
Research Centre.
• Escaffre, L., P. Foulquier, and P. Touron. The fair value controversy: Ignoring the real
issue (November).
• Escaffre, L., P. Foulquier, and P. Touron. Juste valeur ou non : un débat mal posé
(November).
• Sender, S. QIS4: Significant improvements, but the main risk for life insurance is not
taken into account in the standard formula (February). With the EDHEC Risk and Asset
Management Research Centre.

2007 Position Papers

• Sender, S., and P. Foulquier. QIS3: Meaningful progress towards the implementation
of Solvency II, but ground remains to be covered (June). With the EDHEC Risk and Asset
Management Research Centre.

2006 Position Papers

• Foulquier, P., and S. Sender. QIS 2: Modelling that is at odds with the prudential
objectives of Solvency II (November). With the EDHEC Risk and Asset Management
Research Centre.

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EDHEC Position Papers and Publications

from the last four years

2006 Publications
• Amenc, N., P. Foulquier, L. Martellini, and S. Sender. The impact of IFRS and Solvency II on
asset-liability management and asset management in insurance companies (November).
With the EDHEC Risk and Asset Management Research Centre.

EDHEC Economics Research Centre

2009 Position Papers
• Chéron, A. Quelle protection de l’emploi pour les seniors ? (January).
• Courtioux, P. Peut-on financer l’éducation du supérieur de manière plus équitable ?
(January).
• Gregoir, S. L’incertitude liée à la contraction du marché immobilier pèse sur l’évolution
des prix (January).

2008 Position Papers

• Gregoir, S. Les prêts étudiants peuvent-ils être un outil de progrès social ? (October).
• Chéron, A. Que peut-on attendre d'une augmentation de l'âge de départ en retraite ?
(June).
• Chéron, A. De l'optimalité des allégements de charges sur les bas salaires (February).
• Chéron, A., and S. Gregoir. Mais où est passé le contrat unique à droits progressifs ?
(February).

2007 Position Papers

• Chéron, A. Faut-il subventionner la formation professionnelle des séniors ? (October).
• Courtioux, P. La TVA acquittée par les ménages : une évaluation de sa charge tout au
long de la vie (October).
• Courtioux, P. Les effets redistributifs de la « TVA sociale » : un exercice de microsimulation
(July).
• Maarek, G. La réforme du financement de la protection sociale. Essais comparatifs entre
la « TVA sociale » et la « TVA emploi » (July).
• Chéron, A. Analyse économique des grandes propositions en matière d'emploi des
candidats à l'élection présidentielle (March).
• Chéron, A. Would a new form of employment contract provide greater security for
French workers? (March).

2007 Publications
• Amenc, N., P. Courtioux, A.-F. Malvache, and G. Maarek. La « TVA emploi » (April).
• Amenc, N., P. Courtioux, A.-F. Malvache, and G. Maarek. Pro-employment VAT (April).
• Chéron, A. Reconsidérer les effets de la protection de l'emploi en France. L'apport d'une
approche en termes de cycle de vie (January).

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EDHEC Position Papers and Publications

from the last four years

2006 Position Papers

• Chéron, A. Le plan national d’action pour l’emploi des seniors : bien, mais peut mieux
faire (October).
• Bacache-Beauvallet, M. Les limites de l'usage des primes à la performance dans la
fonction publique (October).
• Courtioux, P., and O. Thévenon. Politiques familiales et objectifs européens : il faut
améliorer le benchmarking (November).

EDHEC Leadership and Corporate Governance Research Centre

2009 Position Papers
• Petit, V., and V. Boulocher. Equipes dirigeantes : comment développer la légitimité
managériale ? (May).
• Petit, V. Leadership : ce que pensent les top managers (May)
• Petit, V., and I. Mari. La légitimité des équipes dirigeantes : une dimension négligée de
la gouvernance d'entreprise (January).
• Petit, V., and I. Mari. Taking care of executive legitimacy: A neglected issue of corporate
governance (January).

EDHEC Marketing and Consumption Research Centre – InteraCT

2007 Position Papers
• Bonnin, Gaël. Piloter l’interaction avec le consommateur : un impératif pour le marketing.
(January).

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About Swiss Re

Swiss Re is a leading and highly diversified global reinsurer. The company operates
through offices in more than 20 countries.

Founded in Zurich, Switzerland, in 1863, Swiss Re offers financial services products that
enable risk-taking essential to enterprise and progress. Its clients comprise insurance
companies, captives, governments, NGOs, financial institutions as well as large
companies.

For over 145 years now, Swiss Re has committed itself to identifying and evaluating
emerging risks. Hence, the Group has gained comprehensive expertise in managing risk
and capital and has the ability to offer new solutions required by the new risk landscape,
characterised by more interconnected and complex risks. Swiss Re is well positioned to
be the preferred reinsurer for insurable risks, which include natural catastrophes on the
rise, terrorism, pandemics and ageing population.

The company offers traditional reinsurance products and related services for property and
casualty, as well as the life and health business, which are complemented by insurance-
based corporate finance solutions and supplementary services for comprehensive risk
management. Swiss Re is the industry leader in insurance-linked securities.

Swiss Re's ambition is to provide innovative and sustainable reinsurance solutions and
to meet continued demand for significant solvency support. The Group's strong value
proposition and its outstanding execution capabilities mean that it is well positioned
to assist clients in achieving their ambitious goals in terms of insurance risk-taking or
insurance sales growth.

Find out more about Swiss Re on www.swissre.com

Or contact directly Client Markets, Swiss Re Europe S.A., Succursale de Paris
by phone +33 1 43 18 30 00 or +33 1 43 18 30 94

Compagnie Suisse de Réassurances SA

Mythenquai 50/60
Boîte postale
8022 Zurich - Switzerland
Tél. : +41 43 285 2121 - Fax +41 43 285 2999
www.swissre.com

Swiss Re Europe S.A., Succursale de Paris

7, rue de Logelbach
75847 Paris Cedex 17 - France
Tél.: +33 1 43 18 3000 - Fax +33 1 42 12 9140

An EDHEC Financial Analysis and Accounting Research Centre Publication 167

EDHEC Financial Analysis
and Accounting Research Centre
393-400 promenade des Anglais
BP 3116
06202 Nice Cedex 3 - France
Tel.: +33 (0)4 93 18 32 53
E-mail: joanne .finlay@edhec.edu
Web: www.edhec.com