Mitigation of underwriting risks

Answer:

Insurers may use risk mitigation techniques to reduce the risks they are exposed to. Whether this also leads to a lower SCR depends on whether the risk-mitigation technique complies with the relevant Solvency II requirements. The valuation of the risk-mitigation technique on the Solvency II balance sheet depends on the type of risk-mitigation technique chosen by the insurer. This Q&A outlines the various aspects of Solvency II regulations for the valuation and recognition of risk-mitigation techniques for underwriting risks.

“Risk-mitigation techniques” means all techniques which enable insurers to transfer part or all of their risks to another party (Article 13(36) of the Solvency II Directive). In any case, if the insurer does not actually transfer risk, there is no risk mitigation technique.

Depending on the risk-mitigation technique chosen and whether the standard formula or an internal model is applied, different provisions and concerns apply:

• Solvency capital requirement (SCR): Insurers using the standard formula for the calculation of their SCR are subject to different requirements for the recognition of mitigation using the risk-mitigation technique than insurers using an internal model for that calculation. For the purposes of calculating the SCR, it makes no difference whether the insurer uses a financial instrument, reinsurance, special purpose vehicle or other instrument as a risk-mitigation technique. However, specific additional requirements for these types of risk mitigation techniques apply to the calculation based on the standard formula.
  
  
• Valuation and risk margin: Insurers using a reinsurance or special purpose vehicle use a different valuation method for those instruments than insurers using a financial instrument or another risk-mitigation technique. This will also have an impact on the risk margin. Whether an insurer uses the standard formula or an internal model makes no difference to the valuation and how the insurer determines the risk margin.

Calculation of the solvency capital requirement (SCR) with the standard formula

Recognition of the risk-mitigating effect of the risk-mitigation technique under the standard formula is based on the requirements set out in Articles 209 and 210 of the Solvency II Regulation.

One of the requirements is that the contractual arrangement applicable to the risk-mitigation technique does not result in material basic risk or the creation of other risks, unless this is reflected in the calculation of the SCR (Article 210(2) and (3) of the Solvency II Regulation). This means that any material base risk or other risks should also be reflected in the required calculation of the SCR according to the standard formula, otherwise the calculation of the SCR would not reflect this base risk or other risks. If that requirement is not met, the insurer cannot take into account the risk-mitigating effect of the contractual arrangement in the calculation of the SCR at all. Insurers can use the EIOPA ‘Guidelines for Basic Risk’ (EIOPA-BoS-14/172) to determine whether the base risk is material or not. Basic material risk may arise as a result of, among other things,

• the difference between the insurer’s insurance liabilities and the basis for the instruments (e.g. national mortality instead of the mortality in the portfolio in case of longevity risk mitigation)
  
  
• any early termination options
  
  
• any projections, pre-calculations and other estimation methods to determine the payment of the hedging instrument (such as commutation mechanisms).

Non-proportional reinsurance may be a cause of material (basic) risk that is not reflected by the standard formula. However, the standard formula already provides for an adjustment in the case of non-proportional reinsurance, see Articles 117(3) and 148(3) of the Solvency II Regulation for the calculation of the standard deviation for NSLT health premium and reserve risk. In those cases, those modules already reflect the risks arising from the non-proportional reinsurance and therefore no basic risks arise as a result of the non-proportional reinsurance. This does not mean, however, that there cannot be other causes for material basis risk, nor does it automatically mean that the relevant non-proportional module in the standard formula is appropriate for the risk, after this non-proportional reinsurance.

In addition, depending on the type of instrument used by the insurer to mitigate a risk, specific additional requirements apply:

• For risk mitigation through reinsurance or a special purpose vehicle, Article 211 of the Solvency II Regulation applies.
• If the insurer uses a financial instrument, Article 212 of the Solvency II Regulation is relevant.

Depending on the status of the counterparty, the requirements set out in Article 213 of the Solvency II Regulation may also apply for the recognition of the risk-mitigating effect of the risk-mitigation technique.

Calculation of the SCR using an internal model:

For recognition of the risk-mitigating effect of a risk-mitigation technique in a life insurer with an internal model, the requirements set out in Article 235 of the Solvency II Regulation apply. Paragraph 1 of that article describes situations in which the insurer does not recognise the risk-mitigating effect of the risk-mitigation technique in its internal model and thus cannot reduce its SCR.

Unlike the standard formula, the recognition of risk-mitigation techniques in internal models does not explicitly exclude the creation of material base risk or the creation of new risks that are not reflected in the SCR. However, Article 235(3) of the Solvency II Regulation provides that such risks are not correctly reflected in the internal model, unless the internal model takes into account any reduced effectiveness of the risk-mitigation technique. This can be done, for example, by explicitly modelling the base risk or the new risks in the internal model.

Valuation and risk margin of reinsurance and special purpose vehicle:

If the insurer transfers underwriting risks to another (re)insurer through a reinsurance agreement or to a special purpose vehicle through an agreement, as referred to in Article 211 of the Solvency II Regulation, the valuation of the amounts that the insurer can recover is subject to the provisions of Section 3:67 of the Financial Supervision Act (Wet op het financieel toezicht – Wft) and Articles 41 and 42 of the Solvency II Regulation. In addition, Guidelines 78 to 81 of the EIOPA Guidelines for the valuation of technical provisions (EIOPA-BoS-14/166) contain relevant information. The valuation of amounts recoverable from reinsurance agreements and special purpose vehicles is subject to an adjustment for expected losses due to default of the counterparty.

In calculating the risk margin, the insurer assumes that the reference undertaking also takes over the agreement with the (re)insurer or special purpose vehicle to hedge the risk in accordance with Article 38 of the Solvency II Regulation. This results in a reduction in the risk margin compared to the situation without these instruments.

Valuation and risk margin of financial instruments:

The valuation of a financial instrument must be carried out in accordance with Sections 3:69a et seq. of the Wft and Articles 9 to 16 of the Solvency II Regulation. The EIOPA Guidelines for the recognition and valuation of assets and liabilities other than technical provisions (EIOPA-BoS-15/113) are also relevant. The valuation of a financial instrument may include, in addition to a best estimate of revenue, a risk premium for the risk covered by the financial instrument. This risk premium is similar to the risk margin of the hedged risk, but the calculation and amount of this risk premium may deviate from the Solvency II risk margin; the valuation of the financial instrument including the risk premium is a market-consistent valuation in line with Articles 9 to 16 of the Solvency II Regulation, while the insurer calculates the risk margin according to Articles 37 to 39 of the Solvency II Regulation. In addition, the valuation of the financial instrument includes not only a deduction for expected losses due to default, but also an additional deduction for the risk compensation for this credit risk.

In calculating the risk margin, the insurer assumes that the reference undertaking does not take over the financial instrument to hedge the risk in accordance with Article 38 of the Solvency II Regulation. Therefore, hedging a risk with a financial instrument does not reduce the risk margin. On the other hand, the valuation of the financial instrument may involve a risk premium that contributes to the insurer's own funds. The valuation of amounts recoverable from other (re)insurers and special purpose vehicles does not carry a risk margin or risk premium. In this way, these instruments imply a reduction of the risk margin and contribute to the insurer's own funds.