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Solvency II: Pillar 1 - Standard formula
The Solvency II standard formula consists of a number of risk modules whose outcomes are aggregated step by step to reach a single capital requirement.
The outcome of a risk module is usually determined by calculating how a prescribed scenario would affect the insurer’s balance sheet. In the case of equity risk – i.e. the risk which an insurer runs by investing in equities – the scenario would be a sharp fall in the stock market. The outcome of the module is the decline in the insurer’s own funds as a result of the scenario. There are also some modules whose outcome is the product of an explicit calculation instruction, which is known as the factor-based approach.
The outcomes of all risk modules are then aggregated step by step. For this purpose, use is made of correlations that show the connection between different risk modules. Basically, these correlations provide an estimate of the probability of different risks occurring simultaneously. In cases where risks always occur simultaneously the outcomes of the modules must be aggregated to determine the capital requirement. If risks do not occur simultaneously, they are said to be diversified and the capital requirement is lower than the sum of the modules.
The main modules are market risk (investment), life underwriting, health underwriting and non-life underwriting. These modules themselves consist of sub-modules. In the case of market risk the sub-modules deal separately with interest rate risk, equity risk, property risk, corporate bond risk and foreign currency risk. There is also a module that identifies an excessive concentration of investments in a single business or institution as a risk. In the case of life underwriting the various risk drivers such as longevity, lapse and expenses are identified separately. The sub-modules for health and non-life underwriting involve aggregating the risk of future claims for potential events that are already covered and the run-off risk for claims in respect of events that have already occurred to determine the insurance underwriting risk. In the case of non-life underwriting, this is done separately for the various distinct lines of business such as fire, motor vehicle, transport, etc. The health underwriting risk module includes medical expenses insurance (basic insurance) and income protection insurance.
Besides the modules described above, there is also a counterparty default risk module, which takes account of the default risk of a reinsurer or to other counterparty. In the case of catastrophe risk, there are scenarios prescribed for specific sectors whose outcomes are also aggregated step by step.
In addition to the aggregated outcome of the risk modules described above, a factor-based outcome for operational risk is added to the capital requirement.