Captives
and Solvency ii
Captive
Insurance and Captive Reinsurance Companies after the Solvency ii
Directive
from the Solvency ii
Association, the largest Association of Solvency ii Professionals
in the world
PROPORTIONALITY - LEVEL 2
MEASURES
CEIOPS-CP-45/09, 2 July 2009,
Consultation Paper No. 45
Draft CEIOPS’
Advice for Level 2 Implementing Measures on Solvency II: Technical
Provisions – Article 85 h, Simplified
methods and techniques to calculate technical
provisions
3.
Advice
3.1 Proportionality
3.1.1 Role of proportionality in
the valuation of technical provisions
3.1 This
sub-section considers the overall purpose and role of a proportionality
assessment
in the valuation of technical provisions.
It first sets out how such an
assessment is interlinked with the selection of an appropriate
valuation methodology.
It then considers the notion
of estimation uncertainty (or model error)
and sets out why this is central to a proportionality assessment.
Finally, it introduces the
notions of “simplified methods” and approximations and
considers their role in the
valuation
process.
Selection of
valuation methodology
3.2 Solvency II envisages
a principles-based approach to the
valuation of technical provisions.
This means that the regulatory
requirements relating to the valuation process would generally not prescribe any
specific
approaches to carrying out the valuation.
Instead, there will typically
be a range of different approaches which
are available to the (re)insurance undertaking, which then has to
select a valuation methodology which is appropriate with regard to
the valuation principles established under
Solvency
II.
3.3 Within this context,
the principle of proportionality requires
that the (re)insurance undertaking should be allowed to
choose and apply a valuation method which
is:
•
Suitable to achieve the objective of deriving a market-consistent
valuation according to the Solvency II principles;
but
• Not more
sophisticated than is needed in order to reach this
objective.
3.4 Considering that the
valuation of technical provisions under Solvency II aims at properly
reflecting the risks underlying the obligations, this means that
undertakings should be allowed to choose valuation methods which
are:
•
Compatible with the Solvency II valuation principles;
and
•
Proportionate to the nature, scale and complexity of the
risks
3.5 In this way application of the principle of proportionality
allows a reduction of the complexity of
the valuation methodology where this is still
proportionate to the underlying risk profile of the
portfolio, enabling (re)insurance undertakings to minimise resources in form of e.g. actuarial expertise
or IT implementation costs.
3.6 It is noted that in
the recitals to the Level 1 text, the importance of the principle of
proportionality is explicitly linked to the need to avoid
excessive strain on small and medium-sized
undertakings
This does however not mean
that an application of the principle of
proportionality is restricted to small and medium-sized
undertakings, nor does it mean that size is the
only relevant factor when the principle is considered.
Instead, the individual risk
profile should be the primary guide in assessing the need to apply
the proportionality principle.
Hence where a (simplified) valuation technique is proportionate to the underlying risks and compatible
with the Solvency II valuation techniques, it would be
appropriate for application by the (re)insurance undertaking
irrespective of its size.
Estimation
uncertainty and its link to proportionality
3.7 Due to the uncertainty of future events, any “modelling” of future cash (implicitly or
explicitly contained in the valuation methodology) flows will
necessarily be imperfect, leading to a certain degree of
inaccuracy and imprecision in the measurement.
Sources for this estimation
uncertainty or “model error” are for
example the possibility that the assumptions and parameters used in
the model are incorrect, or that the model itself is deficient.
-----------------------------------------------------------------------------------------------
[In the following, the terms
“estimation uncertainty” and “model error” are used
synonymously.
Hence the term “model error” is uses in a broad sense,
comprising the possibility that the assumptions and
parameters
used in the model are incorrect (in other sources,
this latter risk is sometimes denoted as “parameter
risk” as
distinguished from model risk).
In this context, uncertainty does not refer to the randomness of
future outcomes (sometimes referred to as volatility risk
or process risk),
but to the fact that the nature of this randomness is itself
unknown.
The uncertainty of the risk in
terms of volatility risk or process risk is an inherent quality of
the risk (independent
of the valuation method applied) and is
assessed as part of the nature of the risk]
----------------------------------------------------------------------------------
3.8 Where simplified
approaches are used to value technical provisions, this could
potentially introduce additional uncertainty (or model error).
This is the case
since:
• Often simplified
method are used in situations where there is a lack of
undertaking-specific claims data, in which case the setting of
the parameters and assumptions used in the method will usually
require a considerable amount of judgment;
and
• Due to
its simplicity the method may not be able to fully capture
the nature, scale and complexity of the risks arising from the
contracts.
3.9 The degree of model
error in the measurement of technical provisions is closely linked
to the reliability and suitability of the valuation.
Indeed, the higher the estimation uncertainty, the more
difficult it will be for the (re)insurance undertaking to rely on
the estimation and to verify that it is suitable to achieve the
objective of deriving a market-consistent valuation according to the
Solvency II principles.
3.10 With regard to the
principle of proportionality, these considerations show that the
crucial point in applying this principle consists in assessing the
model error that results from the use of a given valuation
technique.
Simplified
methods
3.11
Typically, there will be a range of different
valuation methods available to the (re)insurance undertaking,
differing in their degree of complexity and sophistication.
Following the proportionality principle as expressed in para.
3.4 will enable the undertaking to simplify a
given valuation method in case where the
simplified method is still proportionate to the underlying
risks.
3.12 In this case, the
term “simplified method” would refer to a situation
where a specific valuation technique has been simplified in
line with the proportionality principle.
In a loose sense, the term
“simplified method” (or “simplification”) could also be used to
refer to a valuation method
which is considered to be simpler
than more complex “commonly used” methods.
3.13 However, it should be
noted that any such distinction between “simplified” and
“non-simplified” methods would necessarily be rather vague and is
unlikely to lead to a clear categorisation of methods.
This is so
because:
• A method which is appropriate for an (re)insurance undertaking’s
particular book of business need not be
appropriate for the book of business of another undertaking,
even within the same line of business; hence it would be difficult
to define any “default” methods which would be appropriate for all
undertakings;
• Within a line of
business, it is common practice for different
valuation methods to be applied, hence in general
there is no single “best practice” method which could be used as a
benchmark or reference;
• Best
practice evolves over time, and so likewise any notion of
what is considered as “more simple” than best practice would not be
static;
• Even where a benchmark method could be established,
in practice it would be very difficult to decide whether a given
valuation method is more simple than the benchmark
method.
3.14 In light of these
considerations, it would not seem appropriate to introduce in Level
2 (on basis of a "hard" definition of what can be considered to be a
“simplified” method) a categorisation of the range of available
methods for the valuation of technical provisions into “simplified”
methods and “non-simplified” methods.
Approximations
3.15 For the valuation of technical provisions,
the amount and quality of the statistical data underlying the
calculation is of central importance.
The Level 1 text therefore
stipulates that (re)insurance undertakings should have in place
internal processes and procedures to ensure the appropriateness,
completeness and accuracy of such data.
3.16 Under certain
circumstances, however, it will be unavoidable
for the undertaking to have only insufficient company-specific data
of appropriate quality to apply a reliable statistical
actuarial method for the determination of technical
provisions.
It is therefore important to
develop valuation techniques which would substitute a lack of
company-specific data by e.g.
using external market
information.
3.17 In the Solvency II
debate, the term “proxy” was introduced to denote such
valuation techniques.
In view of their practical
relevance, a number of proxy techniques have been included in the
QIS4 exercise.
In the Level 1 text, such
techniques are referred to as “approximations”.
3.18 Where approximation
techniques are applied these would typically be based on a fixed set
of assumptions and would tend to be less complex than techniques
which carry out explicit cash flow projections based on
undertaking-specific data.
Approximations may therefore
often be regarded as a specific kind of simplified methods (where
the simplification
is due to a lack of
data).
Role of
simplified methods in the valuation
framework
3.19 We note that CEIOPS
has laid out advice with regard to actuarial and statistical
methodologies for the calculation of the best estimate (as requested
in Article 85(a)).
This has regard
to:
• The
quality and selection of valuation
techniques;
• The
elements that need to be taken into account when estimating the
future cash-flows;
• The
setting of assumptions underlying the valuation;
and
• The
validation methods for ensuring the quality of the
valuation.
3.20 Where the
(re)insurance undertaking selects a valuation methodology
(irrespective of whether this is regarded as a simplified method or
an approximation), it should be appropriate for the calculation of
the technical provision.
Hence, the principles-based
expectations and requirements set out in CEIOPS’ advice as referred
to above are intended
to apply generally, including the use of
approximations and simplified methods and
techniques.
3.21 In this context, it
is noted that Consultation Paper 26 introduces a distinction between
simulation, analytic and deterministic techniques.
A (stochastic) simulation
technique would involve choosing a (suitably large) number of
scenarios which are representative of all possible futures, as for
example in a Monte Carlo simulation.
In contrast, analytical
techniques (based on closed-form solutions) and deterministic
techniques (based on a fixed set of assumptions) would generally be
less complex and capture the uncertainty in the valuation in a more
implicit way.
Hence it can be expected that
simplified methods or approximations would typically lead to an
application of analytic or deterministic
techniques.
3.22 In the same way, the
principle of proportionality should apply generally when a valuation
methodology is chosen, allowing (re)insurance undertakings the
flexibility to select a technique which is proportionate to the nature, scale and complexity
of the underlying risks:
The following sub-sections
will elaborate further on how such a
proportionality assessment could be carried
out.
3.23 Notwithstanding,
following Article 85(h) it could be contemplated to specify
individual simplified methods under Level 2 which (re)insurance
undertakings may use under certain conditions, thus complementing the principles-based approach to
the valuation of technical provisions.
The feasibility of this option
– with regard to individual components of the valuation such as best
estimate, risk margin and reinsurance recoverables – is discussed in
section 3.2 below.
PROPORTIONALITY - LEVEL 2
MEASURES
CEIOPS-CP-45/09, 2 July 2009,
Consultation Paper No. 45
1.
Introduction
2.
Advice - Proportionality
3.
Proportionality Assessment – A three step process
4.
Simplified Methods
5.
Reinsurance Recoverables
6.
Annex A: Gross-to-net Techniques
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