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Calculating Market Value Margins with a Cost of Capital Approach (“CoC”) under the QIS 2 framework. Comité Européen des Assurances. Contents. Calculating Market Value Margins with a Cost of Capital Approach under the QIS 2 framework. Introduction and methodology used Guide to the spreadsheet
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Calculating Market Value Margins with a Cost of Capital Approach (“CoC”) under the QIS 2 framework Comité Européen des Assurances COMITE EUROPEEN DES ASSURANCES
Contents Calculating Market Value Margins with a Cost of Capital Approach under the QIS 2 framework • Introduction and methodology used • Guide to the spreadsheet • Other approaches COMITE EUROPEEN DES ASSURANCES
Introduction & methodology MVM using CoC approach in QIS 2 • The industry clearly supports a CoC approach for the calculation of a Market Value Margin (“MVM”) for non hedgeable risks. • The percentile approach requires significant data analysis and sophisticated calculation methodologies and is not clearly connected to the concept of a MVM. This was a major concern for SMEs in QIS1. • The CoC is a workable solution for companies of all sizes and is the only suggested proxy so far for the MVM that is consistent with an economic approach. • In order to facilitate the CoC approach in the QIS 2 exercise, the CEA project team has adapted the QIS 2 spreadsheets so companies can calculate the Market Value Margin in a simple way. • The methodology followed is similar to the one applied for CEA’s European Standard Approach (“ESA”). Full details about the methodology can be found in CEA’s Working Document on Cost of Capital1. • More sophisticated approaches towards the calculation of the MVM can be taken, we have described some of these options in the final section of this document. • As a reminder, the Market Value Margin calculated with a cost of capital approach is based on three drivers. • The amount of capital that needs to be held to cover non hedgeable risks. • The annual cost of holding that capital • The length of time that this capital needs to be held 1 This document is available at: www.cea.assur.org. COMITE EUROPEEN DES ASSURANCES
Introduction & methodology MVM using CoC approach in QIS 2 • The amount of capital that needs to be held (SCRCoC) is calculated as defined in the QIS2 specification with adjustments as explained in the next section. • The cost of holding capital is set to 6% as in the SST, which is the default option for the calculation of the MVM under QIS 2. • The method to determine for the length of time that the capital needs to be held is done in two possible ways. This is to maximise the participation on QIS2. The methods are: • Alternative 1: Relating the run-off of the SCRCoC to the development of the BEL. • Alternative 2: Relating the run-off of the SCRCoC to a factor based on the duration of the liabilities. • In order to avoid circularity the MVM is not used as an input for the calculation of the SCR: • This means that the SCR calculation is based on the BEL without including the MVM (neither the 75th percentile nor the MVM calculated following the CoC approach) • This approach is equivalent to making the assumption that the MVM will remain equal before and after the shock. • As the MVM is a relatively small proportion of the market consistent liability, this simplifying assumption has only a second order impact on the results but means that circularity is completely avoided . COMITE EUROPEEN DES ASSURANCES
Calculating Market Value Margins with a Cost of Capital Approach under the QIS 2 framework - Contents • Introduction and methodology used • Guide to the spreadsheet • Other approaches COMITE EUROPEEN DES ASSURANCES
Guide to the spreadsheet Changes to the spreadsheet • A spreadsheet is provided with this document to facilitate the calculation of the MVM. • The spreadsheet is based in the one distributed by CEIOPS and no alterations to the formulas have been made. It is important to note that a new spreadsheet will be released by CEIOPS on the 24th of May. As a result, this may require an update to this CoC spreadsheet. • The calculation of the MVM has been introduced by creating additional worksheets where all the necessary calculations are made: • Worksheet ‘CoC Calculation’: Contains the basic steps in the calculation of the MVM both using the run-off of Best Estimate Liabilities and a simplified factor based alternative. • Some adjustments are made to the SCR calculation for credit risk and Non Life Underwriting: • Worksheet ‘SCR Adjustment - Credit’: • The credit risk does not include risk arising from financial assets. Only the exposure to reinsurance is included. • Worksheet ‘SCR Adjustment - NL Underw.’: • Underwriting risk should only reflect run-off risks. The volume measure for premium and catastrophe risk is changed to undiscounted Unearned Premium Reserve. COMITE EUROPEEN DES ASSURANCES
Guide to the spreadsheet MVM using CoC approach in QIS 2 – Alternative 1 • The calculation of the MVM is done on the worksheet ‘CoC Calculation’. Two alternatives are given for the calculation. • Alternative 1 is based on the development of the BEL: • Step 1: Calculation of the SCRCoC at time 0 (CELLS B5:M35) • SCRCoC is calculated by taking out market risk and using the adapted credit and underwriting risk SCR. • SCR is considered before any risk absorption by future profit sharing. • The ratio of the initial SCRCoC over the BEL is calculated (CELL D33). • Step 2: Calculation of the projected SCRCoC(CELLS B40:M96) • The SCRtCoC is calculated for all the run off by applying the above ratio to the future development of the BEL. • The run-off of the BEL is a required input for this calculation. • Step 3: Calculation of the capital charges(CELLS B98:M151) • Capital charges are calculated by applying the cost of capital (6%) to the SCRtCoC at each future point in time. • Step 4: Calculation of the MVM(CELLS B154:M208) • The MVM is calculated as the present value of capital charges, calculated at the risk free rate using the term structure provided by CEIOPS. COMITE EUROPEEN DES ASSURANCES
Guide to the spreadsheet MVM using CoC approach in QIS 2 – Alternative 2 • For those companies who may not be able to provide the future development of the BEL a simplified calculation is presented. • Alternative 2 uses a factor applied to the initial SCRCoC in order to calculate the MVM. • Step 1: Calculation of the SCRCoC at time 0 (CELLS B5:M35) • SCR is determined in the same way as in Alternative 1. • Steps 2-4: Calculation of the MVM(CELLS B211:M221) • The MVM is calculated by applying a factor to the initial SCRCoC. • The factor is dependent on the duration of liabilities. It is calculated as an annuity factor times the cost of capital of 6%. • The annuity factor is based on the duration of the liabilities and the relevant yield rate for that duration following the term structure used for QIS2. COMITE EUROPEEN DES ASSURANCES
Calculating Market Value Margins with a Cost of Capital Approach under the QIS 2 framework - Contents • Introduction and methodology used • Guide to the spreadsheet • Other approaches COMITE EUROPEEN DES ASSURANCES
Other approaches More sophisticated methods • The solutions suggested in this paper are simple and workable alternatives that will help maximise participation in QIS 2. • More sophisticated approaches are possible that will tailor the methodology to a company’s own individual circumstances. This include: • A full calculation of the SCRCoC for each year (most likely using an internal model) • Relating the development of the SCRCoC to the risk drivers for the individual risks. For more details see A Primer for Calculating the Swiss Solvency Test “Cost of Capital” for a Market Value Margin by Philipp Keller. • Implementation of an iterative process that would allow to include the MVM in the calculation of the SCR yet avoiding circularity. 2 This document is available at: www.cea.assur.org. COMITE EUROPEEN DES ASSURANCES
Contact details • CEA has opened a helpdesk to help participants with any questions they may have on QIS2.In case of you have any questions regarding this document or other QIS2 issues please contact: QIS2-helpdesk@cea.assur.org 2 This document is available at: www.cea.assur.org. COMITE EUROPEEN DES ASSURANCES