Insurers grapple with Solvency II economic capital projections

Solvency II’s requirement for insurers to project capital calculations forward over a number of years is a significant challenge for insurers that are still grappling with modelling their year-one requirements. As Clive Davidson finds, there is significant variation between insurers on how to model forward-looking balance sheets, with most companies still developing their approach

One of the major distinctions between Pillar I and Pillar II of Solvency II is that the first takes a snapshot of the here and now, while the latter looks more towards the future. The quantification requirements of Pillar I are based on a ‘time-zero’ balance sheet, with own funds and capital calculated to meet obligations over the next 12 months, whereas the Own Risk and Solvency Assessment (Orsa) of Pillar II is forward-looking and covers the business planning period.

With many insurers still struggling to properly calculate their capital one year out under the new rules as well as perform the stress tests that the Orsa requires, the prospect of modelling a forward-looking balance sheet and the associated capital for the full business planning period can present a significant challenge. Yet it is early days, and insurers are still getting the measure of the task and exploring ways of making the problem more manageable.

“The solvency capital calculations for time-zero balance sheets are complicated, and projecting these [forwards] adds an extra layer of complexity,” says Jim Black, finance director, heritage division, at Friends Life.

For products with significant options and guarantees, such projections can be particularly challenging. Issues can also arise when projecting the impact of stresses and [other] scenarios.  In addition, the modelling of appropriate levels of future new business and allowing for future strategic decisions adds complexity.

“Insurers are complex beasts and what they are trying to do [in the Orsa] is to predict possible futures and at same time predict how their company will change with those future scenarios,” says Theresa Chew, senior consultant at consultancy Towers Watson in London.

“There are many different possible futures and many unknowns, such as economic conditions, how much new business will they write, or how many policies will make a claim or leave the book. All these different things must be brought together into a forward-looking balance sheet,” Chew adds.

Solvency II does not prescribe how far forward insurers must project their balance sheet and acknowledges that firms operate different business planning periods. However, the European Insurance and Occupational Pension Authority (Eiopa) says in its Orsa guidelines that “any regularly developed business plan or changes to an existing business plan need to be reflected in the Orsa process taking into account the new risk profile, business volume and mix as expected at the end of the projection period at least annually”.

Three to five years is typical for business planning in the industry today, and over this time period firms must test a range of possible scenarios. This, says Eiopa, is to provide “a proper basis for decision-making and identify material risks and the consequences for solvency inherent in the business plan”.

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Insurers grapple with Solvency II economic capital projections

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