Putting a dampener on Solvency II

Technical papers

Solvency requirements for EU insurance undertakings are under review. As the current system has been perceived as being insufficiently risk-based, the European Commission has proposed a revision to the solvency standards under the so-called Solvency II project. This solvency framework for (re-) insurance undertakings is scheduled to be implemented in 2012. Like Basel II for banks it is founded on three pillars: financial requirements, including a risk-based solvency capital requirement (SCR) in Pillar I, management and supervisory practices in Pillar II, and supervisory reporting and disclosure requirements in Pillar III.

Recent market events have raised some concerns about risk-based solvency systems such as Solvency II. One concern is the volatility of asset prices. A sharp decline in asset prices could potentially lead to breaches of solvency requirements. This could then lead to fire sales of assets, which in turn would depress prices even further, creating a vicious cycle. Some view declines in asset values as a short-term effect that has no bearing on the long- term return, and believe insurance companies, due to the long-term nature of their investments, should not be forced to take such declines in value into account when determining solvency requirements. In this way, they hope to eliminate incentives to sell off their assets during periods of downturn.

Several measures have been proposed to address this issue within Solvency II. These focus either on Pillar II measures (own risk and solvency assessment, longer recovery period when in breach of the SCR) or on quantitative Pillar I measures focused on addressing equity market volatility, such as 'dampener' approaches. One such dampener proposal is included in the fourth quantitative impact study (QIS4) of CEIOPS.1

Mohamed Lechkar ([email protected]) and Dennis van Welie ([email protected]) are policy advisers in the quantitative risk management department at De Nederlandsche Bank (DNB). They have written this article in a personal capacity. The authors want to thank Marc Propper for valuable comments.

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