‘Flawed’ standard formula currency risk calibration needs revision - Insurance Europe

currency

Insurance Europe, the pan-European industry trade body, is lobbying policy-makers to revise the standard formula's calibration for currency risk in light of evidence that the present methodology is not fit for purpose.

Research conducted by the trade association suggests that the current wording in the draft level 2 text does not reflect the real currency risks faced by insurers, and acts as a deterrent against the holding of asset reserves in local currencies. A report published by Insurance Europe in March called the calibration "flawed" and opposed to Solvency II's fundamental principles.

As it stands, the currency risk charge is calculated as 25% of the sum of net asset values (assets minus liabilities) held in foreign currencies within each entity. This incentivises firms to hold all surplus assets at the group level in a single currency to reduce their exposure to the charge.

Market participants argue that this approach does not accord with good risk-management practices. David Simmons, managing director of analytics at reinsurance broker Willis Re in London, says: "The currency risk charge is counter-intuitive, as you would think any surplus is actually best spread across the currencies you are exposed to, but the standard formula penalises any surplus not held in the reporting currency."

Insurance Europe has petitioned the European Insurance and Occupational Pensions Authority (Eiopa) and the European Commission repeatedly in recent years to alter the calibration to make it more reflective of best practice. They propose to replace it with a Currency Risk Exposure (CRE) calculation that applies a charge based on the mismatch between assets and liabilities held in foreign currencies. Members of the association are now hopeful that there will be changes made to the calibration once the level 1 text is finalised.

André-Philippe Sende, a Brussels-based policy adviser at Insurance Europe, explains: "In discussions we have had with the commission on currency risk, they understood our position and even said it was very sensible. The industry would very much like to see a change in the sub-module happen once Omnibus II is passed."

The industry's preoccupation with the long-term guarantees package and other aspects of the standard formula is blamed by experts for the marginalising of the currency risk problem. Willis Re's Simmons says: "Currency risk is not going to be one of the big capital drivers for most Solvency II companies. The focus has been on underwriting risk, reserve risk, cat risk and the like, so I think some of these smaller issues may have fallen through the cracks to a degree."

However, the outcome of the calibration will be of great importance to all firms that write business in multiple currencies – even those applying to use an internal model for the calculation of the solvency capital requirement. There is a strong concern that supervisors will refer to the standard formula as a benchmark against which internal model outputs will be judged.

Colin Murray, Dublin-based consulting actuary at Towers Watson, explains that regulatory attitudes seem to be hardening against internal models: "On the banking side of things, regulators are getting more and more suspicious about internal models, and if that suspicion filters through to the insurance side of things, which it may very well, firms might find their models held on a short leash."

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