| Abstract: |
The three chapters all address solvency regulation issues, with a focus on
market risks under the Solvency II framework. Chapter 1 deals with
“high-level” aspects of Solvency II as main principles and the general
structure. Chapters 2 and 3 will be devoted to quantitative issues. Chapter 1
describes the main evolutions that led to the development of Solvency II. The
insurance sector has dramatically evolved during the last two decades. Among
others developments, we stress the new risks faced by the sector as natural
catastrophes, changing demographics or market risks. Insurers become
international companies, investing almost 10 trillion € of assets in Europe at
the end of 2014 and being increasingly intertwined with banks and other
financial sectors. Financial innovation and the refinement of risk management
techniques and models developed by companies have gained momentum among the
major European insurance companies. Have these evolutions changed the needs
for the supervisory of insurance companies? The economic foundation for
regulation is based on the presence of market failures, including severe
asymmetric information problems and principal-agent conflicts. Insurance
consumers, particularly individuals and households, face significant
challenges in judging the financial risk of insurers. But the importance of
the insurance sector for financial stability has been increasing. A sound
regulatory and supervisory system is necessary to maintain efficient, safe,
fair and stable financial markets and promote growth and competition in the
insurance sector. The difficult conditions experienced by the industry and the
shortcomings of the previous regulatory and supervisory framework have forced
regulators to take action to change the way in which they regulate insurance
companies’ solvency. Recognizing the shortcomings of Solvency I, EU
policy-makers undertook the Solvency II project. Solvency I was not
consistently applied throughout EU as the directive allowed countries to
implement insurance regulation in different ways. Moreover Solvency I did not
consider risks fully or in detail. In life business, the major criticism was
the lack of consideration of asset risks. Allowances for latest developments
in risk management were also inadequate and companies could not use an
internal model to calculate the solvency capital. Finally, the increasing
presence of conglomerates and groups forced the insurance regulator to align
some requirements with the banking regulation, Basel II/III. Due to the
differences in their core business activities, banks and insurers regulators’
goal does not imply comparability of the overall capital charges. However,
considering the asset side of the balance sheets, the investment portfolios of
banks and insurers contain the same asset classes. In order to avoid
regulatory arbitrage, the capital charges for the same amount and type of
asset risk should be similar. Chapter 2 compares the main regulatory
frameworks in Europe: Solvency II and the Swiss Solvency Test, SST, in
Switzerland, with a focus on potential market implications. Both systems are
quite advanced but some key differences need to be highlighted, including the
treatment of assets, in particular sovereign bonds, the consideration of
diversification or the risk measure applied. Solvency II uses a Value at Risk
at 99.5% whereas the SST is based on a Tail Value at Risk at 99%. Our approach
is both qualitative and quantitative. In particular, based on a numerical
example, we aim at quantifying the level of regulatory capital prescribed by
the standard models. The numerical analysis reveals large differences between
capital charges assigned to the same asset class under Solvency II and the
SST. Solvency II penalizes investment in stocks, mainly due to a lower
diversification benefit under the standard formula. On the other hand the SST
model requires a higher capital for bonds, primary due to a stringent risk
measure and confidence level. The treatment of EU sovereign bonds under
Solvency II is another area of concern as it does not require any capital for
spread risk. The question arises to what extent an internal model leads to
different capital requirements as compared to the SST and Solvency II models.
Therefore we apply an internal approach based on Monte Carlo simulation to
derive the necessary capital based on the Value at Risk at 99.5% (in line with
the Solvency II standard model) and on the Tail Value at Risk at 99% (in line
with the SST standard model). Internal models calculate capital requirements
that more closely matches risks of insurers and promote a culture of risk
management. To develop internal models, companies need incentives to properly
manage their risks, i.e. decreasing capital requirements. One potential
benefit of the standard model is that insurers who use it can be compared to
one another, whereas internal models are by definition specific to individual
insurers. One argument against the standard model is the possibility of some
systemic risk. An unusual event in the capital or insurance market could
encourage all insurers to take the exact same response, thereby causing a run
in the market. The analysis shows that standard and internal models still
display large discrepancies in their results, suggesting a long way ahead to
achieve a harmonized view between the regulators and the insurance sector. The
choice of a statistical model or the refinement of parameters are key concepts
when setting up an internal model and appear to be critical in the Solvency
Capital Requirement calculation. By calculating and comparing the market risk
capital charges for a representative insurer under the Solvency II and the SST
standard approach as well as an internal model, we are able to provide
evidence that the regulatory framework might have an impact on asset
portfolios. The main impacts would be a shift from long-term to shorter-term
debt, an increase in the attractiveness of higher-rated corporate debt and
government bonds, in particular EU sovereign bonds as the consequence of the
special treatment under Solvency II, as well as low level of equity holdings.
But it is unlikely that large-scale reallocations will happen in the short
term, as transitional arrangements are likely to phase in the implementation
of Solvency II over several years. The likely impact on assets portfolios
could have also already been anticipating by insurers. Chapter 3 studies the
effectiveness of the Solvency II reform to prevent the default probability
faced by a life insurance company. The default risk leads to a consequence
that policyholders might not get back their initial investment upon default of
the insurance company. Therefore, policyholders are concerned with the issues
like what probability the insurance company will become bankrupt and which
amount they can expect to obtain after taking account of the default risk of
the insurer. Starting from a theoretical life insurance company which sells a
participation insurance policy containing only a savings component and a
single premium inflow, we simulate a life insurance company on an eight-year
time horizon. We focus only on market risks as there is no mortality risk
attached to the insurance contract. Finally several policies and investment
strategies will be analysed. The purpose of the chapter is to evaluate how
Solvency II can prevent the company to collapse. The papers discussing
Solvency II effectiveness are qualitative in nature. In particular there is
little research on the accuracy of the standard formula with regard to the
proclaimed ruin probability of 0.5% per year. To do so we compare the
probability of default at maturity of the life insurance policy, i.e. if the
company has to enough assets to pay what was promised to the policyholders,
with the early probability of default forced by Solvency II based on standard
and internal models. We have first to calculate the Solvency Capital
Requirement as laid down in the directive. One crucial point is the evaluation
of liabilities. To do so we use an approach recently applied by the insurance
sector called Least-squares Monte Carlo (LSMC). The aim of Solvency II is to
monitor insurers on an annual basis. The SCR level can then be interpreted as
a regulatory barrier, consistent with a model developed by Grosen and
Jørgensen (2002). Key drivers of the ruin probability at maturity include
interest rate parameters, portfolio riskiness and investment strategies in
bonds. The continuously decrease of interest rates creates a challenge for
insurers, especially life insurers that suffer a double impact on their
balance sheet: a valuation effect and a decreasing reinvestment returns of
premiums and maturing bonds. The latter explain also the riskiness of
rolling-bond strategies compared to duration matching strategies. By setting
the confidence level to 99.5% per year, the regulator wants to ensure that the
annual ruin probability equals to 0.5%. Since the SCR from our internal model
equals the 0.5% quantile of the distribution, it exactly matches the targeted
ruin probability. Our analysis reveals that the set-up and calibration of the
Solvency II standard model are inadequate as the solvency capital derived by
the standard formula overestimates the results of the internal model. This is
mainly the consequence of an overestimated equity capital and a lower
diversification benefit. The 0.5% proclaimed goal under Solvency II is not
reached, being too conservative. One declared goal of the directive is to
decrease the duration gap between assets and liabilities. Solvency II
penalizes then rolling-bond strategies. The long-term feature of our policy
should impact the level of regulatory capital. As Solvency II is based on a
quantile measurement, we define the solvency capital using the default
probability objective for different horizons. SCR is not systematically a
decreasing function of the time horizon even if a decreasing form appears on
long-term. This shows undoubtedly that a horizon effect exists in terms of
measurement of solvency. As the standard model overestimated the internal
model capital we expect a forced default probability higher than 0.5% under
the Solvency II framework. The SCR barrier stops the company more often than
it should be. This can be interpreted as one cost of regulation, i.e. closing
down financially sound at maturity companies. The analysis of the evolution of
default probabilities as a function of time horizon reveals that ruin
probabilities at maturity lie always below the Solvency II objective.
Furthermore the gap between the observed default at maturity and the Solvency
II objective is increasing over time; the situation is even worse for
longer-term insurance products. Finally stakeholders are more interested in
their expected return than in the default probability. A cost of regulation
defined as the difference between stakeholder’s returns with and without
regulatory framework exists, particularly for shareholders. |