![]() ![]() There may be some leniency in capital policy, but an adjusted solvency position based on long-term investment conditions is unlikely to be acceptable to regulators if limits are breached. All movements on the balance sheet matter. In other words, there is no “below the line” in Solvency II. ![]() Solvency II is a balance sheet construct, not a measure of earnings.There are two fundamental differences in volatility management under Solvency II: Regulators are unlikely to distinguish between short-term and structural causes of a breach of the minimum requirements when it comes to approving a dividend payment. Insurers have told investors to focus on long-term returns resulting from anticipated mean reversion.įor the first time, however, Solvency II has caused the regulatory balance sheet to be volatile. The life insurance industry has a track record of introducing market-sensitive measures and managing the messaging around earnings volatility by emphasising “operating” earnings. Indeed, managing market volatility as well as underwriting risk is arguably a key objective of traditional guaranteed and profit-sharing business. Falling below that minimum amount has a direct cost to investors as, at best, dividends are reduced, and, at worst, further capital is needed.īalance sheet volatility is not new. Volatility of capital matters because regulators require insurers to hold a minimum amount. Since there is no clear answer as to what is the right measure to manage to, stakeholders may have differing views. Also, it is impracticable to hedge the capital ratio and absolute surplus at the same time. Other sources of volatility are off-balance-sheet exposures, in particular arising from defined benefit pension schemes, which can be both material and difficult to manage. The ability to recalculate transitional measure technical provisions provides a significant cushion against interest rate sensitivity on business written prior to 1 January 2016.Contract boundaries exclude some future premiums and associated liabilities that would be reflected on a fully economic balance sheet.The SCR and risk margin technically have zero duration for the purposes of calculating the interest rate shock. ![]() Moreover, there is a duration mismatch between the official balance sheet and the true economic balance sheet. The discount rate curve is complex and includes a number of non-hedgeable adjustments, including the credit risk adjustment, UFR and last liquid point, the VA reference portfolio, and fundamental spread revision risk, among others. The Solvency II balance sheet is not fully market consistent. To add further complexity, the presence of options and guarantees, as well as profit-sharing contracts, means that market-risk exposures are often non-linear and path-dependent. Shifts in these bases introduce a further asset-liability mismatch, unless rebalanced however, in practice, they are hard to manage given the time lags between cause and recognition. Technical provisions are valued on a market-consistent and best-estimate basis, capturing interest rate movements and removing prudence (and smoothing) respectively.Įven if market risk were to be fully hedged, technical provisions are exposed to a range of traditional underwriting risks, including loss events and customer behavior. ![]() The Solvency II balance sheet is volatile by construction: on a mark-to-market basis, “fair-valued” assets are used to back liability cash flows that are discounted using a risk-free curve. ![]()
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