April 2015 - Question 1, Part (vi)

[p_0910]

Hi,

I have a question in relation to Solvency II, Pillar 1. From the April 2015 paper the question asked for what SII balance sheet components could be used to calculate a 'deposit back' amount. The examiner's report suggests including a BEL and risk margin, however in my answer I proposed a solution that included BEL and some proportion of the SCR e.g., 85% i.e. MCR (or any alternative level that may be comparable to the existing prudent reserves).

My rationale for excluding the risk margin was that since this business is reinsured, the insurer’s capital requirement is much lower and therefore the cost of associated (net) capital is also much lower. Therefore, the insurer should not necessarily require a deposit to compensate for the cost of capital that relates to the risks transferred to the reinsurer in relation to this business (assuming that the reinsurance may be kept in place if this business were to be sold to a third party).

Would the above answer receive credit?

 

[Lindsay Smitherman]

The deposit back will reflect the amount of liabilities passed across to the reinsurer, ie the liabilities for which the reinsurer is now 'at risk', or (equivalently) the reinsurance premium (ignoring any profit or additional loading that the reinsurer wishes to take for itself). Under Solvency II, the TP represents the amount at which market transfers of liabilities takes place.

The point of the deposit back is to reduce risk relating to the reinsurer defaulting, so that the insurer is still able to meet its liabilities (by being able to access the money directly). If the reinsurer defaults, the insurer will be stuck with all of the mortality etc risk, hence needing to include the RM.

By suggesting that a high proportion of the SCR would be deposited back, you are implying that this would be transferred to the reinsurer as part of the reinsurance premium, which would not demonstrate good understanding of the transaction.

 

[p_0910]

Thank you, that is helpful!

I am trying to clear up my understanding of what a deposit back/ collateral amount should include and my current understanding is that if the reinsurer were to default in the above scenario, the insurer would be left with the BEL + cost of capital i.e., the insurer would have assets to back the BEL and along with this an additional amount (risk margin) to go out into the market and 'purchase' capital to back the SCR. So there is an underlying assumption here that this capital would be readily accessible, is that correct?

I appreciate that in pricing the reinsurance premium, the reinsurer is likely to price the 'risk premium' as the amount required to back the 'reinsured BEL' + the cost of capital required to fund the associated SCR (risk margin). This allows the reinsurer to be able to appropriately set a price for the business.

However, if the reinsurer were to default, this is likely to be in a stressed environment and therefore it might be difficult for the insurer who is left with assets to back the BEL + a risk margin to go out into market and actually purchase the required capital associated with the liabilities.

Whereas if the collateral allowed for supporting the BEL + the minimum capital requirement, the insurer would not have the burden of going out into the market and sourcing the capital required to back the SCR. I am struggling with the idea of only allowing for the risk margin, and not the SCR in some way (Although recognise that the RM is the cost of holding the SCR itself).

 

[Lindsay Smitherman]

The point about the collateral is to enable the insurer to access what is basically some of the reinsurer's funds, as and when a reinsurance recovery would be made (and so which the reinsurer could otherwise default on). An amount equivalent to the reinsured liabilities / reserves would be 'deposited back', thus giving the insurer access to an amount that would therefore be expected to cover such recoveries (under Solvency II, likely including a 'market-consistent' allowance for the risk that just the BEL would not be enough in relation to the non-hedgeable risks).

I think you are getting unnecessarily tangled up in this idea about 'cost of capital'. Remember also that the risk margin only covers non-hedgeable risks.