S2 surplus-ch17

[Viki2010]

Thank you for all your answers Lindsay.

The core reading states that a simplified definition os s2 surplus is assets less be liabilities. In this situation the risk margin is considered as part of surplus but this is not always the case, correct? Can we define surplus as assets less technical provisions instead?

 

[Lindsay Smitherman]

You're welcome!

"Surplus" is one of those terms that does not have a standard definition and can be used to mean the excess of assets over liabilities or the excess of assets over {liabilities + capital requirements}. So in Solvency II terms, that could mean assets minus BEL, or assets minus technical provisions, or assets minus the sum of technical provisions and SCR. Hence it is important to be clear on how it is being interpreted within any given context.

For example, in the diagram at the start of Chapter 12 "Surplus" is being defined in the latter sense, i.e. it is the excess of assets over technical provisions + SCR. But other definitions are used in other context. For example, as you point out, the analysis of surplus description starts with a simplified version of surplus which is defined as assets minus BEL. This is done in order to get across the basics of the analysis, before introducing the additional complexities that arise if surplus is defined as being in excess also of the risk margin and SCR.

Hope that helps.

 

[Viki2010]

Hi Lindsay, p.5 of CMP states "The matching adjustment related surplus may also include the impact of asset transactions, for example if the asset sold has a different impact on the matching adjustment than the asset bought"

How is this component of surplus calculated?
How the MA treated when assets are bought and sold during the year?
Is MA adjusted on ongoing basis?

 

[Viki2010]

Hi Lindsay, another question on the chapter from p. 13.
"changes in the size of the SCR components used" - are the components in this sense just the individual insurance risk modules (lapse, expense etc) from the Standard Formula?
and if yes, what would the components be under Internal Model?

 

[Viki2010]

Next question, how would the "reinsurance strategy" impact on the Risk Margin (p.14).
If Reinsurance impacts on the asset side of the BS in SII, then how would that tie in with the impacts on the RM?

 

[Lindsay Smitherman]

Remember that the risk margin is calculated as a % of the run-off of that part of the SCR which relates to non-hedgeable risks. Such risks would include insurance risk. If reinsurance is used, then this should reduce the insurance risk (albeit with a small offset from higher counterparty default risk). So the insurance risk component of the SCR will reduce (bearing in mind that this is based on the change in assets - BEL, under a stress scenario) and hence the risk margin will also reduce.

 

[Viki2010]

It makes sense that when the risk goes down the scr and rm decrease.
The nav = assets - bel
How is reinsurance accounted for in the above? Bel must be gross of reinsurance so assets would increase and nav would increase?

 

[Lindsay Smitherman]

The nav = assets - bel
How is reinsurance accounted for in the above? Bel must be gross of reinsurance so assets would increase and nav would increase?

Yes - but don't forget that the company will have to pay a premium for obtaining the reinsurance, so assets would go down by the amount of reinsurance premium paid.

 

[Lindsay Smitherman]

Hi Lindsay, p.5 of CMP states "The matching adjustment related surplus may also include the impact of asset transactions, for example if the asset sold has a different impact on the matching adjustment than the asset bought"

How is this component of surplus calculated?
How the MA treated when assets are bought and sold during the year?
Is MA adjusted on ongoing basis?

As for any item of surplus, the company would calculate the balance sheet with and without the particular change (eg in this case, using the MA with and without the asset sale(s)) and the contribution to surplus from that event will be the difference in surplus arising between those balance sheets.

The MA is recalculated each time that the balance sheet is revalued, using the method as described on page 11 of Chapter 12.

 

[Lindsay Smitherman]

Hi Lindsay, another question on the chapter from p. 13.
"changes in the size of the SCR components used" - are the components in this sense just the individual insurance risk modules (lapse, expense etc) from the Standard Formula?
and if yes, what would the components be under Internal Model?

Yes, they would include the insurance risk sub-modules, but bear in mind that the subset of the SCR that is used for the risk margin calculation covers all non-hedgeable risks. As described in Section 2.2 of Chapter 12, this will also for example include reinsurance counterparty default risk and operational risk.

if the internal model is used, then the same components would be relevant - the internal model has to cover all of the same risks as the standard formula.

 

[Viki2010]

Yes - but don't forget that the company will have to pay a premium for obtaining the reinsurance, so assets would go down by the amount of reinsurance premium paid.

The Assets will change by the amount of (Pv claims - Pv premiums) so the net asset effect would be a decrease in assets because the pv claims are always smaller than pv premiums?
And therefore SCR goes down because NAV decrease.

 

[Lindsay Smitherman]

The Assets will change by the amount of (Pv claims - Pv premiums) so the net asset effect would be a decrease in assets because the pv claims are always smaller than pv premiums?
And therefore SCR goes down because NAV decrease.

There might be some confusion here, so let me try to set out what happens to each element of the Solvency II balance sheet immediately following the company taking out reinsurance:

Assets: decrease by amount of reinsurance premium paid, increase by expected reinsurance recoveries (net of allowance for defaults), overall maybe a small decrease (= reinsurer's profit and expense loading within premium)
BEL: no change
RM: reduces due to lower SCR for insurance risk
SCR: reduces due to lower insurance risk

If you want to break down the final point into its components to understand why this has happened from a formulaic perspective, then start with:
SCR = {base assets - base BEL} - {stressed assets - stressed BEL}
If reinsurance is used, stressed assets will be higher (due to higher expected reinsurance recoveries under the mortality stress component) and hence SCR is lower.

 

[Viki2010]

Thank you this is a very logical layout which makes perfect sense!

 

[ronaldchling]

There might be some confusion here, so let me try to set out what happens to each element of the Solvency II balance sheet immediately following the company taking out reinsurance:

Assets: decrease by amount of reinsurance premium paid, increase by expected reinsurance recoveries (net of allowance for defaults), overall maybe a small decrease (= reinsurer's profit and expense loading within premium)
BEL: no change
RM: reduces due to lower SCR for insurance risk
SCR: reduces due to lower insurance risk

If you want to break down the final point into its components to understand why this has happened from a formulaic perspective, then start with:
SCR = {base assets - base BEL} - {stressed assets - stressed BEL}
If reinsurance is used, stressed assets will be higher (due to higher expected reinsurance recoveries under the mortality stress component) and hence SCR is lower.

Agree with your statements!

I have 2 more questions about reinsurance.

1. "Reinsurance recoveries is said to be assets in the Solvency II balance sheet
This has to be adjusted to allow for the best estimate of expected losses due to default of reinsurer."
Does this sentence implies an increase or decrease in own fund by reinsurance recoveries?
Or does the increase in own fund is caused solely by the fall in RM?

2. Is there any possibilities where the assets can increase?
For example is it possible in the base scenario
a) expected future reinsurance premium - expected future reinsurance commission < expected future reinsurance recoveries
b) reinsurance reduces the net cost of guarantee

 

[Lindsay Smitherman]

Hi - not sure that I have fully understood the context of your questions, but the following might help:

The present value of future expected reinsurance recoveries (net of future reinsurance premiums, if any) is added to assets.

Higher assets means higher own funds, all else being equal.

If future reinsurance premiums are expected to exceed future reinsurance recoveries, then the additional asset value would be negative - therefore would reduce assets.

However, since the insurance company will already have paid a reinsurance premium in order to set up the reinsurance arrangement, it is more likely that the value of reinsurance recoveries (net of afuture reinsurance premiums) will be positive.

In particular, for a single premium reinsurance arrangement, the value should be positive (as there are no future reinsurance premiums to offset the value of reinsurance recoveries).

But bear in mind that the value will depend on the type of reinsurance. For example, under a catastrophe excess of loss arrangement the insurance company may not be expecting the catastrophe to occur on the best estimate basis and hence the expected reinsurance recoveries will be zero. In this case, the value of the reinsurance will come through into the balance sheet via a lower SCR (and a lower RM by second order), due to the value of the reinsurance recoveries asset increasing under the 1 in 200 year scenario (assuming that such a scenario includes the defined catastrophe event).

Hope that helps you to work out the answers to your questions.