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Solvency II Risk Margin

M

Mohammed

Member
Hello,
I'd just like to check my understanding of the SII Risk Margin, BEL and technical provisions.
  • BEL is based upon best estimate assumptions, which, by definition, have an equal probability of understating or overstating the liabilities.
  • Solvency II pillar 1 requires the use of market-consistent principles.
  • BEL itself is not market-consistent. It is the technical provisions (BEL + Risk Margin) that is market consistent. If BEL was market-consistent, then the riskiness of the liabilities would already be incorporated into the calculation (in an efficient market) and a third party wouldn't require additonal compensation for the risks. Hence risk margin would be zero.
  • It follows that risk margin is the difference between a market-consistent valuation of the liabilities (technical provisions) and a best-estimate valuation of the liabilities (BEL). However, for practical reasons, risk margin is generally calculated using a cost of capital approach. BEL and risk margin are then added together to obtain the technical provisions.
I also have the following questions.
  • For hedgeable cashflows, the value of the technical provisions is equal to the market value of that hedging instrument (Pg 337 in the notes). But does this mean that this is the required approach for calculating risk margin? Could we instead opt to calculate risk margin using a cost of capital approach, as for non-hedgeable cashflows?
  • Could some newer types of securities lead to the interpretation of hedgeable/non-hedgeable to change over time? For example, (as I understand it), longevity swaps are a relatively new type of security and could allow insurers to hedge longevity risk.
Thanks in advance.
 
Mohammed said:
Hello,
I'd just like to check my understanding of the SII Risk Margin, BEL and technical provisions.
  • BEL is based upon best estimate assumptions, which, by definition, have an equal probability of understating or overstating the liabilities.
  • Solvency II pillar 1 requires the use of market-consistent principles.
  • BEL itself is not market-consistent. It is the technical provisions (BEL + Risk Margin) that is market consistent. If BEL was market-consistent, then the riskiness of the liabilities would already be incorporated into the calculation (in an efficient market) and a third party wouldn't require additonal compensation for the risks. Hence risk margin would be zero.
  • It follows that risk margin is the difference between a market-consistent valuation of the liabilities (technical provisions) and a best-estimate valuation of the liabilities (BEL). However, for practical reasons, risk margin is generally calculated using a cost of capital approach. BEL and risk margin are then added together to obtain the technical provisions.
Click to expand...

Yes, your understanding is broadly correct, although bear in mind that the BEL is 'market-consistent' in terms of the 'hedgeable' risks: it is calculated on a risk-neutral market-consistent basis, using risk-free rates (from the market) rather than best estimate investment returns. (So not all of the assumptions used are 'best estimate'.) The risk margin makes it market-consistent in relation to the non-hedgeable risks.
 
Mohammed said:
  • For hedgeable cashflows, the value of the technical provisions is equal to the market value of that hedging instrument (Pg 337 in the notes). But does this mean that this is the required approach for calculating risk margin? Could we instead opt to calculate risk margin using a cost of capital approach, as for non-hedgeable cashflows?
Click to expand...
There is no risk margin to be calculated: if you have a liability which can be replicated by one or more financial instruments (for which the market values can be observed, each within a deep and liquid market) then the market-consistent value of that liability is the market value of those financial instruments.

For example, the unit reserve part of the TP for a unit-linked contract is replicated by the assets within the underlying unit funds, and hence takes the same value. [There would need to be a risk margin calculated in respect of the non-unit part of the liability, but not for the unit part.]
 
Mohammed said:
  • Could some newer types of securities lead to the interpretation of hedgeable/non-hedgeable to change over time? For example, (as I understand it), longevity swaps are a relatively new type of security and could allow insurers to hedge longevity risk.
Click to expand...
Yes, but the hedging has to be done within a sufficiently deep and liquid market so that the observable market value is a true 'fair value'. Although a healthy market, the longevity swap market is not always completely liquid - there have been times when it has become a little saturated and is therefore more difficult to access, particularly for very large transactions.
 
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