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Solvency II Risk Margin

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The Solvency II Directive (as recast) (Article 77) indicates that the “value of technical provisions shall be equal to the sum of a best estimate and a risk margin”.

 

The Directive indicates that the “best estimate shall correspond to the probability-weighted average of future cash-flows, taking account of the time value of money (expected present value of future cash-flows), using the relevant risk-free interest rate term structure”.

 

The Directive also indicates that the “risk margin shall be such as to ensure that the value of the technical provisions is equivalent to the amount that insurance and reinsurance undertakings would be expected to require in order to take over and meet the reinsurance and reinsurance obligations”.

 

If the future cash flows associated with the reinsurance obligations can be replicated reliably using financial instruments for which a reliable market value is observable then Article 77.4 indicates that the value of technical provisions shall be determined on the basis of the market value of those financial instruments. This might, for example, apply to unit liabilities of funds invested in readily marketable investments.

 

However, where this is not possible, the best estimate and risk margin need to be calculated separately, and Article 77.5 indicates that “the risk margin shall be calculated by determining the cost of providing an amount of eligible own funds equal to the solvency Capital Requirement necessary to support the insurance and reinsurance obligations over the lifetime thereof”. This article also mandates that the rate used for this purpose (the ‘Cost-of-Capital rate’) shall be the same for all insurance and reinsurance undertakings and shall be reviewed periodically.

 

A higher Cost-of-Capital rate increases the size of the risk margin and the size of the overall technical provisions. It therefore reduces the calculated solvency position of the undertaking. Not surprisingly, the choice of Cost-of-Capital rate has thus been the subject of discussions between the regulators and the industry, but so far it has remained unchanged at 6% pa, see DA Article 39.

 

Version dated 7 December 2015

 


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