Components of Solvency II in a Layman Language - Phase 2 - Actuarial
Now let’s understand these terminologies in a simple English.
Assets:
- Assets are generally valued at market value which is easily available for the quoted securities.
- For the unquoted, we generally use fair or economic value i.e. the price at which assets can be exchanged or liability can be settled. Under Solvency I, they use book value i.e. original cost possibly with depreciation.
- There are various methods of valuing assets such as:
o
Market value
o
Fair value
o
Discounted Cashflow approach
o
Arbitrage approach
o
Smoothed Market value
o
Written down value
Best Estimate Liability:
- First of all let’s understand what is best estimate ?
- So there are 3 strength of basis i.e.
o Optimistic
– Here the assumptions are set in such a way that places higher value on assets
and/or lower value on liabilities. It means my surplus will be higher, profit
will be higher and thus taxes paid will be higher
o Prudent
– Here the assumptions are set in such a way that places higher value on liabilities
and/or lower value on assets. It means my surplus will be lower.
o Best
Estimate – It is just 50% of overstating and 50% of understating my liabilities.
Let’s understand with the help of an example
- Example:
o Suppose
I have to pay $1000 after 1 year to someone and I have to calculate it’s
present value, so I need discount rate.
Discount
rate |
Present
Value |
Basis |
4% |
1000/1.04 = $961.5 |
Prudent |
6% |
1000/1.06 =
$943.4 |
Optimistic |
5% |
1000/1.05 = $952.4 |
Best Estimate |
- Best Estimate Liability: The best estimate liability (BEL) is the present value of expected future cash flows, discounted using a “risk-free” yield curve. Where interest rates are based on government bond rates adjusting for risk of default by counterparty.
- Published by EIOPA on a monthly basis.
- Please note that BEL is the Present value for only existing policies i.e. in-force business.
- Before going to technical understanding, let’s understand one example.
- Suppose your mother sent you to a grocery store to buy some stuff and accordingly to you it will cost around say $120 but you mother gives you $150 if in case prices are high or something. So your mother is trying to cover the risk where the risk is that you don’t have enough money to buy all the things that your mother wanted. So your mother covers that risk by giving you an extra margin i.e. 150 – 120 = $30
- The risk margin is intended to increase the provisions to the amount that would have to be paid to another insurance company in order for them to take on the best estimate liability. It therefore represents the theoretical compensation for the risk of future experience being worse than the best estimate assumptions, and for the cost of holding regulatory capital against this.
- Margin for future experience being worse than expected. Let’s see an example. Suppose XYZ is an insurance company that sells term assurance, so they are exposed to mortality risk broadly. Loosely speaking, as per there assumptions mortality rate for there portfolio is 4%. Now XYZ wants to sell there business to ABC. Now ABC may think that mortality rate may get higher and they would have to pay more than expected. Thus, risk margin covers the theoretical compensation for the risk of future experience being worse than best estimate assumption
- Now insurer has to kept aside some of the capital against solvency capital requirement. It means that this capital can only be invested in a risk free assets and thus will generate less return than return that would have been generated if assets been invested freely. So this is the cost of capital that would be covered here in Risk margin.
- Risk Margin formula = Cost of Capital * Present value of SCR (for undiversified risks upto run off of the business)
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