The meaning of market consistency in Europe

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1 The meaning of market consistency in Europe

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3 The meaning of market consistency in Europe Introduction Price is what you pay. Value is what you get. ~ Warren Buffet This paper presents the Ernst & Young Global Solvency Taskforce s view on the meaning of market consistent liability valuation principles as they are or may be applied in Europe. Key observations include the following: A market consistent valuation framework utilizes reliable market prices of deeply traded financial instruments as far as appropriate to value illiquid instruments. Market consistency does not imply that a deep and liquid market is postulated when, in reality, there is none. The market consistent value of a liability is determined by first replicating as far as possible the cash flows associated with the liability using deeply traded financial instruments. The remaining part of the cash flow that cannot be replicated gives rise to an additional risk margin that has to be valued using a model. The market consistent value of the liability is then the market value of the replicating portfolio, plus the value of the risk margin. The cash flows used for both the replication and the risk margin depend on the purpose of the valuation. They vary when there is no deep and liquid market and when potential owners of the liability influence its cash flows through their management actions. The market consistent value of a liability differs if it reflects the value of the liability: From the perspective of the insurer holding the liability as an ongoing concern From the perspective of a hypothetical insurer taking over the liability In a situation where the liabilities are run-off in financial distress Market consistent valuation for both assets and liabilities takes into account the liquidity of the instruments. The more deep and liquid the financial instrument which is traded, the more relevant its market price for valuation. The less deep and liquid the financial instrument, the more dominant the mark-to-model component of the valuation. The meaning of market consistency in Europe 1

4 Market consistent valuation: a motivation Market consistent valuation has been discussed widely in recent years, particularly as a valuation framework for Solvency II and for the Swiss Solvency Test (SST). Furthermore, the International Financial Reporting Standards (IFRS) Phase 2 discussion paper is akin to market consistent valuation in that it departs from current exit value. It is seen by many as a valuation system suited for depicting the economic reality of insurance liabilities and informing about the amount, timing and uncertainty of future cash flows of insurance contracts. There are as many different opinions about what market consistency actually means as there are proponents and opponents discussing the topic. In this paper we present our view on the meaning of market consistent valuation of insurance liabilities and some of the concepts necessary to define the valuation. We start with the basic elements: the necessity of deep and liquid reference markets for valuation and the link between valuation and capital. We also review different market consistent valuations that are presently being used: current exit value, production cost and valuation in distress. In the appendices, we outline in greater detail the mechanics of market consistent valuation and how to determine an appropriate cost of capital rate. Deep and liquid markets Before delving into the concept of market consistent valuation of insurance liabilities, we digress and describe how prices are determined in a deep and liquid market. The Bank for International Settlement defines a deep and liquid market as follows: A liquid market is a market where participants can rapidly execute largevolume transactions with a small impact on prices. A deep market denotes either the volume of trades possible without affecting prevailing market prices, or the amount of orders on the order-books of marketmakers at a given time. In a deep and liquid market, agents buyers and sellers constantly trade and thereby define prices for securities. In this case, observed prices are an emergent property and can be seen as the consensus assessment of the security s value by many buyers and sellers. It is important to note that the observed prices cannot be identified with objective values of the traded objects. Each buyer and seller has a specific, personal assessment of value of the security. It is only in the interplay of many buyers and sellers that a consensus opinion emerges about value drivers and utility and thus, at which price a transaction can take place. Deep and liquid markets, therefore, can be seen as machines that supply market prices that reflect the consensus opinions of a wide array of market participants on the value 2 The meaning of market consistency in Europe

5 of securities. These prices have attractive properties which make them singularly suitable for assessing the value of a security: They react quickly to changes in relevant information. The values are additive, i.e., the price of two securities is the sum of the prices. The price of a security does not depend on the specifics of the buyer nor the seller. The market price is unique at a given moment. As an important aside, if a market is not deep or liquid, there is no unique market consistent value of liabilities. The uniqueness of valuation at a certain point in time is an emergent property of the depth and liquidity of a market. Arguably, not many markets are deep and liquid. In many jurisdictions, only certain bonds, interest swaps and blue chip shares constitute a deep and liquid market. In no market, to our knowledge, can insurance liabilities be considered to be traded in this manner. Markets can remain irrational longer than you can remain solvent. ~ John Maynard Keynes The limits of market values In certain situations, even a deep and liquid market can be perceived to lose its representational faithfulness to assessing value. This might be the case when a speculative bubble builds, for example when the spectrum of views on the value of securities narrows and market participants exhibit irrational exuberance. However, markets tend to correct if they are left to their own design. It is very difficult to decide when a market behaves reasonably and when it exhibits signs of irrationality. In retrospect, a bubble is easily identifiable. If we are in the midst of a bubble, the situation is much less clear. The fact that a vast majority of market participants behave in the same way can either be a sign of mass delusion or point to the fact that a structural change has occurred. In such situations, entities that hold an asset or liability may find it unreasonable to dispose of it at the price that the market currently dictates and find it more beneficial to hold and settle it. The question is whether such an ongoing concern should be reflected in the measurement of the asset or liability (its in-use value) or in the disclosures. In our view, as long as the market is deep and liquid, prices should be regarded as proxies for value, irrespective of a company s own assessment of value. As stated above, even in deep liquid markets, prices are not necessarily equal to values, but can deviate randomly. This is because deep and liquid markets are maintained by market parties who do not believe in them. They have other preferences or think they can outsmart the market consensus. If this were not the case, buying or selling would not take place and would not add value for any one. Insurance premiums cannot be identified with market consistent values since the market (between insurers and policyholders) is not deep, liquid and efficient. In most cases, the insurer expects to make a profit and will include this in the price. In addition, sunk costs for product development, marketing and similar functions are expected to be absorbed by premium rates. The less liquid and transparent a market is, the more the premium deviates from a market consistent value. This deviation can be expected to be positive because insurers bridge two markets, i.e., a retail market that cannot be accessed by investors and a wholesale market that cannot be accessed by policyholders. In other situations, the insurer might decide to sell the policies at a loss, e.g., to gain market share. The same is true for transfer prices of insurance portfolios, as long as they are not traded deeply and liquidly. Market consistent valuation An insurance liability is specified by the future cash flow to which it gives rise. The cash flow depends on claims, expenses, changes in the environment, and other chance events. Some cash flows, especially operational cash flows, also depend on the insurer holding the liability in its portfolio. This is an important point and differs from deeply traded securities. The cash flow emanating from such a security does not depend on who owns it. The cash flow of a government bond will not differ if it is owned by a private investor or by an investment bank. The meaning of market consistency in Europe 3

6 Insurance liabilities are different. An insurance policy is a contractual agreement between an insurer and a policyholder. The agreement contains explicit and implicit promises by the insurer to the policyholder. Often the insurer s financial strength and profitability is part of the implicit agreement. The underlying goal of the market consistent valuation is to transfer the problem of valuing an insurance liability, which in general is not traded in a deep and liquid market, into a setting where observable market prices are reliable and useful. This is done by determining the cash flow associated with the insurance liability and then replicating the cash flow as far as possible by using cash flows of deeply traded financial instruments. A given cash flow always has two components: One that can be replicated perfectly using deeply traded financial instruments from a given reference market A second component that cannot be replicated The set of financial instruments from the reference market that replicates the first component of the cash flow is called a replicating portfolio. This is not necessarily the actual asset portfolio the insurer holds. The market consistent value of the cash flow is then the market value of the replicating portfolio, plus a risk margin for the expected cost to buffer nonhedgeable risk. Note that using any valuation framework other than a market consistent one will lead to arbitrage opportunities. Also, the nonhedgeable cash flow component can always be assumed to have mean zero. Otherwise, one can simply replicate the expected cash flow using a government bond to achieve a nonreplicable component with mean zero. Market consistency does not imply that insurance liabilities are deeply and liquidly traded. It only implies that part of the cash flows can be replicated using deep and liquid financial instruments. Of course, if insurance liabilities were traded, then by definition the cash flows could be replicated perfectly and the market consistent value would equal the market value of the replicating portfolio. As outlined above, the valuation of an insurance liability consists of two separate steps. In the first, the cash flow associated with the insurance liability is determined. In the second, the cash flow is split into a component that can be replicated using deeply traded financial instruments and a component that cannot be replicated. In practice, companies do not necessarily use a replicating portfolio approach for the market consistent valuation of liabilities. Some use economic scenario generators and risk-neutral probabilities or closed-form analytical solutions, in particular for the valuation of embedded options. However, all risk neutral valuation assumes that the cash flows can be replicated using deep and liquidly traded financial instruments. It is, therefore, equivalent to the replicating portfolio approach. 4 The meaning of market consistency in Europe

7 As noted above, the depth and liquidity of a market can change. In times of financial distress, many markets that previously were deep and liquid can freeze up. In that case, observed market prices may not be a good proxy for value. In such situations, the reference market will become smaller and contain fewer securities that can replicate the cash flows. The nonhedgeable component then becomes correspondingly larger, as will the risk margin. It is an arbitrary decision as to whether or not a market qualifies as a reference market and risks change from hedgeable into nonhedgeable. Regulators tend to allow this change only under extreme circumstances. Valuation and capital In an economic framework, there is a clear distinction between the role of capital and the role of technical provisions. Capital is used to buffer risks during a given, defined time horizon and provisions cover expected costs. In other words, expected costs are covered in technical provisions and deviations from the expected are covered by capital. The market consistent value of insurance liabilities covers the present value of all expected costs associated with the liabilities: Expected claims costs, including costs related to financial guarantees and contractual options, as well as expected policyholders profit participation Expected expenses Expected capital costs for risks that are not hedgeable Claims costs refer to costs for insurance losses, changes in information leading to a reassessment of provisions or similar factors. Expense costs include those which are directly or indirectly associated with handling insurance liabilities, such as those resulting from claims underwriting. Finally, capital costs are incurred because of the insurer s need to be capitalized, regulatory requirements and management s strategy. Expected claims and expense costs are relatively straightforward and not controversial, which is not to say that they are easy to estimate, but they have always been included in technical provisions. Capital costs are more challenging to determine. It is essential for an insurer to have capital to write and support insurance liabilities. In essence, an insurer takes on risks from policyholders and either keeps them on its books or tries to transfer part or all of them to the market via reinsurance, securitization or other means. In all cases, substantial risks remain on the insurer s balance sheet. Therefore, capital is necessary to buffer the risk that the actual future development of the business deviates from the expected and cost of capital depends on the amount of capital available. This demonstrates that the economic capital model used to define capital and the valuation framework are intimately connected and cannot be considered separately. In the following, we are concerned with capital costs for the purpose of valuation where the cost of hedgeable risks is already embedded in the market price of the replicating portfolio. Therefore, the capital amounts considered are only those to buffer nonhedgeable risks and the cost of capital rate should compensate for frictional costs only. Which cash flows to value: production cost or current exit? As previously discussed, if a market is not deep and liquid, there is no unique market consistent value. The choice of the market consistent framework will depend on the purpose of the valuation. Currently, the main variants of market consistent valuations are: Current exit value Production cost Valuation in distress Each is market consistent, but differs in the choice of cash flows that are associated with the insurance liabilities. To summarize, in the production cost framework, the value of a liability is determined with reference to the insurance company holding the liability. In the case of current exit value, the value is determined for a (hypothetical) insurer to which the liability would be transferred. For a valuation in distress, the value is defined with reference to the entity in case of a run-off in financial distress. The meaning of market consistency in Europe 5

8 Current exit value: Here the purpose is to determine the price of the insurance liabilities that would be charged to transfer them to a knowledgeable third party. Current exit value tries to define a transfer value for insurance liabilities. The price would depend on the portfolio that is transferred, the portfolio of the third party, the capital base and the capital rate cost of the third party taking over the liabilities. In a deep and liquid market, production cost and current exit value would be equal. Production cost: The purpose is to determine the cost for an insurer to hold the insurance liabilities in its portfolio until the end of their lifetime. This is also named entity-specific ultimate settlement value. Valuation in distress: Supervisors and risk managers are also interested in the value of assets and insurance liabilities in case of financial distress, because required solvency depends on it. In such a situation, new business can no longer be assumed and the portfolio of insurance liabilities has to be either run-off or transferred to a third party. Current exit value Both Solvency II and the International Accounting Standards Board (IASB) propose a current exit methodology for valuing insurance liabilities. In our opinion this approach does not fulfill the objective of Solvency II nor of the IASB. As we have outlined above, transfer prices are only reliable in deep, liquid and efficient markets. In the absence of these markets, prices will contain elements that are not relevant for valuation. Current exit basically postulates such a market where there is none. If such a market existed, current exit valuation would be irrelevant since the market consistent value would correspond to the observed prices. Calculation of cash flow Valuation of the cash flow Risk margin for nonhedgeable risks Insurance liability Market value of the replicating portfolio The cash flows are determined not only by the liability but also by the purpose of the valuation Given a cash flow, market consistent valuation is unique (given a reference market of replicating financial instruments) 6 The meaning of market consistency in Europe

9 One advantage of current exit valuation is the fact that the market consistent value of an insurance liability becomes independent of the entity holding it. The value, however, depends strongly on how the hypothetical buyer(s) would assess the liability, which in turn would depend on other factors such as the buyer s portfolio, capitalization and cost of capital rate. There are several ways a current exit valuation could be defined and calculated in practice. In the one extreme, a large number of potential buyers is assumed and the eventual transfer price of a given insurance portfolio might be modeled by making additional assumptions on how this hypothetical deep and liquid market would function. This is highly complex and will likely stay in the realm of theory. In the other extreme, a single buyer is assumed and the current exit value is determined based on this specified buyer. This is a simple way of calculating a current exit value, but it does not bear much resemblance to how real markets function. If a single hypothetical buyer of a block of insurance contracts is assumed, then the market value of liabilities (MVL) based on current exit can be defined if the buyer is specified. The capital base corresponds to the increase in capital necessary to buffer nonhedgeable risks for the hypothetical third party taking over the firm s portfolio. This capital requirement takes into account the diversification of the firm s portfolio with that of the hypothetical buyer as well as new business written by the buyer. One can see that, in general, current exit value is entity-specific as, in this example, the buyer s diversification after taking over the insurance liabilities will be affected by the portfolio that was taken over. Only if the buyer is assumed to be much larger than the seller would the current exit value be independent of the entity hypothetically selling the insurance liabilities. Nevertheless, the current exit value depends on the hypothetical buyer s assumptions. To conclude, current exit valuation if it tries to model a deep and liquid market will not likely be a market consistent valuation that can be made operational. Old boys, as well as young ones, have their playthings; the difference is only in the price. ~ Benjamin Franklin Production cost In contrast to current exit value, production cost does not value the liabilities with reference to a hypothetical buyer, but rather determines the value for the insurer holding the liability. In production cost, no hypothetical market for insurance liability portfolios is assumed. Nor are assumptions needed about how a hypothetical buyer would value the liabilities. Expected claims and expense costs are based on the company s own experience. The expected costs for capital to support nonhedgeable risks are also based on the company s cost of capital rate and the expected future capital it needs to support nonhedgeable risks. The market consistent value based on production cost will depend on the entity holding the liability; it is therefore entityspecific. In our view, production cost is a more appropriate value for shareholders, supervisors and senior management, at least as long as there is no deep and liquid market. The big advantage of production cost compared to current exit valuation is the fact that no assumptions about a hypothetical buyer need to be made. It is, in that sense, more reliable. In addition, as markets for insurance liabilities become deeper and more liquid, the nonhedgeable component of the cash flows becomes smaller and production cost values will converge to market prices. Valuation in distress Supervisors and risk managers are interested not only in the ongoing concerns of an insurer, but also in how the situation would change in the event of financial distress, where the MVL also will change. Expected claims and expenses need to take into account that in the event of financial distress, it is unlikely that new business would be written. Expenses in a run-off situation will differ from the expenses in an ongoing concern and expected future capital costs will differ. The expected costs for capital to support nonhedgeable risks are then based on the cost of capital in a situation where The meaning of market consistency in Europe 7

10 the insurer has only the minimal regulatory required capital. In contrast to current exit and production cost as discussed above, valuation in distress considers a hypothetical situation (at least for most insurers). It is therefore suitable not for determining available capital, but as a supervisory test or a scenario to ensure that even in case of distress, there are sufficient assets for the insurance liabilities to be run-off. Valuation as a basis for economic capital The choice on the market consistent valuation for use in an economic capital model depends to a large degree on the underlying business model of an insurer. Production cost is a conceptually appropriate framework for an insurer that is and intends to be an ongoing concern. Current exit is a more appropriate framework for financial securities that have to be transferred. In reality, an insurer s situation is a mix. Some of the securities it owns will be held while others must be sold off, e.g., to pay claims and expenses. The economic capital model ideally takes into account the liquidity needs of a company in a stressed financial state. Therefore, in an ideal situation current exit and production cost are not opposing frameworks, but complementary ones. For insurance liabilities, conceptually production cost makes more sense, at least as long as the insurer intends to hold the liabilities on its balance sheet. Conclusion If the market consistent valuation framework is based on a production cost approach and if the company can hold the insurance liability as a going concern, there is the choice to either measure it at market prices (to the extent available, even if markets become illiquid) and disclose the benefits of holding it as a going concern or move to a more value in use measurement base that better reflects the expected future cash flows. However, if a current exit framework is used, there is no choice. All financial instruments then have to be valued assuming a transfer to a third party. This would imply the use of market prices for assets, even if they come from a very illiquid market. In such a situation, it is essential to carefully disclose the nature of the change in current exit value. It is extremely important that this approach be combined with very strong liquidity risk management. The insurer needs to take into account the possibility that some of the assets (for which current market prices may be inconsistent with the production cost value) might have to be sold in a thin and illiquid market. In such scenarios, the realized price obtained in the market will be the price the market offers and the production cost value to the insurer will be irrelevant. Since this is a risk, it should be covered in the required capital, which automatically also affects the risk margin. 8 The meaning of market consistency in Europe

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12 Appendix A The mechanics of market-consistent valuation The question remains how to actually calculate the risk margin needed for the valuation of insurance liabilities. As the risk margin covers nonhedgeable risk or equivalently that component of the cash flow that cannot be replicated using deeply traded financial instruments from the reference market, it has to be modeled. Nonhedgeable risk must be buffered by capital. Going back to the initial definition of the market consistent value as one that covers expected claims, expense and capital costs, it is clear that the capital entering the risk margin calculation is defined as the capital necessary to buffer nonhedgeable claims and expense costs. In Europe, capital has to buffer the risks emanating during a one-year time horizon. This is the solvency capital requirement (SCR) definition in both Solvency II and the SST, but it is also how most economic capital models of insurers and reinsurers define required capital. This means that the one-year time horizon for defining required capital also has to be used to calculate the risk margin. The risk margin can be expressed concisely as the expected present value of the cost of capital necessary to buffer the nonhedgeable risk of insurance liabilities during the entire lifetime of the insurance liabilities. Another explanation may be that the risk margin is the expected cost (discounted with the risk-free rate) of the future one-year risk capital necessary to buffer nonhedgeable risk during each year of the run-off of the insurance liabilities. The above can be expressed mathematically as: where r(u)du denotes the risk free rate over a short interval [u, u+du), CoC(t) is the cost of capital rate during year t required by investors for frictional costs and C(t) is the economic capital needed to support nonhedgeable risks during year t. As seen from time t=0, all the above variables are not known with certainty and therefore are random. Thus, the market value margin (MVM) is the expected value ( E[. ]) of the product above. The equation above describes the MVM in a general manner. In practice, simplifications are used to make the calculations more tractable. For example, in the SST, discounting is done via the current (known) risk-free yield curve, and a constant longterm average cost of capital rate CoC is used. The summation starts at year t=1, which means that there is no need to reflect the cost of capital that is currently held; only future costs for capital (i.e., for year 1, 2, etc.) need to be provided for in the MVM. In addition, the capital base C(t) is taken to be the minimal required regulatory capital needed, SCR(t). This leads to the following formulation where B(0,t) stands for the riskfree discount factor of a cash flow in year: Solvency II in QIS4 uses basically the same approach, but requires the summation starting at year t=0. The equation is simple enough to be used operationally. The main difficulty consists of projecting the expected future required economic capital E[SCR(t)] to future years t. The equation above can be written more generally as: Depending on whether production cost, current exit or valuation in distress is chosen, the terms in the equation (the cost of capital rate, the starting year of the summation and the capital base used) will differ. The simplest case would be production cost. Here, E[SCR(t)] is the expected required economic capital for nonhedgeable risk at year t for the company itself. The summation starts at t=1, since there is no cost of capital incurred for capital that the company has already set up during year 0. Current exit is more difficult to calculate operationally. One way of determining a current exit MVM would be to assume a hypothetical buyer. E[SCR(t)] then needs to be determined with reference to that buyer. In practice, one would need to aggregate the insurance liabilities with the (assumed) portfolio of the hypothetical buyer and then calculate the increase in SCR for nonhedgeable risk. If the hypothetical buyer is assumed to be much larger than the insurer determining the MVM, then the MVM becomes, in good approximation, independent of the entity holding it and the MVM then depends only on the hypothetical buyer. For current exit value, the summation over t has to start at year 0. Current exit 10 The meaning of market consistency in Europe

13 implies that the MVM must be sufficient for an immediate transfer of the liabilities. Therefore, the hypothetical buyer needs to be compensated for the cost of capital set-up during year 0. The role of the time horizon The MVM takes into account the risks during the entire run-off of the liabilities. The time horizon of the MVM, therefore, is given by the duration until all liabilities have expired. In contrast, required capital defined by Solvency II, the SST and by most European insurer s internal models, has a fixed oneyear time horizon. Capital then has to buffer risks emanating during the next year. Risks emanating later are covered both by the MVM and by qualitative requirements on risk and capital management. The qualitative requirements are an integral part of European insurance regulation and are a necessary complement for the finite, one-year time horizon for capital. Insurers are required to have a long-term risk and capital management strategy and need to consider their financial position not only at the end of the current year, but also longer-term. have to incorporate how assets would be reallocated in possible future scenarios when financial markets deteriorate or boom, in cases where one asset class would outperform another, and much more. It is clear that such a calculation would not only stretch the limits for internal models, but also would require a long-term commitment of the insurer s strategy over decades. In our view, the combination of a one-year time horizon for capital, strong risk and capital management requirements, the measurement of all options and guarantees and a consistent calculation of the MVM make much more sense. In addition, this approach gives incentives for risk and capital management, which strengthens both the financial system and policyholders protection more than ultra-conservative capital requirements, would do. Needless to say, a one-year time horizon requires an evaluation of all options and guarantees at the end of the year. Some argue that a longer time horizon would be more appropriate for defining capital, i.e., that capital available now should be sufficient to cover all risks that potentially emanate during the entire run-off period of the liabilities. While this would be possible in theory, the calculation would need to take into account the management actions during the entire time-horizon, which could easily be several decades. In particular, the model would The meaning of market consistency in Europe 11

14 Appendix B What is the appropriate cost of capital rate? To define the appropriate cost of capital rate, it is important to have a clear understanding of the purpose of valuation. Although valuation should be a central element of any price setting exercise, it is not pricing. The cost of capital rate used has to be consistent with the methodology to set the MVM. To recapitulate, the MVM is defined as the expected cost of capital for nonhedgeable risks needed to support the liabilities. The capital base used for the MVM consists of the future required capital for nonhedgeable risk only. It is not the capital that is actually required by the company, but only that part of required capital that covers nonhedgeable risks. The cost of capital rate is the spread over risk rates that an investor would require for investing capital in the insurer. The investor needs to be compensated for frictional costs, which are: Financial distress costs Double-taxation costs Agency costs or the costs associated with the misalignment of the interests of the insurer s senior management with those of its shareholders. The investor does not need to be compensated for hedgeable risks since they can be hedged at the costs that already have been embedded in the replicating instruments. Therefore, they constitute a voluntary risk for which the insurer does not need to compensate the investor. Investors also require a return on franchise value, i.e., investors expect a profit stemming from new business. This is, however, not part of the cost of capital rate for valuation, which only takes into account existing business. The expected frictional costs are not directly observable from actual spreads required by investors. Therefore, they need to be estimated using a mix of models, assumptions and observable data. Several main factors determine the cost of capital rate. The tax rate of a jurisdiction: the higher the tax rate, the higher the expected cost of double-taxation The loss carry-forward period for taxes: the longer an insurer is allowed to offset profits with past losses, the lower the cost of double taxation Insurer capitalization: the higher the insurer is capitalized, the lower its expected financial distress costs, but the higher the costs of double-taxation Transparency and governance: agency cost will be lower when an insurer has greater transparency and better governance Market sentiment: the more risk averse the market becomes, the higher the required compensation for expected frictional costs Apart from the insurer s capitalization, transparency and governance, the main factors affecting the cost of capital rate depend on the jurisdiction or the market the insurer operates in. Most estimates for the cost of capital rate range between 2.5% to 6% over the risk free rate, where the cost of capital rate is linked to the rating of the insurer. In the SST, the cost of capital rate for a minimally capitalized insurer, approximated by a BBB rating, was set to 6%. The better capitalized the insurer, the lower the cost of capital rate. It is acceptable to use the same cost of capital rate for all insurers and the same capital base (e.g., SCR), if the capital base and the cost of capital rate are consistent. The absolute value of the MVM is given as the product of the cost of capital rate and the present value of future capital needed to support nonhedgeable risk. The higher the capitalization (i.e., the higher the confidence level to which capital is calibrated), the lower the cost of capital rate. Taken together, the absolute value of the MVM is not very sensitive to the actual capitalization of the insurer. 12 The meaning of market consistency in Europe

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16 Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 130,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve potential. About Ernst & Young s Global Insurance Center Insurers must increasingly address more complex and converging regulatory issues that challenge their risk management approaches, operations and financial reporting practices. Ernst & Young s Global Insurance Center brings together a worldwide team of professionals to help you achieve your potential a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Center works to anticipate market trends, identify the implications and develop points of view on relevant industry issues. Ultimately it enables us to help you meet your goals and compete more effectively. It s how Ernst & Young makes a difference. For more information, please visit EYGM Limited. All Rights Reserved. EYG No. EG NY Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.