CEIOPS-SEC-78/10 25 May 2010 CEIOPS Comments on QIS5 draft technical specifications

Transcription

1 CEIOPS-SEC-78/10 25 May 2010 CEIOPS Comments on QIS5 draft technical specifications 1. Following the submission by CEIOPS of its draft technical specifications for QIS5 and the publication on 15 April by the Commission of revised technical specifications for consultation until 20 May 2010, CEIOPS has taken note of the policy decisions which were adopted by the Commission. In the meantime, CEIOPS has continued to closely follow the discussions held at the Level 2 Solvency Expert Group and participated to the stakeholder meeting and public hearing on QIS5 organised by the Commission. 2. In this regard, CEIOPS has identified various areas where it considers that for the purpose of the QIS5 specifications as well as for the future Level 2 implementing measures, further thought should be given. For this purpose, CEIOPS aims at highlighting areas of concern as well as to the extent possible in the limited time available, to make concrete suggestions. Due to the limited time available, the following list should not be considered as an exhaustive list, as far as some additional issues may be developed at a further stage. General comments 3. CEIOPS underlines the need to remain committed to the European ambitions of the Solvency II project. At this crucial stage, the success of Solvency II depends on the willingness and capacity to engage in constructive discussion which unites all EU actors. In commenting and discussing, the key objective of Solvency II should be kept in mind: the protection of the European policyholder, which needs to be balanced with the competitiveness of the EU market. 4. With regard to the calibration of the solvency capital requirements, there seems to be scope for further discussion and agreement. CEIOPS would however like to underline the need to continue basing the discussion on facts and technical analysis which would greatly benefit the credibility of the process. CEIOPS is pleased with the recent openness of industry representatives to share data with CEIOPS for further improving the calibration of underwriting risk. The information collected during QIS5 will help in setting the basis for future work on calibrations, including future reviews. CEIOPS points out that a recalibration of the MCR is necessary following the revisions made to the SCR, which even more so underlines the need to have a sound technical basis for the review of the calibrations. 5. CEIOPS has carried out an overall impact assessment with regard to the changes made by the Commission. This impact assessment supplements and extends CEIOPS previous preliminary QIS5 impact assessment, which aimed at assessing the impact of the changes to the QIS4 specifications following CEIOPS proposals. CEIOPS considers that such impact assessment should be based on a comprehensive view, taking into account 1/16

2 the design and calibration of the SCR standard formula as well as the requirements on the valuation of technical provisions and on the determination of own funds. 6. With regard to the SCR, the analysis has found that compared to QIS4 the revised calibrations for the standard formula, including the changes introduced by the Commission, could lead to an overall increase in the SCR of about 35%, which is likely to vary considerably among individual undertakings, dependent on their risk profile and risk mitigation programmes. However, the analysis also found that changes introduced by the Commission in other areas, notably so in the valuation of technical provision, are likely to lead to significant increases in the amount of undertaking s own funds, which would more than offset the increase in solvency capital requirements. 7. CEIOPS has noted the willingness of various Member States at the recent Level 2 discussions to allow under QIS5 to test different scenarios in areas where views cannot be reconciled before the start of QIS5, the aim of QIS5 being to allow Commission, CEIOPS and stakeholders to assess the potential impact of the different scenarios where it is material and to take informed decisions in crucial areas before the implementation of Solvency II. 8. In order not to overburden the exercise, CEIOPS pay particular attention to the user-friendliness of the QIS5 spreadsheets and will involve stakeholders in two seminars on the QIS5 specifications in August in order to ensure the best possible comprehension of the specifications. 9. Specific comments to the specifications are contained in annex. Comments on the call for advice 10. As regards CfA9, as mentioned earlier, CEIOPS is committed to ensure the highest participation rate possible but also notes that the participation rate suggested by the Commission aims at doubling it from QIS4 which may prove to be challenging. 11. As regards CfA30, CEIOPS has concerns of high level comparison between QIS4 and QIS5 for undertakings, which will have participated to both exercise as the results will be at year end 2009 for QIS5 and year end 2007 for QIS4. Asking undertakings either to re-run QIS4 at year end 2009 and QIS5 at year end 2007 may be very burdensome and have consequences on QIS5 quality of data. 2/16

3 Annex 1: Specific comments with regard to the valuation of technical provisions 1. Quantification of the illiquidity premium A1. The QIS5 draft specifications foresee the following simple formula for the calculation of the illiquidity premium: LP assets = Max(0; x*(spread y)). A2. In this formula a fixed portion (y) of the total spread between corporate bonds and the basic risk free is assumed to be an allowance for long-term expected losses and a proportion (x) of the remainder can be considered as the liquidity premium. The difference (1-x) of the remainder represents thus the risk premium for unexpected credit risk (or uncertainty).the x and y are chosen to best match three primary methods currently used by practitioners to estimate the illiquidity premium in financial markets. A3. CEIOPS would like to point out that the illiquidity premium is only one component of the total spread between the yield of an asset and the liquid risk-free rate. In addition to expected credit risk and credit risk uncertainty, this spread also includes a compensation for management expense risk. Furthermore, a "residual" element (due to e.g. taxes, conversion costs or costs of market imperfections) remains. The three methods that were considered to determine the calibration of the simple x-y-formula do not allow for these additional components. Therefore, the illiquidity premium component may be systematically overestimated. A4. CEIOPS supports the simple form of the existing formula, but recommends considering these additional elements during the calibration. A5. CEIOPS therefore advises investigating further the methodology to derive the illiquidity premium. A validation with observed historical liquidity costs should also be undertaken. A6. Furthermore, CEIOPS would like to point out the need to ensure a consistency of the approach to the calculation of the illiquidity premium across all currencies to ensure a level playing field and comparability between currencies. Any divergence of approach may have a significant impact on the capital requirement and consequently on competition. A7. The draft QIS5 specifications propose to determine the illiquidity premium estimate by using the proxy measure calibrated with x=50% and y=40bps. The specifications also foresee that the illiquidity premium results based on swaps are increased by 10bps, to reflect the adjustment made to the swap rate for credit risk. A8. CEIOPS agrees that the spread in the formula is based on the risk-free rate rather than the swap rate. However, CEIOPS would like to ask for clarification on the adequacy of this adjustment for credit risk leading to an increase in the illiquidity premium. X needs to be appropriately calibrated (to remove the credit risk) such that any credit adjustment will not impact the calculation of the illiquidity premium. 3/16

4 A9. Furthermore, in view of the implementation of Solvency II, consideration needs to be given as to how often and for which currencies the x and y need to be recalibrated. 2. Application of the illiquidity premium A10. With regard to the conditions under which an illiquidity premium should be applied, CEIOPS has taken note of the aim of the industry as expressed during the work of the Task Force on the Illiquidity Premium to use this as a tool to mitigate procyclical behaviour of the solvency balance sheet during market turmoil. Following the publication of the Task Force report the majority of CEIOPS Members would agree to apply this on a permanent basis, with the provision that if there is no premium to be observed in the market, the liquidity premium would also be set to zero. However, CEIOPS has also noted questions raised by Member States as to when markets can be considered to have returned to normal circumstances and whether a threshold should be defined to ensure that the premium is only applied for the purpose of preventing procyclical behaviour. A11. CEIOPS' view is that the quantification of the illiquidity premium should be based on a reliable and robust calculation methodology, which accurately estimates the illiquidity premium as a component of total spreads between the yields of assets and the liquid riskfree rate in the financial markets. The illiquidity premium derived by this methodology should only be applied to the valuation of technical provisions if it exceeds a specified threshold and if the market circumstances are considered exceptional. A12. Furthermore, the draft specifications presented by the Commission propose a 3-bucket approach not previously discussed by the task force for the application of the illiquidity premium. The categorization of the liabilities into these 3 buckets depends on specific product features and the second bucket with an application of 50% of the illiquidity premium is applied where liabilities do not fall under one of the other buckets. A13. In its letter accompanying the publication of the Task Force Report on the Illiquidity Premium, CEIOPS expressed a clear preference, should the European Commission decides to apply a liquidity premium, for a binary approach, where the interest rate curve including the illiquidity premium is only applied to technical provisions which are considered as fully illiquid. This should prevent the surge of regulatory and product arbitrage through unclear or misguided principles. A14. Having seen the proposal from the Commission, CEIOPS concludes that it cannot support the categorisation by product feature that is currently suggested in the draft specifications, which compromises the principle of substance over form. Furthermore, the 50% and 0% buckets are not sensitive to the illiquidity inherent in liabilities and thus economically not consistent. A15. Following the binary approach proposed by CEIOPS, the illiquidity premium should only apply to insurance contracts whose cash-flows are highly predictable, and where the undertaking is fully resilient to forced sales of illiquid assets covering technical provisions arising from these contracts. 4/16

5 A16. Therefore, CEIOPS recommends a more sound principle-based approach to identify the liabilities that are considered illiquid and proposes to investigate further on how to derive these principles. CEIOPS recommends that the default bucket should be the 0% bucket, unless specific criteria related to predictability of cash flows in timing and amount, existence of policyholder options and the ability to pass surrender losses back to policyholders are met. A17. It is stated in principle #3 of the Task Force Report on the Illiquidity Premium that the allowance for the illiquidity premium should be based on the ability to earn the illiquidity premium. We interpret that an illiquidity premium can be earned at durations in respect of an observable basket of reference assets (primarily bonds) which can be used to construct an illiquid but risk-free portfolio. This may not necessarily coincide with the duration for which the swap curve is liquid and hence this would not preclude the possibility that an illiquidity premium could be earned in the extrapolated part of the curve. Nevertheless, further consideration needs to be given as to whether it is possible to objectively quantify an illiquidity premium at long durations on the extrapolated part of the basic risk-free curve Allowance for diversification in the risk margin A18. The Commission has proposed in its draft implementing measure the allowance for diversification effects between the lines of business in the determination of the risk margin, by basing the calculation of the risk margin on the assumption that the portfolio as a whole will be transferred to the reference undertaking. CEIOPS has noted the support expressed by many Member States during the Solvency Expert Group meeting for the approach proposed by CEIOPS in its advice, and would like to reiterate its position that the insurance and reinsurance obligations of each line of business are transferred to the reference undertaking in isolation, so that no diversification benefits between lines of business are recognised in the determination of the risk margin. A19. CEIOPS has opted for this approach with the key concern to ensure the transfer of the obligations and hence to ensure the right level of policyholder protection. A20. The recognition of diversification may lead to the adverse effect that there may not be enough capital to ensure that the additional cost of the transferee in meeting the obligations from the transferred portfolio (the cost-ofcapital) will be met 2. Hence assuming that there are diversification effects may render the transfer of the obligations more difficult, threatening policyholder protection at a critical time. A21. The points mentioned are all the more relevant from a group perspective as the recognition of the diversification of the risk margin between different entities within a group raises further questions: 1 This issue is distinct from whether the illiquidity premium should apply to the forward or the spot curve, on which point CEIOPS has stated its views in its proposals for the QIS5 specifications. 2 The initial proposals, also from the industry, did not include the proposal for allowing for diversification benefits. 5/16

6 In accounting consolidated accounts, apart from eliminating intra-group operations, solo liabilities are summed up. This leads to having different underlying technical provisions on whether the accounting consolidation based method (default method) is used or the deduction and aggregation as diversification in the risk margin will be recognised with the default method. 4. Basic risk free rate curve: adjustment to the curve for credit risk A22. The current estimation of the adjustment applied on the swap rate to eliminate credit risk presented in the QIS5 specifications is based on a long-term estimation considering the difference between inter-bank and repo rates over the last ten years. This analysis results in a credit risk adjustment of 10 bps for all currencies and all maturities based on the median differences between inter-bank and repo rates. A23. As the credit risk adjustment for application on the swap rate is currently derived based on a long-term estimation, it does not reflect credit spreads currently observable in the financial market and implicitly included in swap rates respectively. Analysis for year end 2008 indicated a far higher credit risk adjustment. CEIOPS is therefore concerned that credit risk adjustment may be underestimated especially within times of stressed financial markets. In addition, the use of the median in credit risk analysis does not represent the skew nature of distributions. There is no attempt to use medians in the regression to determine the illiquidity premium estimates. Certainly, the adjustment for credit risk and the determination of the illiquidity premium should provide a generally consistent message, especially when considering the assumptions for credit risk in the x- and y-formula. A24. CEIOPS recommends using up-to-date adjustment for credit risk to reflect credit spreads observable in the financial markets rather than long term estimations in line with the interest rate curve that is applied and the determination of the LP. Validation of the credit risk adjustments should also take into account the different types of swaps and for some currencies the different rating of government bonds. 4. Basic risk free curve: data issues A25. The fitted curves for QIS5 (adjusted for credit risk) for each currency are based on the Bloomberg data using the Barrie & Hibbert standard yield curve fitting methodology. The method uses a regression spline with smoothing constraints. This method produces rates that are very close to but not exactly equal to market rates. The average absolute error is generally less than 1 basis point. A26. As the method is not fully published in the open domain, the assessment of the liquid part of the term structure is not transparent. Especially the treatment for outliers may strongly influence the extrapolated part of the yield curve. Currently, it is not quite clear how outliers are treated (there are two outliers for TRY for example). Furthermore, companies will not be able to assess the term structure for alternative dates on their own for 6/16

7 purposes such as stress testing. Besides that, market rates are not exactly replicated (we had an exact fit to the market data in QIS4). An average absolute error of 1 bps in each market data point may not be a relevant measure, if errors with opposite signs net out. It is then more relevant to make a statement on the average of the absolute errors. A27. CEIOPS therefore recommends using raw data rather than already smoothed data as an input into the extrapolation mechanism where interest rate curve is inter- as well as extrapolated, thus using the Smith-Wilson methodology consistently throughout the term structure of interest rates. Furthermore, CEIOPS recommends further investigating the treatment of outliers in observable liquid markets. 5. Basic risk free curves: extrapolation A28. The entry points into the extrapolated part of the interest rate curve were selected based on the estimates provided from a range of methods to assess the last liquid market data point. For simplicity one set of entry points for both 2008 and 2009 is proposed, based on the level of liquidity observed at end 2008 being aware that there was less liquidity in the swap market at end 2008 than A29. Considering the importance of the choice of the entry point in the extrapolation, it is necessary to develop a transparent and objective methodology to assess the last liquid market data point. In particular, this choice impacts the valuation of unavoidable market risk and thus the determination of the risk margin. Furthermore, this assessment has to ensure a harmonized treatment for all currencies to ensure level playing field and comparability between currencies. Any divergence among these magnitudes may have a significant impact on the capital requirement and consequently on competition. Using only one set of entry points for both 2008 and 2009, where liquidity in markets was not comparable, may lead to distortions in the yield curve for 2009 as the entry points are based on the level of liquidity observed at year end A30. Therefore, CEIOPS underlines the importance of considering the information in the market beyond these entry points for the yield curve for Nevertheless, this cannot be the issue of the extrapolation technique. A decision on the entry point implies a decision on the liquid data points that are included in the extrapolation. A31. CEIOPS therefore recommends reconsidering the entry points for year end 2009 based on the level of liquidity observed at year end 2009 and to further investigate in the assessment of liquidity in swap curves. A32. CEIOPS is continuing its work on providing the extrapolation of the risk free curve for other currencies than those included in the initial package for inclusion in the final QIS5 package. 6. Extrapolation of the basic risk free curve: determination of the UFR 7/16

8 A33. For the determination of the UFR, CEIOPS considered two macro-economic components, the long-term expected inflation and the expected short term real rate with the expectation of broadly the same value for the UFR around the world in 100 years. A34. The most important economic factors explaining long term forward rates are long-term expected inflation and expected real interest rates. From a theoretical point of view it can be argued that there are at least two more components: the expected long-term nominal term premium and the longterm nominal convexity effect. As empirical data for those component is scarce and methodologies to quantify these show a high variance in results the assessment is based on the estimates of the expected inflation and the expected short term real rate only to ensure a robust and credible estimate for the UFR. A35. In practice a high degree of convergence in forward rates can be expected when extrapolating at these long-term horizons. From a macro economical point of view it seems consistent to expect broadly the same value for the UFR around the world in 100 years. Nevertheless, where the analysis of expected long term inflation or real rate for a currency indicated significant deviations, an adjustment to the long term expectation and thus the UFR was applied. A36. In order to have a robust and credible estimate for the UFR, the standard expected long term inflation rate is set to 2 per cent per anno, consistently to the explicit target for inflation most central banks operate with. A37. CEIOPS continues to support the use of a 2-component approach to capture the UFR and the approach where all currencies are grouped in one of three levels of inflation: low, standard and high. The default level is the standard level of 2 per cent. Based on historical data for the last years, current inflation and expert judgment, currencies with significant deviations are grouped into the two other categories. 7. Boundaries of the insurance contract A38. CEIOPS is concerned about the different understanding the expressions of unlimited ability to amend the premium (in Level 2 proposal) or freely (in QIS5 specifications) may create in interpreting the boundaries of the contract, and the lack of comparability of QIS5 results across different markets and undertakings which could result from this. A39. CEIOPS recommends that further guidance is developed to ensure a level playing field. 8/16

9 Annex 2: Specific comments with regard to own funds 1. Profits included in future premiums - calculation A40. In the draft specifications submitted by CEIOPS to the Commission, CEIOPS included a proposal for calculation of the profits included in future premiums and proposed to treat these elements as Tier 3 capital. The Commission has decided to delete the proposed calculation and treatment as Tier 3. A41. Discussions with industry and in the Level 2 Solvency Expert Group showed that the debate was based on a lack of common understanding. Member States at the Level 2 meeting agreed that where a calculation method could be found, QIS5 should quantify this item, which would allow for an informed decision on the treatment. This was also the subject of discussion at the QIS5 stakeholder meeting where it was agreed that CEIOPS calculation methodology would be discussed with industry in order to achieve a practical approach. A42. CEIOPS regards the profits included in future premiums as the value of profits derived from the inflow of future premiums (as for contracts with regular premiums, the premiums still to earn) that are taken into account in the calculation of the technical provisions. Any profit related to past premiums received by the undertaking are not included in scope. CEIOPS was able to clarify with the industry the difference between these profits and what the industry calculates as the value-in-force (VIF) under the MCEV calculations. Profits from future premiums are as calculated under the Solvency 2 regime while VIF which as used today by the industry is a much wider concept and will not exist under Solvency 2. A43. CEIOPS considers it is crucial to test a calculation method for the profits included in future premiums as it will allow for an informed decision on the treatment and because discussion has shown that this element reflects a crucial aspect of Solvency II: the move from the statutory balance sheet under Solvency I to the economic balance sheet under Solvency II. For the calculation of the amount of available capital under the Solvency II economic balance sheet approach, the profits included in future premiums will be recognised at the moment of conclusion of the contract. Under the statutory balance sheet, these profits are recognised over the lifetime of the product. A44. Industry participants have highlighted the practical difficulties of CEIOPS proposed calculation given it would require a reassessment of pricing at inception and a recalculation of technical provisions and mentioned that in practice it may be difficult to relate the expectations on future profits with the premium payments. CEIOPS had expected that industry could suggest a means to build a more practical approach which still captured the element described by CEIOPS. CEIOPS has asked industry to give this further thought but in the meantime has identified a number of alternative approaches that may be easier to implement on a top-down approach rather than the bottom up methodology already mentioned. It stands ready to develop further the method based on one of these or options proposed by industry before the start of QIS5. 9/16

10 A45. The proposals aim at finding proxies for the calculation of the profits included in future premiums and show that the calculation of profits included in future premiums could be made practicable and not mean an undue additional burden for undertakings in respect of the calculations required under solvency and accounting projects. Proposals on calculation A46. The following proposals represent CEIOPS latest thinking on practical methodologies to arrive at this item for QIS5 purposes. It is looking to engage further with industry in developing these or possibly combining them with any suggestions the industry might put forward. When Solvency II enters into force it is expected that the undertakings would have adapted their systems to produce these numbers more accurately. A47. CEIOPS has considered three different approaches: one alternative using the calculation of technical provisions as an starting point (actuarial principles), another alternative based on own funds subtracting identifiable individual capital components and a final set of alternatives based on the lapse risk charge. Proposal 1: Estimate of the expected profit margin applied to future premiums taken into account in technical provisions 1. The undertaking should identify at the level of homogeneous risk group the future premium inflows taken into account in computing technical provisions. 2. For each homogenous risk group for which there are such future premium inflows the undertaking should produce an estimate of the expected profit margin in relation to such inflows in the form of a percentage. The derivation of the estimate should reflect current information as to the profitability of the different blocks of business relevant to the homogeneous risk groups as utilised for the management of risk and/or decision-making by the undertaking. 3. The profit included in future premiums is then calculated by applying the expected profit margin percentage to the expected present value of the future inflows by homogeneous risk group and calculating a total. In order to illustrate how the high level profit margin percentage might be refined the following approach has been developed. This involves identifying how future cash outflows for the purposes of technical provisions can be split between, and related to, premiums already received and future premiums. Having calculated that split, the amount of future cash outflows relating to future premiums can be deducted from the amount of those future premiums to compute the profit element. Since insurance undertakings have to calculate the value of future premiums, and the value of future cash outflows, the challenge is how to devise 10/16

11 a straightforward method to carry out the split of future cash outflows into the two elements described above. Three examples have been identified Based on pricing 1. For its description we use as an example a contract with five premiums of the first premium payable immediately and the rest payable at the end of the first, second, third and fourth years of the contract. 2. Assuming that at the inception of the contract the current value of the premiums of the contract is the following: 400 = (weighted probable premiums and discounted) 3. Applying a proportional rule, the benefits of the contract are allocated to each premium as follows: 100% = 25.00% % % % %, and therefore the relevant proportions used to determine the future outflows attributable to future premiums would be: 75.00% (first year), 52,50% (second year), 32.50% (third year), 15% (fourth year) and 0% (fifth and following years) Based on the current situation of the contract 1. This method uses the following proportion for the calculation (current value of future premiums) / (current value of future premiums + present value of past premiums) 2. This might be more appropriate if there have been significant changes in the profile of premiums since the start of a contract. 3. The challenge is how to calculate the present value of past premiums. For that purpose the following is suggested: The ideal calculation would be to run the calculation with the set of assumptions used to price the contract (including the interest rate used in the pricing). Note this calculation needs to be carried out only once in the life time of the contract. An appropriate proxy might be a financial calculation with a reduction factor (less than 1) to estimate the influence that biometric/lapse/other factors would have had in the calculation based on the complete set of assumptions used in the pricing. Where that interest rate is not easily obtainable or relevant, the calculation of the current value of past premiums should be based on the same interest rate curve used to calculate the current value of future premiums. 11/16

12 Based on allocation of the accounting profit day-1 1. Under this method the undertaking needs to calculate at each reporting date the profits embedded in the contract that should be recognized over the lifetime of the contract. 2. Since the accounting allocation of such profits may differ from a solvency allocation, and because it is necessary to consider the profits allocated to past premiums, the only straightforward method seems to be one starting with the total profits at day-1. Once these profits are known it is necessary to allocate them to each of the premiums of the contract (e.g. using the approach described above). The advantage of this approach is that it focuses on the profits included in future premiums. It is recognised that the key issue is how to arrive at a simple and practicable approach that can deliver a harmonised outcome. The various suggestions set out above are intended to explore how this could be achieved. Proposal 2: Calculation based on the residue of Basic Own Funds after deducting capital items from the list of basic own funds for Tier 1 1. The starting point is the overall amount of Basic Own Funds defined as the excess of assets over liabilities. 2. Subtract all individual capital components identifiable in the statutory balance sheet and mentioned in the Tier list of items (e.g. paid up and called up common equity, initial fund, ). The remaining amount of Basic Own Funds includes expectations on future profits (independent of their nature) which are inherent in the economic valuation of assets and liabilities in the SII balance sheet. (Part of these expectations would also be reflected in the future discretionary benefits included in Technical Provisions.) 3. In order to quantify the expected future profits related to future premium income, the premiums already received should be compared with the outstanding premiums. The share of the outstanding premiums on the total amount of premiums shall be used as a proxy. 4. So, for example where the remaining amount of Basic Own Funds is 100 and for the existing contracts 40% of the premiums would still be outstanding, the profits related to future premiums would be 40% of 100, i.e. 40. This proposal has the merit of being relatively simple to calculate but applies a premium percentage to the amount representing the move from the accounting balance sheet to the Solvency 2 balance sheet. A48. Proposal 3: Calculation based on lapse scenario 100% The value of profits included in the future premiums could be estimated by calculating the difference in basic own funds between the current scenario 12/16

13 and the scenario underlying the Lapse Risk Module with a lapse shockup equal to 100%. A49. Proposal 4: Calculation based on SCR Lapse module Consider the value of the SCR Lapse as an approximation of the profits included in the future premiums. This proposal has the advantage that no additional calculation is needed by the undertaking. 2. Profits included in future premiums - tiering A50. With regard to the tiering of these elements, CEIOPS would like to point out that the Level 1 text requires explicitly in its articles 93 and 94 to test the loss-absorbing capacity of the own funds. CEIOPS recognizes that the uncertainty in the amount of the net-asset-value should be addressed in the level of the capital requirements on a going concern basis. However, for the quality of the own funds the Level 1 text explicitly requires for the economic and prudential assessment of the solvency position to consider the loss-absorbency of own funds in times of winding-up. Accepting profits related to future premiums as Tier 1 would mean that these elements could cover large amounts of the minimum capital requirements, which per essence should shield an undertaking from winding-up. However, it is exactly in times of financial stress, that these elements are highly unlikely to provide any capital relief. Although on the SII economic balance sheet the profits are reflected from the first day and hence contribute to the net asset value, these elements do not have the sufficient loss-absorbing capacity required by Level 1 for capital elements of highest quality. Therefore, CEIOPS is still convinced that these items do not meet the criteria to be classified 100% Tier Ring-fenced funds A51. CEIOPS, industry and the Commission are engaged in positive discussions to clarify the situations in which ring fencing adjustments apply and how these would apply in practice. 13/16

14 Annex 3: Specific comments with regard to solvency capital requirements 1. Capital charge for participations of a strategic nature A52. CEIOPS has followed the debate on when participations can be considered to be of a strategic nature in the Solvency Expert Group meeting and has taken note of the proposal made by the Commission the latest draft implementing measure in this area. CEIOPS supports a workable and practicable definition criteria for defining the strategic nature of the participations, to which it would like to contribute. CEIOPS would support that such criteria would be tested as part of the exercise. A53. With regard to the capital charge, CEIOPS would like to point out that the calibration of the charge for participations of a strategic nature would require further substantiation. CEIOPS points out that there are potential alternative calculation methods which may be more appropriate to build on the valuation approach proposed by the Commission for participations. CEIOPS is willing to further discuss concrete proposals in view of QIS5. CEIOPS believes that the capital charge for participations should be built on the basis of the following principles: a. The SCR of a participating undertaking is independent on how participated undertakings organize behind the former one b. Double gearing should be not encouraged to limit the risk that both participating and participated undertaking experience difficulties simultaneously, c. The capital charge of participation should be based on an economic approach. 2. Design and calibration of the Health underwriting risk module A54. CEIOPS is involved in the Task Force set up by the Commission where stakeholders, Commission and CEIOPS discuss a revised segmentation and accompanying calibration of the module. CEIOPS is also discussing the introduction of the use of risk equalization pools in this area. The discussions are ongoing and CEIOPS will continue contributing to the Task Force and submit a common CEIOPS view on the proposals. 3. Design of the spread risk A55. CEIOPS has received some input from industry on specific aspects with regard to the design of the spread risk module. This includes for example questions on the application on the liability side following the inclusion of an illiquidity premium or the calculation of the charge for structured products, credit derivates and mortgage loans. CEIOPS will continue analyzing 14/16

15 these comments and expects to provide the outcome of the discussion in time to be considered in QIS5 specifications. A56. A further issue raised by industry is the calculation of the charge for covered bonds, for which CEIOPS is currently analyzing further data. 4. Dynamic hedging (SCR 12.24) A57. We would like to clarify a misunderstanding that seems to have occurred in stakeholders interpretation of a paragraph of the specifications, which would give the impression that dynamic hedging would be allowed for in the SCR standard formula. A58. Therefore, we suggest amending paragraph in the following way: Future contracts meeting this paragraph shall be considered to assess only the period of effectiveness of the risk mitigation technique during the next twelve months. Where the current and future techniques provide different mitigation (be it through a change in the asset portfolio, or a change in the nature or amount of the hedging instruments themselves) the level of mitigation that shall be considered to reduce the SCR calculated according with the standard formula shall be the one providing the lowest level of mitigation existing during the next twelve months. A59. The asset portfolio to be considered shall be the asset portfolio prevailing at the opening of the twelve months period, and without taking into account any mitigation that could result from a change in the asset portfolio itself during the following twelve months period, considering that this change cannot be effective before the occurrence of a shock: the shock is assumed to be taking place as soon as the opening of the twelve month period. 5. Standardised catastrophe scenarios A60. CEIOPS is continuing its work on the final set of standardised catastrophe scenarios which should result in a proposal in the course of June, in time to be tested in QIS5. 15/16

16 Annex 4: Specific comments with regard to group capital requirements CEIOPS strongly supports where the draft specifications stipulate that, when groups apply the deduction and aggregation methods, the floor to the MCR should be kept in order to avoid regulatory arbitrage between the default and the alternative method in case the difference between the group SCR and the sum of solo SCR is only explained by elimination of intra-group transactions in the default method and not by additional real diversification. The MCR is a legal boundary under which the solo authorization is withdrawn and therefore CEIOPS considers this to be a floor in the consolidated method. The same reasoning should apply with the deduction aggregation to ensure that the group own funds are at least equal to the sum of solo MCRs. As already expressed and explained in its advice, CEIOPS supports the EC proposal to limit the eligibility at group level of non available own funds to the contribution to the group SCR of the entity for which those own funds can absorb risks. CEIOPS also would like to reiterate that diversification of the risk margin should not be recognized also at group level. The arguments made at solo level before in this respect apply even more so at group level. 16/16