Solvency II - Lesson learned?

Table of Content

1. Introduction

1.1 Subject and background of the study

1.2 Objectives of this thesis

1.3 Course of the analysis

1.4 Scope and limitations

2. Solvency II – A major European regulatory initiative

2.1 The development of Solvency II

2.2 The three pillar approach

2.3 The current second phase

2.4 Quantitative impact studies

2.5 A risk based economic system

2.5.1 The economic balance sheet

2.5.2 Overall structure of the standard formula

2.5.3 Measurement and assessment of risk

3. Treatment of investment risk under the standard formula

3.1 Interest rate risk

3.1.1 The discount rate

3.1.2 The illiquidity premium

3.2 Equity risk

3.2.1 Symmetric adjustment mechanism

3.2.2 Duration based equity dampener

3.3 Spread risk

3.3.1 Spread risk on bonds

3.3.2 Spread risk on structured credits

3.3.3 Spread risk on credit derivatives

3.4 Illiquidity premium risk

3.5 Property risk

3.6 Currency risk

3.7 Concentration risk

3.8 Counterparty default risk

3.9 Aggregation of risk modules

4. Potential implications caused by Solvency II

4.1 The beginning of an EU wide asset reallocation

4.1.1 Summary of capital requirements of major asset classes

4.1.2 The driver for solvency capital requirements

4.1.3 The changing investment behavior

4.2 The possibility of new risk due to changed market conditions

4.2.1 Negative feedbacks as a consequence of market consistent valuation

4.2.2 A new interesting investment market

4.2.3 Multiple additional threats for the insurers and the market

5. Conceptual drawbacks of Solvency II

5.1 Theory, reality and the model

5.1.1 The independence of price changes

5.1.2 Price changes adhere to a probability distribution

5.2 False confidence in Value at Risk

5.2.1 Underestimation of tail risk

5.2.2 Sub-additive

5.2.3 Different methodology leads to a different Value at Risk

5.3 Black Swans and the Big Bang

5.4 Reliance on credit rating agencies

5.4.1 The non transparent business model

5.4.2 No liability or regulation

5.4.3 Mistakes in the past

6. Conclusion

Objectives and Core Themes

This thesis examines the Solvency II regulatory framework to determine its effectiveness and reliability in measuring risk for European insurance companies. It explores whether the transition to a market-consistent valuation approach is sufficient or if it introduces new, unforeseen risks to the industry and the broader financial market.

• Foundational principles and development of Solvency II.
• In-depth analysis of investment risk treatment within the standard formula.
• Potential implications of new regulatory rules on insurer investment behavior and asset allocation.
• Conceptual limitations of risk measurement models like Value at Risk (VaR).
• Critical evaluation of the reliance on external credit rating agencies.

Excerpt from the Book

Summary of Chapters

1. Introduction: Provides background on the shift toward risk-based regulation and outlines the thesis objectives, including the analysis of Solvency II's reliability.

2. Solvency II – A major European regulatory initiative: Explains the development, the three-pillar architecture, and the quantitative assessment methods of the framework.

3. Treatment of investment risk under the standard formula: Analyzes the specific risk modules, including interest rate, equity, spread, and counterparty risks, and how they are aggregated.

4. Potential implications caused by Solvency II: Investigates how the framework influences investment behavior, specifically the shift toward government bonds and potential negative market feedback.

5. Conceptual drawbacks of Solvency II: Critically evaluates the reliance on statistical models like VaR, the influence of credit rating agencies, and the challenges of predicting extreme events.

6. Conclusion: Summarizes findings, noting that while Solvency II is an improvement, it is not a perfect solution and highlights the need for ongoing adaptation.

Key Words

Solvency II, Insurance Industry, Risk Management, Value at Risk, Market-Consistent Valuation, Investment Risk, Interest Rate Risk, Equity Risk, Spread Risk, Credit Rating Agencies, Capital Requirements, Asset Allocation, Financial Regulation, Quantitative Impact Study, Basel Accord.

Frequently Asked Questions

What is the primary focus of this work?

The work primarily focuses on the Solvency II regulatory framework, analyzing how it measures financial risks for insurance companies and the subsequent impacts of these rules on the European financial market.

What are the central themes discussed in the thesis?

Central themes include the standard formula for risk calculation, the shift toward market-consistent valuation, the impact on asset allocation strategies, and conceptual critiques of current risk measurement techniques.

What is the ultimate research goal?

The goal is to determine if the Solvency II risk measurement approach is reliable and useful, or if it requires significant further adaptations to avoid creating new systemic risks.

Which scientific methods are applied?

The analysis utilizes an examination of regulatory directives, a review of existing financial literature, and a critical study of Quantitative Impact Studies (QIS) and statistical risk modeling theories.

What is covered in the main part of the work?

The main part covers the detailed mechanics of the standard formula, including specific modules for interest rate, equity, spread, and counterparty risk, alongside the broader implications for the insurance industry.

Which keywords characterize this paper?

Keywords include Solvency II, risk management, Value at Risk, market-consistent valuation, asset reallocation, and regulatory capital requirements.

How does the author view the role of credit rating agencies in Solvency II?

The author is highly critical of the heavy reliance on credit rating agencies, highlighting their lack of transparency, susceptibility to conflicts of interest, and tendency to lag behind actual market developments.

What are "Black Swans" in the context of this thesis?

Black Swans refer to unpredictable, high-impact events that lie outside regular expectations, which the author argues are not adequately captured by the mathematical models used in Solvency II.