A GlobeRisk Perspective on Basel2 and Solvency2
Basel2 and Solvency2 represent the most important changes to financial sector regulation for 20 years. The key factor is not necessarily the exact content of these initiatives by themselves, but the structural move of global regulators towards risk based supervision and capital setting.
Within the new regulatory paradigm firms will be offered “incentives” to establish control mechanisms, capital and liquidity resources to reduce risks to the financial system (and therefore to the regulatory bodies). Consistent emerging evidence suggests that regulators have noticed that they have a “one-off” opportunity for influence before firms receive their incentives. The net effect is that Regulators are taking a very tough approach towards accrediting the new infrastructure.
The two initiatives each have three elements or “pillars”; modelled capital requirements (Pillar1), discretionary additional requirements(Pillar2) and risk reporting(Pillar3). However the impact of the first two pillars is quite different between Basel2 and Solvency2
In Basel2, due in part to historical calibration issues which cannot now be resolved, the key area is Pillar2. The UK implementation of Pillar 2 is basically defined by sections 1.2.26/30/34/37 and 1.2.42 of the General Prudential Rule Book (GENPRU).
To all intents and purposes this requires that firms establish and use– in a manner proportionate to the nature, sophistication and scale of their business activities:
- A firmwide risk management framework
- A capital assessment mechanism for all significant types of risk (in addition to which a firm will need to demonstrate sufficient liquidity resources)
- A stress and scenario testing framework
Although GENPRU also applies to all full license firms, including Banks and Insurance firms, the major impact of Solvency2 occurs through the Pillar1 element = modelled capital requirements.
In the case of most Life Insurance firms this will largely take the form of market risk, ALM, credit risk and operational risk elements whilst for most Non Life firms the majority of required capital will arise from technical insurance risks.
The issue for insurance firms is that direct risk taking activity is a more important driver of their financial performance than it is for banks – so that it becomes very important for almost all firms to take advantage of the flexibility to use in house models to calculate capital requirements rather than using the mechanisms proposed by the regulator i.e.
- a conservative formulaic calculation for each risk module
- a defined, conservative, correlation structure which recognises only limited diversification
This compares with the internal models approach (which may be applied partially) in which anything goes providing a firm meets the standards set out in Section 6.449 of CEIOPS CP20.
- the use test: “is the actuarial model genuinely relevant for and used within risk management”.
- the calibration test: “is the SCR calculated by the undertaking an unbiased estimate of the risk and measured by the common SCR target criteria”
- the statistical quality test: “Are the data and methodology underlying both internal and intend and regulatory applications sound and sufficiently reliable to support both satisfactorily?”
CP20 distinguishes between its risk ranking and risk calibration and proposes a minimum standard for the former of first-order stochastic dominance.
(A has first order stochastic dominance over B if A gives an outcome that is at least as good as B in every possible state)
GlobeRisk Basel2 and Solvency2 services
For both banks and Insurance firms meeting the requirements of Pillar2 will be a major challenge. GlobeRisk has designed the following services to help:
- A Pillar2 health check; this is designed to be a low cost external review of the extent to which a firm is meeting our understanding of Pillar2 standards, with a view to identifying any areas which need further work
- Economic Capital Design and Implementation; GlobeRisk can help a firm to design a quantitative mechanism to meet the requirements of GENPRU 1.2.26/30/34 and 1.2.42. As a minimum, an Economic Capital Model is an aggregate risk model. To meet the GENPRU requirements it must be extended to include business risk. GlobeRisk also recommends implementing Economic Capital in the form of a Solvency model to remove problems caused by arbitrary choices of horizon and/or consideration of business run off. GlobeRisk can undertake all aspects of an Economic Capital Project unto and including IT implementation.
- Pillar2 program design and management; including risk management infrastructure design and documentation, stress testing, capital management infrastructure and the formal Pillar2 submission itself
- Construction of Solvency2 risk rating models
- Solvency2 Program Management
- Design and implementation of Insurance Risk management framework and Infrastructure