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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:

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.

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.

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: