11 December 2015Actuarial & underwriting

Solvency II ratios not always reflective of economic capitalisation

Solvency II ratios won’t always reflect economic capitalisation of insurers, according to a new report by Moody's. The firm said that Solvency II ratios may underestimate or overestimate insurers' actual economic capitalisation due to the challenges in calibrating all risks on a pure economic basis at a 99.5 percent confidence level and the impact of the transitional measures agreed to smooth Solvency II implementation. As a result, the emphasis that Moody's will place on Solvency II ratios in its assessment of insurers' capitalisation will vary, notably by category of insurer, said the firm in the report, 'Solvency II Ratios Will Not Always Reflect Economic Capitalisation'. In the Solvency II directive, which comes into force on 1 January 2016, capital requirements are defined as the amount of resources needed to absorb all economic losses with a probability of 99.5 percent. "On the basis of this economic approach, we have evaluated that a 100 percent Solvency II ratio is consistent with a low business associate agreement (Baa) level of capitalisation and a 200 percent ratio is consistent with a low Aa level of capitalisation," said Benjamin Serra, vice president and senior credit officer of Moody's. “However, the calibration process and transitional measures have partly taken the Solvency II ratios away from a pure economic view.”Moody's said it plans to place little emphasis on Solvency II ratios with transitional measures in its assessment of economic capitalisation, because it considers the transitional measures to be non-economic. The rating agency will place more emphasis on Solvency II ratios without transitional measures (aka "fully loaded" ratios), when it considers that the Solvency II calibration is economic, for example, when the ratio captures and reflects well the risks specific to an insurer. The amount of emphasis Moody's will place on fully loaded Solvency II ratios depends on the typology of insurers. In particular, Moody's expects to gradually increase the emphasis it places on fully loaded Solvency II ratios in its analysis of P&C insurers and reinsurers. Conversely, Moody's said it will usually place a lower emphasis on Solvency II ratios in its analysis of life insurers. "Nonetheless, Solvency II ratios remain important in Moody's overall assessment of insurers' financial strength because, regardless of their economic meaning, Solvency II ratios will determine the level of regulatory scrutiny over insurers", added Serra. According to Moody's, an insurer which reports (i) a Solvency II ratio with transitional measures below or close to 100 percent, or (ii) a fully loaded ratio below or close to 100 percent, with a low probability to reach a reasonable level over 100 percent at the end of the transitional period, will be subject to regulatory constraints which will limit its business and financial flexibility and therefore constrain its credit profile and rating. The comfort level above 100 percent varies by insurer and is a function of the ratio's volatility which most of the time also partly reflects the insurer's risk profile, according to the firm. Currently Moody's does not expect the impact of Solvency II on its rated universe to lead to many rating changes. Moody's will continue to focus on other ratios in assessing capitalisation when Solvency II ratios do not incorporate sufficient economic information.