Flawed Solvency II risk margins must be reviewed
Significant flaws exist in in the formula used to calculate the risk margin under Solvency II and a fundamental review of its methodology and calibration is required, Willis Towers Watson has claimed in a response to a European Insurance and Occupational Pensions Authority (EIOPA) Discussion Paper on the upcoming review of Solvency II.
Willis Towers Watson’s submission notes that the risk margin has become a much more material component of insurers’ balance sheets, leading to a number of challenges and changes in business practice.
These include Asset Liability Matching, noting that insurers’ ALM challenges related to risk margin have been exacerbated by falling interest rates; risk transfer, with Willis noting that the bigger the risk margin relative to the rest of the technical provisions, the more insurers are incentivised to offload risk to reduce the risk margin; and longevity reinsurance. Willis said it believes that the growth in the longevity reinsurance market has been caused primarily because the Solvency II risk margin is materially too large for relevant primary insurance business (mainly immediate annuities).
The consultancy’s submission, principally focused on the risk margin, recommends an independent review of the purpose of the risk margin and what an appropriate methodology and calibration should be.
Kamran Foroughi, director at Willis Towers Watson, said: "We believe the high level of risk margin currently attached to long-term insurance products is resulting in higher premium rates and reduced competition, leading to worse value for consumers.
"The Solvency II Draft Directive was published in July 2007 and defined the risk margin to be part of the technical provisions and calibrated as a 6 percent per annum capital charge on non-hedgeable risks. Throughout the rest of the Solvency II project up to adoption on 1 January 2016, there seems to have been no mechanism available to revisit this definition.
"After a fundamental review to confirm the broad model for the risk margin, stress and scenario testing should then be used to determine whether it should also change in different markets. If a risk margin model were to be permitted that varies with market movements, we would advocate an anti-cyclical approach as opposed to the current approach which we believe ends up being dangerously pro-cyclical."
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