The SCR: early warning system or panic button?

Solvency II will introduce a two tier regulatory capital requirement: the Minimum Capital Requirement (MCR) and the more tolerant Solvency Capital Requirement (SCR). Because breaching the latter will trigger a less severe regulatory response, EIOPA is concerned that market participants will misinterpret this as a ‘relaxation’ of the regulator’s attitude. EIOPA recognises the need to educate market participants that a breach of the SCR is as an early warning system and not a ‘panic button’.

A regulatory ladder of intervention

The MCR is an absolute minimum metric that, if breached, will trigger serious regulatory intervention and potential closure of the firm. The SCR, on the other hand, is a target level that the firm should aim for. Breaching the SCR will be considered by the regulator as a sign of a firm’s deteriorating financial soundness and it will intervene to make sure the firm takes appropriate action to restore the SCR. The ‘space’ between the two capital requirements will allow for a supervisory ladder of intervention – a cornerstone of a risk based framework that focuses on pre-emption.

A breach, is a breach, is a breach …

Any defined measure, regulatory or otherwise, could easily becoming a benchmark. So the regulator’s concerns are understandable. The SCR is defined as “The potential amount of own funds that would be consumed by unexpected large events whose probability of occurrence within a one year time frame is 0.5%.” Whereas the MCR represents the same provisions but with a probability of a 15% occurrence within the one year time frame.

The SCR is supposed to represent a comprehensive measure of all material risks the firm faces. As such it is quite possible that the industry will be intolerant of a breach. “A breach of the SCR is unlikely to be viewed as an ‘early warning’ by market analysts,” Omar Ripon, Director at Mazars, said.

Mr Ripon believes that while the SCR will not be the only risk performance indicator used by analysts to assess financial strength and profitability, it will be very prominent. “The SCR is likely to a be a key indicator in the future purely because it represents an ‘all-in’ risk figure, which takes into account both qualitative and quantitative risks faced by insurers. These include factors such as management decisions and operational risks in addition to core insurance and asset risks. Any breach of the SCR is likely to indicate poor risk management decisions by senior management and capital deterioration as a symptom of other major failures.”

The amount of time and resources invested in preparing for Solvency II (in particular by the larger internal model firms) will contribute to this attitude, and this all-in risk measure will dominate the view of an insurer’s financial condition, according to Mr Ripon. “We can expect that, at least initially, there will be some misinterpretation of the SCR numbers before the market is better educated.”

The SCR in the wider context

The SCR is likely to be considered in the context of a set of parameters used to evaluate the financial state of an insurance firm. Fitch logoThe rating agency Fitch said it will take notice of the SCR but will form its own view of the company. “Regulatory capital often doesn’t tell you what the rating will be, but we look at the SCR if for no other reason than as an indicator,” David Prowse, Senior Director, Fitch, said. “If the regulatory solvency metric drops very suddenly, that is a warning light and we will look at it on our own basis.”

Mr Prowse noted that in many respects Solvency II will be formalising a process that exists under the current regulatory regime. “At the moment, under Solvency I, we have, in effect, an MCR. There is just one clear metric and you must have 100% coverage of that. But over and above that there is a ladder of intervention that takes place behind the scenes. If coverage weakens significantly the regulators will have private discussions with insurers well before they are likely to breach the coverage of the current metric.”

But even though a temporary breach of the SCR will not have a direct effect on the agency’s assessment, it could trigger a number of debt instruments and this could have a significant effect on the firm’s rating.

According to the latest available advice from EIOPA (CP 46 - then CEIOPS) for debt instruments to be counted toward Tier 1 and Tier 2 capital, dividends and coupon payments must be suspended or cancelled if the SCR is breached.

For Tier 1 capital, reinstatement of any payments cannot be cumulative, while for Tier 2 capital deferred payments can only be resumed with the consent of the supervisor. This, according to Mr Prowse, would have significant implications on a firm’s rating both at the point of deferral and more generally.

Looking beyond the SCR

But some argue that the breach of the SCR will not matter as much as the relationship between existing funds and the new capital requirement. The focus will be on a firm’s capital buffer – above the SCR – when Solvency II comes into force and how that buffer changes over time.

SGCIB logo“Understanding the SCR is much more complex than just looking at one figure, if you want to really understand the status of the company,” Ludovic Antony, Director, Financial Institutions Advisory at SGCIB said. He believes that reviewing the performance of a firm against its peers will be much more critical under Solvency II and that the solvency ratio will play a key part in that process.

Solvency II will allow for a more acute distinction between companies that are similarly capitalised under Solvency I. Initially a firm’s solvency ratio – the amount of capital held over the SCR – will be assessed. When Solvency II comes into force this will mean that, literally overnight, the solvency ratios will have changed, whereas the financial status of companies has not. “The first step will be to compare the Solvency II ratios with Solvency I ratios and understand the differences,” Mr Antony said.

“Our gut feeling is that for many life companies, for example, Solvency II ratios will be above Solvency I ratios, in particular because of the inclusion of Value In Force as Tier 1 capital.”

Mr Antony believes that the Solvency II ratios will set a new definitive benchmark for the industry. “What will matter then in a competitive environment is how companies compare with peers and with the industry, and not just whether a company is covering its SCR or not.”

Market participants will also consider the sensitivity of these new solvency ratios. “Indeed, we find that in general, Solvency II ratios are much more volatile than under Solvency I,” Mr Antony said.

So rather than breaching the SCR, firms might find themselves under more scrutiny for a significant drop in the solvency ratio or in own funds away from the previous position. Whether the volatility is caused by temporary factors (such as a temporary spike in options implied volatility) or hard losses due to defaults or natural catastrophes will also be critical.

The exposure to further damage and the potential for recovery from the current position will also be taken into account. And factors such as the ability to implement stop losses in case the solvency has been depleted, or to increase premiums to restore profitability and build reserves will be considered.

“What is likely to be of much more significance is not a breach of the SCR,” Mr Antony concluded, “but simply the ‘derivative’ of the solvency ratio, i.e. its propensity to move away from one position to the next depending on the change in the state of the economy, and the ability of firms to move on after a shock has occurred.”

More discerning peer review

In this context, Solvency II will allow for a more discerning comparison between firms than Solvency I. Mr Antony explained, “For example, two life insurance companies might have a similar Solvency I ratio. But if Company A has implemented protections (such as purchased equity put options or received swaptions to manage both equity and interest rate risk) and accumulated significant ‘hidden’ reserves in the past, while Company B did not, Solvency II will reflect that in the solvency ratios and their volatility. Company A is likely to have a much better Solvency ratio and less volatility than Company B, especially if guarantees are close to the money.”

“So I think there will be a lot more discrimination between companies and we will see the winners and losers much more than we were able to see under Solvency I, especially in bad times,” he added.

Latching onto the SCR in a crisis

Indeed, times of crisis could refocus attention on the SCR as a single metric. Experience has shown that sensitivity to peer review and benchmarking will increase in times of extreme market stress. This is exactly what happened in the 2008 crisis when the minimum measure of regulatory capital under the Insurance Group Directive (IGD) became the focus of attention.

As interest in the IGD figures grew, Fitch began to explore if the larger insurance companies managed their business based on it. Most respondents said they treated the measure as a blunt tool which they filled in for regulatory purposes and that they managed capital on other criteria. “But then gradually as the crisis deepened the IGD became more of the focus of attention,” Mr Prowse said. “This was because it was a number that the media and the analysts could latch onto. You saw this peer pressure amongst the major players to report high positions above the IGD. So you can imagine a similar position with Solvency II.”

The regulator will set the tone

Whether the SCR or solvency ratio becomes the focus of attention under Solvency II, it seems that much of how market participants will understand, and act on, a breach of the SCR will depend on the regulator’s attitude to the new capital requirement.

Kevin Ryan, Insurance Analyst at Investec Securities believes interpreting the breach is less about education per se and more a case of making the regulatory requirement clear. “What satisfies a regulator and what is acceptable to a commercial third party seeking to do business with the regulated insurance entity may be two very different things. It is not yet clear how much data will be made public but analysts and other users will certainly make up their own minds about a situation.”

Details of the dialogue with the regulator will also continue to be important, if not more important, in the new regulatory environment. Sonja Zinner, Director, Fitch, said that part of the agency’s ongoing dialogue with firms includes understanding their discussions with the regulator. “If there is some serious intervention and there is some discussion on suspension of new business or winding up, which would be very serious, then that obviously will have an impact on the ratings.”

Can market participants be educated?

Despite the regulator’s best efforts, the mere fact that a change is introduced is sufficient to cause turmoil and confusion. Carlos Montalvo, Executive Director of EIOPA, has noted that Solvency II represents “a major cultural shift” in the supervision of insurance firms. If recent history is anything to go by, educating market participants could prove challenging.

“Any change and any new form of reporting will only complicate things, at least in the short term. I think that is inevitable,” Mr Prowse, said. “We have seen that when some companies switched to mark to market valuation (MCEV) and much lower numbers were reported as a result. So although no reality had changed, some numbers that were in front of the analysts and the investors suddenly looked different and that seemed to create a degree of panic.”

Allianz logoHowever, others argue that as long as the SCR remains the focus of Solvency II, it will always be open to misinterpretation. Tom Wilson, Chief Risk Officer, Allianz, said, “Even with a substantial educational effort, it is likely that a breach of a 100% SCR ratio will be negatively viewed by the analyst community if the SCR remains the focal point of Pillar III public disclosures.”

“The most effective way to mitigate this risk,” he said, “would be to put the primary emphasis on the MCR for Pillar III public disclosures. Although this practice is not without its drawbacks, it has been followed in the past, for example by EIOPA when announcing the results of the recent stress test exercise.”

The notion of ‘educating’ markets is problematic – perhaps even naively optimistic. Markets make up their own views and no amount of ‘education’ and explanation will sway them – the Eurozone’s repeated attempts to calm the bond markets is a case in point. But Solvency II will usher in a major cultural change in the way insurance firms are supervised. Leaving the interpretation of an SCR breach to market participants alone may simply not be good enough.

 

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