A Comment on the Solvency II equity dampener: more change to come?
Posted on 16-02-2011 | 0 comments
Co-founder and Adviser
In the Solvency II standard formula for an insurer’s Solvency Capital requirement (SCR), the standard stress adopted for equity risk for the purpose of the 5th Quantitative Impact Study (QIS5) was 39%. This was somewhat less severe than what had previously been proposed by CEIOPS in its level-2 advice where a majority of regulators proposed a standard equity stress of 45%.
Under the proposed Solvency II framework this standard assumption is adjusted using a ‘dampener’ in order to avoid procyclicality. The stress test may be modified up or down depending on the where global equity prices are trading relative to their recent average. For QIS5, the dampener was calculated based on market prices relative to their 3-year moving average. At end-2009, equity prices were 9% below their 3-year moving average and so the equity stress was reduced by 9% to 30% for QIS5. At end-2010, equity prices were 11% above the 3-year moving average (MA) and so the equity stress would be adjusted up (by a capped 10%) to 49% on the same basis. The chart below plots the differences of the MSCI World Index used in CEIOPS’ studies to its 3-year MA and the resulting modified stress on the right-hand scale.
So, capital requirements to support equity risk would have been raised substantially over the year for those using a standard formula approach modified using the dampener. It is worth noting the contrast with market-based measures of equity risk. During the year, option implied volatilities (for a broad range of maturities) were broadly unchanged. Of course, we have argued in the past that a truly objective stress test following a stress test would be more severe not less severe as under the dampener. This is because – following equity stress – although risk premia tend to rise, this effect is offset by the typical increase in uncertainty and volatility (see link). In practice, it seems considerations of procyclicality outweigh cold analysis.
It is also worth noting another property of the dampener. The adjustment to the equity capital charge is described in both the Solvency II directive and guidance as being ‘symmetric’. Of course, it is symmetric in the sense that it can raise or reduce the capital charge by equal amounts. However, you can see from the chart that it certainly is not symmetric in the frequency of adjustment i.e. the adjustment upwards is applied far more frequently than the downward adjustment because equity markets tend to rise over the long term. The table below shows the proportion of time at the floor and ceiling for the equity capital charge and compares results with the CEIOPS ‘majority’ view where the dampener is based on 1-year MA and centred on a basic charge of 45%.
This is no mere accident of history. A very simple simulation of price paths shows virtually identical results:
I have no fundamental difficulty with the notion of procyclicality or the desire of regulators to limit its damaging impact. However, in an environment where equity values are reduced, it seems we are unable to face the economic reality and say the words: “policyholder security is reduced to x%; firms will rebuild their capital base to meet the 99.5% requirement over the next N years”.
If as for end-2009, the averaging period is to be selected to produce the answer firms can live with, perhaps regulators should just say so. Pretending the averaging is the result of objective analysis won’t help improve transparency or build faith in the insurance industry’s emerging capital measures.
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