How does a global pandemic impact Solvency II?

Navigating the COVID-19 pandemic calls for outlining possible scenarios on how the financial statements of (re)insurance companies will be impacted.

Depending on the nature of the business and the types of products in investment portfolios, companies may face increased mortality rates, economic contraction, slowing business activity, falling equity markets and interest rates, and widening credit spreads. These events substantially impact both the insurance and reinsurance markets. Also, to some extent, all businesses are exposed to increased operational risks. Doubtlessly, the occurrence of these effects are highly correlated.

This article’s goal is twofold: 1) to discuss how the current economic capital framework of Solvency II addresses the uncertainties that have arisen with the COVID-19 pandemic, and 2) to analyse how the processes implemented within this framework protects insurance companies from growing risk concerns.

In this article, we aren’t discussing the impact on business interruption products as the outcome is dependent on the terms and conditions of individual products and on legal outcomes under separate jurisdictions.

Revisiting Solvency II

Solvency II, which has three pillars, is a risk-based directive that offers insurers, their stakeholders and regulatory authorities the means to face extreme risks and gain a clear vision on how to act accordingly.

The first pillar of Solvency II sets out quantitative requirements

It includes principles to value assets and liabilities (in particular, technical provisions) so as to calculate capital requirements and to identify eligible own funds to cover those requirements. This ensures that re(insurance) companies are solvent enough to cover their obligations in case of unfavourable events that impact negatively the financial markets, including a pandemic scenario over a one-year horizon.

The second pillar of Solvency II focuses on governance and risk management

It introduces the Own Risk Solvency Assessment (ORSA). This process is designed to reflect the unique risk management characteristics and risk-profile of a company, in order to support sound management and decision making. The coverage of this process is wide ranging from strategic planning and projection analysis over financial statements to risk assessment, risk appetite analysis, defining of risk thresholds, triggers, risk measures, sensitivity and stress testing, internal and external controls and more.

The third pillar of Solvency II is about disclosure and transparency requirements

It merges financial projection with risk assessment and should, in theory, provide (re)insurance companies with the appropriate tools—sensitivity and stress testing—to capture the impacts of extreme events, like the COVID-19 pandemic. This, while taking into account the data limitations to estimate solvency shocks in case of pandemic.

Possible spotted deficiencies when treating pandemic-related events

There are some deficiencies in the way Solvency II defines a pandemic risk and how the ORSA process has been structured to face such scenarios.

The possible risks associated with how (re)insurers should react in case of a pandemic event (under the Solvency II regime) fall under the responsibility of the European Insurance and Occupational Pensions Authority (EIOPA) and local regulatory authorities. In turn, the ORSA process is reported and reviewed by the local regulator.

The possible risks are as follows:

Whether EIOPA’s Catastrophe Task Force defined appropriately the shocks caused by pandemic-related events due to limited data history for these type of situations;
Whether the clients performed adequate risk assessments and identified all relevant risks;
Whether appropriate stress and sensitivity tests were performed by the Client within the ORSA process to cover for pandemic events.

Digging into the Solvency II Pillars

Pillar I – Solvency Capital Requirement (SCR)

The solvency capital requirement is the amount of funds that insurance and reinsurance companies are required to hold under the European Union’s Solvency II Directive. This is to guarantee a 99.5% confidence they could survive expected losses over the course of a year.

Under Solvency II, EU-based insurance companies must hold sufficient eligible own funds on an ongoing basis to cover their Solvency Capital Requirement. It enables insurance businesses to absorb significant losses and give confidence to policyholders and beneficiaries that payments will be made as they fall due.

There are underwriting risks in all health, life and non life insurance, namely, potential loss an insurer may have resulting from faulty underwriting.

The impact of a possible catastrophic event is captured in the SCR calculation in all three underwriting risk modules: the non-life underwriting risk, the life underwriting risk and the health underwriting risk. All of them are calculated in a catastrophic (CAT) submodule.
Let’s revisit what these submodules are.

Pillar 2 – ORSA

The Solvency II Directive introduced the Own Risk and Solvency Assessment (ORSA). It’s a component of pillar two that’s about governance and risk management. Its goal is to reflect the risk profile of a company in order to support appropriate risk management and decision making.

How does ORSA differ from SCR?

	ORSA	SCR
Time frame	The ORSA process is forward looking. The time horizon corresponds to the company’s business planning horizon—typically 3 to 5 years—as it asks for an economic capital review rather than regulatory-driven capital calculations.	The calculation focuses on the capital requirement considering a 1-year time horizon based on an identified list of risks.
Scope	Identification and assessment of all risks that the (re) insurance company could be facing.	SCR is just a calculation, a value. Calculating SCR is part of the ORSA process.

ORSA and COVID-19

The ORSA process allows (re) insurance companies to design catastrophic scenarios so they can assess their solvency in regards to the impact of such events.
When developing the stress testing that ORSA requires, a (re)insurer may consider different types of scenarios.

For instance, “top-down” macroeconomic scenarios—capturing systematic exposure to economic and financial market outcomes; “bottom-up” scenarios—reflecting firm-specific risk exposures arising from their strategy; and operational profile and systematic insurance risk scenarios, such as longevity and underwriting risks (reserving, pandemic, catastrophe, etc.)

With ORSA, Solvency II offers insurers as well as stakeholders and regulatory authorities the means to have a clear vision of the attitude towards extreme risks which are not necessarily taken into account in the framework of the directive. But beyond the framework, the exercise of ORSA is only of interest if scenarios such as that of the COVID-19 outbreak are regularly tested to estimate the capacity of risk management systems in the insurance world to cope with such events and assess their cost in terms of capital adequacy.

Learn about ORSA

Because ORSA is a unique process defined by each particular insurer, there are major guidelines that (re)insurers want to take into account. In fact, ORSA requires either the use of the regulatory capital measure (SCR) and/or the use of an economic capital measure produced as a result of an internal model.

Also, the scope of stress testing in ORSA is comprehensive and should include:

A standard scenario and sensitivity analysis
Reverse stress testing that assesses the ability of the insurer or (re)insurer to face business failure, a breach of economic solvency, a breach of SCR and minimum capital requirement (MCR), and other circumstances endangering the going concern principle considered appropriate by the senior management and the board.

One of the characteristics of the ORSA process is that it provides a focus on risk mitigation and management actions set by the insurer in order to cope with both economic and operational impacts emerging from the tested scenarios.

It defines the extent of decisions and risks that should be mitigated either by capital or by management actions.

Did you know?

We notice that before the COVID-19 outbreak, insurers were reluctant to design realistic pandemic scenarios. Certainly, the likelihood was low but possibly also because of an underestimation of the real impacts of such scenarios on their own business and on the economy in general.

In fact, EIOPA performs a Europe market stress test exercise. The last test, performed in 2018, showed that no pandemic scenarios were taken into account (link).

Official EIOPA statement regarding the COVID-19 outbreak

On 17 March 2020 EIOPA issued an official statement on the impact of the COVID-19 outbreak and its impact on the European insurance market. The outlook of EIOPA remains positive mainly due to following facts:

The risk-based approach of Solvency II, enabling the companies to absorb significant losses;
Overall good capital position of European insurers;
Regular stress test exercises performed.

ORSA is a tool for insurers to respond to a pandemic event. Without underestimating the impact and consequences of COVID-19, it has a positive side. For instance, the pandemic gives the regulator more data on how such an event affects insurers and (re)insurers. It gives room for a possible revision of the Solvency II Directive that should be adapted to respond to the current and any potential similar event.

What we think

Milan Petrmann, Actuarial Manager at PwC Luxembourg

The covid-19 pandemic has opened our eyes. An until now inimaginable situation like the one we’re living took the world by surprise and can happen again anytime in the future. Regulation should give financial organisations a chance to flexibly and safely react to a pandemic event. Our experience from the past one and a half years will change the way we respond to not just (re)insurance, but to everyday risks.