Group Support Regime and the United Kingdom

Enhancing group supervision under Solvency II
A discussion paper April 2008

There has been considerable debate about whether the Group Support Regime is really necessary to allow the benefits of diversification to be realized at group level.

In fact group-level diversification is just one instance of a more general phenomenon in insurance.

In many kinds of different cases the question of the impact on capital requirements of diversification arises and brings with it the question of capital transferability, which is a core issue in the Group Support Regime.

Insurance is the business of pooling and diversifying risk.

If an insurance company were atomised into each of its liabilities and then assets were attributed separately to those liabilities and if capital requirements were then calculated in each case, writing insurance business could never be economically sustainable.

In order to produce insurance services in an economically efficient way it is necessary to pool and diversify risk and to do this, the capital backing those risks must be capable of being transferred.

The issue of group level diversification and the Group Support Regime is just one example, albeit a very prominent one.

Another example is the activity of reinsurance – in order for insurers to diversify risk through reinsurance treaties it has to be possible for capital to be transferred to the insurer if risks triggering the treaty crystallize.

Wherever risks are not fully correlated, capital which is transferable across any  given boundary has greater potential to absorb unexpected losses and thereby protect policyholders than capital which is not transferable.

This is the real motivation for the group support regime – it gives capital in an insurance group loss-absorbency across a wider range of risks thereby allowing the group to hold less regulatory capital while still delivering the same level of protection for policyholders.

Solvency II requires a solo undertaking to hold eligible own funds to meet its Solvency Capital Requirement (SCR). The valuation of technical provisions, of assets and of non-insurance liabilities are also vital, as are the elements of Pillars two and three.

The SCR is therefore not the only source of protection for policyholders which the framework provides but clearly it is a key element.

In the group context the fundamental question is what requirements does an insurance group have to meet in order to provide the equivalent level of protection for policyholders as a solo undertaking which is complying with its Solvency Capital Requirement (SCR).

This section addresses the key issue of whether the group Solvency Capital Requirement (SCR), calculated on consolidated data, is the appropriate capital requirement for the group as a whole.

It is generally recognised that there are group-wide diversification effects; if there were not, the answer to the question above would be trivial - a group would need to hold capital equal to the sum of the solo SCRs of the undertakings in the group.

With some group level diversification benefits, the group SCR, calculated on consolidated data, is less than the sum of the solo SCRs of the undertakings within the group.

Of course the group is committed to mitigate any unexpected loss in any of the subsidiaries up to at least the level of the subsidiary’s Solvency Capital Requirement (SCR).

So a key question is whether eligible own funds equal to the group SCR is a sufficient requirement to ensure that the probability that the commitment to policyholders in each of the subsidiaries will be met is equivalent to the level of protection afforded to policyholders in a solo undertaking.

The group SCR calculated on consolidated data will reflect the diversification between the risks of all of the undertakings in the group. It will therefore be different for each insurance group.

Nevertheless it is possible to state under certain conditions the feasible range for the group Solvency Capital Requirement (SCR) relative to the solo SCRs for the undertakings within the group:

• the group Solvency Capital Requirement (SCR) cannot exceed the sum of the undertakings’ solo SCRs

• nor can the group Solvency Capital Requirement (SCR) be less than the SCR of the undertaking in the group which has the largest SCR

The upper limit to the group Solvency Capital Requirement (SCR) will be binding as long as the benefits of diversification at group level are not outweighed by possible costs; for example risk concentration at group level could in theory increase the group Solvency Capital Requirement (SCR) above the level of the SCRs of the solo undertakings.

This is a theoretical possibility but not a credible practical one – it would imply that the economic costs of the insurance group being constituted as a group were greater than the benefits.

In such a case the rational outcome is that the group would be split up to unwind the net costs of the group.

The lower bound to the range for the group Solvency Capital Requirement (SCR) also holds good under certain conditions only. In essence the requirement is that the correlations between the risks in the undertakings in the group are not sufficiently negative overall.

This assumption is a credible practical lower bound on the extent of diversification at group level.

One way to illustrate this is to consider the correlations between the various risks in the proposed specification of the standard formula for the Solvency Capital Requirement (SCR): none of these is negative.

Of course this fact does not imply that correlations between certain risks in different subsidiaries cannot be negative, but it does indicate that it is not realistic that across all risks in the various undertakings in the group the weighted average correlation could be negative.

There are two main cases where correlations between entire risk factors are likely to be negative.

First, the case of mortality and longevity risk in life underwriting.

Second, the possibility that for any two undertakings in a group one might have its maximum fixed interest stress where there is a rise in interest rates and the other where there is a decline.

However, it is still not credible that they could be large enough to yield an average negative correlation across the group.

A key reason for this relates to the fact that if the bilateral correlation between certain risks in any pair of subsidiaries is negative then any other subsidiary in the group which is exposed to the same risk factor must have a positive correlation with one of those two subsidiaries in respect of those risks.

The two conditions above are not especially demanding – they allow for a very wide range of group-level diversification effects, far in excess of any level that has been suggested as realistic for any actual insurance group.

In practice the group Solvency Capital Requirement (SCR) will generally be well above the solo Solvency Capital Requirement (SCR) of the largest undertaking in the group.

This mainly reflects the fact that the average correlation between risks in the undertakings in the group will be positive.

The stronger is the positive correlation between unexpected losses in the subsidiaries, the higher will be the group Solvency Capital Requirement (SCR) and correspondingly the lower will be group-level diversification effects.

The actual level of diversification effects will be different in every group.

It is important to keep in mind that those effects are additional to the diversification within each undertaking in the group which will already be reflected in its Solvency Capital Requirement (SCR).

However even if diversification effects are comparatively modest, the potential impact on policyholder protection can be very large. This is shown in the next section which considers how group diversification relates to the probability of simultaneous losses occuring in each subsidiary equal to its Solvency Capital Requirement (SCR).   

In addition to the requirement that a group hold eligible capital to meet its consolidated group Solvency Capital Requirement (SCR) the second key condition which must be met if the Group Support Regime is to provide policyholders of undertakings in an insurance group with equivalent protection to those of a solo undertaking relates to the transferability of capital.

It is likely that there will be a number of ways in which legally binding commitments can deliver the requirements imposed by the Directive proposal; for example one specific proposal is for a ‘first demand guarantee’.

The Commission’s proposal places a key constraint on capital transferability – the requirement to hold eligible capital to meet the Minimum Capital Requirement (MCR) in each subsidiary.

Capital cannot be transferred from a subsidiary if the transfer would cause the subsidiary no longer have to capital to cover its MCR.

These own funds are therefore not even potentially transferable capital in the group support regime.

Own funds which are not required to be held in the subsidiaries which are in excess of the MCR are potentially transferable but may or may not be actually transferable.

That depends on whether they meet the test in the Directive, set out in Article 237, in particular that: “there is no current or foreseeable material practical or legal impediment to the prompt transfer of own funds…”.

This test will have to be applied to any eligible own funds which the insurance group proposes to employ to deliver the group support commitment.

There are three main stages to this test:

1. Potentially transferable capital - the first stage is to identify where in the group capital is held which exceeds the regulatory requirements for the undertaking in which it is held – this generates information on what capital is potentially transferable.

2. Actually transferable capital - the second stage is to identify the extent to which any material practical or legal impediments exist to the transfer of that capital, as required by Article 237 and demonstrate to the supervisor that there are no material practical or legal impediments to the transfer of capital relied upon – this generates information on what capital is actually transferable.

3. Transferability of capital under stressed conditions – for the third stage the group will need to have in place a capital management strategy to assess capital transferability in stressed financial conditions.

Group Support Regime and Group Supervision - Assessment of Group Solvency

Consultation Paper No. 60
Draft CEIOPS’ Advice for Level 2 Implementing Measures on Solvency II: Assessment of Group Solvency

1. Assessment of Group Solvency - Introduction

2. Level 1 Text

3. Advice from CEIOPS

4. Third Countries

5. Calculation Method

6. Fungibility and Transferability

7. Transferability of Own Funds

8. Calculations

9. Annex 1 to Annex 5