Questions about SCR and MCR liabilities

[curiousactuary]

Practice question 18.1 of the EV chapter says "net assets will be the total asses in excess of those covering technical provisions plus SCR under solvency ii?

1.Why is MCR not included in the definition of net assets above? Isn't this also a liability separate to the SCR?
2. Is MCR a subset of SCR? Why is MCR shown separately from the SCR in diagrams - is this correct?

 

[curiousactuary]

When a component of the EV is defined as net assets which in turn is defined as assets in excess of liabilities - should the SCR and MCR be included as liabilities - or are liabilities just the technical provisions?

 

[Lindsay Smitherman]

Practice question 18.1 of the EV chapter says "net assets will be the total asses in excess of those covering technical provisions plus SCR under solvency ii?

1.Why is MCR not included in the definition of net assets above? Isn't this also a liability separate to the SCR?
2. Is MCR a subset of SCR? Why is MCR shown separately from the SCR in diagrams - is this correct?

Yes, the MCR is effectively a subset of the SCR. The Core Reading states that it must lie between 25% and 45% of the SCR. [See Chapter 11 Section 4] Diagrams might therefore show it as being a smaller 'box' within the SCR 'box'.

If you are including the SCR in a calculation, this automatically therefore includes the (smaller) MCR.

The SCR and MCR represent different levels of capital requirements that must be held under Solvency II. The SCR is the higher level: breaching this will trigger certain elements of regulatory intervention. The MCR is the lower level: breaching this will trigger very serious regulatory actions. [See Chapter 11 Section 5]

For example, if TP = 200, MCR = 15, SCR = 50:
- the company would be unable to cover its SCR if its assets were <250
- the company would be unable to cover its MCR if its assets were <215

 

[Lindsay Smitherman]

When a component of the EV is defined as net assets which in turn is defined as assets in excess of liabilities - should the SCR and MCR be included as liabilities - or are liabilities just the technical provisions?

The SCR (and MCR) are 'capital requirements' not 'liabilities'. The technical provisions are 'liabilities'.
So if 'net assets' are strictly defined as being 'assets - liabilities', then the SCR would fall into net assets. If the company is reporting under Solvency II (as is implied by the references to SCR and MCR) then under this definition we would actually have net assets = own funds.

Having said that, if a company were performing a traditional EV calculation then it could choose to define 'net assets' how it wished. The definition could be 'assets - liabilities' or it could be 'assets - liabilities - capital requirements'. In the latter case, the capital requirements would not be included in the net assets component, but would be released in the projection of future profits and hence be part of the PVIF component instead.

[If an EEV approach is being used with a Solvency II balance sheet, then the SCR would be part of the 'required capital' component. However, as is discussed in Chapter 18 of the course, companies might also include the RM in that component. If the RM isn't included in the required capital component, it would be released as part of PVIF.]

 

[curiousactuary]

Yes, the MCR is effectively a subset of the SCR. The Core Reading states that it must lie between 25% and 45% of the SCR. [See Chapter 11 Section 4] Diagrams might therefore show it as being a smaller 'box' within the SCR 'box'.

If you are including the SCR in a calculation, this automatically therefore includes the (smaller) MCR.

The SCR and MCR represent different levels of capital requirements that must be held under Solvency II. The SCR is the higher level: breaching this will trigger certain elements of regulatory intervention. The MCR is the lower level: breaching this will trigger very serious regulatory actions. [See Chapter 11 Section 5]

For example, if TP = 200, MCR = 15, SCR = 50:
- the company would be unable to cover its SCR if its assets were <250
- the company would be unable to cover its MCR if its assets were <215

Thanks for your crystal clear explanation Lindsay.

So what is meant by "supervisory reserves" or "solvency reserves" - are they both the same thing and do they refer to either the BEL only or technical provisions?

 

[curiousactuary]

The SCR (and MCR) are 'capital requirements' not 'liabilities'. The technical provisions are 'liabilities'.
So if 'net assets' are strictly defined as being 'assets - liabilities', then the SCR would fall into net assets. If the company is reporting under Solvency II (as is implied by the references to SCR and MCR) then under this definition we would actually have net assets = own funds.

Having said that, if a company were performing a traditional EV calculation then it could choose to define 'net assets' how it wished. The definition could be 'assets - liabilities' or it could be 'assets - liabilities - capital requirements'. In the latter case, the capital requirements would not be included in the net assets component, but would be released in the projection of future profits and hence be part of the PVIF component instead.

[If an EEV approach is being used with a Solvency II balance sheet, then the SCR would be part of the 'required capital' component. However, as is discussed in Chapter 18 of the course, companies might also include the RM in that component. If the RM isn't included in the required capital component, it would be released as part of PVIF.]

Thanks a lot for this. Could you clarify each point in turn:

1. My understanding is that EEV equals:
i) Free surplus
ii) + required capital
iii) less the cost of holding that required capital
iv) + PVIF

2. I see that there are two approaches for the required capital under SII - either:
i) approach a) SCR + Risk Margin?
ii) approach b) SCR only?

3. So for an EEV approach or MCEV for that matter, is the cost of holding the required capital for each respective approach as follows:
i) approach a) Risk Margin
ii) approach b) Nothing? If not, what would this be?

4. As for the PVIF, my understanding for each approach is as follows:
i) approach a) There is no release of margins from the Risk Margin.
ii) approach b) There is a release of margins from the Risk Margin

5. For conventional without profits business, my understanding is that the release of "solvency reserves" are are a component of the PVIF. If so, what is meant by the release of "solvency reserves" under each approach:
i) approach A - does it mean the release of the BEL? I thought the BEL didn't have any margins - in which case is there any release of anything whatsoever?
ii) approach B - does release of solvency reserves mean the release of margins within the risk margin?

6.
i) Is it correct to say the release of margins within the Risk Margin? Or should it be the release of Risk Margin? Do they mean the same thing?
ii) Same question applies in relation to "solvency reserves" - should it be the release of "margins within the reserves" or "release of reserves"?

 

[Lindsay Smitherman]

So what is meant by "supervisory reserves" or "solvency reserves" - are they both the same thing and do they refer to either the BEL only or technical provisions?

Yes, referring to the same thing.

What precisely the phrase refers to under Solvency II might depend on context, so need to be a bit careful about that. I would stick with using the phrase 'technical provisions'. Basically, the technical provisions = the market-consistent value of the liabilities.

 

[Lindsay Smitherman]

1. My understanding is that EEV equals:
i) Free surplus
ii) + required capital
iii) less the cost of holding that required capital
iv) + PVIF

Yes

2. I see that there are two approaches for the required capital under SII - either:
i) approach a) SCR + Risk Margin?
ii) approach b) SCR only?

Yes

3. So for an EEV approach or MCEV for that matter, is the cost of holding the required capital for each respective approach as follows:
i) approach a) Risk Margin
ii) approach b) Nothing? If not, what would this be?

i) - not necessarily. That could be assumed as a short-cut to simplify the calculation. However, more likely that the cost of holding required capital is calculated explicitly. This should be based on the opportunity / frictional / agency cost of having the capital locked-in earning a return that falls short of what the shareholders would be able to (or require to) earn on it. This is described on page 8 of Chapter 18. And this is also the answer to ii) - it's not nothing, it's the frictional or opportunity costs of locking in that required capital.

 

[Lindsay Smitherman]

4. As for the PVIF, my understanding for each approach is as follows:
i) approach a) There is no release of margins from the Risk Margin.
ii) approach b) There is a release of margins from the Risk Margin

i) Yes - although this would be better expressed as 'The PVIF does not contain the release of the RM' (since this is in the RC component)
ii) It's not the release of 'margins' from the RM, but the release of the whole RM. If the EV projection (or experience) basis is best estimate (or rather, the same assumptions as used for the BEL), then the BEL will be the right amount to meet the company's obligations to policyholders and the RM will simply be released to shareholders. So it forms part of the EV = value of shareholders' interest in the company.

5. For conventional without profits business, my understanding is that the release of "solvency reserves" are are a component of the PVIF. If so, what is meant by the release of "solvency reserves" under each approach:
i) approach A - does it mean the release of the BEL? I thought the BEL didn't have any margins - in which case is there any release of anything whatsoever?
ii) approach B - does release of solvency reserves mean the release of margins within the risk margin?

You might be confusing two things here. You can either consider the PVIF to reflect the release of prudential margins in reserves, or it reflects the release of reserves minus the net cashflows required to pay obligations to policyholders. These are the same thing: prudential margins are basically just the extra bit in reserves over and above what is actually needed.

Under a) there are no explicit prudential margins in the BEL, so no release of margins from the BEL, so yes: on the face of it there is no PVIF. However, there might be some PVIF if what we expect to happen in future (in our EV projection basis) is not precisely the same as in the BEL basis. For example, the BEL ignores profits arising beyond the contract boundary but in our EV we might want to include those. These additional considerations are covered in Section 3 of Chapter 18.

Under b) you could consider the RM to be 'the margins in the technical provisions': not needed to meet our best estimate future obligations to policyholders, so can be released to shareholders (as the business runs off) and so the RM is part of the PVIF.

6.
i) Is it correct to say the release of margins within the Risk Margin? Or should it be the release of Risk Margin? Do they mean the same thing?
ii) Same question applies in relation to "solvency reserves" - should it be the release of "margins within the reserves" or "release of reserves"?

Covered in the above, I hope?

 

[curiousactuary]

Thanks so much Lindsay. That clears some things up.

Just to clarify the difference between "release of reserves" and "release of margins within reserves"? In relation to without-profit business:
1. Can the entire embedded value be defined as the "release of margins within the solvency reserves"? Or is this just the PVIF component only?
2. Alternatively, can the entire embedded value be defined as follows:
a) present value of net cashflows (premiums plus investment income less claims less expenses) plus the "release of solvency reserves")?
3) What is meant by the "release of solvency reserves"? How is it different from the "release of margins within the solvency reserves?

 

[Lindsay Smitherman]

Glad it's helping.
1: this is just the PVIF.
2: this is also just the PVIF.
3. If we express reserve = best estimate liability + prudential margin, then release of reserve = total reserve (i.e. best estimate liability + prudential margin) as it runs off over time (release of reserve from period t to t+1 = reserve at t - reserve at t+1) and release of margin = release of prudential margin only as it runs off over time (= remaining prudential margin at t - remaining prudential margin at t+1)

 

[curiousactuary]

This is helpful.

4. So is the release of reserves just the change in reserves between two successive time periods?

5. Can the release of reserves over t and t+1 be negative?

6. Given 1 and 2, does this mean the release of margins within the reserves (since this equals PVIF) is greater than the release of reserves (as this is a component of PVIF)?

7. How is Point 4 possible, particularly where the release of reserves are both a release of both the best estimate liability and the prudent margin - I thought this release would be larger than that of just the margins within the reserves?

6. Is this numerical example correct for release of reserves?

a) Solvency reseve in year t = BEL1 + Margin1 = 80 + 20.

b) Solvency Reserve in year t + 1 = BEL2 + Margin2 = 70 +15

c) Release of reserves = 100 - 85 = 15?

7. I'm having trouble comprehending "release of margins within the reserves", particularly what is meant by "remaining prudential margin"? In terms of the release of margins within Solvency reserves:
a) is it as simple as 20 - 15? I assume not and think I'm missing something here - could you give a numerical example for the release of margins within the Solvency reserves, where possible using the same numbers above?

 

[Lindsay Smitherman]

This is helpful.

4. So is the release of reserves just the change in reserves between two successive time periods?

Yes - although we tend to use the phrase 'release of reserves' to refer to the situation when reserves are reducing over time.

5. Can the release of reserves over t and t+1 be negative?

Yes, in which case we would tend to refer to it as being an 'increase in reserves'.
Remember that (simplistically, for conventional business):
Profit = premiums + investment return - expenses - claims + release of reserves
OR (equivalently)
Profit = premiums + investment return - expenses - claims - increase in reserves

6. Given 1 and 2, does this mean the release of margins within the reserves (since this equals PVIF) is greater than the release of reserves (as this is a component of PVIF)?

No. By definition, must have margins < total reserves. The 'margins within reserves' means just the element of prudence within the reserves, as described in earlier answers.

7. How is Point 4 possible, particularly where the release of reserves are both a release of both the best estimate liability and the prudent margin - I thought this release would be larger than that of just the margins within the reserves?

Yes, it is.

6. Is this numerical example correct for release of reserves?
a) Solvency reseve in year t = BEL1 + Margin1 = 80 + 20.
b) Solvency Reserve in year t + 1 = BEL2 + Margin2 = 70 +15
c) Release of reserves = 100 - 85 = 15?

Yes

7. I'm having trouble comprehending "release of margins within the reserves", particularly what is meant by "remaining prudential margin"? In terms of the release of margins within Solvency reserves:
a) is it as simple as 20 - 15? I assume not and think I'm missing something here - could you give a numerical example for the release of margins within the Solvency reserves, where possible using the same numbers above?

Yes - the release of margins in this example would be 20-15 = 5. At the start of the year, we had to hold 20 in prudential margins, at the end of the year we have to hold only 15. So that means that we can release the no-longer-needed 5 - this doesn't need to be tied up into reserves anymore so could be released to shareholders. And so falls into the 'profit' calculation.

So let's think about the two different definitions of profit being released. Please note that these are simplistic statements, which I am using to help you get to grips with the over-riding concepts. There are other elements (for example, investment return earned on the margins in reserves), but it's not helpful to go into those: the high-level concepts are important rather than these sorts of details.

So, simplistically: profit being released over the time period equals:
release of prudential margins in reserves
OR
premiums + investment return - expenses - claims + release of reserves

In your example, our best estimate liab has reduced from 80 to 70. Let's assume that investment return on the assets backing the reserves = 0% to make things easier (and so we are also discounting reserves at 0%), and that experience = best estimate.

The reduction in liability of 10 at the end of the year implies that we must have {benefits + expenses - premiums} arising during the year = 10 [since reserves = PV{benefits + expenses - premiums}]. So, switching this round: {premiums - benefits - expenses} = -10.

So in this example:
Release of margins in reserves = 5
OR
Profit = P + I - E - C + Release of reserves = -10 + 15 = 5

In other words, the release of the BEL part of reserves pays for what is actually happening during the period in terms of meeting obligations to policyholders, and the prudential margins part isn't needed for that and so falls into profit.

[If we were allowing for investment returns and discounting, the investment return earned on the start year reserves offsets the discounting impact.]

Your questions sound more like SP2 than SA2 questions, so do make sure that you have thoroughly understood the basics that are covered in the SP2 material - this will be assumed knowledge for SA2, and it will be difficult to layer on the more advanced material if you don't have a really good foundation.

 

[curiousactuary]

Thanks heaps, you have cleared almost all of it up - there's just one more thing..

The solution to Q18ii states the PVIF is the release of the risk margin plus the "release of the SCR"
1. Why has the release of the SCR been added here? The SCR is not the reserves but the capital requirement. I understood PVIF to be the release of margins within "reserves".

This is from CMP 2019

 

[mulita]

Thanks heaps, you have cleared almost all of it up - there's just one more thing..

The solution to Q18ii states the PVIF is the release of the risk margin plus the "release of the SCR"
1. Why has the release of the SCR been added here? The SCR is not the reserves but the capital requirement. I understood PVIF to be the release of margins within "reserves".

This is from CMP 2019

Hi, I am also going for my first attempt at SA2 this September. Let me give it a try.

From the information in the question, net assets are excess assets above technical provisions and solvency capital requirements. Since there is no with profit business, everything that remains belongs to shareholders. So release of assets supporting risk margins in the technical provisions and assets supporting SCR will be attributed to shareholders.

To answer your question, SCR are additional assets or 'reserves' set aside by shareholders. So in principle, they are also Reserves that may be released.

Thanks.

 

[mulita]

Hi, I am also going for my first attempt at SA2 this September. Let me give it a try.

From the information in the question, net assets are excess assets above technical provisions and solvency capital requirements. Since there is no with profit business, everything that remains belongs to shareholders. So release of assets supporting risk margins in the technical provisions and assets supporting SCR will be attributed to shareholders.

To answer your question, SCR are additional assets or 'reserves' set aside by shareholders. So in principle, they are also Reserves that may be released.

Thanks.

.... and also note that the question has redefined EV with two components unlike in the notes where we have three (one for required capital). So here the required capital component goes to PVIF

 

[Lindsay Smitherman]

Thanks mulita - great responses!

If the company were following EEV or MCEV rules, solvency capital requirements should be included in the 'required capital' component. However, the question doesn't state that this is the case.

Referring to my answer in an earlier post above (repeated as follows), this means that the company can define the 'net assets' component however it wishes to do so:

Having said that, if a company were performing a traditional EV calculation then it could choose to define 'net assets' how it wished. The definition could be 'assets - liabilities' or it could be 'assets - liabilities - capital requirements'. In the latter case, the capital requirements would not be included in the net assets component, but would be released in the projection of future profits and hence be part of the PVIF component instead.

In this case, the question states that the company has chosen to define net assets = 'assets - liabilities - capital requirements' and so the capital requirements are NOT part of the 'net assets'. Instead, they are released into the PVIF - effectively being treated as a margin over and above what is required to meet obligations to policyholders. [So in this case, profits being projected = { release of any margins in reserves + release of capital requirements } or, equivalently, profit = { premiums + investment return - claims - expenses + release of reserves + release of capital requirements }.]

 

[User 1234]

it could be 'assets - liabilities - capital requirements'. In the latter case, the capital requirements would not be included in the net assets component, but would be released in the projection of future profits and hence be part of the PVIF component instead.

Thanks Lindsay, I don't quite follow this part. Given EV = (a) Net assets + (b) Capital requirement - Cost of holding capital + (c) PVIF, if Capital requirements is not included in net assets component, i.e. (a), wouldn't it be sitting in component (b), why it would be part of PVIF component, i.e. (c)?

Also, similarly I cannot get my head around the point where, if RM is not included in net assets (ie belong to shareholder immediately), it would be released as part of PVIF to shareholder over time. I thought RM represents the non-hedgeable risk and hence it's a cost, including it in PVIF will reduce the PVIF and bring down the value to shareholder, it seems contradictory to it being released to shareholder over time.

Thanks a lot for your help in advance!

 

[Lindsay Smitherman]

Hi - you need to be careful that you aren't mixing up traditional EV calculations with EEV/MCEV calculations.

Under traditional calculations, EV = net assets + PVIF. This is what I was referring to in your quote. If the company defines net assets as {assets - liabs - capital requirements} then the release of the capital requirements to the shareholders would be in the PVIF. If the company defines net assets as {asset - liabs} then the release of the capital requirements is part of the net assets.

If we are using EEV/MCEV principles, EV = free surplus (not 'net assets') + required capital (minus cost of holding) + PVIF. The release of solvency capital requirements is in the 'required capital' component.

Let's assume that we are using an EEV/MCEV approach and are subject to the Solvency II regime. If the RM is assumed to be part of the 'reserves' (= technical provisions) rather than as part of the required capital, it will be released as a positive cashflow in the PVIF, if experience is in line with the best estimate. PVIF = present value of future profits on in-force business. For conventional business, PVIF = present value of {premiums + investment earnings - claims - expenses + release of 'reserves'}. If 'reserves' includes the RM, these will be released (as a positive amount) into the PVIF, hence increasing PVIF.

Another way to think about this is to consider the technical provisions (TP) as a whole: how much of this amount is expected to be needed to pay policyholder liabilities and how much is left over for the shareholders? If experience is in line with a best estimate basis, only the BEL part of the TP is needed to meet policyholder obligations. The amount held to back the RM will therefore fall to shareholders - and hence is part of the EV (= value of shareholders' interest in the business).

Hope that helps.

 

[Arush]

Hi, sorry I am but confused with this discussion.

it’s somewhere said, profit = release of prudential margins in the reserve and then it’s also said profit = release of margins plus release of reserves and further release of SCR. So what is the correct answer? Is it dependent on the fact whether net assets include capital or not? But still that doesn’t answer why release of reserves is considered

 

[Em Francis]

Hi, sorry I am but confused with this discussion.

it’s somewhere said, profit = release of prudential margins in the reserve and then it’s also said profit = release of margins plus release of reserves and further release of SCR. So what is the correct answer? Is it dependent on the fact whether net assets include capital or not? But still that doesn’t answer why release of reserves is considered

It will all depend on what (if any capital requirement) is included in the definition of the net assets. If net assets is defined as {assets - liabs - total capital requirements} then yes the release of the SCR will be part of the PVIF.
In answer to your question, why release of reserves is included, release of reserves is meaning release of reserves over and above that needed to pay claims and expenses etc.