Chapter 12 - assets vs capital quality

[Eleanor Cawston]

I am looking at chapter 12 on Solvency 2, and trying to connect Section 6 - Quality of capital resources to what is earlier in the chapter.

The SCR is defined in terms of a VaR measure looking at variation of "basic own funds", where basic own funds is essentially assets - technical provisions.
I take assets to mean whatever bonds, equities and other investments the company has purchased with the premiums/other funds it receives - correct?
The basic own funds is also shown on the diagram on page 2 of the chapter, similarly: asset side of the balance sheet, not required to back BEL + RA+other liabilities.

I am stuck with how to connect this to the description on page 29 of basic / ancilliary own funds in terms of paid-up / unpaid share capital and sub-debt. I thought debt and shareholders' funds belong on the liabilities side of the balance sheet (as have to be paid back to them at some time, theoretically), so how do they "back" the SCR / MCR?

Is there an implicit intermediate step of saying assets are bought with funds received from share/debt holders, and the "quality" of those funds determines what quality we assign to the capital bought when looking at what is backing SCR/MCR? But what about the quality of the assets themselves (in an "RBC sense")?

 

[Sarah Byrne]

Hi Eleanor

Assets are indeed whatever investments the company holds, and as you say they will be from a variety of sources including premiums, investment income, equity capital etc.

As far as the Solvency II balance sheet is concerned (and that is what we are concerned about in SA1), the 'liability' element of capital such as sub debt and equities issued by the insurer don't need to be shown on the liability side of the balance sheet as the repayment ranks below policyholder benefits. The Tier rating of these types of debt will affect their usage in terms of whether they are suitable to be held to back the SCR or MCR.

In terms of what the insurer does with the capital it raises, it doesn't really matter what it purchases with these assets. For example, they could raise $100m via sub debt and purchase some government bonds with this amount. It may then use those bonds to back the technical provisions as these bonds are a suitable match in terms of nature and duration to those liabilities. However, it still needs to allocate $100m of its assets as 'sub debt' capital. This could be made up of a mix of assets such as cash, bonds and other investments - obviously not any lower ranking capital that the sub debt though. So, we are just 'allocating' the assets to different bits of the liabilities rather than 'earmarking' those funds as being a particular type of capital.

I hope this helps,
Sarah