IFRS 17 and Solvency II both aim for an economic valuation of insurance liabilities and share some common principles (like probability-weighted cash flows and discounting), they have different objectives and specific requirements, meaning you cannot directly "determine" the IFRS 17 cost of risk from Solvency II parameters in a one-to-one mapping.1
However, insurers often leverage their existing Solvency II calculations and models as a starting point for IFRS 17 due to significant overlaps and the considerable investment already made in Solvency II systems.
But trying something is very different from achieving it, as we will see a little later in this article.
To begin with, let's see a breakdown of how Solvency II parameters can inform or be adapted for IFRS 17's cost of capital (known as the "risk adjustment"):
1. Conceptual Similarities and Key Differences:
Solvency II Risk Margin: This is a component of technical provisions, calculated using a prescribed Cost of Capital (CoC) approach (typically 6% of the Solvency Capital Requirement (SCR) for non-hedgeable risks).3 Its primary purpose is to ensure policyholder protection by covering non-hedgeable risks in a transfer value context.4 It is calculated net of reinsurance.
IFRS 17 Risk Adjustment: This represents the compensation an entity requires for bearing the uncertainty about the amount and timing of future cash flows arising from non-financial5 risk. It's a principles-based adjustment, meaning IFRS 17 doesn't prescribe a specific methodology or confidence level, but requires disclosure of the method and the equivalent confidence level.6 It's calculated separately for gross liabilities and reinsurance held.
Key Differences to Bridge:
Scope of Risks:
Solvency II Risk Margin: Covers all non-hedgeable risks, which generally include non-financial risks (insurance risk, operational risk, lapse risk, expense risk, etc.).7
IFRS 17 Risk Adjustment: Explicitly excludes general operational risk and focuses only on non-financial risks.8 This requires careful consideration of what risks are included in your Solvency II SCR and how to isolate only the relevant non-financial risks for IFRS 17.
Confidence Level/Methodology:
Solvency II Risk Margin: Calculated based on a 99.5th percentile for the SCR over a one-year horizon using a prescribed Cost of Capital approach (6%). The resulting risk margin itself does not directly correspond to a 99.5th percentile.
IFRS 17 Risk Adjustment: No prescribed confidence level or methodology. Insurers choose a method (e.g., Cost of Capital, Value-at-Risk (VaR), Conditional Tail Expectation (CTE), Margin for Adverse Deviation) and then must disclose the equivalent confidence level.9 This offers more flexibility but also requires more judgment.
Level of Aggregation:
Solvency II Risk Margin: Calculated at the entity level or line of business.
IFRS 17 Risk Adjustment: Calculated at the group of contracts level (which further disaggregates into annual cohorts and profitability groups). This often means Solvency II models need to be run at a finer granularity or results need to be allocated down to IFRS 17 groupings.
Reinsurance:
Solvency II Risk Margin: Calculated net of reinsurance.
IFRS 17 Risk Adjustment: Requires separate risk adjustments for gross liabilities and for reinsurance contracts held.
2. Leveraging Solvency II for IFRS 17 Risk Adjustment Calculation:
Despite the differences, many European insurers leverage their Solvency II framework to calculate the IFRS 17 risk adjustment, primarily using the Cost of Capital (CoC) approach or Value-at-Risk (VaR) approach.
Cost of Capital (CoC) Approach:
This is the most common approach as it aligns with the Solvency II Risk Margin calculation.
You can start with the Solvency II capital requirements (SCR) related to non-financial risks.
Adaptations needed:
Scope adjustment: Exclude operational risk and any financial risks from the Solvency II SCR that are not considered non-financial risks under IFRS 17.
Cost of Capital rate: While Solvency II prescribes 6%, IFRS 17 requires using the entity's actual own cost of capital, which may differ.
Time horizon: Solvency II SCR is typically 1-year VaR. The IFRS 17 risk adjustment should reflect the uncertainty over the full remaining duration of the contract. This may involve projecting the capital requirements over the contract's lifetime and discounting them.
Granularity: Re-evaluate and re-calculate or allocate the risk adjustment to the IFRS 17 "group of contracts" level.
Reinsurance: Calculate gross and ceded risk adjustments separately.
Confidence level disclosure: Even if using a CoC approach, you need to determine and disclose the equivalent confidence level of the IFRS 17 risk adjustment. This often requires actuarial judgment and potentially some re-calibration or back-testing against various confidence intervals.
Value-at-Risk (VaR) Approach:
Solvency II often uses VaR methodologies (e.g., standard formula or internal models) to calculate capital requirements.10 These can be a starting point.
Adaptations needed:
Focus on non-financial risks: Isolate the VaR for non-financial risks from your Solvency II models.
Confidence level: IFRS 17 doesn't prescribe a confidence level, so you'd need to determine what confidence level is appropriate for your entity's risk appetite (often lower than Solvency II's 99.5%, with common ranges observed around 75%-85% for IFRS 17).
Time horizon and duration: Align the VaR horizon with the IFRS 17 requirements for the remaining duration of the contracts.
Granularity and reinsurance: Similar to the CoC approach, ensure calculations align with IFRS 17 grouping and separate gross/ceded adjustments.
Steps to Consider:
Understand IFRS 17 Requirements: Deeply understand the principles and specific requirements for the risk adjustment under IFRS 17, including the definition of non-financial risk, disclosure requirements (method, confidence level), and level of aggregation.
Analyze Solvency II Components: Identify the components of your Solvency II SCR and risk margin that relate to non-financial risks.
Choose a Methodology: Select a methodology for your IFRS 17 risk adjustment (e.g., Cost of Capital or VaR). The CoC approach is often favored for its alignment with Solvency II.
Parameter Mapping & Adjustment:
Risk Scope: Carefully delineate the non-financial risks for IFRS 17, excluding operational risk and other risks not in scope.
Capital Base (if CoC): Adapt the Solvency II capital figures to reflect only the IFRS 17 in-scope risks, potentially re-running internal models or adjusting standard formula components.
Cost of Capital Rate (if CoC): Determine your entity's actual cost of capital, rather than the prescribed 6% from Solvency II.
Confidence Level (if VaR or for disclosure): Determine an appropriate confidence level for IFRS 17 that reflects the entity's risk appetite.
Discount Rates: Ensure consistency with IFRS 17 discount rate requirements (which may differ from Solvency II).
Granularity and Aggregation: Develop processes to calculate or allocate the risk adjustment to the IFRS 17 group of contracts level.
Gross vs. Net: Implement processes to calculate the gross risk adjustment and the risk adjustment for reinsurance held separately.
Documentation and Disclosure: Document your chosen methodology, the assumptions made, and how the equivalent confidence level was determined. This is crucial for auditability and transparency.
3.Technological infrastructure:
In essence, while Solvency II provides a robust framework and valuable data, determining the IFRS 17 cost of risk involves a careful adaptation and recalibration of Solvency II parameters and methodologies to meet the specific principles and requirements of IFRS 17.
But this is only possible with an architecture that holistically allows us to analyze what are ultimately different manifestations of the same reality. And that architecture is the SAP Integrated Financial and Risk Architecture y sus componentes Financial Products Subledger (FPSL), Profitability and Performance Management (PaPM) and Finance and Risk Data Platform (FRDP).
The Integrated Financial and Risk Architecture provides us with answers to the most critical questions: the value we are generating or not generating by market segment, the liquidity we are generating or not generating by segment, and the capital consumed. Analyses are performed with the maximum granularity, which is the contract. The results are then aggregated according to the required analysis criteria while maintaining traceability back to the contract.
The SAP Integrated Financial and Risk Architecture opens the door to Capital Optimization if we integrate the Real Economy's risk flows and their hedging contracts into the Financial Economy. And if we remember that SAP systems manage 70% of the world's GDP, this goal is perfectly achievable.
For the past 12 years, our team has worked on modeling all economic events and business flows represented in Real Economy SAP systems, in terms of capital and liquidity consumption and generation. With this information, our systems measure how to offer financial instruments to cover capital and liquidity gaps or invest excess capital and liquidity, thus optimizing the system's capital consumption and liquidity.
We are working to introduce our system to the market and are looking for business partners and investors. If you are interested, please do not hesitate to contact me.
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Kindest Regards,
Ferran Frances.
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