Bridging the Gap: Using Solvency II Models for IFRS 17 Risk Adjustment with SAP Integrated Financial and Risk Architecture

While both IFRS 17 and Solvency II aim for an economic valuation of insurance liabilities, they have distinct objectives and requirements. This means you can't simply take a one-to-one mapping from Solvency II parameters to determine the IFRS 17 cost of risk. However, many insurers leverage their existing Solvency II calculations and models as a practical starting point, given the significant overlaps and the substantial investment already made in these systems. Conceptual Similarities and Key Differences The core of the challenge lies in the differences between the Solvency II Risk Margin and the IFRS 17 Risk Adjustment. 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 or SCR). Its purpose is to ensure policyholder protection by covering non-hedgeable risks in a transfer value context. It’s calculated net of reinsurance. IFRS 17 Risk Adjustment: This represents the compensation an entity requires for bearing the uncertainty about future cash flows from non-financial risk. It's a principles-based adjustment with no prescribed methodology or confidence level. Instead, insurers must choose a method and disclose the equivalent confidence level. It's calculated separately for gross liabilities and reinsurance held. To effectively leverage your Solvency II framework, you need to bridge these key differences: Scope of Risks: The Solvency II Risk Margin covers all non-hedgeable risks, including general operational risks. The IFRS 17 Risk Adjustment, however, focuses exclusively on non-financial risks, explicitly excluding general operational risk. You must carefully isolate the relevant non-financial risks from your Solvency II SCR. Confidence Level and Methodology: Solvency II's SCR is based on a 99.5% confidence level over a one-year horizon. In contrast, IFRS 17 has no prescribed confidence level, giving insurers more flexibility but also requiring more judgment. Level of Aggregation: Solvency II calculates the Risk Margin at the entity or line-of-business level. IFRS 17 requires the Risk Adjustment to be calculated at a much finer granularity—the group of contracts level (which disaggregates into annual cohorts and profitability groups). This often requires Solvency II models to be run at a lower level or for results to be allocated down to the IFRS 17 groupings. Reinsurance: Solvency II's Risk Margin is calculated net of reinsurance, while IFRS 17 requires separate risk adjustments for gross liabilities and for reinsurance contracts held. Leveraging Solvency II for IFRS 17 Calculations Despite these differences, many European insurers use their Solvency II framework to calculate the IFRS 17 risk adjustment, most often by adapting the Cost of Capital (CoC) or Value-at-Risk (VaR) approach. Cost of Capital (CoC) Approach This is the most common approach because it aligns with the Solvency II Risk Margin calculation. You can start with the Solvency II capital requirements for non-financial risks and make the following adaptations: Scope Adjustment: Exclude operational risk and any financial risks that aren't considered non-financial under IFRS 17. CoC Rate: While Solvency II prescribes 6%, IFRS 17 requires using the entity’s actual own cost of capital, which may differ. Time Horizon: The IFRS 17 risk adjustment must reflect uncertainty over the full remaining duration of the contract, not just the one-year horizon of the Solvency II SCR. 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: You must determine and disclose the equivalent confidence level of the IFRS 17 risk adjustment, which often requires actuarial judgment. Value-at-Risk (VaR) Approach Solvency II often uses VaR methodologies (e.g., standard formula or internal models) to calculate capital requirements, which can serve as a starting point. Focus on Non-Financial Risks: Isolate the VaR for non-financial risks from your Solvency II models. Confidence Level: Since IFRS 17 doesn't prescribe a confidence level, you’ll need to choose one that aligns with your entity's risk appetite (often lower than Solvency II's 99.5%, with a common range of 75%-85%). 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 To successfully navigate this process, you should: Understand IFRS 17: Deeply understand the principles and requirements for the risk adjustment under IFRS 17, including the definition of non-financial risk, disclosure requirements, and level of aggregation. Analyze Solvency II: 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 (CoC is often favored for its alignment with Solvency II). Parameter Mapping & Adjustment: Carefully delineate the in-scope risks, adapt capital figures, determine the appropriate cost of capital rate and confidence level, and ensure consistency with IFRS 17 discount rates. Re-evaluate Granularity: 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. Document and Disclose: Document your chosen methodology, the assumptions made, and how the equivalent confidence level was determined. This is crucial for auditability and transparency. The Role of Technology: The Foundation for Capital Optimization Ultimately, while Solvency II provides a robust framework and valuable data, determining the IFRS 17 cost of risk requires a careful adaptation and recalibration of Solvency II parameters and methodologies. This is only possible with a robust technological architecture that can analyze different manifestations of the same reality. This is where the SAP Integrated Financial and Risk Architecture (IFRA) comes in. With components like Financial Products Subledger (FPSL), Profitability and Performance Management (PaPM), and the Finance and Risk Data Platform (FRDP), this architecture provides a comprehensive solution. It allows for analyses to be performed at the maximum granularity—the contract level—with traceability back to the source data. The results can then be aggregated according to the required analysis criteria, helping you answer critical questions about the value, liquidity, and capital consumed by different market segments. The integrated nature of the IFRA provides the essential foundation for running simulation and AI technologies that can multiply capital optimization opportunities. Because the architecture connects all economic events and business flows—from the real economy to the financial economy—it can serve as a robust data source for: Simulation & Scenario Analysis: The integrated data platform allows for sophisticated "what-if" scenarios. You can simulate the impact of changes in interest rates, new business volumes, or different reinsurance structures on capital and liquidity. This capability helps in strategic decision-making and stress testing. AI-Powered Optimization: With clean, granular data, AI and machine learning models can be trained to identify patterns and predict future capital and liquidity needs. For example, an AI model could analyze millions of data points to recommend the optimal mix of financial instruments to hedge risks or to suggest the most capital-efficient product structures. Proactive Capital Management: Instead of simply reporting on past performance, the IFRA enables a proactive approach. AI can continuously monitor financial and risk data to alert managers to potential capital shortfalls or surpluses, allowing for timely adjustments and capital deployment. By seamlessly connecting the real economy's risk flows and their hedging contracts into the financial economy, the IFRA makes powerful capital optimization possible. Given that SAP systems manage more than 70% of the world's GDP, this goal is perfectly achievable. Connect and Stay Informed: Join the Conversation: Connect with fellow professionals in the SAP Banking Group on LinkedIn. https://www.linkedin.com/groups/92860/ Stay Updated: Subscribe to the SAP Banking Newsletter for the latest insights. https://www.linkedin.com/newsletters/sap-banking-6893665983048081409/ Explore More: Visit the SAP Banking Blog for in-depth articles and analyses. https://sapbank.blogspot.com/ Connect Personally: Feel free to send a LinkedIn invitation; I'm always open to connecting with like-minded individuals. ferran.frances@gmail.com I look forward to hearing your perspectives. Kindest Regards, Ferran Frances-Gil. #sapifra #sapbanking #capitaloptimization #baselIV #ifrs9 #sapbankanalyzer #sapfpsl #sapjobs #sapindia #solvency2 #sappapm #sapcms #ifrs17