ICIR Working Paper Series No. 11/12Edited by Helmut Grundl and Manfred Wandt

Will Solvency II Market Risk Requirements Bite?The Impact of Solvency II on Insurers’ Asset Allocation∗

Dirk Horing

July 17, 2012

Abstract

The European insurance industry is among the largest institutional investors inEurope. Therefore, major reallocations in their investment portfolios due to thenew risk-based economic capital requirements introduced by Solvency II wouldcause significant disruptions in European capital markets and corporate financing.This paper studies whether the new regulatory capital requirements for market riskare a binding constraint for European insurers by comparing the market risk capitalrequirements of the Solvency II standard model with the Standard & Poor’s ratingmodel for a fictitious, but representative, European-based life insurer. The resultsshow that for a comparable level of confidence, the rating model requires 68% morecapital than the standard model for the same market risks. Hence, Solvency IIseems not to be a binding capital constraint for market risk and thus would notsignificantly influence the insurance companies’ investment strategies.

Keywords: Solvency II, Rating, Market Risk, Capital Requirements∗This is a pre-print of an article published in The Geneva Papers on Risk and Insurance - Issues and

Practice, Advance Online Publication available online at doi: 10.1057/gpp.2012.31.

1

1 Introduction

According to Berger et al. (1997, p. 525) the insurance industry provides three principalservices, namely risk pooling and bearing, real services related to insured losses suchas risk surveys or loss settlement services, and financial intermediation. For the latter,insurance companies collect premiums from policyholders and invest these borrowed fundsin market securities. Indeed, European (life) insurance companies are among the largestinstitutional investors in Europe. The assets in their investment portfolios totalled morethan EUR 7.4 trillion in 2010 (Figure 1). Therefore, the role of insurance companies inthe financing of European sovereigns and corporates is undisputed. For example, morethan 10% of bank liabilities are provided by insurance companies.1

Figure 1: European Insurers’ Investment Portfolios

This figure shows the investment portfolios of the CEA members in EUR trillion at current exchangerates. For 2008 the split between life & health insurance companies (L&H) and property & casualtyinsurance companies (P&C) is shown. For 2009 the portfolio shares of France (FR), United Kingdom(UK), and Germany (DE) are illustrated. The figure is based upon ’CEA Statistics N◦44 – EuropeanInsurance in Figures’ by CEA (2011).

Insurance companies in the European Economic Area (EEA) face probably the great-est regulatory reform they have ever witnessed with the introduction of a new economicrisk-based regulatory framework called Solvency II. The main objective of Solvency IIis the adequate protection of policyholders and beneficiaries by enhancing the financialstability of the insurance companies. Furthermore, the new regulatory framework strivesto harmonise legislation within Europe in order to enable fair competition and increasedtransparency. Among other measures, Solvency II introduces economic risk-based capitalrequirements for market risks to capture the riskiness of different investment strategies.2

The question of whether these new risk-based capital requirements will impact the assetallocations and strategies of European insurance companies polarises politicians, aca-demics and practitioners.

On the one hand, for example, Fitch (2011) captions its report on the potential impactof Solvency II on the European insurance industry with ’Solvency II set to reshape assetallocation and capital markets’, and CGFS (2011, p. 1) state that ’they [the insurancecompanies] may rebalance their asset portfolios in line with the new risk charges’. On the

1 See Kaserer (2011, p. 4) and Deutsche Bank Research (2011, p. 15).2 See CGFS (2011, pp. 25-26).

2

other hand, the European Commissioner for Internal Market and Services, Michel Barnier,strongly disagrees. In a letter to the insurance industry, he writes: ’The criticisms leviedagainst Solvency II, particularly that the calibrations are excessively high, have not beenconfirmed by evidence’.3 Likewise, the authors of the Deutsche Bank Research (2011, p.1) report on the interaction of Solvency II and Basel III with bank financing are muchmore cautious with their conclusion that ’although this scenario will cause some assetsto be reallocated, we do not expect to see any dramatic changes’. The expectationsinspired by academics and empirical evidence on the effect of the introduction of risk-based capital requirements on insurance companies’ asset allocation are mixed. On theone hand, Eling et al. (2008, p. 436) conclude that ’the new, risk-oriented control of assetmanagement as envisioned by the SST [Swiss Solvency Test] will change the investmentpolicies of insurers and thus have a substantial impact on the capital markets’. Onthe other hand, the empirical analysis of the effect of risk-based capital requirementson U.S. life insurers’ investment portfolios by Petroni and Shackelford (1996) indicatesthat ’despite wide-spread expectations of major restructuring in the investments of lifeinsurers, our exhaustive set of tests generally fails to detect a response to the asset riskcomponent of RBC [risk-based capital] standards’.

This paper studies the question of whether the market risk capital requirements out-lined by the new risk-based regulatory framework Solvency II will significantly impactthe European insurance companies’ asset allocations and investment strategies. It anal-yses whether these new requirements are a binding constraint for insurers enforcing arestructuring of their investment portfolios and disrupting European capital markets. Itcompares the required market risk capital of the Solvency II standard model with theStandard & Poor’s rating model for a fictitious, but representative, European-based lifeinsurer.

The study reveals that the rating model requires 68% more capital for market risk than thestandard model for a comparable level of confidence mainly due to the high diversificationcredits and loss-absorbing effects of technical provisions and deferred taxes granted bythe standard model. This result is robust for a range of different asset allocations for therepresentative European-based life insurer.

The remainder of this paper is structured as follows. Section 2 locates the paper withinthe context of previous literature. Section 3 provides an overview on the new Solvency IIregulation. Section 4 introduces the concept of capital management by insurance compa-nies. Section 5 describes the methodology and procedure used to compare the regulatoryand rating capital requirements in this paper. Section 6 describes the representativeEuropean-based life insurer’s investment portfolio. Results and sensitivity analyses areprovided in Section 7; Section 8 concludes.

2 Literature Review

There have been multiple contributions both from academics and practitioners studyingthe determinants of insurers’ investment strategies. In the light of the upcoming changesin the regulatory regimes for the European insurance and banking industry, the focus hasshifted to the potential implications of Solvency II for the insurers’ investment strategies

3 See Barnier (2011, p. 2).

3

and the interdependencies between Solvency II and Basel III. This paper contributes tothe literature by studying the question of whether the market risk capital requirementsunder Solvency II are a binding constraint for a typical European-based life insurancecompany enforcing a restructuring of its investment portfolio. It compares the marketrisk capital requirements of the Solvency II standard model with the Standard and Poor’srating model. The work closest to this study is a quantitative analysis by Morgan Stanleyand Oliver Wyman (2010). However, the authors make a comparison of regulatory capitalrequirements and rating capital requirements only for premium and reserve risk of non-lifeinsurance companies.

2.1 Academic Literature Review

There are two different strands of literature investigating investment strategies of insur-ance companies. The first strand of literature, including Badrinath et al. (1996), Chenet al. (2006) and Da Silva et al. (2011), studies the investment strategies for specificmarket security types in general. Badrinath et al. (1996) empirically investigate thecommon stock portfolios of U.S. institutional investors, including insurance companies,between 1986 and 1988. The authors show that insurers exhibit prudent behaviour whenselecting a firm for investment. However, safety net considerations do not explain theextent or size of the investment in a firm. Chen et al.’s (2006) empirical study analysesthe determinants of U.S. insurers’ corporate bond portfolios. Their regression analysisshows that insurers with greater background risk from insurance operations tend to in-vest less riskily with regard to their corporate bond portfolios. However, if the insurersuffers from poor operating performance, the relationship between background risk andbond portfolio risk reverses, consistent with a gambling incentive. Finally, Da Silva et al.(2011) analyse the determinants of Brazilian insurance companies’ equity holdings. Theauthors confirm past evidence that insurance companies tend to invest in large, liquid,leveraged companies with good corporate governance practices.

The second strand of literature discusses the effects of introducing regulatory risk-basedcapital requirements on insurance companies’ investment portfolios for three case studies.Petroni and Shackelford (1996) empirically investigate the effect of risk-based capitalrequirements on U.S. life insurers’ investment portfolios. Their results show no strongevidence for a major restructuring of investments into assets requiring low capital as aresponse to the introduction of risk-based capital requirements for investments in 1994.Cheng and Weiss (2011) study the investment behaviour of U.S. property & liabilityinsurers in response to the introduction of risk-based capital requirements. In contrastto Petroni and Shackelford (1996), the authors find that insurers in weaker financialpositions adapt to the new regulatory requirements by adjusting their target ratio ofleverage, their proportion of premiums written in high-risk lines and their proportion ofstock and real estate investments.

Eling et al. (2008) discuss the implication of the SST for Swiss insurance companies’ assetand liability management, corporate financing and product design based upon a studyby Schmeiser et al. (2006). The authors conclude that the SST will motivate insurancecompanies to shift towards long-term bonds to reduce their duration gaps. Furthermore,insurers are expected to increase rating quality of their bond portfolio and to reducetheir real estate exposure. The effects on corporate financing will be moderate due to the

4

sufficient capitalisation of the Swiss insurance industry. Life and non-life product designwill adapt in order to reduce capital intensity. Eling et al. (2008, p. 431) note that manyinsurers already fulfil the capital requirements due to binding capital constraints fromtheir own internal model or due to their desire to satisfy rating requirements.

Several authors discuss the implications of Solvency II for the investment strategies andpolicies of insurance companies in the EEA either in general or in combination with theeffects of the implementation of the new Basel III regulations for banks. Rudschuck etal. (2010) argue that the new risk-based capital requirements will force life insurancecompanies to reduce their equity exposures. However, they remark that in the currentlow-interest environment, returns could suffer, which creates a problem for life insurancecompanies which compete with other financial intermediaries for funds. Van Bragt et al.(2010) simulate the results of the fourth Qualitative Impact Study (QIS4) parametrisationfor a typical life insurance company for different investment policies. The authors findthat the asset allocation and asset duration have a major impact on the regulatory capitalrequirements. Moreover, their simulation indicates that duration matching changes moreefficiently the risk and return profile of the investment portfolio than reducing the equityexposure. The CGFS (2011) study analyses the effect of accounting and regulatorychanges on insurers’ investment strategies. The authors also survey industry analysts andexperts as to the effects of Solvency II on the insurers’ investment strategies. Overall,the authors expect a shift to less capital-intensive assets in the investment portfolios.Their survey shows that equities remain a viable asset class under the new regime. Fordebt instruments, the authors expect a shift into EEA sovereign debt and short-dated,high quality corporate debt. Regarding the importance of ratings, the authors notethat rating requirements could determine insurers’ investment strategies. However, therating agencies’ reputation has suffered during the financial crisis, questioning their futurerelevance. Finally, Fischer and Schlutter (2012) construct a theoretical model that showshow the standard formula’s equity risk calibration influences the equity position andinvestment strategy of a shareholder value-maximising insurer. The authors show whateffect individual insurers’ characteristics have on investment strategies, capitalisation anddefault probability.

Jaffee and Walden (2010) investigate in a general equilibrium the effect of a joint im-plementation of Basel III and Solvency II on the Swedish economy. They conclude thatthe new regulations will have only a marginal long-term effect on availability and cost ofcapital for Swedish households and firms. However, they share concerns that SolvencyII will impose heavy regulatory cost on the insurance companies, which will ultimatelyresult in higher insurance premiums and lower demand for insurance policies. They arguethat it is unclear whether the benefits of higher capital requirements outweigh these costs.Happe (2011) discusses the interdependencies between the regulatory reforms Basel IIIand Solvency II. He argues that Basel III will force banks to issue further core equity cap-ital and longer-term debt in order to satisfy the new capital and liquidity requirements.However, long-term corporate bonds face increasing capital requirements in the spreadrisk module of Solvency II, implying an immanent threat for bank financing which couldtranslate into higher interest rates for loans and slower economic growth. Furthermore,he argues that the Solvency II standard model parametrisation favours EEA sovereigndebt and AAA-rated covered bonds, and penalises investment in long-term, unsecuredcorporate debt and hybrid bank debt. Similarly, Kaserer (2011) studies the implicationsof a joint reform of both banking and insurance regulations on corporate financing. He

5

states that insurance companies will reduce their exposure to long-term corporate bondsespecially with lower credit quality in favour of EEA sovereign debt. He claims that theimpact of the restructuring of the insurance companies’ investment portfolios is large,since insurers are a major institutional investor in Germany in both corporates and fi-nancials. This could significantly increase financing costs for corporates and individuals,which may result in economic slowdown. In an event study, Kaserer (2011) shows thatthe stock prices of insurance companies decreased by 15% on average in light of news ofSolvency II. Al-Darwish et al. (2011) discuss the consequences of a joint implementationof Basel III and Solvency II. The authors conclude that since the Solvency II durationmultiplier penalises long-term maturities, insurance companies may opt to invest in EEAsovereign debt, short-dated maturities, or high-rated bank debt such as covered bonds,which may reduce the ability of banks to issue longer-term unsecured debt. The authorsalso raise concerns that both regulatory reforms motivate investment in sovereign debt,which may increase the interconnectiveness of banks and insurers.

2.2 Industry Literature Review

A background study for the Solvency II project by CEA and Oliver Wyman (2005)provides an overview and comparison of regulatory and other solvency assessment frame-works, including Solvency I and the Standard & Poor’s European rating model. Thestudy indicates that Solvency I clearly differs from the new risk-based approaches such asthe Standard & Poor’s rating model. However, the study does not include the SolvencyII capital framework.

The joint report by Morgan Stanley and Oliver Wyman (2010) simulates the results of thenew Solvency II regulation based upon QIS5 specifications for four stereotype insurancecompanies, including a global composite insurer, a global life insurer, a reinsurer anda pure non-life insurer. The authors expect a shift away from traditional participatingcontracts into unit-linked and innovative, less capital intensive products as a responseto the new regulatory regime. Furthermore, a step-up in hedging, asset and liabilitymanagement and use of reinsurance as part of a risk mitigation strategy is predicted.Regarding the investment policies, the authors find a shift away from equities and illiquidinvestments such as private equity into short-dated corporate bonds. The authors alsocompare the QIS5 capital requirements for premium and reserve risk with the capitalrequirements for a BBB-rating from Standard & Poor’s. Their analysis shows that ratingcapital is still the binding constraint for their non-life insurers.

Fitch (2011) simulates the impact of different investment strategies including a typicalasset mix, a heavy equity and heavy duration mismatch asset mix, and a heavy long-termand lower quality corporate bond asset mix on the regulatory capital requirements underSolvency II. The authors show that the investment strategy has a great influence onthe regulatory capital requirements. Moreover, the authors gather data on the return onregulatory capital for credit spread risk for different asset classes showing that short-termcorporate bonds are an attractive investment.

Deutsche Bank Research (2011) and the joint work of the IIF and Oliver Wyman (2011)analyse the reciprocal effects between Basel III and Solvency II. Both studies argue thaton the one hand, Solvency II favours short maturities and good credit ratings as wellas EEA sovereign debt and covered bonds. On the other hand, Basel III requires banks

6

to issue more stable, long-term sources of funding. The authors of the Deutsche BankResearch (2011) report, however, do not expect insurers to cease serving as investorsin bank securities. They argue that insurers still require long-term assets, that they areconcerned about an efficient use of their capital, that diversification is an important driverof regulatory capital requirements, and that internal models may reduce the appeal ofother alternatives to bank bonds.

Finally, the UBR (2011) studies the return on regulatory capital for different asset classesand simulates the effect of different investment strategies such as convertible bonds onthe regulatory capital requirement. The authors conclude that Solvency II is unable tochange the fundamental attractiveness of different asset classes, although it creates someopportunities for arbitrage.

3 Solvency II

Solvency II is a new regulatory supervision framework introducing economic risk-basedcapital requirements across all member states of the European Economic Area (EEA) forthe first time. The implementation of the new framework is scheduled for 1 January 2014,when the European Union (EU) legislation is to be translated into national law. Theproposed Solvency II Directive applies to all insurers and reinsurers except the verysmall insurance companies with annual gross premium income below EUR 5 million andpension funds. The main purpose of Solvency II is the protection of policyholders andbeneficiaries by ensuring the financial soundness of insurance companies and the stabilityof the financial system. Solvency II is intended to establish a harmonised, principle-based and risk-sensitive solvency supervision across the EEA based upon the actual riskprofile of each individual insurance company to promote better regulation, comparability,transparency, international competitiveness, and to instil value-based management.4

Similar to Basel II, the Solvency II Directive is organised into three pillars. Pillar 1stipulates quantitative risk capital requirements; Pillar 2 involves qualitative require-ments regarding governance, control and processes and specifies supervisory activities;and Pillar 3 specifies risk reporting and public disclosure requirements.

Pillar 1 defines two capital requirements representing different levels of regulatory inter-vention. The Solvency Capital Requirement (SCR) is the major solvency control levelfor regulatory supervision. The SCR is intended to ensure a 99.5% confidence level, i.e.the insurer’s capital is insufficient to absorb unforeseen losses in only 1 out of 200 caseswithin the next year. In the case of a breach of the SCR, the insurer is required to provideadditional reporting to the regulator, to provide a financial recovery plan to restore neces-sary capital, and closure to new business is possible. The Minimum Capital Requirement(MCR) is a lower minimum threshold calculated as a combination of a linear formulaand with a floor of 25% and a cap of 45% of the SCR.5 A breach of the MCR triggersthe ultimate supervisory intervention, i.e. a closure to new business is required, and ifrecovery is deemed unsuccessful, the authorisation is withdrawn.6 The SCR calculation

4 See CGFS (2011, pp. 25-26), Buckham et al. (2011, pp. 72-73) and the EU Directive 2009/138/EC ofthe European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of thebusiness of Insurance and Reinsurance (Solvency II).

5 See CEIOPS (2010, p. 287).6 See Buckham et al. (2011, pp. 78-79).

7

is based on a total balance sheet approach that measures assets and liabilities at marketvalues. The calculation covers all quantifiable risks, including actuarial risk, market risk,credit risk, risk arising from intangible assets, operational risk, and accounts for diver-sification, reinsurance and other risk mitigation techniques as well as the loss-absorbingcapacity of technical provisions and deferred taxes.7 Solvency II allows insurers to makeuse either of a standard model which is calibrated on ’average’ data across the Europeaninsurance industry, company-specific adjustments of the standard formula, partial or fullinternal models that allow a more customised assessment of the insurers’ specific riskprofile. However, internal models require approval by the regulators.8

Pillar 2 stipulates qualitative requirements for the governance system of insurance com-panies to provide sound and prudent management and specifies supervisory activities toprovide early warning to the regulator and sufficient power for intervention.9 An effec-tive governance system builds upon an adequate transparent organisation structure, aclear allocation and appropriate segregation of responsibilities, and an effective systemfor information transmission which is adequately documented and regularly reviewed.The system covers risk management, the actuarial function, internal control, compli-ance, internal audit and outsourced services, and is run by persons with adequate pro-fessional qualifications, knowledge and experience (fit), as well as good reputation andintegrity (proper).10 Furthermore, Pillar 2 requires insurance companies to regularly re-view their overall solvency needs in an Own Risk and Solvency Assessment (ORSA)procedure to complement Pillar 1 requirements and enhance awareness of the interrela-tionships between risks and internal capital needs. The ORSA is intended to capture allquantifiable and non-quantifiable material risks, taking into account a company’s specificsituation, business plan and projections, and a multi-year perspective.11 The supervi-sory review process is a uniform tool kit of supervisory activities to assess the insurancecompany’s ability to provide an early warning mechanism for regulators. The processassesses whether the insurance company’s governance system is adequate for identifying,assessing and managing the material risks of the company.12

Pillar 3 stipulates supervisory reporting and public disclosure requirements for insurancecompanies. Supervisory reporting includes provision of information to the regulator basedupon annual and quarterly quantitative reporting templates and the Regular SupervisorReport (RSR). Moreover, insurance companies are required to publish a Solvency andFinancial Condition Report (SFCR).13 The aim of Pillar 3 is to create transparency toenable market participants to exercise market discipline.14

Solvency II is being implemented using a four-step Lamfalussy process which started in2003. In 2009, the European Parliament and the Council passed a directive on the taking-up and pursuit of the business of insurance and reinsurance, stipulating the key principlesof Solvency II (Level 1). The European Insurance and Occupational Pensions Commit-tee (EIOPC) specifies the directive with detailed implementing measures (Level 2). The

7 See Deutsche Bank Research (2011, pp. 5-6).8 See Morgan Stanley and Oliver Wyman (2010, p. 67).9 See Van Hulle (2011, p. 181).10See the EU Directive 2009/138/EC (Solvency II), Articles 41-42.11See Buckham et al. (2011, pp. 80-81).12See Van Hulle (2011, p. 181) and Buckham et al. (2011, p. 82).13See Van Hulle (2011, p. 181).14See Eling (2010, p. 1).

8

EIOPC is an advisory body for the European Commission, the members of which arefrom the insurance supervisory and regulatory authorities of the 27 member states. TheEuropean Insurance and Occupational Pensions Authority (EIOPA) is developing tech-nical specifications (Level 3) in preparation for the implementation of Solvency II innational law. The European Commission and EIOPA are monitoring the implementationand compliance of the Solvency II Directive planned to take effect on 1 January 2014(Level 4).15

4 Insurance Capital Management

The objective of an insurance company should be the maximisation of its market value.Insurance companies can maximise their market value by earning risk-adjusted returnon capital (RAROC) above the cost of capital, i.e. identifying profitable business lines,products, or customers, as well as exiting from unprofitable ones.16 Specifically, the min-imisation of capital required by regulation is not necessarily a market value-maximisingstrategy. Hence, arguments for a restructuring of the investment portfolio based purelyon a comparison of regulatory capital requirements for different asset classes after theintroduction of risk-based capital requirements may be misleading. For example, evenif long-term corporate debt requires more regulatory capital than short-dated corporatedebt, the risk premium may justify the investment on a risk-adjusted return on capitalbasis. The search for excess yield is especially important in the current low-interest en-vironment in which insurance companies are struggling to meet guaranteed returns anddefined benefits and competition is increasing.17

Previous analyses of capital management concentrate on the risk-adjusted return on reg-ulatory capital to compare the incentives of insurance companies to invest in differentasset classes.18 Such analyses are complex and are usually conducted using strongly sim-plifying assumptions. A common assumption is the exclusion of interest rate risk causedby a duration mismatch between assets and liabilities from the analysis by assuming thatliabilities are cash-flow matched interest rate derivatives such as swaps.19 However, theinterest rate risk component of fixed income instruments makes up a significant share ofthe market risk capital requirements of insurers according to QIS5.20 Furthermore, therisk-reducing effect of diversification and the loss-absorbing capacity of technical provi-sions and deferred taxes is often factored out.21 However, although market risk capitalrequirements seem to be large in isolation, the effect of diversification significantly lowersthe final capital requirements.22

Using the risk-adjusted return on capital requires an answer as to which definition ofcapital should be used, i.e. what is the right denominator for this performance measure-

15See Deutsche Bank Research (2011, p. 4).16See Cummins (2000).17See CGFS (2011, p. 32).18See Van Bragt et al. (2010), Morgan Stanley and Oliver Wyman (2010), Fitch (2011), CGFS (2011) and

UBR (2011).19See for example Morgan Stanley and Oliver Wyman (2010, p. 10) and Fitch (2011, p. 6).20See Deutsche Bank Research (2011, pp. 7-8) and EIOPA (2011, p. 72).21See for example UBR (2011, p. 3).22See Deutsche Bank Research (2011, p. 9) and EIOPA (2011, pp. 63-64 and p. 72).

9

ment. Insurance companies have to manage different types of capital simultaneously tosatisfy the needs of all their stakeholders. For example, Swiss Re (2011, p. 35) states:

We actively manage our capital to ensure that the Group and the Group com-panies are adequately capitalised at all times. The level of capitalisation andthe capital structure are determined by regulatory capital requirements, ratingagencies requirements, as well as management’s view of risks and opportuni-ties [internal capital requirements].

Regulatory capital is an externally imposed minimum capital threshold required by theregulating authorities in order to avoid regulatory intervention.23 Regulatory capitalframeworks include, for example, Solvency I, Solvency II, Swiss Solvency Test and U.S.Risk-Based Capital.24 Rating agencies such as A.M. Best and Standard & Poor’s evalu-ate the insurance companies using multiple quantitative and qualitative criteria to assigncredit ratings. One of the criteria is the assessment of the capital adequacy of the insur-ance company using risk-based capital models.25 Rating capital is an externally imposedcapital requirement to fulfil the capital adequacy criteria for a certain target rating. Ofthe 28 leading European insurance groups, 21% have a counterparty credit rating of AA,72% of A and 7% of BBB. Hence, the average counterparty credit rating as of December2010 is an A-rating.26 Finally, insurance companies – especially large firms – have devel-oped internal economic capital management models for planning, pricing and managingtheir business. Internal capital or economic capital is the capital required by managementto ensure continued operations even after extreme adverse events.27

Insurance companies direct their capital management efforts towards the scarcest re-source, i.e. the most binding capital constraint.28 In the past, it seems as though reg-ulatory capital has not been a major constraint for most insurers under the Solvency Iregime.29 The CEIOPS (2008b) and EIOPA (2011) impact studies reveal that even thestricter Solvency II regulatory capital framework does not threaten insurers’ regulatorycapital adequacy (Figure 2).30 For example, QIS5 indicates that based upon 2009 data,15% of the participating insurance companies do not meet the SCR threshold and around5% do not meet the lower MCR threshold that may require withdrawal of the operatingauthorisation.31

There is some anecdotal evidence to suggest that rating or internal capital has beenthe relevant capital constraints in the insurance industry in the past that have attractedcapital management efforts.32 This paper analyses the question of whether the market riskcharges under Solvency II are a binding constraint for insurers, enforcing a restructuringof their investment portfolios.

23See Cummins (2000, p. 11).24See Eling and Holzmuller (2008) for an overview and comparison of risk-based capital standards.25See Hirschmann and Romeike (2004, p. 37).26See EIOPA (2010b, p. 9).27See Deutsche Bank Research (2011, p. 9) and Swiss Re (2011, p. 36).28See Morgan Stanley and Oliver Wyman (2010, p. 32) and SCOR (2011, p. 26).29See Doff (2007, p. 99).30See Jaffee and Walden (2010, p. 28), Barnier (2011, p. 2) and CGFS (2011, p. 31).31See EIOPA (2011, p. 25 and 27).32See Morgan Stanley and Oliver Wyman (2010, p. 3) and Fitch (2011, p. 12).

10

Figure 2: Distribution of Solvency Capital Ratios for Selected European Countries

This figure shows the 25% percentile, median, and 75% percentile of the Solvency I and II capital ratiosbased upon 2007 data for France (FR), United Kingdom (UK), and Germany (DE) in percent. TheSolvency I capital ratio is the available capital divided by the required capital according to Solvency Ispecifications. The Solvency II capital ratio is the available capital divided by SCR according to SolvencyII specifications (QIS4). The figure is based upon ’CEIOPS’s Report on its fourth Quantitative ImpactStudy (QIS4) for Solvency II – Annex of Selected Tables’ by CEIOPS (2008b, p. 32 and 40).

5 Methodology

This paper compares the market risk capital requirements for a representative European-based life insurance company for the Solvency II standard model and the Standard & Poor’srating model.33 Internal capital requirements cannot be included in the analysis, sincethe internal models are proprietary and not publicly observable.

The Solvency II standard model is based upon a total economic balance sheet approach.Hence, all assets and liabilities are considered at market-consistent valuations, i.e. assetsand liabilities are either marked to market or marked to model to reflect their actualeconomic value.34 The standard model is divided into six risk modules including marketrisk, counterparty default risk, life underwriting risk, non-life underwriting risk, healthunderwriting risk and intangible asset risk, each consisting of sub-modules. The sixrisk modules are aggregated using correlations to calculate the Basic Solvency CapitalRequirement (BSCR). To arrive at the SCR, a capital charge for operational risk is addedand adjustments for the loss-absorbing capacity of technical provisions and deferred taxesare incorporated.35 The market risk module is one of the most important risk modules.Market risk makes up around 69% of the BSCR for solo insurance companies in Europe.36

33For Solvency II market risk regulatory capital requirements, the latest QIS5 calibrations and specifica-tions in CEIOPS (2010) are used. For the rating capital requirements, the latest 2010 Standard & Poor’sInsurance Capital Model Version 3 for Europe, the Middle East and Asia (EMEA) is used. Sourced fromwww.standardandpoors.com/ratings/insurance-capital-model/en/eu, accessed 25 January 2012.

34See Buckham et al. (2011, pp. 88-89).35See CGFS (2011, p. 29).36See EIOPA (2011, p. 63).

11

The market risk module consists of seven sub-modules, namely interest rate risk, equityrisk, property risk, credit spread risk, currency risk, concentration risk and illiquidity risk.It is intended to account for risks arising from the volatility of financial instrument marketprices. The sub-modules are aggregated using correlations to account for diversificationeffects arising between different market risks.37

Standard & Poor’s uses its risk-based capital adequacy model as one building block forthe analysis of insurance companies’ capitalisation. However, to evaluate the credit rating,other quantitative and qualitative criteria of enterprise risk management, investments,competitive position, liquidity, operating performance, financial flexibility, managementand corporate strategy are considered. The factor-based model provides target risk-basedcapital requirements for the different rating levels, establishing a specific degree of cer-tainty. The levels of confidence are 97.2% for BBB, 99.4% for A, 99.7% for AA and99.9% for AAA.38 Hence, a target rating of A with a confidence level of 99.4% coin-cides with the Solvency II 99.5% calibration.39 The rating model is mainly based uponnational generally accepted accounting practices (GAAP) or International Financial Re-porting Standards (IFRS).40 The rating model is divided into six risk modules, namelyinvestment risk, credit risk, other assets risk, life underwriting risk, non-life underwritingrisk and other liabilities risk, each consisting of sub-modules. The rating model aggre-gates all module risk charges considering only the diversification between life and non-liferisks. The investment risk module consists of five sub-modules: interest rate risk forbonds, equity risk, property risk, credit spread risk for bonds and concentration risk.The sub-modules are aggregated, accounting for diversification effects between the assetclasses bonds, equities and real estate. Furthermore, a size effect and analyst adjustmentsare considered. The size effect incorporates the risk associated with smaller investmentportfolios.41

In a first step, I will compare the gross risk charges before diversification and other risk-reducing measures of the standard model and the rating model for different asset classesfor equity risk, credit spread risk and property risk. All three risk sub-modules are amongthe most important market risk sub-modules for solo insurance companies, with a shareof 31%, 22% and 9% respectively of total market risk before diversification. Interest raterisk, with a share of 21% of total market risk before diversification, is included in theanalysis in a further step. The risk sub-modules for currency risk, illiquidity risk andconcentration risk, with shares of 7%, 6% and 4% respectively of total market risk beforediversification, are excluded from the analysis.42 To compare the aggregated charges forthe market risk sub-modules equity risk, credit spread risk, property risk and interest raterisk in a second step, I will use a representative European-based life insurance company’sinvestment portfolio and balance sheet as a benchmark. The underlying assumptionand the investment portfolio are explained in the subsequent section. The comparisonof aggregated charges for the market risk accounts for the intra equity risk sub-modulediversification credit between the asset classes global and other equity described by theQIS5 technical specifications for Solvency II. In a third and final step, I will aggregatethe capital requirements for the single risk sub-modules to a total market risk capital

37See EIOPA (2011, pp. 106-109).38See Standard & Poor’s (2010a, p. 4).39See CRO Forum (2011) for a discussion of economic and actual insolvency.40See Standard & Poor’s (2010b, p. 3).41See the Standard & Poor’s Insurance Capital Model.42See EIOPA (2011, p. 72) for composition of market risk.

12

charge for the standard model and the rating model, thereby including the risk-reducingeffects of diversification within the market risk module between different market risks.Also included are diversification effects between market risk and other risks such as un-derwriting or counterparty credit risk, risk-absorbing capacity of technical provisions anddeferred taxes for the Solvency II standard model, as well as diversification between theasset classes and the size effect for the Standard & Poor’s rating model. I will conductscenario analysis to substantiate the reliability of the results.

6 A Representative European-Based Life Insurer

The creation of the representative European-based life insurer’s balance sheet and invest-ment portfolio relies on several sources, including statistics from regulators, insurance as-sociations and rating agencies, as well as individual insurance companies’ annual reportsand investor presentations from 2009 and 2010. The main balance sheet composition, in-cluding the share of market risk module-relevant assets among total assets and the shareof companies’ own funds among total liabilities, is based upon the QIS5 results.43 Theasset class composition of the investment portfolio, the geographical investment focus,the rating distribution and the maturity profile are based upon 2009 and 2010 annual re-ports and investor presentations of European insurance companies.44 Aggregate financialstatistics for insurers’ investment portfolios from regulators or insurance associations donot contain the necessary details and investment portfolio splits for the standard modeland the rating model and the required look-through approach.45 The look-through ap-proach demands a scrutinising of investment funds and other indirect investment vehiclesfor the underlying investment securities.46 The level of detail of the investment portfolio isdetermined by the more granular requirements of either the standard model or the ratingmodel. For example, whereas the standard model does not distinguish between differentproperty classes, the rating model applies different risk charges to properties dependingon one’s own versus third party use and the investment region. Therefore, the ratingmodel defines the granularity for the property investment portfolio of the representativeEuropean-based life insurer.

Furthermore, both capital models rely on two substantially different input factors thatrequire further simplifying assumptions. On the one hand, the standard model workspurely with market values, whereas the rating model requires IFRS and market valuesfor the valuation of assets in the investment portfolio. However, since most of the rel-evant investment portfolio assets are classified as either held for trading, designated atfair value through income, or available for sale requiring a marked-to-market or marked-to-model valuation, the difference between an evaluation at market value and at IFRSvalues is negligible.47 Moreover, due to the financial crisis, the valuation reserves ofinsurance companies’ investments have been significantly reduced. For example, the val-uation reserves of German primary insurance companies’ investments are only 5% of the

43See EIOPA (2011, pp. 36-39).44The sample consists of Allianz, AXA, Ageas, Aviva, Baloise, CNP Assurances, Fondaria SAI, Fortis,

Generali, Helvetia, Legal & General, Swiss Life, Vienna Insurance and Zurich.45See for example BaFin (2011, p. 14), EIOPA (2010a), GDV (2011, p. 27) and CEA (2011, p. 28).46See CEIOPS (2010, p. 109).47See, for example, the annual report of Allianz (2011, p. 208).

13

investments’ book value.48 Therefore, I assume for the purpose of my analysis that thedifference between the market and accounting value of the investments is insignificant.On the other hand, the standard model and the rating model apply modified durationand time to maturity respectively to determine the capital charge for credit spread risk.49

Information on the time to maturity distribution of different asset classes is publicly avail-able in annual reports and investor presentations. To translate these time to maturitydistributions into a modified duration, the Market iBoxx EUR fixed income benchmarkindex (ISIN DE0009682716) as of 9 December 2011 was used. The index includes invest-ment grade fixed income securities, including sovereigns, agency and supranational debt,collaterialised bonds, and corporates. Based upon this universe, the average percentagedifference between time to maturity and modified duration was calculated to assign amodified duration to different time to maturity buckets of the portfolio (Table 1).

[Insert Table 1 here]

The total economic balance sheet composition of the representative life insurer is basedupon the average market value balance sheet of insurance companies according to QIS5(Figure 3).50 Total assets and the market risk portfolio of the life insurer are assumed toequal EUR 4.0 and 3.0 billion respectively. EUR 3.0 billion is approximately the averagetotal investments of German life insurers companies in 2009.51

Figure 3: The Representative European-Based Life Insurer’s Economic Balance Sheet

This figure shows the economic balance sheet in percent of the representative European-based life insurerbased upon the QIS5 results. The market risk portfolio on the asset side includes investments relevant forthe market risk modules such as equities, alternatives, real estate properties, and debt instruments. Thecredit risk portfolio contains assets relevant for the counterparty default risk modules such as mortgages,policy loans, reinsurance assets, and cash held at a bank. Other liabilities include for example short-termdebt and deferred tax liabilities.

48See BaFin (2011, p. 17).49See CEIOPS (2010, p. 120) and Standard & Poor’s (2010b, p. 11).50See EIOPA (2011, pp. 36-39).51BaFin (2011, p. 7) reports the number of German life insurers as being 343 in 2009. Furthermore, in

the BaFin (2011, p. 15) statistics, the related investments equal EUR 977,507 million.

14

On the asset side, a differentiation is made for assets relevant for the market risk modules(market risk portfolio), including equities, alternatives, real estate properties and debtinstruments. Separately, assets relevant for the counterparty default risk modules (creditrisk portfolio) include, for example, mortgages, policy loans, reinsurance assets and cashheld at a bank. On the liability side, a differentiation is made between companies’ ownfunds, technical provisions and other liabilities such as short-term debt and deferred taxes.The representative insurance company provides traditional life insurance products anddoes not engage in either unit-linked products, asset management, or banking activities.The insurance liabilities have a duration of 8.9 years, which is the median durationfor life insurance liabilities in Europe according to the results of QIS4.52 The durationmismatch between assets and liabilities is 2.1 years. Hence, a parallel downward shiftin the interest yield curve decreases companies’ own funds due to the long-term timehorizon of the life technical provisions. Standard & Poor’s assumes a duration mismatchof one to ten years depending on the market and its structural features including the loss-absorbing capacity of technical reserves.53 The implied duration mismatch is one year forthe United Kingdom or Spain, two years for Belgium, France, Italy, The Netherlands orSwitzerland, three years for Germany, Austria or Central and Eastern Europe, and fouryears for Northern Europe. For my representative European-based life insurer, I haveused the average European implied duration of two years within the rating model.

The market risk portfolio consists of equities, alternatives, real estate property and debtinstruments (Figure 4). The portfolio is invested relatively conservatively and follows thecongruence principle, i.e. congruent characteristics such as economic area between assetsand liabilities.

The majority of the market risk portfolio, with 82%, is invested in debt or fixed incomeinstruments. 49% thereof is invested in sovereign, supranational or agency debt. Theremainder of the debt portion of the market risk portfolio consists of corporate bondsand covered bonds, mainly mortgage covered bonds. Structured products such as assetbacked securities (ABS) or collateralised debt obligations (CDO) and bank deposits areexcluded from the analysis due to their small portion in a typical fixed income portfolioof about 2.5% and 2.0% respectively. Although structured products are seen as one ofthe root causes of the recent financial crisis, the capital risk charges in the standardmodel and the rating model are not substantially different from regular corporate bondsexcept for lower rating classes.54 A smaller share of the market risk portfolio of only 7% isinvested in equities and alternatives. The equity and alternatives allocation of the marketrisk portfolio is thus at a historically low level due to the equity bubble in 2001 and therecent financial crisis.55 Alternative investments include private equity, infrastructureand renewable energy projects, and hedge funds. The real estate properties make uparound 11% of the market risk portfolio and consist mainly of properties leased to thirdparties.

For equities, the standard model distinguishes between global equities listed in the reg-ulated markets in countries which are members of the EEA or the OECD and otherequities which contain equities listed in emerging markets, non-listed equities, privateequity, hedge funds, and any other investments not covered elsewhere in the market risk

52See CEIOPS (2008a, p. 182).53See Standard & Poor’s (2010a, pp. 31-32).54See Grundl and Post (2009) for a discussion of the role of ABS and CDOs in the financial crisis.55See CGFS (2011, p. 32).

15

Figure 4: Composition of the Market Risk Portfolio

This figure shows the composition of the market risk portfolio at market values in percent of the repre-sentative European-based life insurer based upon my sample of individual insurers’ annual reports andinvestor presentations.

module.56 The rating model distinguishes equities according to the country of their listingor, in the case of a well diversified equity portfolio, according to the region of their list-ing.57 For the equity portfolio of my representative European-based life insurer, I assumethat the equity portfolio is sufficiently diversified to allow for the regional rather than thecountry classification of the rating model. The regions specified by Standard & Poor’saccording to their equity volatility characteristics are Europe (Category 1), World andFar East (Category 2), Emerging Far East and Latin America (Category 3), Nordic andArabia (Category 4), and the BRIC countries (Category 5).58 To compare the standardmodel and the rating model, I assume that equities listed in the regional categories Europeand World and Far East are equities listed in the OECD or EEA. Most of the countriesof the other regional categories, including Emerging Far East and Latin America, Nordicand Arabia, and the BRIC countries, are not member states of either the OECD or theEEA. Based upon the insurance company sample used, more than 90% of equities arelisted in the OECD or the EEA. Finally, the rating model requires private equities to beallocated to a country or region. I assume that private equities are domiciled in Europe(Category 1), which is 80% of the equity portfolio (Figure 5).

56See CEIOPS (2010, p. 113).57See Standard & Poor’s (2010a, p. 22).58Arabia is defined as the member countries of the Gulf Cooperation Council (GCC).

16

Figure 5: Regional Splits of Equities, Real Estate Properties, and Sovereign Debt

This figure shows the regional composition of the equity portfolio, the real estate properties used by thirdparties, and the sovereign debt portfolio in percent of the representative European-based life insurer.

While the standard model does not differentiate between different types of real estateproperties, the rating model categorises real estate properties as one’s own use or owner-occupied properties and third party use properties. Real estate properties leased or rentedto third parties are classified into three regional categories. Category 1 contains Austria,Germany, The Netherlands, New Zealand and Switzerland. Category 2 consists of Japanand other European countries. Category 3 includes Ireland, Spain, the United Kingdom,the United States and other countries not included in any of the other categories. Sim-ilarly to the equity portfolio, the real estate portfolio is invested prudently with highallocation to the more stable real estate markets in Categories 1 and 2 (Figure 5).

Whereas the rating model relies only on rating and time to maturity to calculate capi-tal charges for sovereign debt, the standard model distinguishes between sovereign debtissued by or guaranteed by national governments of an EEA state in local currency andother sovereign debt.59 According to my sample of insurance companies, more than 80%of a representative sovereign debt portfolio is invested in the EEA (Figure 5). The largestallocations in the sovereign debt EEA portfolio are for countries such as Germany, Franceand Italy. Non-EEA countries, with a 20% share of the sovereign debt portfolio, mainlyinclude countries such as the United States and Switzerland. For a detailed overview ofthe representative sovereign debt portfolio see Table 2.

[Insert Table 2 here]

The credit spread risk modules of both models require a combination of rating andtime to maturity or modified duration to determine the credit spread risk capital charge(Figure 6).60 The majority of sovereign debt instruments, with 98.0%, is rated invest-ment grade, although the ratings of major European countries such as Greece and Italyhave suffered during the sovereign debt crisis.61 The average rating for sovereign debt in

59See CEIOPS (2010, p. 123).60See CEIOPS (2010, p. 120).61See CGFS (2011, pp. 48-49).

17

my analysis is AA. Corporate debt is mostly investment grade with 92.5% as well. How-ever, the average rating for corporate debt is A. Covered bonds have an average rating ofAAA due to the collateral backing of the bonds. Table 3 shows an overview of the ratingdistribution of the fixed income portfolio.

[Insert Table 3 here]

Figure 6: Rating and Time to Maturity of the Fixed Income Portfolio

This figure shows the rating and time to maturity distribution in percent of the fixed income portfolioof the representative European-based life insurer based upon my sample of individual insurers’ annualreports and investor presentations.

The credit spread risk module of the rating model requires a classification of bondsaccording to their time to maturity into five time to maturity buckets, namely <1 year,1–5 years, 5–10 years, 10–20 years and >20 years. In general, longer-term sovereigndebt and covered bonds are used to match the cash flows expected to occur more than20 years in the future. Corporate bonds in the insurers’ portfolio typically have shortto medium-term maturities. For example, the average time to maturity of bank bondsissued in 2010 is 5.6 years.62 Table 4 shows the distribution of time to maturities for thedifferent fixed income asset classes. The duration for each asset class is calculated usingthe time to maturity distribution and modified duration assumptions for each maturitybucket from Table 1.63

[Insert Table 4 here]

I assume that the time to maturity distribution is equal for each rating category withineach fixed income asset class. For the total fixed income portfolio, the percentage ofhigher quality ratings increases with the time to maturity of the fixed income instru-ments mainly due to the higher rating quality of longer-term sovereign bonds compared

62See Deutsche Bank Research (2011, p. 13).63 I assume a uniform distribution of maturities within each maturity bucket, i.e. I use 15 years as the

average distribution for the maturity bucket 10–20 years. The relevant percentage discount on 15 yearstime to maturity is applied to calculate the relevant modified duration for the maturity bucket. Forthe maturity bucket > 20 years a maximum time to maturity of 29 years is assumed, which is the 99%percentile of the time to maturity of sovereign bonds in the Market iBoxx EUR dataset used.

18

to short to medium-term corporate bonds. This relationship is representative of insur-ance investment portfolios.64 Table 5 shows the relationship between rating and time tomaturity of the fixed income portfolio. Table 6 gives a comprehensive overview of therepresentative European-based life insurer’s market risk investment portfolio.

[Insert Tables 5 and 6 here]

7 Comparison of Capital Models

7.1 Gross Risk Capital Charges

The analysis starts with a comparison of gross risk charges before diversification andother risk-reducing effects such as loss-absorption of technical provisions and deferredtaxes as well as the size effect for the equity risk, property risk and credit spread riskmodules for the Solvency II standard model and the Standard & Poor’s rating model.The level of confidence for the standard model of 99.5% is compared to different targetratings which represent levels of confidence of 97.2% for BBB, 99.4% for A, 99.7% forAA and 99.9% for AAA. In particular, the target rating of A with a confidence level of99.4% thus coincides with the Solvency II 99.5% calibration.

For the comparison of gross equity charges, I assume that the equity portfolios are suf-ficiently internationally diversified so that the use of regional equity risk charges of therating model is justified. Furthermore, the equities in the regional categories Europe(Category 1) and World and Far East (Category 2) correspond to listings in EEA orOECD countries, whereas equities in the regional categories Emerging Far East andLatin America (Category 3), Nordic and Arabia (Category 4), and BRIC (Category 5)do not contain equities listed in EEA or OECD countries. Finally, I assume that privateequities are domiciled in Europe (Category 1). Comparing the gross equity risk charges,the rating model is more restrictive than the standard model for all confidence levelsabove an A-rating or a confidence level of 99.4%. Table 7 shows an overview of the grossequity risk charges.

[Insert Table 7 here]

Regarding real estate property risk, the rating model applies a weighted average capitalcharge on owner-occupied real estate properties based upon third party use properties.Comparing the gross property risk charges, the standard model is generally more restric-tive except for target ratings of AAA (99.9% confidence level) and AA (99.7% confidencelevel) for highly volatile real estate markets such as the United Kingdom, Ireland, Spainand the United States (Category 3), and owner-occupied properties for a target ratingof AAA (99.9% confidence level). Table 7 shows an overview of the gross real estateproperty risk charges.

The credit spread risk modules of the standard model and the rating model apply tosovereign bonds, corporate bonds, covered bonds, subordinated debt, hybrid debt, asset

64See, for example, the investor presentation of CNP Assurances (2011, p. 71).

19

backed securities, structured credit products, credit derivatives not held as part of a hedg-ing programme, bank deposits, and other debt and fixed income securities.65 However,the rating model distinguishes bank deposits from other debt and fixed income securities.

The Solvency II standard model requires no gross capital charge for credit spread riskindependent of the actual rating for sovereign debt issued in local currency in memberstates of the EEA.66 This practice has been criticised due to the current developmentof the recent sovereign debt crisis when sovereign ratings deteriorated and credit spreadincreased to historical heights.67 In contrast, the rating model only differentiates AAA-rated sovereign debt from other corporate debt. Hence, the rating model is more restric-tive than the standard model for any target rating and confidence level for sovereign debtissued in local currency in the EEA not rated AAA. Table 8 shows an overview of thegross credit spread risk charges on EEA sovereign debt.

[Insert Table 8 here]

For sovereign debt not issued in local currency in EEA member states, the standardmodel applies specific risk charges.68 In addition to a risk factor depending on the rating,the standard model stipulates a duration floor of one year and a duration cap dependingon the rating. The duration floor is binding for the exemplary non-EEA sovereign bondswith a time to maturity of 1 year and a modified duration of 0.9 years. The duration capis binding for the exemplary non-EEA sovereign bonds with rating lower than or equal toBB and time to maturities exceeding 20 years. While the lowest rating for the standardmodel is B, the rating model provides a specific risk charge for ratings of CCC or lower.For unrated bonds, the rating model uses risk factors equal to a BBB-rating, whereasthe standard model is slightly less conservative and provides risk factors in between arating of BBB and BB. There is mixed evidence regarding the credit spread risk chargefor non-EEA sovereign debt. The rating model is, in general, more restrictive for a targetrating of A or a confidence level of 99.4% except for lower investment grade ratings of Aand BBB. Table 9 shows an overview of the gross credit spread risk charges on non-EEAsovereign debt.

[Insert Table 9 here]

For corporate debt, the comparison of gross credit spread risk capital charges indicatesthat the standard model is more restrictive than the rating model for corporate debtexcept for lower rating qualities. However, it should be noted that this does not includerisk-reducing effects of diversification and the loss absorption of technical provisions anddeferred taxes, which significantly reduce the risk capital charges, especially for the stan-dard model.69 Moreover, the longer the time to maturity or the modified duration and thelower the quality of the credit rating, the higher is the risk capital charge for credit spreadrisk. Table 10 shows an overview of the gross credit spread risk charges on corporate debt.

65See CEIOPS (2010, pp. 119-120).66See CEIOPS (2010, pp. 122-123).67Compare for example IIF and Oliver Wyman (2011, p. 12).68See CEIOPS (2010, p. 122).69See Deutsche Bank Research (2011, p. 9) and Morgan Stanley and Oliver Wyman (2010, p. 3).

20

[Insert Table 10 here]

For covered bonds, the standard model applies a special lower credit spread risk chargein the case of an AAA-rating.70 Still, the standard model remains more restrictive thanthe rating model for covered bonds except for lower rating qualities. Table 11 shows anoverview of the gross credit spread risk charges on covered bonds.

[Insert Table 11 here]

7.2 Capital Charges for Market Risk Sub-Modules

Building on the analysis of gross risk capital charges, I now calculate the aggregatedcharges for the risk sub-modules equity risk, credit spread risk, property risk and inter-est rate risk for the representative European-based life insurance company’s investmentportfolio and balance sheet defined in the previous section. The aggregation is done forthe Solvency II standard model and the different target ratings of the Standard & Poor’srating model. The aggregation includes the intra equity risk sub-module diversificationeffects between the asset classes global and other equity described by the QIS5 techni-cal specifications for Solvency II.71 The analysis assumes that the investment portfolioreflects the actual economic risk exposures, i.e. hedging programmes do not distort theeconomic risk exposure significantly.72

To calculate the equity risk sub-module capital charge, the value of equities in the specificequity asset classes is multiplied by the respective gross capital charge. For the equity risksub-module, the higher gross capital charges of the rating model translate into a highertotal capital charge for the equity risk sub-module even before diversification effects withinthe equity risk sub-module, as specified by QIS5, are considered. QIS5 accounts for thediversification effects between the equity asset classes ’Global Equity’ and ’Other Equity’using a correlation matrix which specifies a correlation coefficient of 0.75.73 Comparingthe capital charges for the equity risk sub-module, the rating model is more restrictive forany target rating above BBB (97.2% confidence level). For a comparable confidence level,i.e. a target rating of A, the rating model requires 37% more capital than the standardmodel for equity risk (Table 12).

[Insert Table 12 here]

Likewise, the property risk sub-module capital charge is calculated by multiplying thevalue of real estate properties in the specific real estate asset classes by the respectivecapital charge. The higher gross capital charges for property risk of the standard modeltranslate into a higher total capital charge for the property risk module. Comparingthe capital charges for the property risk sub-module, the standard model is always morerestrictive. For a comparable confidence level, i.e. a target rating of A, the standard modelrequires almost 86% more capital than the rating model for property risk (Table 12).

70See CEIOPS (2010, p. 123).71See CEIOPS (2010, p. 114).72See CEIOPS (2010, p. 112).73See CEIOPS (2010, p. 114).

21

To calculate the credit spread risk sub-module capital charge according to the QIS5specifications, the simplified approach was used.74 The approach basically allows one touse the weighted average modified duration for bond portfolios of equal rating instead of abottom-up calculation. The credit spread risk capital charge is calculated as the productof the value of the bond portfolio with a specific rating times the modified duration ofthe portfolio times the rating dependent risk factor. The rating model stipulates a grossrisk charge for each time to maturity bucket and rating category which is multiplied bythe debt security’s value. For the calculation, the simplifying assumption was made thatthe lowest rating is B.

For EEA sovereign debt, the rating model is more restrictive, since only AAA-ratedinstruments are considered risk-free. For non-EEA sovereign debt, corporate debt andcovered bonds, the higher gross capital charges for credit spread risk of the standard modeltranslate into higher capital charges. Comparing the total credit spread capital charges,the standard model is always more restrictive than the rating model, i.e. the impact ofEEA sovereign debt is outweighed by the higher capital risk charges for corporate debt.For a comparable confidence level, i.e. a target rating of A, the standard model requires152% more capital than the rating model for credit spread risk (Table 12).

To calculate the capital charge for interest rate risk for the standard model, a simplifiedapproach was used. The QIS5 technical specification usually requires a scenario-basedapproach which specifies individual interest rate shocks per year applied to interest rate-sensitive assets and liabilities.75 However, since I do not assume specific cash flow profilesfor assets and liabilities, I approximated the interest rate shock using a parallel shift ofthe swap rate curve multiplied by the duration mismatch of assets and liabilities. Usingthe interest rates provided by BaFin and the QIS5 upward and downward interest rateshocks, the average parallel upward and downward interest rate shocks are 1.3 and –1.3percentage points (ppt) respectively.76 Table 13 shows the calculation of the interestrate shock. Since the representative European-based life insurer has a negative durationmismatch, i.e. the duration of the liabilities exceed the duration of the assets, onlythe downward interest rate shock has a negative impact on the insurer’s own funds.The interest rate capital charge for the standard model is calculated by multiplying thedownward interest rate shock of –1.3% by the negative duration gap of –2.1 years andthe market value of total assets of EUR 4.0 billion.

[Insert Table 13 here]

The rating model stipulates a capital charge on bonds backing shareholders’ equity andlife liabilities depending on an implied mismatch between assets and liabilities basedupon the domicile of the life liabilities. In case assets cannot be segregated, the lower-risk bonds are firstly allocated to life liabilities before they back shareholders’ equity.77

This is the approach used for my representative life insurer. Furthermore, I assume thatthe liabilities are domiciled in European markets such as Belgium, France, Italy, TheNetherlands or Switzerland (Category 2) which have an implied duration mismatch of

74See CEIOPS (2010, pp. 126-127).75See CEIOPS (2010, pp. 110-111).76The BaFin interest rates are based upon swap rates as of December 2009 and a EUR liquidity premium

of 50bps. See CEIOPS (2010, p. 111) for the interest rate shocks.77See Standard & Poor’s (2010b, p. 12).

22

two years according to the rating model. Furthermore, the life insurer does not qualify toreduce the duration mismatch due to strong or excellent asset and liability managementrisk controls. The rating model applies a capital charge depending on the target ratingof 4.9% for AAA, 4.4% for AA, 4.0% for A and 3.0% for BBB. Comparing the capitalcharges for the interest rate risk sub-module, the standard model is more restrictive forany target rating below AAA (99.9% confidence level). For a comparable confidence level,i.e. a target rating of A, the standard model requires 15% more capital than the ratingmodel for interest rate risk (Table 12).

7.3 Capital Charges for the Market Risk Module

Comparing the sum of the capital charges for market risk sub-modules, the standardmodel remains more restrictive than the rating model for all target ratings and confidenceintervals. For a comparable confidence level, i.e. a target rating of A, the standardmodel requires 33% more capital than the rating model for gross market risk (Table 12).However, there are substantial risk-reducing effects allowed for by the standard modelthat reverse the relationship of the standard model and the rating model. The standardmodel specifies the risk-reducing effect of diversification between different market risksby providing a correlation matrix which states, for example, a correlation coefficientof 0.75 between equity and real estate property risk when a downward interest rateshock scenario is used.78 The rating model specifies a correlation matrix in terms ofasset classes including equities, real estate properties and debt securities. Debt securitiesinclude the interest rate risk and the credit spread risk arising from the asset class. Forexample, a correlation coefficient of 0.75 is specified for equities and real estate properties.However, given the uncertainties around tail correlations, Standard & Poor’s applies a50% haircut to the diversification credit.79 Moreover, if the insurers’ invested assets arebelow EUR 1.2 billion, a size factor is used to further reduce the diversification creditin the rating model. The rating model’s diversification credit is thus significantly lowerthan the standard model’s. Therefore, for a comparable confidence level, i.e. a targetrating of A, the standard model requires only 14% more capital than the rating modelfor market risk (Table 12). Furthermore, the standard model requires the calculationof diversification credit between market risk and other risks, such as underwriting riskand counterparty default risk.80 For example, the correlation coefficient between marketrisk and counterparty default risk is 0.25.81 Based upon the results of QIS5, an averagediversification credit of 18% on market risk is used here. The rating model allows nofurther diversification credit between market and other risks. Finally, the standard modelincludes the risk-absorbing effect of technical provisions and deferred taxes which reducethe BSCR after diversification on average by 36%.82 Including these latter two risk-reducing effects, the rating model is now more restrictive than the standard model forany target rating and confidence level. For a comparable confidence level, i.e. a targetrating of A, the rating model requires 68% more capital for net market risk than thestandard model (Table 12). Hence, the rating model seems to remain a binding capital

78See CEIOPS (2010, p. 108).79See Standard & Poor’s (2010a, p. 16).80See Hanewald et al. (2011) for an analysis of the correlation between mortality and market risk.81See CEIOPS (2010, p. 96).82See EIOPA (2011, p. 63).

23

constraint rather than the new regulatory capital requirements imposed by Solvency II(Figure 7).

Figure 7: Comparison of Capital Requirements for an European-Based Life Insurer

This figure shows the capital charges in EUR million for the standard model according to QIS5 speci-fications and the rating model for a target rating of A. Net Diversification includes the diversificationcredit between market risks and the 50% diversification haircut for the rating model. Other Adjustmentscontain the diversification credit between market and other risk and the loss absorbing effect of technicalprovisions and deferred taxes according to the standard model.

Extrapolating the market risk capital requirements for the standard model using the re-lationship between market risk and SCR according to the QIS5 results, the representativeEuropean-based life insurer would have a Solvency I ratio of approximately 310% anda Solvency II ratio of approximately 132%. The Solvency I ratio is calculated as EUR400.0 million own funds divided by EUR 129.0 million required Solvency I capital. Therequired Solvency I capital is the product of EUR 3.0 billion technical provisions timesa charge of 4.3%. The Solvency II ratio is calculated as EUR 400.0 million own fundsdivided by EUR 291.3 million Solvency II required capital. The required Solvency IIcapital is the market risk capital of EUR 297.2 million divided by 102%, which is theaverage relationship between market risk capital and SCR.83 The required Solvency IIratio could increase to 150% before the regulatory capital constraint starts to become abinding constraint.

Based upon this case, I conducted sensitivity analysis to substantiate my previous re-sults. The sensitivity analysis changes the value of the asset classes equities, properties,sovereign debt, corporate debt and covered bonds, as well as the corporate debt portfolio’s

83See EIOPA (2011, p. 63).

24

average rating and modified duration ceteris paribus. The analysis shows the obtainedresult is, in principle, robust to different asset compositions. The rating model requires50-101% more capital than the standard model. Table 14 shows the sensitivity analysis.

[Insert Table 14 here]

Using the results from the sensitivity analysis, the impact of four investment strategiescan be discussed, namely a decrease of equity and alternatives exposure, an increase ingovernment bonds exposure, a focus on higher credit rating quality for corporate debtand a shortening of corporate bond duration on the regulatory capital requirements. Adecrease of the equity and alternatives exposure results in a significant reduction of the netmarket risk required capital. Less equity exposure and increased allocation to other fixedincome instruments decreases the capital requirements for equity and interest rate risk.The impact is slightly reduced by higher capital requirements for property and/or creditspread risk caused by higher allocations of real estate property and/or debt instruments.In contrast, an increase of the (EEA) sovereign debt exposure decreases the requirementsfor credit spread risk which are exempt from the credit spread risk requirements of QIS5.Furthermore, equity risk, property risk and interest rate risk capital requirements arereduced due to lower allocations and a decreased duration mismatch. However, thisinvestment strategy potentially involves lower expected returns. Likewise, increasing theaverage rating quality of the corporate debt portfolio decreases the capital requirementsfor credit spread risk at the cost of lower expected investment returns from higher creditquality corporates. Finally, shortening the duration of the corporate debt portfolio hastwo opposing effects. On the one hand, the capital requirements for credit spread riskare reduced, while on the other hand, the duration mismatch is increased ceteris paribus,which requires higher capital for interest rate risk. Therefore, the net effect of thisinvestment strategy is relatively small (Figure 8).

Figure 8: Impact of Different Investment Strategies on Gross Market Risk

This figure shows the gross market risk requirements before diversification and other risk-reducing effectsfor different investment strategies according to the QIS5 standard model in EUR million.

25

8 Conclusion

This paper investigates the question of whether the market risk charges outlined by thenew risk-based regulatory framework Solvency II will significantly impact the Europeaninsurance companies’ asset allocations and investment strategies. It analyses whether thenew regulatory capital requirements for market risk are a binding constraint for insurers,enforcing a restructuring of their investment portfolios and disrupting European capitalmarkets. It compares the required market risk capital of the Solvency II standard modelwith the Standard & Poor’s rating model for a fictitious, but representative, European-based life insurer.

The comparison of the standard and the rating models’ gross charges indicate that therating model – calibrated to a target rating of A – is only more restrictive for the assetclasses equities and alternatives and EEA sovereign debt. However, the standard modelgrants larger diversification credits between market risks and between market risks andunderwriting risks, as well as a larger risk reduction due to the loss absorbency of technicalprovisions and deferred taxes. Altogether, the rating model requires 68% more capitalfor market risk on a comparable confidence level to the standard model, i.e. a targetrating of A. However, even for a target rating of BBB, i.e. a level of confidence of 97.2%,the rating model requires 27% more capital than the standard model. The sensitivityanalysis shows that this result is robust for a range of different asset compositions.

Hence, insurance companies which defined a risk appetite above or equal to a targetrating of BBB, i.e. a confidence level of 97.2% or an annual probability of economic in-solvency of 2.8%, did and do not face a binding regulatory capital constraint for marketrisk as defined by Solvency I or the Solvency II standard model. Likewise, internal capitalrequirements defined above a 99.5% confidence level would be more restrictive than theSolvency II standard model. Therefore, companies with a good credit rating and regula-tory solvency standing are not expected to significantly alter their asset allocations due tothe introduction of the risk-based regulatory requirements of Solvency II. Indeed, surveysof European insurance companies indicate that a reduction in the heavily penalised assetclass of equities and alternatives is not expected.84 In this sense, a recent survey on behalfof Black Rock, Inc. of 223 European insurers found that allocations to alternative assetsare expected to increase.85 In contrast, insurance companies with lower rating targetsand low regulatory capitalisations will derisk their asset allocations.86 However, theseinsurance companies represent a minority within the European insurance landscape.87

Therefore, major disruptions of European capital markets due to asset reallocations ofEuropean insurance companies caused by Solvency II are not expected.88 Nevertheless,insurance companies are going to reposition their investment portfolio in light of thelatest financial crisis and the current sovereign debt crisis. For example, insurance com-panies are reducing their bank exposure due to increased systemic risk and the prospectof loss-sharing arrangements such as the German restructuring law (Restrukturierungsge-

84See CGFS (2011, p. 32).85See press clipping BlackRock study reveals significant challenges for insurers under Solvency II as of

13 February 2012. Sourced from www.ftseglobalmarkets.com, accessed 13 February 2012.86See Cheng and Weiss (2011) and CFGS (2011, p. 31).87See EIOPA (2011, p. 25 and 27).88See Neville (2011) for comments on the current impact of Solvency II on debt capital markets.

26

setz RStruktG).89 Moreover, insurance companies are currently reducing their exposureto high risk sovereigns such as Greece.

There are several limitations inherent to the design of this study. Although the balancesheet and investment portfolio of the representative European-based life insurer is basedupon the annual reports and investor presentations of a sample of European insurancecompanies and the result is reinforced using sensitivity analysis, the result is specific tothe chosen example, which limits the general applicability of the conclusions. There areindividual as well as regional differences for the asset allocation. For example, French in-surance companies typically have an above-average equity and corporate bond allocationand German life insurance companies have to cope with larger duration mismatches be-tween assets and liabilities than the average European-based life insurers.90 Furthermore,the comparison of regulatory and rating capital is based upon the implicit assumptionthat insurance companies hold exactly the capital required. However, market pressuremay force insurers to hold capital in excess of the SCR. Furthermore, insurers may needeither more or less than the standard required capital to achieve their target rating dueto analyst adjustments within the rating process and due to the fact that the requiredrating capital is only one of several components of the overall credit rating analysis.91 Thecalibrations for the Solvency II standard model and the rating model are not finalisedand will potentially change over time.92 Moreover, European insurers will potentiallyadapt partial or full internal models instead of the standard formula to calculate theirregulatory capital requirements. The impact of the use of internal models on the SCRis still unclear and internal models have to be finalised by the insurance companies andhave to be approved by the regulator.93 The results of QIS5 show that while individ-ual companies can reduce SCR by only 1% on average, insurance groups benefit frominternal models by a 20% reduction on average.94 The importance of ratings differs forindividual insurers. For example, reinsurance companies and property & casualty insurerswith strong commercial business lines depend on good credit ratings.95 The importanceof credit ratings overall changes over time, while the reputation of rating agencies hassuffered during the financial crisis.96 Finally, the analysis limits the comparison of thestandard model and the rating model to market risk capital requirements excluding cap-ital requirements for other risks such as counterparty credit risk, underwriting risk oroperational risk, as well as available capital definitions. If the rating capital model re-quires significantly less capital for other risks compared to the standard model and/or issignificantly less restrictive on the capital instruments allowed to cover required capital,the relationship may reverse. However, there is some evidence to suggest that the ratingcapital model is more restrictive in other building blocks of the solvency calculation.97

Hence, interesting avenues for future research include the extension of the comparison to

89See Kaserer (2011, p. 59) and CGFS (2011, p. 34).90See Deutsche Bank Research (2011, p. 4).91See Standard & Poor’s (2010a, p. 5).92See CGFS (2011, p. 37), Deutsche Bank Research (2011, p. 10) and Standard & Poor’s (2009).93See CGFS (2011, p. 37).94See EIOPA (2011, p. 114).95See Morgan Stanley and Oliver Wyman (2010, p. 38).96See CGFS (2011, p. 38).97See Morgan Stanley and Oliver Wyman (2010). Moreover, it seems like Standard & Poor’s (2010a, p.

9) is more restrictive with regard to their definition of available capital which for example considers only50% of the value-in-force.

27

other risks and include available capital as well as other insurance lines such as property& casualty insurance and reinsurance companies.

References

Al-Darwish, Ahmed, Michael Hafeman, Gregorio Impavido, Malcolm Kemp, and PadraicO’Malley (2011), ’Possible unintended consequences of Basel III and Solvency II’(August), Working Paper, IMF.

Allianz SE (2011), ’Allianz Group Annual Report 2010’.Badrinath, S. G., Jayant R. Kale, and Harley E. Ryan, Jr. (1996), ’Characteristics of

common stock holdings of insurance companies’, Journal of Risk and Insurance, 63(1):49-76.

BaFin (2011), ’Statistik der Erstversicherungsunternehmen 2009’ [’Statistics for primaryinsurance companies 2009’] (February).

Barnier, M. (2011), ’Letter from Commissioner Barnier to insurance industry’ (June).Berger, Allen N., J. David Cummins and Mary A. Weiss (1997), ’The coexistence of

multiple distribution systems for financial services: The case of property-liability in-surance’, Journal of Business, 70(4): 515-546.

Buckham, David, Jason Wahl, and Stuart Rose (2011), ’Executive’s guide to SolvencyII’, Hoboken, NJ: John Wiley & Sons, Inc.

CEA [Comite Europeen des Assurances] (2011), ’CEA Statistics N◦44 – European Insur-ance in Figures’ (December).

CEA and Oliver Wyman (2005), ’Solvency assessment models compared’.CEIOPS (2008a), ’CEIOPS’s Report on its fourth Quantitative Impact Study (QIS4) for

Solvency II’ (November).CEIOPS (2008b), ’CEIOPS’s Report on its fourth Quantitative Impact Study (QIS4) for

Solvency II – Annex of Selected Tables’ (November).CEIOPS (2010), ’QIS5 technical specifications’ (July).CGFS [Committee on the Global Financial System] (2011), ’Fixed income strategies of

insurance companies and pension funds’ (July), Bank for International Settlements.Chen, Xuanjuan, Tong Yao, and Tong Yu (2006), ’How does background risk affect in-

vestment risk-taking? Evidence from insurers’ corporate bond portfolios’, WorkingPaper, University of North Carolina.

Cheng, Jiang and Mary A. Weiss (2011), ’The regulatory effect of risk-based capital inproperty-liability insurance’, Working Paper, Indiana State University.

CNP Assurances (2011), ’CNP Assurances annual results 2010 investor presentation’(February).

CRO Forum (2011), ’Economic (in)solvency is different from actual (in)solvency’ (Febru-ary).

Cummins, J. David (2000), ’Allocation of capital in the insurance industry’, Risk Man-agement and Insurance Review, 3(1): 7-27.

Da Silva, Andre C., Christiane Tsai, and Margarida Gutierrez (2011), ’Determinants ofequity investments by long-term institutional investors: Evidence from Brazil’, OpenManagement Journal, 4: 9-15.

Deutsche Bank Research (2011), ’Solvency II and Basel III’ (September).Doff, Rene (2007), ’Risk management for insurers’, London: Incisive Financial Publishing

Ltd.

28

EIOPA (2010a), ’Statistical annex insurance 2009’ (December).EIOPA (2010b), ’Financial stability report 2010 – Second half-yearly report’ (December).EIOPA (2011), ’EIOPA Report on the fifth Quantitative Impact Study (QIS5) for Solvency

II’ (March).Eling, Martin (2010), ’What do we know about market discipline in insurance?’, Working

Paper, University of Ulm.Eling, Martin and Ines Holzmuller (2008), ’An overview and comparison of risk-based

capital standards?’, Journal of Insurance Regulation, 26(4): 31-60.Eling, Martin, Nadine Gatzert, and Hato Schmeiser (2008), ’The Swiss Solvency Test and

its Market Implications’, Geneva Papers on Risk and Insurance – Issues and Practice,33: 418-439.

Fischer, Katharina and Sebastian Schlutter (2012), ’Optimal investment strategies forinsurance companies in the presence of standardised capital requirements’, WorkingPaper, Goethe-University Frankfurt.

Fitch (2011), ’Solvency II set to reshape asset allocation and capital markets’ (June).GDV [Gesamtverband der Deutschen Versicherungswirtschaft](2011), ’Die deutsche Lebensver-

sicherung in Zahlen 2010/11’ [’German life insurance in numbers 2010/11’] (June).Grundl, Helmut and Thomas Post (2009), ’Transparency through financial claims with

fingerprints: A mechanism for preventing financial crises’, Financial Analyst Journal,65(5): 17-23.

Hanewald, Katja, Thomas Post and Helmut Grundl (2011), ’Stochastic mortality, macroe-conomic risks and life insurer solvency’, Geneva Papers on Risk and Insurance – Issuesand Practice, 36: 458-475.

Happe, Karl (2011), ’Wie reagieren die Versicherungen auf die neue Qualitat von Bankrisiken?’[’How do insurance companies react to the new quality of bank risks?’], Zeitschrift furdas gesamte Kreditwesen, 14: 703-706.

Hirschmann, Stefan and Frank Romeike (2004), ’Rating von Versicherungsunternehmen’[’Rating of insurance companies’], Cologne: Bank-Verlag GmbH.

IIF and Oliver Wyman (2011), ’The implications of financial regulatory reform for theinsurance industry’ (August).

Jaffee, Dwight and Johan Walden (2010), ’The impact of Basel III and Solvency 2 onSwedish banks and insurers – An equilibrium analysis’ (December).

Kaserer, Christoph (2011), ’Solvency II und Basel III’ [’Solvency II and Basel III’] (June),Report for the Munich Financial Centre Initiative.

Morgan Stanley and Oliver Wyman (2010), ’Solvency 2: Quantitative & strategic impact– The tide is going out’ (September).

Neville, Laurence (2011), ’Solvency II drives changing appetite for fixed income’, Life &Pension Risk (3 May 2011).

Petroni, Kathy R. and Douglas A. Shackelford (1996), ’The effect of risk-based capital onlife insurers’ investment portfolios’, Working Paper, University of Pennsylvania.

Rudschuck, Norman, Tobias Basse, Alexander Kapeller, and Torsten Windels (2010),’Solvency II and the investment policy of life insurers: Some homework to do for thesales and marketing departments’, Interdisciplinary Studies Journal, 1(1): 57-70.

Schmeiser, Hato, Martin Eling, Nadine Gatzert, Stefan Schuckmann, and Denis Toplek(2006), ’Volkswirtschaftliche Implikationen des Swiss Solvency Tests’ [’Economic im-plication of the Swiss Solvency Test’].

SCOR (2011), ’SCOR Annual Report 2010’.Standard & Poor’s (2009), ’Solvency II: Wounded, but still alive and kicking’ (February).

29

Standard & Poor’s (2010a), ’Refined methodology and assumptions for analyzing insurercapital adequacy using the risk-based insurance capital model’ (June).

Standard & Poor’s (2010b), ’Application: Standard & Poor’s GAAP/IFRS Capital ModelVersion 3.0’ (July).

Swiss Re (2011), ’Swiss Re Financial Report 2010’.UBR (2011), ’Investment opportunities and Solvency II’ (July).Van Bragt, David, Hens Steehouwer, Bart Waalwijk, Twan Possen, Arianne Eckhardt,

and Steven Hooghwerff (2010), ’Impact of the Solvency II guidelines on ALM for lifeinsurers’ (April).

Van Hulle, Karel (2011), ’Solvency II: State of play and perspectives’, Zeitschrift fur diegesamte Versicherungswissenschaft, 100: 177-192.

30

Appendix

Table 1: Modified Duration Discount on Time to Maturity

Maturity (Years) Duration (Years) Discount (Percent)

1 0.9 7.12 1.9 7.53 2.7 9.84 3.6 11.15 4.3 13.56 5.0 16.87 5.7 18.78 6.3 20.79 7.0 21.9

10 7.9 21.411 8.4 23.612 8.6 28.013 8.8 32.414 10.0 28.415 10.6 29.616 10.4 34.917 11.1 35.018 11.6 35.619 10.6 44.320 10.8 45.921 11.0 47.422 12.9 41.523 12.9 43.824 12.9 46.325 14.7 41.226 14.4 44.527 16.5 39.028 14.7 47.329 15.1 47.830 16.2 46.0

This table shows the modified duration and the percentage difference to time to maturity for the bonduniverse of the Market iBoxx EUR fixed income benchmark index as of 9 December 2011. For the timeto maturity bucket 20 years the modified duration and the discount are extrapolated since the originaldata shows only a discount of 5% due to few data points.

31

Table 2: Details on the Sovereign Debt Portfolio

Country EEA Member S&P Rating Allocation (Percent)

Germany Yes AAA 20.0Italy Yes A+ 11.0France Yes AAA 10.0Belgium Yes AA+ 10.0Austria Yes AAA 5.5Spain Yes AA 5.0United Kingdom Yes AAA 5.0The Netherlands Yes AAA 3.5Finland Yes AAA 3.0Portugal Yes A− 2.0Ireland Yes A 1.5Slovenia Yes AA 1.5Greece Yes BB+ 1.5Romania Yes BBB− 0.5United States No AAA 7.0Switzerland No AAA 5.0Japan No AA 2.5Brazil No BBB+ 2.0Canada No AAA 1.0Australia No AA 1.0South Korea No A+ 0.5Other No B, Lower or Unrated 1.0

This table shows the composition of the sovereign, supranational, and agency debt portfolio. The tableis based upon the sample of individual insurance companies’ annual reports and investor presentationsfrom 2009 and 2010. Country specifies the country of the government, supranational, or agency issu-ing the debt instruments in the representative insurers portfolio. EEA Member indicates whether thecountry is member of the EEA. S&P Rating states the Standard & Poor’s local currency rating as of31 December 2010. Allocation gives the percentage share of the countries sovereign debt in the sovereigndebt portfolio. For Other non-EEA countries debt instruments it is assumed that 0.6% are rated B and0.4% are unrated.

32

Table

3:

Rat

ing

ofth

eF

ixed

Inco

me

Por

tfol

io

Ass

et

Cla

ssA

lloca

tion

Rati

ng

Dis

trib

uti

on

(Per

cent)

Avera

ge

(Per

cent)

AA

AA

AA

BB

BB

BB

orL

ower

Unra

ted

Rati

ng

Sov

erei

gnD

ebt

(EE

A)

39.0

58.8

20.6

18.1

0.6

1.9

--

AA

Sov

erei

gnD

ebt

(Non

-EE

A)

9.8

65.0

17.5

2.5

10.0

-3.

02.

0A

ASov

erei

gnD

ebt

(Tot

al)

48.8

60.0

20.0

15.0

2.5

1.5

0.6

0.4

AA

Cor

por

ate

Deb

t36

.017

.515

.040

.020

.02.

00.

55.

0A

Cov

ered

Bon

ds

15.2

92.0

4.0

2.0

1.0

--

1.0

AA

A

Fix

ed

Inco

me

Port

foli

o100.0

49.6

15.8

22.0

8.6

1.5

0.5

2.1

AA

Th

ista

ble

show

sth

era

tin

gd

istr

ibu

tion

ofth

efi

xed

inco

me

port

foli

o.

Th

eta

ble

isb

ase

du

pon

the

sam

ple

of

ind

ivid

ual

insu

ran

ceco

mp

an

ies’

an

nual

rep

ort

san

din

vest

orp

rese

nta

tion

sfr

om20

09an

d20

10.

Ass

etC

lass

spec

ifies

the

diff

eren

tass

etcl

ass

esin

the

fixed

inco

me

port

foli

oof

the

rep

rese

nta

tive

insu

rer.

All

ocati

on

des

crib

esth

ep

erce

nta

gesh

are

ofth

eas

set

clas

sin

the

fixed

inco

me

port

foli

o.

AA

A–

Un

rate

dst

ate

sth

ep

erce

nta

ge

of

each

ass

etcl

ass

wit

hin

the

spec

ific

rati

ng

cate

gory

.A

vera

geR

ati

ng

give

sth

ew

eigh

ted

aver

age

rati

ng

of

the

ass

etcl

ass

.

Table

4:

Tim

eto

Mat

uri

tyan

dD

ura

tion

Pro

file

ofth

eF

ixed

Inco

me

Por

tfol

io

Ass

et

Cla

ssA

lloca

tion

Tim

eto

Matu

rity

Dis

trib

uti

on

(Per

cent)

Du

rati

on

(Per

cent)

<1

year

1–5

year

s5–

10ye

ars

10–2

0ye

ars

>20

year

s(Y

ears

)

Sov

erei

gnD

ebt

48.8

5.0

26.0

32.5

24.0

12.5

6.9

Cor

por

ate

Deb

t36

.013

.827

.935

.123

.3-

5.4

Cov

ered

Bon

ds

15.2

9.0

27.0

34.0

24.0

6.0

6.2

Fix

ed

Inco

me

Port

foli

o100.0

8.8

26.8

33.7

23.7

7.0

6.3

Th

ista

ble

show

sth

eti

me

tom

atu

rity

dis

trib

uti

onan

dth

em

od

ified

du

rati

on

of

the

fixed

inco

me

port

foli

o.

Th

eta

ble

isb

ase

du

pon

the

sam

ple

of

ind

ivid

ual

insu

ran

ceco

mp

anie

s’an

nu

alre

por

tsan

din

vest

orp

rese

nta

tion

sfr

om

2009

an

d2010

an

dth

eM

ark

etiB

oxx

EU

Rd

ata

.A

sset

Cla

sssp

ecifi

esth

ed

iffer

ent

ass

etcl

asse

sin

the

fixed

inco

me

por

tfol

ioof

the

rep

rese

nta

tive

insu

rer.

All

ocati

on

des

crib

esth

ep

erce

nta

ge

share

of

the

ass

etcl

ass

inth

efixed

inco

me

port

folio.

Th

e<

1ye

ar,

...,>

20

years

-col

um

ns

conta

inth

ep

erce

nta

geof

each

ass

etcl

ass

wit

hin

the

spec

ific

tim

eto

matu

rity

bu

cket

.D

ura

tion

giv

esth

em

od

ified

du

rati

on

inye

ars

ofth

eas

set

clas

s.

33

Table 5: Rating versus Time to Maturity of the Fixed Income Portfolio

RatingTime to Maturity

<1 year 1–5 years 5–10 years 10–20 years >20 years

AAA 41.0 49.0 49.0 49.9 64.2AA 14.7 15.7 15.7 15.8 17.9A 27.1 22.4 22.4 21.8 13.3BBB 12.2 8.8 8.8 8.4 2.3BB 1.5 1.5 1.5 1.4 1.3B or Lower 0.4 0.5 0.5 0.5 0.5Unrated 3.1 2.2 2.2 2.1 0.5

Total 100.0 100.0 100.0 100.0 100.0

This table shows the relationship between time to maturity and rating. Rating specifies the differentrating categories in the fixed income portfolio of the representative insurer. The <1 year,...,>20 years-columns contain the percentage of each rating category within the specific time to maturity bucket.

34

Table

6:

The

Rep

rese

nta

tive

Euro

pea

n-B

ased

Lif

eIn

sure

r’s

Mar

ket

Ris

kP

ortf

olio

Sta

nd

ard

Mod

el

Rati

ng

Mod

el

Rati

ng

Tim

eto

Matu

rity

(Per

cent)

Tota

lT

ota

l

<1

year

1–5

year

s5–

10ye

ars

10–2

0ye

ars

>20

year

s(P

erce

nt)

(EU

Rm

illi

on)

Glo

bal

Equ

itie

sC

ateg

ory

11-

--

--

-4.

012

0C

ateg

ory

22-

--

--

-0.

515

Oth

erE

qu

itie

sC

ateg

ory

33-

--

--

-0.

26

Cat

egor

y44

--

--

--

0.1

3C

ateg

ory

55-

--

--

-0.

26

Pri

vate

Equ

ity9

--

--

--

1.0

30H

edge

Fu

nd

s-

--

--

-1.

030

Equ

itie

sT

ota

l-

--

--

-7.0

210

Rea

lE

stat

eC

ateg

ory

16-

--

--

-6.

519

5P

rop

erti

esC

ateg

ory

27-

--

--

-3.

090

Cat

egor

y38

--

--

--

0.5

15O

wn

er-O

ccu

pie

d-

--

--

-1.

030

Real

Est

ate

Tota

l-

--

--

-11.0

330

Sov

erei

gnD

ebt

Bon

ds

AA

A0.

94.

96.

14.

52.

418

.856

4(E

EA

)A

A0.

31.

72.

11.

60.

86.

619

8D

ura

tion

=6.

9A

0.3

1.5

1.9

1.4

0.7

5.8

174

BB

B0.

00.

10.

10.

00.

00.

26

BB

0.0

0.2

0.2

0.1

0.1

0.6

18B

orL

ower

--

--

--

-U

nra

ted

--

--

--

-S

over

eign

Deb

tB

ond

sA

AA

0.3

1.4

1.7

1.2

0.7

5.2

156

(Non

-EE

A)

AA

0.1

0.4

0.5

0.3

0.2

1.4

42D

ura

tion

=6.

9A

0.0

0.1

0.1

0.0

0.0

0.2

6B

BB

0.0

0.2

0.3

0.2

0.1

0.8

24B

B-

--

--

--

Bor

Low

er0.

00.

10.

10.

10.

00.

27

Un

rate

d0.

00.

00.

10.

00.

00.

25

Sovere

ign

Deb

tT

ota

l-

2.0

10.4

13.0

9.6

5.0

40.0

1,2

00

35

Table

6(C

onti

nued):

The

Rep

rese

nta

tive

Euro

pea

n-B

ased

Lif

eIn

sure

r’s

Mar

ket

Ris

kP

ortf

olio

Sta

nd

ard

Mod

el

Rati

ng

Mod

el

Rati

ng

Tim

eto

Matu

rity

(Per

cent)

Tota

lT

ota

l

<1

year

1–5

year

s5–

10ye

ars

10–2

0ye

ars

>20

year

s(P

erce

nt)

(EU

Rm

illi

on)

Cor

por

ate

Deb

tB

ond

sA

AA

0.7

1.4

1.8

1.2

-5.

215

5D

ura

tion

=5.

4A

A0.

61.

21.

61.

0-

4.4

133

A1.

63.

34.

12.

7-

11.8

354

BB

B0.

81.

62.

11.

4-

5.9

177

BB

0.1

0.2

0.2

0.1

-0.

618

Bor

Low

er0.

00.

00.

10.

0-

0.1

4U

nra

ted

0.2

0.4

0.5

0.3

-1.

544

Corp

ora

teD

eb

tT

ota

l-

4.1

8.2

10.3

6.6

-29.5

885

Cov

ered

Bon

ds

Bon

ds

AA

A1.

03.

13.

92.

80.

711

.534

5D

ura

tion

=6.

2A

A0.

00.

10.

20.

10.

00.

515

A0.

00.

10.

10.

10.

00.

38

BB

B0.

00.

00.

00.

00.

00.

14

BB

--

--

--

-B

orL

ower

--

--

--

-U

nra

ted

0.0

0.0

0.0

0.0

0.0

0.1

4

Covere

dB

on

ds

Tota

l-

1.1

3.4

4.3

3.0

0.8

12.5

375

Fix

ed

Inco

me

Port

foli

oT

ota

l11

-7.2

22.0

27.6

19.5

5.8

82.0

2,4

60

Mark

et

Ris

kP

ort

foli

oT

ota

l-

--

--

-100.0

3,0

00

Th

ista

ble

show

sth

eco

mp

osit

ion

ofth

em

arket

risk

inve

stm

ent

port

foli

oin

per

cent

an

dE

UR

mil

lion

.S

tan

dard

Mod

elco

vers

the

rele

vant

ass

etcl

ass

esfo

rth

eS

olve

ncy

IIst

and

ard

mod

el.

Rati

ng

Mod

elco

vers

the

rele

vant

ass

etcl

ass

esfo

rth

eS

tan

dard

&P

oor’

sra

tin

gm

od

el.

(1)

Equ

ity

Cate

gory

1in

clu

des

equ

itie

sli

sted

inE

uro

pe.

(2)

Equ

ity

Cat

egor

y2

incl

ud

eseq

uit

ies

list

edin

Worl

dan

dF

ar

East

.(3

)E

qu

ity

Cate

gory

3in

clu

des

equ

itie

sli

sted

inE

mer

gin

gF

ar

East

and

Lat

inA

mer

ica.

(4)

Equ

ity

Cat

egor

y4

incl

ud

eseq

uit

ies

list

edin

Nord

ican

dA

rab

ia.

(5)

Equ

ity

Cate

gory

5in

clu

des

equ

itie

sli

sted

inB

RIC

.(6

)P

rop

erti

esC

ateg

ory

1in

clu

des

pro

per

ties

inA

ust

ria,

Ger

man

y,T

he

Net

her

lan

ds,

New

Zea

lan

d,

an

dS

wit

zerl

an

d.

(7)

Pro

per

ties

Cate

gory

2co

nsi

sts

of

Jap

an

an

doth

erE

uro

pea

nco

untr

ies.

(8)

Pro

per

ties

Cat

egor

y3

incl

ud

esIr

elan

d,

Sp

ain

,U

nit

edK

ingd

om

,U

nit

edS

tate

s,an

doth

erco

untr

ies.

(9)

Pri

vate

equ

itie

sare

dom

icil

edin

Eu

rop

e.(1

0)F

ixed

Inco

me

Por

tfol

ioT

otal

incl

ud

esS

over

eign

Deb

tT

ota

l,C

orp

ora

teD

ebt

Tota

l,an

dC

over

edB

on

ds

Tota

l.

36

Table 7: Gross Capital Charges for Equity and Property Risk

Standard Model Rating ModelGross Capital Charges (Percent)

QIS5 AAA AA A BBB(99.5%) (99.9%) (99.7%) (99.4%) (97.2%)

Global Equities Category 11 30.0 47.0 42.0 38.0 27.0Category 22 30.0 52.0 47.0 42.0 30.0

Other Equities Category 33 40.0 59.0 54.0 49.0 35.0Category 44 40.0 68.0 63.0 58.0 45.0Category 55 40.0 77.0 72.0 68.0 55.0Private Equity9 40.0 63.3 56.5 51.2 37.0Hedge Funds 40.0 58.8 52.5 47.5 33.8

Real Estate Category 16 25.0 15.0 13.0 11.0 8.0Category 27 25.0 20.0 18.0 15.0 10.0Category 38 25.0 30.0 27.0 24.0 18.0Owner-Occupied10 25.0 25.4 22.4 19.5 14.1

This table shows the gross capital charges before diversification and other risk-reducing effects in percentfor the equity risk and property risk modules for the Solvency II standard model according to the QIS5calibration and the Standard & Poor’s rating model v3. The gray shaded cells indicate whether the ratingmodel at the specified target rating is more restrictive than the standard model. (1) Equity Category 1includes equities listed in Europe. (2) Equity Category 2 includes equities listed in World and Far East.(3) Equity Category 3 includes equities listed in Emerging Far East and Latin America. (4) EquityCategory 4 includes equities listed in Nordic and Arabia. (5) Equity Category 5 includes equities listedin BRIC. (6) Properties Category 1 includes properties in Austria, Germany, The Netherlands, NewZealand, and Switzerland. (7) Properties Category 2 consists of Japan and other European countries.(8) Properties Category 3 includes Ireland, Spain, United Kingdom, United States, and other countries.(9) Private equities are domiciled in Europe. (10) Assuming the real estate portfolio composition of therepresentative European-based life insurer.

37

Table

8:

Gro

ssC

apit

alC

har

ges

for

Sov

erei

gnD

ebt’

s(E

EA

)C

redit

Spre

adR

isk

Rati

ng

Tim

eto

Matu

rity

/M

odifi

ed

Dura

tion

(Yea

rs)

1.0

/0.9

5.0

/4.3

10.0

/7.9

20.0

/10.8

30.0

/16.2

QIS

5A

QIS

5A

QIS

5A

QIS

5A

QIS

5A

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

AA

A-

--

--

--

--

-A

A-

0.2

-0.

4-

1.1

-1.

5-

1.9

A-

0.2

-0.

6-

1.4

-2.

0-

2.8

BB

B-

0.7

-2.

4-

4.8

-5.

6-

5.8

BB

-2.

8-

10.4

-19

.1-

23.3

-25

.1B

-10

.4-

26.2

-34

.8-

36.9

-36

.9C

orL

ower

-48

.4-

59.8

-69

.8-

69.8

-69

.8U

nra

ted

-2.

8-

10.4

-19

.1-

23.3

-25

.1

Th

ista

ble

show

sth

egr

oss

cap

ital

char

ges

bef

ore

div

ersi

fica

tion

an

doth

erri

sk-r

edu

cin

geff

ects

inp

erce

nt

for

the

cred

itsp

read

risk

mod

ule

of

the

stan

dard

mod

elan

dth

era

tin

gm

od

el.

Th

eS

olve

ncy

IIst

and

ard

mod

elu

sin

gth

eQ

IS5

cali

bra

tion

isco

mp

are

dto

the

Sta

nd

ard

&P

oor’

sra

tin

gm

od

elv3

for

ata

rget

rati

ng

of

A.

Th

ista

ble

con

sid

ers

only

sover

eign

deb

tis

sued

inlo

cal

curr

ency

inm

emb

erst

ate

sof

the

EE

A.

Th

eex

emp

lary

tim

esto

matu

riti

esare

tran

slate

din

tom

od

ified

du

rati

ons

usi

ng

the

dis

cou

nt

fact

ors

from

Tab

le1.

38

Table

9:

Gro

ssC

apit

alC

har

ges

for

Sov

erei

gnD

ebt’

s(N

on-E

EA

)C

redit

Spre

adR

isk

Rati

ng

Tim

eto

Matu

rity

/M

odifi

ed

Dura

tion

(Yea

rs)

1.0

/0.9

5.0

/4.3

10.0

/7.9

20.0

/10.8

30.0

/16.2

QIS

5A

QIS

5A

QIS

5A

QIS

5A

QIS

5A

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

AA

A-

--

--

--

--

-A

A-

0.2

-0.

4-

1.1

-1.

5-

1.9

A1.

10.

24.

70.

68.

71.

411

.92.

017

.82.

8B

BB

1.4

0.7

6.0

2.4

11.1

4.8

15.1

5.6

22.7

5.8

BB

2.5

2.8

10.8

10.4

19.8

19.1

27.0

23.3

32.5

25.1

B4.

510

.419

.426

.235

.634

.845

.036

.945

.036

.9C

orL

ower

4.5

48.4

19.4

59.8

35.6

69.8

45.0

69.8

45.0

69.8

Unra

ted

3.0

2.8

12.9

10.4

23.7

19.1

32.4

23.3

36.0

25.1

Th

ista

ble

show

sth

egr

oss

cap

ital

char

ges

bef

ore

div

ersi

fica

tion

an

doth

erri

sk-r

edu

cin

geff

ects

inp

erce

nt

for

the

cred

itsp

read

risk

mod

ule

of

the

stan

dard

mod

elan

dth

era

tin

gm

od

el.

Th

eS

olve

ncy

IIst

and

ard

mod

elu

sin

gth

eQ

IS5

cali

bra

tion

isco

mp

are

dto

the

Sta

nd

ard

&P

oor’

sra

tin

gm

od

elv3

for

ata

rget

rati

ng

ofA

.T

his

tab

leco

nsi

der

sso

ver

eign

deb

tn

otis

sued

inlo

cal

curr

ency

or

not

ina

mem

ber

state

of

the

EE

A.

Th

eex

emp

lary

tim

esto

matu

riti

esare

tran

slate

din

tom

od

ified

du

rati

ons

usi

ng

the

dis

cou

nt

fact

ors

from

Tab

le1.

Th

egra

ysh

ad

edce

lls

ind

icate

for

each

com

bin

ati

on

of

rati

ng

an

dti

me

tom

atu

rity

/m

od

ified

du

rati

onw

het

her

the

rati

ng

mod

elor

the

stan

dar

dm

od

elis

more

rest

rict

ive.

39

Table

10:

Gro

ssC

apit

alC

har

ges

for

Cor

por

ate

Deb

t’s

Cre

dit

Spre

adR

isk

Rati

ng

Tim

eto

Matu

rity

/M

odifi

ed

Dura

tion

(Yea

rs)

1.0

/0.9

5.0

/4.3

10.0

/7.9

20.0

/10.8

30.0

/16.2

QIS

5A

QIS

5A

QIS

5A

QIS

5A

QIS

5A

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

AA

A0.

90.

13.

90.

37.

10.

99.

71.

015

.21.

1A

A1.

10.

24.

70.

48.

71.

111

.91.

518

.61.

9A

1.4

0.2

6.0

0.6

11.1

1.4

15.1

2.0

23.7

2.8

BB

B2.

50.

710

.82.

419

.84.

827

.05.

632

.55.

8B

B4.

52.

819

.410

.435

.619

.145

.023

.345

.025

.1B

7.5

10.4

32.3

26.2

59.3

34.8

60.0

36.9

60.0

36.9

Cor

Low

er7.

548

.432

.359

.859

.369

.860

.069

.860

.069

.8U

nra

ted

3.0

2.8

12.9

10.4

23.7

19.1

32.4

23.3

36.0

25.1

Th

ista

ble

show

sth

egr

oss

cap

ital

char

ges

bef

ore

div

ersi

fica

tion

an

doth

erri

sk-r

edu

cin

geff

ects

inp

erce

nt

for

the

cred

itsp

read

risk

mod

ule

of

the

stan

dard

mod

elan

dth

era

tin

gm

od

el.

Th

eS

olve

ncy

IIst

and

ard

mod

elu

sin

gth

eQ

IS5

cali

bra

tion

isco

mp

are

dto

the

Sta

nd

ard

&P

oor’

sra

tin

gm

od

elv3

for

ata

rget

rati

ng

of

A.

Th

ista

ble

con

sid

ers

corp

orat

ed

ebt.

Th

eex

emp

lary

tim

esto

matu

riti

esare

tran

slate

din

tom

od

ified

du

rati

on

su

sin

gth

ed

isco

unt

fact

ors

from

Tab

le1.

Th

egra

ysh

aded

cell

sin

dic

ate

for

each

com

bin

atio

nof

rati

ng

and

tim

eto

matu

rity

/m

od

ified

du

rati

on

wh

eth

erth

era

tin

gm

od

elor

the

stan

dard

mod

elis

more

rest

rict

ive.

40

Table

11:

Gro

ssC

apit

alC

har

ges

for

Cov

ered

Bon

d’s

Cre

dit

Spre

adR

isk

Rati

ng

Tim

eto

Matu

rity

/M

odifi

ed

Dura

tion

(Yea

rs)

1.0

/0.9

5.0

/4.3

10.0

/7.9

20.0

/10.8

30.0

/16.2

QIS

5A

QIS

5A

QIS

5A

QIS

5A

QIS

5A

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

(99.

5%)

(99.

4%)

AA

A0.

60.

12.

60.

34.

70.

96.

51.

010

.11.

1A

A1.

10.

24.

70.

48.

71.

111

.91.

518

.61.

9A

1.4

0.2

6.0

0.6

11.1

1.4

15.1

2.0

23.7

2.8

BB

B2.

50.

710

.82.

419

.84.

827

.05.

632

.55.

8B

B4.

52.

819

.410

.435

.619

.145

.023

.345

.025

.1B

7.5

10.4

32.3

26.2

59.3

34.8

60.0

36.9

60.0

36.9

Cor

Low

er7.

548

.432

.359

.859

.369

.860

.069

.860

.069

.8U

nra

ted

3.0

2.8

12.9

10.4

23.7

19.1

32.4

23.3

36.0

25.1

Th

ista

ble

show

sth

egr

oss

cap

ital

char

ges

bef

ore

div

ersi

fica

tion

an

doth

erri

sk-r

edu

cin

geff

ects

inp

erce

nt

for

the

cred

itsp

read

risk

mod

ule

of

the

stan

dard

mod

elan

dth

era

tin

gm

od

el.

Th

eS

olve

ncy

IIst

and

ard

mod

elu

sin

gth

eQ

IS5

cali

bra

tion

isco

mp

are

dto

the

Sta

nd

ard

&P

oor’

sra

tin

gm

od

elv3

for

ata

rget

rati

ng

of

A.

Th

ista

ble

con

sid

ers

cover

edb

ond

s.T

he

exem

pla

ryti

mes

tom

atu

riti

esare

tran

slate

din

tom

od

ified

du

rati

on

su

sin

gth

ed

isco

unt

fact

ors

from

Tab

le1.

Th

egra

ysh

aded

cell

sin

dic

ate

for

each

com

bin

atio

nof

rati

ng

and

tim

eto

matu

rity

/m

od

ified

du

rati

on

wh

eth

erth

era

tin

gm

od

elor

the

stan

dard

mod

elis

more

rest

rict

ive.

41

Table 12: Calculation of Market Risk Capital Requirements

Capital Charges QIS5 AAA AA A BBB(EUR million) (99.5%) (99.9%) (99.7%) (99.4%) (97.2%)

Global Equities 40.5 64.2 57.5 51.9 36.9Other Equities 30.0 46.8 42.1 38.4 28.0

Gross Equity Risk 70.5 111.0 99.6 90.3 64.9

Equity Diversification1 -4.4 - - - -

(a) Equity Risk 66.1 111.0 99.6 90.3 64.9

(b) Property Risk 82.5 59.4 52.3 44.4 31.5

Sovereign Debt (EEA) - 9.2 8.6 8.1 7.1Sovereign Debt (Non-EEA) 6.0 5.2 5.0 4.7 4.2Corporate Debt 78.9 26.6 25.1 23.8 20.9Covered Bonds 15.7 4.0 3.7 3.4 2.9

(c) Credit Spread Risk 100.7 45.0 42.4 40.0 35.2

(d) Interest Rate Risk 112.2 120.5 107.0 97.9 74.0∑Gross Market Risk 361.4 335.9 301.3 272.6 205.6

Market Risk Diversification2 -64.3 -27.0 -24.1 -21.6 -15.9Diversification Haircut3 - 13.5 12.1 10.8 8.0Size Effect4 - - - - -

Market Risk 297.2 322.4 289.3 261.8 197.7

Other Diversification5 -53.2 - - - -Loss-Absorption6 -88.6 - - - -

Net Market Risk 155.4 322.4 289.3 261.8 197.7

This table shows the calculation of capital charges for the market risk module of the standard modeland rating model in EUR million for the representative European-based life insurer with total assetsof EUR 4.0 billion. (1) Equity Diversification indicates the risk reduction due to the diversificationeffects between global equities and other equities stipulated by the QIS5 technical specifications. (2)Market Risk Diversification provides the diversification credit between market risks for the standardmodel and the rating model. (3) Diversification Haircut is the regular 50% haircut of the rating model’sdiversification credit. (4) Size Effect is a factor that decreases the effect of diversification of the ratingmodel for smaller insurance undertakings. (5) Other Diversification is the diversification credit betweenmarket risk and other risks such as underwriting or counterparty default risk allowed for by the ratingmodel. The analysis assumes an average diversification credit of 18% on market risk (6) Loss-Absorptionof technical provisions and deferred taxes is a risk-reducing effect allowed for by the standard model.The analysis assumes an average reduction of 36% on market risk after other diversification effects.

42

Table 13: Calculation of Parallel Interest Rate Shocks

YearSpot Rate Upward Scenario Downward Scenario

(Percent) ShockU RateU ChangeU ShockD RateD ChangeD

1 1.5 70.0 2.5 1.0 -75.0 0.4 -1.12 2.1 70.0 3.5 1.4 -75.0 0.5 -1.53 2.5 64.0 4.0 1.6 -75.0 0.6 -1.84 2.8 59.0 4.4 1.6 -65.0 1.0 -1.85 3.0 55.0 4.7 1.7 -56.0 1.3 -1.76 3.2 52.0 4.9 1.7 -50.0 1.6 -1.67 3.4 49.0 5.1 1.7 -46.0 1.8 -1.68 3.6 47.0 5.3 1.7 -42.0 2.1 -1.59 3.7 44.0 5.4 1.6 -39.0 2.3 -1.5

10 3.9 42.0 5.5 1.6 -36.0 2.5 -1.411 4.0 39.0 5.5 1.6 -33.0 2.7 -1.312 4.1 37.0 5.6 1.5 -31.0 2.8 -1.313 4.2 35.0 5.6 1.5 -30.0 2.9 -1.314 4.2 34.0 5.7 1.4 -29.0 3.0 -1.215 4.3 33.0 5.7 1.4 -28.0 3.1 -1.216 4.3 31.0 5.6 1.3 -28.0 3.1 -1.217 4.3 30.0 5.5 1.3 -27.0 3.1 -1.118 4.2 29.0 5.4 1.2 -28.0 3.0 -1.219 4.2 27.0 5.3 1.1 -28.0 3.0 -1.220 4.1 26.0 5.2 1.1 -28.0 3.0 -1.221 4.1 26.0 5.2 1.1 -29.0 2.9 -1.222 4.1 26.0 5.2 1.1 -29.0 2.9 -1.223 4.1 26.0 5.1 1.1 -29.0 2.9 -1.224 4.1 26.0 5.1 1.1 -30.0 2.8 -1.225 4.0 26.0 5.1 1.0 -30.0 2.8 -1.226 4.0 25.8 5.0 1.0 -30.0 2.8 -1.227 4.0 25.6 5.0 1.0 -30.0 2.8 -1.228 3.9 25.4 4.9 1.0 -30.0 2.8 -1.229 3.9 25.2 4.9 1.0 -30.0 2.7 -1.230 3.9 25.0 4.8 1.0 -30.0 2.7 -1.2

Mean 1.3 -1.3

This table shows the calculation of the parallel interest rate shock. The Spot Rate-column contains swaprates as of December 2009 and a 50bps liquidity premium until year 20 as provided by BaFin. Shock arethe applied interest rate shocks per year specified by QIS5. Rate are the shocked interest rates in theupward and downward interest rate scenarios. Change are the absolute differences between the interestrate and the shocked interest rate in each scenario.

43

Table 14: Results of the Sensitivity Analysis

Scenario Scenario Net Market Risk (EUR million) Delta

Description Change QIS5 (99.5%) A (99.4%) (Percent)

Base Scenario - 155.4 261.8 68

Equities – +3.5ppt 170.9 298.5 75Allocation −3.5ppt 140.3 225.9 61

Properties – +5.5ppt 173.9 268.9 55Allocation −5.5ppt 138.1 255.0 85

Sovereign Debt – +20.0ppt 111.5 224.1 101Allocation −20.0ppt 199.4 300.0 50

Corporate Debt – +14.8ppt 156.9 248.0 58Allocation −14.8ppt 155.2 275.9 78

Covered Bonds – +6.3ppt 150.3 253.3 69Allocation −6.3ppt 160.5 270.3 68

Corporate Debt – AA 144.4 248.0 72Average Rating BBB 178.9 298.2 67

Corporate Debt – +1 year 157.2 265.5 69Modified Duration −1 year 154.1 258.7 68

This table shows the results of the sensitivity analysis. For each asset class the allocation within themarket risk portfolio is altered by ±50%, e.g., the allocation of equities and alternatives is altered from7% in the base case to 10.5% and 3.5% respectively. For the corporate debt rating scenario the averagerating is altered to an AA-rating and a BBB-rating. For the corporate debt duration scenario themodified duration of the corporate debt portfolio is changed by 1 year. Delta is the percentage differencebetween the net market risk required by the rating model and the standard model.

44