A new risk-based solvency standard is going to be set for the European insurance industry with the adoption of the Solvency II framework in 2007. Like Basel II, the analog for the banking industry, the Solvency II framework is based on three pillars: quantitative requirements, supervisory activities, and public disclosure.

I will first discuss the formal setup of the quantitative pillar, which includes available capital, required capital and market value margins for liabilities. Focus is on the Swiss Solvency Test, which I was co-developing at the Swiss Federal Office of Private Insurance. Special features of the Swiss Solvency Test are the aggregation of scenarios for determining the solvency capital requirement and the group solvency view.

The main part of this talk is about the group solvency view. That is, the realization of diversification effects within financial and insurance conglomerates. Regulators and local management may constrain the mobility of capital between legal entities. Standard risk aggregation methods, such as the plain covariance method, fail to take this vital aspect into account. As a result, the designated "economic" global diversification effect will not be approved by the local regulators which have a legal entity view. However, diversification is at the core of any global insurance and other financial business. I thus propose a new method of risk aggregation, which consists of a set of legally enforceable standardized capital and risk transfer instruments. The group management's task is then to find an optimal capital and risk transfer across the legal entities which minimizes the group (=sum of stand alone) capital requirement(s). Such optimal capital and risk transfers have very strong and useful properties, which will be illustrated by numerical examples. This part is based on a joint paper with Michael Kupper, "Optimal Capital and Risk Transfers for Group Diversification," which is forthcoming in Mathematical Finance.

Slides

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