Introduction
1. This paper gives an overview of the different approaches envisaged for the calculation of the Minimum Capital Requirement (MCR) and intends to make an inventory of the pros and cons of each method.

2. On 19 July 2007 the European Commission has sent a letter to CEIOPS’ Chair, Thomas Steffen, thanking CEIOPS for its advice to date which enabled the Commission to publish its draft Directive text on 10 July 2007.

This letter also set out the areas the Commission wanted CEIOPS to focus on and give advice as part of future implementing measures and supervisory guidance.

The letter stated in addition that:

"With respect to the MCR, the [QIS3] report should include an analysis of the pros and cons of different approaches that could be used for its calculation using the data collected for QIS3 (including the CEIOPS modular approach, the CEA compact approach, the compact approach based solely on the standard formula as well as an approach based on a margin over liabilities)."

3. Following the QIS3 exercise, CEIOPS identified the Minimum Capital Requirement (MCR)  as one of the critical issues on which a decision will need to be made on political as well as on technical level.

4. The purpose of this paper is to provide an *assessment of the three 3 Minimum Capital Requirement (MCR)  approaches* detailed by the European Commission above.

Quantitative results and qualitative feedback from QIS3 on the two approaches tested have been added.

Background
5. The main categories of calculation methods that have been envisaged are:

1. A modular approach: this method consists in aggregating capital charges for the different risks the company is exposed to, in a simpler way than for the Minimum Capital Requirement (MCR) taking into account underwriting risk and market risk;

- this proposal was tested by CEIOPS in QIS3;

2.  A fixed percentage of the SCR: the CEA suggested a Minimum Capital Requirement (MCR) equal to 1/3 SCR, using the firm’s calculation method (standard formula or internal model).

The European Commission rejected using an internal model in the Solvency Working Group, but an alternative compact approach deemed acceptable was a percentage of the SCR using solely the standard formula (even for firms using an internal model for their SCR calculation). Both variants will be considered here.

3. A fixed percentage of the technical provisions: the Commission has suggested that this so-called Margin over Liabilities (MoL) approach be back-tested to determine its calibration.

The Minimum Capital Requirement (MCR) in the Solvency II Directive Proposal

5. Pending the results of QIS3, the EC did not take a final decision on the architecture of the Minimum Capital Requirement (MCR) in its Directive Proposal. However, the Directive Proposal specifies the definition of the MCR, and provides some guidelines on the design
and calibration in Articles 125 to 128.

Non-compliance with the MCR is dealt with in Articles 136 and 141.

The publication of the breach of the MCR is detailed in Articles 50 and 53.

6. The main Article in the Directive Proposal concerning the Minimum Capital Requirement (MCR) is Article 126. It states the following:

"1. The Minimum Capital Requirement shall be calculated in accordance with the following principles:

(a) it shall be calculated in a clear and simple manner, and in such a way as to ensure that the calculation can be audited;

(b) the Minimum Capital Requirement shall correspond to an amount of eligible basic own funds below which policyholders and beneficiaries are exposed to an unacceptable level of risk if insurance and reinsurance undertakings were allowed to continue their operations;

(c) the level of the Minimum Capital Requirement shall be calibrated to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level in the range of 80% to 90% over a one-year period;

(d) it shall have an absolute floor of 1 000 000 EUR for non-life insurance and reinsurance undertakings and 2 000 000 EUR for life insurance undertakings.

2. Insurance and reinsurance undertakings shall calculate the Minimum Capital Requirement at least quarterly and report the results of that calculation to supervisory authorities".

7. The firm must inform the supervisory authority as soon as it observes non compliance,
or a risk of non-compliance, of the MCR in the coming 3 months.

If the situation is not restored within 3 months of the observation of the breach, the
supervisory authority must withdraw the licence (Articles 136 and 141).

8. Any breach of the MCR must be disclosed in the report on solvency and financial condition (even if it is by a small amount and even if it has been subsequently resolved).

If there is non-compliance during the year and no viable recovery plan exists, the firm must immediately disclose the non-compliance of the Minimum Capital Requirement (MCR), as well as an explanation of its origin and consequences. (Articles 50 and 53).

9. Given the Directive Proposal, the assessment therefore needs to focus on the following key aspects:

Clear, simple and auditable: A clear and simple manner to perform the Minimum Capital Requirement (MCR) calculation, especially as insurers and reinsurers are required to calculate the MCR on a quarterly basis. As breaching the MCR leads to withdrawal of
the licence, there must be legal certainty attached to the calculation.

Safety net: the MCR is a safety net that provides for adequate capital to protect policyholders and beneficiaries against an unacceptable level of risk.

This safety net function has the consequence that the MCR overrides the SCR when the latter is too low. There is agreement that the MCR, on the contrary to the SCR, does not aim at being risk-sensitive. In extreme circumstances the Minimum Capital Requirement (MCR) could dominate the SCR because of a very low SCR.

Calibration: the calibration indicated (80% - 90% VaR over a one-year time horizon) should ensure a proper interplay with the SCR in the majority of cases and also a certain risk-sensitiveness.

A proper interplay means that, for the vast majority of firms, the SCR should be constantly higher than the Minimum Capital Requirement (MCR). Otherwise the MCR would drive the capital requirement on a regular basis, which would question the proper functioning of the risk-based Solvency II framework.

A proper interplay is needed to ensure that there is space for a ladder of supervisory intervention. The lack of a gap between the Minimum Capital Requirement (MCR) and the SCR may remove incentives to build an internal model and to have better risk management. The SCR and an independent Minimum Capital Requirement (MCR) may not
move in a consistent manner over time, which would make it difficult for
firms to plan their capital requirements.

Whatever the approach, the final amount is not allowed to be lower than an
absolute minimum.

10. The Directive Proposal thus gives 4 characteristics for the Minimum Capital Requirement (MCR) that can be summarised as:

A. simplicity and auditability;

B. safety net;

C. calibration;

D. absolute floor.

11. The 4th characteristic is not questioned so the different Minimum Capital Requirement (MCR) approaches will be judged according to the first three criteria.

12. The notion of simplicity can be interpreted in different manners. While some consider that simplicity must reside only in the calculation, others consider that both the calculation and the input data must be simple.

The question relates especially to the assessment of the compact approach (Minimum Capital Requirement equals a percentage of the SCR) should a method that involves the calculation of a percentage of a result stemming from a complex model (or complex standard formula) be
regarded as a simple method?

The method is obviously “time-saving” given that the complex calculations have already been carried out, but it is not “noncomplex”.

13. Stand-alone calculations are required in all proposed methods except the compact approach in alternative 1 (percentage of the SCR, whether calculated through an internal model or the standard formula).

As such, some members view standalone approaches as an unnecessary administrative burden.

14. Auditability has also been much discussed. Different views have been expressed, ranging from considering that technical provisions are not auditable to stating that the SCR internal model result is potentially auditable.

15. Although all criteria should be respected, the relative importance given to some
criteria over others can guide the choice of design of Minimum Capital Requirement (MCR).

However, Member States seem to have different views as to the relative importance of these criteria. For the majority of the Member States, the main criteria are simplicity and
auditability, and safety net. For others it is the calibration and the consequence
on the interplay with the SCR that are most crucial. From this difference of views
follows a different evaluation of the MCR approaches.

16. There are links between the Minimum Capital Requirement (MCR) and other aspects of the Solvency II system: capital add-ons, group support regime and the treatment of “old” composites.

The issue of composites is mentioned below because it can be considered to be common to several approaches; the issues of groups and add-ons are mentionedunder the compact approach where the direct link between the Minimum Capital Requirement (MCR) and SCR can be problematic.

17. For composites dating from before the third life Directive, a notional life Minimum Capital Requirement (MCR) and a notional non-life Minimum Capital Requirement (MCR) need to be calculated (Article 72 of the Solvency II Directive Proposal).

Therefore any input to the MCR calculation will need to be split between life and non-life. This difficulty could be more of a technical nature.

However, assets also need to be split between life and non-life.

Several approaches are affected by this difficulty. Such difficulties are proportionate to the complexity of asset-side inputs in the different approaches to the calculation of the Minimum Capital Requirement (MCR).

18. This paper will examine the possible approaches for calculating the Minimum Capital Requirement (MCR). For the three approaches that have been proposed before the end of QIS3 in June 2007 (modular approach, percentage of SCR and percentage of technical provisions), a brief description of the approach will be followed by an assessment according to the criteria listed above and a short QIS3 feedback.

Additionally, two new approaches will also be suggested: the combined and the linear approaches.

The combined approach consists in the higher number between a percentage of the SCR and a percentage of technical provisions.

The linear approach has been developed following QIS3 criticism of the modular approach, to simplify this modular approach.

Finally, the paper relates the decision taken by CEIOPS Members on the testing proposal for QIS4.

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