The Minimum Capital Requirement (MCR)
from the Solvency ii
Association, the largest Association of
Solvency ii Professionals in the
world
Consultation Paper No 55
Draft CEIOPS’ Advice for Level 2 Implementing Measures on Solvency
II:
Calculation of the MCR
Introduction
In its
letter of 19 July 2007, the European Commission requested CEIOPS to
provide final, fully consulted advice on Level
2 implementing measures by October 2009 and recommended CEIOPS to
develop Level 3 guidance on certain areas to foster
supervisory convergence.
On 12 June
2009 the European Commission sent a letter with further guidance
regarding the Solvency II project, including the list of
implementing measures and timetable until implementation.
This Paper aims at providing advice with
regard to the calculation of the Minimum Capital Requirement (MCR)
as requested in Article 128 of the Solvency II
Level 1 text (herein “Level 1 text”).
The
objective of this paper is to specify the calculation of the MCR in
a clear and detailed way, including the following aspects:
• The calculation of the MCR, including the
linear formula subject to the SCR based cap and floor and the
absolute floor defined in the Level 1 text
• The quarterly calculation of the MCR,
required by Article 127(4) of the Level 1 text
• The calculation of the notional life and
non-life MCR required for composite undertakings by Article
73(3) of the Level 1 text
This Paper does not include advice regarding the calibration of the
MCR linear formula factors.
The
calibration of these factors is connected to the calibration of the
parameters of the SCR standard formula.
CEIOPS is
planning to provide a calibration proposal in its third set of
consultation papers on Level 2 in October 2009.
Extract from Level 1 Text
Article 128 – Implementing measures:
The Commission shall adopt implementing measures
specifying the calculation of the Minimum
Capital Requirement, referred to in Articles 126 and 127.
Recitals:
(42) When the amount of eligible basic own funds
falls below the Minimum Capital Requirement,
the authorisation of insurance and reinsurance undertakings should
be withdrawn, if those undertakings are
unable to reestablish
the amount of eligible basic own funds at the level of the Minimum
Capital Requirement within a short period of time.
(43) The Minimum Capital Requirement should
ensure a minimum level below which the amount of financial
resources should not fall.
It is necessary that it is calculated in accordance with a
simple formula, which is subject to a
defined floor and cap based on the
risk-based Solvency Capital Requirement in order to allow for an
escalating ladder of supervisory intervention and that it is based
on the data which can be audited.
2.3. Articles:
Article 126 – General provisions
Member States shall require that insurance and reinsurance
undertakings hold eligible basic own funds,
to cover the Minimum Capital Requirement.
Article 127 – Calculation of the Minimum Capital Requirement
(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) it 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 linear function referred to in
paragraph 2 used to calculate 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 of 85% over a one-year period;
(d) it shall have an absolute floor of:
(i) 2.200.000 EUR for non-life
insurance undertakings, including captive insurance undertakings,
except in the case where all or some of the risks included in one
of the classes 10 to 15 listed in point A of Annex 1 are covered,
in which case it shall not be less than
3.200.000 EUR,
(ii) 3.200.000 EUR for life insurance
undertakings, including captive insurance undertakings,
(iii) 3.200.000 EUR for reinsurance
undertakings, except in the case of captive reinsurance
undertakings, in which case the
Minimum Capital Requirement shall not be
less than a minimum of 1.000.000 EUR,
(iv) the sum of the amounts set out in points (i) and (ii) for
insurance undertakings as referred to in Article 72(5).
(2) Subject to paragraph 3 the Minimum Capital Requirement shall
be calculated as a linear function of
a set or sub-set of the following variables:
the undertaking’s technical provisions, written premiums,
capital-at-risk, deferred tax and administrative expenses.
The variables used shall be measured net of reinsurance.
(3) Without
prejudice to point (d) of paragraph 1,
the
Minimum Capital Requirement shall not fall below 25%
nor
exceed 45%, of the undertaking’s Solvency Capital Requirement,
calculated in
accordance with Chapter VI, Section 4, Sub-sections 2 or 3, and
including any capital addon imposed in accordance with Article 37.
Member States shall allow their supervisory authorities, for a
period not exceeding two years after
the date referred to in Article 310(1), to require an insurance or
reinsurance undertaking to apply the
percentages referred to in the previous subparagraph
exclusively to the undertaking's Solvency Capital Requirement
calculated in accordance with Chapter VI, Section 4, Sub-section
2.
(4) Insurance and
reinsurance undertakings
shall calculate the Minimum Capital Requirement at least quarterly
and report the results of that calculation to supervisory
authorities.
If either of the limits referred to in paragraph 3 determines an
undertaking’s Minimum Capital Requirement, the undertaking shall
provide to the supervisory authority information allowing a proper
understanding of the reasons for this.
(5) The Commission shall submit to the European Insurance and
Occupational Pensions Committee, at the
latest five years after the date referred to in Article
310(1), a report on Member States' rules and supervisory
authorities' practices adopted pursuant to paragraphs 1 to 4.
That report shall address, in particular, the use and level of the
cap and the floor set out in paragraph 3 as well as any problems
faced by supervisory authorities and by undertakings in the
application of this Article.
Furthermore,
Article 73 of the Level 1 text states the
following:
Article 73 – Separation of life and non-life insurance management
Without prejudice to Articles 100 and 126, the insurance
undertakings referred to in Article 72(2) and (5) shall calculate
both of the following:
(a) a
notional life Minimum Capital Requirement
with respect to their life insurance or reinsurance
activity, calculated
as
if the
undertaking concerned only carried on that
activity, on the basis of the separate accounts referred to
in paragraph 6;
(b) a notional non-life Minimum Capital
Requirement with respect to their non-life insurance or
reinsurance activity, calculated
as
if the
undertaking concerned only carried on that
activity, on the basis of the separate accounts referred to
in paragraph 6.
(3) As a minimum, the insurance undertakings referred to in
Article 72(2) and (5) shall cover the following by an equivalent
amount of eligible basic own fund items:
(a) the notional life Minimum Capital
Requirement, in respect of the life
activity;
(b) the notional non-life Minimum Capital
Requirement, in respect of the
non-life activity.
The minimum financial obligations referred to in the first
subparagraph in respect of the life insurance activity and the
non-life insurance activity may not be borne by the other
activity. [...]
Advice
3.1
Explanatory text
3.1.1. Previous advice
3.1. Previously, CEIOPS provided advice on the MCR in its Answers
to the European Commission on the second wave of Calls for Advice
in the framework of the Solvency II project (CEIOPS-DOC-07/05,
October 2005) and in its further advice to the European Commission
on Pillar 1 issues (CEIOPS-DOC-08/07, March 2007).
3.2. More recently in its MCR pros and cons paper (Architecture of
the MCR: Pros and cons of different approaches – CEIOPS-DOC-22/07,
December 2007) CEIOPS analysed the
advantages and disadvantages of different proposed approaches to
the design of the MCR in the context of the European
Commission’s framework Directive proposal.
While this paper did not conclude on a final
recommended MCR design for the Solvency II framework, it
recommended the testing of a linear approach in QIS4.
3.3. The combined approach eventually tested in QIS4 did not
follow CEIOPS’ recommendation but reflected guidance by the
European Commission of February 2008.
Later, this approach became the basis of the current MCR design
included in the Level 1 text.
3.1.2. The MCR in QIS4
3.4. The MCR approach tested in QIS4 combined the linear approach
recommended by CEIOPS with a cap of 50% and a floor of 20% of the
SCR.
Overall, this approach was found workable in
QIS4.
The calculation of the MCR in QIS4 caused
little or no practical difficulty for most undertakings.
The calibration of the linear component of the MCR in QIS4 was
regarded as satisfactory for non-life business, whereas it was
also concluded that the calibration of the linear formula for life
business would need improvement.
3.1.3. The overall structure of the MCR in the combined approach
3.5. Article 127 of the Level 1 text sets
out a combined approach for calculating the MCR.
This combined approach consists of
• A “linear formula”, i.e. a simple factor-based combination of
basic volume measures (written premiums, technical provisions,
capital-at risk, deferred taxes and administrative expenses),
combined with
• A cap of 45% and a floor of 25% of the SCR (calculated using
either the standard formula or an internal model) to ensure a
proper ladder of supervisory intervention.
The cap and the floor together are hereafter referred to as the
“corridor”.
In the final step, an absolute floor is
applied to the result of the above calculation.
The values of the absolute floor for different types of
undertakings are set out in Article 127(1)d.
3.6. The general rule is that
if
an undertaking has an approved internal model, then the corridor
used for calculating its MCR is determined by the internal model
SCR result.
However, for no longer than two years after
the entry into force of Solvency II, the supervisory authority has
the power to
require that the corridor is calculated from the SCR standard
formula.
3.7. The definition of the corridor includes capital add-ons
imposed on the undertaking’s SCR in accordance with Article 37.
3.1.4. Structure and segmentation of the linear formula
3.8. This section describes the structure of the linear formula as
recommended by CEIOPS, including the segmentation of the volume
measures used in the linear formula.
The linear formula structure suggested below is based on the
formula tested in QIS4, however some changes to the segmentation
are suggested.
3.9. Following the separation of life and non-life insurance
management required in Article 73(1) of the Level 1 text,
the MCR linear formula is divided between
life and non-life activities.
When the word “activities” is used in this paper,
the distinction between “life activities”
and “non-life activities” reflects the legal classification for
administrative authorisation.
3.10. In addition to the split reflecting the legal distinction
between life and non life activities, a second split is made
according to the technical nature of insurance obligations
(whether they are technically similar to life or non life).
The combination of these two splits defines
the following four components of the linear formula:
A. Non-life activities practised on a
non-life technical basis
B. Non-life activities technically similar to life
C. Life activities practised on a life technical basis
D. Life activities – supplementary obligations practised on a
non-life technical basis
For the purposes of determining the MCR,
health obligations are divided between the above life and non-life
categories A to D according to the nature of the contracts and
their underwriting, in line with the criteria set out below.
3.11. The volume measures referred to in the linear formula, in
particular technical provisions, written premiums and
capital-at-risk, should be allocated between
the above four components without double counting.
It is also suggested that all volume measures in the linear
formula are subject to a floor of zero.
3.12. For the purpose of the calculation of the linear formula,
the technical provision net of reinsurance
is the difference between the gross technical provision and the
reinsurance recoverables, where the recoverables should not
include recoverables from finite reinsurance.
3.13. For the purpose of the calculation of the linear formula,
the premiums net of reinsurance are the premiums received from the
policyholders less the reinsurance premiums paid for reinsurance
contracts which correspond to these policyholder premiums.
The reinsurance premiums should not include payments of
reinsurance premiums for finite reinsurance.
3.14. For consistency with the volume measures used in the SCR
standard formula, it is suggested that the technical provision
volume measures in the linear formula are
understood without the risk margin.
3.15. The volume measures prescribed in Article 127(2) of the
Level 1 text do not allow to explicitly
reflect in the linear formula all risks that an undertaking is
exposed to.
Such risks as e.g. market risk are reflected implicitly in the
calibration of the factors.
A.
Non-life activities practised on a non-life technical basis
3.16. This component of the linear formula should be calculated as
the sum over all lines of business of the
higher of the following two results:
• A fixed percentage
(αlob)
of net
technical provisions, reflecting underwriting risk for long-term
business;
• a fixed percentage
(βlob)
of net written premiums, reflecting underwriting risk for
short-term business.
3.17. It is suggested that the segmentation
of lines of business for the purposes of this linear
formula component should be consistent with the segmentation of
non-life technical provisions, and with the segmentation of
non-life and health lines of business used
in the SCR standard formula (CP 272, CP48 and CP50).
The following segments are suggested:
-
A.1 Motor vehicle liability
-
A.2 Motor, other classes
-
A.3 Marine, aviation, transport
-
A.4 Fire and other property damage
-
A.5 Third party liability
-
A.6 Credit and suretyship
-
A.7 Legal expenses
-
A.8 Assistance
-
A.9 Miscellaneous non-life insurance
-
A.10 Non-proportional reinsurance – property
-
A.11 Non-proportional reinsurance – casualty
-
A.12 Non-proportional reinsurance – marine, aviation, transport
-
A.13 Accident and health (segmentation pending)
3.18. The segments A.1 to A.9 and A.13 include both insurance and
proportional reinsurance accepted.
Other reinsurance accepted than proportional reinsurance should be
allocated to the segments A.10 to A.12.
3.19. The segmentation of Accident and health lines of business
(A.13) should follow the segmentation of lines of business in the
SCR standard formula non-SLT health underwriting risk submodule
(CP 50).
Regarding the segmentation of these lines, several options are
currently under consideration by CEIOPS.
B.
Non-life activities technically similar to life
3.20. The calculation of this linear formula component should be
the same as the calculation for life
activities, with the same segmentation and the same factors as
described below in component C.
3.21. Examples of non-life activities that are similar in nature
to life insurance include long-term health insurance and non-life
annuities.
3.22. The rationale for change relative to the QIS4 treatment of
this component is that the QIS4 approach may not cover all types
of non-life insurance which are similar to life insurance.
Furthermore,
arbitrage opportunities should be avoided: the MCR should not
depend on whether an activity is done by a life or by a non-life
insurer.
C.
Life activities practised on a life technical basis
3.23. This component of the linear formula should be calculated as
the sum of the following results:
• A fixed percentage (αi)
of net technical provisions excluding non-retail unit linked
business, at an appropriate granularity, to reflect long-term
risks relating to life business; and
• A fixed percentage of net capital-at-risk (βj),
at an appropriate granularity, depending on the outstanding term
of the contract.
3.24. For the purposes of the MCR linear formula, CEIOPS suggests
a segmentation that is somewhat different from the life segments
suggested in CEIOPS’ draft Level 2 advice on the segmentation of
technical provisions (CEIOPS-CP-27/09).
The changes mainly affect the second level of the segmentation.
Some second-level segments have been introduced to capture major
differences in risk profiles.
However, because of the need for simplicity and comparability, the
granularity of second-level segments is kept at the minimum in the
suggested segmentation, which is described below:
3.25. Technical provisions – with-profit segment:
Technical provisions relating to contracts with profit
participation clauses are split between the following two
sub-segments:
C.1.1 provisions for guaranteed benefits
C.1.2 provisions for future discretionary benefits
3.26. As the linear formula charge for the discretionary
sub-segment is negative, it is suggested to include
a with-profit floor (expressed as a
percentage of the technical provisions for guaranteed benefits) in
the linear formula charge of the overall with-profit segment to
prevent it from falling too low.
3.27. Technical provisions – unit-linked
segment: Technical provisions relating to contracts where
the policyholder bears the investment risk (not including
non-retail unit-linked business which is defined below) are split
between the following sub-segments:
C.2.1 provisions for unit-linked contracts
without guarantees
C.2.2 provisions for unit-linked contracts with guarantees
3.28. Technical provisions – non-profit segment:
Technical provisions
relating to contracts without profit participation clauses are
treated as a single segment:
C.3 provisions for contracts without profit participation clauses
3.29. Technical provisions – life reinsurance:
Reinsurance accepted is not treated as a separate segment in the
linear formula but should be apportioned according to the
segmentation of direct business, using the same factors as for
direct business.
The technical provisions of reinsurance accepted of with-profit
business should be completely assigned to segment
C.1.1.
3.30.
Capital-at-risk
is defined as the sum of financial strains for each policy on
immediate death or disability where it is positive.
The financial strain on immediate death or disability is the
amount currently payable on death or disability of the insured and
the present value of annuities payable on death or disability of
the insured less the net technical provisions (not including the
risk margin) and less the increase in reinsurance recoverables
which is directly caused by death or disability of the insured.
3.31. Capital-at-risk is split between the following segments,
depending on the
duration:
C.4.1 capital-at-risk for contracts with an
outstanding term of 5 years or more
C.4.2 capital-at-risk for contracts with an outstanding term of 3
to 5 years
C.4.3 capital-at-risk for contracts with an outstanding term less
than 3 years
D.
Life activities – supplementary obligations practised on a
non-life technical basis
3.32. The calculation of this linear formula component is the same
as the calculation for non-life activities practised on a non-life
technical basis, with the same segmentation and the same factors
(although some classes are unlikely as supplementary insurance, it
is not in the scope of this advice to decide which supplementary
classes should be possible).
Deferred taxes
3.33. According to Article 127 of the Level 1 text, deferred tax
liabilities can be used as a variable in the calculation of the
linear MCR.
The objective of the inclusion of the deferred tax liability in
the calculation would be to capture the loss-absorbing capacity of
this balance sheet item: in case an undertaking incurs losses, the
deferred tax liabilities potentially decrease and thereby offset a
part of the losses.
The SCR calculation allows for this effect
by an adjustment to the Basic SCR.
3.34. An allowance for deferred taxes in the linear MCR could
increase the risk sensitivity of the formula.
On the other hand, there are strong
arguments not to allow for deferred taxes in the linear MCR as
follows:
• When the MCR becomes relevant, i.e. when
the own funds of an undertaking are close to the MCR, it has
usually incurred losses in the past that made the deferred tax
liabilities vanish. Therefore, deferred tax liabilities are
likely only to have a significant effect on the linear MCR in case
the MCR itself is not relevant for the undertaking.
• The loss-absorbing characteristics of deferred taxes depend on
the tax regulation of the state that the undertaking is situated
in. It is unclear whether the characteristics of different
(probably complex) tax regimes can be reflected in one risk
factor. Moreover, there seems to be no database yet for an
analysis of this question. The QIS4 results do not appear to be a
reliable basis as the participants' approach to deferred taxes
differed significantly.
3.35. For these reasons, CEIOPS considers
that the inclusion of deferred tax liabilities in the MCR linear
formula would not lead to any significant regulatory benefit.
3.1.5. Notional non-life and life MCR for composite undertakings
3.36. For composite undertakings, the
notional non-life and life MCR (NMCRNL and NMCRLife)
are capital requirements that must be covered by eligible basic
own funds with respect to the non-life and life activity.
3.37. While the Level 1 text
explicitly requests separate notional life and non-life MCR
calculations for composite undertakings, this is not the case for
the SCR.
This raises the question of how to calculate the cap and the floor
as a percentage of the SCR for composites.
CEIOPS considers that the corridor needs to
be calculated separately for non-life and life activities,
and applied to the non-life and life linear formula respectively.
Without applying the separate corridors, the supervisory ladder
properties of the overall combined approach cannot be retained.
In QIS4, the separate corridors in respect of non-life and life
were not yet defined: their calculation is a new element in this
preparatory advice.
3.38. For determining the separate non-life
and life corridors, in turn, a notional non-life SCR and a
notional life SCR (NSCRNL and NSCRLife) need
to be calculated.
It is noted that the notional non-life and
life SCR results do not constitute a capital requirement on their
own: they are regarded as interim results of the notional non-life
and life MCR calculations.
3.39. While splitting the linear formula between non-life and life
components is self-explanatory, calculating notional non-life and
life SCR results is not straightforward.
3.40. CEIOPS recommends that, when the two notional SCRs are
calculated, the overall SCR of an undertaking is split in such a
way that
NSCRNL + NSCRLife = SCR.
This means that CEIOPS
recognises the diversification benefits
that arise between the non-life and life activities of a composite
undertaking.
3.41. More precisely, NSCRNL and NSCRLife
are calculated directly by splitting the overall SCR charge
according to the ratio of the non-life and life MCR linear formula
results.
The advantages of this method are that:
• it is very simple to calculate;
• it avoids the burden of calculating the full SCR separately for
non life and life;
• it is directly applicable regardless of whether the corridor is
derived from the standard formula or from an internal model;
• given that the linear formula and the corridor are split
according to the same ratio, the sum of the notional non-life MCR
and the notional life MCR is always equal to the overall MCR.
3.42. Furthermore, the notional non-life MCR should not be lower
than the non life absolute floor defined in point (i) of Article
127(1)d, and the notional life MCR should not be lower than the
life absolute floor defined in point (ii) of Article 127(1)d of
the Level 1 text.
3.43. If capital add-ons are taken into
account in the definition of the corridor, then an add-on imposed
on a composite undertaking should also be allocated between
non-life and life activities for the purposes of calculating the
MCR split between life and non-life.
The split should be declared by the
supervisor imposing the add-on for that particular
undertaking.
3.1.3. Quarterly calculation of the corridor
Frequency of calculation
3.44. According to the Level 1 text Member States shall require
that insurance and reinsurance undertakings hold eligible basic
own-funds to cover the MCR, that
the
calculation of the MCR shall be carried out at least quarterly
and that the results should be reported to
supervisory authorities.
3.45. By way of the corridor, the
calculation of the MCR is linked to the calculation of the SCR.
Regarding the frequency of the SCR calculations, the Level 1 text
in Article 102(1), requires that an undertaking shall calculate
its SCR at least once a year.
In addition, extraordinary SCR calculations are required whenever
there is a significant change in the risk profile.
3.46. Therefore, for the purpose of the MCR
calculation, the SCR shall be calculated on a quarterly basis.
3.47. Since the objective of the quarterly MCR calculation is to
ascertain whether or not the MCR has been breached,
the own funds eligible to cover the MCR
should also be calculated in parallel on a quarterly basis.
Simplification for the quarterly calculation of the SCR for the
purpose of MCR calculation
3.48.
When the SCR is calculated using the standard formula, for the
quarterly calculation that is not at year end, undertakings are
allowed to use a simplification.
3.49. The simplification consists of
a
partial recalculation of the last reported SCR.
A partial recalculation means that only
those (sub)modules of the SCR whose main risk drivers have changed
significantly since the last calculation are recalculated.
3.50. A minority of CEIOPS’ members suggested that a simple carry
forward of the last reported SCR should be used as a
simplification.
3.51. However, no simplifications are
allowed in the following cases:
a. (significant change in risk profile:) if
there has been a significant change in the risk profile of an
undertaking since the last reported SCR,
b. (proximity of intervention point:) if the undertaking falls
below the following capital thresholds, indicating that there is
an increased probability of MCR level intervention in the
forthcoming period:
i. the undertaking has breached the SCR,
ii. the undertaking has breached the MCR, or
iii. the undertaking does not hold eligible Tier 1 and Tier 2
basic own funds covering at least 200% of the MCR, without taking
into account the absolute floor.
3.52. Under the principle of proportionality
(see CEIOPS advice on proportionality), undertakings using
undertaking-specific parameters, a partial internal model or a
full internal model, shall apply a quarterly calculation that is
sufficiently sophisticated.
3.53. Regarding the thresholds in point b, to avoid circularity,
if the last full MCR/SCR calculation indicated that any of the
thresholds i.–iii. has been breached, then the simplification
should not be used.
If the simplification has been used but it indicates a breach of
any of the thresholds i.–iii., then the undertaking shall not use
the simplification.
3.54. The reason for not taking into account the absolute floor in
iii. of point b. above is to avoid demanding extraordinary
full SCR recalculations in those cases where the capital
requirements are dominated by the absolute floor.
 
To learn more you may visit:
Architecture of the
Minimum Capital Requirement (MCR)
Minimum Capital Requirement (MCR) -
Pros and cons of
different approaches
Consultation
Paper No 55 - Draft CEIOPS’ Advice (Level 2): Calculation of the MCR
Final CEIOPS’ Advice for Level 2 Implementing Measures on Solvency II:
Article 130,
Calculation of the MCR,
October 2009
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