OAC

Solvency 2:
The value and risk of Value at Risk

Solvency 2 has now been given the
formal go ahead with a planned
introduction date of 31 October 2012.
This date is fast approaching, so it is
important that all stakeholders are
concentrating on fully understanding
and implementing the requirements.
This Topical Article discusses the
method used for determining firms’
solvency levels, and some of the
OAC Topical Article > Insurance Consulting Edition > Published July 2009
The problem here is that the process actually more like 1-in-10, and occurs
will clearly not always directly follow broadly in line with common economic
the distribution – practise will not cycles of expansion followed by
always follow statistical theory. This contraction.
can be ‘lost’ in the science ruling the
VaR calculation, with the result that The problem is compounded where
the VaR is considered to be fact, with there is little or no historical statistical
sight being lost of the actual risk data as the 1-in-200 event is
itself being considered. This issue effectively anecdotal. The issue boils
is compounded by the fact that the down to what ‘feels’ like a 1-in-200
process will deviate furthest from event. This is highly subjective and it

concerns that have been raised over
its use – since the method used is
based on that which seemingly failed
to protect the banks during the recent
financial downturn.
The Solvency Capital Requirement
One of the central aspects of Solvency
2 is the introduction of the Solvency
Capital Requirement (SCR), which is
the additional capital that firms need
to hold to cover the risks facing their
business. The SCR is based on a
‘Value at Risk’ (VaR) measurement,
similar to that introduced for the
banking industry under the Basel 2
regulations in 2004. In brief, VaR
seeks to place a maximum loss that
could be expected, with a given
probability (or confidence level), over
a specific time horizon. The banking
system generally looks at one day
VaR, while the SCR calculation under
Solvency 2 uses one year. The
confidence level is usually chosen
such that the associated probability
is very small, typically 0.5%, which
the assumed pattern during extreme quickly becomes very difficult to judge
situations. what is a 1-in-100 event (say) and
what is a 1-in-200 event: both are by
To illustrate this point, statistical definition rare, yet one is twice as rare
analysis on UK equity returns 18 as the other!
months ago suggested that a suitable
1-in-200 event was a fall in markets Why wasn’t the recent downturn
of around 40% over a one year time ‘predicted’?
horizon. The graph below shows
monthly FTSE 100 Index levels Criticism has been levelled at the Basel
and demonstrates that, in fact, 2 regime, and in particular the concept
movements of this magnitude occur of VaR, for not ensuring that the banks
fairly frequently – certainly more than remained resilient throughout the
once every 200 years! Just since 1984 recent crisis in the financial markets.
for example, the FTSE 100 Index has While it is true that the scale of the
fallen 28% in 2001, 37% in 2003 and downturn was not anticipated by the
42% in 2008. regulatory measures in place, VaR is
not designed to ensure ‘zero failure’
So what we might consider as extreme (indeed, losses of similar magnitude
events are not really anything of the to the 1-day 99.5% VaR would be
sort; for UK Equity markets, it might expected 1-2 times in any given year).
simply be that what we consider at To do this would require very large
present to be a 1-in-200 event is amounts of available capital, meaning
FTSE 100 Index (1984 to 2009)
8000

gives rise to the ‘1-in-200 event’.

7000

What is a ‘1-in-200’ event?

6000

The concept of VaR (and more

specifically confidence intervals) 5000

comes from statistical theory: where

a process conforms, or has historically 4000

conformed, to a known statistical

distribution, we can compute 3000

confidence intervals around the

possible outcomes of that process.
2000
So if we can fit such a distribution to
a process we are interested in – eg
1000
equity returns over a one year period
– we can derive these confidence
intervals eg the fall in the equity 0
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market consistent with a 1-in-200

year event.
Download this document: oacplc.com/publications/ta0709ic.pdf
Page 2
that only those firms with suitably deep
pockets could compete in the market.
The failings of the regime may be because
too much reliance was placed on VaR.
This may have been implicitly encouraged
by the Basel 2 regime itself, in placing
VaR at the forefront of the strategy. In
other words, rather than all the risks
in the business being fully understood,
the temptation may have been to look
at VaR and assume that as long as this
was “reasonable” (ie easily covered by
available capital) then everything was
“OK”.
It is also questionable whether holders of
many new asset types eg collateralised
debt obligations (CDOs), fully understood
how such assets would behave under
stressed conditions. This would make it
almost impossible to make any realistic
assessment of the VaR needed to back
those asset types.
Is Value at Risk still a valid measure?
VaR remains an extremely useful measure
of risk. It supplies an objective assessment
of the total risk faced by the firm, and
more importantly the contribution each
individual risk makes. Using VaR the
Board can therefore very easily see which
are its most significant risks, and ensure
they satisfy its risk appetite. If they do
not, then the risks need to be mitigated,
with the effectiveness of suitable
mitigation strategies measured by looking
at the reduction in VaR they supply.
A useful phrase that has emerged from the
recent financial downturn is “If you don’t
fully understand an asset, don’t buy it. If
you don’t understand a liability, don’t write
it”. While this may seem common sense,
it is not always the case that the decision
makers fully understand the effect that
complex financial instruments such as
CDOs may have on its balance sheet
(especially in extreme situations). A VaR-
type measure will force this understanding.
Without VaR the Board may only be able
to form subjective opinions on what it
considers are its chief risks, and so may
be “surprised” by a risk that had not been
considered to be suitably significant to
consider. VaR would highlight such risks
via their contribution to the aggregate.
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OAC Topical Article > Insurance Consulting Edition > Published July 2009
Further, forcing the whole balance sheet
to be considered shows just how different
risks interact (many of which may move in
opposite directions).
Analysing VaR also helps the Board to
formalise the management actions it
needs to take under stressed conditions
in advance, rather than only considering
what to do once such events have
occurred. VaR can be calculated without
any such reactive measures in place;
then suitable actions considered (for
example the sale of equities at certain
“trigger” points of an agreed index) until a
satisfactory reduction in VaR is achieved.
These actions can then form part of the
Board’s formal procedures, so that it
immediately knows what it needs to do as
equity markets fall (for example) without
having to only start considering such
actions during the storm itself.
As recent events demonstrate, the
most significant danger arises when
the measure becomes the control itself
– and regulation allows this to occur. The
control must always be the relevant risk
management function (and the Board),
who will of course make extensive use of
such measures as VaR. Simply minimising
VaR must not be their primary objective.
Instead it should be to ensure that the risk
profile matches the risk appetite of the
company. The VaR measure is but one
tool available to the Board in making that
assessment.
Conclusion
So do we know what 1-in-200 events are?
The answer is probably not. Even for risks
where we have a reasonable amount of
credible statistical data, recent events
have shown that models don’t quite work
in the real world. The recent “failings” of
VaR arose from the difficulty in estimating
what these 1-in-200 events are, rather
than the method itself being flawed.
But it would be unfortunate if the many
significant positives introduced with the
use of capital models were tarnished by
recent events, as if they were somehow to
blame. Instead the lessons learned should
provide useful refinements to how the
Solvency 2 process evolves, and where
the focus falls. It is not unreasonable to
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suppose that recent events would have
been significantly worse without the
improved systems in place thanks to these
measures.
Solvency 2 will certainly present a
challenge but it is to be hoped that this
will help embed a greater understanding
and transparency in insurers’ assessment
of risk. While many firms already claim to
have a deeply embedded risk management
culture, a key aim of Solvency 2 is a more
transparent demonstration of this, and the
SCR, as part of the Solvency 2 process, is
designed to help prove this.
How can OAC help?
OAC is committed to the positive
change that Solvency 2 is introducing.
We are helping firms deal with
Solvency 2 by:
n calculating Solvency 2 capital
requirements on our state-of-
the-art financial modelling tool
Mo.net (we have a QIS4 model
that models the majority of
insurance business);
n training executives and non-
executives on the implications of
Solvency 2;
n assisting them project manage
their implementation plans;
n providing general help and
support; and
n monitoring and auditing the
implementation of Solvency 2
across their business.
Of course we can also help by
providing AFH and WPA services and
we would be delighted to talk to firms
looking to get the best value from
their actuarial suppliers: our unique
working methodology ensures that
our rates are highly competitive.
For more information contact:
David Gregson
Consultant Actuary
+44 (0)20 7278 9500
david.gregson@oacplc.com
oacplc.com/insuranceconsulting
OAC Actuaries and Consultants
Portsoken House Minories London EC3N 1LJ
www.oacplc.com enquiries@oacplc.com
+44 (0)20 7278 9500
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