In the past, government bonds and loans to member states of the European Economic Area (EEA) or Organisation for Economic Co-operation and Development (OECD) were essentially classified as risk-free. At least since the European sovereign debt crisis, however, this approach has been subject to a fundamental rethink.
It has become clear that government bonds are also exposed to credit or even default risk.
Nevertheless, these risks are not currently reflected in the regulations on the capital charge under Europe's Solvency II supervisory system. Insurers that calculate their solvency capital requirement (SCR) using an internal model must take material sovereign risks into consideration. By contrast, when calculating the SCR using the standard formula, government bonds are only included in interest and currency risk and not in spread or concentration risk.
Solvency capital requirement (SCR)
Since 1 January 2016, insurers that are subject to the Solvency II Framework Directive have been required to constantly maintain eligible own funds at least equivalent to their SCR, in accordance with section 89 of the Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG). This is aimed at covering all material quantifiable risks to which an insurer is exposed. In accordance with section 96 (1) of the VAG, undertakings can calculate the SCR using either a uniform European standard formula or an internal model specific to the undertaking.
However, these insurers should also thoroughly examine sovereign risks, in particular as part of Pillar II, i.e. the requirements for the system of governance. This is clear from the new Insurance Supervision Act and various guidelines issued by the European Insurance and Occupational Pensions Authority (EIOPA), as noted by BaFin and the insurance industry at an investment symposium in June.
Own risk and solvency assessment
The own risk and solvency assessment (ORSA) is a key component of the system of governance for insurers. It involves insurance undertakings analysing their individual risk profiles and the resulting risk capital requirement. In accordance with section 27 of the VAG, this is separate from the SCR based on the standard formula. Under the ORSA, insurers must also take into account risks that are not or not adequately included in the standard formula, and must develop a suitable assessment procedure for them. This also concerns risks associated with exposures to government bonds, since these have a zero-risk weighting under the standard formula.
Risk types
Interest rate risk: interest rate risk denotes the risk of changes in the term structure of interest rates, or in the volatility of interest rates.
Currency risk: currency risk denotes the risk of changes in the level or in the volatility of currency exchange rates.
Spread risk: spread risk is the risk of changes in the level or in the volatility of credit spreads over the risk-free interest rate term structure.
Concentration risk: concentration risk stems either from a lack of diversification in the investment portfolio or from a large exposure to default risk by a single issuer of securities or a group of related issuers.
Insurers must therefore also examine whether their risk profiles deviate significantly from the assumptions underlying the calculation of the solvency capital requirement using the standard formula. BaFin assumes that insurers will come to the conclusion that there is deviation within the spread and concentration risk modules due to the fact that they do not take into consideration a capital charge for government bonds. They must examine whether this, together with other undervalued risks, if any, will cause their overall risk profiles to deviate significantly from the assumptions of the standard formula. They must document their findings, providing justification for them and details of any quantification carried out. In order to determine the level of the capital requirement and how this can be covered, the insurers must subject the material risks to a sufficiently broad range of stress tests specific to the undertaking. BaFin expects that insurers with a high level of sovereign exposure will attach particular importance to such exposure in their stress testing. The undertakings are required to simulate various scenarios, for instance the default of one or more states.
Significance
If the risk profile deviates from the assumptions underlying the calculation of the solvency capital requirement using the standard formula, this is "significant" if it results in risks being underestimated. The undertakings must independently determine the significance threshold in line with their risk profiles by reference to appropriate and transparent criteria. They can base this on the threshold values for capital add-ons set out in Article 279 of the Delegated Regulation supplementing Solvency II. In accordance with this, deviations of ten percent must generally be regarded as significant. Deviations of 15 percent are regarded as undeniably significant. Further information can be found in BaFin's Interpretative Decision (only available in German) on the Own Risk and Solvency Assessment (ORSA).
If there are significant deviations, the insurer must contemplate which measures it intends to take. It is possible to adjust the risk profile to the standard formula, for instance through reallocating assets or making sufficient capital available. However, insurers can also develop an internal or partial internal model.
In addition, undertakings must develop risk management measures and set time limits for exposures that are not backed by collateral. The ORSA report required to be submitted to BaFin must detail all qualitative and, if appropriate, quantitative findings, including those of the stress tests, as well as the planned internal measures. The report must also include statements on the suitability of the standard formula.
Prudent person principle
Section 124 of the VAG requires that insurance undertakings invest all their assets in accordance with the prudent person principle. They may only invest in assets whose risks they can properly identify, measure, monitor, manage and control. This also applies to investments in government bonds. Assets held to cover the technical provisions must be invested in a manner appropriate to the nature and duration of the corresponding liability and the best interests of the policyholders.
In addition, section 124 (1) no. 2 of the VAG stipulates that all assets must be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole. The EIOPA Guidelines on System of Governance require that undertakings establish an investment risk management policy. In it, the undertakings should establish the level of security that they are aiming for with regard to the whole portfolio of assets and outline how they plan to achieve this. In addition, insurers must compile an internal schedule of investments, in which they should establish quantitative limits for investments and exposures, including sovereign exposures.
The investment risk management policy must make it clear that the undertaking assesses the financial market environment and takes this into consideration accordingly. The financial market environment should be understood to mean both the general conditions as well as current developments and regulatory changes.
BaFin symposium
On 21 June, BaFin held a symposium in Bonn on the topic of government bonds in the guarantee assets (Sicherungsvermögen) of insurers. BaFin Chief Executive Director Dr Frank Grund and other BaFin experts held discussions with representatives of the insurance industry and the Deutsche Bundesbank on how to assess sovereign risks for which no capital charge is currently stipulated under the standard formula.
The industry representatives outlined how they invest in government bonds and manage the associated risk. The German Insurance Association (Gesamtverband der Deutschen Versicherungswirtschaft – GDV) and the Bundesbank detailed the impact of the low interest rate environment on investment policy, while representatives of BaFin discussed the treatment of government bonds from a supervisory standpoint. Marc Wolbeck, Head of the BaFin Division for Investments by Insurers (Referat für Kapitalanlagen von Versicherern), described how to handle risks in the own risk and solvency assessment (ORSA), in application of the prudent person principle and as part of an undertaking's own credit risk assessment. BaFin expert Dr Andreas Zapp made the connection to the internal model.
The undertakings and BaFin agreed that insurers holding government bonds in their portfolios must take these exposures and the associated risks into account. BaFin's insurance supervision is now planning to organise workshops with the insurance industry from the third quarter; these are aimed at reaching a common understanding of sovereign risk and its treatment under the new Solvency II supervisory system.
Own credit risk assessments
In addition, section 28 (2) of the VAG requires that insurers comply with the obligations resulting from the 2013 amendment to the Credit Rating Regulation. Of particular importance to insurers is Article 5a, which requires them to carry out their own credit risk assessments.
The details have not yet been finalised. Until the three European Supervisory Authorities (ESAs) publish more detailed information, BaFin's insurance supervision will follow the Notes on the use of external ratings and on making own credit risks assessments, which it published in October 2013. According to these, insurers must carry out their own credit risk assessments for government bonds by reviewing the plausibility of an external rating assessment, since government bonds are investment assets rated on normal market terms. The credit risk assessment must be documented in a verifiable manner. If an undertaking rates a bond higher than a credit rating agency, an appropriate quantitative assessment must be carried out in addition to the qualitative assessment. The higher the sovereign exposure, the more comprehensive the own credit risk assessment must be.
For the examination of external sovereign credit ratings, it is suggested that undertakings compile and compare national economic indicators. The undertaking must gain an overview of the country's national finances. However, it is insufficient to merely consider a state's deficit and debt-to-GDP ratio. Other criteria to consider would include e.g. sovereign or government guarantees to which the state is exposed. It may also be advisable to analyse the stability of the country's government and its legal and financial system, as well as the obligations associated with membership of international organisations.
Good practice approaches
BaFin's objective is to work together with the insurance industry to gain a common understanding of the risks and how to handle them, in particular as part of the ORSA, in application of the prudent person principle and when carrying out the own credit risk assessment.
In the next few months, BaFin intends to organise workshops to develop "good practice approaches" – i.e. sensible procedures – in partnership with the insurance industry.
