Basel II to Solvency II

Without a sound risk allocation system, risk-related decisions are likely to be suboptimal and lead to higher volatility, following unanticipated negative events, and less investment.

 

 

The rules for banking supervision at the Bank of International Settlement (BIS) in Basel have changed business in all OECD countries. Basel I was launched in 1988.

The justification of a framework is based on the interdependence of banks and the role of the sector.

The current directive is known under Basel II: an extension of Basel I which will become effective this decade. Under the impression of the financial market and economic crises, the Basle Committee of Banking supervision is now even extending the Basel II requirements before it has been implemented in the national legislations in all OECD countries. The most significant innovation is the invention of a so called leverage ratio rule which has to be satisfied in addition to the existing Basel II rules. In contrast to the Basel II philosophy, the leverage ratio is an equity requirement which depends only on the sum of the balance sheet assets but not on the risk implied by these assets. Hence, a possible Basel III framework will have equity requirements depending on the risk associated to the financial institution and – in addition to this – a requirement which depends only on the size of the financial institution.

In 2002, a framework for the insurance sector was launched by the European Commission: Solvency II. Not dissimilar to Basel II, the framework carries the Basel II capital adequacy rules for the banking sector to determine the minimum solvency capital for insurers.

Without a sound risk allocation system, risk-related decisions are likely to be suboptimal and lead to higher volatility, following unanticipated negative events, and less investment.

The future of banking
Two pure banking systems can be distinguished: financial institution oriented systems as in Germany or Japan and investment and capital market oriented systems as in the US or UK. The positions of these banking systems have changed since 1988. Since then, banking has become much more market oriented and less affected by financial institutions. In 1990, six Japanese banks were ranked top in terms of market capitalisation, Deutsche Bank was ranked seventh. Barclays, National Westminster, and JP Morgan were the biggest Anglo-Saxon banks ranked eighth to tenth. In 2005, the biggest bank was Citigroup. Deutsche Bank was ranked 25 and none of the Japanese banks were ranked among the top 15. And after the financial market crises 2007 – 2009, the ranking will again be completely reorganised. Probably with significant lower weights of the US banks and with much more weight of the Chinese banks.

Basel has enhanced capital market orientation. Basel I requires OECD banks to hold equity capital according to the risk of asset and liability positions. Before, balance sheet risks in banks were covered by a standardised equity fraction of assets. The Basel accord applied risk weights to each balance sheet. Higher risks require a higher amount of comparatively expensive equity capital. Before the launch of Basel I, the more beneficial the bank transactions, the more riskier they were.

Before the accord, a loan to a noninvestment-grade counterparty was covered by the same amount of equity capital like a loan to a first-class counterparty. Since expected return on a low-rated counterparty is higher than on counterparties with higher ratings, this creates incentives for loans with parties that have poor credit qualities and makes loans to first-class counterparties unattractive. Under Basel II, the equity coverage of a bank loan depends on the credit rating of the counterparty. One important effect is that banks tend to buy more hedging and diversification instruments for credit risk in capital markets. New asset classes like credit derivatives, collateralised debt obligations, or asset backed securities were created during the same time the Basel rules were developed. Due to disappointing experiences with these types of instruments, the leverage ratio rule mentioned above goes one step back in the direction of Basel I by putting less emphasize on a bank’s risk and more emphasize on a bank’s size.

The lack of a developed investment banking industry in Germany and Japan compared to very strong US and UK investment banks has caused market capitalisation of German and Japanese banks to lag behind. Basel I and Basel II are shifting risk management away from financial institutions toward more transparent capital markets.

In 2002, the European Commission launched a framework for the insurance industry. Transparency is reached by adapting the minimum solvency capital (MSC) in an insurance company to its risks. Insurance institutions diversify risks and nondiversifyable insurance risks are reinsured. It is not unlikely that capital market products will secure insurance risks like catastrophe or weather risks in the P&C sector, and longevity or mortality risks in the life sector. One should also not forget that Solvency II is currently European, not global. The development towards capital market in the insurance sector has already begun. Instruments like weather derivatives, cat bonds (catastrophe bonds), or longevity bonds are not yet common, but are gaining significance.

P&C insurers
Although Solvency II is related to Basel II, the implementation of a risk-management framework for insurers is more than a simple application of a value at risk (VaR) model to insurance.

The determination of the joint probability distribution of all risks is undertaken on a dynamic financial analysis (DFA) approach. The goal is to identify the MSC of the company. This is the amount of capital required to provide a given level of safety to policy holders over a time horizon, given the enterprise-wide risk distribution of the insurer.

There are 10 probability distributions needed to characterise eight risk factors: interest rates, inflation, stock market returns, credit risk (ie, the risk for a reinsurer’s default), risk in the growth rate in the number of contracts, catastrophic-and noncatastrophic-risks.

The joint probability distribution of these factors expresses the distribution for the loss reserves of the company. A computation of the MSC must be based on a simulation approach, such as DFA. Both the catastrophe and the noncatastrophe distribution depend loss frequency and loss severity. Severity is typically modeled as lognormal distribution. The frequency for catastrophe losses is often modeled by a Poisson distribution while noncatastrophes are characterised by normal distributions. The joint distribution cannot be expressed in analytical terms.

Risk management for life insurers
While the complexity of risk factors was important in the P&C sector, there are two dominant risk factors for life insurers: interest rate risks and biometric risks.

One of the best options in life insurance contracts is the bonus option, guaranteeing a minimum return to the policy holder. This option depends on interest rates on the capital market. It can be hedged by fixed income derivatives, which are traded with great liquidity.

The surrender option is difficult to handle. It provides the policy holder’s contract with an early liquidation feature. The early liquidation likelihood is due to changes in market conditions. It might be driven by changes in the tax regime associated with life insurance contracts. Early liquidation also depends on the interest rate scenario in the capital market: the higher interest rates are, the higher the likelihood of an early exercise.

For the valuation and the risk management of a life insurance contract, it is not sufficient to apply VaR tools developed for bank risk management.

This article is an edited version of an entry in the “Encyclopedia of Quantitative Risk Analysis and Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by
permission.

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