The German Insurance Association's standard formula

There are already examples of standard formulas in Europe and throughout the world. These include the US model of the National Association of Insurance Commissioners (NAIC), the British model to calculate the enhanced capital requirement (ECR) and the regulations of the Australian Prudential Regulation Authority (APRA), in force since mid-2002. In Germany, the German Insurance Association (GDV), in collaboration with the German Federal Financial Supervisory Authority (BaFin), has developed a discussion proposal for a European standard formula. One of the principal ideas behind this formula is to calculate solvency capital on a more risk-adequate basis than under Solvency I, and in particular to incorporate diversification effects in this calculation.

The extent of the diversification effects for individual insurers strongly depends on the size of their portfolio and on their business model. Thus, the volatility of claims expenditure falls in line with portfolio growth and diversity. Also, the broader the geographical sphere of activity, the more likely it is that positive and negative deviations from the desired business performance will be evened out.

The GDV's proposed "Discussion paper for a Solvency II-compatible standard approach" contains the following features:

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  Consideration of companies' individual claims history: This offers companies a significant incentive to improve their technical profitability and risk management without having to establish a complex internal model.
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  Transparent use of correlation factors between risk classes and lines of insurance business: Correlation factors in the GDV model are calculated conservatively (i.e. they can also be used for extreme situations) and can be read directly from the formula.
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  Representation of diversification effects: In some standard approaches, risk capital is simply added together so that diversification effects between lines of insurance business or risk classes remain invisible. In such cases, there is no distinction between the calculation for high and low diversification of portfolios. In spite of significant differences in their risk situation, specialist insurers handling only few classes of business and broad-based companies are treated the same. By contrast, the GDV standard approach uses a root formula to calculate capital aggregation, which makes it possible to directly see the diversification effect.
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  Risk relief through reinsurance: The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) is calling for full recognition of reinsurance under Solvency II. In non-life in particular, non-proportional reinsurance has a significant risk-relieving effect if used properly. For reasons of principle, this effect may only be reflected on a limited basis in factor formulas, although the GDV discussion paper does try to represent reinsurance as far as possible.
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  For life business, the GDV proposal models both proportional and accumulation reinsurance.
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  Natural hazards: Although accumulation exposures are difficult to measure using a standard formula, windstorm exposure is still considered as an accumulation hazard in this standard approach. In spite of this, there is scope for extending the approach by considering further natural hazards (e.g. flood or earthquake).

The GDV standard formula goes some way to meeting the requirements for standard approaches set out by the EU Commission and CEIOPS. Naturally, it only presents a rough picture of an insurance company's individual risk situation. An internal model permits a far more accurate representation. The proposal should be seen as an attempt to find a middle way between more basic standard formulas and fundamentally more complex stochastic models (such as the Swiss solvency test or complete internal models). Compared with more simple approaches, this achieves greater risk adequacy of the required risk capital with only slightly higher complexity for insurance companies in terms of data requirements and calculation.

We can only estimate what form the future solvency rules will actually take. One thing is certain: small and medium-sized insurance companies will have to prepare for changes in risk management, product design and product range. Observation of economic principles in evaluating assets and liabilities is a significant step towards a risk-adequate, transparent and harmonised solvency system. The inclusion of diversification effects in the measurement of solvency and the consideration of possible impacts on the insurance market show that all concerned — actuaries, supervisory authorities and industry associations — will benefit from a modern solvency system geared to the requirements of the insurance industry.