INSURANCE AUDIT FINANCIAL SERVICES Risk margins: An area of conflict between accounting and supervision Joachim Kölschbach Vienna, October 2005

2 Interdependencies between accounting and supervision In principle different aims of accounting and supervision Accounting: provide information that is useful to a wide range of users in making economic decisions; preference: investors, i.e. profitability (IASB Framework, par. 9, 10, 12, 17) Supervision/Solvency system: essentially protection of policyholders and beneficiaries (IAIS Principle No. 3, par. 1)

3 Interdependencies between accounting and supervision But: Supervisory rules should be compatible with accounting rules elaborated by the IASB in order to… provide for one single set of figures for management decisions enhance quality avoid public confusion reduce administrative burden

4 Equivalent ideas in accounting (IASB) and supervision (IAIS, EU): Technical liability/provision = estimated expected value of future cash flows + risk margin Key question: Interpretation of risk margins? Evaluation of technical provisions

5 Interpretation of risk margins (1) Supervisory view (IAIS, Solvency II) Technical provisions should be sufficient to cover all expected and some unexpected claims and expenses and make use of reliable and objective methods Risk margin = Prudence margin Accounting view (IASB) Market price for deviation risk Risk margin = Market value margin

6 Interpretation of risk margins (2) Problem: No mathematical model suitable for all distributions Discussion of moments models, percentile models and combinations of both e.g. EU Solvency II * Confidence level for technical provisions: 75% of the probability distribution Risk margin as a minimum equal to half a standard deviation (in order to take account of strongly skewed distribution) * (Solvency II, Amended Framework for Consultation, par. 16)

7 Questions Determination of risk margins for accounting and supervisory purposes different or identical? Theoretically results should be the same for supervisory and accounting purposes: Market Value Margins But: In the absence of perfect markets the supervisory objective requires a security margin higher than market value margins

8 Approaches for determination of risk margins Concretisation by IASB/ regulator or supervisor Freedom, e.g. prudence Principle, e.g. MVM Professional Actuarial Judgement Fixed Rule, e.g. ½б, 75% percentile no gain without proof/ approval of internal model

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