IntroductionThe SCR coverage ratio is considered to be the new measure of an insurer’s capital strength under Solvency II. Like all headline metrics it serves a useful purpose, but does not tell the whole story. Understanding the underlying assumptions and drivers of the ratio can help to assess both the strength of an insurer’s capital and the reliability of the measure as a whole.
Capital coverRegulators expect firms to have at least as much capital as their Solvency Capital Requirement (SCR). The SCR represents the maximum loss over the next year at a confidence level of 99.5% (or 1-in-200 years). This means that for a firm with an SCR of £100m, there is a 99.5% chance that the loss over the next year will not be more than the SCR. The SCR coverage ratio is the ratio of capital that insurers have available to support their SCR (the “eligible own funds”) to the SCR. It provides a measure of the buffers a firm has in place to withstand balance sheet volatility while still holding enough capital to comply with the regulatory requirement. The following graph shows the 20 least well-capitalised firms out of 100 of the top non-life insurers across the UK and Ireland. [caption id="attachment_1587734" align="aligncenter" width="1449"] Eligible own funds ratio – bottom twenty, SOURCE: LCP analysis & Solvency II Wire Data [/caption] Two firms, Ageas, and Ambac Assurance, breached their SCR coverage ratio and did not have sufficient capital in place to cover their SCRs as at the balance sheet date. The rest had sufficient capital to meet the regulatory requirement, but in some cases, the buffers were very small (see for example Tradex and Tesco Underwriting). All else being equal, the more capital a firm has, the less likely it is that it will need to recapitalise in future. To test the likelihood of the need to recapitalise other metrics need to be considered in order to assess the strength of the SCR coverage ratio. The Minimum Capital Requirement (MCR) may prove an effective way of assessing what a “reasonably foreseeable” loss might be, by applying an MCR shock to the SCR coverage ratio.
Impact of an MCR lossThe MCR is calculated using a simple formula linked to the amount and type of business written. It is intended to represent the maximum loss over the next year at a confidence of 85% (or 1-in-6.67 years). The formula for calculating the MCR differs from the SCR calculation in a number of ways:
- it is much less complex than the SCR calculation;
- it makes no allowance for any diversification; and
- it is retrospective (based on prior year measures), whereas the SCR is prospective.
- material exposures to catastrophe risks or non-insurance risks (which increase the SCR but are not considered in the MCR calculation); and/or
- writing fewer lines of business – which results in less diversification benefit (diversification reduces the SCR but is not allowed for in the MCR).