P2.T7.413. Solvency II versus Basel III: capital requirements

David Harper CFA FRM

David Harper CFA FRM
Subscriber
AIMs: Contrast the use of VaR parameters and confidence intervals in the Basel II/III and the Solvency II frameworks. Explain the difference between classes of risks taken into account in Basel II/III and Solvency II. Differentiate between solvency capital requirements (SCR) and minimum capital requirements (MCR), and describe the repercussions to an insurance company for breaching the SCR and MCR under the Solvency II framework.

Questions:

413.1. Solvency II and Basel III appear superficially similar because they both have three pillars. Solvency II modeled the three-pillar structure in Basel II (and Basel III by extension). The European Commission said the general rules in banking and insurance should be compatible, to the extent necessary, in order to establish consistent regulation across the financial sector, to avoid opportunities for regulatory arbitrage, and to create a level playing field among financial market participants. However, at the same time, due to the differences in economics and business activities, the the two regulatory regimes (Solvency II versus Basel III) necessarily differ.

About the differences between banks (which operate under Basel III) and insurance companies (which operate under Solvency II), each of the following is true EXCEPT which is false?

a. Banks tend to handle horizontal term risk transformation between assets and liabilities, but insurance companies tend to undertake vertical risk transformation on the liability side
b. Banks are exposed mainly to financial risks which are subject to rather high correlation due to the common factor sensitivities, but insurance companies are exposed to both financial and non-financial risks which are generally idiosyncratic and non-systematic and consequently experience a lower correlation
c. Banks are heavily funded through short-term deposits and borrowing, but insurance companies are funded mainly by premiums paid in advance
d. Banks conduct primarily negative term transformation which creates low liquidity needs and low interconnectedness, but insurance companies are more susceptible to contagion given their higher exposure to systematic risks

413.2. With respect to their first pillars (aka, Pillar One), Solvency II and Basel II/III have each of the following in common EXCEPT for which is not true?

a. Both first pillars (i.e., Solvency Pillar 1 and Basel III First Pillar) at least establish minimum capital requirements that are quantitative
b. Both first pillars include market risk, counterparty default risk and operational risk
c. Both first pillars conduct valuations based on forward-looking approaches and the total balance sheet from a purely economic perspective
d. Both first pillars in principle use value at risk (VaR) as the relevant risk measure

413.3. Which of the following best summarizes the solvency capital requirement (SCR) under Pillar One of the Solvency II framework?

a. To absorb unexpected losses, market risk requires a one-tailed 99.0% confidence level while credit and operational risk require a 99.9% confidence level
b. To absorb unexpected losses and ensure a given one-year solvency probability for the insurance company as a whole, a confidence level of 99.5% applies to the entire insurance company
c. Underwriting risks (i.e., life, non-life and health) require a confidence level of 85.0% over at least a three-year horizon ("soft floor") but financial risks (i.e., market, counterparty default, and operational) require 99.5% confidence over ten-day horizon ("hard floor")
d. While the solvency capital requirement (SCR) seeks to ensure a given one-year probability for the insurance company as a whole, the unexpected losses within each risk category are considered individually and without aggregation

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