The day an accounting treatment hatched into a risk
Why do we hold SCR for Currency Risk? The SCR is the capital required to ensure that the (re)insurance company will be able to meet its obligations over the next 12 months (with a probability of at least 99.5%). SCR should therefore serve to provide a capital buffer for any threats to the solvency position.
Any mismatch in currency between assets and liabilities within a legal entity does warrant a currency charge. This is captured in Solvency II QIS 5 specifications and provides generally a sensible approach for legal entities whose liabilities are mostly in one currency. The question this paper focuses on is the extent to which a further currency risk charge is warranted on a Group level when legal entities are in non-EURO jurisdictions. Indeed when summing up the parts (including non-EU based entities), foreign currency movements will have an impact on Group valuations. Currency changes lead to accounting translations that affect amounts reported. However, this does not by itself affect a (re-)insurers’ ability to meet its obligations – which would have already been evidenced at solo level.
To get back to basics here, we have asked ourselves the question: How will movements in the currencies of non-EUR denominated entities and business affect our solvency position and hence our ability to meet our obligations?
In this paper we discuss the idea behind currency risk. If the guidance for the required capital calculation for FX risk is based on a shock applied to the Net Asset Value of the entities in their respective reporting currencies, then this can create hedge incentives that endanger the solvency of the group and hence policyholder benefits. We illustrate later in this paper why this is the case. For the Group calculation the QIS4 approach to apply the shock only to the Net Asset Value over the SCR would provide a more appropriate treatment of the FX risk to within the standard formula. However, we believe that the most appropriate treatment of FX risk for multinational Groups is through the usage of an (partial) internal model.