We previously published the results of our survey looking at how prepared Irish companies are in relation to assessing the appropriateness of the Solvency II Standard Formula for their risk profiles. One interesting finding was that almost half of high/medium-high companies in the survey, as assessed under the Central Bank of Ireland's risk rating system, the Probability Risk and Impact SysteM (PRISM), said they were not intending to include an assessment of the appropriateness of the Standard Formula parameters in their 2015 Own Risk and Solvency Assessments (ORSAs) or Forward-Looking Assessments of Risk (FLAORs) as the ORSA is known during the preparatory phase in lead up to Solvency II.

The European Insurance and Occupational Pensions Authority (EIOPA) paper on the background to the calibration of the Standard Formula is of particular interest in making such an assessment. Key calibration assumptions include:

- The equity portfolio is well diversified and there is no adverse exposure to a rise in equities
- The portfolio of liability benefits is well diversified in terms of applying the underwriting risk stresses
- There is no inflation risk on insured benefits
- Concentration risk doesn't capture geographic or sector diversification

For certain asset and/or liability portfolios some of these assumptions may not be well borne out, and this needs to be taken into account in deciding whether the Standard Formula is appropriate to a company's business.

In situations where companies are using active investment strategies such as dynamically hedging liabilities, we have often seen the need to model risks not captured by the Standard Formula. For example, equity risk, interest rate volatility risk, and basis risk.

Doubts have been expressed within the industry over the appropriateness of the Standard Formula for interest rate risk in the current low interest rate environment. For example, in recent times we have seen multiple quarters in which euro swap rates have moved more than would be implied by the 1-in-200-year Standard Formula shock. Companies with exposure to changes in the steepness or shape of the yield curve also need to think hard about the appropriateness of the Standard Formula for interest rate risk.

For underwriting risks, such as lapse risk and expense risk, companies should analyze their own experience data. If a company has had significant shifts in experience it could be hard to justify a 10% expense stress or a 50% relative lapse stress, for example. If there is a possibility of significant jumps in lapses, which could be due to some product feature for example, this would have to be considered in the context of the Standard Formula being a fixed relative stress. The mass-lapse stress is designed to target such situations but there could be conditions where you might expect that, in a 1-in-200-year event, more than 40% of the portfolio would lapse (e.g., if your portfolio is particularly concentrated by product type and/or territory, channel, etc.).

A further area where we see pushback from regulators is in the use of the Standard Formula for operational risk. This is particularly the case for more complex companies running lots of operational processes and/or engaging in a lot of outsourcing.

For companies with a small number of risk factors, care should be taken in considering the appropriateness of the Standard Formula diversification benefits. Tail correlation could be a significant issue in such circumstances.

In 2016 all Irish companies will need to carry out the task of assessing the appropriateness of the Standard Formula to their businesses. This post has just touched on some of the areas to be considered, focusing on the quantitative aspects likely to come up under Pillar I. Through the ORSA process, companies are also likely to identify other risks not covered by the Standard Formula, such as legal risk, reputational risk, and liquidity risk, some of which may have implications for the appropriate amount of capital to hold.

While the Standard Formula is expected to be appropriate for many companies, the work involved in carrying out this assessment should not be underestimated. It is likely that companies have a significant amount of work yet to do in order to ensure this assessment fully meets the relevant requirements.