Derivatives: Forwards vs Futures

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  Before understanding what is derivative, let’s learn what is underlying asset. Underlying asset: Underlying asset can be real asset such as commodities, gold etc or financial assets such as index, interest rates etc. Derivatives: ·         These are financial instruments who value depend upon or is derived from some underlying asset. ·         A derivative does not have its own physical existence, it emerges out of contract between the buyer and seller of derivative instrument. ·         Its value depends upon the value of underlying asset. Hence returns from derivative instruments are linked to returns from underlying assets. ·         The most common underlying assets are stocks, bonds, commodities, market indices and currencies. ·         Derivatives are mainly used to control risks. They can be used to reduce risks (a process known as hedging) or to increase risks in order to enhance returns (speculation)   Classification of Derivatives: ·         Broadly we c

Overview on Solvency II in a Layman Language - Phase 1 - Actuarial

Overview

Solvency II is set of rules set by regulatory body that tells insurance company regarding how much capital should they hold.

Let’s understand with the help of an example…

Suppose there are 2 insurance companies i.e. Company X and Company Y

Company X

Company Y

Assets

100 million

Assets

100 million

Liability

80 million

Liability

80 million

On the basis of only this information, what do you think, which company is financially strong ? which company is performing better ?
Your answer would be that both these companies have same level of security.

Now let us give you further information i.e. breakdown of asset classes

Company X – Assets

Company Y – Assets

Equities

80 million

Govt. Bonds

80 million

Derivatives

20 million

Corporate Bonds-AAA credit rating

20 million


Now tell us, which company is less risky ? which company has more likelihood of not making default on there obligation i.e. payment to policyholders….

Obviously company X is more risky than company Y. That’s why the concept of Risk Based Capital regime comes into existence which states that

The more risky the company is, the more will be the capital requirement.

Now question is what is capital requirement ?

Capital requirement is the amount of capital that a company has to hold to ensure that they have sufficient assets available to pay off their liabilities whenever they due within a given time frame with a given degree of confidence.

Definition of Solvency II

·         It is the rules governing how insurers  are funded and governed. Here, insurers will need enough capital to have 99.5 percent confidence they could cope with the worst expected losses over a year. The rules take a risk-based approach to regulation: the riskier an insurer’s business, the more precautions it is required to take (i.e. more will be the capital requirement)

·         It applied to insurers based in European Union and UK as well

·         All EU insurance and reinsurance companies with gross premium income exceeding €5 million or gross technical provisions in excess of €25 million (Now question is what is Technical provisions ?? we will discuss it in the end)

·         Regulator is PRA i.e. Prudential Regulatory authority but supervision is being done by EIOPA i.e. The European and Occupational Pensions Authority, which is the EU’s insurance regulator.

Three Pillars of Solvency II

Solvency II is based on 3 pillars i.e.

Pillar 1: Quantitative requirements

·         It covers the concept that how can we quantify the risk into the capital requirement that company should hold.

·         It sets the two distinct capital requirements i.e. SCR and MCR

o   SCR: Solvency Capital requirement is the amount of capital that company should hold as prescribed by regulatory basis (i.e. methods and assumptions). If company does not hold SCR then regulator will intervene in insurance company business and try to reduce the risk within the business such as:

§  Asset liability matching

§  Investment in less risky assets

§  No bonus distribution

§  Increase in reinsurance

o   MCR: Minimum capital requirement. If company does not hold even MCR level of capital, then insurance company license may get cancel to sold new business

Pillar 2: Qualitative requirements

·         It focuses on

o   Risk management

o   Governance

·         Insurers are required to carry out an Own Risk and Solvency Assessment (ORSA)- The Economic capital model is a key element of the ORSA process, and this is required to be reviewed by the supervisor.

Pillar 3: Reporting and Public disclosures

·         It comprises of disclosures and reporting regime. Reports to public and regulators are required to be made.




In our next article we will discuss each and every component of this balance sheet in detail and in a simple and layman language.

But let’s see one good example based on this balance sheet.

Suppose Assets = 100, Liabilities i.e. Technical provisions = 60

Then Own Funds or NAV i.e. Net Assets Value = 100 - 60 = 40 million

Now Let’s say SCR = 15 and MCR is 5 million

Then Surplus or Excess Assets = Own Funds – SCR = 40 -15 = 25 million

So that is what we are trying to say if my NAV (or OF i.e. Own funds) is less than 15 million (i.e. SCR) then regulator will intervene and if my NAV is less than 5 million (i.e. MCR) then insurance company will not be allowed to sell new business!!!!


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We hope that you enjoyed this article, we are creating a series of articles on Solvency II. Stay Tuned


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