In the insurance industry, we often use Solvency Capital Requirement (SCR) cover ratios as a key metric for comparing insurers’ financial strength. While these ratios provide valuable insights, their interpretation requires careful consideration of numerous factors that can make direct comparisons misleading. This article explores why seemingly straightforward comparisons of SCR cover ratios can mask significant differences in underlying risk profiles.

The Basics: Why Hold More Than 1x SCR?

Before diving into comparison challenges, it’s worth briefly considering why insurers typically maintain SCR cover ratios well above 1.0. The obvious reason is to maintain a buffer above regulatory minimums, but there are several other important considerations:

• Supporting future business growth and associated strain
• Providing capacity for opportunistic investments or acquisitions
• Covering risks not captured by the standard formula, such as reputational risk and strategic risk
• Accounting for cases where the standard formula may not perfectly reflect an insurer’s specific risk profile. (This is a pet area of mine. There are multiple problematic areas, from treatment of concentration risk, to no scale adjustment for non-life underwriting risk, the lack of a flood catastrophe scenario, too light mortality catastrophe, possibly too-high equity stresses, too-low retrenchment stresses and more!)
• The old idea of holding a buffer to allow a riskier investment strategy is less relevant with whole balance sheet risk capital measures, where the higher risk investment strategies themselves result in higher SCR.

There are clear reasons to want to hold as little capital as possible, related to capital rationing and aiming to increase Return on Equity. Perhaps I’ll cover that in a different post – there are some quirks related to the discussion, as more capital inevitably feels like it drives a conversation towards taking greater risk, rather than tax-optimised, liquidity-optimised market consistent value optimisation.

Life Insurers: Different Business Models, Different Dynamics

The comparison of SCR cover ratios becomes particularly interesting when examining life insurers with different business models. Consider these key differences:

Risk Protection vs Investment Products

Insurers focused on risk protection business demonstrate fundamentally different SCR cover behavior under stress compared to those primarily writing annuities or investment products. This stems from the different nature of their key risks and how these respond to adverse scenarios.

One of these impacts is how mass lapse risk affects SCR cover ratios. When a mass lapse event occurs, both own funds and SCR can decrease simultaneously due to the loss of negative reserves. This means that insurers with significant exposure to mass lapse risk might show surprisingly resilient SCR cover ratios during stress scenarios for those with significant mass lapse risk – quite the opposite of an annuity writer’s exposure to longevity, interest rate, or spread risks which will drive a good portion of their capital.

One aside, SCR cover resilience doesn’t necessarily indicate lower real-world risk to shareholders, who can still lose significant shareholder value (whether measured by Own Funds or Embedded Value) in a mass lapse event. The probability of actually defaulting on promises to policyholders remains remote.

Market Risk Considerations

Equity risk exposure creates another layer of complexity. Insurers with significant shareholder equity portfolios benefit from a natural risk reduction mechanism during market stress – as equity values fall, the exposure and thus the required capital for equity risk also decreases. This creates very different SCR cover behaviour compared to insurers whose primary risks (like mortality) don’t have this characteristic.

Bancassurers or newer insurers typically have less equity risk in their portfolios relative to older, more diversified business (especially those with mutual/with profit ancestry).

Non-Life Insurers: The Reinsurance Effect

For non-life insurers, reinsurance strategies play a crucial role in understanding SCR cover ratios:

Beyond the 1-in-200

Most non-life insurers purchase reinsurance protection beyond the 1-in-200 year event level that drives SCR calculations. Some might secure coverage for 1-in-400 or 1-in-500 year events, while others might optimise their reinsurance purely for SCR efficiency, stopping at the 1-in-200 level. Two insurers with identical SCR cover ratios might therefore have vastly different protection against extreme events.

Purchasing reinsurance cover just up to 1-in-200 also runs the risk of business volumes and exposure growing more than expected, overflowing those reinsurance limits.

This creates an interesting paradox: The probability of severe losses (where Assets < Liabilities) can vary dramatically between insurers with the same SCR cover ratio, depending on their reinsurance limits. However, their chances of breaching the SCR cover ratio in moderate stress scenarios (1-in-20 to 1-in-50) might be similar, as these events typically fall within reinsurance coverage limits.

In practice, many Boards and management teams really worry about the more realistic risks of beaching regulatory solvency. This is because the likelihoods involved feel more plausible, because this event will happen before outright insolvency, and because in general the 1 in 500 or larger events are likely industry-wide. There is an element of better to be in trouble along with everyone else…

A Common Challenge: Government Bond Treatment

Both life and non-life insurers face challenges around the treatment of government bonds as risk-free assets. Two insurers with identical SCR cover ratios might have vastly different exposures to sovereign default risk, despite this being treated as zero in standard formula calculations.

Conclusion

While a higher SCR cover ratio (say 1.8x versus 1.5x) might seem to clearly indicate stronger financial resilience, the reality is far more nuanced. Before drawing conclusions from peer comparisons, we need to consider:

• The underlying business mix and its risk characteristics
• Reinsurance structures and their effectiveness beyond regulatory capital requirements
• The appropriateness of standard formula assumptions for each entity
• The rigour applied in implementing regulatory standards

Only by understanding these factors can we begin to make meaningful comparisons of insurers’ true financial strength and risk resilience.