Risk Margin = Technical Provisions - best estimate liabilities
The technical provisions are intended to be market-consistent, and are defined as the amount required to be paid to transfer the business to another undertaking.
For non hedgeable liabilities, technical provisions cannot be directly calculated
How to calculate
The PRA rulebook doesn't appear to go into detail about how to perform the cost of capital method. https://www.prarulebook.co.uk/rulebook/Content/Chapter/212665/01-05-2021
However we have the following resources to look at:
The risk margin represents compensationfor the cost of holding regulatory capital against the risk experience is worse than best estimate assumptions. It is determined using the “cost of capital” method, i.e. the cost of holding capital to support those risks that cannot be hedged in financial markets. These risks include
- insurance risk
- reinsurance credit risk
- operational risk
- residual market risk
The risk margin calculation involves:
- projecting forward the future capital that the company is required to hold at the end of each projection period during the runoff of the existing business
- projected capital amounts are then multiplied by a cost of capital rate (6%)
- these amounts are discounted, using risk-free discount rates, and aggregated to give the overall risk margin.
- the projection of the SCR is potentially complex
- various simplified approaches can be used.
- For example, selecting a driver (e.g. reserves or sum at risk) which has an approximately linear relationship with the required capital or its components.
- The initial capital requirement can be expressed as a percentage of that driver, and the projected capital is then approximated as the same percentage of the projected values of the driver.
- In practice, more sophisticated methods using a combination of drivers and correlations may have to be used.
- risk margin must be disclosed separately for each line of business
- it can be reduced to take into account diversification between lines up to legal entity level however.
- The allocation of diversification benefit can be approximated by apportioning the total diversified risk margin across lines of business in proportion to the SCR calculated on a standalone basis for each line, or by other approximate methods if appropriate given the materiality of the results.