Allowance for surplus funds under Solvency II: adequate reflection of risk sharing between policyholders and shareholders in a risk-based solvency framework?

In several member states of the European Union, collective bonus reserves are set up as part of the statutory reserves backing traditional participating life insurance business. Although primarily reserved for policyholders’ future surplus participation, national law (for example in Germany and Austria) allows the insurance companies to use these funds to (partly) cover future losses. Under the risk-based solvency framework Solvency II, the loss absorbency of these buffer reserves is explicitly recognized by so-called surplus funds which are classified as Basic Own Funds. This paper performs a profound analysis of the approach currently used in Germany to reflect this type of risk sharing between policyholders and shareholders in the Solvency II framework. The comprehensive methodology developed in this paper can be used to determine the economic value of surplus funds and ensures that no double-counting of future cash flows occurs. It can easily be adapted to other countries, in particular Austria. Based on a stochastic balance sheet and cash flow projection model, we present numerical results that illustrate how the allowance for Surplus Funds affects Basic Own Funds, Solvency Capital Requirement, Risk Margin and Deferred Taxes under Solvency II. We conclude that the current valuation approach appears to be internally consistent, but some of the underlying assumptions are questionable. In particular, the valuation approach should be refined in order to better reflect local statutory requirements, including both, accounting rules and other regulatory constraints for participating business.