Market-consistent valuations and Solvency II: Implications of the recent financial crisis

The recent financial crisis has raised challenges to market-consistent valuation, both in its implementation and application. These include both commercial and technical challenges. The whole concept of mark-to-market accounting has been questioned in some quarters. There have been commercial challenges in deciding how to assess business strategies given recent volatile market-consistent results, including the implications for ALM and new business pricing. Industry-wide, macroeconomic concerns have been raised regarding procyclicality. This paper recognises these commercial challenges and highlights how a combination of different forms of management information covering both market-consistent and other measures can help in making decisions. This paper sets out some possible approaches to mitigate procyclicality. There have been technical challenges in: –assessing how to value instruments in markets which are or have become illiquid–selecting an appropriate ‘risk-free’ or reference rate–deciding whether and how to make additional allowance for the liquidity premium or own credit risk–the calibration of stochastic models used to value embedded financial options and guarantees–assessing an appropriate allowance for non-hedgeable risk. This paper discusses these technical challenges. The paper proposes a way forward in some areas, taking into account the recent dislocation of the financial markets and drawing on recent Solvency II, IASB, FASB and MCEV developments.