Comments on the Solvency II Risk Margin and proposed amendments

The Risk Margin under Solvency II is determined as the cost of holding capital over the lifetime of liabilities, whereby future costs are discounted to the valuation date at risk-free rates. An implicit assumption of the current method is that the Risk Margin should allow for new capital to be raised after the occurrence of losses no larger than required capital. Using “Cost of Capital” as general valuation method, various approaches are discussed, giving rise to several alternative calculation methods of the Risk Margin. A comparison is made with the adjustment proposed by EIOPA in 2020 and also an approach is explored where future capital raisings are treated as contingent commitments. Each of the approaches discussed can be justified on its own merits in the context of Solvency II legislation, and leads to substantially different results for liabilities with long durations. Therefore, a more precise specification of the function of the Risk Margin and underlying assumptions is desirable.