Answers to the European Commission on the ... - Eiopa - Europa

10.26 The risk of asset liability mismatch is also significant, particularly in life
insurance business. ALM risk can manifest itself through all of <strong>the</strong>se
risk categories and <strong>the</strong>refore its quantifiable aspects should be
addressed as part of <strong>the</strong> SCR. But it is important that capital
requirements are supported by an appropriate framework for assessing
asset liability management under Pillar II.
10.27 Dependencies between risks will also require close consideration. The
Sharma report noted that risk dependencies can be part of a 'causal
chain' of events leading <strong>to</strong> <strong>the</strong> failure of an undertaking. In addition,
concentrations of risk, both within and across <strong>the</strong>se categories, demand
special attention. These <strong>the</strong>mes are considered later in this answer.
Operational risk
10.28 Operational risk is defined as <strong>the</strong> danger of losses resulting from
inadequate or failed internal processes, people and systems, or from
external events. Such risks are difficult <strong>to</strong> classify and <strong>to</strong> quantify.
Fur<strong>the</strong>rmore, sound risk management by undertakings might be
expected <strong>to</strong> identify and overcome any weaknesses in internal
processes. This might suggest operational risk is predominantly a Pillar
II issue, where <strong>the</strong> emphasis should be on testing <strong>the</strong> sufficiency of an
undertaking’s internal processes.
10.29 In <strong>the</strong> banking sec<strong>to</strong>r, similar difficulties regarding <strong>the</strong> classification
and quantification of operational risk have been acknowledged. But
regula<strong>to</strong>ry capital requirements have been developed <strong>to</strong> encourage
improved measurement and understanding of operational risk. For
similar reasons (and <strong>to</strong> avoid regula<strong>to</strong>ry arbitrage), operational risk
should be subject <strong>to</strong> a Pillar I treatment under Solvency II.
Asset Liability Management (ALM)
10.30 The goal of an ALM system is <strong>to</strong> manage business development over a
period with <strong>the</strong> aim of ensuring <strong>the</strong> right balance between assets and
liabilities. ALM should form an integral part of <strong>the</strong> business of <strong>the</strong>
overall risk management of an undertaking, supporting <strong>the</strong> definition of
business strategies, product design, pricing, valuation and investment
functions. It should address all relevant risks and should reflect
assumptions regarding policyholder behaviour and management
actions. ALM <strong>the</strong>refore encompasses Pillar I and Pillar II elements.
10.31 In <strong>the</strong> context of Pillar I, <strong>the</strong> focus should be on quantifying <strong>the</strong> effects
of any mismatch between assets and liabilities over <strong>the</strong> time horizon of
<strong>the</strong> solvency assessment. Due <strong>to</strong> <strong>the</strong> long-term nature of life contracts,
<strong>the</strong> duration of liabilities sometimes greatly exceeds <strong>the</strong> average
duration of assets. Significant mismatches can also occur in non-life
business, although liabilities are typically of a much shorter duration. In
general, though, asset-liability mismatches can increase sensitivity <strong>to</strong>
changes in <strong>the</strong> term structure of interest rates. Consequently, Pillar I
capital requirements should take in<strong>to</strong> account <strong>the</strong> duration mismatch
when measuring interest rate risk. A duration mismatch may also
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