an introduction to solvency ii philadelphia actuaries club may 13, 2010 john c. knauss, fsa, maaa...

An Introduction to Solvency II

Philadelphia Actuaries ClubMay 13, 2010

John C. Knauss, FSA, MAAAVice President and Corporate ActuaryLondon Life Reinsurance Company

May 13, 2010 An Introduction to Solvency II Slide 2

Key Objectives

• What is it?• Why did it come about?• What are the basics?• What does it mean?• Why should we care?


Outline

• Brief History – US vs. Europe• What’s so bad about Solvency I?• Structure of Solvency II Regime• Implications of Solvency II


Some History – U.S. vs. EuropeUnited States Europe

Early 1990’s Current RBC Regime Introduced

1970’s Solvency margin requirements introduced

1986 NY Regulation 126

2000 C3 Phase I 2002 Solvency I

2005 C3 Phase II

2009 VA CARVM 2007 Solvency II Proposal Adopted

2010 Risk-Focused Examinations

2011? C3 Phase III 2012 Solvency II effective


Abbreviations and Definitions

• CEIOPS: Committee of European Insurance and Occupational Pensions Supervisors

• IFRS: International Financial Reporting Standards

• QIS: Quantitative Impact Study• SCR: Solvency Capital Requirement• MCR: Minimum Capital Requirement• VaR: Value at Risk• SRP: Supervisory Review Process


Solvency I – The Basics

• Simple factor-based model• Focuses on the liability side of the balance

sheet• Regulatory capital requirement

– P&C: function of written premiums and loss reserves

– Life: function of amount at risk– Basically “RBC-extra light”


So what’s wrong with Solvency I?

• Simple formula approach disregards actual risk profile of the business

• Leads to unintended incentives (e.g., lower reserves = lower required capital)

• Applied to legal entity – no consolidation for groups of companies

• Limited disclosure requirements• Need for more comprehensive approach was

clear even during development


So what’s wrong with Solvency I?

• “Sharma Report1” (2002) showed that vast majority of insolvencies were preceded by internal management or governance shortcomings or some external trigger events.

• Report further noted that there was a period of time between such events and insolvency, suggesting that better information may have prevented the insolvency.

• Thus was born the Solvency II project.

1. Prepared under the leadership of Paul Sharma, head of the Prudential Risks Department of the UK Financial Services Authority


Solvency II – Essence

• Promote a robust, forward-looking risk management framework to guide both insurance company management and regulators

• Require implementation of risk practices appropriate for size, nature and complexity of the insurer’s business

• Reduce reliance on capital requirements as an exclusive early warning tool


Solvency II – Advantages

• Market-consistent valuation of assets and liabilities

• Identify and quantify risks and their interdependence

• Prospective risk management focus

• “Ladder of interventions” – upper threshold (plan for corrective action) to lower threshold (regulator takes over)

• Group supervision


Solvency II – Basic Structure

• Introduces economic risk-based solvency requirements across all EU member states

• Total balance sheet approach

• 3 pillars:

– Quantitative requirements

– Supervisory review

– Supervisory reporting and public disclosure


Solvency II Balance Sheet

Total Assets

MCR

RM

Best-Estimate Liability

Free Surplus

Technical Provisions = Best-Estimate + Risk Margins (RM)

Solvency Capital Requirement (SCR)(MCR is a subset of the SCR)


Pillar 1: Quantitative Requirements

Addresses the following:• Calculation of technical provisions (i.e.,

reserves)– Valued according to IFRS definition of fair value– QIS4: discount rates are term-dependent risk-free

rates at time of valuation (revisited in QIS5)• Calculation of solvency capital requirements• Investment management


Solvency II Capital Requirements

• SCR: capital such that the probability of ruin within one year = 0.5% (i.e., 99.5% VaR)– In other words, holding 100% of calculated SCR

would result in becoming insolvent once in every 200 years

– Calculated using standard formula, internal models, or combination

• MCR: floor below which a company will not be permitted to operate

• Between MCR and SCR, company subject to supervisory action


Standard Formula

• Linear, factor-based approach• Intended to be conservative approximation of

the 99.5% VaR objective• Specific structure not yet finalized and factors

not yet calibrated– Final calibration to be completed by October 2011

to allow 12 months’ lead time for full implementation

– Will likely include market, counterparty, mortality, morbidity, catastrophe, and operational risks


Use of Internal Models

• Solvency II encourages firms to use internal models under the premise that it will result in – a better alignment between firm risk and capital

requirements– Stronger risk management culture in the firm

• Use of internal models should lead to reduced required capital relative to the standard formula

• Regulatory approval required for use (must satisfy number of standards for calibration, validation, documentation, etc.)


Pillar 2: Supervisory Review

Focus: provide supervisors with means of identifying firms that have a higher risk profile, and the ability to intervene

Qualitative aspects:• Internal controls• Risk management processes• Corporate governance


Pillar 2: Supervisory Review

• Requires firms to conduct an Own Risk and Solvency Assessment (ORSA)

• ORSA is responsibility of the Chief Risk Officer (not an actuarial function)

• Objectives of ORSA– Tool for firm’s own decision making– Tool for supervisors to better understand the risk

profile of the firm


Pillar 3: Reporting and Disclosure

• Supervisory Reporting• Public Disclosure• Focus: increasing the transparency of the

insurer’s risks and capital position• Group Supervisor – a single regulator will

oversee a group of companies operating in multiple jurisdictions


Implications

Risk Management Practices

• Insurers must have an actuarial function and a risk management function

• Insurers will be required to have “adequate and transparent governance system”

• Increased use of ERM• “I would not position it as having to be ready

for Solvency II. Instead, we have to be ready for proper enterprise risk management and Solvency II is part of that.”

– Jeroen Potjes, Chief Insurance Risk Officer, ING


Implications

“Third-Country Insurers”

• Specific rules exist for European branches of non-EU insurers

• Solvency II contains provisions that enable the equivalence of a third-country solvency regime to be assessed.

• Equivalence with U.S. may be difficult without federal charter (i.e., single regulator)


Implications

Insurers’ Capital Requirements

• Per Industry: As currently proposed, required capital will increase dramatically

• Per Regulators: Required capital will now be at an appropriate level


Implications

Impact on Products• Will affect EU companies (including U.S.

companies with EU parent)• QIS4: Long-term products likely to suffer

– due to risk-free discounting (This was changed in QIS5).

– Longevity: immediate mortality improvement of 25%

– Mortality: mortality deteriorates 15%• CEIOPS: Consumers will have a more

uniform and enhanced level of protection, and increased competition will put downward pressure on prices


Industry Reactions

• “Why Excessive Capital Requirements Harm Consumers, Insurers and the Economy”– Published by CEA (“Euro-ACLI”) in March 2010– Written in response to requirements of QIS4

• Increase in required capital could be “65-75%” while sources of available capital are reduced “25-50%”


Industry Reactions (con’t)

• “The price of many life products would go up by up to 20-30% due to higher capital requirements…”

• “…non-life product prices would increase on average by 5-10% for more capital-intense products… or those with a long tail… due to higher capital costs…”


Implications

U.S. Regulation• Continued convergence of insurance

accounting regimes (IFRS) – are capital requirements far behind?

• Risk-focused examinations introduced by NAIC for year-end 2010

• NAIC is examining models-based catastrophe charges for RBC

• NAIC is re-examining asset RBC charges• NAIC to consider some measure of

operational risk?• NAIC to require something similar to the

ORSA?


Questions?

an introduction to solvency ii philadelphia actuaries club may 13, 2010 john c. knauss, fsa, maaa...

Documents

solvency iislide

structure of solvency

development slide

effective slide

capital requirements

risk srp

rbcextra light slide

riskfocused examinations