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CEIOPS-SEC-81/10

7 June 2010

CEIOPS answers to Commission questions on QIS5 draft technical

specifications

1. Following the submission by CEIOPS of its draft technical specifications for

QIS5 and the publication on 15 April by the Commission of revised techni-cal specifications for consultation until 20 May 2010, CEIOPS has taken

note of the policy decisions which were adopted by the Commission. In the meantime, CEIOPS has continued to closely follow the discussions held at the Level 2 Solvency Expert Group and participated to the stakeholder

meeting and public hearing on QIS5 organised by the Commission.

2. In this regard, CEIOPS has identified various areas where it considers that

for the purpose of the QIS5 specifications as well as for the future Level 2 implementing measures, further thought should be given. On 25 May

CEIOPS has provided the Commission with comments on QIS5 draft tech-nical specifications. The aim of that document was to highlight the areas of concern as well as to the extent possible in the limited time available, to

make concrete suggestions.

3. As was mentioned in our comment note on QIS5 sent on 25 May, CEIOPS

has moreover carried out an overall impact assessment with regard to the changes made by the Commission. This impact assessment supplements and extends CEIOPS‟ previous preliminary QIS5 impact assessment, which

aimed at assessing the impact of the changes to the QIS4 specifications following CEIOPS‟ proposals. Details on the results of this impact assess-

ment are contained in the annex.

4. Also the Commission has sent on 25 May to CEIOPS a list of questions on the draft technical specifications on which it was agreed that the answers

will be provided on 7 June.

4.5. Following considerations constitute the answer to the Commission‟s ques-

tions to CEIOPS on the draft QIS5 technical specifications as well as fur-ther explanations to issues raised in CEIOPS comments on QIS5 draft technical specifications.

A. Technical provisions

Segmentation

A1. The EC raised a question on segmentation „According to paragraph TP.1.35

undertakings should segment their obligations by country when they cal-culate the best estimate. How relevant is this provision for QIS5 purposes? (We assume that no reporting of technical provisions per country is envis-

aged for QIS5.)‟

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A2. The purpose of this requirement is to capture risks belonging to the same line of business that may have substantially different local regulations,

market practices or social and economic conditions. It is not necessary for QIS5 to report technical provisions by country. However, it is necessary to

ensure that the differences highlighted above are captured, to the extent that they exist. In addition, should an undertaking wish to allow for geo-graphical diversification in the calculation of the non-life SCR, the level of

segmentation should be sufficient to provide the inputs for such a calcula-tion. Naturally, the proportionality principle applies.

The reference rate for constructing the basic risk-free curve

A3. We understand that the preliminary basic risk-free interest rate structures provided by the CRO-Forum are derived using mid-market rates. The QIS4

exercise used swap rates derived from bid rates. Although the difference between bid rates and mid-market rates is small for the major currencies,

it can be material for less developed markets.

A4. To ensure consistency between the asset and liability valuation and align-ment with the IFRS fair value approach of „the price that would be re-

ceived to sell an asset or paid to transfer a liability in the most advanta-geous market at the measurement date (an exit price)‟, we would recom-

mend using bid rates.

Parameterisation of the alpha parameter in the Smith-Wilson extrapolation

method

A5. We have received some comments that the QIS5 curves converge too quickly to the Ultimate Forward Rate compared to market data at long du-

rations. The methodology defined in the draft QIS5 specifications states:

A6. We do not consider it valid to compare the extrapolated curve with market

data points at long durations, since these market data points are beyond the points determined as liquid in the market and therefore are not a rele-vant comparison. We stand by our proposed methodology as stated above

for the purpose of QIS5. However, we do recognise that the alpha is based on opinion rather than hard technical evidence and therefore we intend to

work further on the parameterisation of alpha.

Consistency of non-hedgeable market risk in risk margin and extrapolation of yield curve

A7. It is important that the risk-margin for non-hedgeable market risk and the extrapolation of the risk-free curve are done in a consistent manner, to

ensure that the risks are fully captured and not double counted. It is criti-cal to emphasise that the two issues of non-hedgeable market risk and ex-trapolation are inextricably linked. Any change in approach to one of these

elements will likely require a change to methodology for the other.

A8. CEIOPS‟ considers that it can be assumed that a “transfer value premium”

exists to compensate the investor for both:

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(1) the fact that the market risk cannot be hedged and hence the risk

that interest rate may change adversely, and

(2) for tying up their capital for the long term.

Consistent with this view, CEIOPS‟ proposed extrapolation methodology for QIS5 uses a two-factor approach in the determination of the Ultimate For-

ward Rate which implicitly covers item(2) and an additional explicit risk margin to cover item(1).

A9. We recognise that there is considerable technical debate about how to capture these risks. We therefore intend to carry out further work in this area. With regard to the standard formula, this would require to consider

how the capital charge for interest rate risk could be recalibrated to ensure compatibility with the applied extrapolation methodology and the relative

invariance of the ultimate long-term forward rate.

Consideration of whether swaps should be limited to the government bond yield

A10. We have received some comments that suggest that the basic risk-free

rate should be restricted to a minimum of the government bond yields where swap yields are below government bond yields. Our view is that to

ensure a practical and market consistent approach to deriving the basic risk-free rate, no such restriction should be applied.

Guidance on how to calibrate the liabilities to the risk free curve

A11. The QIS5 guidance paragraphs on calibration, TP.1.263 and TP.1.320 are currently not consistent with each other, as they imply that the asset

model should be calibrated to both asset prices and implied volatilities. A problem arises because the Black-Scholes formula, relating implied volatil-ities to option prices, also uses the risk free rate as an input.

A12. The over-the-counter options market convention is to use risk-free rates derived from swaps. If Solvency II requires a different risk free rate in the

ESG, then the ESG cannot simultaneously replicate market option prices and market implied vols. Our proposal is therefore to calibrate ESG‟s to

market option implied volatilities, not replicating option prices, in line with current market practice. We recognise that further work and guidance may be required in the area of calibration.

B. SCR standard formula – spread risk

Granularity of bond spread risk calculation in relation to senior/subordinated debt

and contingent capital instruments issued by banks

B1. The EC raised the following question: `Should there be a different treat-ment between investments by insurers in senior debt and investments in

subordinated debt? In such cases the probability of default may be the same, but the loss given default may be different. Similarly, should there

be a different treatment where insurers invest in contingent capital in-struments issued by banks? Under the recent Basel proposals it is likely that such instruments may convert into equity at a certain trigger point,

but it is not clear that the equity risk embedded in these instruments if they do convert is captured in the SCR.´

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B2. CEIOPS points out that usually these debt instruments would have a lower rating, especially when comparing subordinated debt to senior debt. Hence

the rating-based approach for bonds would generally lead to higher capital requirements for investments in subordinated debt compared to invest-

ments in senior debt, so that the effect mentioned above would already be captured. Moreover, the introduction of a differentiated treatment for ei-ther subordinated/senior debt or for investments in contingent capital is-

sued by banks into the determination of the spread risk capital charge for bonds would lead to additional complexity in the calculations, and would

require additional data substantiating such more granular treatment.

B3. Therefore, CEIOPS considers that it would not be appropriate to introduce such a differentiated treatment into the determination of the spread risk

capital charge for bonds in the standard formula.

B4. CEIOPS notes that the Crisis Task Force of CEIOPS Financial Stability

Committee is in the process of collecting exposure data of insurance un-dertakings towards banks, including a breakdown into subordinated (and other hybrid) debt. These results will be available by mid July 2010 and

may be used to consider this issue further after the QIS5 exercise.

Scope of application of the liquidity part of the spread risk calculation

B5. The EC raised the following question: `Shouldn't the illiquidity premium offset (5.112 to 5.116) apply across all sub-sections of the spread risk and

not only to bonds?´ Related to this, it also raised the question: `Is appli-cation of the maximum of the widening/narrowing of spreads at the right point in the calculation? Shouldn't the maximum function be applied to the

next effect of assets falling (less changes in liabilities) at the overall level to capture appropriate asset mixes. In other words, shouldn't the maxi-

mum function move from paragraph 5.108 to 5.107? The capital charge for spread would be:

Max{ [mktsp(bonds) + mktsp(struct) + mktsp(cd) + mktsp(re) - deltail-

liquid liabs]up; [mktsp(bonds) + mktsp(struct) + mktsp(cd) + mktsp(re) - deltailliquid liabs]down}´

B6. CEIOPS considers that the maximum of the widening/narrowing of "spreads" should only apply to bonds, and not to the other components of

the spread risk module, because the illiquidity premium is only stressed for bonds. Hence the specification of the `max´ function in para. 5.108

should remain unchanged, and should not be shifted to para. 5.107.

Duration floor

B7. The EC raised the following question: `What is the rationale for the intro-

duction of a duration floor in SCR 5.109? Wouldn't the minimum duration give excessive charge for bonds with duration shorter than a year?´

B8. CEIOPS considers that a duration floor is necessary to avoid arbitrage op-portunities for insurers. A majority of CEIOPS members is in favour of keeping the 1 year floor, whereas a minority would accept a reduction of

the floor to 6 months.

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Further clarifications concerning the application of the shock on the illiquidity premium in the calculation of the spread risk charge for bonds

B9. The EC raised the following question: `SCR 5.114 gives the calibration for the shock on the illiquidity premium but does not explicit the shock itself.

This would clarify the calculation if the shock is specified explicitly by cur-rency and buckets. Examples would also help the reader.´

B10. CEIOPS has provided further clarifications in this regard. A suggestion for

an amended specification is contained in the annex.

Regulatory arbitrage opportunities in relation to structured products

B11. The EC raised the following question: `Has CEIOPS ensured that there is no regulatory arbitrage between direct holdings of bonds and holdings through structured products (5.118 to 5.123)?´

B12. CEIOPS has not tested yet the potential impact of regulatory arbitrage be-tween directed holding of bonds and holdings through structured products

(5.118 to 5.123).

Alignment of simplified formula in SCR 5.133 with general approach

B13. The EC raised the following question: `Is the simplified formula in SCR

5.133 aligned with the formula in 5.108? What does F(rating duration) means? Is F standing for Fup and/or Fdown?´

B14. The `Max (up, down) shock´ and the `Delta illiquid Liab´ factor should also be introduced into the simplified formula.

B15. Also at the end of footnote 53 it should be added: "these terms are not calculated for the technical provisions to which no illiquidity premium is applied”.

Calculation of the charge for credit derivatives

B16. Both CEA and CRO Forum criticised the spread risk shocks for credit deriv-

atives prescribed in the QIS5 Draft Technical Specifications (+600% and -75% of the current spread) for being not in line with the respective cali-bration for bonds.

B17. CEIOPS has analysed this issue further and has considered whether a more granular treatment for credit derivatives could be applied. Details on

the analysis are contained in the annex.

B18. Following these considerations, it could be considered to introduce the fol-lowing more granular charges for the spread risk charge on credit deriva-

tives:

up down

AAA +130 basis points -75% of current spread

AA +150 basis points -75% of current spread

A +260 basis points -75% of current spread

BBB +450 basis points -75% of current spread

BB +840 basis points -75% of current spread

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B or lower +1620 basis points -75% of current spread

Unrated +500 basis points -75% of current spread

B19. It should be noted that this would still follow a scenario-based approach for credit derivatives as the factor-based approach used for bonds with its reference to the market value is not suited for credit derivative structures

with potential leverage effects.

Calibration of the spread risk charge for bonds

B20. CEIOPS does not consider that a calibration of the spread risk factors for bonds based on Moody‟s bond spreads (as suggested by CRO Forum) would be appropriate. Such a calibration would not reflect market price

changes of a portfolio typically held by European insurance undertakings.

B21. CEIOPS points out that the Moody‟s index in question:

Is denominated in USD, so there is the issue how to extrapolate for other currency zones

Contains bonds of maturities of at least 20 years, whereas Euro-

pean bonds would generally exhibit a duration of lower than 10 years, so that there would be the potential for material distortion

does not cover the financial sector (which, as CP 70 indicates, ex-hibits bigger spread moves), but only the industrial and commer-cial sector.

Calibration of the spread risk charge for covered bonds

B22. CEIOPS has continued the analysis for the capital charge for covered

bonds following comments collected during the stakeholder meetings on QIS5. Details on the analysis are contained in the annex.

B23. The final calibration of the functions Fup(Ratingi) and Fdown(Ratingi) for AAA-

rated covered and non-covered bonds resulting from this analysis woulb be as follows:

Fup(Ratingi) Fdown(Ratingi) Duration floor Duration cap

AAA, covered 0.6% -0.7% 1 -

AAA, non-covered 1.0% -0.4% 1 -

Table 1: Final calibration proposal for function F

B24. Several CEIOPS members would support introducing a separate category

for covered bonds into the calculation of the spread risk capital charge for bonds. Within this category, the above-mentioned factors Fup and Fdown

would apply. The scope of this sub-category should be consistent with the treatment of covered bonds in the concentration risk sub-module and should only be applied to AAA or AA rated covered bonds.

B25. However, other CEIOPS members have expressed concerns about intro-ducing such separate category for covered bonds into the calculation of

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the spread risk capital charge for bonds. They would not support re-opening a debate on the appropriateness of the spread risk factors for

bonds and point out that the introduction of a separate spread risk charge for covered bonds would lead to additional complexity in the standard for-

mula.

C. SCR standard formula – concentration risk

Further clarifications on conditions on covered bonds

C1. The EC raised the following question: ` In the definition of covered bonds set out in SCR 5.159 (concentration risk section), could you provide fur-

ther clarity on these two requirements:

the portfolio of mortgages backing the asset is diversified into a

sufficiently high number of borrowers

there is no evidence of high correlation or connection among the default of one or few borrowers´

C2. With regard to the second condition mentioned above, this may be speci-fied more concisely as “an exposure with a customer or group of mutually

connected customers may not, after subtracting particularly secure claims, exceed 25 per cent of the base capital".

C3. With regard to the first condition mentioned above, CEIOPS notes that it

would not be practicable to be more specific on the number of borrowers, considering that is part of the business model of covered bonds to gather

the highest number of borrowers in order to benefit from economy of scale in the management, together with the increasing diversification with the increasing size of the portfolio.

C4. CEIOPS notes that the following qualitative criteria on covered bonds are stipulated in Article 22(4) of the UCITS Directive (Directive 85/611/EEC):

i. The covered bond issuer must be a credit institution.

ii. Covered bond issuance has to be governed by a special legal framework.

iii. Issuing institutions must be subject to special prudential public su-pervision.

iv. The set of eligible cover assets must be defined by law.

v. The cover asset pool must provide sufficient collateral to cover bondholder claims throughout the whole term of the covered bond.

vi. Bondholders must have priority claim on the cover asset pool in case of default of the issuer.

C5. Moreover, in the CRD Directive, the list of classes of assets that are eligi-ble as collateral for covered bonds are:

Exposures to public sector entities;

Exposures to institutions;

Mortgage loans (commercial & residential);

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Senior MBS issued by securitization entities;

Loans secured by ships

C6. In CEIOPS opinion, qualitative criteria on covered bonds should be consis-

tent with those indicated in UCITS Directive.

D. SCR standard formula – non-life premium and reserve risk

D1. The EC raised the following question: ` At the last meeting of the Solvency Expert Group, some Member States suggested that QIS5 should be used

to collect data in order to revise the calibration the non-life premium and reserve risk sub-module. How could this be done? In particular:

a. Which kind of data would need to collected for this purpose?

b. How could the data be used to revise the calibration?

c. How could the practicability of the data collection be ensured?

d. How could any confidentiality issues in relation to the provided data be addressed?

e. How could be ensured that the data is not biased (for example, that only data with low volatility are provided)?

Data to be collected

D2. CEIOPS proposes to collect run-off triangles and historic series of premi-ums by company, line of business and accident year. The data could be

collected during QIS 5 using the same specification and in the same for-mat as collected by CEIOPS for the non life and health calibrations.

Use of data to revise calibration

D3. The calibration process used by CEIOPS prior to QIS 5 could be re-run us-ing the new data collected.

Practicability of the data

D4. As part of QIS 5 CEIOPS could provide all undertakings in EU with a tem-plate so that they can provide their data. Data would be submitted at the

same time and in the same format by all undertakings. Regulators should provide all data received to CEIOPS and this should be collected into a

centralised database.

D5. Under supervision by CEIOPS, the exercise could be carried out preferably

by CEIOPS or by a centralised task force.

Confidentiality of the data

D6. CEIOPS should ensure confidentiality. A standardization process can ad-

dress the confidentiality concerns, as was done in the calibration process pre-QIS 5, however standardization is a source of bias. Enlarging the

number of ranges in standardization (e.g. 4 instead of 3) could improve this drawback.

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D7. There is generally a trade-off between reinforcing confidentiality and the statistical quality of the resulting analysis. For example a process of ran-

dom sampling the database per country could improve the confidentiality, but is detrimental to the overall size of the database used.

Avoidance of bias in the data

D8. This issue cannot be fully addressed in QIS 5, because data cannot be fully audited. Consistency checks should be put in place by the local supervi-

sors. Further guidelines should be developed to avoid and/or detect any manipulation of data.

E. SCR standard formula – undertaking-specific parameters

Excel-support for calculation of standardised methods

E1. With regard to undertaking-specific parameters the Commission raised the question „The QIS5 technical specifications define several complex stan-dardised methods for the calculation of undertaking-specific parameters.

Would it be possible to support the application of these methods in QIS5 with excel tools?‟

E2. CEIOPS can provide Excel templates as part of QIS 5 that can replicate the methods proposed for the use of undertaking specific parameters.

Premium risk methodology

E3. When DOC-71/10 (former CP75) was issued, the standard volatility factors for the non-life premium risk and reserve risk elements of the standard

formula were expressed on a net of reinsurance basis, consistent with the calibration work done as part of CP71.

E4. CEIOPS subsequently revised its advice for non-life premium volatility fac-

tors to be on a gross basis, with the application of an undertaking specific adjustment factor to allow for non-proportional reinsurance. As a result of

this change there are potential implications for the USP advice, which should be clarified.

E5. The current advice is that undertakings use their own data (or suitable ex-

ternal / pool data) to determine a user specific standard deviation, which is then blended with the standard factor to come up with the USP. For

premium risk two possible approaches can be identified that could be adopted:

Method A: Undertakings would use gross data to come up with a

gross user specific standard deviation. This would then be blended with the gross standard factor to produce a gross USP to which the

usual adjustment factor for non-proportional reinsurance would be applied.

Method B: Undertakings would use data net of reinsurance as en-visaged in the original CP75 advice. This would result in a net un-dertaking specific standard deviation. This would then need to be

blended with a net standard factor – and this could be defined as the gross standard factor to which the usual adjustment for non-

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proportional reinsurance is applied. The result would then be a net USP, which, importantly, would then not need to be further ad-

justed when used within the Standard Formula.

E6. CEIOPS takes the view that the preferred approach for determining the

premium risk USP would be to use method B above – i.e. for an undertak-ing to calculate the USP based on its own data net of reinsurance. We be-lieve that this would give the best potential allowance for non-proportional

reinsurance, as it would be better able to deal with the specific details of the reinsurance programme (such as inner aggregates and limited rein-

statements) than the currently proposed adjustment for non-proportional reinsurance.

E7. However, it should be allowed for undertakings to adopt method A if they

considered this was more appropriate. As with their choice of which method(s) to use for their undertaking specific standard deviation, under-

takings would need to justify why they have chosen method A, instead of the default method B.

E8. If the Commission introduces changes to the premium volume measure to

be gross of excess of loss reinsurance, as included in its recent draft Level 2 implementing measures (IM28), then care will be needed if USP under

option B is adopted. These should be applied to the former net of reinsur-ance premium volume measure to prevent over-statement of capital re-

quirements. Strictly, if there is insufficient data to achieve full credibility for the undertaking‟s own result, there should be a similar level of credibil-ity applied to the net of reinsurance premium volume measure – however

since undertakings will probably be seeking to gain the maximum possible credibility for their data, on proportionality grounds, it is probably accept-

able to adopt the simplified approach of simply using a net premium vol-ume measure.

Use of pool data

E9. At present the advice does not include any different methods for use with pool data. The current methods for premium and reserve risk have been

expressed in terms of data from a single undertaking, and so may not be appropriate for use with pool data without further adjustment. Generally, there is a danger that standard deviations produced will be representative

of the whole pool of data, and not that for the undertakings participating in the pool – and so risk being too low as they will be more appropriate for

a larger organisation.

E10. To address this risk, it is necessary to state clearly that pool data can only be used for a single undertaking when the data is representative for the

individual risk profile and nature of business of this undertaking. There-fore, in its advice CEIOPS restricted the use of pool data to only those un-

dertakings where this is the case.

E11. Nevertheless, an alternative approach could be to widen the conditions where pool data can be used. It is then necessary to state clearly what

methods can be used to estimate the volatilities based on pooled data. As a consequence new standardised methods could then be introduced to be

used based on pooled data consistent with the methods which were used for the non-life calibration exercise, as this was effectively performed us-

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ing data from several undertakings to derive standard deviations for a rep-resentative undertaking. This would ensure that the resulting factors are

consistent with the original calibration.

F. SCR standard formula – inflation indexed annuities

F1. The EC raised the following question: `Where annuities are inflation linked, the risk of a change in (expected) inflation rates does not seem to

be captured in the life underwriting risk module and the SLT health under-writing risk module. Is it necessary to capture this risk in the SCR stan-dard formula? If yes, how could it be done? (This question was raised by

the industry in our Health Task Force.)´

F2. CEIOPS noted that inflation risk can interfere with several risks modelled

in the standard formula: underwriting risk in Non-Life, Life and health in-surance, market risk (e.g. indexed linked bonds). CEIOPS has already in-cluded some aspects of these interactions but not all in the standard for-

mula: some issues have been identified, but not fully addressed. The risk associated with inflation indexed annuities has not yet been fully ad-

dressed.

F3. If this risk is to be included, CEIOPS proposes to address this risk within existing related modules: two candidates would then be the "Revision risk

module", whose scope could be extended to capture the variation of the annuities due to inflation. The "Expense risk" sub-module already captures

the variation of expenses due to inflation, but not the variation of the an-nuities due to inflation: it would be less logic to extend its scope than the "Revision risk".

F4. To achieve an explicit recognition, an alternative option could be to create a specific sub-module in Health risk and Life risk. Under this option, other

specific inflation sub-modules could then be considered to address other inflation related issues in other modules. However, this option would cre-ate more complexity within the standard formula.

G. SCR standard formula – factor method in catastrophe risk

G1. The current QIS 5 specifications for catastrophe risk under the standard formula can be summarised as follows:

Method 1 – Standardised Scenarios

Gross scenarios covering EEA countries

Aggregate by country and peril for natural and man-made

cats

Need to be netted down using undertaking‟s reinsurance

programme

Inappropriate when:

Undertakings have exposures outside the EEA

Undertakings write NPL reinsurance that cannot be re-flected properly by the scenario

Undertakings write miscellaneous business

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Method 2 – Factor Method

Factors for 13 different events

Apply to net written premium for forthcoming year to give gross single event sizes

Need to be netted down using undertaking‟s reinsurance programme

Applies when:

Standardised scenarios not relevant (e.g. exposure out-side EU) and partial internal model route is not feasible

Undertakings write miscellaneous line of business

Undertakings write NPL reinsurance that cannot be re-flected properly by the scenario

Issues identified

G2. There are a number of mistakes in the current QIS 5 specifications. The

QIS 5 specifications was based on an old version of the task force docu-ments and unfortunately the updates did not get through appropriately. The factor method is not explained correctly.

G3. We need to be clear about:

How should methods be combined, if at all?

E.g. Method 1 and Method 2

Need to be clear about how the calculation should work:

Split of premium between events

Factors correspond to single event

Combination of factors allowing for correlation (e.g. be-

tween direct and reinsurance business)

Consider allowing factors by country:

Reinsurance may differ by country so easier to net down

Easier to integrate with standardised scenarios

Additional clarity should lead to a more consistent approach to cal-

culating net factors

Potential solutions

G4. The current advice is confusing and stakeholders do not understand how the standardised scenarios and factor method will interact. We propose that the additional clarifications are introduced:

Should an undertaking have an exposure profile that is mixed: for example :

EEA and non EEA

EEA and miscellaneous

EEA non proportional reinsurance and other EEA

They may use the standardised method for the exposures that meet the criteria and the factor method for the remainder.

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G5. Undertakings using the standard formula should use the standardised methods for the exposures where this is possible and where it is not they

should use the factor method, i.e. a combination should be allowed.

G6. The design of the factor method: To allow a practical combination of the

standardised methods and factor method it would be best if the factors were country specific. Reinsurance may differ by country so this would make it easier to calculate net exposures, and also easier to integrate with

standardised scenarios which are also split by country. CEIOPS is not able to provide factors by country so we would propose to have the same fac-

tors for all countries. Splitting premium by country, although key to combining methods, may prove tricky for some so there may need to be suggestions of acceptable proxies, e.g. proportionate to exposure.

G7. CEIOPS suggests that generally losses are combined by assum-ing independence of events and 100% correlation between direct and NPL

reinsurance for the same line of business.

G8. The calculation of the factor method is not clear. We should add:

Factors represent a single event. This is a simplification of the

standard formula.

The premium for a given line of business should be split between

different events before applying the factors.

The factors are gross and this should be stated clearly.

The premium input should be gross written premium.

G9. The formulae in QIS 5:

The current formula for the capital charge for the non-life CAT risk:

2

12,10,4,3101044

2

121233

2

ttt PcPcPcPcPc

Should be replaced by:

13,10,9,8,7,4

2

121266

2

2

1111

5,3,2,1

2

t

tt

t

ttCAT PcPcPcPcPcNL

The rationale for the revised formula is that it assumes events are inde-

pendent, except for direct and non-proportional reinsurance business, which are 100% correlated as per QIS4 (Major MAT disaster is correlated with NPL MAT and the events that affect Fire and property are added to-

gether assuming independence and then correlated with NPL Property).

G10. Finally, the catastrophe standardised scenarios allow for geographical di-

versification. However we do not mention this anywhere. If we don‟t then this should be stated clearly. If we do we need to state this explicitly.

H. Design and calibration of the Health underwriting risk module

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H.1. CEIOPS was involved in the Task Force set up by the Commission where stakeholders, Commission and CEIOPS discussed a revised segmentation

and accompanying calibration of the module. CEIOPS has also been dis-cussing the introduction of the use of risk equalization pools in this area.

H.2. The main issues discussed in the Task Force were as follows:

The Definition of Health insurance obligations

Segmentation of Health Non-SLT business

Calibration of risk factors according to the revised calibrations

Risk equalisation mechanisms

Definition of Health insurance obligations

H.3. During the discussions the industry had proposed a definition of health insurance obligations which differs from the CEIOPS definition. CEIOPS

continues to support its definition and does not consider the industry pro-posal to be more appropriate.

Segmentation of Health Non-SLT business

H.4. It is envisaged to introduce a segmentation for Health Non-SLT business into:

Medical Care

Income Protection

Workers compensation

H.5. CEIOPS generally supports this new segmentation. However, it does not

seem clear whether some accident products may fall outside this Health segmentation and would lead to a accident LOB under Non-Life insurance.

H.6. Consistent with previous advice, for the purposes of calculating the stan-

dard formula CEIOPS proposes to apply a decision tree to allocate insur-ance contracts to one of the underwriting risk modules (i.e. health under-

writing risk, life underwriting risk and non-life underwriting risk), using the definition of health insurance obligations in a first step to decide whether a contract should be treated under the health module. Following this ap-

proach would clarify to what extend accident products would have to be treated within the health risk module.

Calibration

H.7. Based on the discussions in the Health Task Force and additional data re-ceived CEIOPS is carrying out a revised calibration according to the new

segmentation of Non-SLT Health insurance as outlined above.

H.8.

I. Own funds – restricted reserves

I.1. The EC raised the following question: `Paragraph OF.13 sets out the treatment of restricted reserves in the determination of eligible own funds.

These reserves should only be eligible for inclusion in own funds in relation to the risks they cover.

15/37 © CEIOPS 2010

a) What does "the risks they cover" mean and how should it be quanti-

fied?

b) We are concerned that the approach does not lead to consistent out-

comes. For example, let an undertaking be exposed to three risks A, B

and C. Let A and B be independent and be of size 100 each. Let the ag-

gregate risk A + B be SQR(100^2+100^2) = 141. Let's assume the

undertaking has a restricted reserve of 200 that can cover the risks A

and B. Then only 141 of the restricted reserve are eligible for Tier 1.

Now assume another undertaking is exposed to the same risks, but has

two restricted reserves of each 100 that can only cover the risks A and

B respectively. Then for each restricted reserve an amount of 100

would be eligible. Consequently, the first undertaking has less eligible

own funds (141) than the second undertaking (200), although the own

funds of the second undertaking are more restricted. Is the example in

line with CEIOPS' approach to restricted reserves? How can its outcome

be explained?

c) We understand that a solution to the issue illustrated in the above ex-

ample could be to eliminate diversification from the quantification of

the risk that the restricted reserve covers. However, this may raise

some technical and practicability issues. Has CEIOPS analysed such an

approach?´

Definition and quantifications of risks covered by restricted reserves

I.2. The type of risks covered by restricted reserves will generally be specified in the national legal frameworks of those Member States where restricted

reserves are established in the financial statements. For example, in one member state non-life undertakings establish a type of restricted reserve which shall cover losses in the insurance business, comprising both the

technical insurance result and part of the investment result. In this case the related SCR capital requirements could be used in order to quantify

the risks covered by the restricted reserves.

I.3. CEIOPS notes that typically restricted reserves are not associated with any

specific restricted assets or liabilities in the insurer‟s balance sheet; in-stead, typically any assets could be used to meet losses in respect to risks covered by the restricted reserves. This implies that generally it would be

challenging to apply a `notional SCR´ as it will require identifying ele-ments of the undertaking‟s SCR which relate to the risks covered by the

restricted reserve.

Treatment of cases where restricted reserves cover several risks

I.4. The Commission seeks to understand how consistent outcomes might be

achieved in the treatment of this item. It cites an example where two in-dependent risks where a restricted reserve can cover both leads to a lower

recognition of own funds as compared with the same fact pattern but with two restricted reserves each covering the respective risks.

I.5. In order to address this apparent inconsistency we must first note the

Commission‟s draft implementing measure (IM33) on ring fenced funds

16/37 © CEIOPS 2010

which also applies to restricted reserves. So it is important that there is consistency between RFF and restricted reserves.

I.6. In CEIOPS advice on RFF it recommends using the notional SCR for the RFF as the measure for determining whether any adjustment to exclude

own funds in excess of the notional SCR is needed. One option considered was whether the test should be against the contribution of the notional SCR to the overall SCR. This is similar to the approach envisaged for

groups when own funds which are only available to cover a subsidiary‟s solo SCR are restricted by reference to the contribution of the SCR to the

group SCR – ie after adjusting for the effects of consolidation and diversifi-cation.

I.7. With respect to RFF it was considered that a simpler method was needed

given that this area was already one which has proved difficult for stake-holders to grasp. And while the use of the notional SCR itself could over-

state the recognition of own funds – and, as noted above, may be chal-lenging - it was considered in the detailed work on this that a clear and straightforward approach would be simpler to apply in practice.

I.8. On this basis and unless an alternative and more simple approach could be derived it would seem appropriate to follow the same approach for the

quantification of risks covered by restricted reserves so that the treatment would be the same for both cases in the Commission‟s example. However,

this does not imply that it would necessarily be appropriate to treat the amount of own funds exceeding the risks associated with RFF and re-stricted reserves in the same manner. For example, in many cases a re-

stricted reserve is available for covering all types of losses in a winding-up situation. It could then still be appropriate to include any excess of the re-

stricted reserves over and above the level of covered risks as a lower tier item in the own funds of the undertaking, instead of excluding such an ex-cess as would be the case under the RFF framework.

I.9. It should be noted that the above does not undermine the case for the groups treatment where the adjustments for lack of availability of own

funds at group level may arise in respect of a significant number of group members and where the impact of intra-group transactions is also a major factor. The examples cited by CEIOPS at the QIS 5 stakeholder meeting on

30 April meeting clearly demonstrated this.

J. Own funds – expected future profits

J.1. CEIOPS in its comments on QIS5 draft technical specifications presented three different approaches for the calculation of the profits included in fu-ture premiums: one alternative using the calculation of technical provi-

sions as an starting point (actuarial principles), another alternative based on own funds subtracting identifiable individual capital components and a

final set of alternatives based on the lapse risk charge.

17/37 © CEIOPS 2010

J.2. CEIOPS further considered the methods of the calculation of profits in-cluded in future premiums and finally suggest to use method 3 - Calcula-

tion based on the assumption that no contract has any additional pre-miums (calculation based on the same assumptions as where the future

premiums are considered – therefore this calculation will apply neither contractual lapse-penalizations shall apply, nor any assumption, even contractually set out, different than those used for the calculation of tech-

nical provisions). If the aforementioned calculation reveals difficult to run for some undertakings, a reasonable approximation within this method 3 is

the lapse value (excluding any penalty), although such proxy does not mean a change in the conceptual approach. Eventually a proxy to this me-thod 3 might be the calculation based on SCR Lapse module (method 4).

J.3. According to method 3, the value of profits included in future premiums could be estimated by calculating the difference in basic own funds be-

tween the current scenario and the scenario described in the previous pa-ragraph.

J.4. According to method 4, undertaking will need to consider the value of the

SCR Lapse as an approximation of the profits included in the future pre-miums (no additional calculation is needed by the undertaking in this

case).

J.5. We have received preliminary feedback from industry supporting this

choice of methods in order to quantify profits included in future premiums. They highlight that the additional calculation required differs from the ex-isting SCR lapse calculation and hence would require additional work.

However, they recognise that such an approach, subject to some refine-ments to the methodology and in particular the intended definition of lapse

could be used to estimate the item.

J.6. Following this preliminary feedback CEIOPS intends to refine method 3 such that the term „lapse‟ for the purpose of this calculation means that

the policyholder exercises the option to cease paying future premiums. The precise impact of this will vary depending on the product type. For

some contracts, it may be appropriate to assume that they are cancelled, for other contracts it may be appropriate to assume that they will be run-off with no further premiums paid. For contracts for which no future pre-

miums would be expected (in particular, for insurance contracts with sin-gle premiums paid at inception), the calculation would not apply.

K. Own funds – participations

K.1. CEIOPS attempted to reconcile the various outcomes being sought in re-spect of a treatment of participations. In the annex CEIOPS presents a po-

tential approach to determine a risk charge for participations which takes account of the very different exposures they represent on account of their size – both in terms of the undertaking and the interest held by the partic-

ipating undertaking – their business models, their relative levels of risk/exposure and their value.

K.2. This approach was supported by a majority of Member States as it adopts a risk based approach, and it links the risk charge for a participation in an

18/37 © CEIOPS 2010

insurance undertaking to the SCR of that insurance undertaking – reflect-ing that different participations carry very different levels of risk.

K.3. We note that this approach could be used

to either calibrate or substantiate the percentage factor in an equi-

ty risk charge approach for participations (i.e. a capital charge which is measured as the loss in the basic own funds that would result from an instantaneous decrease of a pre-specified percen-

tage in the value of the participation); or

as a potential alternative, more risk-based methodology to mea-

suring the risk arising from the participation.

The description of the approach in the annex also indicates that a combi-nation of the above could be possible, by e.g. measuring the capital

charge in terms of one of several „percentage buckets‟, where the alloca-tion to one of the buckets would depend on the strategic nature of the

participation as well as on the SCR of the participated undertaking.

K.4. However a minority of CEIOPS members is convinced that participations should be treated as equity investments and therefore be subject to a re-

duced equity risk charge approach based on the market value of the par-ticipation, and support the 22% calibration. Hence they consider that using

the approach outlined in the annex as an alternative methodology would not be in line with the Level 1 text.

K.5. In order to substantiate the 22% charge in the draft QIS 5 tech specifica-tions with regards to participations in strategic related undertakings, CEIOPS recommends to gather the relevant data in QIS5 which would be

needed to carry out a more risk-based approach as outlined in the annex (i.e. own funds and SCR of the strategic participations). Such information

could support an assessment of the appropriateness of a 22% capital charge for strategic participations after the QIS5 exercise.

19/37 © CEIOPS 2010

Annex 1: Impact Assessment Analysis

Background

1. At the end of March 2010, the Committee of European Insurance and Oc-cupational Pensions Supervisors (CEIOPS) provided the European Commis-

sion (EC) with the Draft Technical Specifications for the Fifth Quantitative Impact Study (QIS5) exercise, which is scheduled to start in mid-August.

These specifications were based on previously published CEIOPS Level 2 advice, with some (generally minor) adaptations to achieve a coherent document for the purpose of developing a QIS exercise and taking into ac-

count additional guidance which CEIOPS received from the EC on specific issues.

2. Along with the Technical Specifications, CEIOPS provided an exhaustive calibration paper, as the main support to the calibrations proposed. Fur-thermore, CEIOPS delivered a preliminary impact assessment of the Tech-

nical Specifications, comparing the expected results of the new design and calibration of the standard formula, the calculation of technical provisions

and the assessment of available own funds with those tested in the previ-ous exercise (QIS4).

3. The preliminary impact assessment was subject to a large range of neces-

sary assumptions. It evidenced an overall estimated increase of the SCR by 50%, compared to QIS4. Regarding technical provisions, an overall

quantitative assessment was not possible, as the relevant parameters and calculation methods were still under discussion, and in many cases the data required to perform a full analysis did not exist; instead a qualitative

analysis with several examples was produced. Concerning own funds, in the preliminary impact assessment CEIOPS noted that the main changes

from QIS4 to QIS5 stemmed from the new methods introduced in the valuation of technical provisions (for example relegating certain capital to tier 3).

There are other potential drivers of a change in the amount of own funds, such as the exclusion or restriction of any items for available own funds

(e.g. in relation to expected future profits) and the operation of the limits structure to identify those owns funds eligible to meet the SCR and MCR.

CEIOPS has noted that the comparison of these with QIS4 is extremely practically difficult, as significant changes have been introduced, and the information available is insufficient to allow a proper assessment.

CEIOPS wishes to stress that it is extremely important to consider the re-sults of these preliminary impact assessments with caution, given the

technical challenges, assumptions required, and impossibilities in deliver-ing an accurate quantitative evaluation, using the available information.

4. On 15th April 2010, the EC started its consultation of the QIS5 Technical

Specifications. For this consultation, a number of significant changes have been introduced in the Technical Specifications, as other stakeholders‟ in-

put and Commission‟s own work were also taken into account. The main changes introduced were highlighted in the cover note that accompanied the consultation package provided by the EC.

5. The purpose of this note – which supplements CEIOPS‟ earlier impact as-sessment exercise - is to provide detail on how we consider the latest draft

20/37 © CEIOPS 2010

QIS5 is likely to change our previous impact assessment, we have used our previous work as a starting point, and only modified areas where the

Commission‟s draft differs from CEIOPS‟. Whereas current discussions tend to focus on isolated parts of the framework (SCR, discount rates, technical

provisions, own funds), CEIOPS considers it to be fundamental to provide an integrated view of expected Solvency II impacts, as the framework stands today. Attention must be given to the fact that all changes intro-

duced in any specific area have a “domino” effect over the entire solvency regime. Therefore, different subjects should not be discussed in isolation,

since the sum of the small impacts, when taken in by themselves, may add up to significant aggregate changes, which could jeopardize the main objectives of the Solvency II regime. For example a change which in-

creases the standard formula SCR for a particular business line may be dwarfed by a change which reduces technical provisions for the same line,

a holistic approach must always be considered.

6. Therefore, CEIOPS considers there is a danger that a debate which focus on very specific areas (such as recent discussions on one or two SCR sub

modules), may lead to the overall picture being neglected. We urge that all decisions consider the overall picture of the balance sheet, and that the

underlying principles of market consistent technical provisions coupled with appropriate calibrated 1:200 capital requirements is always kept at

the forefront of the debate.

7. In spite of the inherent difficulties behind an impact assessment exercise already highlighted, this note attempts to approach this issue from an in-

tegrated perspective, and to give a picture of how we consider the latest commission proposals may alter the QIS5 balance sheet.

QIS4 Information

8. To enable the rough impact assessments presented in the following sec-tion, some information was collected regarding QIS4.This was mainly

achieved through an issue of an information request to QIS4 analysts. An IT tool was developed which, after direct application to a QIS4 database,

returned the average balance sheets of QIS4 participants, split by type of undertaking. In this data collection exercise, data from 23 countries1 was received. Furthermore, some additional information relating to QIS4 was

gathered, which is publicly available in the QIS4 Report and its Annex of Selected Tables.

9. It is important to highlight that the results used for this preliminary as-sessment refer to end-2007, the reference date of the QIS4 exercise. Much has changed since then, so additional precaution should be adopted

when analysing the results of this impact assessment exercise.

1 AT, BE, BG, CY, CZ, DE, EE, ES, FI, HU, IE, IT, IS, LT, LU, LV, MT, NL, PL, PT, SI, SK, UK

21/37 © CEIOPS 2010

Figure 1: Average balance sheets of QIS4 participants weighted average BS composition All Life Non-life Composite Reinsurer Captive

Total Assets 100% 100% 100% 100% 100% 100%

Reinsurance 6% 5% 9% 3% 11% 9%

Investments 58% 51% 65% 77% 73% 60%

Unit-linked investments 21% 32% 0% 8% 1% 0%

Other assets 15% 12% 26% 12% 15% 31%

Total Liabilities 100% 100% 100% 100% 100% 100%

Own Funds 16% 9% 29% 21% 24% 51%

Best Estimate 51% 49% 54% 56% 47% 38%

Risk Margin 2% 2% 2% 2% 7% 2%

Unit-linked liabilities 22% 34% 0% 7% 1% 0%

Other liabilities 9% 6% 15% 14% 21% 8%

10. Other important information, to better assess the likely impact of the cur-rent proposals in QIS5 could be found in the QIS4 Report:

Average duration liabilities (life) 10,3 years

Average duration liabilities (non-life) 3,7 years

Eligible own funds – Total 873.231 mill. euros

Eligible own funds – Tier 1 825.720 mill. euros

Eligible own funds – Valuation adjustments to liabilities 124.573 mill. euros

QIS5 Impact Assessment

11. Regarding the design and calibration of the standard formula, this

has been one of the subjects most criticized by stakeholders, arguing that CEIOPS has proposed a too high calibration, beyond the desired confi-

dence level, which will imply a generalized need to raise additional capital across the European insurance market.

12. CEIOPS would like to stress the following points:

The changes in SCR should not be analysed in isolation to changes in technical provisions. In many cases QIS5 has a higher SCR charge

than QIS4, in order to be more in line with a 99.5% VaR measure, but simultaneously has a lower TP measure in order to have market consis-tency in technical provisions. These measures offset, so that overall

capital held will not increase to the magnitude suggested by a solely analysis of the SCR.;

Furthermore, the changes introduced by the EC in the draft Technical Specifications are expected, according to a CEIOPS initial approxima-tion, to translate into a significant reduction in the increase of capital

requirements in QIS5, when compared to QIS4, from 50% to roughly 35%. This means a reduction of about 10% in the anticipated QIS5

capital requirements.

13. Concerning the calculation of technical provisions, CEIOPS would like to stress the existence of several innovations in QIS5, when compared to

QIS4, which will lead to a lower level of technical provisions. Given the

22/37 © CEIOPS 2010

composition of the average stylized balance sheets presented above, dif-ferent impact can be anticipated, depending on the type of undertaking:

a. Concerning life business, an impact of 1:9 can be expected to take place (meaning that, for each 1% decrease in insurance liabilities

(best estimate and risk margin, including unit-linked), a 9% in-crease in available own funds will materialise);

b. Regarding non-life business, this ratio would be of about 1:2;

c. For composite undertakings, a ratio of 1:3 was calculated.

14. Given the lack of information regarding the liabilities‟ cash-flows used by

the undertakings to estimate their technical provisions in QIS4, it is not possible to perform a detailed quantitative assessment of changes intro-duced in QIS5. Therefore, the impacts presented below are the result of

simplified calculations, mainly based on the duration of liabilities identified in QIS4.

for life business, the introduction of a liquidity premium, assuming that 10% of total liabilities would fall under the 100% bucket, 0% of total li-abilities would apply the 0% liquidity premium and the remaining would

fall under the 50% bucket, considering an average duration of 10 years, would imply a reduction of technical provisions by about 3.5%

(and a correspondingly much higher increase in own funds). Regarding non-life business, QIS4 evidenced an average duration of about 4

years, with 25% of cash-flows in the first year, leading to a 1% poten-tial reduction (with again, a higher increase in own funds). CEIOPS notes that these estimations were performed assuming a 53 bps liquid-

ity premium (as proposed for the Euro interest rate term structure). It is important to clarify that for the purpose of this estimate, the liquidity

premium was assumed to be an additive, flat adjustment to the entire curve.

Type of business

Level of Illiquidity Premium Assumed

(Consistent with origi-nal impact assessment

report)

% of Technical Provisions

with 100%

Illiquidity Premium applied

% of Technical Provisions

with 50% Illiquidity Premium applied

% of Technical Provisions

with no Illiquidity Premium applied

Mean average duration of Tech-nical Pro-

visions (Rounded

QIS4)

Mean average duration of Tech-nical Pro-

visions for which 100%

Illiquidity Premium applied

Estimated reduction in Best

Estimate of Tech-nical Pro-visions

Life Insur-ance

53bps 10% 90% 0% 10 years 20 years 3,5%

Non-Life Insurance

53bps 0% 75% 25% 4 years N/A 1%

The introduction of diversification in the risk margin will also lead to

further reductions in the overall amount of technical provisions. QIS4 evidenced that, on average for both life and non-life undertakings, the

risk margin represented about 2% of the total balance sheet, or about

23/37 © CEIOPS 2010

2% and 4% of total technical provisions (including unit linked), respec-tively, for life and non-life. CEIOPS estimates that the introduction of

diversification may lead to a reduction of about 1/3 for life undertak-ings, and 1/2 for non-life firms, meaning that, in following the same

order as above, a further 1% and 2% reduction in overall technical provisions can be expected to take place.

Type of business

Risk Margin as % of Best Estimate of Technical Pro-

visions

(Weighted aver-age from QIS4)

Assumed Diversifi-cation Benefit

Estimated reduc-tion in Technical

Provisions

Life Insurance 2% 1/3 1%

Non-Life Insur-

ance 4% 1/2 2%

Regarding the discount rates used to assess the amount of technical

provisions, the EC proposed the use of swap rates adjusted to eliminate credit risk. For QIS5, a 10 bps adjustment is being proposed. QIS4 was based on unadjusted swap rates. CEIOPS estimates that the impact of

the change to be broadly a 1% increase in life technical provisions and a 0.5% increase in non-life technical provisions. In addition, CEIOPS

considers that such an adjustment may be under-calibrated. The im-pact of a larger credit adjustment could be assessed based on the sen-sitivity calculated above. Some expert opinions collected by CEIOPS in-

dicate an underestimation ranging up to 40 bps, by end-2009.

Type of business

Mean average duration of Tech-nical Provisions (Rounded QIS4)

Estimated reduc-tion in Best Esti-mate of Technical

Provisions

Life Insurance 10 years 1%

Non-Life Insur-ance

4 years 0.5%

15. The inclusion of future premiums in the calculation of technical provisions

may also have a significant impact, although it is not possible to accurately assess it, as it is not clear how such calculations have been carried out by undertakings in QIS4 (the degree of future premiums incorporated in the

best estimate calculations). This is also a broader and complex subject, re-lated to the definition of the boundaries of insurance contracts, and the

recognition of profits included in future premiums as a component of eligi-ble own funds, as approached in the following paragraphs.

24/37 © CEIOPS 2010

16. In the area of own funds, little information is available to allow proper estimations of the impact of changes proposed in the QIS5 Technical

Specifications, when compared to QIS4.

17. One of the areas under discussion is the classification of profits embedded

in future premiums taken into account in the assessment of technical pro-visions. CEIOPS proposed that these should be separately calculated and included in Tier 3, which would be taken into account for the calculation of

the coverage ratio of the SCR, subject to a 15% cap (in % of the SCR). EC followed a different approach when drafting the QIS5 Technical Specifica-

tions for consultation, but remains open to test all options in QIS5. Re-garding this issue, CEIOPS would like to highlight the fact that QIS4 data evidences that, even if the full reduction in liabilities (mainly technical pro-

visions) observed was attributed to this effect (which means assuming 100% of valuation adjustments to liabilities, identified as a Tier 1 capital

element, stem from the profits embedded in future premiums – this is a clear overestimation, as such valuation adjustments may also result from other changes), and classified as Tier 3, this should have little impact on

the coverage ratios of insurance undertakings, as this own funds element would only represent about 14,3% of total own funds and the remaining

Tier 3 elements represent only about 1% of total own funds. With respect to the overestimation of the amount as mentioned above, the restriction

that the amount of Tier 3 items must be less than 15% of the SCR should therefore not effect undertaking‟s solvency position.

18. Regarding other issues affecting own funds, such as grandfathering, tier-

ing system and limits and the treatment of participations, it is not possible to provide a quantitative assessment of changes introduced by EC, due to

lack of detailed information. However CEIOPS have undertaken research on the amount of hybrid capital in issuance in Europe. We believe around €80bn of hybrid capital exist in Europe, with maybe nearly half of it being

classified as tier 1.

Conclusions

19. With this note, CEIOPS provides further detail in the assessment of the potential impacts of the main changes introduced in the QIS5 exercise, taking QIS4 as a starting point.

20. The development of a quantitative evaluation of the impact of the new proposals is a very difficult task to complete, due to the lack of detailed in-

formation regarding specific elements necessary to replicate all QIS calcu-lations performed by participants.

21. Regarding the standard formula SCR, CEIOPS has attempted to revise our

estimate of the change from QIS4 to take into account the commissions most recent proposals. As such new set of assumptions were broadly

equivalent with the ones described in the original IA Paper developed by CEIOPS, the most material changes were in respect of the equity risk sub-module (where the increase from QIS4 to the commissions‟ proposals is

perhaps half the increase from QIS4 to CEIOPS‟ final advice). It should be noted that there are various limitations to the exercise, not least the in-

tangible asset risk module and symmetric adjuster for equity were not modelled, and the treatment of non proportional reinsurance and geo-

25/37 © CEIOPS 2010

graphical diversification were significantly simplified. CEIOPS‟ rough esti-mate of the increase in the standard formula SCR with respect to QIS4 has

decreased from 50% (on the QIS5 specification draft from CEIOPS) to 35% on the commission draft specification.

22. The results of the work carried out evidence the existing interconnections between the different components of the Solvency II framework (valuation of assets and other liabilities, technical provisions, SCR and own funds).

Such interconnections stress the need for an integrated evaluation of the impacts of the new solvency regime, as particular item-specific analysis

will likely fail in capturing such second order impacts. This approach also made evident the existence of compensation mechanisms intrinsic to the Solvency II framework, which will largely contribute to its overall equilib-

rium and stability.

23. CEIOPS stresses, once again, the relevance of a holistic approach in the

assessment of QIS5 impacts, when compared to QIS4. An excessive focus in very specific issues, one at a time, might hinder the ability to assess the overall picture and impacts, therefore leading undesirable results and fail-

ure to deliver a framework consistent with the demanding requirements of the Level 1 text.

24.Although only a couple of points were approached in this note, CEIOPS would like to highlight that, taking QIS4 results as the starting point, a

number of impacts have been identified leading to a reduction in technical provisions (5.5% for life, and 3.5% for non-life business), which would be translated into significant own funds increases (49.5% for life and 7% for

non-life business). These impacts are expected to be heavily dependent on the profile of liabilities of each specific undertaking, and their overall im-

pact may easily exceed the estimated increase of capital requirements leading to a final overall capital requirement lower under QIS5 than QIS4. This would be due to the leverage effect embedded in undertakings‟ bal-

ance sheets, as presented above. This fact cannot be neglected when de-fining the final methodologies and parameters to be tested in QIS5.

26/37 © CEIOPS 2010

Annex 2 Outline of an approach to participations

1. The following is an attempt to reconcile the various outcomes being sought in respect of a treatment of participations. These outcomes or objectives can be summarised as follows:

Consistency with Level 1 text – specifically providing a risk charge

which can be distinguished from global / standard equity risk charge for strategic participations

Delivers the benefit of a risk charge that represents lower risk / volatil-

ity for strategic participations; Risk based approach that reflects the economics of the exposure

Ensures a prudent treatment of the solo position of the participating undertaking.

Consistency with CEIOPS majority view

Potential to accommodate CEIOPS minority view

2. Within the equity risk module there are currently 3 candidates for risk

charges which have been derived or calibrated to cover specific constitu-encies and which may or may not be relevant for participations. Setting aside any concerns as to their relevance they nevertheless represent

points in the spectrum of potential risk charges.

3. So the challenge is to determine how to calibrate a risk charge for partici-

pations which takes account of the very different exposures they represent on account of their size – both in terms of the undertaking and the interest held by the participating undertaking – their business models, their rela-

tive levels of risk/exposure and their value and achieve the objectives above.

Taking insurance participations as a starting point:

4. The valuation of the participation will be determined by reference to the valuation methodology – market price where listed and adjusted equity

method where not.

5. The adjusted equity method is essentially the net asset value of the par-

ticipation on a Solvency 2 basis – in other words the participating under-taking‟s share of the basic own funds of the participation. (To keep this simple assume that the participation does not have external subordinated

debt).

6. What is the shock to which this value is exposed on a 99.5% confidence

level under Solvency 2 and how can we calibrate it? In fact the SCR of the participation represents exactly this concept. So we can calibrate the

shock by taking the percentage of the SCR of the participation to its basic own funds.

7. This percentage could then form a risk charge to be applied to the value of

the participation as held by the participating undertaking. It has the ad-vantage that it could meet all the objectives set out above but it also re-

flects the specificities of the participation. So where the participation is relatively highly capitalised versus its SCR this would be reflected in a low risk charge. However a thinly capitalised participation versus its SCR would

27/37 © CEIOPS 2010

drive a higher risk charge properly reflecting that more capital should be held by the participating undertaking against that risk of the loss of value

of its participation.

Could this be done in practice?

8. All the data required would be necessary either for the participating under-taking‟s solo calculations or for the group of which it and its participation forms part. So there is no additional calculation burden. (If the data are

not available or unreliable article 214 (a) might apply - suggesting a 100% risk charge.)

How could significant participations be distinguished from non-significant?

9. For the latter the current approach would be to use the relevant equity risk charge – 49% or 39%. These could be compared with the result of the

calibration referred to above and used as a floor. So non-strategic partici-pations could attract an equity risk charge which would be no lower than

49% or 39%, as appropriate.

10. Strategic participations could then reflect their reduced volatility by having no floor whatsoever. If the percentage calculated as above was as low as

5% then that would apply. However the converse would also be the case so that were the calculation to give a figure higher than any of the current

charges that higher percentage, sensitive to the risks of that specific case, should apply.

Could this be simplified?

11. Provided the calculations were carried out as set out above a stratified ap-proach could be developed. This would reduce the risk sensitive nature of

the approach but could enable risk charges to be banded albeit the choice of risk charge points might be arbitrary. However the existing options of

22%, 39/49% could form part of this with a further point to reflect high risk participations – 75-80% could form an upper bound.?

Could this apply to other types of participation?

12. CEIOPS advice distinguished financial non-regulated participations from other non-regulated participations. This was based on the fact that the

groups treatment envisages the calculation of a notional SCR. The ap-proach set out above could be applied mutatis mutandis substituting the notional SCR for the insurance participation‟s SCR.

13. The same proxy does not exist for non-financial non-regulated participa-tions. So it is more challenging to identify how a risk sensitive approach

can be derived other than by reference to the calibrated charges of 39% or 49% as for any other equities. This was as set out in CEIOPS advice. It should be noted that the concept of a strategic investment in this category

may not necessarily depend on the length of time it might be held which would bring into question the applicability of the 22% charge derived from

the duration approach.

14. However it should be noted that ancillary services companies would also fall into this category and the risk exposure of these entities may be of a

different order to what might otherwise be large equity investments. It

28/37 © CEIOPS 2010

may be appropriate for further consideration to be given to an appropriate risk charge for these entities. They may carry out activities essential to the

operations of the participating undertaking but other insurers may keep such activities within their own organisation. An economic approach should

reflect a similar outcome and not incentivise or penalise specific business models.

Participations example

15. Participating undertaking A owns

Participa-tion

A‟s % owner-

ship

SCR

NAV = basic OF of par-

ticipation

Risk charg

e %

Valua-tion in A

„s S2 balance sheet

Risk charg

e

Risk charg

e on Comm

1 100% 100 400

25% 400 100 88

2 100% 80 100 80% 100 80 22

3 60% 80 800 10% 480 48 105.6

4 60% 80 200

40% 120 48 26.4

5 listed 20% 100 400 25% 100 25 22

6 listed 20% 80 100 80% 18 14.4 3.96

7 (not stra-

tegic)

20% 100 400 25%

(49%)

80 39.2 39.2

8 (not stra-tegic listed )

20% 80 100 80% 30 24 11.7

9 (not stra-tegic listed)

20% 100 400 25% (39%)

100 39 39

Notes re examples above

1. well capitalised wholly owned subsidiary

2. thinly capitalised wholly owned subsidiary 3. Very high capitalisation – partly owned subsidiary 4. good coverage of SCR – partly owned subsidiary

5. well capitalised participation with market price above NAV 6. thinly capitalised participation with market price below NAV

7. Non strategic participation well capitalised but “standard other” applies as a minimum

8. Thinly capitalised (with market price below NAV) - risk charge based on

80% as it is higher than 39% 9. well capitalised participation (with market price above NAV) but standard

global applies as a minimum

Further work might be developed regarding the proposed floor and the capital

charge on positive and negative goodwill, where the participation is valued at market value.

29/37 © CEIOPS 2010

Annex 3: Details on analysis on covered bonds

Covered bond analysis - data

1. Information contained in Corporate Bond Indices from Merrill Lynch was used for the calibration. For the peergroup “EMU Corporates&Pfandbriefe”

(which also includes other types of covered bonds), a monthly rebalanced index covering all maturities (0-10Y+) and the AAA rating class is available

back to February 1999. For this calibration exercise, data until February 2010 has been used.

2. The monthly index composition of the index was downloaded from Bloom-

berg and a sub-index for covered bonds created. Then a split-up into new maturity buckets with a range of 1 year and a maximum time to maturity

of 10.5+ years (0.5-1.5Y, 1.5-2.5Y, ..., 9.5-10.5Y, 10.5Y+) was per-formed.

3. Given the composition at the beginning of each month, the daily yield

spread was downloaded for every issuance for the relevant month. All in all, 5,462 unique index members could be identified in the composition

lists; for 4,277 of these, daily time series of yield spreads were available in Datastream.

4. Especially for lower rating classes the monthly rebalancing of corporate

bond indices led to severe jumps in the time series, e.g. when a sparsely populated index with only two or three members was amended by a simi-

lar number of issues with significantly diverging spreads. For reasons of simplicity, the spread move at the first trading day of each month was therefore set to zero. For AAA-rated covered bonds, this procedure was al-

so applied in order to get consistent results.

5. Each portfolio spread series (rating & maturity) was first transformed into

a 3 month moving average function in order to smooth out short-term spikes. Then the rolling year-on-year difference was computed. Both the 99.5% quantile (for widening spreads) and the 0.5% quantile (for narrow-

ing spreads) were determined.

Results

6. The table below summarises the spread shocks for different rating classes and maturity buckets of the bond portfolio.

Fup AAA, covered AAA, non-covered

0.50 - 1.49 years 1.70% 2.63%

1.50 - 2.49 years 0.94% 0.95%

2.50 - 2.49 years 0.83% 1.74%

3.50 - 4.49 years 0.83% 1.64%

4.50 - 5.49 years 0.70% 0.83%

30/37 © CEIOPS 2010

5.50 - 6.49 years 0.51% 0.64%

6.50 - 7.49 years 0.71% 1.91%

7.50 - 8.49 years 0.33% 1.11%

8.50 - 9.49 years 1.71% 0.65%

9.50 - 10.49 years

0.28% 0.61%

10.50 years+ 0.39% 1.06%

Fdown AAA, covered AAA, non-

covered

0.50 - 1.49 years -0.85% -0.83%

1.50 - 2.49 years -0.70% -0.38%

2.50 - 2.49 years -0.79% -0.47%

3.50 - 4.49 years -0.69% -0.50%

4.50 - 5.49 years -0.72% -0.29%

5.50 - 6.49 years -0.72% -0.33%

6.50 - 7.49 years -0.52% -0.41%

7.50 - 8.49 years -0.62% -0.69%

8.50 - 9.49 years -0.58% -0.33%

9.50 - 10.49 years

-1.29% -0.36%

10.50 years+ -0.55% -0.41%

Table 2: Calibration results for function F

7. As some of the buckets exhibit some abnormal results due to low repre-

sentativeness, an asymmetrically truncated mean was calculated by delet-ing the two highest absolute values and calculating the mean with the re-sults for the nine remaining buckets.

31/37 © CEIOPS 2010

8. The final calibration of the functions Fup(Ratingi) and Fdown(Ratingi) for AAA-rated covered and non-covered bonds looks as follows:

Fup(Ratingi) Fdown(Ratingi

) Duration floor

Duration cap

AAA, cov-ered

0.6% -0.7% 1 -

AAA, non-covered

1.0% -0.4% 1 -

Table 3: Final calibration proposal for function F

32/37 © CEIOPS 2010

Annex 4: Details on analysis on spread risk charge for credit de-

rivatives

1. Both CEA and CRO Forum criticised the spread risk shocks for credit deriv-atives prescribed in the QIS5 Draft Technical Specifications (+600% and -

75% of the current spread) for being not in line with the respective cali-bration for bonds.

2. CEA has stated: “We request reconsideration of design of charge for credit derivatives. The capital charge for credit derivatives (widening of spreads by 600%, narrowing of spreads by 75%) has nothing to do with the

spread risk of the same underlying corporate bond, which depends on rat-ing and duration. How are these spread factors derived? Adding xBPs/

substracting yBPs (additive, not relative spread charge) was also more practicable. If simplifications in calibration are used, practicability should

be the focus. It is far easier to apply spread duration times additive spread widening than having to re-calculate the price of every single CDS for its “personal” spread movement.”

3. The CRO Forum has stated: “Credit Default Swaps should be treated in the same way as corporate bonds (i.e. based on the rating of the underlying

name). For the calibration of CDS in the spread module, CEIOPS should use the same data used in the calibration of bonds in the final advice (i.e. CDS data and not the real bonds index). A different CDS shock would give

the wrong risk management incentives: companies will optimize their SCR by including hedges either in the bonds module or in the CDS module (if

there is a large part of CDS where protection is sold, it will be cheaper to treat hedges in the CDS module since they will lead to a netting).”

4. The graph below depicts the highly volatile nature of capital charges by

applying relative shocks: The green line shows the initially proposed rela-tive capital charge of +600% of the current spread – especially in the

second half of 2008, this type of capital charge turned out to be highly procyclical.

0

200

400

600

800

1000

1200

01.2007 01.2008 01.2009

Max 1Yr Spread Widening

Absolute Capital Charge

Relative Capital Charge

33/37 © CEIOPS 2010

5. Therefore, the capital charge for CDS with a AAA-rated underlying is a constant 130 bps for selling CDS protection. The chart shows the absolute

capital charge of 130 bps (red line) and the maximum spread widening that happened over a period of one year after the protection was sold

(blue line). Since the peak CDS spread of 234 bps (March 2009) was very short lived we are comfortable with the fact that the blue line is above the red line for a relatively short time prior to the Lehman collapse.

6. Therefore it would seem appropriate, in principle, to use the same upward shocks for credit derivatives as are used for bonds. One exception should

be made for AAA-rated CDS underlyings for which the 1.0% upward shock used for bonds proves to be insufficient based on observed CDS spread changes – instead 1.3% as in the January Level-2 Advice should be used.

7. The downward shock proposed in the QIS5 Draft Technical Specifications (-75%) should remain unchanged in order to avoid the occurrence of neg-

ative CDS spreads when applying an absolute shock. In addition, the graph below shows that this relative shock which was originally calibrated for QIS4 purposes proved to be effective – the relative capital charge of

75% of the current value (green line) mirrors closely the maximum spread tightening that occurred over a period of one year after the protection as

bought (blue line).

-140

-120

-100

-80

-60

-40

-20

0

01.2007 01.2008 01.2009

Max 1Yr Spread

Tigthening

Capital Charge

8. Following these considerations, the following charges could be considered:

up down

AAA +130 basis points -75% of current

spread

AA +150 basis points -75% of current

spread

A +260 basis points -75% of current

spread

34/37 © CEIOPS 2010

BBB +450 basis points -75% of current

spread

BB +840 basis points -75% of current

spread B or

lower +1620 basis points

-75% of current

spread

Unrated +500 basis points -75% of current

spread

9. It should be noted that this would still follow a scenario-based approach for credit derivatives as the factor-based approach used for bonds with its

reference to the market value is not suited for credit derivative structures with potential leverage effects.

35/37 © CEIOPS 2010

Annex 5: Further clarification of the specification for spread risk (Tracked changes are towards the draft technical specification published by the Commission)

SCR.5.112 Further to this, where an insurer has liabilities for which it is claiming an illiquidity premium this would be supplemented by also looking at the impact

of Fup and Fdown on the liability side.

SCR.5.113 The illiquidity premium for the individual currencies is quantified on

basis of the "x-and-y formula" provided in the report on the liquidity premium:

liquidity_premium_level = 50%*(spread_model_portfolio - 40bps)

where spread_model_portfolio refers to the average spread over and above the

risk-free rate in a model portfolio of bonds.

SCR.5.114. On basis of this modeling of the illiquidity premium, an equivalent shock for the model portfolio is calculated as follows:

Equivalent_shock_for_model_portfolioup= Fup (average_rating_model_portfolio)

Equiva-lent_shock_for_model_portfoliodown=Fdown(average_rating_model_portfolio)

where average_rating_model_portfolio denotes the average rating of bonds in the model portfolio which is used to quantify the illiquidity premium.

The following average ratings for the

model portfolios of the individual cur-rencies are specified: Currency

Average rating of

model portfolio

EUR, GBP, USD, CHF, JPY 2,0% AAA

20,7% AA

47,9% A

29,3% BBB

SEK, DKK AAA

NOK AA

CZK, PLN, HUF, EEK, LVL, LTL same as EUR

RON, BGN, TRY, ISK -

SCR.5.115 For year end 2009, the equivalent shock for the model portfolio based on the average rating of the model portfolio as given in the previous paragraph would be as follows: Comment [k1]: May need to be adjusted

depending on the final treatment of covered

bonds

36/37 © CEIOPS 2010

Equivalent Shock for Model Portfolio

Currency Shock for

Up-

Scenario

Shock for

Up-

Scenario

EUR, GBP, USD,

CHF, JPY 2,89% -1,91%

SEK, DKK 1,00% -0,40%

NOK 1,50% -1,00%

CZK, PLN, HUF, EEK,

LVL, LTL 2,89% -1,91%

RON, BGN, TRY, ISK - -

SCR.5.115 116 Applying the formula for the illiquidity premium as given

above this leads to a shock to the illiquidity premium component of the inter-est rate curve applied to liabilities to which an illiquidity premium is applied at

the level of 50%* of the Equivalent_shock_for_model_portfolio. For year end

2009 this leads to the following shocks to the full illiquidity premium component:

Shock to the illiquidity premium component

Currency Shock for

Up-

Scenario

Shock for

Up-

Scenario

EUR, GBP, USD, CHF,

JPY 1,45% -0,95%

SEK, DKK 0,50% -0,20%

NOK 0,75% -0,50%

CZK, PLN, HUF, EEK,

LVL, LTL 1,45% -0,95%

RON, BGN, TRY, ISK - -

SCR.5.117 For year end 2009, the illiquidity premium component for each

currency would thus be as follows:

Formatted: Font: Verdana, Kern at 5pt

37/37 © CEIOPS 2010

Illiquidity Premium Component by currency

Currency Base

illiquidity

premium

Increased

illiquidity

premium

under Up-

Shock

Decreased

illiquidity

premium

under Down-

Shock*

EUR 0,53% 1,98% -0,42%

GBP 0,82% 2,27% -0,13%

USD 0,71% 2,16% -0,24%

CHF 0,09% 1,54% -0,86%

JPY 0,15% 1,60% -0,80%

SEK 0,54% 1,04% 0,34%

DKK 0,40% 0,90% 0,20%

NOK 0,20% 0,95% -0,30%

CZK 0,19% 1,64% -0,76%

PLN 0,19% 1,64% -0,76%

HUF 0,19% 1,64% -0,76%

EEK 0,19% 1,64% -0,76%

LVL 0,19% 1,64% -0,76%

LTL 0,19% 1,64% -0,76%

RON 0,00% 0,00% 0,00%

BGN 0,00% 0,00% 0,00%

TRY 0,00% 0,00% 0,00%

ISK 0,00% 0,00% 0,00%

* A cap to zero would need to be applied to the overall interest rate curve.

SCR.5.118 Two new interest rate curves will thus be derived, one with the stress ofincreased illiquidity premiapremium increasing, and one with illiquidi-ty premiapremium decreasing.

SCR.5.116119. ΔIlliquidLiabsUp and ΔIlliquidLiabsDown are then calculated by using these new stressed interest rate curves to value the liabilities for which

illiquidity premium is being claimed.

Formatted: Font: Verdana, Kern at 5pt