mima pillar 1 – quantitative requirements · luxembourg captives can be explained by the...
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MIMAPillar 1 – Quantitative RequirementsDecember 2nd, 2011
Marsh Risk Consulting
MARSH
Agenda
1. Quantitative requirements : the new deal
2. Impact on Captives
3. Best practices for capital optimization
4. Conclusion
3MARSH
The rationale behind Solvency II
� Main objectives of Solvency II
� Improve protection of policy holders and beneficiaries
� Increase financial sustainability of insurance and reinsurance undertakings
� Improve risk management practices
� Complete harmonization throughout Europe and enhance competition
�More sophisticated measure and efficient control of the risks of the undertaking
� 3-Pillar approach
SOLVENCY II
Pillar III
Pillar 1 Pillar 2 Pillar 3
Quantitative
requirementsQualitative
requirementsDisclosures
Some quantitative elements are embedded in Pillar 2
Solvency II
4MARSH
Solvency I reminder
Advantages Drawbacks
•Simple to use (legibility of the formula):
�Non-life
�18% / 16% of premiums
�26% / 23% of claims
� Life
� 4% of Mathematical provisions + 0.3% /
0.1% / 0.15% of capital at risk
•Uniform calculation
•Based on actual historical observation
•Supported by prudential reserving policy
• Formula only based on underwriting
parameters, other risks are not explicitly taken
into account
• Does not take into account underlying volatility
• Does not take into account risks correlation
• Does not take into account diversification of the
portfolio (simple aggregation of capital
requirements calculated for each line of
business)
• Risk mitigation through reinsurance is only
partially recognized
• …
Solvency I
Solvency II
Aims at mitigating the above
drawbacks
Max of the 2
5MARSH
Solvency II - Pillar 1
Pillar 1 is supported by 2 principles
�Fair value valuation of assets and liabilities
�Risk based capital approach
-Explicit assessment of all risks the undertaking is exposed to
-Seeking to create a capital position at least equivalent to BBB+ rated company
-Creates need to be 99.5% certain that the undertaking will meet liabilities over the next 12 months
Strong corporate governance processes defined under Pillar 2
�Aims at supporting the assumptions used to assess capital needs of the undertaking in accordance
with Pillar 1 principles
6MARSH
Pillar 1 - Fair value principle
… to a consistent
fair value
Assets
Prudent
approach
Own capital
From a local
GAAP valuation…
AssetsMarket value
Technical
reservesBest estimate
+ risk margin
“NAV”Market
consistent
value of the
company
Assets
“NAV (Net Asset Value) is the difference between the market consistent value of assets
and liabilities”
Fair value
� Assets : market value
� Liabilities : “best estimate” approach
Economic value of the undertaking
= Assets minus Liabilities (NAV)
Technical
reserves
7MARSH
Liabilities
Probability
Best estimate+ risk
margin
VaR 99.5%
SCR amount
Loss amount resulting in the
insolvency of the undertaking
Pillar 1 – Risk-based capital approach
“Solvency Capital
Requirement (SCR) is the VaR of the market
consistent value of the
company to a 99.5%
confidence level on a 1
year horizon”
Stress tests
- market risks,
- underwriting risks,
- operational risks,
- …
« Buffer » in case of adverse risk development
MARSH
Pillar 1 - SCR & MCR calculation
� The capital requirements under Solvency II:
– The Solvency Capital Required (SCR): the amount of capital held by a company ensuring it can meet
its liabilities over the next 12 months
– The Minimum Capital Required (MCR): the amount of capital below which the insurance license is
withdrawn
� The Directive provides three options for calculating the SCR:
– Standard Model – the Directive states the required calculation of the capital.
– Partial Internal Model – this incorporates the Standard Model but individual modules can be replaced
with an internal approach that is agreed with the Regulator
– Full Internal Model – this is a bespoke model developed by the company covering at least the same
aspects as the Standard Model and which have been tailored to the specific characteristics of that
company. Given the complexity of such full internal models, these are an opportunity for large
insurance or reinsurance undertakings
Free Surplus
SCR
MCRAssets
Market value
Technical
provisions
Market value
“NAV”
Market consistent
value of the company
NAV (Assets – Liabilities) > SCR (including MCR)
Coverage of a 99.5% probability of ruin,
should cover the 1 in 200 years loss
Free Surplus
SCR
MCR
SCR
MCRAssets
Market value
Technical
provisions
Market value
“NAV”
Market consistent
value of the company
NAV (Assets – Liabilities) > SCR (including MCR)
Coverage of a 99.5% probability of ruin,
should cover the 1 in 200 years loss
9MARSHMarsh
9
Level 1:
Evaluation of each
risk module
Level 2:
Aggregation of
risks by typology
Level 3
Level 4
Bottom up approach with the aggregation of capital charges through correlation matrix
Pillar 1 – Modular approach
MARSH
Pillar 2 - Quantitative aspects
• Capital add-on:
� The Solvency Capital Requirement standard formula is intended to reflect the risk profile of most insurance
and reinsurance undertakings. However, there may be some cases where the standardized approach does
not adequately reflect the very specific risk profile of an undertaking.
� Under exceptional circumstances, supervisory authorities have the power to impose a capital add-on to the
Solvency Capital Requirement, only in the following cases:
� The undertaking’s risk profile deviates significantly from the assumptions underlying the SCR
calculation
� The system of governance of the undertaking deviates significantly from the standards and does not
allow to properly identify, measure, monitor, manage and report the risks that it is or could be exposed
to
• Own Risk and Solvency Assessment (ORSA)
� As part of the ORSA process, the undertaking shall:
� quantify its overall solvency needs on a forward-looking basis covering each year of the business
planning period (generally 3 to 5 years)
� Subject identified risks to a sufficiently wide range of stress test/scenario analyses
� Complement the quantitative approach with a qualitative description of the risks
� If the undertaking’s risk profile deviates materially from the assumptions underlying the SCR calculation,
it shall quantify the significance of the deviation
MARSH
Agenda
1. Quantitative requirements : main principles / the new deal
2. Impact on Captives
3. Best practices for capital optimization
4. Conclusion
12MARSH
QIS 5 Results - Benchmark analysis
� Source : ECIROA – Captive report on QIS 5
� Sample size : 132 captives (Marsh contribution on 41 captives)
� 51 direct writing undertakings / 78 reinsurance undertakings
� 9 domiciles represented
� Distribution of SCR coverage
Based on Marsh’ sample
13MARSH
QIS 5 results – SCR coverage and captive size
• 35 % of captives (mainly small ones) wouldn’t have enough capital to reach the SCR
• 35 % of captives have 180 % of SCR as available capital
• The first 10 % of captives have more than 400% of SCR
Part of Small Captives
Part of Medium Captives
Part of Large Captives
Part of Captives
< 90
%90
% -
100%
100%
-12
0%12
0% -
150%
150%
-18
0%18
0% -
250%
250%
-40
0%
> 40
0%
Solvency Ratio
0%
5%
10%
15%
20%
25%
30%
35%
14MARSH
Main impacting elements
12
29
12
29
29
12
2
39
1
40
0
5
10
15
20
25
30
35
40
45
Part of captives
Market RiskDefault Risk Non Life
Risk
Health Risk Life Risk
Higher than 50% of the SCR
Lower than 50% of the SCR
• Non-life risk is the major risk in terms of impact on the level of the SCR, mainly due to catastrophic risk
�Non-life risks for captives represent in the average 44% of the SCR compared with 13% for traditional
(re)insurers.
• Market risk mainly consists of the concentration risk on intragroup loans, which is a common practice in
the captive market.
• Default risk is most often a direct consequence of the cat risk, as its scope includes risk-mitigating
contracts
�Capital charge required to absorb counterparty default risk shall take into account potential insolvency of
reinsurers in the case of claims losses arising from catastrophic scenarios
• Life & Health risk only concern a limited number of captives
15MARSH
QIS 5 results – SCR coverage and domiciles
• A large majority (65%) of the captives having the higher solvency ratios (more than 200%) are
Luxembourg captives
�Can be explained by the equalization reserve mechanism and the maturity of domicile
• As far as Malta and Ireland are concerned (the other “traditional” captive domiciles), the proportion of
captives facing potential capital shortfall is more important
�More direct writing undertakings in these domiciles used as fronting facilities for reinsurance captives: this
generates higher counterparty default risk due to risk mitigation agreement with unrated undertakings
16
Focus on Malta: Impact of Deferred Tax Adjustment
QIS 5 did not provide any concrete criteria, other than those set out in the technical specification. EIOPA recommended to follow relevant IFRS Criteria. However some guidance provided by EIOPA is as follows:
This can be an important aspect to consider when choosing domicile to set-up your company and Malta is well placed to provide the full benefit in this. The SCR can only be reduced in those cases where deferred tax on instantaneous losses can be realised in the very short term and as depicted above.
Eur
SCR Before Adj
Own Funds
Recognise DTA @ 35% tax
rate based on IFRS Criteria
Do not Recognise the DTA unless
otherwise demonstrated based on
IFRS Criteria
Own Funds
MARSH
Agenda
1. Quantitative requirements : main principles / the new deal
2. Impact on Captives
3. Best practices for capital optimization
4. Conclusion
18MARSH
Best practices - Investment policy
� ALM is key
� A differentiated approach “external investments” versus “intragroup deposits” can be
contemplated in order to increase diversification and reduce the concentration risk
� Possibility to exempt captive undertakings from the concentration risk module to the
extent that there exists legally effective formal provisions where the captive’s liabilities
can be offset by intra-group exposures it may hold on entities of the group (captive
simplification – Technical specifications SCR.14.19.)
� When assets are placed in collective investment funds, it is important to have as much
details as possible to analyse their economic substance (look-through approach)
� Be attentive to counterparties’ ratings
� Question on the risk free treatment of european sovereign risks (risk charges vs M-t-M)
19MARSH
Best practices – underwriting, catastrophic and default risks
� The Catastrophic risk calibration has been detailed within two methods :
- A method based on standardized cat scenarios (“man made” and “NatCat”)
- A factorial method to be applied, if the first one is not applicable or if available data are not
sufficient
� We recommend specific monitoring and information regarding the Cat Risk exposures and claims
history so that the capital charge can be calculated as precisely as possible, in order to avoid
overcharge due to approximate approach
� Optimization of reinsurance strategy specially for the extreme risks
� Avoid pure fronting captives who will experience much higher levels of SCR (Risk mitigation effect
on counterparty default risk)
� Retention policy to be adjusted with a view to optimize the total cost of risk (TCOR), including the
cost of capital � iterative process
Retentionpolicy
Captive capital
allocation
TCORoptimization
Markettransfer
conditions
MARSH
Agenda
1. Quantitative requirements : main principles / the new deal
2. Impact on Captives
3. Best practices for capital optimization
4. Conclusion
21MARSH
Conclusion
• Increase barriers to entry for newly formed captives
• For a majority of existing captives, operations will require higher level of capital
• Increase complexity of retention strategy : arbitrage own funds / retention level /
market transfer conditions
• Captive management will become more complex
• Require better risk awareness and management
• Programme structures to be reviewed to minimize risk mitigation impact on
counterparty default risk
• Investment policy to be optimized
Solvency II
Consequences
for captives
General application of Solvency II on the traditional insurance market may give rise to increased premiums and reduced capacity to cover certain risks.
Captives will therefore become all the more strategic tools to address potential market gaps.
22MARSH
ORSA : “the heart of Solvency II” (EIOPA)
StrategyBusiness plan
Risk identification
Risk management
Stress-tests
Impact on SCR
Risk strategy
ORSA
Time horizon 3-5 years
- Quantitative- Qualitative
- Mitigation- SCR-calculation- Evaluation of risk assessment
- Internal stress- External stress
Review SCR-calculation (assumptions & risk
picture)
Considering own funds
• ORSA is a top-down process for an overall and holistic risk understanding
• It gives a picture of the company’s short-term and mid-term risks (=> stress-tests, scenarios)
• It must be integrated into the decision-making process of the top management
• It’s an evaluation of the company’s risk and solvency, regarding its risk appetite and business
model (=> it goes further than the SCR-calculation and Pillar 1 risks)
MARSH S.A.
Société de Courtage d'Assurances - Société Anonyme à Directoire et Conseil de Surveillance
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