Solvency II Part 2 Pillar 1 quantitative requirements

Solvency II Part 2: Pillar 1 (quantitative requirements) Vesa Ronkainen Insurance Supervisory Authority, Finland 30. 11. 2006 1

Agenda (based an a presentation in Finland by Raoul Berglund) Ø Possible structure of the new solvency regime Ø Solvency II and IASB Ø Current approach to liability valuation (technical provisions) Ø Solvency II approach to liability valuation Ø Interaction between assets and liabilities (ALM) Ø Solvency capital requirement (SCR) Ø Adjusted solvency capital requirement (ASCR) Ø Internal models for SCR Ø Minimum capital requirement (MCR) Ø Eligible capital Ø Safety measures Ø Pillar I interaction with pillars II and III 2

Possible structure of the new solvency regime Solvency structure in Solvency I and II (the height of the bars are fictive) Required minimum margin Solvency II Capital held in excess of regulatory capital requirements Regulatory capital requirements Minimum guarantee fund Technical provision with prudential margins 3 Regulatory capital requirements Risk margin Best estimate liability Adjusted solvency capital Requirement (ASCR) Solvency capital requirement (SCR) Minimum capital requirement (MCR)

Possible structure of the new solvency regime (cont. ) 4

Solvency II and IASB Realistic economic valuation Bridge Realistic economic valuation Regulatory purposes (to ensure insurance consumers’ interest) Financial markets International Financial Reporting Standards (IFRSs) 5 Solvency II Not equal

Current approach to liability valuation Ø 6 Some problems with the current EU approach to technical provisions a. The risk of adverse deviation is addressed by building conservatism into reported estimates; b. A prudent valuation is required, but limited guidance is provided on how this should be arrived at or the degree of protection that should result; c. Different valuation approaches and variability in the prudence included in the calculation; d. For life insurance future bonuses, costs of options and guarantees are commonly implicitly included (without taking into account their financial nature) within the unknown and variable level of prudence;

Current approach to liability valuation (cont. ) 7 e. Fails to reflect changes in the underlying uncertainty associated with the liability because the required margin fluctuates with other variables (=> appropriate management responses and regulatory intervention may be delayed, increasing the risk of insolvency); f. Does not reflect the economic nature of the liability cash flows (cannot be used for realistic reporting).

Solvency II approach to liability valuation Ø 8 The general liability valuation approach can be defined in the following way: a. It should require a best estimate increased with a risk margin for the uncertainty in the insurance liability b. The best estimate equals the expected present value (probability weighted average) of all future potential cashflows (probability distributional outcomes), based upon current and credible information and realistic assumptions. c. Where the benefits being valued contain options that may potentially be exercised against the company, or the potential liability outcomes have an asymmetrical distribution (e. g. guarantees), then the best estimate liability must include an appropriate value in respect of those options and/or asymmetries. d. The risk margin should cover the risk linked to the future liability cash-flows over their whole time horizon.

Solvency II approach to liability valuation (cont. ) e. Best estimate – – – 9 Biometric, expense, surrender assumptions etc should reflect historical averages adjusted with future trends; Applies an appropriate interest rate term-structure for discounting the future payments (risk free interest rate); Avoids inappropriate application of surrender value floors in life insurance (realistic surrender rates); – Measures the costs of options and guarantees embedded in insurance contracts in a market consistent way (explicitly taken into account); – Includes constructive as well as contractual liabilities, where the insurer has discretion over benefits – even if they have not been allocated (principles for distribution of bonuses); – Allows possible management actions (regarding bonuses in withprofit life insurance business for instance)

Solvency II approach to liability valuation (cont. ) Ø In order to achieve optimal market consistency the valuation is divided into hedgeable and non-hedgeable components; Ø If an exposure can be perfectly hedged or replicated on a sufficient liquid and transparent market, the ”hedge or replicating portfolio” provides a directly observable price (marked-to-market). Ø The no arbitrage assumption implies that the market consistent value of the hedgeable liability component should be equal to the market value of the relevant hedge (replicating) portfolio. Ø For the non-hedgeable liability component and for the remaining risk on partial hedges, the valuation process would need to rely on methodologies to deliver adequate proxies determined on a market consistent basis, i. e. arbitrage-free mark-to-model techniques; 10

Solvency II approach to liability valuation (cont. ) Ø In each case where risks are non-hedgeable, a conservative valuation based on the “best estimate plus uncertainty (risk margin) approach” should be applied (the general valuation approach). Ø This may also include financial risks, whenever these risks can not be hedged in liquid and transparent markets or market prices tend not to be reliable including an implicit additional uncertainty. Ø Most insurance obligations needs to be marked-to-model because there is no truly liquid secondary market in the contracts that could be used as benchmarks for marking to market. 11

Solvency II approach to liability valuation (cont. ) Ø When setting this risk margin the following issues need to be considered: a. b. c. Ø 12 Any risk premium necessary to ensure the transferability of the liabilities to a third party; Achieving an appropriate level of policyholder protection over the run-off period of the liabilities; and Addressing uncertainty (model, parameter etc. ) in the valuation of the ‘best estimate’; Thus, while market consistency is the appropriate guiding principle for the risk margin, the determination of a risk margin should take into account regulatory aspects;

Interaction between assets and liabilities Simplified balance sheet Equity risk FX risk Interest rate risk Real estate risk Realistic value of assets Realistic value of liabilities 13 Real estate risk Commodity risk Credit risk Commodity risk Interest rate risk Credit risk Net asset value (NAV) Aggregated NAV impact

Interaction between assets and liabilities (cont. ) Ø A deep understanding of the interaction is needed (ALM). Ø Strongly related to management actions in life insurance (ALM). Ø Possible management actions and their impact on the assets and the liabilities (especially) should be carefully analysed and documented. Ø Should take into account policyholders’ expectation and the duty to treat insurance customers fairly. 14

Solvency capital requirement - SCR Ø The SCR should be a capital requirement which guarantees the minimum capital strength to maintain appropriate policyholder protection and market stability; Ø Can be determined either by a standard approach or by internal models; Ø SCR should in principle be sufficiently larger than the MCR; Ø Should be risk-based and based on the going-concern principle Ø The EU Commission has suggested a 99. 5 percent confidence level (percentile, Va. R) over a one-year time horizon as a working hypothesis for the calibration of the SCR; 15

Solvency capital requirement - SCR (cont. ) Ø Thus prudential regulation of insurance can be seen to be based on a non-zero failure regime and is broadly consistent with the levels of capital associated with a ”BBB” rating. Ø In practise each risk is calibrated to this level Ø The dependencies among the different risks should be taken into account Ø Reinsurance and other mitigation effect should be taken into account Ø The calibration of the SCR should not be influenced by the existence of any guarantee schemes. 16

Adjusted solvency capital requirement - ASCR Ø Solvency II should provide a mechanism to deal with situations where the standardized approach underestimates (due to a unrecognized or recognized risk in the standard approach) the capital required given the firm’s risk profile. Ø Two possible approaches: - Require higher capital as part of Pillar II or - Require the firm to develop an internal model. Ø The supervisory review process in Pillar II should also allow Pillar I capital requirements to be adjusted for risks that cannot be quantified. (e. g. adequacy of internal control) 17

Internal models for SCR Ø All firms will have the option of using their internal models in place of all or parts of the standard approach; Ø Changing parameters in the standard approach is not considered to be an internal model; Ø Internal models should have references to full probability distributions; Ø Regulatory approval will be required to help ensure that it is reasonable to rely on a firm’s model for regulatory capital purposes; Ø The purpose of the validation criteria is to enable a regulatory judgment about the extent to which the models’ results provide accurate view of the firm’s risks; 18

Internal models for SCR (cont. ) Ø Both qualitative and quantitative aspects should be include, which could for instance be - Model governance; - Model inputs; - Model structure and - Model output. Ø The models selected should be used by the firm’s management to run the business; Ø Selecting internal models solely to minimize capital requirements – ”cherry picking” – should be in a regulatory control; 19

Minimum capital requirement - MCR Ø Given that SCR is the risk-based capital requirement and the key solvency control level, a logical role for the MCR is to facilitate runoff when breached. Ø Thus, the MCR will not be fully risk-based Ø There should not be an option for firms to estimate their MCR Ø Should not be seen as a driver for capital requirement Ø The MCR should provide capital as a buffer against the risk that the firm’s financial strength deteriorates during the process of run-off (MCR has already been breached) 20

Eligible capital Ø Solvency II will need to specify the types of capital that are eligible to meet solvency requirements. Ø A Basel II tier-type approach is under consideration, where the capital is categorized according to the extent to which they meet the regulatory purposes of capital. 21

Safety measures Ø The EU directive should set out a sliding scale of supervisory actions with respect to the solvency control levels, providing regulators with more discretion in their responses to breach of the adjusted SCR than for a breach of Pillar I SCR and MCR. Ø This is illustrated in the table below: 22

Pillar I interaction with Pillar II and III Ø Pillar II should provide a framework to deal with any simplifications and assumptions required to capture risks in Pillar I as well as those risks not covered by Pillar I SCR. Ø The interaction of Pillar III information with Pillar I and II needs also to be given appropriate considerations. 23