Swiss Regulation and Supervision of Reinsurance Companies Swiss

Swiss Regulation and Supervision of Reinsurance Companies: Swiss Solvency Test Federal Office of Private Insurance Bern, 4 April 2006 1

Timeline of the SST Development Task Force BPV to assess shortcomings of regulatory and supervisory framework 2003 2004 2005 2006 2007 2008 Herbert Lüthy becomes new director of FOPI (Federal Office of Private Insurance) in Fall 2002, reorientation to prudential supervision Start of Swiss Solvency Test project Mai 2003 with participation of industry, actuarial and insurance association, consulting companies and others, conceptual work finished end of 2003 Up to Mai 2004, development of first version of the standard model Field test 2004 with 10 insurers, supported by consulting companies Adaptations and improvements on the standard model and the methodology of the SST Further development underway on Field test 2005 with 45 insurers requirements on covering approx 90% of the market internal models and Insurance supervision act implemented 1. 1. 2006 group effects Field test 2006, mandatory for all large life & nonlife companies Field test 2007, mandatory for all large life & nonlife companies Small companies, reinsurers and groups prepare for full SST calculations in 2008+ Build-up of FOPIs staff by 50% over two years As of 2008 all companies have to implement the SST, as of 2011 target capital requirement will be in force 2

SST Transition Period Introduction of VAG / AVO 2006 2007 2008 2009 2010 2011 Plan for implementation of SST Full SST implementation for all insurers and reinsurers as of 2008 All insurers Life Insurers with CH-GPV > 1. 0 Mia Target capital requirement has to be satisfied SST has to be done, Swiss business has to be calculated exactly, for branches approximations can be used P&C insurers with CH-GPV > 0. 5 Mia Groups Full SST implementation Plan for implementation of SST with close coordination with FOPI Full SST implementation 3

Reinsurance Regulation Reinsurance companies have to fulfill the same solvency requirements as direct companies Solvency Requirements: • Solvency 1: Compatible with EU requirements, based on statutory valuation • SST: Risk based solvency requirements based on market consistent valuation of assets and liabilities both on legal entity and group level Both requirements have to be satisfied simultaneously Corporate Governance and Risk Management requirements: • Appointed actuary for each reinsurance company • Risk and capital management requirements • Fit and Proper, checks and balances, internal controls have to be in place 4

Inward Reinsurance Treatment of ceded reinsurance: Solvency 1: • Life insurers : provisions have to be held on a gross basis • P&C insurers: provisions are net of reinsurance • Limited recognition of reinsurance for Solvency 1 ratio SST: • All calculations can be based net of reinsurance, however a charge is added to the capital requirement based on the default probabilities of the reinsurers to which risks are ceded • Proxy for default probabilities: ratings or using risk based solvency ratios 5

Solvency 1 Requirements for Reinsurers For P&C business: Equal to Solvency 1 requirements for P&C direct companies 16% - 18% of written premiums For life business: 4% (1% if no financial risks are accepted) of technical provisions + 0. 1% of the net SAR All calculations are net of retrocession The calculations are based on statutory accounting, reviewed by audit companies, the statutory technical provisions have to be determined by the appointed actuary of the reinsurer Remark: Solvency 1 requirement are not sufficiently risk sensitive. Risk based solvency ratios were uncorrelated to Solvency 1 ratios based on results of a field test conducted with P&C companies 6

SST Requirements Risk based solvency requirements have to be calculated by each reinsurer supervised by FOPI both on a legal entity level and on a group level Each supervised reinsurer has to develop an internal model satisfying regulatory requirements During 2006 and 2007 internal models are being developed or existing ones adapted in conjunction with close supervision by FOPI. As of 2008 all reinsurers will have to do a full SST based on internal models Group supervision of Converium and Swiss Re Standard models are not applicable to reinsurers which have heterogeneous risks and unique risk profiles. The same is true for insurance groups and conglomerates 7

SST Requirements To allow for comparability of capital requirements between different reinsurers, the internal models have to satisfy certain preconditions: • All calculations have to be based on a market consistent valuation of assets and liabilities, taking into account market, credit and insurance risk • All relevant risk and capital transfer instruments (intra- and extra-group) have to be taken into account • The model has to be based on a stochastic methodology • Capital requirement is given by 99% Tail. Va. R for a 1 year time horizon (corresponds to approx. 99. 6%99. 8% Va. R) • The internal model needs to be embedded within the companies and well understood For group-level models, all legal entities and web of riskand capital transfer instruments need to be modeled consistently As one of the results of the calculations, FOPI obtains a default probability for each supervised entity Responsibility lies with senior management, the methodology of the model needs to be publicly disclosed 8

The SST Concept: Principle-Based 1. All assets and liabilities are valued market consistently 2. Risks considered are market, credit and insurance risks Defines Output 3. Risk-bearing capital is defined as the difference of the market consistent value of assets less the market consistent value of liabilities, plus the market value margin 4. Target capital is defined as the sum of the Expected Shortfall of change of risk-bearing capital within one year at the 99% confidence level plus the market value margin 5. The market value margin is approximated by the cost of the present value of future required regulatory capital for the runoff of the portfolio of assets and liabilities 6. Under the SST, an insurer’s capital adequacy is defined if its target capital is less than its risk bearing capital 7. The scope of SST is legal entity and group / conglomerate level domiciled in Switzerland 8. Scenarios defined by the regulator as well as company specific scenarios have to be evaluated and, if relevant, aggregated within the target capital calculation 9

The SST Concept: Principle-Based 9. Defines How-to All relevant probabilistic states have to be modeled probabilistically 10. Partial and full internal models can and should be used. If the SST standard model is not applicable, then a partial or full internal model has to be used 11. The internal model has to be integrated into the core processes within the company 12. SST Report to supervisor such that a knowledgeable 3 rd party can understand the results Transparency Responsibility 13. Disclosure of methodology of internal model such that a knowledgeable 3 rd party can get a reasonably good impression on methodology and design decisions 14. Senior Management is responsible for adherence to principles 10

The SST Concept: Building Blocks Building blocks: Market consistent (economic) balance sheet Free capital Risk bearing capital Target capital Market value of assets Wherever possible, marketconsistent valuation is based on observable market prices (marking to market) If such values are not available, a market-consistent value is determined by examining comparable market values, taking account of liquidity and other product-specific features, or on a model basis (marking to model) Market-consistent means that up to date values are used for all parameters SCR: Required capital for 1 -year risk Market Value Margin Market consistent value of liabilities Best estimate of liabilities Best-estimate = Expected value of liabilities, taking into account all up to date information from financial market and from insurance. All relevant options and guarantees have to be valued. No explicit or implicit margins Discounting with risk-free interest rate 11

The SST Concept: Building Blocks Building blocks: Year 0 Year 1 Risk bearing capital Market Value Margin Revaluation of liabilities due to new information Probability < 1% New business during one year Change in market value of assets Market consistent value of liabilities Market value of assets Probability density of the change of risk bearing capital Claims Catastrophes Average value of RBC in the 1% ‚bad‘ cases = Expected Shortfall = SCR Best estimate of liabilities Economic balance sheet at t=0 (deterministic) Economic balance sheet at t=1 (stochastic) 12

The SST Concept: Market Value Margin: to cover policyholders against risks emanating beyond 1 year • SCR: To cover risks which emanate during a 1 year time horizon • Market Value Margin: To cover cost of capital to cover risks during the whole run-off of the portfolio There should not be doublecounting between SCR and Market Value Margin Possible Approaches: • Statutory: Taking undiscounted reserves, using prudent assumptions, adding a simple factor on best-estimate etc. • Quantile: Taking e. g. the 75% quantile of the ultimate loss distribution of the liabilities: Used by APRA for P&C liabilities, discussed within Solvency 2. MVM Best Estimate Provisions • Market Value Margin: the additional amount on top of the best estimate which is required by a willing buyer in an arms-length transaction to assume the liabilities the loss reserves are held to meet: Discussed within Fair Value Accounting, used within the SST. 13

The SST Concept: Market Value Margin Definition: The market value margin is the smallest amount of capital which is necessary in addition to the best-estimate of the liabilities, so that a buyer would be willing to take over the portfolio of assets and liabilities. Idea: A buyer (or a run-off company) needs to put up regulatory capital during the run-off period of the portfolio of assets and liabilities a potential buyer needs to be compensated for the cost of having to put up regulatory capital Market Value Margin = cost of the present value of future regulatory risk capital associated with the portfolio of assets and liabilities Problem: How to determine future regulatory capital requirement during the run-off of the portfolio of assets and liabilities? -> Assumptions on the evolution of the asset portfolio are necessary 14

The SST Concept: Market Value Margin Co. C: 6% over risk free ES at t=0 does not enter calculation of the market value margin necessary at t=0 risks taken into account for 1 -year risk capital and market value margin are completely disjoint and there is no double-counting Future SCR for years 1, 2, … t=0 t=1 t=2 SCR: 1 -Period (e. g. 1 year) risk capital = Expected Shortfall of risk-bearing capital t=3 Years Future SCR entering calculation of MVM at t=0 15

The SST Concept: Scenarios For 2006, FOPI expects that groups and reinsurers formulate and evaluate about 5 scenarios which capture the specific risk situation of the company. FOPI also expects that the formulation and evaluation of the scenario will not be a compliance exercise but will entail a detailed and comprehensive discussion not only of primary but also of secondary and tertiary effects. Example: A scenario ‘Earthquake in Tokyo’ should not only specify the financial impact due to loss of life and to the collapse of buildings, but also discuss the implication on the financial markets (e. g. the collapse of the global financial market for a given duration, the effect on global markets of Japan having to rebuild the infrastructure, etc. ). Example: A scenario ‘Dirty Bomb in European City’ should not only specify the financial impact due loss of life but should in addition discuss the impact on real estate prices, airline travel, financial markets, consumer confidence, long term effects on mortality and morbidity, … The formulation of the scenario should comprise a) the event occurring during the following year b) the effects of the scenario in the future 16

The SST Concept: Scenarios The valuation of scenarios during the field test was uneven: Some companies calculated the impact mechanically whereas others did an in -depth analysis of the consequences of the different scenarios. For 2006 more guidance will be given: Definition of Scenario (SST Glossary): Scenarios can be seen as thought experiments about possible future states of the world. Scenarios are not forecasts. In that they do not need to predict the future development, but rather should illuminate extreme but still possible situations. Scenarios are also different from sensitivity analysis where the impact of a (small) change of a single variable is evaluated. Scenarios are especially useful to assess a situation where there is no historical experience. Hermann Kahn expressed this in the context of the cold war and studies on possible nuclear war succinctly as “Ersatz experience is a better guide to the future than the real past and present. ” 17

Internal Models: Challenge In insurance, models are often assumption driven: Up to 90% of the economic capital requirement due to insurance risks emanates from assumptions and only 10% from historical data: • models can often not be back-tested; • The review has to rely less on formalized requirements as for Va. R market risk engines; • The assessment of models has to rely more on experience, comparison with similar models and embedding of the model within the company The regulatory review of models will rely heavily on discussions with quants and actuaries, assessment of company‘s know-how of the model and its limitations and public transparency There are limits on what a regulator can demand from internal models of insurers and reinsurers: • Model verification is impossible • Falsification is in many cases unpractical • The scientific method can not be formalized. There can be no set of guidelines codifying the model approval process • We need to accept that some properties of a model can not be ‚proven‘ statistically (e. g. some dependency structures, some parameters) • Models can, however, be persuasive 18

Acceptable and Unacceptable Models Acceptable Models Unacceptable Models • Clearly stated and understood assumptions • Theory is misapplied • Clear on idealizations and simplifications • Hidden and unclear assumptions • Transparent on which effects are neglected • All relevant risk factors are taken into account • The model relies not purely on historical data but aims to model the future risks using theory, scenarios, expert opinion etc. • The model is tested • Pure statistics, no explanation • Too many simplifications • The model is not tested against the real world • Inappropriate or stale parameters • The model is not sufficiently understood within the company • … • The model is regularly challenged, and compared against industry best-practice • … 19

Acceptable and Unacceptable Models It is the aim of FOPI to promote a wide variety of different models in order to reduce systemic risk within the market. The main requirement on the internal model is adherence to the SST principles Reinsurers should therefore not feel restricted by the SST standard model methodology Multi-year models would be acceptable as long as the 1 -year risk measure (Tail. Var on 99% confidence level) can be backed out. 20

Internal Models: Review Even worse than having a bad model is having any kind of model – good or bad – and not understanding it If internal models are used for regulatory purposes, it will be unacceptable if the model is not understood within the company Senior management is responsible for internal models and the review process. The review of internal modes will be based on 4 pillars There needs to be • Internal Review; • deep and detailed knowledge by the persons tasked with the upkeep and improvement of the model • External Review; • Review by the Supervisor; • Public Transparency. • Knowledge on the underlying assumptions, methodology and limitations by the CRO, appointed actuary etc. The regulator is responsible for ascertaining that the review process is appropriate • Sufficient knowledge to be able to interpret the results and awareness of the limitations by senior management and the board Companies using internal models have to disclose publicly the methodology, valuation framework, embedding in the risk management processes etc. 21

Transition to Full SST Federal Office of Private Insurance Bern, 4 April 2006 22

Transition to Full SST To achieve the successful development and implementation of internal models satisfying the requirements of FOPI, regular contacts and meetings between companies and FOPI have to take place between 2006 and 2008 Formulation and evaluation of scenarios (30 Sep 2006)* Discussion of the project plan together with senior management * Results from prototype (if feasible) 2006 Kick-off Meeting Formulation and evaluation of scenarios (30 Sep 2007)* Discussions on conceptual and technical issues Initial discussion, identification of issues and way forward Draft for future transparency of internal model* Pre-Approval of internal model 2007 2008 Discussions on conceptual and technical issues Depending on the size and complexity of the company, the frequency of the meetings can vary (monthly or quarterly) Results from internal models* * With senior management 23

Transition to Full SST FOPI will contact each company and arrange a sequence of meetings over the next two years: • Initial discussions on key risk drivers of the company, existing internal capital models, gap analysis, first contact with persons responsible for modeling, quants, actuaries, risk management • Definition of responsibilities for the model development and project plan • Discussion of the project plan with senior management (CEO, CRO, CFO, …) and project team, agreement on milestones • Interim meetings to discuss state of the project, technical issues, milestones etc. • At end of 2007, assessment of the acceptability of the model for SST purposes by FOPI Deliverables: End of September 2006 and 2007: Reinsurer specific scenarios signed off by senior management Fall 2007: Trial run of the internal model Fall 2007: Draft of public transparency of internal models Spring/Summer 2008 SST calculation using the internal model 24

Transition to Full SST Development of requirements on internal models is being done by FOPI’s R&D department together with supervisors • Consistency of requirements can be achieved • Learning process for regulators, supervisors and companies • Mix of bilateral discussions (companies and FOPI) and meetings with all of industry allows for transfer of information and harmonization of requirements 25