Solvency II – A view from the US Casualty Loss Reserve Seminar – 2008 Robb W. Luck Insurance &...

Solvency II – A view from the USCasualty Loss Reserve Seminar – 2008

Robb W. LuckInsurance & Actuarial Advisory ServicesErnst & Young LLP19 September 2008

Solvency II – A view from the US

Agenda

► General background► Solvency I vs. Solvency II► Solvency II readiness survey summary► Summary results from Quantitative Impact Studies► Specifications of QIS 4

► Key differences between Solvency II and current solvency measures in the US

► Illustrative case study results► Difference in solvency ratios under RBC, Solvency II QIS 4 formula, and

other estimated rating agency formulas► Difference in technical provisions for reserves – nominal versus

discounted with risk margin

► What could this mean for the US market and the reserving actuary?


Solvency I versus Solvency II balance sheet

Solvency II balance sheet

Best estimates

Risk margin

MV liabilitiesMV assets

Technical provisions

Free surplus

MCR

Solvency capital requirement

Free surplus

Risk margin

Solvency I balance sheet

Best estimates

BV liabilitiesBV assets

Technical provisions with implicit risk margins

Free surplus

Capital requirement

Free surplus


Timeline for Solvency II

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Pha

se I

Pha

se I

IDefinition of the general form of the solvency system

Three calls for advice

Consulting documents

Level 2

Implementing measures

Level 3

Application guidelines

QIS 1

QIS 2

QIS 3

QIS 4

QIS etc.

Preparation of the draft

Level 1 directive (major principles)

Level 1 process for directive approval by the Parliament and

European Council

Transposition of the directive into local law

Entry into force of the new Solvency II prudential system


Solvency II readiness survey

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%We have indicators based on accounting data

We have some additional indicators on performance

We have some additional indicators on performance and risk management (e.g., return on risk capital)

We have already converged towards economic value-based criteria (e.g., return on economic capital)

Measuring performance in relation to risk



Statutory measures only

Rating agency formulas

Developed EC models but will require significant enhancements to comply with Solvency II

Existing EC models will comply with Solvency II

Economic capital models

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%



Current systems will be sufficient

Minor changes needed

Major changes needed

Haven’t analyzed the issues

The systems challenge

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%



Current actuarial and risk management expertise fall far short

Some expertise but will require upgraded skill and additional risk management professionals

Some upgrade of skills needed for actuaries and risk management professionals

Current have necessary expertise

Current level of expertise

0%

10%

20%

30%

40%

50%

60%


Quantitative Impact Studies

Technical provisions

► QIS 1► Discounting in non-life leads to a reduction of 10-15%► In most cases: best estimate + MVM (75% quantile) < current technical

provisions

► QIS 2► Cost of capital vs. quantile approach for MVM: results heterogeneous

► QIS 3► Industry asks for guidance on the assessment of best estimates► Cost of capital approach for risk margins► Proxies allowed for risk margins (fixed % of best estimates)


Quantitative Impact StudiesFinancial impact on balance sheets – QIS 3

► Technical provisions tended to decrease, with the release of the prudence margin in Solvency I being greater than the additional risk margin under Solvency II.

► This tended to be more than offset by an increase in the capital requirements, the overall solvency ratio tended to decrease. ► Most significant for nonlife companies

► 98% of companies met the MCR and 84% met the SCR, a large scale capital injection is unlikely. However there could be significant reallocation of capital.

► Results for MCR were consistent with 80-90% value at risk over one year time horizon.

► Formula SCR tended to be higher than internally modeled SCR, approximately 25% driven by insurance risk.


Quantitative Impact StudiesSolvency Capital Requirement (SCR) – QIS 3

► Provisions for expected profit and loss was removed

► Factor based approach for nonlife underwriting risk vs. scenario approach for life companies

► CAT risk in specified regional scenarios

► Operational risk added at top level, function of technical provisions and premium

► Diversification effect from correlation between segments and risk modules was about 20%

► Underwriting risk dominated the overall SCR for non-life companies, 75%

Results:► Internal models produce significantly lower SCR than standard approach (around 25%), mainly

due to underwriting risk► Decrease in solvency ratios: 19.5% of nonlife companies would need additional capital to meet

SCR► Significant fluctuations in available surplus for non-life companies, 40% would decrease by 50% or

more, 20% would increase by 50% or more


QIS 4 highlightsKey changes in response to QIS 3 issues

QIS 3 issue QIS 4 solution

Nonlife issues

QIS3 technical specification was ambiguous about premium provisions (also referred to as stand-ready obligation or preclaims liabilities). In consequence most nonlife insurers did not use QIS3 as an opportunity to recast their balance sheet onto a full economic basis as Solvency II requires (most introduced discounting but did not rework the traditional unearned premium provision UPR). Proposed QIS4 specification is clearer and proposed simplification is consistent in that combined ratio approximates for estimate of future cash flow.

Nonlife technical provisions


QIS 4 highlightsKey changes in response to QIS 3 issues

QIS 3 issue QIS 4 solutionNonlife issues

Calibration of NL underwriting risk module of standard formula SCR regarded as unsatisfactory. Some changes to calibration proposed for QIS4.

A simple formula (Layer 1) will apply in QIS4 if regional scenarios (now referred to as Layer 2) are not available. QIS4 also introduces Layer 3 where insurers will calculate capital based on the personalized catastrophe scenarios which are regarded as appropriate to their business.

Nonlife underwriting risk

Nonlife catastrophe


Key differences between Solvency II and current US solvency measures► Solvency II focus is on capitalizing to a level such that the probability

of insolvency over a one year time horizon is remote, 0.5%

► Solvency II is intended to be more aligned with the individual risk profile of a company► Formula vs. internal model vs. partial internal model► More recognition of risk diversification benefit

► Line of business and risk module correlations► Zero correlation between life and nonlife entities

► Technical provisions for loss reserves are comprised of a discounted best estimate and an explicit risk margin► Question around nominal vs. discounted + risk margin


Risk margin

► Based on a Cost-of-Capital methodology► Cost of providing amount of eligible own funds equal to SCR,

necessary to support obligations over their lifetime► Cost-of-Capital rate = 6.0%

► For QIS 4 purposes, SCR calculations performed on the basis of the standard formula► Net of reinsurance

► SCR calculation only considers operational risk, underwriting risk and counterparty default risk

► QIS 4 specifies benchmark risk margins as a percent of technical provisions for use if the company cannot determine based on internal data


Cost-of-capital methodology (1)Steps to calculate the risk margin

Step 1: Calculate SCR for t=0 and for each future year* for each segment

* throughout the lifetime of obligations in that segment

* SCR(0) corresponds to today’s capital requirement of the firm

* but only part of the risks is considered: operational, underwriting and counterparty default

t=0 t=1 t=2 t=Tt=3 ………………



Step 2: Multiply each of the SCR’s by the Cost-of-Capital rate* determination of cost of holding future SCR’s

* CoC rate = 6% (return above risk free)

t=0 t=1 t=2 t=Tt=3 ………………



Step 3: Discount the amounts calculated in Step 3* using the risk free yield curve at t=0

* sum of discounted values is risk margin (for this segment)

Step 4: Total risk margin is sum of risk margins in all segments

t=0 t=1 t=2 t=Tt=3 ………………


Case studies

► Case studies were prepared using US Statutory information to look into three areas of impact under Solvency II► Calibrated companies to 250% RBC and measured solvency ratios

under Solvency II QIS 4 formula and estimated rating agency formulas

► Authorized Control Level RBC compared to Minimum Capital Requirement (MCR)

► Difference between nominal loss reserves and discounted with risk margin using the Solvency II cost of capital method for industry aggregate Schedule P lines of business


Case studySolvency ratios

Large long-tailed company

Midsize short-tailed company

Multiline companies

0%

50%

100%

150%

200%

250%

300%

RBC Rating Agency #1 Rating Agency #2 Solvency II QIS 4


Case studySolvency ratios

Monoline medical malpractice

Monoline work comp

Monoline companies

0%

50%

100%

150%

200%

250%

300%

RBC Rating Agency #1 Rating Agency #2 Solvency II QIS 4


Case studyAuthorized control level RBC vs. MCR

0%

20%

40%

60%

80%

100%

120%

MCR %

Large long-tailed company

Midsize short-tailed company

Monoline medical malpractice

Monoline work comp


Case studyNominal reserves vs. discounted with risk margin for US industry

Risk margin

Best estimate

HO/FO

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

Nominal Solvency II QIS 4

Change = 0.3%



Risk margin

Best estimate

Private passenger auto liability

0

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

70,000,000

80,000,000

90,000,000

100,000,000


Change = (3.5)%



Risk margin

Best estimate

Commercial auto liability

Change = (4.5)%

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000




Risk margin

Best estimate

Commercial multiperil

Change = (3.8)%

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

35,000,000

40,000,000




Risk margin

Best estimate

General liability

Change = (5.0)%

0

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000




Risk margin

Best estimate

Workers’ compensation

Change = (9.8)%

0

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000




Risk margin

Best estimate

Medical malpractice

Change = (4.1)%

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

35,000,000




Risk margin

Best estimate

Special property

Change = (0.3)%

0

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000



What does this mean for the US market?

► Changing competitor behavior from companies based in Solvency II regulated countries► New capital structures and solvency levels

► How different are nominal reserve levels from discounted with risk margin?

► “Use Test” will require the framework to be embedded in the business process, driving strategic decision making

► Pricing differences

► Convergence with IFRS► Question of when, not if

► Changing reinsurance market in Bermuda► BMA is currently in the process of adopting solvency measures expected

to be similar to Solvency II

► Increased M&A activity and group structure


What does this mean for the US market?

► Emphasis is on enhancing economic capital modeling and strengthening enterprise risk management frameworks

► Results from the QIS show significant decreases to required capital when modeled internally

► Companies face upward capital adjustments under Solvency II Pillar 2 based on risk management capabilities

► US rating agencies are continuing to emphasize ERM as a factor in assigning ratings

► Initial bar was set and will continue to be raised


What does this mean for the reserving actuary?► Increased focus on the overall distribution of loss reserves vs. range

of reasonable estimates► Increased need to understand the correlations between reserve segments

► Need to analyze the timing of reserve variability emergence► Ultimate variability vs. one-year time horizon

Solvency II – A view from the US Casualty Loss Reserve Seminar – 2008 Robb W. Luck Insurance &...

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