Solvency II:Future Regulatory Capital Requirements

CAS CARE Seminar, June 2005

Susan Witcraft

Guy Carpenter 2

Agenda

Changing Financial Environment

Changing Regulatory Standards Concept of Solvency II Determination of Solvency Capital Requirement (SCR) Reinsurance Implications of Solvency II

Alignment of Regulatory and Economic Capital

Guy Carpenter 3

Changing Financial Environment

Financial

Conglomerate

Bank entities Insurance entities

Solvency IIBasel II

Regulatory Environment

Interdependencies

IFRSIFRS

Accounting Environment

Broad Conclusions:

• Higher minimum capital likely

• Transparency

• Robust risk managementsystem crucial

• Consistency

• Transparency

• More volatility

Guy Carpenter 4

Changing Regulatory Standards Solvency II – Background

Current Solvency I inadequately reflects risk profile of insurers

= establishment of new complex solvency system

Solvency II applicable for EU domiciled (re-)insurers

Solvency II is interlinked with developments of IASB– Consistent definition of capital resources available

Solvency II will likely shift risk management approach in the insurance industry– Burden placed on company to defend its capital adequacy

Solvency II moves toward a more risk-based architectureencouraging companies to properly measure and manage risks

Guy Carpenter 5

Impact of IFRS on future Solvency Rules

Main areas IFRS will influence Solvency II regulations:

– Determination of capital resources available

– Measurement of insurance reserves

– Increased transparency

Investments(partially)

atfair value

Assets Equity & Liabilities

Insurance Reserves

fair value?

Capital

Guy Carpenter 6

Comite Europeen des Assurances (CEA) published comparative study on solvency regimes March 2005

– CEA: The European Federation of National Insurance Associations

Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) published third-wave call in Spring 2005

– CEIOPS: European umbrella organisation for national regulators

EU publishing framework based on CEIOPS and CEA recommendations, targeted for 2006

European Framework Directive published Q2 2006?

– Framework Directive will determine first substantial results as guideline for insurance industry

Directive finalised and agreed 2008?

Implementation of Directive in local regulations 2009/10?

Solvency II - Timetable

Guy Carpenter 7

Solvency II – 3-Pillars

Pillar III

Transparency

Disclosures

Reporting requirements

Pillar II

Supervisory review process

Internal control & risk

management

Intervention powers and responsibilities

of supervisors

3-Pillar Approach

Within Solvency II framework, determination of SCR will be one of the major issues

Pillar I

Quantitative requirements

Quantification insurance reserves

Investment rules

Capital Requirement

• Minimum Capital Requirement (MCR)

• Solvency Capital Requirement (SCR)

• Standardized model

• Internal model

Guy Carpenter 8

Goals Based Capital Structure (1. Adequacy and 2. Predictable and Sustainable Results)

Insurance Asset Operational

1. Underwriting

2. Accumulation / Cat

3. Reserve Deterioration

4. Credit (Counterparty)

5. Market

6. Liquidity (ALM)

7. Admin / Compliance / Governance

8. Strategic

9. Technology /Infrastructure

Influence:

Internal: BOD / Management

External: Rating / Regulatory / Stock Analyst

Insurance Risk Management Framework

Risk Environment

Risk Categories

Guy Carpenter 9

Solvency II – Determination of SCR

SCR likely follows a risk-based capital approach covering all major risk categories of an insurer, not only underwriting risk

Calculation of SCR will be most likely based on

– Standardized model or

– Internal model or

– Combination of both standardized and internal model

(partial internal model)

Guy Carpenter 10

Solvency II – Calculation of SCR

Current approaches to anticipate calculation of SCR vary across Europe

UK, Swiss and Dutch most recently reformed their domestic regimes

– ECR calculations have shown that majority of UK non-life insurers are faced with significantly higher capital requirements

German Regulator (BaFin) and Insurance Association (GDV) currently working on a standard model to anticipate Solvency II (expected mid 2005)

Guy Carpenter Recommendation:

– Insurers that have not yet started to assess future capital adequacy are advised to benchmark with existing regulatory capital adequacy measures

– Capital Adequacy Projector

Guy Carpenter 11

(net-)Premiums

(net-) reserves

Credit risk (reinsurance recoverables)

investment / assetrisk

Possibly other risks such as

operationalrisk

Standardised model

lines of business

lines of business

Solvency I

(net-)Premiums

(net-) claims/-reserves

Solvency II- solvency capital(Standardised Model)

Other risks or risk categories

are not addressed

Solvency IIAnticipated Standardized Factor Based Model

Guy Carpenter 12

Solvency II Evaluation of Capital Requirements

Approximation of regulatory capital benchmarks…:

Approximation of rating agencies’ capital requirements….:

Risk category

ModelInvestment

RiskReserve

RiskPremium

RiskCredit Risk

Operating Risk

Covariance Adj

Net 250 year PML Total

ECR (UK)MCR (AUS) XRBC (US)GDV (Germany)

Risk category

ModelInvestment

RiskReserve

RiskPremium

RiskCredit Risk

Operating Risk

Covariance Adj

Net 250 year PML Total

A.M.Best*S&P* A.M. Best does not make CAT adjustments to calculate the risk capital but deducts the greater of 1/100 wind or 1/250 quake from available capital resources

Guy Carpenter 13

Solvency II – FSA (UK) – Approach

Minimum Capital

Requirement (MCR)

(Solvency I)

Enhanced Capital

Requirement (ECR)

Internal Capital

Assessment (ICA)

Actual Capital ResourcesIndividual

Capital Guidance

(ICG)

BASED ON FSA REVIEW OF ICA AND

ECR

Hard Test

Soft Test

Company Calculation / FSA ReviewComparison ofICG to Actual

Guy Carpenter 14

Solvency II – Internal Models

An internal model is a risk-based capital model developed by the management (DFA-concept)

Development of full-scale and partial internal models will be likely encouraged by regulators

Partial internal models would ease the move from standardized models to full-scale internal models

Both full-scale and partial internal models are subject to regulatory approval

– Will regulators be prepared?

Internally modeled capital will likely be benchmarked with risk capital based on standardized model by regulator

Guy Carpenter 15

Solvency II – Reinsurance Implications

Reinsurance constitutes exchange of insurance risk (primarily underwriting & accumulation) for asset risk – Asset risk carries a lower capital charge than insurance risk, thus

reinsurance can be an effective way to manage regulatory capital needs

Factor based models do not distinguish between proportional and non-proportional reinsurance

Risk mitigating effect of non-proportional reinsurance compared to ceding of profits are reflected more adequately within simulation based models

Accumulation risk reduction impact of reinsurance has most likely to be considered in both standardized and internal models

Guy Carpenter 16

Treatment of Accumulation Risk

Current regulatory guidelines as to ability to withstand catastrophic events

– Australia Prudential Requirements Internal model: reduce probability of default to 1 in 200 year Prescribed method: add net 1 in 250 PML to minimum capital

– U.K Internal Capital Adequacy Standards Internal model: reduce probability of default to 1 in 200 year

– U.S. Risk-Based Capital No specific requirements

– Revised German model (BaFin/GDV) will most likely require additional capital for NATCAT exposure (1 in 200 storm)

Will there be pressure to raise limits under Solvency II?

Guy Carpenter 17

Credit Risk under Solvency II

Concentration in credit risk to be considered– FSA (UK) monitors annual premiums ceded to one reinsurer

(group) to 20%– FSA (UK) monitors total recoverables from any one insurance

group not to exceed 100% of capital resources

Rating of reinsurers to be factored in– The higher the rating of a reinsurer the lesser capital is needed– Increasing tendency to cover credit risk arising from reinsurance

recoverables Retrospective and prospective coverage reinsurance solutions

Diversification and quality of reinsurance recoverables will become more important

Guy Carpenter 18

Dual Effect of Reinsurance on Solvency Rules

Reinsurance provides:

– Capital relief in MCR and especially SCR as discussed

– Protection of capital resources available defined as Equity according to balance sheet (local GAAP or IFRS)

adjusted by items such as

Non-admissible assets

Hybrid capital

Off-balance sheet items

When evaluating impact of reinsurance both risk capital relief and coverage of capital resources available have to be

taken into account

Guy Carpenter 19

Adequate Capitalization: Competing Interests of Stakeholders

Interested Parties Potential Objectives Related Internal Metrics

Directional Pressure on

Capital

1 Management Maintain capital adequacy based on internal measures to support current business and expected growth

Allocate capital to profit centers and measurevolatility around profitability and capital adequacy Optimize Based

on Business Plans

2 Shareholders / Analysts

Predictable, acceptable return on optimal invested capital

Probability of achieving return targets Reduce to Optimum

3 Regulators Capital adequacy Probability of available capital resources fallingbelow target risk-based capital (internal or externalmodels)

Increase to Achieve Cushion over Regulatory

Target

4 Rating Agencies

Capital adequacy Probability of achieving target S&P and A.M. BestCapital Adequacy Ratios (SPCAR, BCAR)

Increase to Exceed Rating Agency Target

Companies generally start with management view and compare against views of other interested

parties

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Economic Capital Covers Unexpected Losses

Potential Losses

UnexpectedLosses

Taken into account in pricing and valuation

decisions

ExpectedLosses

Projection of expected result

Require capital to protect policyholder

interests

Avoids cyclical pricing behaviour

Capital requirements Solvency II

The starting point for Solvency II is that financial strength should only cover unexpected losses. Expected losses should be included in pricing and valuation decisions. Henrik Bjerre-Nielsen, Chairman of CEIOPS, 18 June 2004

Guy Carpenter 21

Regulatory Capital based on Economic Capital

Economic capital as realistic measure for required regulatory capital

– Commensurate with risk-based capital

Companies using internal DFA based models are better able to align internal management goals with regulatory requirements

– Prerequiste: internal models are approved by regulator

Companies having no internal models in place

– Application of standardized model – most likely factor-based - to fulfill regulatory requirements

– Factor-based models are conceptually inadequate for internal management purposes

– Companies are faced with co-existence of regulatory and management capital perspectives

Solvency II:Future Regulatory Capital Requirements

CAS CARE Seminar, June 2005

Susan Witcraft