Solvency II

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Solvency II A view from the USCasualty Loss
Reserve Seminar 2008

• Robb W. Luck
• Insurance Actuarial Advisory Services
• Ernst Young LLP
• 19 September 2008

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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?

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Solvency I versus Solvency II balance sheet
Solvency II balance sheet
Solvency I balance sheet
BV liabilities
BV assets
MV liabilities
MV assets
Free surplus
Free surplus
Free surplus
Free surplus
Solvency capital requirement
Capital requirement
MCR
Risk margin
Best estimates
Risk margin
Best estimates
Technical provisions with implicit risk margins
Technical provisions
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Timeline for Solvency II
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Definition of the general form of the solvency
system
Phase I
Three calls for advice
Preparation of the draft Level 1 directive
(major principles)
QIS 1
Phase II
QIS 2
Consulting documents
Level 2 Implementing measures
Level 3 Application guidelines
QIS 3
Level 1 process for directive approval by the
Parliament and European Council
QIS 4
QIS etc.
Transposition of the directive into local law
Entry into force of the new Solvency II
prudential system
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Solvency II readiness survey
Measuring performance in relation to risk
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)
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Solvency II readiness survey
Economic capital models
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
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Solvency II readiness survey
The systems challenge
Current systems will be sufficient Minor changes
needed Major changes needed Havent analyzed the
issues
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Solvency II readiness survey
Current level of expertise
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 Curren
t have necessary expertise
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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)
  lt 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)

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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.

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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

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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
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QIS 4 highlightsKey changes in response to QIS 3
issues
QIS 3 issue QIS 4 solution
Nonlife 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
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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

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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

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

• Step 1 Calculate SCR for t0 and for each future
  year
• for each segment
• throughout the lifetime of obligations in
  that segment
• SCR(0) corresponds to todays capital
  requirement of the firm
• but only part of the risks is considered
  operational, underwriting and counterparty
  default

t0
t1
t2
tT
t3

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Cost-of-capital methodology (2)Steps to
calculate the risk margin

• Step 2 Multiply each of the SCRs by the
  Cost-of-Capital rate
• determination of cost of holding future SCRs
• CoC rate 6 (return above risk free)

t0
t1
t2
tT
t3

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Cost-of-capital methodology (3)Steps to
calculate the risk margin

• Step 3 Discount the amounts calculated in Step 3
• using the risk free yield curve at t0
• sum of discounted values is risk margin (for
  this segment)
• Step 4 Total risk margin is sum of risk margins
  in all segments

t0
t1
t2
tT
t3

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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

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Case studySolvency ratios
Multiline companies
Large long-tailed company Midsize short-tailed
company
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Case studySolvency ratios
Monoline companies
Monoline medical malpractice Monoline work comp
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Case studyAuthorized control level RBC vs. MCR
Large long-tailed company Midsize short-tailed
company Monoline medical malpractice Monoline
work comp
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Case studyNominal reserves vs. discounted with
risk margin for US industry
HO/FO
Risk margin Best estimate
Change 0.3
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Case studyNominal reserves vs. discounted with
risk margin for US industry
Private passenger auto liability
Risk margin Best estimate
Change (3.5)
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Case studyNominal reserves vs. discounted with
risk margin for US industry
Commercial auto liability
Risk margin Best estimate
Change (4.5)
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Case studyNominal reserves vs. discounted with
risk margin for US industry
Commercial multiperil
Change (3.8)
Risk margin Best estimate
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Case studyNominal reserves vs. discounted with
risk margin for US industry
General liability
Risk margin Best estimate
Change (5.0)
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Case studyNominal reserves vs. discounted with
risk margin for US industry
Workers compensation
Risk margin Best estimate
Change (9.8)
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Case studyNominal reserves vs. discounted with
risk margin for US industry
Medical malpractice
Risk margin Best estimate
Change (4.1)
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Case studyNominal reserves vs. discounted with
risk margin for US industry
Special property
Change (0.3)
Risk margin Best estimate
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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 MA activity and group structure

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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

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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