Solvency II and the Swiss Solvency Test

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Solvency II and the Swiss Solvency Test

• János Blum

Casualty Loss Reserve Seminar San Diego, 11
September 2007
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Contents

• Swiss Solvency Test
• Industry Engagement -Test Runs

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Swiss Solvency Test
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Swiss Solvency Test

• Switzerland is not member of the European Union,
  but Swiss companies have pivotal interest in EU
  regulation
• Compatibility to EU is a main objective of SST
• Swiss Federal Office of Private Insurance
  designed, tested and partially implemented the
  new solvency system between 2002 and 2006
• New Insurance Supervisory Law effective since
  2006
• Full implementation of SST beginning 2011

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Old Insurance Supervision

• Rule based
• Product and Tariff Approval
• Restrictions on products, investments and pricing
• No consideration of asset risks

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Old Insurance Supervision - Problems

• Overexposure to risky assets
• Underpriced long term guarantees
• Accounting and regulatory arbitrage
• Compliance culture
• Abrogation of responsibility to the regulator

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New Insurance Supervision Act of 1.1.2006

• No restrictions on products (except for some
  mandatory life and health products)
• Less restrictions on investments
• Corporate governance and risk management
  requirements
• Appointed Actuary for all insurers and reinsurers

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New Insurance Supervision Act of 1.1.2006

• Supervision of groups and conglomerates
• Consistent requirements for insurers and
  reinsurers
• Responsibility with senior management
• Principle based

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The SST PrinciplesOutput Methodology
Transparency - Responsibility

• 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. All relevant probabilistic states have to be
  modeled probabilistically
• 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
• The internal model has to be integrated into the
  core processes within the company
• SST Report to supervisor such that a
  knowledgeable 3rd party can understand the
  results
• Public disclosure of methodology of internal
  model such that a knowledgeable 3rd party can
  get a reasonably good impression on methodology
  and design decisions
• Senior Management is responsible for the
  adherence to principles

• All assets and liabilities are valued market
  consistently
• Risks considered are market, credit and insurance
  risks
• 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
• 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
• The market value margin is approximated by the
  cost of the present value of future required
  regulatory capital for the run-off of the
  portfolio of assets and liabilities
• Under the SST, an insurers capital adequacy is
  defined if its target capital is less than its
  risk bearing capital
• The scope of the SST is legal entity and group /
  conglomerate level domiciled in Switzerland

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Timetables
EU Switzerland
Political Decision 2002 2002
Project Start 2003 2003
Consulting Phase 2003 to 2009 2003 to 2005
Quantitative Impact Studies / Field Tests 2005 to 2008 (?) 2004 to 2007
New Legislation 2007 to 2011 2006
Mandatory Reporting 2012 2008
New Intervention Regime 2012 2011
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Some Differences SST Solvency II

• 99 TVar vs. 99.5 Var confidence level
• Cost of Capital approach for Market Value Margin
• EU has not yet decided between i) 75th percentile
  and ii) Cost of Capital approach
• Minimum Capital Requirement 60 of Solvency
  Capital Requirement
• EU has not yet decided between i) percentage of
  SCR and ii) separate calculation for MCR, i.e.
  90 confidence level
• Operational Risk taken into account, but not part
  of Pillar I, as not sufficiently quantifiable
• No restrictions on eligibility of capital no
  tiers

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Cost of Capital Approach

• SCR absorbs risks with 1 year time horizon
• At the end of year 1, portfolio is assumed to be
  taken over by another company
• New company provides regulatory capital to absorb
  run-off risk
• Market Value Margin is the NPV of the future cost
  of capital at risk free rate 6

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Internal Models

• If standard model not applicable, internal models
  mandatory
• reinsurance, groups, entities with foreign
  branches
• estimated 80 entities will have to develop
  internal models
• Internal models encouraged, as they demonstrate
  high risk management skills and provide relevant
  company specific information
• High technical standards stochastic modelling
  required. Building and validating internal models
  is resource intensive.
• Consistency same model should be used for all
  external reporting (regulator, rating agencies)
  and internal steering purposes

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Groups

• Incentive to simplify complex group structures
• SST required both on entity level and group level
• Detailed internal model for groups
• Diversification benefit on group level
• Explicit modeling of Capital and Risk Transfer
  Instruments
• internal reinsurance
• loans
• participations
• guarantees
• capital mobility

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Small Companies

• Increased consolidation pressure
• Complexity of Solvency II is a challenge for
  small entities
• limited availability of resources and data
• low participation in test runs indicates lack of
  awareness
• loss mitigation relatively expensive
• standard model leads to high capital
  requirements, building more favourable internal
  models not viable

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Risk Management Risk Mitigation

• Risk Management will become key competence
• Data quality
• Capital adjusted pricing and product structuring
• Modelling capabilities
• Demand for Risk Mitigation will increase
• Hedging financial risk for life insurers
• Reinsuring or securitizing cat risk for PC
  insurers

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Industry Engagement -Test Runs
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Quantitative Impact Studies

• 2005 QIS 1
• compared reserves under Solvency I and Solvency
  II
• measured existing levels of prudence
• tested Cost of Capital approach
• increased awareness in the insurance industry
• 2006 QIS 2
• tested methods for calculating provisions, asset
  values, SCR and MCR
• gathered information on practicability, data
  issues and resource requirements
• measured changes of overall level of solvency
  ratio
• 2007 QIS 3
• calibrates risk and correlation matrices
• tests impact on groups
• tests internal vs standard models
• results to be published in fall 2007
• 2008 possibly QIS 4 to back test draft
  directives

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Quantitative Impact Study 2

• 514 companies (out of 4000) from 23 countries
  participated
• 237 PC, 161 Life, 81 Composite, 22 Health, 13
  Reinsurance
• Overall market share 65 for Life, 56 for PC
• vary from 11 to 94 from country to country
• Generally lower participation by small companies
• Data quality inhomogeneous
• Results published on a no name basis

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QIS 2 Impact on Solvency

• Assets valuated higher
• Liabilities valuated lower
• gt Resulting Available Capital higher
• Required Capital much higher
• gt Solvency Ratios decrease in general
• Most Companies still with Solvency Ratios gt 100

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Swiss Field Tests

• Facultative in 2004 and 2005 (before new
  legislation)
• Mandatory for large companies in 2006 and 2007
• 46 (out of 150) entities participated in 2006, 29
  of them on a voluntary basis. gt90 market share
  covered.
• Mandatory reporting for all companies starting
  2008
• Intervention based on new regime starting 2011,
  i.e. three year transition period

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SST - Solvency Ratios

• Solvency Ratios lower, but mostly still
  sufficient (similar to QIS results)
• Life low correlation between old and new
  Solvency Ratios (R2 12)
• PC no correlation between old and new Solvency
  Ratios (R2 lt 1)
• i.e. completely new situation for most companies

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SST - Breakdown of Balance SheetsApproximative
Numbers

Life Health PC
Reserves at Best Estimate 90 50 90
Solvency Capital Required 8 25 7
Market Value Margin 2 0 0
Excess Capital 0 25 3

Solvency Ratio 100 200 150
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SST - Breakdown of SCR MVMApproximative
Numbers

Life Health PC
Market Risk 70 80 30
Credit Risk 5 5 10
Insurance Risk 15 25 90
Scenarios 10 30 0
Diversification (SCR reduction) -20 -20 -25
Expected Profit (SCR reduction) 0 -20 -10
Market Value Margin 20 0 5
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SST Historic Scenarios - LifeApproximative
Numbers

Solvency drops from 100 to...
Market Crash 2000/2001 lt 60
European Currency Crisis 1992 70
Market Crash 1987 75
LTCM 1998 75
Real Estate Crash 1994 80
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Breakdown of Insurance Risk PCApproximative
Numbers

Normal Claims 45
Large Claims 15
Reserves 40
Diversification 0
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Key findings

• Life insurers sufficiently, PC insurers well
  capitalized
• Assets main risk for life insurers, balance
  sheets vulnerable to historic economic scenarios
• Insurance (underwriting incl. cat) main risk for
  PC insurers, balance sheets resistant to
  scenarios
• Market Value Margin (reserve risk beyond 1 year)
  almost negligible for PC insurers, more
  important for life companies