INTRODUCTION TO SOLVENCY II - A NEW FRAMEWORK FOR REGULATION OF INSURANCE COMPANIES IN THE EU

1
Solvency IIPart 2 Pillar 1(quantitative
requirements)
Vesa Ronkainen Insurance Supervisory Authority,
Finland 30.11.2006
2
Agenda(based an a presentation in Finland by
Raoul Berglund)

• Possible structure of the new solvency regime
• Solvency II and IASB
• Current approach to liability valuation
  (technical provisions)
• Solvency II approach to liability valuation
• Interaction between assets and liabilities (ALM)
• Solvency capital requirement (SCR)
• Adjusted solvency capital requirement (ASCR)
• Internal models for SCR
• Minimum capital requirement (MCR)
• Eligible capital
• Safety measures
• Pillar I interaction with pillars II and III

3
Possible structure of the new solvency regime

• Solvency structure in Solvency I and II (the
  height of the bars are fictive)

Solvency I
Solvency II
Required minimum margin
Adjusted solvency capital Requirement (ASCR)
Capital held in excess of regulatory capital
requirements
Capital held in excess of regulatory capital
requirements
Regulatory capital requirements
Regulatory capital requirements
Solvency capital requirement (SCR)
Technical provision with prudential margins
Minimum guarantee fund
Risk margin
Best estimate liability
Minimum capital requirement (MCR)
4
Possible structure of the new solvency regime
(cont.)
5
Solvency II and IASB
Realistic economic valuation
Realistic economic valuation
Bridge
Regulatory purposes (to ensure insurance
consumers interest)
Financial markets
International Financial Reporting Standards
(IFRSs)
Solvency II
Not equal
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Current approach to liability valuation

• Some problems with the current EU approach to
  technical provisions
• The risk of adverse deviation is addressed by
  building conservatism into reported estimates
• A prudent valuation is required, but limited
  guidance is provided on how this should be
  arrived at or the degree of protection that
  should result
• Different valuation approaches and variability in
  the prudence included in the calculation
• For life insurance future bonuses, costs of
  options and guarantees are commonly implicitly
  included (without taking into account their
  financial nature) within the unknown and variable
  level of prudence

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Current approach to liability valuation (cont.)

• Fails to reflect changes in the underlying
  uncertainty associated with the liability because
  the required margin fluctuates with other
  variables (gt appropriate management responses
  and regulatory intervention may be delayed,
  increasing the risk of insolvency)
• Does not reflect the economic nature of the
  liability cash flows (cannot be used for
  realistic reporting).

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Solvency II approach to liability valuation

• The general liability valuation approach can be
  defined in the following way
• It should require a best estimate increased with
  a risk margin for the uncertainty in the
  insurance liability
• The best estimate equals the expected present
  value (probability weighted average) of all
  future potential cash-flows (probability
  distributional outcomes), based upon current and
  credible information and realistic assumptions.
• Where the benefits being valued contain options
  that may potentially be exercised against the
  company, or the potential liability outcomes have
  an asymmetrical distribution (e.g. guarantees),
  then the best estimate liability must include an
  appropriate value in respect of those options
  and/or asymmetries.
• The risk margin should cover the risk linked to
  the future liability cash-flows over their whole
  time horizon.

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Solvency II approach to liability valuation
(cont.)

• e. Best estimate
• Biometric, expense, surrender assumptions etc
  should reflect historical averages adjusted with
  future trends
• Applies an appropriate interest rate
  term-structure for discounting the future
  payments (risk free interest rate)
• Avoids inappropriate application of surrender
  value floors in life insurance (realistic
  surrender rates)
• Measures the costs of options and guarantees
  embedded in insurance contracts in a market
  consistent way (explicitly taken into account)
• Includes constructive as well as contractual
  liabilities, where the insurer has discretion
  over benefits even if they have not been
  allocated (principles for distribution of
  bonuses)
• Allows possible management actions (regarding
  bonuses in with-profit life insurance business
  for instance)

10
Solvency II approach to liability valuation
(cont.)

• In order to achieve optimal market consistency
  the valuation is divided into hedgeable and
  non-hedgeable components
• If an exposure can be perfectly hedged or
  replicated on a sufficient liquid and transparent
  market, the hedge or replicating portfolio
  provides a directly observable price
  (marked-to-market).
• The no arbitrage assumption implies that the
  market consistent value of the hedgeable
  liability component should be equal to the market
  value of the relevant hedge (replicating)
  portfolio.
• For the non-hedgeable liability component and for
  the remaining risk on partial hedges, the
  valuation process would need to rely on
  methodologies to deliver adequate proxies
  determined on a market consistent basis, i.e.
  arbitrage-free mark-to-model techniques

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Solvency II approach to liability valuation
(cont.)

• In each case where risks are non-hedgeable, a
  conservative valuation based on the best
  estimate plus uncertainty (risk margin) approach
  should be applied (the general valuation
  approach).
• This may also include financial risks, whenever
  these risks can not be hedged in liquid and
  transparent markets or market prices tend not to
  be reliable including an implicit additional
  uncertainty.
• Most insurance obligations needs to be
  marked-to-model because there is no truly liquid
  secondary market in the contracts that could be
  used as benchmarks for marking to market.

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Solvency II approach to liability valuation
(cont.)

• When setting this risk margin the following
  issues need to be considered
• Any risk premium necessary to ensure the
  transferability of the liabilities to a third
  party
• Achieving an appropriate level of policyholder
  protection over the run-off period of the
  liabilities and
• Addressing uncertainty (model, parameter etc.) in
  the valuation of the best estimate
• Thus, while market consistency is the appropriate
  guiding principle for the risk margin, the
  determination of a risk margin should take into
  account regulatory aspects

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Interaction between assets and liabilities
Simplified balance sheet
Equity risk
Equity risk
FX risk
FX risk
Realistic value of liabilities
Interest rate risk
Realistic value of assets
Interest rate risk
Real estate risk
Real estate risk
Commodity risk
Credit risk
Credit risk
Net asset value (NAV)
Commodity risk
Aggregated NAV impact
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Interaction between assets and liabilities (cont.)

• A deep understanding of the interaction is needed
  (ALM).
• Strongly related to management actions in life
  insurance (ALM).
• Possible management actions and their impact on
  the assets and the liabilities (especially)
  should be carefully analysed and documented.
• Should take into account policyholders
  expectation and the duty to treat insurance
  customers fairly.

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Solvency capital requirement - SCR

• The SCR should be a capital requirement which
  guarantees the minimum capital strength to
  maintain appropriate policyholder protection and
  market stability
• Can be determined either by a standard approach
  or by internal models
• SCR should in principle be sufficiently larger
  than the MCR
• Should be risk-based and based on the
  going-concern principle
• The EU Commission has suggested a 99.5 percent
  confidence level (percentile, VaR) over a
  one-year time horizon as a working hypothesis for
  the calibration of the SCR

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Solvency capital requirement - SCR (cont.)

• Thus prudential regulation of insurance can be
  seen to be based on a non-zero failure regime and
  is broadly consistent with the levels of capital
  associated with a BBB rating.
• In practise each risk is calibrated to this level
• The dependencies among the different risks should
  be taken into account
• Reinsurance and other mitigation effect should be
  taken into account
• The calibration of the SCR should not be
  influenced by the existence of any guarantee
  schemes.

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Adjusted solvency capital requirement - ASCR

• Solvency II should provide a mechanism to deal
  with situations where the standardized approach
  underestimates (due to a unrecognized or
  recognized risk in the standard approach) the
  capital required given the firms risk profile.
• Two possible approaches
• Require higher capital as part of Pillar II or
• Require the firm to develop an internal model.
• The supervisory review process in Pillar II
  should also allow Pillar I capital requirements
  to be adjusted for risks that cannot be
  quantified. (e.g. adequacy of internal control)

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Internal models for SCR

• All firms will have the option of using their
  internal models in place of all or parts of the
  standard approach
• Changing parameters in the standard approach is
  not considered to be an internal model
• Internal models should have references to full
  probability distributions
• Regulatory approval will be required to help
  ensure that it is reasonable to rely on a firms
  model for regulatory capital purposes
• The purpose of the validation criteria is to
  enable a regulatory judgment about the extent to
  which the models results provide accurate view
  of the firms risks

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Internal models for SCR (cont.)

• Both qualitative and quantitative aspects should
  be include, which could for instance be
• Model governance
• Model inputs
• Model structure and
• Model output.
• The models selected should be used by the firms
  management to run the business
• Selecting internal models solely to minimize
  capital requirements cherry picking should
  be in a regulatory control

20
Minimum capital requirement - MCR

• Given that SCR is the risk-based capital
  requirement and the key solvency control level, a
  logical role for the MCR is to facilitate run-off
  when breached.
• Thus, the MCR will not be fully risk-based
• There should not be an option for firms to
  estimate their MCR
• Should not be seen as a driver for capital
  requirement
• The MCR should provide capital as a buffer
  against the risk that the firms financial
  strength deteriorates during the process of
  run-off (MCR has already been breached)

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Eligible capital

• Solvency II will need to specify the types of
  capital that are eligible to meet solvency
  requirements.
• A Basel II tier-type approach is under
  consideration, where the capital is categorized
  according to the extent to which they meet the
  regulatory purposes of capital.

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Safety measures

• The EU directive should set out a sliding scale
  of supervisory actions with respect to the
  solvency control levels, providing regulators
  with more discretion in their responses to breach
  of the adjusted SCR than for a breach of Pillar I
  SCR and MCR.
• This is illustrated in the table below

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Pillar I interaction with Pillar II and III

• Pillar II should provide a framework to deal with
  any simplifications and assumptions required to
  capture risks in Pillar I as well as those risks
  not covered by Pillar I SCR.
• The interaction of Pillar III information with
  Pillar I and II needs also to be given
  appropriate considerations.