Particularities of nonlife insurance Solvency II 24 June 2005 Martin Overbeek

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Particularities of (non)life insuranceSolvency
II 24 June 2005Martin Overbeek
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Agenda

• Introduction
• Financial Assessment Framework Structure
• Valuation Principles
• The Solvency Test
• Continuity Analysis

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Agenda

• Introduction
• Financial Assessment Framework Structure
• Valuation Principles
• The Solvency Test
• Continuity Analysis

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Why risk-based supervision?

• Increasing complexity and globalization of the
  financial sector,
• New and more complex financial instruments and
  funding opportunities
• Increasing attention to enterprise wide risk
  management.
• Economical principle ? pay more attention to
  institutions that need it
• More timely intervention

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Relation with Solvency II and Basel II
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8 IAIS Solvency Cornerstones1

• Look at short-term and long-term robustness
• Be risk sensitive
• Be open on prudence in your requirements
• Define valuation method

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8 IAIS Solvency Cornerstones-2

• Define the provisions
• Use discounted best estimate of liaibilities
• Define control levels
• Use standard models and internal controls

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Agenda

• Introduction
• Financial Assessment Framework Structure
• Valuation Principles
• The Solvency Test
• Continuity Analysis

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What is the Financial Assessment Framework?

• New framework under construction for insurance
  companies in the Netherlands
• Aimed at
• Better insight in the financial position of a
  insurance company
• Risk sensitive capital requirements
• Promoting professional risk management
• Structured early intervention

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Financial Assessment Framework

• Does the insurer have an adequate capital funding
  of the liabilities on the reporting date? ---)
  fair value
• Does the insurer have sufficient capital in order
  to withstand 1-year scenarios with a probability
  of (100 - ?)? ---) solvency test
• Is the insurer able and willing to survive
  certain long term scenarios using all available
  control instruments? ---) continuity analyses
• (investment policy, product policy, financing
  policy, etc.)

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A total balance sheet approach
Assets Liabilities Surplus
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Agenda

• Introduction
• Financial Assessment Framework Structure
• Valuation Principles
• The Solvency Test
• Continuity Analysis

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Actual Value of Liabilities - 1

• A provision that must be determined prospectively
  as the sum of the expected value and a risk
  margin.
• But consists at least of the amount the insurer
  would be obliged to pay the policyholder for
  transferring all of the obligations associated
  with the insurance liability at that moment.

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Actual Value of Liabilities - 2

• Determine what factors, both with regard to their
  nature and scope, have an effect on possible cash
  flows during the intended maturity of the
  insurance contract with regard to these
  liabilities.
• Foreseeable possible future social, legal,
  medical, technological and economic trends, which
  may affect the cash flows in relation to these
  liabilities, must be taken into account.

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CBS Future of life expectancy
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Actual Value of Liabilities - 3

• In determining these liabilities, it will be
  necessary to subdivide underwriting risk groups
  with similar characteristics (homogenous risk
  groups), with suitable balancing of homogeneity
  and statistical confidence.
• This subdivision must be based partly on
  information which can be derived from historic
  data relating to the insurance portfolio in
  question and from relevant data from the
  insurance industry.
• Embedded options will have to be valued and
  included in the provisions as well.

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Valuation Principles

• Ideally, this risk margin is a market value
  margin
• Markets were pricing of this risk can be obtained
  do not exist or they lack the liquidity and depth
  needed
• Interim solution the insurance undertaking could
  approximate this margin for unavoidable risks
  using max acceptable confidence level
• The insurance undertaking may use this approach
  if it meets certain conditions in this regard
• Otherwise, a table of risk factors prescribed by
  the supervisor should be applied
• ? prudence is made explicit

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Non-life technical provisions

• Overview
• The technical provisions should be divided into
  different homogeneous risk groups ---? branches
• For each homogenous risk group the technical
  provisions should be split into Outstanding Claim
  Liabilities Premium Liabilities
• The risk factors are defined as a percentage of
  the best estimate
• No complete proportionality larger sized
  portfolios tend to have a smaller non-systematic
  risk component
• gt research in cooperation with the industry

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NonLife underwriting risk
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Life underwriting risk

• Segmentation

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Agenda

• Introduction
• Financial Assessment Framework Structure
• Valuation Principles
• The Solvency Test
• Continuity Analysis

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Aim Solvency test

• The fair value of freely disposable assets must
  at least equal to the total foreseeble
  liaibilties at fair value
• Shareholdersequity at actual value is adequate
  at the given confidence level to meet the first
  requirement a year after the reporting date,
  given the nature and size of the actual risks

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Financial Assessment Framework Solvency Test

• Within the Solvency Test two capital concepts are
  introduced
• Available capital
• Surplus at realistic valuation of assets and
  liabilities.Does the insurer has an adequate
  capital funding of the liabilities on the
  reporting date?
• Target capital
• Does the insurer has sufficient capital in order
  to withstand 1-year risks with a high
  probability?

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Overview of the solvency test
Underwriting risk
Concentration risk
Assets Liabilities Surplus
Operational risk
Market risk
Credit risk
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Risk Classifications by IAA (International
Actuarial Association)
Political Risk
Invested Asset Credit
Credit Risks
Business Credit
Sovereign Risk
IAA Risks
Underwriting Risks
Market Risks
Interest Rate
UW Process Risks
Equity and Property
Pricing Risks
Currency
Claims Risks
Basis
Economic Env. Risks
Reinvestment
Net Retention Risks
Concentration
Policyholder Risks
ALM
Reserving Risks
Off-Balance Sheet
Operational Risks
Liquidity Risks
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Solvency Models

• Simplified
• Standard
• Internal

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Internal model criteria
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Design of the standard approach

• Credit market risk
• Interest rate risk (S1)
• Equity risk andReal estate risk (S2)
• Commodity risk (S3)
• Currency risk (S4)
• Credit risk (S5)
• Underwriting risk (S6)
• Life insurance
• Non-life insurance
• Operational risk
• Concentration risk

Scenarios Single event based What-if?
Factor based approach
Individual Assessment
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Interest rate risk scenario (1)
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Interest rate risk scenario (2)
Event Fall in rates

• Example
• Surplus changes by -14,5 ?solvency surcharge
  for interest rate risk is 14,5

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Credit Liquidity Risk Scenario (1)

• Standard approach
• Credit spread as risk proxy for credit risk
• - higher credit spread gt larger shock
• - longer maturity gt larger impact shock
• Only systematic risk considered

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Credit Liquidity Risk Scenario (2)

• Standard approach
• Impact on surplus of a 60 increase of the credit
  spread.
• Credit fixed income portfolio with a 5 year
  duration
• Credit spread is 100 basis points
• So spread moves up by 60 basis points
• Fall in asset value of (approximately)
• 60 x 1 (spread) x 5 (duration) 3
• Surplus changes by -3 ?solvency surcharge for
  credit risk is 3 of credit portfolio

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Influence of non-linear instruments (1)
Scenario Equity benchmarks drop 40
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Influence of non-linear instruments (2)
Scenario Equity benchmarks drop 40
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Design of the standard approach
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Regulatory Intervention
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Agenda

• Introduction
• Financial Assessment Framework Structure
• Valuation Principles
• The Solvency Test
• Continuity Analysis

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Philosophy of the Continuity Analysis

• Goals from perspective of regulator/supervisor
• Incorporate a long-term perspective
• Identify possible problems at an early stage
• Bring forward the moment of intervention
• Stimulating risk-awareness

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Continuity Analysis is an extension to Solvency
Test

• Horizon is further away
• Including sales / new liabilities
• Policy and policy instruments are assessed

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Continuity Analysis

• Analysis of continuity including the availability
  and power of institutions policy instruments
• Determining expectation with respect to
  indexation
• Identifying early regulatory intervention moment
• Thinking about a disaster recovery plan in
  advance
• Methodology
• The institution itself draws up a baseline
  scenario for its future development and possible
  stress scenarios for the main risk factors it has
  identified

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Contents of the Continuity Analysis

• Projection (base scenario)
• Financial forecast
• Assumptions (environment)
• Policy instruments
• Stress-testing (shocks and trends)
• Management of the insurance company should
  identify most relevant risk factors
• Stress these risk factors and show how policy
  instruments will help you out of a difficult
  situation

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Continuity Analysis (schematic)
Projections
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Conclusions

• Better insight in the financial position
• Risk sensitive capital requirements
• Structured early intervention

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Questions ???