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Federal Office of Private Insurance

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Title: Federal Office of Private Insurance


1
Der Schweizer Solvenztest und Risk Management
  • Federal Office of Private Insurance
  • Philipp Keller
  • Research Development
  • Düsseldorf, 16 January 2007

2
Overview
Valuation
Economic Balance Sheet
Limit System
Internal Models
Group Diversification
Risk and Capital Management
Scenarios
Risk Mitigation and Transfer
Responsibilities
Risk Based Supervision
3
Contents
  • Principles-Based Supervision
  • Swiss Solvency Test Methodology
  • Market Consistent Valuation
  • Internal Models
  • Scenarios
  • Risk and Capital Management
  • Outlook

4
Supervision in the Past Statutory Valuation
The actuarial convention according to which the
composition of the assets determines the size of
the liabilities is one of the weirdest emanations
of the human mind. It's a metaphor - like saying
that the advent of jet planes made the Atlantic
narrower - and metaphor has a limited place in
finance Speech given by Martin Taylor to the
National Association of Pension Funds conference
  • Discount rates for liabilities were set with
    reference to an expected asset profit based on
    past experience
  • Implicit - often unknown - prudence in
    liabilities
  • No explicit valuation of embedded options and
    guarantees
  • Amortized cost for bonds
  • Solvency 1 No capital requirement for market and
    credit risk
  • High risk assets resulted in reduction of
    liabilities
  • Sales-forces pushed for adding high guarantees to
    life policies
  • Foreclosing of investment opportunities due to
    amortized cost approach for bonds
  • Cash flow underwriting
  • Downward spiral when business contracts
  • Underwriting cycles are exacerbated

5
Correlation between Solvency 1 and SST
The correlation between the Solvency 1 ratio and
the SST solvency ratio is 0 for nonlife and
approx. 0.5 for life (based on provisional data
from field test 2006)
Nonlife
Life
Solvency 1 ratio
Solvency 1 ratio
Risk bearing capital / target capital
Risk bearing capital / target capital
correlation ? 0.56
correlation ? -0.178
6
Rules- vs. Principles-Based Supervision
Underlying most arguments against the free market
is a lack of belief in freedom itself, Milton
Friedman
Regulation A system of laws, decrees, rules,
principles, implicit and explicit conventions and
expectations, incentives, rewards and
punishments, etc.
Rule Based Approach
Principles Based Approach
A system trying to define and micro-manage the
insurance market
A system promoting a free and liberal market
Regulator
Regulator
The system needs to promote competition, punish
collusion and create a level playing field via
risk based capital requirements and transparency
The complexity grows over time, the system needs
to be adapted continuously to new products
Liberal Insurance Market
Dirigistic Insurance Market
The market decides which companies succeed or fail
? The 5-year plan approach to regulation
7
Principles vs Rules
.. in designing Solvency 2 our principal aim
should be to incentivise insurance firms to use,
and reward them for using, modern risk management
practices appropriate to the size and nature of
their business. Speech by John Tiner, Chief
Executive, FSA, ABI conference on Solvency II
and IASB Phase II, 6 April 2006
A risk based solvency system has to rely on
principles rather than rules if it has to give
incentives for risk management
Principles-based standards describe the objective
sought in general terms and require
interpretation according to the circumstance.
A rule-based approach is not be possible if
internal models will be used for regulatory
purposes
A principles based approach however only works
with a responsibility culture and not with a
compliance culture
8
Elements of Supervision
Indirect supervision to ascertain that
professional standards are defined and in-line
with regulatory expectations
Principles based supervision will depend on a web
of relationships between the company,
professional bodies and the supervisor For a
liberal, principles based approach to function,
all have to see to it that the system of checks
and balances works
Supervisor
Direct supervision and check that oversight
responsibilities are implemented
Actuarial Profession
Accounting Profession
Professional guidance and enforcement of code of
conduct
Implications for supervision closer contact and
dialogue with the board, professional bodies and
all relevant functions within the company
Board of Directors
9
Expectations on the Board
  • The Board of Directors is responsible for
  • the governance, guidance and oversight
    responsibilities that are critical to an
    effective internal control structure
  • defining necessary board committees (e.g. audit
    committee, nomination and compensation
    committee,)
  • The Board as a whole needs to have sufficient
    technical as well as strategical insurance
    know-how to be able to supervise and guide the
    company as well as the necessary stature and
    mindset
  • A Board must be prepared to question and
    scrutinise managements activities, present
    alternative views and have the courage to act in
    the face of obvious wrongdoing
  • The Board and management need to know how adverse
    a risk must be for it to impair the insurers
    financial position. This should include all risks
    arising from the insurers assets and liabilities
  • The members of the Board need to satisfy fit and
    proper requirements and have to minimize conflict
    of interests
  • The Board needs to define the risk appetite and
    see to it that it is in line with the actual risk
    capacity of the company

10
Elements of Supervision
As of 2007, FOPI will meet external Board of
Directors and Senior Management to discuss risk
positions of companies and alignment of strategy
with risk capacity For large or complex companies
or companies with a high risk exposure, the
meetings will be at least yearly
FOPI will discuss with the Board the results of
the SST/internal models and specific risk
exposures of the company FOPI will discuss with
senior management in addition the embedding of
the SST/internal model within the company, the
relevance of risk management as well as the
influence of risk on the strategic
FOPI has no intention to set the strategies of
the supervised companies but wants to have
comfort that strategic decisions are discussed
within senior management and with the board in
the context of the companys actual risk capacity
11
Contents
  • Principles-Based Supervision
  • Swiss Solvency Test Methodology
  • Market Consistent Valuation
  • Internal Models
  • Scenarios
  • Risk and Capital Management
  • Outlook

12
Swiss Solvency Test 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
  • Scenarios defined by the regulator as well as
    company specific scenarios have to be evaluated
    and, if relevant, aggregated within the target
    capital calculation
  1. All relevant probabilistic states have to be
    modeled probabilistically
  2. 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
  3. The internal model has to be integrated into the
    core processes within the company
  4. SST Report to supervisor such that a
    knowledgeable 3rd party can understand the
    results
  5. Public disclosure of methodology of internal
    model such that a knowledgeable 3rd party can
    get a reasonably good impression on methodology
    and design decisions
  6. Senior Management is responsible for the
    adherence to principles

Defines How-to
Defines Output
Transparency
13
Swiss Solvency Test Basic Equations
  • Most capital models consist of two basis
    components
  • A valuation V(.) is a mapping from the space of
    financial instruments (assets and liabilities) in
    R
  • V A L ? R, where A L is the space of all
    assets and liabilities
  • A risk measure rm(.) of a random variable (e.g.
    VaR, TVaR,)

AC(t) V(A(t))-V(L(t)), t0,1
SCR - rm( AC(1) AC(0) )
Available capital at time t random variable
Available capital at time 0 known
Valuation Market consistent Risk Measure
Expected Shortfall
For the SST
14
The Economic Balance Sheet
The market consistent (economic) balance sheet
Free capital
Available capital
SCR Required capital for 1-year risk
Market Value Margin
Cost of Capital Margin
Market value of assets
Market consistent value of liabilities
Market value of the replicating portfolio
Discounted best estimate of liabilities
15
Risk as Change of Available Capital
Risk quantification via standard models or
internal models
Available capital changes due to random events
Year 0
Year 1
Probability density of the change of available
capital
Revaluation of liabilities due to new information
Available Capital
Market Value Margin
New business during one year
Probability lt 1
Claims
Change in market value of assets
Average value of available capital in the 1
bad cases TailVaR -SCR
Catastrophes
Market consistent value of liabilities
Market value of assets
Best estimate of liabilities
Economic balance sheet at t0 (deterministic)
Economic balance sheet at t1 (stochastic)
16
Standard vs. Internal Models
  • Risk Quantification
  • Using standard models for life, PC and health
    companies, if the standard models capture the
    risk the companies are exposed to appropriately
  • Using internal models for reinsurers, insurance
    groups and conglomerates and all companies for
    which the standard model is not appropriate (e.g.
    if they write substantial business outside of
    Switzerland)

The use of an internal model is the default
option, the standard models can only be used if
they adequately quantify the companys risks
17
Market Consistent Valuation
Market Consistent Value of Liabilities Best
Estimate MVM
  • market value (if it exists) or
  • value of a replicating portfolio of traded
    financial instruments cost of capital margin
    for remaining basis risk as a proxy for the MVM

Replicating portfolio a portfolio of financial
instruments which are traded in a deep, liquid
market, with cash flow characteristics matching
either the expected cash flows of the policy
obligations or, more generally, matching the cash
flows of the policy obligations under a number of
financial market scenarios (IAIS Structure Paper)
Simple version (replication of expected cash
flows) Replicating portfolio consists of
government bonds, MVM does not contain credit
risk component Complex version (replication of
cash flows under a number of financial market
scenarios) Replicating portfolio consists of
government and corporate bonds, swaps and other
derivatives to capture payouts of embedded
options and guarantees. MVM contains credit risk
component, but basis risk is generally smaller
than under the simple replicating portfolio
18
Market Consistent Valuation Life
Profit participation features The market
consistent value of life portfolios containing
substantial profit participation features
necessitates - in theory the calculation of the
economic and statutory position of the company
over the whole run-off of the company.
  • The complexity in a group setting becomes
    daunting
  • The management options/strategy of the company
    rsp. group needs to be modeled over a long time
    horizon
  • Current discussions with industry Which
    simplifications are acceptable

Review of models Supervisors need to have
comfort that the management rules correspond to
the actual strategy the requirements on the
technical sophistication of companies increases
massively The theoretically correct method
implies the use of multi-year risk models for the
whole group taking into account management
options per legal entity as well as intra-group
capital transfers over the whole duration of the
run-off
19
SST Standard Models
Market Consistent Data
Mix of predefined and company specific scenarios
Standard Models or Internal Models
Scenarios
Risk Models
Valuation Models
Market Risk
Market Value Assets
Credit Risk
Life
Best Estimate Liabilities
PC
MVM
Health
Output of analytical models (Distribution)
Aggregation Method
Target Capital
SST Report
20
Contents
  • Principles-Based Supervision
  • Swiss Solvency Test Methodology
  • Market Consistent Valuation
  • Internal Models
  • Scenarios
  • Risk and Capital Management
  • Outlook

21
Internal Models
A generic, scenario based model for economic
capital calculations
Risk Factors
Portfolio of Assets and Liabilities
Capital and Risk Transfer Instruments
Dependency Assumptions
The main task of an model used for the SST or
Solvency 2 is the projection of the economic
balance sheet of a company from now (t0) to 1
year in the future (t1) For the valuation of
assets and liabilities in one years time, the
(possible) states of the world have to be
determined In a scenario based model, future
states of the world at t1 have to be simulated.
These states encompass the evolution of all
relevant risk factors over the whole duration of
the assets and liabilities
Scenarios
s1, s2,..., sn
Valuation
Profit and Loss
e1, e2,.., en
22
Internal Models
(s1(t) ? s0)
(s1(t) ? s1(1))
(s2(t) ? s0)
t0
(s2(t) ? s1(1))
s0
s0 State of the world now (observable)
(s3(t) ? s0)
t1
(s1(t) ? s3(1))
Economic balance sheet at t1
Economic balance sheet at t0
23
Internal Models
The valuation of the economic balance sheet
now (t0) depends on the state of the world now
as well as the projection of the risk factors
(e.g. the possible evolution of the state of the
world) from now until the run-off of assets and
liabilities. Risk factors are company specific
(interest rates, FX rates, mortalities,
catastrophes, etc.)
The valuation of the economic balance sheet in
1 year depends on the simulated states of the
world at t1 as well as projections of the risk
factors given the simulate states of the world at
t1
Insurance model are substantially more complex
conceptually than most bank models due to the
long time horizon of liabilities. The long time
horizon makes model not just more difficult to
calibrate but qualitatively different from 10 day
VaR engines or Basel 2 type credit risk models
used by banks.
To make the calculations tractable, most
models use simplifications (e.g. using only the
expected risk free interest rate for discounting,
assuming steady states for the evolution of risk
factors etc.). It is then important, that the
company is aware of the simplifications and the
underlying assumptions
24
Internal Models Applications
Impact of changes in mixture of assets and
liabilities for ALM, product development,
exploring business opportunities, etc.
Analysis of the impact of capital and risk
instruments on PL (e.g. reinsurance, contingent
capital,)
Analysis of the value of the firm for different
investors (policy holders, share holders, bond
holders, etc.)
Different valuations (economic, statutory,) to
assess risks for relevant metrics
Specific scenarios allow detailed analysis of
underlying causes of a companys risk exposure
Analysis of liquidity constrains
Capital allocation
Setting of limit systems
Different risk measures (VaR, TailVaR,) for
various confidence levels to capture risk
25
Modelling Deficiencies
Modelling Deficiencies
Key Success Factors
  • Rule based mindset of some companies
  • Embedding within risk management
  • Senior management pushing for desired results
  • Lack of appropriate documentation
  • The modeling of optionalities is uneven
  • Credit risk modeling For some companies, credit
    risk is new
  • Real estate modeling some companies insist on
    modeling real estate as a mix of bond-like and
    equity like tranches
  • State dependent parameters are often calibrated
    to normal experiences (e.g. correlations)
  • The evaluation of scenarios is spotty
  • Lack of peer review
  • Data quality
  • Risk culture Willingness to know about risks and
    acceptance that strategy has to be aligned with
    the companys risk bearing capacity, engaged
    board of directors
  • Open dialogue within the company (e.g.
    departments communicate well, in particular CRO,
    CFO, Actuary and CIO)
  • Direct reporting line of the CRO to the CEO
  • Integrity of responsible persons
  • Risk management and capital management aligned
  • Deep know-how of modellers, know-how and support
    of senior management and the board

26
Contents
  • Principles-Based Supervision
  • Swiss Solvency Test Methodology
  • Market Consistent Valuation
  • Internal Models
  • Scenarios
  • Risk and Capital Management
  • Outlook

27
Scenarios
Company specific scenarios Allow senior
management and the board to have an informed
discussion on strategic decisions For
supervisors, the quality of company specific
scenarios is a good indication on the quality of
the companys risk management Predefined
scenarios Allow the analysis of the risk
exposure of the company For supervisors, they
allow a discussion with senior management and the
board on the actual risk exposure of the company
Both company specific and predefined scenarios
are important tools for supervisors to assess the
quality of risk management and the companys
internal processes. They are the basis of an
informed dialog of supervisors with senior
management and the board of directors
28
Risk Concentrations
  • The knowledge about the limitation of risk
    concentrations is an essential part of risk
    management
  • Insurers need to formulate and evaluate scenarios
    to identify and quantify its main risk
    concentrations
  • The identification of risk concentrations has to
    encompass the whole spectrum of risks, and should
    not be limited to exposures to counterparty only
  • Senior management and the board of directors have
    to be informed on the risk concentrations and the
    companys strategy aligned
  • The insurer then has to put into place an
    effective limit system

Scenarios
Risk Concentrations
Limit System
Risk Management Internal Models
Senior Management
Board of Directors
Strategy
29
Contents
  • Principles-Based Supervision
  • Swiss Solvency Test Methodology
  • Market Consistent Valuation
  • Internal Models
  • Scenarios
  • Risk and Capital Management
  • Outlook

30
Risk Management
Warren Buffetts three key principles for running
a successful insurance business
  • They accept only those risks that they are able
    to properly evaluate (staying within their circle
    of competence) and that, after they have
    evaluated all relevant factors including remote
    loss scenarios, carry the expectancy of profit.
    These insurers ignore market-share considerations
    and are sanguine about losing business to
    competitors that are offering foolish prices or
    policy conditions.
  • They limit the business they accept in a manner
    that guarantees they will suffer no aggregation
    of losses from a single event or from related
    events that will threaten their solvency. They
    ceaselessly search for possible correlation among
    seemingly-unrelated risks.
  • They avoid business involving moral risk No
    matter what the rate, trying to write good
    contracts with bad people doesn't work. While
    most policyholders and clients are honorable and
    ethical, doing business with the few exceptions
    is usually expensive, sometimes extraordinarily
    so.

February 28, 2002, Warren E. Buffett
31
Risk Management
The Need for Probabilistic Thinking For a risk
culture to develop, senior management, the board
and supervisors must be able to understand the
probabilistic nature of the world
Example A CRO hedges the risk of interest rates
falling since the company is short in duration.
Interest rates then increase and the hedge
expires worthless. Senior management then
criticizes the CRO for destroying
profit Example A CRO models the exposure to
hurricane risk according to industry
best-practice but the actual loss is a multiple
of the predicted loss. The supervisor then assume
wrong-doing and an intentional optimistic
assumption to minimize required regulatory capital
In insurance, reality can and often will be
different from prediction. While only one of the
possible outcomes will be realized, there
nevertheless are many a-priori potentialities,
which the company and risk management have to
consider
32
Risk Mitigation and Transfer
Internal Models will enable also mid-sized
insurers and groups to manage risks firm wide and
will open many channels for risk transfer and
mitigation
Asset mix to optimize diversification between
asset classes
Use of derivatives, dynamic hedging of embedded
optionalities,
Improved ALM
Insurer
Securitization, SPEs
Reinsurance
Transfer of peak risks, cat risks and
optimization of LoB diversification
Optimized Diversification
Optimized LoB diversification business mix,
geographical spread via coinsurance, reinsurance,
portfolio swaps,
Optimized intra-group capital allocation ?
intra-group capital and risk transfer
33
Impressions from the Industry
Zusammen mit aussenstehenden Aktuaren haben wir
die notwendigen, aufwendigen Arbeiten frühzeitig
in Angriff genommen und erachten sie als
Fitnesstest. Zudem sehen wir die Chance, optimale
Beurteilungsgrundlagen für unsere neue
Rückversicherungslösung zu erhalten. Die
bisherigen Zwischenresultate bestätigen die gute
Solvabilität und Risikofähigkeit der
emmental. Geschäftsbericht 2005, Emmental
Versicherung
For our risk and investment strategy we need to
be able to quantify the cash flow structure and
the risk bearing capacity of our portfolios. For
this the SST is a good (although in many aspects
still to be modified and enhanced) basis. In
addition, we can use the SST to test capital
requirements for alternative investment
strategies. As we have not yet an equally well
suited internal model, the SST is for us of great
benefit. We see it as an integral part within our
ALM process. Comment by René Bühler from the
National Versicherung
The SST produces a lot of interesting data,
and we now know more about the company and
understand its business better. Most important of
all, however, is that we are now sure we have
enough reserves, and we know that the reserves
could in fact be smaller. Interview with
Patrizio Polesana, Metzgerversicherung in Life
and Pension Magazine
34
Management of Group Diversification
The SCRs of a groups legal entities can be
optimized using capital and risk transfer
instruments The amount of optimization available
to the group depends on the definition of the MCR
SCR
MCR
SCR
SCR
Legal Entity 1
MCR
MCR
Legal Entity 2
Legal Entity 3
35
The CRTI Approach
Group Test Assumes capital transfer only via
formal capital and risk transfer instruments
  • The CRTI approach for groups is consistent with
    FOPIs solo solvency test Only formal CRTI are
    considered, non-legally enforceable promises by
    the group to support a subsidiary are not
    quantified within the solo SST
  • The CRTI approach requires modeling of (major)
    legal entities, thereby giving incentives for
    appropriate capital management according to legal
    entities economic capital needs
  • The CRTI approach better captures the options and
    strategy of a group in case of financial distress
    than the consolidated model
  • ?FOPI decided to choose the CRTI approach for the
    group solvency test

Solo Test Assumes capital transfer only via
formal capital and risk transfer instruments
Formal capital and risk transfer instruments
36
CRTI Approach Risks
The risk of a subsidiary for the parent company
is emanating from the change in economic value of
the subsidiary and potentially from CRTI
which will be implemented during a time horizon
of one year
No CRTI in place The subsidiary is in default,
the economic value of the subsidiary for the
parent is zero. The CRTI approach takes into
account the legally limited liability structure
The model assumes that in case of financial
distress, the group will not support a subsidiary
if no CRTI are in place
Adverse event impacting the subsidiarys balance
sheet, subsidiary is insolvent
Subsidiary
Parent
A
A
L
L
Subsidiary
Parent
A
A
L
L
A
L
A
L
An insolvency protection guarantee from the
parent to the subsidiary is in place The
subsidiary is in run-off, the value of the
subsidiary for the parent is zero and capital is
further depleted due to payout of guarantee
Economic value of subsidiary as asset of the
parent
Missing capital of subsidiary is replenished with
assets from the parent
37
CRTI Approach Properties Diversification
Group Level Diversification A parent company
benefits endogenously from group level
diversification by taking into account the
dependency structure between the risks of its
subsidiaries and the risks of the parent
company Down-streaming of Diversification A
parent company can down-stream group level
diversification via capital and risk transfer
instruments (e.g. intra-group retrocession,
guarantees, etc.) to its subsidiaries. A
guarantee from the parent to a subsidiary allows
a subsidiary to reduce the economic capital
requirement but increases the capital requirement
for the parent If there is no formal instrument
from the parent to the subsidiary which ensures
that the parent will support the subsidiary, then
the subsidiary cannot benefit from being part of
a group
Parent Company
Subsidiary1
Subsidiary2
Parent Company
Subsidiary1
Subsidiary2
Assets exceeding technical provisions and debt
SCR
Within the SST, diversification is not seen as a
(virtual) asset but as the fact that required
capital is reduced due to a legal entity being
part of a group
Effect of Diversification
SCR without taking into account diversification
38
Contents
  • Principles-Based Supervision
  • Swiss Solvency Test Methodology
  • Market Consistent Valuation
  • Internal Models
  • Scenarios
  • Risk and Capital Management
  • Outlook

39
Outlook
Prediction is very difficult, especially about
the future Niels Bohr
Consequences of an economic and risk based view
  • A consistent quantification of all risks will
    demand that many functions within a company work
    together actuaries, underwriter, claims
    managers, RI specialists, CROs, CIOs, CFOs,
  • An economic view of business will demand deeper
    quantitative skills
  • Companies will have to optimize their economic
    performance ? optimization of asset liability
    mismatch, coherent reinsurance programs,
    securitization of risks, optimization of
    diversification via coinsurance, geographical
    spread, etc.
  • Mid-sized companies might become being squeezed
    between smaller, specialized and nimble insurers
    and large, well diversified insurance groups
  • Large companies will have to optimize their risk
    and capital allocation to maximize diversification

40
Outlook
Whether a pervasive risk culture can develop and
lead to an innovative, thriving insurance market
depends not only on the re/insurance market, but
also on how future regulation will be implemented
  • Main issues
  • Group Diversification Will group level
    diversification be recognized or do local
    supervisors insist on full (physical)
    capitalization of all legal entities in their
    territory?
  • Legacy Regulation Will implicit prudence
    margins, limits on investment, eligibility of
    assets be replaced with an economic view of risk
    and transparency or will the old prudence driven
    approach with supervision coexist with the
    risk-based solvency framework?
  • Internal Models Will supervisors accept that
    company-specific risk-based solvency will entail
    to a certain degree the subjective assessment of
    re/insurers of their risk exposure or will
    supervisors prefer to achieve comparability of
    calculation steps via standard-models rather than
    comparability of results via internal models?

41
Outlook
I believe we are on an irreversible trend toward
more freedom and democracy - but that could
change Dan Quayle
  • The success of principles based supervision will
    depend crucially on
  • Trust and an open and informed dialog between the
    industry and the supervisor
  • Development of a responsibility culture ? the
    willingness to do the right thing rather than
    purely complying with a minimal set of rules
  • Adequate self-governance of the industry and
    relevant professional associations (actuaries,
    accountants,)

The ultimate responsibility for ascertaining
adherence to principles lies with the supervisor
but a principles based supervisory framework will
depend on devolving responsibility for
implementing the principles away from the
supervisor to the board of directors, senior
management and professional organizations
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