Emerging European Issues Accounting and Solvency

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Emerging European Issues Accounting and Solvency

• September 21, 2007

Susan Witcraft, St. Paul, Minnesota
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Emerging Accounting Issues
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IFRS Concept

• The International Accounting Standard Board
  (IASB) issues the International Financial
  Reporting Standards (IFRS, formerly IAS)
• From 2005 onwards, all companies listed in the EU
  have to report according to IFRS for their
  consolidated financial statements
• Generally, local GAAP still stays effective for
  financial statements of single entities
  (stand-alone)
• Local taxation is in general not based on IFRS
• IASB tries to harmonize accounting standards
  world-wide
• IFRS rules are influenced by U.S. accounting
  rules (U.S. GAAP)

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IFRS Concept
Assets
Equity and Liabilities
Investments IAS 39
Equity (net asset value)
Insurance Reserves IFRS 4
Other Assets
Other Liabilities
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IFRS Investments
Financial Instrument Categories
Category
Measurement
Changes in carrying amount
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IFRS Insurance Contracts
IFRS 4
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IFRS Insurance ContractsAccounting Mismatch
Phase I (2005 2010?)
Assets
Equity Liabilities
Investments (partially) at fair value
Equity
Insurance Reserves not at fair value
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IFRS Insurance ContractsPhase II

• Exposure draft published in 2007 adoption of
  Phase II in 2010 or later
• Phase II will most likely implement a market
  value approach (fair value accounting) to
  recognize assets and liabilities arising from
  insurance contracts
• Market value approach likely to result in higher
  volatility of net income and equity

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IFRS Insurance ContractsPhase II

• If fair value accounting is adopted, consensus
  appears to be that
• Premium and expenses will be recognized at
  contract inception
• Deferred expenses and premiums will be eliminated
  (e.g. deferred acquisition costs)
• Reserve estimations are based on present value of
  expected cash flows
• Present value will include some form of risk
  margin

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Emerging Solvency Issues
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Solvency IIOverall Objective
EU flag

• Establish a solvency system that is matched to
  the true net risks of an insurance company

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Solvency IIStructural Approach
3-Pillar Approach
Harmonisation among European supervisors.
Pillar I Quantitative method for determining
solvency capital requirement. Pillar II
Supervisors intervention powers. Possible
solvency capital add-on in addition to the
quantitative requirement. Pillar III
Harmonised reporting requirements. Increases
transparency and makes comparison of companies in
different regions easier.
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Solvency IITime Table
?
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Solvency IIEconomic Balance Sheet
ASSETS
LIABILITIES
ASSETS
LIABILITIES
ASSETS
LIABILITIES

• Market values
• Full balance sheet
• Recognition of risk mitigation
• Two solvency levels, solvency capital
  requirement (SCR) and minimum capital requirement
  (MCR)

SCR
SCR
SCR
AC
MCR
MVA
MVA
MVA
MVL
MVL
MVL
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Solvency IIEconomic Balance Sheet
ASSETS
LIABILITIES
ASSETS
LIABILITIES
ASSETS
LIABILITIES

• Market values
• Full balance sheet
• Recognition of risk mitigation
• Two solvency levels, solvency capital
  requirement (SCR) and minimum capital requirement
  (MCR)

SCR
SCR
SCR
AC
MCR
MVA
MVA
MVA
MVL
MVL
MVL
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Solvency IIEconomic Balance Sheet
ASSETS
LIABILITIES
ASSETS
LIABILITIES
ASSETS
LIABILITIES

• Market values
• Full balance sheet
• Recognition of risk mitigation
• Two solvency levels, solvency capital
  requirement (SCR) and minimum capital requirement
  (MCR)

SCR
SCR
SCR
MCR
AC
MVA
MVA
MVA
MVL
MVL
MVL
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Solvency IINon-hedgeable Liabilities Market
Value Margin (MVM)
LIABILITIES
MVL
Market Value of Liabilities Best Estimate
Market Value Margin
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Solvency IIMarket Value Margin (MVM)
Company A
Company A
A
L
A
L
SCR
Solvent
Technical insolvency
t0
t1
tn
Company B
Company B
A
L
A
L
SCR
SCR
SCR
Solvent
Solvent
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QIS 3 Standard ModelSolvency Capital Requirement
Framework
SCR

• Methodology for standard formula
• Bottom up approach
• 1 Risk categories identified
• 2 Capital allocated to each subcategory
• VaR, 99.5, 1 year solvency and risk assessment
  period
• 3 Total company SCR calculated
• Aggregate
• Consider diversification

Operation
BSCR
Health
Credit
UW
Market
Life
Prem/Res
F/X
Life sub risks
Health sub risks
CAT
Property
Interests
Concen- tration
Equity
Spread
Risk silos combined into overall company risk
bottom up approach
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QIS 3 Standard ModelMarket Risk Module

• Purpose of SCRmkt
• Measure impact of movements in the level of
  financial variables, such as stock prices,
  interest rates, real estate prices and exchange
  rates.

• Modules in SCRmkt
• Mktint Interest Rate risk. Upward and downward
  shocks to yield curve.
• Mkteq Equity risk. Downward shock.Taking
  account of the offsetting effect on the value of
  derivaties and short positions.
• Mktprop Property risk. Downward shock to the
  market value of property exposures.
• Mktsp Spread risk. Widening of credit spreads.
• Mktconc Risk Concentrations.
• Mktfx Currency Risk. Shock to exchange rates.

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QIS 3 Standard ModelMarket Risk Module - Mktint
- Market interest rate risk stress test
Evaluate effect of interest rate changes on both
assets and liabilties
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QIS 3 Standard ModelCounterparty Credit Default
Risk Module

• SCRdef
• The risk of default of a counterparty to risk
  mitigating contracts like reinsurance and
  financial derivatives.
• Data requirements
• Replacement cost - Difference between gross and
  net technical provisions plus the extra premium
  minus recoveries
• Probability of default

Ratingi PDi
AAA 0.002
AA 0.01
A 0.05
BBB 0.24
BB 1.20
B 6.04
CCC or lower and NR 30.41
Probability of default
Default risk in standard formula requires
replacement cost estimation
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QIS 3 Standard ModelCounterparty Credit Default
Risk Module
Few reinsurers ? increased counterparty default
risk
Low rating ? increased counterparty default risk
Demand for high securitized reinsurance might
increase
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QIS 3 Standard ModelNon-life Underwriting Risk
Module

• Purpose of SCRnl
• Cover excess losses that might occur due to
  existing insurance provisions and new business.
  Both for CAT and Non-CAT losses.

• NLpr
• Capital charge for the premium and reserve risk.
• NLcat
• Capital charge for the losses arising from
  Catastrophes
• Scenarios defined by local supervisors (local).
• Scenarios defined by CEIOPS (trans-regional).
• Individual CAT scenarios (if more severe than
  prescribed above).

• independence assumed

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QIS 3 Standard ModelOperational Risk Module

• Capital charge Factors applied to gross premium
  and gross technical provisions
• Approximative approach (due to lack of
  operational loss data)
• Currently no recognition of risk management or
  mitigation

Operational risk model in QIS 3 - simplistic
approach
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QIS 3 Standard ModelTotal SCR Formula Aggregation

• Aggregation to SCR Bottom up approach
• Step 1 Combine risks from sub-categories to
  major category (SCRmkt, SCRdef, SCRlife, SCRnl)
• Step 2 Combine major risk categories using
  prescribed correlation matrix (BSCR)
• Step 3 Add operational risk capital charge

• Correlation between risk categories

• SCR calculation

SCR BSCR SCRop

Diversification is a key issue
Undiversified companies are generally penalised
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Internal ModelsScope

• Full Internal Model (long term goal)
• Model and simulate all important aspects of the
  business
• Take correlation between risks into account
  (cause-effect)
• Derive Net Operating Income distribution
• SCR 1 in 200 year negative result
• Partial Internal Model (valuable starting point)
• Model and measure risk using Partial Internal
  Models
• Clearly identify what are the main capital
  drivers of the SCR standard formula and focus on
  these risks first
• Aggregate capital requirements to total capital
  requirement
• Correlation needs to be considered

Metarisk XMR suitable for partial and full
internal modeling
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Internal Models Regulatory Approval
Preapproval required to use internal model for
regulatory solvency assessment
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