Solvency II – A view from the USCasualty Loss Reserve Seminar – 2008
Robb W. LuckInsurance & Actuarial Advisory ServicesErnst & Young LLP19 September 2008
Solvency II – A view from the USPage 2
Agenda
► General background► Solvency I vs. Solvency II► Solvency II readiness survey summary► Summary results from Quantitative Impact Studies► Specifications of QIS 4
► Key differences between Solvency II and current solvency measures in the US
► Illustrative case study results► Difference in solvency ratios under RBC, Solvency II QIS 4 formula, and
other estimated rating agency formulas► Difference in technical provisions for reserves – nominal versus
discounted with risk margin
► What could this mean for the US market and the reserving actuary?
Solvency II – A view from the USPage 3
Solvency I versus Solvency II balance sheet
Solvency II balance sheet
Best estimates
Risk margin
MV liabilitiesMV assets
Technical provisions
Free surplus
MCR
Solvency capital requirement
Free surplus
Risk margin
Solvency I balance sheet
Best estimates
BV liabilitiesBV assets
Technical provisions with implicit risk margins
Free surplus
Capital requirement
Free surplus
Solvency II – A view from the USPage 4
Timeline for Solvency II
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Pha
se I
Pha
se I
IDefinition of the general form of the solvency system
Three calls for advice
Consulting documents
Level 2
Implementing measures
Level 3
Application guidelines
QIS 1
QIS 2
QIS 3
QIS 4
QIS etc.
Preparation of the draft
Level 1 directive (major principles)
Level 1 process for directive approval by the Parliament and
European Council
Transposition of the directive into local law
Entry into force of the new Solvency II prudential system
Solvency II – A view from the USPage 5
Solvency II readiness survey
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%We have indicators based on accounting data
We have some additional indicators on performance
We have some additional indicators on performance and risk management (e.g., return on risk capital)
We have already converged towards economic value-based criteria (e.g., return on economic capital)
Measuring performance in relation to risk
Solvency II – A view from the USPage 6
Solvency II readiness survey
Statutory measures only
Rating agency formulas
Developed EC models but will require significant enhancements to comply with Solvency II
Existing EC models will comply with Solvency II
Economic capital models
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Solvency II – A view from the USPage 7
Solvency II readiness survey
Current systems will be sufficient
Minor changes needed
Major changes needed
Haven’t analyzed the issues
The systems challenge
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Solvency II – A view from the USPage 8
Solvency II readiness survey
Current actuarial and risk management expertise fall far short
Some expertise but will require upgraded skill and additional risk management professionals
Some upgrade of skills needed for actuaries and risk management professionals
Current have necessary expertise
Current level of expertise
0%
10%
20%
30%
40%
50%
60%
Solvency II – A view from the USPage 9
Quantitative Impact Studies
Technical provisions
► QIS 1► Discounting in non-life leads to a reduction of 10-15%► In most cases: best estimate + MVM (75% quantile) < current technical
provisions
► QIS 2► Cost of capital vs. quantile approach for MVM: results heterogeneous
► QIS 3► Industry asks for guidance on the assessment of best estimates► Cost of capital approach for risk margins► Proxies allowed for risk margins (fixed % of best estimates)
Solvency II – A view from the USPage 10
Quantitative Impact StudiesFinancial impact on balance sheets – QIS 3
► Technical provisions tended to decrease, with the release of the prudence margin in Solvency I being greater than the additional risk margin under Solvency II.
► This tended to be more than offset by an increase in the capital requirements, the overall solvency ratio tended to decrease. ► Most significant for nonlife companies
► 98% of companies met the MCR and 84% met the SCR, a large scale capital injection is unlikely. However there could be significant reallocation of capital.
► Results for MCR were consistent with 80-90% value at risk over one year time horizon.
► Formula SCR tended to be higher than internally modeled SCR, approximately 25% driven by insurance risk.
Solvency II – A view from the USPage 11
Quantitative Impact StudiesSolvency Capital Requirement (SCR) – QIS 3
► Provisions for expected profit and loss was removed
► Factor based approach for nonlife underwriting risk vs. scenario approach for life companies
► CAT risk in specified regional scenarios
► Operational risk added at top level, function of technical provisions and premium
► Diversification effect from correlation between segments and risk modules was about 20%
► Underwriting risk dominated the overall SCR for non-life companies, 75%
Results:► Internal models produce significantly lower SCR than standard approach (around 25%), mainly
due to underwriting risk► Decrease in solvency ratios: 19.5% of nonlife companies would need additional capital to meet
SCR► Significant fluctuations in available surplus for non-life companies, 40% would decrease by 50% or
more, 20% would increase by 50% or more
Solvency II – A view from the USPage 12
QIS 4 highlightsKey changes in response to QIS 3 issues
QIS 3 issue QIS 4 solution
Nonlife issues
QIS3 technical specification was ambiguous about premium provisions (also referred to as stand-ready obligation or preclaims liabilities). In consequence most nonlife insurers did not use QIS3 as an opportunity to recast their balance sheet onto a full economic basis as Solvency II requires (most introduced discounting but did not rework the traditional unearned premium provision UPR). Proposed QIS4 specification is clearer and proposed simplification is consistent in that combined ratio approximates for estimate of future cash flow.
Nonlife technical provisions
Solvency II – A view from the USPage 13
QIS 4 highlightsKey changes in response to QIS 3 issues
QIS 3 issue QIS 4 solutionNonlife issues
Calibration of NL underwriting risk module of standard formula SCR regarded as unsatisfactory. Some changes to calibration proposed for QIS4.
A simple formula (Layer 1) will apply in QIS4 if regional scenarios (now referred to as Layer 2) are not available. QIS4 also introduces Layer 3 where insurers will calculate capital based on the personalized catastrophe scenarios which are regarded as appropriate to their business.
Nonlife underwriting risk
Nonlife catastrophe
Solvency II – A view from the USPage 14
Key differences between Solvency II and current US solvency measures► Solvency II focus is on capitalizing to a level such that the probability
of insolvency over a one year time horizon is remote, 0.5%
► Solvency II is intended to be more aligned with the individual risk profile of a company► Formula vs. internal model vs. partial internal model► More recognition of risk diversification benefit
► Line of business and risk module correlations► Zero correlation between life and nonlife entities
► Technical provisions for loss reserves are comprised of a discounted best estimate and an explicit risk margin► Question around nominal vs. discounted + risk margin
Solvency II – A view from the USPage 15
Risk margin
► Based on a Cost-of-Capital methodology► Cost of providing amount of eligible own funds equal to SCR,
necessary to support obligations over their lifetime► Cost-of-Capital rate = 6.0%
► For QIS 4 purposes, SCR calculations performed on the basis of the standard formula► Net of reinsurance
► SCR calculation only considers operational risk, underwriting risk and counterparty default risk
► QIS 4 specifies benchmark risk margins as a percent of technical provisions for use if the company cannot determine based on internal data
Solvency II – A view from the USPage 16
Cost-of-capital methodology (1)Steps to calculate the risk margin
Step 1: Calculate SCR for t=0 and for each future year* for each segment
* throughout the lifetime of obligations in that segment
* SCR(0) corresponds to today’s capital requirement of the firm
* but only part of the risks is considered: operational, underwriting and counterparty default
t=0 t=1 t=2 t=Tt=3 ………………
Solvency II – A view from the USPage 17
Cost-of-capital methodology (2)Steps to calculate the risk margin
Step 2: Multiply each of the SCR’s by the Cost-of-Capital rate* determination of cost of holding future SCR’s
* CoC rate = 6% (return above risk free)
t=0 t=1 t=2 t=Tt=3 ………………
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Cost-of-capital methodology (3)Steps to calculate the risk margin
Step 3: Discount the amounts calculated in Step 3* using the risk free yield curve at t=0
* sum of discounted values is risk margin (for this segment)
Step 4: Total risk margin is sum of risk margins in all segments
t=0 t=1 t=2 t=Tt=3 ………………
Solvency II – A view from the USPage 19
Case studies
► Case studies were prepared using US Statutory information to look into three areas of impact under Solvency II► Calibrated companies to 250% RBC and measured solvency ratios
under Solvency II QIS 4 formula and estimated rating agency formulas
► Authorized Control Level RBC compared to Minimum Capital Requirement (MCR)
► Difference between nominal loss reserves and discounted with risk margin using the Solvency II cost of capital method for industry aggregate Schedule P lines of business
Solvency II – A view from the USPage 20
Case studySolvency ratios
Large long-tailed company
Midsize short-tailed company
Multiline companies
0%
50%
100%
150%
200%
250%
300%
RBC Rating Agency #1 Rating Agency #2 Solvency II QIS 4
Solvency II – A view from the USPage 21
Case studySolvency ratios
Monoline medical malpractice
Monoline work comp
Monoline companies
0%
50%
100%
150%
200%
250%
300%
RBC Rating Agency #1 Rating Agency #2 Solvency II QIS 4
Solvency II – A view from the USPage 22
Case studyAuthorized control level RBC vs. MCR
0%
20%
40%
60%
80%
100%
120%
MCR %
Large long-tailed company
Midsize short-tailed company
Monoline medical malpractice
Monoline work comp
Solvency II – A view from the USPage 23
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
HO/FO
0
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
Nominal Solvency II QIS 4
Change = 0.3%
Solvency II – A view from the USPage 24
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
Private passenger auto liability
0
10,000,000
20,000,000
30,000,000
40,000,000
50,000,000
60,000,000
70,000,000
80,000,000
90,000,000
100,000,000
Nominal Solvency II QIS 4
Change = (3.5)%
Solvency II – A view from the USPage 25
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
Commercial auto liability
Change = (4.5)%
0
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
30,000,000
Nominal Solvency II QIS 4
Solvency II – A view from the USPage 26
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
Commercial multiperil
Change = (3.8)%
0
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
30,000,000
35,000,000
40,000,000
Nominal Solvency II QIS 4
Solvency II – A view from the USPage 27
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
General liability
Change = (5.0)%
0
20,000,000
40,000,000
60,000,000
80,000,000
100,000,000
120,000,000
140,000,000
Nominal Solvency II QIS 4
Solvency II – A view from the USPage 28
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
Workers’ compensation
Change = (9.8)%
0
20,000,000
40,000,000
60,000,000
80,000,000
100,000,000
120,000,000
Nominal Solvency II QIS 4
Solvency II – A view from the USPage 29
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
Medical malpractice
Change = (4.1)%
0
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
30,000,000
35,000,000
Nominal Solvency II QIS 4
Solvency II – A view from the USPage 30
Case studyNominal reserves vs. discounted with risk margin for US industry
Risk margin
Best estimate
Special property
Change = (0.3)%
0
2,000,000
4,000,000
6,000,000
8,000,000
10,000,000
12,000,000
14,000,000
Nominal Solvency II QIS 4
Solvency II – A view from the USPage 31
What does this mean for the US market?
► Changing competitor behavior from companies based in Solvency II regulated countries► New capital structures and solvency levels
► How different are nominal reserve levels from discounted with risk margin?
► “Use Test” will require the framework to be embedded in the business process, driving strategic decision making
► Pricing differences
► Convergence with IFRS► Question of when, not if
► Changing reinsurance market in Bermuda► BMA is currently in the process of adopting solvency measures expected
to be similar to Solvency II
► Increased M&A activity and group structure
Solvency II – A view from the USPage 32
What does this mean for the US market?
► Emphasis is on enhancing economic capital modeling and strengthening enterprise risk management frameworks
► Results from the QIS show significant decreases to required capital when modeled internally
► Companies face upward capital adjustments under Solvency II Pillar 2 based on risk management capabilities
► US rating agencies are continuing to emphasize ERM as a factor in assigning ratings
► Initial bar was set and will continue to be raised
Solvency II – A view from the USPage 33
What does this mean for the reserving actuary?► Increased focus on the overall distribution of loss reserves vs. range
of reasonable estimates► Increased need to understand the correlations between reserve segments
► Need to analyze the timing of reserve variability emergence► Ultimate variability vs. one-year time horizon