MIMAPillar 1 – Quantitative RequirementsDecember 2nd, 2011

Marsh Risk Consulting

MARSH

Agenda

1. Quantitative requirements : the new deal

2. Impact on Captives

3. Best practices for capital optimization

4. Conclusion

3MARSH

The rationale behind Solvency II

� Main objectives of Solvency II

� Improve protection of policy holders and beneficiaries

� Increase financial sustainability of insurance and reinsurance undertakings

� Improve risk management practices

� Complete harmonization throughout Europe and enhance competition

�More sophisticated measure and efficient control of the risks of the undertaking

� 3-Pillar approach

SOLVENCY II

Pillar III

Pillar 1 Pillar 2 Pillar 3

Quantitative

requirementsQualitative

requirementsDisclosures

Some quantitative elements are embedded in Pillar 2

Solvency II

4MARSH

Solvency I reminder

Advantages Drawbacks

•Simple to use (legibility of the formula):

�Non-life

�18% / 16% of premiums

�26% / 23% of claims

� Life

� 4% of Mathematical provisions + 0.3% /

0.1% / 0.15% of capital at risk

•Uniform calculation

•Based on actual historical observation

•Supported by prudential reserving policy

• Formula only based on underwriting

parameters, other risks are not explicitly taken

into account

• Does not take into account underlying volatility

• Does not take into account risks correlation

• Does not take into account diversification of the

portfolio (simple aggregation of capital

requirements calculated for each line of

business)

• Risk mitigation through reinsurance is only

partially recognized

• …

Solvency I

Solvency II

Aims at mitigating the above

drawbacks

Max of the 2

5MARSH

Solvency II - Pillar 1

Pillar 1 is supported by 2 principles

�Fair value valuation of assets and liabilities

�Risk based capital approach

-Explicit assessment of all risks the undertaking is exposed to

-Seeking to create a capital position at least equivalent to BBB+ rated company

-Creates need to be 99.5% certain that the undertaking will meet liabilities over the next 12 months

Strong corporate governance processes defined under Pillar 2

�Aims at supporting the assumptions used to assess capital needs of the undertaking in accordance

with Pillar 1 principles

6MARSH

Pillar 1 - Fair value principle

… to a consistent

fair value

Assets

Prudent

approach

Own capital

From a local

GAAP valuation…

AssetsMarket value

Technical

reservesBest estimate

+ risk margin

“NAV”Market

consistent

value of the

company

Assets

“NAV (Net Asset Value) is the difference between the market consistent value of assets

and liabilities”

Fair value

� Assets : market value

� Liabilities : “best estimate” approach

Economic value of the undertaking

= Assets minus Liabilities (NAV)

Technical

reserves

7MARSH

Liabilities

Probability

Best estimate+ risk

margin

VaR 99.5%

SCR amount

Loss amount resulting in the

insolvency of the undertaking

Pillar 1 – Risk-based capital approach

“Solvency Capital

Requirement (SCR) is the VaR of the market

consistent value of the

company to a 99.5%

confidence level on a 1

year horizon”

Stress tests

- market risks,

- underwriting risks,

- operational risks,

- …

« Buffer » in case of adverse risk development

MARSH

Pillar 1 - SCR & MCR calculation

� The capital requirements under Solvency II:

– The Solvency Capital Required (SCR): the amount of capital held by a company ensuring it can meet

its liabilities over the next 12 months

– The Minimum Capital Required (MCR): the amount of capital below which the insurance license is

withdrawn

� The Directive provides three options for calculating the SCR:

– Standard Model – the Directive states the required calculation of the capital.

– Partial Internal Model – this incorporates the Standard Model but individual modules can be replaced

with an internal approach that is agreed with the Regulator

– Full Internal Model – this is a bespoke model developed by the company covering at least the same

aspects as the Standard Model and which have been tailored to the specific characteristics of that

company. Given the complexity of such full internal models, these are an opportunity for large

insurance or reinsurance undertakings

Free Surplus

SCR

MCRAssets

Market value

Technical

provisions

Market value

“NAV”

Market consistent

value of the company

NAV (Assets – Liabilities) > SCR (including MCR)

Coverage of a 99.5% probability of ruin,

should cover the 1 in 200 years loss

Free Surplus

SCR

MCR

SCR

MCRAssets

Market value

Technical

provisions

Market value

“NAV”

Market consistent

value of the company

NAV (Assets – Liabilities) > SCR (including MCR)

Coverage of a 99.5% probability of ruin,

should cover the 1 in 200 years loss

9MARSHMarsh

9

Level 1:

Evaluation of each

risk module

Level 2:

Aggregation of

risks by typology

Level 3

Level 4

Bottom up approach with the aggregation of capital charges through correlation matrix

Pillar 1 – Modular approach

MARSH

Pillar 2 - Quantitative aspects

• Capital add-on:

� The Solvency Capital Requirement standard formula is intended to reflect the risk profile of most insurance

and reinsurance undertakings. However, there may be some cases where the standardized approach does

not adequately reflect the very specific risk profile of an undertaking.

� Under exceptional circumstances, supervisory authorities have the power to impose a capital add-on to the

Solvency Capital Requirement, only in the following cases:

� The undertaking’s risk profile deviates significantly from the assumptions underlying the SCR

calculation

� The system of governance of the undertaking deviates significantly from the standards and does not

allow to properly identify, measure, monitor, manage and report the risks that it is or could be exposed

to

• Own Risk and Solvency Assessment (ORSA)

� As part of the ORSA process, the undertaking shall:

� quantify its overall solvency needs on a forward-looking basis covering each year of the business

planning period (generally 3 to 5 years)

� Subject identified risks to a sufficiently wide range of stress test/scenario analyses

� Complement the quantitative approach with a qualitative description of the risks

� If the undertaking’s risk profile deviates materially from the assumptions underlying the SCR calculation,

it shall quantify the significance of the deviation

MARSH

Agenda

1. Quantitative requirements : main principles / the new deal

2. Impact on Captives

3. Best practices for capital optimization

4. Conclusion

12MARSH

QIS 5 Results - Benchmark analysis

� Source : ECIROA – Captive report on QIS 5

� Sample size : 132 captives (Marsh contribution on 41 captives)

� 51 direct writing undertakings / 78 reinsurance undertakings

� 9 domiciles represented

� Distribution of SCR coverage

Based on Marsh’ sample

13MARSH

QIS 5 results – SCR coverage and captive size

• 35 % of captives (mainly small ones) wouldn’t have enough capital to reach the SCR

• 35 % of captives have 180 % of SCR as available capital

• The first 10 % of captives have more than 400% of SCR

Part of Small Captives

Part of Medium Captives

Part of Large Captives

Part of Captives

< 90

%90

% -

100%

100%

-12

0%12

0% -

150%

150%

-18

0%18

0% -

250%

250%

-40

0%

> 40

0%

Solvency Ratio

0%

5%

10%

15%

20%

25%

30%

35%

14MARSH

Main impacting elements

12

29

12

29

29

12

2

39

1

40

0

5

10

15

20

25

30

35

40

45

Part of captives

Market RiskDefault Risk Non Life

Risk

Health Risk Life Risk

Higher than 50% of the SCR

Lower than 50% of the SCR

• Non-life risk is the major risk in terms of impact on the level of the SCR, mainly due to catastrophic risk

�Non-life risks for captives represent in the average 44% of the SCR compared with 13% for traditional

(re)insurers.

• Market risk mainly consists of the concentration risk on intragroup loans, which is a common practice in

the captive market.

• Default risk is most often a direct consequence of the cat risk, as its scope includes risk-mitigating

contracts

�Capital charge required to absorb counterparty default risk shall take into account potential insolvency of

reinsurers in the case of claims losses arising from catastrophic scenarios

• Life & Health risk only concern a limited number of captives

15MARSH

QIS 5 results – SCR coverage and domiciles

• A large majority (65%) of the captives having the higher solvency ratios (more than 200%) are

Luxembourg captives

�Can be explained by the equalization reserve mechanism and the maturity of domicile

• As far as Malta and Ireland are concerned (the other “traditional” captive domiciles), the proportion of

captives facing potential capital shortfall is more important

�More direct writing undertakings in these domiciles used as fronting facilities for reinsurance captives: this

generates higher counterparty default risk due to risk mitigation agreement with unrated undertakings

16

Focus on Malta: Impact of Deferred Tax Adjustment

QIS 5 did not provide any concrete criteria, other than those set out in the technical specification. EIOPA recommended to follow relevant IFRS Criteria. However some guidance provided by EIOPA is as follows:

This can be an important aspect to consider when choosing domicile to set-up your company and Malta is well placed to provide the full benefit in this. The SCR can only be reduced in those cases where deferred tax on instantaneous losses can be realised in the very short term and as depicted above.

Eur

SCR Before Adj

Own Funds

Recognise DTA @ 35% tax

rate based on IFRS Criteria

Do not Recognise the DTA unless

otherwise demonstrated based on

IFRS Criteria

Own Funds

MARSH

Agenda

1. Quantitative requirements : main principles / the new deal

2. Impact on Captives

3. Best practices for capital optimization

4. Conclusion

18MARSH

Best practices - Investment policy

� ALM is key

� A differentiated approach “external investments” versus “intragroup deposits” can be

contemplated in order to increase diversification and reduce the concentration risk

� Possibility to exempt captive undertakings from the concentration risk module to the

extent that there exists legally effective formal provisions where the captive’s liabilities

can be offset by intra-group exposures it may hold on entities of the group (captive

simplification – Technical specifications SCR.14.19.)

� When assets are placed in collective investment funds, it is important to have as much

details as possible to analyse their economic substance (look-through approach)

� Be attentive to counterparties’ ratings

� Question on the risk free treatment of european sovereign risks (risk charges vs M-t-M)

19MARSH

Best practices – underwriting, catastrophic and default risks

� The Catastrophic risk calibration has been detailed within two methods :

- A method based on standardized cat scenarios (“man made” and “NatCat”)

- A factorial method to be applied, if the first one is not applicable or if available data are not

sufficient

� We recommend specific monitoring and information regarding the Cat Risk exposures and claims

history so that the capital charge can be calculated as precisely as possible, in order to avoid

overcharge due to approximate approach

� Optimization of reinsurance strategy specially for the extreme risks

� Avoid pure fronting captives who will experience much higher levels of SCR (Risk mitigation effect

on counterparty default risk)

� Retention policy to be adjusted with a view to optimize the total cost of risk (TCOR), including the

cost of capital � iterative process

Retentionpolicy

Captive capital

allocation

TCORoptimization

Markettransfer

conditions

MARSH

Agenda

1. Quantitative requirements : main principles / the new deal

2. Impact on Captives

3. Best practices for capital optimization

4. Conclusion

21MARSH

Conclusion

• Increase barriers to entry for newly formed captives

• For a majority of existing captives, operations will require higher level of capital

• Increase complexity of retention strategy : arbitrage own funds / retention level /

market transfer conditions

• Captive management will become more complex

• Require better risk awareness and management

• Programme structures to be reviewed to minimize risk mitigation impact on

counterparty default risk

• Investment policy to be optimized

Solvency II

Consequences

for captives

General application of Solvency II on the traditional insurance market may give rise to increased premiums and reduced capacity to cover certain risks.

Captives will therefore become all the more strategic tools to address potential market gaps.

22MARSH

ORSA : “the heart of Solvency II” (EIOPA)

StrategyBusiness plan

Risk identification

Risk management

Stress-tests

Impact on SCR

Risk strategy

ORSA

Time horizon 3-5 years

- Quantitative- Qualitative

- Mitigation- SCR-calculation- Evaluation of risk assessment

- Internal stress- External stress

Review SCR-calculation (assumptions & risk

picture)

Considering own funds

• ORSA is a top-down process for an overall and holistic risk understanding

• It gives a picture of the company’s short-term and mid-term risks (=> stress-tests, scenarios)

• It must be integrated into the decision-making process of the top management

• It’s an evaluation of the company’s risk and solvency, regarding its risk appetite and business

model (=> it goes further than the SCR-calculation and Pillar 1 risks)

MARSH S.A.

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