Solvency II and the Swiss Solvency Test

János Blum

Casualty Loss Reserve Seminar San Diego, 11 September 2007

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Contents

Swiss Solvency Test

Industry Engagement -Test Runs

Swiss Solvency Test

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Swiss Solvency Test

Switzerland is not member of the European Union, but Swiss companies have pivotal interest in EU regulation

Compatibility to EU is a main objective of SST

Swiss Federal Office of Private Insurance designed, tested and partially implemented the new solvency system between 2002 and 2006

New Insurance Supervisory Law effective since 2006

Full implementation of SST beginning 2011

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Old Insurance Supervision

Rule based

Product and Tariff Approval

Restrictions on products, investments and pricing

No consideration of asset risks

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Old Insurance Supervision - Problems

Overexposure to risky assets

Underpriced long term guarantees

Accounting and regulatory arbitrage

Compliance culture

Abrogation of responsibility to the regulator

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New Insurance Supervision Act of 1.1.2006

No restrictions on products (except for some mandatory life and health products)

Less restrictions on investments

Corporate governance and risk management requirements

Appointed Actuary for all insurers and reinsurers

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New Insurance Supervision Act of 1.1.2006

Supervision of groups and conglomerates

Consistent requirements for insurers and reinsurers

Responsibility with senior management

Principle based

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The SST PrinciplesOutput – Methodology – Transparency - Responsibility

1. All assets and liabilities are valued market consistently

2. Risks considered are market, credit and insurance risks

3. 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

4. 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

5. 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

6. Under the SST, an insurer’s capital adequacy is defined if its target capital is less than its risk bearing capital

7. The scope of the SST is legal entity and group / conglomerate level domiciled in Switzerland

8. Scenarios defined by the regulator as well as company specific scenarios have to be evaluated and, if relevant, aggregated within the target capital calculation

9. All relevant probabilistic states have to be modeled probabilistically

10. 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

11. The internal model has to be integrated into the core processes within the company

12. SST Report to supervisor such that a knowledgeable 3rd party can understand the results

13. Public disclosure of methodology of internal model such that a knowledgeable 3rd party can get a reasonably good impression on methodology and design decisions

14. Senior Management is responsible for the adherence to principles

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Timetables

EU Switzerland

Political Decision 2002 2002

Project Start 2003 2003

Consulting Phase 2003 to 2009 2003 to 2005

Quantitative Impact Studies / Field Tests

2005 to 2008 (?) 2004 to 2007

New Legislation 2007 to 2011 2006

Mandatory Reporting 2012 2008

New Intervention Regime 2012 2011

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Some Differences SST – Solvency II

99% TVar vs. 99.5% Var confidence level

Cost of Capital approach for Market Value Margin– EU has not yet decided between i) 75th percentile and ii) Cost of

Capital approach

Minimum Capital Requirement 60% of Solvency Capital Requirement– EU has not yet decided between i) percentage of SCR and ii)

separate calculation for MCR, i.e. 90% confidence level

Operational Risk taken into account, but not part of Pillar I, as not sufficiently quantifiable

No restrictions on eligibility of capital – no tiers

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Cost of Capital Approach

SCR absorbs risks with 1 year time horizon

At the end of year 1, portfolio is assumed to be taken over by another company

New company provides regulatory capital to absorb run-off risk

Market Value Margin is the NPV of the future cost of capital at risk free rate + 6%

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Internal Models

If standard model not applicable, internal models mandatory– reinsurance, groups, entities with foreign branches– estimated 80 entities will have to develop internal models

Internal models encouraged, as they demonstrate high risk

management skills and provide relevant company specific information

High technical standards: stochastic modelling required. Building and validating internal models is resource intensive.

Consistency: same model should be used for all external reporting (regulator, rating agencies) and internal steering purposes

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Groups

Incentive to simplify complex group structures

SST required both on entity level and group level

Detailed internal model for groups

Diversification benefit on group level

Explicit modeling of Capital and Risk Transfer Instruments – internal reinsurance– loans– participations– guarantees– capital mobility

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Small Companies

Increased consolidation pressure

Complexity of Solvency II is a challenge for small entities:

– limited availability of resources and data

– low participation in test runs indicates lack of awareness

– loss mitigation relatively expensive

– standard model leads to high capital requirements, building more favourable internal models not viable

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Risk Management & Risk Mitigation

Risk Management will become key competence

– Data quality

– Capital adjusted pricing and product structuring

– Modelling capabilities

Demand for Risk Mitigation will increase

– Hedging financial risk for life insurers

– Reinsuring or securitizing cat risk for P&C insurers

Industry Engagement -Test Runs

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Quantitative Impact Studies

2005: QIS 1 – compared reserves under Solvency I and Solvency II– measured existing levels of prudence– tested Cost of Capital approach – increased awareness in the insurance industry

2006: QIS 2 – tested methods for calculating provisions, asset values, SCR and MCR– gathered information on practicability, data issues and resource

requirements – measured changes of overall level of solvency ratio

2007: QIS 3– calibrates risk and correlation matrices– tests impact on groups– tests internal vs standard models – results to be published in fall 2007

2008: possibly QIS 4 to back test draft directives

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Quantitative Impact Study 2

514 companies (out of 4‘000) from 23 countries participated– 237 P&C, 161 Life, 81 Composite, 22 Health, 13

Reinsurance

Overall market share 65% for Life, 56% for P&C – vary from 11% to 94% from country to country

Generally lower participation by small companies

Data quality inhomogeneous

Results published on a no name basis

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QIS 2 – Impact on Solvency

Assets valuated higher

Liabilities valuated lower

> Resulting Available Capital higher

Required Capital much higher

> Solvency Ratios decrease in general

Most Companies still with Solvency Ratios > 100%

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Swiss Field Tests

Facultative in 2004 and 2005 (before new legislation)

Mandatory for large companies in 2006 and 2007

46 (out of 150) entities participated in 2006, 29 of them on a voluntary basis. >90% market share covered.

Mandatory reporting for all companies starting 2008

Intervention based on new regime starting 2011, i.e. three year transition period

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SST - Solvency Ratios

Solvency Ratios lower, but mostly still sufficient (similar to QIS results)

Life: low correlation between old and new Solvency Ratios (R2 = 12%)

P&C: no correlation between old and new Solvency Ratios (R2 < 1%)

i.e. completely new situation for most companies

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SST - Breakdown of Balance SheetsApproximative Numbers

Life Health P&C

Reserves at Best Estimate

90% 50% 90%

Solvency Capital Required

8% 25% 7%

Market Value Margin 2% 0% 0%

Excess Capital 0% 25% 3%

Solvency Ratio 100% 200% 150%

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SST - Breakdown of SCR & MVMApproximative Numbers

Life Health P&C

Market Risk 70% 80% 30%

Credit Risk 5% 5% 10%

Insurance Risk 15% 25% 90%

Scenarios 10% 30% 0%

Diversification

(SCR reduction)

-20% -20% -25%

Expected Profit

(SCR reduction)

0% -20% -10%

Market Value Margin 20% 0% 5%

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SST – Historic Scenarios - LifeApproximative Numbers

Solvency drops from 100% to...

Market Crash 2000/2001 < 60%

European Currency Crisis 1992 70%

Market Crash 1987 75%

LTCM 1998 75%

Real Estate Crash 1994 80%

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Breakdown of Insurance Risk – P&CApproximative Numbers

Normal Claims 45%

Large Claims 15%

Reserves 40%

Diversification 0%

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Key findings

Life insurers sufficiently, P&C insurers well capitalized

Assets main risk for life insurers, balance sheets vulnerable to historic economic scenarios

Insurance (underwriting incl. cat) main risk for P&C insurers, balance sheets resistant to scenarios

Market Value Margin (reserve risk beyond 1 year) almost negligible for P&C insurers, more important for life companies