solvency ii - practical implementation & implications 2011/richard payne.pdf · shock for each...

Solvency II - Practical Implementation & ImplicationsNov 24, 2011

Richard Payne

SRegional Actuary – Solvency II

Prudential Corporation Asia

Solvency II: Practical Implementation & Implications

1. Principles

2 Solvency II Outputs2. Solvency II Outputs

3. Implications

4. Benefits


Health Warning: Rules/Regulations are subject to change

1. Solvency II Principles

The European Commission outlined the following aims for a new solvency regime1:

To increase policyholders’ protection by affording supervisors an adequate time window in hi h t id tif d d d i f ili ithi iwhich to identify and remedy adverse experience or failings within an insurance company;

To provide comparability and transparency thus creating a level playing field;

To establish a solvency margin requirement that is better matched to the true risks;

To establish principles and not be excessively prescriptive;

Wh ibl t b b d ti ti t dWhere possible to be based on common accounting practices so as to produce expenditure savings and avoid the duplication of financial reporting systems.

1European Commission document titled “Solvency II: Presentation of the proposed work” dated 13 March 2001

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1. Solvency II Principles: 3 Pillars

Pillar 2Risk

Management

Pillar 1Risk

Measurement

Pillar 3Disclosureg

Harmonised Market consistent Balance Sheets

Risk-Based Solvency Capital R i t (SCR)

System of Governance

Supervisory review of firms processes, risk management

t d it l d

Annual publicly-available Solvency & Financial Condition Report (SFCR)

Q t l /A lRequirement (SCR)

Minimum Capital Requirement (MCR)

Standard Formula or Internal

system and capital adequacy

Own Risk & Solvency Assessment (ORSA)

Quarterly/Annual Quantitative Reporting Template (QRT)

Annual Regulatory Supervisor’s ReportStandard Formula or Internal

Model approachSupervisor s Report (RSR) Market


1. Principles


3. Implications

4. Benefits

2. Solvency II Outputs - Balance SheetBoth assets and liabilities are to be fair valued (market value of assets and liabilities)

Excess of Assets Over

Liabilities

Market Consistent Assets & Liabilities

Valued at the amount for which they could be

Basic Own FundsOwn funds is the Solvency II terminology for “available capital”

Risk

Otherliabilities

Risk Margin:(for “non-market” risks)

Margin to value technical provisions equivalent to the amount that another undertaking would be expected to require in

they could be exchanged between knowledgeable willing parties in an arm’s length

Assets at Market Value

Marging p q

order to take over and meet the insurance and reinsurance obligationsCost of Capital approachReflects uncertainty in best estimate assumptions

gtransaction

AssetsMarket Value

Insurers must

Best EstimateLiabilities

Best Estimate Liabilities (BEL):Probability-weighted average of future cash-

flows, taking account of expected present value of future cash-flows, using the relevant risk-free interest rate term structure

invest in assets according to the prudent person principle

Liabilities interest rate term structureRisk-Free Rate of Return/Discount Rate Best Estimate AssumptionsStochastic Valuation of Guarantees

Contract Boundaries

Significant

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Technical Provisions(Value of Market Consistent Liabilities for “fully hedgeable” risks)

outstanding issue

2. Solvency II Outputs: Balance SheetSolvency Capital Requirement is regulatory “Required Capital”

Own Funds

Solvency Capital Requirement (SCR)SCR is the Solvency II terminology for

“required capital”

Solvency Capital Requirement

(SCR)

Risk

Otherliabilities

Own Funds must be greater than SCR otherwise regulator notified/recovery plan

Minimum Capital Requirement (MCR) represents min level of resource & level of ultimate regulatory intervention

Assets at Market Value

Margin of ultimate regulatory interventionCan be calculated by Standard

Formula or by Internal ModelInternal Model subject to regulatory

approval – much more than a capital

Best EstimateLiabilities

approval much more than a capital calculation

Contract BoundariesAl i f SCR l l tiLiabilities Also an issue for SCR calculation

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2. Solvency II Outputs: SCR – Standard Formula Approach

Current Balance Sheet Sh k d B l Sh tCurrent Balance Sheet

Own Funds

Shocked Balance Sheet

Apply Risk S

Own Funds

Own Funds

Driver Shock (e.g. equity) SCR

Assets

Liabilities Assets

Fall in Own Funds = (Equity) SCR

Liabilities

Calculated on Going-Concern basisSCR calc includes allowance for 12 months of New Business

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SCR calc includes allowance for 12 months of New Business

2. Solvency II Outputs: SCR – Standard Formula Approach

Shock for each Risk Driver

Equity

Interest Rate (up & Down) Correlation Matrix

Property

Credit Spread

Counterparty Default x

Eq Int Prop Cred C/D Curr Etc

Eq

SCRConcentration

Currency

Mortality

x Int

Prop

C d

=SCR

Mortality

Morbidity

Lapse Up/Down/Mass

L it

Cred

C/D

CurrLongevity

Expense

Operational

Etc

Internal Model – Prudential can specify its own calibrations & risk profile subject to meeting key

2. Solvency II Outputs – SCR: Prudential’s Internal Model

Internal Model – Prudential can specify its own calibrations & risk profile, subject to meeting keyprinciples in SII directiveSCR is based on 1-in-200 shocks, uses a 1-year Value-at-Risk modelProject all (100,000) possible scenarios of Solvency II balance sheets in 1 year100 000 scenarios are multi-risk – some good outcomes some bad outcomes100,000 scenarios are multi-risk – some good outcomes, some bad outcomesCalculate the Change in Own Funds for each scenario, and rank high to lowInternal Model SCR is equal to the 500th worst outcome (99.5th percentile)Calculation of 100,000 projected balance sheets creates a practical problem

100,000 Possible SCR =

500thBalance Sheet 100,000ranked

Outcomes (Risk Scenarios)

500th

worst outcomeProjection Model Balance Sheets(Change OF)

Risk Scenario Generator Lite Models

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2. Internal Model SCR: Risk Scenario Generator

100,000 Risk Scenarios

Risk Driver Experience

Investigations

Risk Driver PDFs Risk Scenario

Generator

EquityInterest Rate

Credit

LapseMortality

EtcOperational

Etc

100,000Expert Judgement Random

Numbers

Judgement

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2. Internal Model SCR: Lite Models

Lite Model Aggregator

LM Calibration Scenarios Prophet Lite Model

Calibration

EquityInterest Rate

CreditLapse 250

MortalityEtc

150

200

0

50

100

00% 50% 100% 150% 200% 250%

Eq uit y

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2. Solvency II Outputs: Issues

Fungibility Groups: deficit in one country supported by surplus in anotherBut capital movements may be restricted by local regulations (inc. solvency)Treatment of Ring Fenced funds (with Profits)Treatment of Ring-Fenced funds (with-Profits)

Contract Boundaries (tbc)Removes future profits from BEL calculation for certain productsRemoves future profits from BEL calculation for certain productsPotentially significant impact on Medical, Unit Linked productsMay require tightening of policy conditionsNot consistent with proposed IFRS definitionp p

RegulationsStill outstanding – makes modelling and business decisions difficult

BAU TimetableExtremely tight – operating efficiencies necessary at year-end

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1. Principles


3. Implications

4. Benefits

3. Solvency II Implications: What is an ‘internal model’?“Solvency II is not just about Capital. It is a change of Behaviour.” Thomas Steffen, Former Chairman of CEIOPS Group’s definition is very specific

”the systems and processes used to quantify risks for the purpose of calculating the SCR and management’s own assessment of geconomic capital requirements”Holistic view of the firm’s unique risk profile in order to identify, measure and manage risks on a continuous basis

DA

TA &

TEC

HN

OLO

GYC

ULT

UR

E

Must be fully integrated into day to day business and must demonstrably underpin a holistic cultural and behavioural approach to risk managementRobust governance is essential & will beRobust governance is essential & will be subject to approval and monitoring by the regulator

Internal Model enables management to:

• Assess impacts of business decisions on capital requirements

• Calculate Solvency Capital RequirementThe Internal Capital Model (ICM) – the “engine”

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3. Solvency II Implications: Internal Model Key TestsFSA are looking for 6 key tests to demonstrate that Internal Model is widely used in business and its outputs support key decisions

Must be evidenced that business decisions are made with consideration of impact on the Group solvency position that have been informed by internal model and risk exposure p y p y pagainst pre-defined risk appetite limits

Business performance will be measured on a risk adjusted basis.

Model will be regularly updated and improved reflecting its significance to business

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Model will be regularly updated and improved, reflecting its significance to business

3. Solvency II Implications: Internal Model Use Test

1 Ri k t f R i1. Risk transfer - ReinsuranceCurrently, the assignment of new reinsurance is based on credit rating and rates competitiveness. As counterpartyexposure limits are not used, we may be overly reliant on certain reinsurers for recovery, for example Swiss Re.Going forward, an explicit reinsurance strategy is required that takes into account counterparty exposure as well asany reduction in insured risks. It must also pass various prescribed tests in order to qualify for solvency credit,a y educt o su ed s s t ust a so pass a ous p esc bed tests o de to qua y o so e cy c ed t,e.g. allowance for counterparty default, irrevocabilityRisk limits are to be set and monitored for each reinsurer; procedures are to be in place in the event that ourexposure to a reinsurer exceeds risk limits

2. Capital management – consideration of Risk Adjusted RewardsCurrently, the allocation of capital to each LBU is based on local statutory requirements and marketing pressure. Littleallowance is made to the risk-adjusted reward from the country (i.e. Return on Economic Capital), therefore countrieswith more stringent capital rules are allocated a larger share of the group’s capitalGoing forward, Return on Solvency II capital will be used, which can take the form of new business value creation(on a Solvency II basis) over Solvency II capital. An LBU with a higher return will warrant greater capital allocation forbusiness expansion

3. Business planning - stress testing SII surpluses3. Business planning stress testing SII surplusesCurrently, the business plan focuses on IGD free surplusThis will be replaced by Solvency II free surplus. Further, additional risk limits (e.g. NT$ interest rate exposure,Singapore morbidity exposure) may need to be observed. The business plan will need to be stress-tested toensure that it remains resilient to changes in various risk factors (Group Risk Appetite tests), for example, PCA SII free

l t f ll b th % h i t t t f ll b %

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surplus to fall by no more than x% when interest rates fall by y%As with IGD, SII free surplus is likely to become a PCA KPI

3. Solvency II Implications: Internal Model Governance

Strengthened Governance3 lines of defence model – enhanced Financial Risk ManagementBoard ResponsibilitiesTechnical/Executive Risk CommitteesTechnical/Executive Risk Committees

Regulatory OversightInternal Model ApprovalInternal Model ApprovalModel Change Control – including regulatory approval for major changeIndependent Model Validation

DocumentationLots of it!Expert Judgementp gJustification of all modelling assumptions

Data & Model ControlData quality requirements

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3. Solvency II Implications: Own Risk Solvency Assessment (ORSA)

1 2 3

Own Risk & Solvency Assessment (ORSA) Process Components

Solvency position Risk profile Risk Governance

ORSA ComponentsCapital Management and Business Planning

Description of Risk Management Processes

Data

4 5 6

Integration of output

7 8 9

ValidationModelling assumptions and methodology

Integration of output into risk based

decisions

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3. Solvency II Implications: Risk Management Cycle

Risk AppetiteRisk AppetiteGroups and local companies’ appetite/limits for more or less riskExample: want to reduce exposure to lapse risk, increase exposure to longevity riskRisk Appetite applies similarly to profit & cashflow measures

“The EEV earnings should be resilient to withstand a 1-in-10 event with no more than x% fall”

Risk-Based Decision MakingRisk-Based Decision MakingApplication of Use TestHolistic Balance Sheet Management

Product DesignProduct MixInvestment StrategyCapital Management Solutions

Risk MonitoringRisk MonitoringContinuous Solvency MonitoringRegular Risk Monitoring activitiesExposure Monitoring – Asset DatabaseCourse of action when risk-limits are breached


1. Principles


3. Implications

4. Benefits

4. Solvency II: positives & negatives

NegativePositive

Regulations not finalisedStandard Formula is the “simple” option, but it’sfar from simple!

Negative

Solvency Capital Requirement that reflects the risks we face as a business – better protection for policyholders?More consistency between EU insurers

Positive

Internal model option comes with significantburden of documentation and governancerequirementsLack of data availability means Internal Model

h i i ifi t f E t

More consistency between EU insurersGreater transparency into the Group’s capital position and risk exposure, enabling better informed strategic decision-making -potentially leading to enhanced financial

approach requires significant use of ExpertJudgementAre these really 1-in-200 events?Over-reliance on the models by

growth based on risk/reward balanceContinuous Solvency Monitoring & Exposure Monitoring, plus modelling of “What-if” sensitivity analysis helps the business take preventative action management/public?

Complexity of models/volume of dataResource

preventative actionSenior Management accountabilityInternal model option offers potential for a lower overall capital requirement than under the Standard FormulaAdditional control requirements reduces Operational RiskGoodwill with local regulators?

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solvency ii - practical implementation & implications 2011/richard payne.pdf · shock for each...

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