Proposal by Swiss Re and Deloitte
Philipp Keller
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Global Insurance Capital Standard Interaction with BCR and HLA
HLA (Higher loss absorbency requirements) for non-traditional and noninsurance activities. In the absence
of a global capital standard as a basis, these will be built upon straightforward, basic capital requirement for
all group activities, including non-insurance subsidiaries. HLA requirements will need to be met by the
highest quality capital.
BCR: straightforward, basic capital requirement to apply to all group activities, including non-insurance
subsidiaries,
ICS
BCR
HLA
Insurance Capital
Standard, for
IAIG
Basic Capital
Requirement,
for G-SII
Higher Loss
Absorbency,
for G-SII
BCR
HLA
BCR
HLA
Less likely options
G-SII specific
risk based
capital
standard
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Regulatory models Typology
Linear function A simple combination of factors applied to balance sheet elements or other
volume measures. Diversification between different risks cannot be taken into
account except implicitly by reducing the factors.
Pure scenarios Predefined scenarios for whose the impact has to be evaluated. The capital
number is then a function of the impacts, e.g. the maximum or average of the
losses.
Factor formula A straightforward formula, based on the modeling of underlying risk factors,
taking into account diversification and that is transparent in which risks are
quantified and which are not.
Standard formula A complex set of equations for different risk classes that are combined using a
correlation matrices and other approaches and that aims to capture all risks.
Standard model A stochastic model that can capture dependencies naturally on the level of the
underlying events or risk factors.
Level of
Com
ple
xity
Internal Models Approaches relying on the use of (partial) internal models to determine the
capital requirements, where the models have to follow principles that ensure
consistency and comparability of results
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Regulatory models Typology
Linear
function
Pure
scenarios
Factor
formula
Standard
formula
Standard
model
Internal
Models
SPAN by
the CBOT
SST
Solvency I RiskMetrics
Solvency II
HK DST
SST for
reinsurers and
insurance
groups
Basel II
market risk APRA
Basel II
Credit Risk
BCR
ICS
proposal
HLA?
MCT
MCCR
US-RBC
J-RBC
Lloyds RDS
S&P
CreditMetrics Fitch
FFF
Risk Classes Risk Factor
based, complex
Risk Factor
based, simple
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Insurance Capital Standard Desirable key characteristics
The global insurance capital standard (ICS) should
• Satisfy IAIS core principles (ICP) 14 and17 and be aligned with ComFrame
considerations on capital assessment (M2E5) to ensure consistency with economic and
risk-based capital standards
• Be based on a clear, transparent and public underlying methodology
• Be extendable and adaptable over time
• Reflect the risk-sensitivity, legal diversity and economic reality of IAIGs (including total
balance sheet considerations)
• Be consistent with and extendable from group to legal entity requirements
• Give relevant and useful information to management and to supervisors
• Allow for the analysis of global and market-wide exposures to risk
• Give incentives for appropriate risk management
• A well-defined, risk-based capital standard for IAIGs will be an improvement for the
insurance industry and provide for a level playing field
• The proposed approach has been developed by Swiss Re's experts, based on the
Group's global experience, with the support of Deloitte
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Elements of Capital Standards Events, Exposures, Impact and Framework
Events
Possible future states of the
world impacting the balance
sheet of groups or
conglomerates. A state of the
world is given by the state of
the financial market, natural
and man made catastrophes
occurring, pandemic events,
operational risk events, etc.
Exposure to risks, due to
insurance policies, other
liabilities, investments,
operations etc.
The impact of events on an
IAIGs balance sheet, given by
the exposures and the
valuation standards being used
to measure the impact
The implemented framework
(standard formula, standard
model, factor based approach,
etc.) quantifies the potential
change in available capital
over a given time horizon and
assesses capital needed to
cover risks
Exposures Impact Integrated framework
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Development and Calibration Key steps
• The proposed approach is feasible and allows for adaptations and extensions. It builds on
existing regimes without undermining tested approaches
• The use of tested capital regimes in combination with scenarios for calibration ensures a risk-
sensitive and robust factor formula
• The use of scenarios for the calibration allows for the consistent assessment not only of the
risks of IAIGs, but also of market-wide exposures to risk and the potential interconnectedness of
IAIGs
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Define a set of realistic, possible and adverse states of the world (scenarios) covering events
impacting IAIGs
Define principles to extend the set of scenarios to take into account local events and risks, or
update scenarios in a consistent way
Define a set of base-case and adjusted balance sheets for calibration and consistency
Evaluate impacts of scenarios on actual, base-case and adjusted balance sheets
Define the structure of the factor formula based on tested regulatory approaches (e.g. APRA
capital standard, EU Solvency II standard model, Swiss Solvency Test, US RBC, etc.)
Calibrate the factor formula using the evaluation of scenarios and other parameters
Compare results of factor formula with existing methodologies (standard formulae and internal
models) - adjust scenarios and calibration if necessary to arrive at a robust result
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Development and Calibration Illustration
Framework methodology
Adjusted and base-
case balance sheets
for consistency and
calibration
Calibration
Realistic, possible
states of the world Original balance
sheets
Output of impact of scenarios,
allowing in-depth analysis of specific risks of
IAIGs, analysis of market-wide exposures to
risk, supporting macro-prudential surveillance
Internal models
Regulatory frameworks
Historical data
Ca
lib
rati
on
Testing • Company-specific scenarios
• Regional / National scenarios
• Global scenarios
Insurance Capital Standard
Structure of the Factor Formula
Final calibration of
Factor Formula
Factor Formula
Evaluation of the impact of scenarios
based on a common or local valuation
standards
Actual Balance Sheets
from Field Test
Participants
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3
4 5
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Comparing the calibration
Principles for formulating
states of the world
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More details on the aggregation of the scenarios'
evaluation under the proposed Factor Formula
Event Scenario Impact on
Adjusted Balance
Sheet
Initial Adjusted
Balance Sheet
Qualifying
capital
resources
Initial qualifying
capital resources:
QCR(0)
QCR1
QCR2
QCR3
QCRn
f(QCR1, QCR2,…, QCRn) = PCR
Factor formula, combining the
results of the evaluation of the
scenario to the prescribed
capital requirement (PCR)
The factor formula takes into
account dependencies between
scenarios and allows for the
calibration of the PCR, based on
existing risk-based solvency
frameworks (e.g. from APRA,
Solvency II, US-RBC, SST…)
and internal models
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Principles
Principle 1: Assets and liabilities are valued using an economic valuation standard and a total balance
sheet approach, reflecting also the long-term nature of the insurance business;
Principle 2: IAIGs initial balance sheets (which can be regulatory or accounting balance sheets) are
adjusted using principles derived from the economic valuation standard, to arrive at comparable balance
sheets;
Principle 3: Qualifying capital resources are defined with reference to the adjusted balance sheet;
Principle 4: A state of the world is a description of a joint realization of risk factors describing the world;
Principle 5: The capital resources in a state of the world are quantified based on the economic valuation
standard;
Principle 6: The ICS is defined such that the IAIG has a given positive amount of capital resources with a
given confidence level at the end of a given time horizon;
Principle 7: IAIG determine the impacts of scenarios on the adjusted balance sheet in a transparent
manner;
Principle 8: The impacts of scenarios are aggregated using a specified factor formula to arrive at the
capital requirement.
Principle 9: Scenarios are to be chosen such that they cover all material market, credit, underwriting and
operational risks for the given confidence level.
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Factor Formula Framework The structure of the factor formula
• The factor formula is to be based on a clear separation of events that impact an insurer‘s
balance sheet and the valuation standard on which the balance sheet is determined. This
allows for flexibility with respect to the valuation being used and easy adaptation of the
factor formula to different valuation standards.
• The separation implies that the factors are to be derived as far as possible on the events
rather than on insurer’s balance sheet elements, premia etc.
• These factors can then be applied to the balance sheet, e.g. via sensitivities, the
calculation of losses, or other approaches.
• For example, rather than to calculate 3 per mille times Sum at Risk to determine
mortality risk, the factor would be linked to the mortality (e.g. an increase in mortality of
20%) and the impact then assessed by the insurer. The results of the impacts are then
combined, taking into account the inter-dependencies between the different risk factors.
• In other words, the factors are applied to underlying risk factors that describe a given
event, and then the impact on the insurer’s balance sheet is determined. In this way, the
calibration of the factors does not depend on the valuation being used.
• This has the additional advantage that diversification is taken into account on the level of
underlying risk factors and its impact for the insurers is determined then via the valuation.
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Factor Formula Framework The structure of the factor formula
• If there is a complete separation between events and valuation, then the factor formula
framework would be a truly global standard, in the sense that it could be applied to any
valuation standard being used. This would allow comparison of internal models, and
national risk-based solvency standards against a global standard.
• Such a complete separation between external events and the valuation standard is likely
not possible. It is achievable for financial market risk and for life insurance and annuities
as well as for part of non-life insurance.
• Other risk, e.g. operational risk might be modeled differently. However, the aggregation of
the capital requirements emanating from these other risks can be done in such a way that
the factor formula remains predominantly valuation independent and would still serve as a
truly global standard.
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Factor Formula Framework The structure of the factor formula
Market Risk Credit Risk Underwriting Risk Operational Risk
Group Risk
Liquidity Risk
Market liquidity
Funding liquidity
Monetary liquidity
People
Systems
Processes
Interest rates
Spreads
Volatilities
Equities
FX
Counterparty default
Sovereign
Intra-group credit
Reinsurer default
Life Insurance
General Insurance
Mortality trend
Mortality level
Morbidity
Reserve
Nat Cat
Man Made Cat
Currency mismatch
Translation
Pandemic
Concentration Risk
Cash flow liquidity
Capital mobility
Taken into account by the factor formula ORSA, capital
quality, etc.
Ris
k
Cate
go
ries
Ris
k S
ub
-Cate
go
ries, Illu
str
ati
ve
Quantitative Elements Qualitative
Elements
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Design Criteria Summary
Straightforward factor
formula
Clear methodology,
separating risks,
exposures and valuation
Calibration based on
scenarios and tested
regulatory regimes
A straightforward factor formula allows the ICS to be regularly
assessed for each IAIG and recalibrated to changing global and
national risks. The use of scenarios as an additional means for
assessing risks more than compensates the potential shortcomings of
a straightforward but transparent factor formula.
The proposed approach will allow the ICS to be updated and internal
models to be used as a means for testing and improving the factor
formula. It allows for flexibility for the use of the valuation standard(s),
either globally or locally.
Using a combination of scenarios and global parameters in
conjunction with tested regulatory capital approaches will result in a
stable and robust calibration.
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Development
• The separation of the events impacting an insurer’s balance sheet and the valuation standard to be
used to measure the impact allows for an efficient development of the factor formula framework. The
calibration of the risk factors can be done independently of the choice of valuation.
• The structure of the factor formula depends mainly on the events chosen and risk factors used to
describe and parameterize the scenarios. There is also some dependency on the valuation
standards, but a major part of the structure of the factor formula can be defined with reference to the
events and risk factors only.
Choice of
Events
Calibration of
risk factors and
dependencies
Development of the balance
sheet adjustments
Main structure
of the factor
formula
Evaluation of
the impact of
events
Overall structure
of the factor
formula
Further development of the
balance sheet adjustments
Evaluation of
the impact of
events
Overall structure
of the factor
formula (update)
Events
Valuation
2014 2015 2016 2017 2018 2019+
Dec: Consultation on design of ICS
First ICS test Second ICS test ICS reporting
to supervisors
(all IAIGs)
ICS reporting
to supervisors
+ public
disclosure (?) Adoption of
ComFrame by IAIS
including ICS
ICS full
implementation
2013
Initial Development Improvements and Extensions
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Conclusion
• Developing a global insurance capital standard by 2016 is challenging but possible
• There is a wide variety of IAIGs, with different exposures to risks, legal structures,
business models and valuation bases. The ICS needs to be able to address this diversity
• A factor formula framework can be developed that is
• relatively straightforward and transparent
• based on adjusted and base-case balance sheets to achieve comparability and
consistency
• calibrated based on scenarios further ensuring comparability
• using the experience of tested regulatory capital frameworks
• supplemented with scenarios as additional risk governance measures
• Creating incentives for appropriate risk management
• Flexible and adaptable to different valuation standards and risk profiles
• consistent with ICP 14 and 17, and aligned with ComFrame capital considerations
(M2E5)
• Tested regulatory regimes should be utilised to define the structure and improve the
calibration of the factor formula framework.
• ComFrame should facilitate the recognition of economic and risk-based capital regimes
aligned with the proposed factor formula framework
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Diversification and Dependencies
• Diversification is at the core of insurers business models. By having heterogeneous
portfolios with different exposures to risk, insurers aim to be in a situation where no one
single event can endanger their solvency.
• If an insurance capital standard were not to consider diversification, it would give a
comparative advantage to insurers that take on risk concentration. These insurers are
often able to earn more than their better diversified competitors, but tend to fail
catastrophically.
• Diversification is the fact that not all events that can cause losses occur at the same time.
The amount of diversification that can be actually be used by the insurer depends on its
exposures to these events.
• The factor formula framework takes diversification into account where it objectively occurs:
at the level of events impacting the insurer’s balance sheets. This is quantified via the
evaluation of the impact of scenarios and sensitivities to risk factors.
• The factor formula approach – by its clear separation of events and exposures – allows for
a IAIG-specific quantification of diversification
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Diversification and Dependencies
Two main approaches of modeling diversification
Risk class approach
Risk factor approach
• First capital charges for major classes of risks are determined (e.g.
market, credit, underwriting and operational risks)
• Then diversification is taken into account by aggregating these
separate capital charges using a correlation matrix
• Typical examples of this approach are the US RBC, the S&P
model, or the Solvency II standard formula
• Diversification is taken into account on the level of events that
impact the insurer’s balance sheet
• Dependencies between equity prices, spreads, interest rates,
mortality and morbidity, natural catastrophes etc. are modeled
• Examples of this approach are the RiskMetrics covariance
approach for financial market risk and a number of internal models
by banks and insurers
• The advantage of the risk class approach is its simplicity. It requires merely a
small correlation matrix to arrive at a total capital requirement
• However, the calibration of the correlation matrix is highly subjective and cannot
be based on historical data
• In addition, diversification changes with the insurer’s exposures. The correlations
depend on the insurer’s exposures and they are dependent on the specific IAIG.
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Diversification and Dependencies Modeling approaches
Examples
Pandemic
scenario
Historical
financial market
risk scenario
Market risk
factors
Life insurance
risk factors
Abstract nat cat
scenario
{S│P(S)<α}
Nat Cat
Market Risk Credit Risk Underwriting Risk Operational Risk Liquidity Risk
quantitative qualititative
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Events, Scenarios and States of the World
• Risk is defined as the (random) change of the qualifying capital resources over a given
time horizon. The qualifying capital resources at the end of the time horizon t are
determined by the specific state of the world that has been realized. A state of the world is
described by risk factors (e.g. the value of shares, yield curves, magnitudes of
earthquakes, etc.).
• A future state of the world at time t is arrived at from a given initiation state of the world
now (at time t=0) via the occurrence of events during the time interval from zero to t.
• At time t=0, the events that will occur until time t are not known and have to be modeled.
Different events require different techniques of modeling. A scenario is a more formal
definition of the concept of an event that can capture the different types of events.
State of the
World at time 0 State of the
World at time t
Events
Risk factors
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Events
For the purpose of the factor formula
framework, a scenario can describe:
A single event, e.g. a specific
earthquake in Los Angeles, a stock
market crash, etc.
An implicit event that is defined
implicitly. Examples are reverse
scenarios that are defined as ‘events
that lead to a given loss’ or ‘an
earthquake event to which a specific
insurer has highest exposure’, etc.
A set of events. In some
circumstances, the distribution and
dependency of risk factors can be
modeled sufficiently reliably. This model
then describes a set of potential events
with relative weights. Examples are
certain financial market risk events, life
insurance risk events, etc.
Implicit
Events
Set of
Events {E│P(E)<α}
{E│Capital(E)<0}
X ~ LN(x,α,β)
Events
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Types of Scenarios
Possible, internally
consistent events,
parameterized by a
set of risk factors
Scenarios AKG Photo
Global Events
Regional / National Events
Company Specific Events
Events that have
global reach and that
impact all IAIGs, e.g.
global financial
market events or
pandemics.
Events that have regional or
national reach and that impact
those IAIGs that have
exposures to the specific
region. Examples are a
regional financial market
event, a SARS epidemic, etc.
Scenarios that are
tailored to the risk
exposure of a specific
IAIG, defined either by
the supervisory
authorities or by the
insurer.
Historical Events
Events that are patterned after
historical events. Risk factors are
calibrated based on historical data,
but taking into account possibly
changes in the environment.
Examples are past financial crisis
(e.g. the credit crunch, the global
recession, pandemic)
Conceivable Events
Events that have not
occurred before, e.g. EU
split-up, USD default, legal
liabilities due to
nanotechnology, etc.
{S│P(S)<α}
Implicit Events
Events that are described
implicitly, e.g. ‘an earthquake
event to which a specific
insurer has maximal exposure
and that occurs with a
likelihood of less than 1 in 100.
Set of Events
A set of events with relative
weights, e.g. financial
market risk factors with joint
distribution function defining
an (infinite set) of possible
financial market risk events
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Proposed principles for defining scenarios
• Principles for defining scenarios ensure that the set of global scenarios can be extended
and adapted over time and company specific and national scenarios can be formulated
consistently
• Given the experience of insurance supervisory authorities (e.g. Australia, Belgium,
Bermuda, Canada, EIOPA, Germany, Hong Kong, Japan, Singapore, Switzerland, USA
and others) as well as the industry with stress testing and scenario analysis, a framework
can be implemented that ensures both a stable calibration and relevant information on
the impacts of scenarios on IAIGs.
• The principles for defining scenarios could include:
• Adequate documentation (reasons for choice of the scenario, narrative, data basis,
etc.)
• Range of likelihoods of the event considered
• Time frame over which events take place
• Effects to be included (initial event(s), secondary effects, ripple effects)
• Granularity of the numerical specification of the event
• Specification for the evaluation of the impact of the scenario (e.g. granularity, valuation
basis, management actions to be taken into account, etc.)
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Choice of Scenarios for IAIG
Global Scenario
Regional Scenario
National Scenario
Company Specific
Extensions
Regional and national
scenarios derived from global
scenarios. Detailed
specification of regional and
local risk factors, based on a
high-level, global event.
National
scenarios
derived from
regional but not
global events
Company specific scenarios
formulated to target specific
vulnerabilities
Adaptations and extensions of the scenario
descriptions to take into account company-specific
exposures and relevant risk factors
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Scenarios
Scenarios
Core set of global
scenarios, defined
by the IAIS
Local / National
scenarios, defined by
supervisory authorities
Company specific
scenarios
Realistic, adverse
possible states of the
world, covering major
global and regional
events impacting IAIGs.
Scenarios covering
financial market risk
events, pandemic,
natural catastrophes etc.
Local and national event,
consisting of more detailed
global events with local
impacts and additional events
tailored to the local situation
Company specific
events, targeting
exposure to risk of
single companies for
additional information
National calibration Base calibration
Global scenarios,
detailed for
national effects
National scenarios
Capital requirement Capital requirement
Impact of
scenarios
Calibration
A scenario is defined by
values taken on by a set of
risk factor that describe the
relevant state of the world
given a realistic, adverse
event occurs. Risk factors are
for example interest rates,
equity prices, mortality rates,
loss ratios etc.
Risk factors
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Events impacting IAIGs Examples
Global Events
Regional or
market wide
events
Scenarios that potentially
affect most or all IAIGs
Company-
Specific Events
Scenarios that potentially
affect a few IAIGs
Scenarios that are
specific to a single IAIG
Pandemic, Global financial market events (e.g. impacting
global interest rates, global credit crunches, etc.)
Regional war between major powers (?)
Sovereign defaults impacting a major currency
Default of a G-SIFI with ripple effects
Global high inflation
Regional financial market events (e.g. due to central bank
policies, regional collapse of economy), large natural
catastrophe (e.g. earthquake California, Tokyo, etc.)
Default of a regional or local sovereign
Events impacting entire business classes leading to
under-reserving
Specific products incurring catastrophic losses, specific
assets holding
Under-reserving
Default of the home jurisdiction (minor economy)
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Philipp Keller
Head Financial Risk Management
Philippe Brahin
Head Governmental Affairs & Sustainability
Managing Director
Deloitte AG
General-Guisan Quai 38
8022 Zurich
Switzerland
Swiss Reinsurance Company Ltd
Mythenquai 50/60
8022 Zurich
Switzerland
Tel: +41 58 279 6290
Fax: +41 58 279 6600
Mobile: +41 79 874 2575
Email: [email protected]
Direct: +41 43 285 7212
Fax: +41 43 282 7212
Mobile: +41 79 777 9835
E-mail: [email protected]
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