global life actuarial internal use only assal-iais training seminar: swiss solvency test market...

Global Life Actuarial

INTERNAL USE ONLY

ASSAL-IAIS Training Seminar: Swiss Solvency TestMarket Consistent Balance Sheet21st November 2012Alex Summers

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Important note

The views expressed in this presentation are the presenter’s own and do not necessarily represent the views of either Zurich Insurance Group (Zurich), or FINMA

I am very grateful to colleagues within Zurich and at FINMA for their assistance in preparation

Further information from FINMA on the Swiss Solvency Test can be found on FINMA’s website at http://www.finma.ch

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Agenda

SST MCBS Context, Purpose and Principles

Elements of the SST MCBS

Risk-free rate: technicalities and implications

Case study: risk-neutral stochastic scenarios for Time Value of Options and Guarantees

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The SST protects policyholders by requiring a high probability of orderly run-off of business

SST identifies insurers* at risk of being unable to honour their existing obligations

A ladder of intervention allows appropriate actions to be taken when insurers run into difficulties

SST sets capital requirements so that there is high probability of orderly run-off of business

InternallyTransfer of liabilities to a third party if necessary

Both fulfilment and transfer value concepts are thus central to the SST

Risk Total required 0 margin capital

SST ladder of intervention

Based on FINMA SST technical document p8

*: The term “Insurers” has been used throughout to indicate both insurance and reinsurance undertakings

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The economic balance sheet is the foundation on which the entire SST is built

Scenarios

Standard Models or Internal Models

Mix of predefined and company specific scenarios

Target Capital SST Report

Market Consistent Data and Best Estimate Assumptions

Market Risk

Credit Risk

Life

P&C

Market Value Assets

Risk Models Valuation Models

Best Estimate Liabilities

Risk margin

Output of analytical models (Distribution)

Health

Aggregation Method

Source: FOPI, 2007

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Principles of market consistent valuation for SST

All assets and liabilities are to be valued in accordance with economic principles in a market-consistent manner

“In accordance with and not at variance with information that can be gleaned from trade in liquid financial markets”IFRS (fair value) valuations may be used where compatible

Mark-to-market where possible, otherwise mark-to-model

Market-consistent value “such that knowledgeable business partners would purchase or sell the positions at this price in an arm’s length transaction”

“Plausible” methods and estimates should be used in stressed markets

Own credit risk should not be taken into consideration except for hybrid instruments

Often requires mark to model adjustments to market valuesSource for quotations: FINMA Circular 2008/44

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No allowance for own credit risk in SST, so best estimate of liabilities is typically greater than market value

Suppose an insurer1. Issues USD 100MM 10 year zero coupon bonds2. Writes single premium pure endowments with guaranteed

maturity values* totalling USD 100MM

Suppose the 10 year risk-free rate is 5%, and there is a 2% credit spread above risk-free for debt issued by the insurer

Market value of the bonds is 100 x (1+5%+2%)-10 = USD 51MM

However in the SST MCBS, the bonds and pure endowments should each be valued at 100 x (1+5%)-10 = USD 61MM

This creates an asymmetry for debt internal to groupsSymmetric treatment can be permissible on application to FINMA

*: For purposes of this example, ignoring all cash flows other than maturity payment, and assuming 100% survival

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Ideal characteristics of market data for use in SST

Either sufficient transactions for an asset or liability take place at arm’s length between knowledgeable business partners, or

A sufficient number of securities traders or brokers quote prices in the capacity of business partners for a potential transaction, in good faith and in a binding manner, and for significant volumes

Market data can still be used if these conditions aren’t met subject to test of plausibility

Testing adherence to these conditions proportionate to significance

No explicit link to “deep, liquid & transparent” requirementsInherited criteria from IFRS

Price is what you pay, value is what you get

Warren Buffet

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Marking-to-model in the SST

Only if marking-to-market not possible

Apply “sound finance mathematics and actuarial methods for assets and liabilities”

Principle of proportionality can allow simplifications

Models and parameters calibrated as much as possible on the basis of objectively observable data

Documentation must be sufficient

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Agenda





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SST Market Consistent Economic Balance Sheet

The economic balance sheet gives a realistic picture of a company’s financial position at a given point in time

Risk Margin

Required capital for 1-year risk

Free capital

Market consistent value of liabilities

Available Capital Total required capital

Market value of assets Certainty

equivalent best estimate of discounted liabilities

Time Value of Options and Guarantees

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Cash flows to be considered in discounted best estimate value of liabilities

Life Non-Life General

In-flows Out-flowsDiscounted best

estimate

Premiums

Other revenue

Death benefitsMaturity benefitsAnnuity benefits

Surrender benefitsOther benefitsCommissions

Administrative costs, including investment

costs

Discounted best estimate of future

claims and expense payments related to

claims incurred before the valuation date,

whether or not reportedUnearned premium

reserve

Bonds issuedPlanned

dividendsContractual

profit sharing with

policyholdersOwn shares

Tax provisionsPensions

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Valuation of life insurance liabilities for SST (1)

Best estimate: no loadings for safety, fluctuation or anything else

Projection all the way to run-off

Model points at policy levelGrouping permissible

In force business only – future new business is excluded

Going concern basis for calculating expenses

FINMA circular states that employee benefit schemes are in scope, and should be valued according to same principles as insurance liabilities

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Valuation of life insurance liabilities for SST (2)

Pre-tax: deferred tax assets are not to be valued

Net of reinsuranceCan show liabilities gross, with a corresponding asset for reinsurers’ share of liabilities

Only contractually guaranteed benefits in SST standard modelOther approaches can be considered in SST internal models e.g. as for MCEV, future discretionary benefits are includedExtra accuracy and usefulness but considerable extra complexity for insurersConsistent treatment of loss absorbency in risk calculations is important

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Does exclusion of future discretionary benefits (FDB) matter?

If the aim is only to calculate solvency ratio, ignoring FDB gives a prudent view to extent that FDB are fully loss absorbing

R1. SST standard formula ratio 1: (MVA – BEL) / (SCR + RM)

R2. Internal models: (MVA – BEL – FDB) / (SCR + RM – LAC)

If FDB are fully loss absorbing, LAC = FDB, so R2>R1*However, understanding the nature of policyholders’ reasonable expectations of future discretionary benefits can be very helpful in managing the business

Consistency with other reporting metrics e.g. MCEVUse test

*: Assuming R1>100%; LAC = Loss Absorbing Capacity

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Risk margin is a key part of the balance sheet, and will be discussed tomorrow morning

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Different yield curves are proposed for different purposes

FINMA SST MCEV(Zurich used as

example)

Other MCEVs – guide to SII?

Underlying risk free yield curve data

German Government

Bonds

Swap Swap

Deduction for credit risk

No No Yes

Adjustment added to underlying curve

No Illiquidity premium (bucketed) in line with MCEV

principles

Yes – discussions ongoing on Counter-Cyclical Premium and

Matching Adjustment

YC interpolation/ extrapolation

Smith-Wilson Smith-Wilson Smith-Wilson used in QIS5

Entry to extrapolation

30 yr 50 yr Considering even earlier extrapolation than QIS5 30yr

Ultimate forward rate

3.9% Longest market spot rate (ie. 2.6%)

Stable 4.2%UFR used in QIS5

Speed of convergence

Moderate Irrelevant given full use of market data and moving UFR

Moderate for QIS5; under discussion

EUR yield curves Q411

SST offers flexibility in the choice of risk-free yield curve used so long as it is clearly documented, with shadow impact analysis

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Recent FINMA proposals for “lightening” of SST

FINMA has proposed a further update to SST yield curve methodology, prompted by

Low interest rates observed in Europe; possible distortions in Swiss goviesDeveloping Solvency II package to address the challenges to business with Long Term Guarantees (LTG) posed by full market consistency

Details uncertain, but appear to allow Solvency II QIS5 yield curves to be used for a transitional period of 3 years

Shadow calculations on govies would still be required

New business would need to be separated for purposes of calculation

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Careful consideration is needed before applying QIS5 proposals designed for Europe to Latin America

Where there is little market data e.g. 10 years or less, early extrapolation and fast convergence to a low, fixed ultimate forward rate can lead to unintended consequences

Real yield curve may be more relevant than nominal

A more plausible solution would be to keep forward rates flatter

Slower convergence, and/orAllow some movement in UFR

Smith-Wilson approach can work well given appropriate parameters

UFR has substantial impact if market data available only to 5 years e.g. BRL Q411

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UFR moves with market data Q411 +500bps 1 year fwd ratesUFR moves with market data Q411 -100bps 1 year fwd ratesStable 4.2% UFR Q411 +500bps 1 year fwd ratesStable 4.2% UFR Q411 -100bps 1 year fwd rates

Speed of convergence has substantial impact if working with fixed UFR and market data available only to 5 years e.g. BRL Q411

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UFR moves with market data Q411 alpha 0.1 1 year fwd ratesUFR moves with market data Q411 alpha 0.2 1 year fwd ratesStable 4.2% UFR Q411 alpha 0.1 1 year fwd ratesStable 4.2% UFR Q411 alpha 0.2 1 year fwd rates

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“Smith-Wilson” approach can give smooth curves passing exactly through the market data

Smith-Wilson curves pass exactly through market data

Necessary for market consistencyWorks well with swap market dataPre-smoothing needed for govies

The smoothness of the forward rate curve is important for correct behaviour of actuarial cash flow models

Simple linear interpolation of spot rates would not be good enough for use in cash flow models

USD annually compounded spot rates Q410

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Zurich 0% LP Swap spot rates Linear interpolation spot rates

USD 1 year forward rates Q410

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Zurich 0% LP Swap 1 year fwd rates Linear interpolation 1 year fwd rates

Reasonable looking spot rates can hide problems with forward

rates

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Discounted cash flow models for life business require projections of economic variables

Fund-based policyholder benefits and

fees

Dynamic policyholder actions e.g.

lapses

Inflation linked benefits

Dynamic management actions e.g.

bonus crediting

© 2010 The Actuarial Profession www.actuaries.org.uk

Bond prices

Inflation

Cash index

Equity and property indices

Movements in economic assumptions are often the single biggest driver of changes

in market consistent valuation

Best estimate liabilities

DiscountingCash flow

model

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Different types of stochastic economic scenarios can be used for SST Internal Models


Best estimate

liabilities and sensitivities

Proxy representation of liabilities

Market risk capital

requirement

Real world economic scenarios

Risk neutral economic scenarios

Fitting and validation scenarios

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We need stochastic modelling for valuation because the future is uncertain, and good outcomes don’t always average out bad ones

Time Value of Options & Guarantees (TVOG) = Stochastic BEL – Deterministic BEL

Deterministic modelling is often good enough

TVOG is the impact on valuation of considering uncertainty

Stochastic modelling is needed when TVOG is material due to asymmetries

TVOG is greatest when guarantees are on the point of biting

Value of an interest rate floor with 5% strike for different initial levels of interest rates

3.0% 5.0% 7.0%

Initial interest rate

Val

ue o

f opt

ion

Deterministic value(price with zerovolatility)Stochastic value(price with non-zero volatility)TVOG

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Time Value of Options and Guarantees (TVOG), Risk Margin and “SCR” all arise from different aspects of uncertainty

TVOG is the extra component within the best estimate liabilities arising due to uncertainty across an asymmetric range of possible outcomes

Allowance needed even for hedgeable risks

Required capital for one year risk (SCR) is the increase to market value sufficient to ensure high probability of solvency in one year’s time

Risk margin is the minimum extra amount needed to give high probability of orderly run-off by giving just enough capital to fund future SCRs

Risk Margin


Free capital






Risk Margin


Free capital






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Ideal characteristics of risk-neutral economic scenarios from diverse sources

Ideal characteristics of asset models:Reproduce market price of assetsNo arbitrageConsistency with prescribed yield curve

It is not always possible in practice to achieve all of these simultaneously

SST does not impose specific generic requirements for stochastic modelling of assets

Many sources of requirements for economic scenarios apart from regulation

Industry standards e.g. CFO-F MCEV PrinciplesAuditorsInternal need for high quality management information


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6

15

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20

25

30

35

40

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Volatility

Tenor

Term

GBP market swaption volatilities Q411

40-45

35-40

30-35

25-30

20-25

15-20

10-15

5-10

0-5

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Market-consistent Economic Scenario Generator calibration

• Three stages:– Market prices (or substitutes)– Calibrate model to the data– Simulate scenarios from the model

Observable market prices

Model of the


Simulation of the

Model of the


28

Source: Towers Watson

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A feedback loop can help to quantify materiality of impacts and define relevant tolerances


1. Define targets, tolerances and

number of scenarios, based

on materiality

2. Gather data and produce

scenarios

4. Analyse liabilities and model results to assess limitations of ESG and which market data are

most relevant

3. Test scenarios

against targets and tolerances before release for model runs

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SST Market Consistent Balance Sheet: Summary

SST MCBS is the foundation for all other parts of SSTAll assets and liabilities are to be valued in accordance with economic principles in a market-consistent mannerMarket-consistent value “such that knowledgeable business partners would purchase or sell the positions at this price in an arm’s length transaction”Mark-to-model often needed

SST risk-free rate methodology based on goviesAlternatives are possibleChoice of appropriate risk-free rate methodology and consequences for long term business need careful thought for LATAM

TVOG can be a key component of the SST balance sheetStochastic valuation challenging where market data limited, but solutions can be found

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APPENDIX: Tiering of available capital is not a central concept for SST

SST tiering aims for transparency without fixed limits and restrictionsFixed limits not consistent with principles based framework

Tiering of available capital distinguishes contribution to available capital from “hybrid instruments” but unlike SII, tiering has no impact on solvency ratio

Hybrid instruments assessed on substance rather than formAbility to buffer risksAvailability in case of need

Guarantees and contingent capital can be acceptableClear wording, legally binding, embedded within the risk and capital management processes of companiesAdequate and consistent modeling needed

global life actuarial internal use only assal-iais training seminar: swiss solvency test market...

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