Philipp Keller

International Actuarial Association /

Association Actuarielle Internationale

IAA Seminar, Basel 20 May 2014

1

2

Balance Sheets Insurers and Banks

Investments

Retained

Liabilities

Capital Liquidity

Debt

Capital

Reinsurance

Receivables

Reinsured

Liabilities

Loans

Deposits

Insurers Banks

Liabilities prefunded: (Uncertain

future claims payments funded

by premiums that have been

received earlier

Banks leverage deposits

for lending

Insurers take in money in order to pay it back later while

banks give away money in order to get it back later

3

Re/insurance is a catalyst for economic growth

What Re/insurers do

Benefits to society Pre-requisites

Risk transfer function

Diversify risks on a global basis

Make insurance more broadly available and less expensive

Global mobility of premiums and capital

Capital market function

Invest premium income according to expected pay-out

Provide long-term capital to the economy on a continuous basis

Ability to invest in real economy (equity, corporate bonds, etc)

Information function

Put a price tag on risks

Set incentives for risk adequate behaviour

Market and risk-based pricing

Re/insurers absorb shocks, provide capital for the real economy and

support risk prevention

4

Balance Sheets of Insurers

Reinsurance

Recoverables: 11%

Total

Investments

73%

Other Assets:

11%

Intangibles: 3% Deferred acq. Costs: 2%

Technical

Reserves, gross:

56%

Other Liabilities

18%

Debt: 4%

Hybrid Debt: 4%

Shareholders’

Equity

20%

Assets

matched to

liabilities,

often held to

maturity

Insurance is

pre-funded

by premiums

Payment is

triggered by

real event

Low level

of short-

term debt

5

Insurer balance sheet

Liabilities

Available

Capital

Assets

Pool large number of sufficiently

independent risks, to make

aggregate claims more predictable

Hold risk capital to absorb

unexpected losses

Control ALM risk

Asset-liability management

Hold enough liquid assets to

meet expected and un-expected

liquidity requirements

Control diversification Ensure asset liquidity

Invest premiums and capital to

match market risk of liabilities

Ensure capital adequacy

Balance Sheets of Insurers

6

Balance Sheets of Insurance Groups

Reinsurance Receivables

Participations

LLPO to Participations

‘Real’ assets

Intra - Group Transactions, Asset

Government Guarantee

LLPO to shareholders

(own credit)

Insurance Liabilities

Capital

Risk Margin

Intra – Group Transactions, Liability

Other Liabilities Assets serving as collateral

Asset for

Shareholders Liability for

taxpayers

Liability for debtors

of participation

7

Primary causes of financial impairments for re/insurers

8

Major Stress Events for Insurers

Past sources of stress

• High guarantees to policy

holders

• Contagion from bank,

liquidity problems

• Fraud

• CDS guarantee business

and securities lending

• Mass lapse due to

inappropriate products,

liquidity problems

• Cultural incompatibility

Consequences

• Run-off

• Insolvency

• Bailouts

Likely future problems

• Low interest rate environment, leading to erosion of balance sheets of life insurers

• Financial repression, leading to inappropriate investments

• Liquidity problems due to financial repression and liquidity transformations with banks

Example of regulatory

failings

• Lack of supervisory

scrutiny

• Lack of risk-based

supervisory framework

• Lack of group /

conglomerate supervision

• Inappropriate valuation

standards (off balance

sheet, amortized cost)

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10

Natural

catastrophes

Financial

Market Risks

Political

Risks

Man Made

Risks

Meteorological

Phenomena

Geophysical

Phenomena

Hydrological

Phenomena

Astronomical

Phenomena

Protectionism

Sovereign Default

Financial Repression

Expropriation

Interest Rate Risk

Credit Crunches

Equity Market Crashes

FX Risks

Counterparty risks

Solar Storms

Gamma Ray Bursts

Meteorite Impacts

Supernovae

Tsunami Rogue Waves

Limnic Eruptions

Sudden changes of ocean currents

Earthquakes Avalanches

Landslides

Volcano

Wildfire

Wind Storm Heat Waves

Hurricane Draughts

Cyclone Tornado

Cyber risks

Terror events

War

Nuclear risks

Mispricing

Inflation risks

Capital controls

Biological

Risks

Pandemics

Epidemics

Longevity

Obesity

Industrial Accident

Risks Complex and Heterogeneous Exposures to Risks

Plane Crashes

11

Risks

Relevant for Regulatory Risk

Capital

Relevant for Reserving Capital not

appropriate anymore

12

• 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.

• 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.

Diversification

13

Diversification

Dependencies can occur due to two possibilities:

• Several exposures are influenced by the same risk factor (e.g. a hurricane might affect several lines of business)

• Several risk factors are dependent (e.g. equity risk and credit risk)

Dependency is a property that emerges from the model, it ideally should not be

imposed ad-hoc (e.g. via correlations between major risk classes)

Diversification: Consider two portfolios A and B. Let R(A) and R(B) be the risk capital necessary for portfolio A and B respectively. Assume R(.) is determined using a risk measure. Then, if R(A+B) < R(A)+R(B), i.e. if the necessary risk capital for the combined portfolio is less than the sum of the risk capitals necessary for portfolio A and B, there is diversification between portfolio A and B

Note that diversification depends not only on the portfolios A and B but also on

the risk measure R(.)

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• Insurers are exposed to heterogonous risks

• In most cases, events occur independently, leading to diversification

• An earthquake in Japan and windstorm Europe tend to be independent

• Natural catastrophes do not impact the financial market material and vice

versa

• However, some insurers are not well diversified and in extreme cases,

dependencies between events can increase:

• Some life insurers have mainly interest rate risk which cannot be

diversified, only hedged

• Mortality risks cannot be diversified (mortality tends to improve globally)

• Very large natural catastrophes can potentially impact the financial market

or cause other natural catastrophes (e.g. re-bounce of earth crust after

earthquake causing clustering of earthquakes)

Diversification

15

Diversification and Dependencies Largest insured losses since 1970

Insured Losses Victims Start Date Event Location

In USD, indexed to

2012

76254 1836 25.08.2005 Hurrican Katrina US, Gulf of Mexico, Bahamas, North Atlantic

35735 19135 11.03.2011 Earthquake Japan Japan

35000 237 24.10.2012 Hurrican Sandy US, Gulf of Mexico, Bahamas, North Atlantic

26180 43 23.08.1992 Hurricane Andrew US, Bahamas

24349 2982 11.08.2001 Terror attack 9/11 US

21685 61 17.01.1994 Northridge earthquake US

21585 136 06.09.2008 Hurricane Ike US, Caribbean, Gulf of Mexico

15672 124 02.09.2004 Hurricane Ivan US, Caribbean, Barbados

15315 815 27.07.2011 Monsson rains Thailand

15315 181 22.02.2011 Earthquake New Zealand New Zealand

14772 35 19.10.2005 Hurrican Wilma US, Mexico, Jamaical, Haiti

11869 34 20.09.2005 Hurricane Rita US, Gulf of Mexico, Cuba

11000 123 15.07.2012 Drought in Corn Belt US

9784 24 11.08.2004 Hurricane Charley US, Cuba, Jamaica

9517 51 29.09.1991 Typohone Mirelle Japan

8467 71 15.09.1989 Hurricane Hugo US, Puerto Rico

8421 562 27.02.2010 Earthquake Chile

8205 95 25.01.1990 Winter storm Daria France, UK, Belgium, Netherlands

7994 110 25.12.1999 Winter storm Lothar Switzerland, UK, France

No market-wide

distress nor impact

on the financial

market impacts ->

diversification

between insurance

and financial market

risks

16

Diversification and Dependencies Tambora Eruption 1815

Shift in thermohaline circulation

1816 Summer Temperature Anomaly

Tambora Eruption 1815

Immediate local

devastation, estimated

deaths 70’000+

100 km^3 of debris ejected into

atmosphere (~10 times Vesuvius)

Lung infections due to

sulfur acid and ashes

Global cooling, failed crops in Europe and

North America and Yunnan, China

Snow in June 1816 in North America

Floods and low temperatures in Europe

Disruption of Indian monsoon

Shift in jet stream

Most livestock died during winter 1816/17 in the US

Doubling of mortality in Switzerland

1818 return to normal

climatic situation

Cholera pandemic in India , China and Indonesia: 1817to 1824

Typhus epidemics in Ireland 1816 – 1819 (100000+ victims)

Catastrophic collapse of ice dam in

Switzerland in 1818 (Gietro Glacier)

For extreme events, dependencies between risk factors can change

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18

• Reinsurance is a major element of the risk management of insurers.

• Reinsurers have to deal with the problem that insurers do know the business they transfer to reinsurers

much better, leading to the risk of moral hazard and adverse selection

• To deal with this, reinsurers and insurers are guided by two principles in their dealings:

• Utmost good faith (Uberrima Fides ) means that all parties have to disclose the relevant business and

to treat the ceded part of the business similar to the one which is kept on own account. It derives from

the “marine rule” of underwriting which requires an affirmative duty on the party seeking insurance to

disclose all potentially material information; The insurer is obliged to act as if it had no reinsurance.

As used in reinsurance, utmost good faith means that the maxim of caveat emptor has no

application to either party in the relationship . . . . The duty exists with respect to any action

necessary or desirable in order to place and maintain both parties within a fair and equitable

bargain . . . .

(Henry T. Kramer in Reinsurance 9 (Robert W. Strain ed., 1980).

• Follow the fortunes means that a reinsurer has to indemnify a direct insurer for any payments

covered by the underlying policy, by settlement or adverse judgment, as long as those claims are not

fraudulent, collusive or made in bad faith

As a general rule, the follow-the-fortunes doctrine requires a reinsurer to indemnify a reinsured for

any payments made by the reinsured for claims covered by the underlying policy, by settlement or

adverse judgment, as long as those claims are not fraudulent, collusive or made in bad faith. See,

e.g., Commercial Union Ins. Co. v. Seven Provinces

Insurers, Reinsurers and Moral Hazard

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Contract Phase Settlement Phase

Utmost good faith

Follow the Fortunes

All material and

relevant

information on the

portfolio, pricing,

claims history,

contractual

features etc.

Material and

relevant new

information that

lead to a change

in the

assessment of

value and risk

Prompt

information on

claim occurring

All material

and relevant

information

during the

settlement

phase

Cedent

Reinsurer

Prompt

information

on the

termination

of the claims

settlement

Insurers, Reinsurers and Moral Hazard

Utmost good faith and follow the fortunes are principles which distinguish the transfer of risk to

reinsurers from the risk transfer of banks to the shading banking sector

20

21

Inconsistent Consistent

Global National

Banks and Insurers Regulation

Market Stability Policyholder

Protection

Main focus on Pillar 2, governance

and processes

Total balance sheet approach but weakened

since financial crisis

Inconsistent Consistent

Focus Consistent

Focus

Culture

Pillar 1 Valuation

Pillar 1 Risk

Pillar 2

Basel II/III, global requirements by Basel

Committee but becoming more national Regulation national but increasingly supra-

national (Solvency II) or global (ComFrame)

Trading and banking book with different

valuation standards

Different approaches for different risk, time

horizon linked to liquidity, additive aggregation

Consistent treatment of all risk categories with

common time horizon

Increasing focus on Pillar 2 to compensate for

weakened Pillar 1

Weak Strong Pillar 1

Generally weak and compromised Stronger focus on quantitative measures, but

weakened since the financial crisis

Increasingly focusing on market stability due

to financial repression

Banks

Insurers

22

Banks and Insurers Risk

Duration Short Long

Market Low High

Credit Low High

Liquidity Low High

Insurance Low High

Operational Low High

Legal Low High

Systemic Low High

To other banks, to capital market,

taxpayers To reinsurers Risk transfer

Dynamical hedging ALM Risk mitigation

Spread Low High

Banks

Insurers

23

Entry barriers

Banks and Insurers Business

Liquidity transformation

Rent seeking Risk transfer Business model

Capital allocation, lending

Capital supply

Pricing of risk, long-term saving

Capital protection Social benefit

Compliance Business (P&C), compliance (life) Culture

Low High Complexity of business

High Medium Complexity of organization

Short Term Medium to long-term (reinsurers) Management outlook

National Global Management outlook

High Low to medium Lobbying power

Focus of models Valuation for pricing Valuation for reserving (life), risk (P&C)

Risk modeling Basic, risk assumed to be captured by

market prices Sophisticated

Consolidated

group Legal entity Management view

Strong focus on group and functional units, but

recent regulatory requirements lead to view on

legal entities

Historical focus on legal entities, recent

regulatory frameworks (Solvency II,

ComFrame) also with group view

Banks Insurers

Low High

Low entry barriers for bank and reinsurers High entry barriers for life insurers

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25

The Financial Market Today

Central

Bank

Markets

Net Stable Funding Ratio

Liquidity Coverage Ratio

No Domestic Credit Risk

Banking/Trading Book Option

Going-Concern Contingent Capital

Low-Trigger Contingent Capital Additional Capital Buffers

Counter Cyclical Premium

Matching Adjustment

No EUR Credit Risk

Equity Dampener

Lack of diversification across jurisdictions

Sovereign

Banks

Sovereign Bonds

Toxic Assets

Market influence, e.g. via prohibition of short selling, buying up of government bonds, etc.

Moral Suasion

Hold to Maturity

Approaches, IAIS ICP 14

Transfer of illiquid assets from

banks to insurers and pension funds

in exchange for liquid assets

Markets with

impaired price

finding function

Insurance regulation geared to

support banks and sovereigns

Lowered asset quality, lower reserves / technical

provisions; disincentives to sell assets with declining

market values, lower market liquidity

Taking on of banking

debt, CoCos etc. Ultimate Forward Rate

Solvency

II, etc

BSCB Basel

II/III

SIFI

Liquidity, Cash

IAIS

IASB

Expropriation of Pension Funds

Sovereign Bonds

Moral Suasion

Moral Suasion

Banking

SIFIs

Liq

uid

ity T

ran

sfo

rmati

on

s

Lo

ng

-Term

Fin

an

cin

g

Co

mp

eti

tive D

isad

van

tag

e

Liq

uid

ity T

ran

sfo

rmati

on

s

Basel II

I / S

olv

en

cy II

EM

IR, D

od

d-F

ran

k A

ct

Basel II

I

Liquidity pumps

Dir

ect

Bailo

ut

SIFI Designation

Pre

fere

nti

al

investm

en

t in

SIF

Is

Growth of SIFIs due to funding advantage and being Too

Big To Fail, Too Big to Prosecute and Too Big to Supervise

Low Interest Rate Policies

Central banks issuing and buying

sovereign bonds, Quantitative Easing,

Outright Monetary Transactions etc.

Closer link between

sovereigns and central

banks

Neglect

Conflicts of

interests

Pension

Funds

Insurers

Inefficient capital

allocation

Decline due to competitive

disadvantages and low-

interest rate environment

Lobbying power

Government Guarantee

Sovereign Bonds

Full Diversification within Conglomerates

Lo

we

r co

st o

f ca

pita

l

(~5

0 to

10

0 b

p)

Repo Facilities

Pension

Funds

Insurers Insurance

SIFI

Insurers

Insurance SIFI Regulation No preferential

IAIS /

ComFrame

Inve

stm

en

t

Increasing protectionism

Enhanced supervision, resolution, higher loss absorption capacity

Offshore

Jurisdiction

De-facto control

Capital Flows

Rating

Agencies Pressure Rating Uplift

Sovereign Rating

Protectionist measures: Capital flow restrictions, trade barriers, hurdles for foreign investment, etc.

Competing

Jurisdiction

Capital Flows

Closure via

supranational

agreements

Offshore

Jurisdiction

Currency Wars

Capital Transfers to SIFI Banks: ~500bn Annually

26

Insolvencies and Bailouts

27

Stages of the Financial Crisis A Greek tragedy in three acts

Financial Repression Bailout Pre-Crisis

Protectionism

Criticality reached?

Insurers

Regulatory

Industrial Complex

Regulation

Today

Compliance driven Politically and

relationship-driven

Weak Pillar 1

requirements steering

investments and products

to further political goals

Explosion of Pillar 2

requirements

Limited group diversification

Legal entity requirements

Limited capital flows

Restricted recognition of IGTs

Supervisory practices preferring

incumbents

28

Stages of the Financial Crisis Bailout phase

Investments in

banks

Pressure to adapt

regulation

Sovereign Regulation

Banks

Regulation based on systemic

importance of banks

• Socialization of banking losses;

• Ultra-low interest rate policies to

support banking sector and to

stabilize economies

• Bailouts imply government

support for large banks

• Erosion of capital of insurers due

to low interest rates

Capital injections

Toxic assets transferred to tax payers

Markets

Insurers

Markets

contracting

29

Stages of the Financial Crisis Financial repression phase

Insurance Credit Risk 29

SIFI Regulation

Repressionary Regulation:

Matching adjustment, amortized

cost, no EUR sovereign risk, etc.

SIFI regulation

Liquidity

Transformation

Investments in

banks

Pressure to adapt

regulation

Government Support, Guarantees etc.

Sovereign Regulation

Insurers

Regulation based on macro-

economic arguments

Downward spiral of supra- and

international regulatory frameworks

through regulatory contagion

• Compliance cultures spreading,

further growth of regulatory-

industrial complex, dependency

between governments and the

financial sector

• Compensation of weakened Pillar

1 with Pillar 2 requirements

• Use of insurers to further

government aims (i.e. social

housing, infrastructure, supply of

long-term guarantees)

• Competitive distortions between

insurance and banking sector and

between jurisdictions

• Smaller insurers (and banks)

squeezed out of the market due

to rising compliance costs Suasion, pressure to invest in desired asset classes

and to write long-term guarantee business, etc.

Liquidity Coverage Ration; Net

Stable Funding Ration; etc. Banks

Lobbying for more Pillar

2 regulation and less

Pillar 1 requirements

Markets

Markets contracting

and becoming less

diverse

30

Stages of the Financial Crisis Protectionist phase

Regulation based on nationalistic

arguments

Re-nationalization of regulation

• No level playing field between

jurisdictions

• Retaliatory protectionist

regulation and supervisory

practices

• Necessary change of business

models for international groups

• Rise of domestic champions

• Further deterioration of

efficiency and innovation

• Competition based on political

influence, rather than on

economics

Repressionary Regulation

SIFI regulation

Liquidity Transformation

Investments in banks

Sovereign

Regulation

Suasion, pressure to invest in desired asset classes

and to write long-term guarantee business, etc.

Protectionist regulation limiting market

access; supervisory practices giving

incumbents advantages; Pillar 2

requirements to exclude foreign players

Insurers

Banks

Government Support, Guarantees etc.

Markets

31

32

Financial Repression Examples

A few weeks ago, EIOPA reported on the critical issue of the long-term guarantees

assessment and closed its consultation on proposals for preparatory guidelines.

We now have acceptance that the classic matching adjustment is a prudent

measure, which is hugely important for the UK life insurance industry. We know

that many of you still have concerns around the restrictions built into the classic

matching adjustment, particularly around the assets that can be used and the effect

of possible downgrades in portfolios which are held for the long-term. We will

continue to push for a prudent solution that will meet the needs of UK insurers and

allows for the continued provision of annuities to policyholders. In doing so, we

recognise that some restrictions are needed for the classic matching adjustment to

be an effective and prudent measure.

Meeting the challenges of a changing world – the view from the PRA,

Andrew Bailey, PRA, 9 July 2013

33

Financial Repression Examples

Another potential side effect of risk-based solvency regulations is that they may aggravate

procyclical investment behaviour such as the forced sale of assets during market downturns,

especially if market valuation is used to calculate assets and liabilities. There were many

examples of procyclicality during the recent financial crisis. Many of the countries with risk-

based solvency and funding regulations made changes to their regulations to protect against

fire-sales of assets which could have worsened market conditions.

Severinson, C + Yermo, J, The Effect of Solvency Regulations and Accounting

Standards on Long-Term Investing, OECD Working Papers on Finance,

Insurance and Private Pensions No. 30, OECD Publishing, 2012

Countercyclical forces. At the same time, as in the case of banking regulation, stronger

regulation raising the resilience of the sector should also help to counteract procyclicality. In

addition, an illiquidity premium, if included in the discount rate under Solvency II, would

counteract the procyclicality arising from market illiquidity. The recognition that procyclical

behaviour can have destabilising effects on markets has also prompted discussions to allow

for the use of dampeners in the Solvency II framework. Such dampeners can be thought of as

countercyclical buffers (as in Basel III), and may be quantitative or qualitative in nature.

Fixed income strategies of insurance companies and pension funds, Committee

on the Global Financial System Papers, No 44, BIS, July 2011

34

Financial Repression Examples

[…] At the same time, there is concern about a possible lack of investors to fund banking

institutions over the medium term, possibly forcing them to deleverage and to reduce lending

as a result. Banks’ refinancing needs remain high, and regulatory standards will require

greater issuance into the longer-term segment in fulfillment of the Net Stable Funding Ratio

under Basel III. European insurance companies (and pension funds to a lesser extent)

constitute a bank funding source of considerable importance (Section 2). However, since the

start of the crisis, insurance companies and pension funds have been reducing their exposure

to financial institutions, and prospective regulatory risk charges provide little incentive to raise

their allocation to corporates.

Fixed income strategies of insurance companies and pension funds, Committee

on the Global Financial System Papers, No 44, BIS, July 2011

The current market conditions are leading to substantial downward adjustments in the value

of commercial property, and the specific characteristics of properties, such as location,

vacancy rates and rent reductions are also impacting their value. Although there are locations

where properties are still in good demand and values are still rising, the number of properties

facing difficulties is increasing. Prices of Dutch commercial property have now been falling for

around four years, especially in the offices (-20% and industrial (-26%) segments. The gap

between supply and demand for space is widening steadily, again particularly in the offices

and commercial segment […]

Annual Report 2012, De Nederlandsche Bank

35

Financial Repression Examples

A larger role for Dutch pension funds and insurers in the mortgage market could also reduce

vulnerabilities. Mortgages are long-term investments that generally carry a fixed interest rate,

making them relatively suitable for covering long-term commitments. Life insurers have

recently become more active on the Dutch mortgage market and in fact their mortgage

portfolio has grown by 28% over the last two years. When investing indirectly in mortgages,

for example through the purchase of bank securitisations, the fundability of the deposit

funding gap improves. If insurers provide these mortgages themselves, this will contribute to

a more rapid fall in the banking sector’s LTD (Loan-To-Deposit) ratio. Pension funds could

also play a more active role on the mortgage market. After all, the supervisory authority does

not preclude an increase in investments in mortgages. However, investing in or providing

mortgages does require adequate knowledge of credit risk control on the part of both insurers

and pension funds.

Overview Financial Stability Spring 2013, De Nederlandsche Bank

Due to the strong reliance on market funding, mortgage providers are also exposed to

funding risk. Rising arrears and lack of clarity about the risks of the mortgage portfolio can

dampen the enthusiasm of investors to finance Dutch mortgages, thus raising funding costs.

In this light, the recent entry of new players such as insurers to the Dutch mortgage market is

a welcome development. They promote competition and can help to overcome obstacles in

the supply of mortgage loans resulting from the strong concentration at banks

Overview of Financial Stability, Spring 2014, De Nederlandsche Bank

36

Regulatory Contagion

Amortized Cost Approaches

Countercyclical premium, Matching

adjustment, volatility dampeners,…

Maximum harmonization of EU Basel III implementation,

pushed through by D and F; minimal Basel III

requirements cannot be exceeded by national regulators

Equity Dampener

Expropriation of private

pensions, H, PL,…

No EUR Sovereign Risk

Ultimate Forward Rate

Full Diversification

within Conglomerates

Restrictive diversification

across jurisdictions

IAIS ICP 14 defines ‘economic valuation’ to

include amortized cost approaches Global spread

Weakened requirement for

Basel III leverage ratio

37

Procyclicality and Dampeners

Procyclicality Type 1 Procyclicality Type 2

Dampeners (e.g. countercyclical

premium, equity dampener, Ultimate

Forward Rate, etc.)

Common investment incentives from

dampeners lead to increased herd

behavior, uneconomic allocation of

capital and distorted market prices

Procyclicality type 1: Investors increasing the exposure to similar risks during seemingly

benign times of the market and then incurring simultaneously large losses in financial

market downturns

Procyclicality type 2: selling non-performing assets in a market downturn, leading to

further deterioration of market prices

38

Procyclicality Type 1 and 2 Après nous la déluge

Market values without

counter-cyclical measures

Dampeners impair price finding function

of markets and stabilize market prices

during transitory crises During structural crises, dampeners are

not sufficient anymore to prop-up market

prices, leading to catastrophic losses

Transitory crises Structural crisis

Procyclical effects of Type 1: Herd behavior,

common investment strategies leading to

increasing market values, aligned business models

Market values with counter-

cyclical measures

39

Banks and Insurers

Bank

SIFIs

US subsidy in 2012 to

banking sector: 83bn of

which 45bn to the 5 largest

banks; Why Should

Taxpayers Give Big Banks

$83 Billion a Year?,

Bloomberg, Feb 2013

Funding cost advantage of SIFIs ~80bp, Quantifying Structural

Subsidy Values for Systemically Important Financial Institutions,

Kenichi Ueda and Beatrice Weder di Mauro, IMF May 2012

Implicit subsidy for

SIFIs: ~300bn pa

(Andrew G Haldane:

On being the right size,

Oct 2012)

Implicit subsidy for UK banks:

~100bn pa (The implicit

subsidy of banks, Financial

Stability Paper No. 15 – May

2012, Bank of England)

Rating uplift for SIFI

banks: 1 to 2 notches.

Bank Risk Report,

Moody’s, March 2012

Cost for insurers of low-interest rate policies:

~500bn pa, Swiss Re Sigma study, 2011

Growing risk appetite to:

• Profit from government guarantee

• To grow and pay back bailout

• Increase systemic risks

• To stay too big to fail and too big to prosecute

Insurers

Growing risk appetite to:

• Compete against SIFI banks

• Restore balance sheets that are eroded

by the low interest rate policies

Competitive Distortions

40

Conflict of regulatory objectives Between supervisory authorities

Strong conflicts of interest

Mandate:

Price stability

Mandate:

Policyholder protection

Mandate:

Market stability

Conflicts between Basel II/III and insurance

regulation

Low interest rate policies to support banks

and economy leading to erosion of financial

position of insurers and pension funds

Mainly conflicts regarding

competencies

Banking

Regulator

Insurance

Regulator

Central

Bank

41

4

2

• Insurers tend to be long term buy and hold while banks tend to be short term risk holders

• Banks need to have expertise in whom to lend money while insurers need to know from whom

to accept risks

• Insurers are less likely to experience liquidity squeezes since claims payments do not have to

be immediate and there is no analogue to a run on the bank

• Exception are:

• if insurers are highly concentrated on variable products or highly concentrated in a cat

zone along with their reinsurers

• Collateral calls in case of down-grades, leading to liquidity strain

• Limited capital mobility due to supervisory firewalling of capital, leading to liquidity crunch

• For traditional insurers, liquidity crunches are micro events

• Insurers and reinsurers have a long tradition in dealing with moral hazard, in contrast to the

shadow banking industry. Follow the fortune and utmost good faith help reducing the risk of

moral hazard and impose discipline in the market

• Insurers face complex and heterogeneous risks. They have a long tradition of risk management,

modelling and valuation, employing relatively many more quants and actuaries than banks

• Financial repression and increasing protectionism exposes insurers however to higher level of

sovereign risks. This is becoming a major problem for life insurers and for international groups

Conclusions

Proposal by Swiss Re and Deloitte

Philipp Keller

43

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

44

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

45

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

46

47

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

48

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

49

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

1

2

3

4

5

6

7

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

50

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

2

1

3

4 5

6

7

Comparing the calibration

Principles for formulating

states of the world

51

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

52

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.

53

54

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.

54

55

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.

55

56

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

56

57

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.

57

58

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

58

59

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

59

60

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

61

62

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.

62

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

63

64

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

65

66

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

66

67

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

67

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.)

68

69

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

69

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

70

71

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)

71

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: phkeller@deloitte.ch

Direct: +41 43 285 7212

Fax: +41 43 282 7212

Mobile: +41 79 777 9835

E-mail: Philippe_Brahin@swissre.com

72