solvency ii – the final test israel april 5 th, 2011 prepared by marc beckers of aon benfield...

Solvency II – The Final Test

Israel

April 5th, 2011

Prepared by Marc Beckers of Aon Benfield Analytics

Solvency II: Executive Summary

Harmonizes insurance regulation across Europe, replacing Solvency I (est. 1973) and local regimes (e.g. UK ICAS)

Start date January 2013 + transitional period of up to 5-10 years

Capital charges under Solvency II will be finalised in Dec 2011

Risk-based approach to required capital that demands insurers to develop robust risk management practices

Risk and capital mitigation effect of reinsurance only allowed if the reinsurance counterparty has a Solvency II ratio above 100% or a rating of at least BBB

The average non-life solvency ratio expected to decrease from about 200% under Solvency I to 165% under Solvency II

Captives and mono-lines are at a significant disadvantage as the standard formula penalises those writing less diverse portfolios – both geographically and in terms of class of business.

The capital charges for counterparty default risk may drive a flight to quality for reinsurance counterparties (rating A or better)

Catastrophe risk is a key concern within the Solvency II Standard Formula

The local catastrophe scenarios under QIS 5 often lead to a materially higher result than the commercial catastrophe models

2Aon Benfield | Israeli Market presentationProprietary & Confidential | 5 April 2011

Topics for discussion

Section 1 Summary Conclusions QIS 5

Section 2 Life, Non-Life and Health within QIS 5

Section 3 Partial Internal Models in QIS 5


Section 1: Summary Conclusions QIS 5

Solvency Ratio from 310% in Solvency I to 165% under QIS 5 ! Diversification for composite solo submissions 32% and 46% for groups Quality of QIS 5 submission debatable Significant issues with the QIS 5 requirements for some key risks Time is running out

Summary: Surplus falling under QIS 5 but still acceptable on average

Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 5

Surplus: Solvency I to QIS 5

Overall 2009 level of surplus for European industry has decreased by 30% representing a €120bn reduction (from €480m to €360m)

The margin under the MCR has increased by €200bn

Industry wide solvency ratio falls from 310% to 165% under QIS 5

SR = 310% 165% 466%

Valuation Adjustment Effect +99%

Analysis of Surplus Movement

Market consistent valuation of assets under QIS 5 reduces solvency ratio by 14%

Technical provisions assessed at fair value increases solvency ratio by 107%

Risk based capital requirements are the key driver for the reduction in solvency ratio

Aon Benfield | Israeli Market presentationProprietary & Confidential | 5 April 2011

Are diversification and loss absorbing mechanisms too large ?


Source: EIOPA QIS 5 report

32% diversification for solo composites and 46% for groups versus a diversification benefit by S&P of below 10% !


Groups – Key Observations

Under Standard Formula, average group surplus reduces by 43% vs Solvency I, but using internal model surplus increases by 6%

Average group diversification 20% under accounting consolidation

Significant adjustment for loss absorbency and deferred taxes

Equal balance between life and non-life insurance risk

Market risk is substantial at 57% of BSCR

– Equity risk and spread risk are significant

– High interest rate charge suggests poor ALM

Counterparty charge large relative to other risk categories

Diversified Group SCR


UK: Acceptable quality except for USPs and SCR Underwriting Risk !


Source: FSA QIS 5 report


What issues transpired in QIS 5 ?

Ireland difficulties:

1. Complexity, especially counterparty default risk module and non-life cat risk

2. Non-Life underwriting risk calibration

3. Life contract boundaries and Expected Profits in Future Premiums (EPIFP) France difficulties:

1. Asset risk fair value very different from today

2. Complexity SCR, especially non-life cat and non-proportional reinsurance

3. Calculating technical provisions, eg. contract boundaries and illiquidity premium

4. EPIFP Spain:

1. Complexity counterparty default risk (need to run the model twice !)

2. Catastrophe risk for non-life and life, eg. consorcio not taken into account in life Cat

Other observations: poor data “quality control”

Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 9Aon Benfield | Israeli Market presentationProprietary & Confidential | 5 April 2011

Solvency II implementation to cost in excess of €3m on average




Was QIS 5 “only” a test ?

Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 11Aon Benfield | Israeli Market presentationProprietary & Confidential | 5 April 2011

Solvency II implementation by 2013

2005 2006 2007 2008 2009 2010 2011 2012 2013

Directive Development(Commission)

Directive Adoption(Council & Parliament)

Level 1 Implementation in member states

Solvency II Start Date1 Jan 2013

Level 2Implementation Measures (CP’s)

Level 3Guidelines by

Regulators

Proposal expected in June 2011Final measures by end 2011

Expected before March 2012

(depends on Level 2)

QIS

Omnibus II

QIS 1 QIS 2 QIS 3 QIS 4 QIS 5 QIS5 results expected by March 2011

Transitional Phase?

QIS = Quantitative Impact Studies

Key Dates for 2011 July 2011 Sept 2011 Q3 2011 Nov 2011 Dec 2011

EC finalise technical standards for Solvency II

Pan European Stress Test

EIOPA Advice on assessment of Switzerland, Bermuda, Japan

3rd country assessment methodology

EC confirm transitional measures for Solvency II


?

Transitional measures under “Draft” Omnibus II

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Valuation of Assets & Liabilities

Requirement for fair value assessment of assets and liabilities delayed for up to 10 years Existing member state rules as at 31 December 2012 will apply during transitional period

Calculating Technical Provisions

Requirement for calculation of technical provisions delayed for up to 10 years No requirement to be as best estimate with discounting and risk margin, Existing Solvency I directives will apply during transitional period

Tiering of Own Funds

Requirement for criteria by which funds classified into various tiers delayed for up to 10 years Existing Solvency I directives for classification of own fund items will apply during transitional period

Public Reporting

Delayed for up to 3 years Higher level reporting in Solvency II

directive required from 2013

SCR

Requirement for SCR calculation delayed for up to 10 years Calculation of ‘transitional SCR’ may include modifications to standard formula calculations Insurers must comply with a transitional SCR that is no higher than the SCR and no lower than the

sum of the MCR and 50% of the difference between the SCR and the MCR.

Governance Delayed for up to 3 years Existing Solvency I directives will apply

during transitional period

Draft Omnibus II directive published by European Commission on 19 January 2011

Solvency II start date confirmed as 1 January 2013

Omnibus II provides maximum transitional periods

EC will publish delegated acts in 3rd quarter 2011 confirming actual transitional measures – likely to be shorter than the maximum time periodsEquivalence

of third countries

Criteria for equivalence delayed up to 5 years Decisions would be made on case by case basis under delegated

acts of law

Supervisory Reporting

and Governance

RSR is delayed for up to 3-5 years (including supporting systems and governance)

Existing Solvency I reporting applies


Section 2: Life, Non-Life and Health in QIS 5

QIS 5 shows that key challenges remain before the implementation of Solvency II

Underwriting risk is the key SCR component for non-life insurers

Non-Life Solo SCR

Average capital requirement for non-life insurers is higher than life insurers under Solvency II

– This is driven by the loss absorbency of life mathematical provisions Greater diversification in the BSCR for non-life insurers Underwriting risk is the key component for non-life insurers Market risk is largest component of life insurance capital requirement

* Adjustment for tax is estimated for non-life SCR based on group value provided in EIOPA report on QIS 5. ** Diversification is estimated using QIS 5 correlations and non-life / life individual risk SCR’s post-diversification

Life Solo SCR


QIS 5: Life and Health Cat Risk 11% of U/W risk pre-diversification

LIFE CAT RISK 1.5 per mille on capital at risk

HEALTH CAT RISK Arena risk (50% of stadium) + Concentration risk (100% + 300m around) + Pandemic risk (0.075 per mille)

Accidental Death 10%

Permanent total disability 1.5%

Long term disability 5%

Short term disability 13.5%

Medical / Injuries 30%


QIS 5 results show the importance of EQ risk (net of reinsurance)

Overall reinsurance is a key aid to reduce the exposure to NatCat risks

Overall (net) EQ exposure within a local Cypriot non-life insurer would be about 25% of the total capital requirement

“The CTF recommends a more accurate and appropriate estimation of the undertaking's catastrophe risk through the use of a partial internal model”


NatCat: Earthquake

)()( ZoneZoneZoneZoneCountryEarthquake

CountryEartquake TIVFTIVFAGGQCAT

Calculate the gross 1/200 OEP per country

Total Insured Value per Cresta

Vulnerability factor (quake)

“Aggregation” Matrix (quake)

1 in 200 OEP factor

Parameters-non-life-catastrophe-risk_en.xlsEQ_CRESTA_CY

Provided by company


Evaluating catastrophe models – components

Industry Exposure database

Industry Exposure database

Geocoding ResolutionGeocoding Resolution

Occupancy Type

Occupancy Type

Vulnerability Regions

Vulnerability Regions

Construction Type

Construction Type

Post-Loss Amplification

Post-Loss Amplification

Loss by Geographical RegionLoss by Geographical Region

DeductiblesDeductibles

Losses by LoB / Coverage

Losses by LoB / Coverage

Regional CorrelationRegional

CorrelationBusiness InterruptionBusiness

Interruption

Line of BusinessLine of Business

Hazard EP Curves / RPsHazard EP

Curves / RPs

Several steps along the catastrophe modelling chain where we can evaluate and compare models


Potentially significant difference in output between Standard Formula approach and cat models Scenario testing vs cat model by client Negative percentage = cat model lower

than scenario For over 80% of clients the standard

formula for natural cat is unacceptable

Standard Formula Nat Cat – Cat Models vs Scenario

France

Comparison with Cat Models

Damage by Cresta zone is going back more than 15 years in time Munich Re / Swiss Re approach prior to

cat models? Almost all clients have data more

granular than Cresta All commercial cat models have

finer granularity Data quality is ignored

No impact for location granularity No differentiation by occupancy No impact for construction, age, height Single damage function

No differentiation by buildings, contents, BI

No application of limits, excess, original deductibles

Issues with Standard Formula

Our Recommendation: Catastrophe Partial Internal Model

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

A B C D E F G H I J K L M N O P Q R S T U V W X Y Z AA AB AC AD AE AF AG AH AI AJ

Per

cen

tag

e

Cedants

PML QIS 5 > PML vendor models

PML QIS 5 < PML vendor models


Non-Life Solos – Key Observations

Non-life cat risk has significant issues with calibration under Standard Formula

Health care component relatively small but complex to compute

– Segmentation into SLT and non-SLT of workers comp difficult

– Similar to life (SLT) only 2.5% of BSCR for non-life firms

• Is the complexity justified? Life risk close to nil Market risk smaller for non-life

companies reflecting lower risk investment strategies

– Equity risk largest component

Diversified Non-Life Solo BSCR


Non-life SCR (Solos)

Manmade Cat

Natural CatM

etho

d 1

28%

Premium risk largest driver of non-life capital

– Most entities did not use USP’s or NP adjustment Cat risk split fairly evenly between Method 1 and 2

– Non-EEA cat risk carries significant capital charge Manmade cat charge similar to Nat cat

– Does this make sense for a risk not currently explicitly modelled?

Lapse assumed nil by most companies

Non-Life SCR (Solos)


Health SCR (Solos)

Health Cat

Similar to Life (SLT) Disability is the largest risk within SLT (76%)

– Income protection disability charge too penal Lapse risk also significant, many reported difficulties to identify

+ve and –ve surrender strains Health cat does not factor in medical expenses for pandemics

– Also difficult to calculate and inconsistent with life cat Cat scenarios too generic for local markets and insurers

Health SCR (Solos)

39%

11%


Life SCR (Solos)

Lapse risk and longevity risk are most material life risks

– Feedback on longevity risk critical of it only being a shock on level, rather than accounting for trend risk

– Lapse risk calculation was criticised as too onerous on a policy by policy basis Revision risk is nil

– Surprising result: possible error in report? (in appendix to EIOPA report = 2.9%)

– Or indicator that calculation is too complex for most companies?

Life SCR (Solos)


Market Risk SCR (Solos)

Credit Quality

Equity and spread risk are most significant

– Both criticised as too penal

– Spread risk excludes Sovereign risk

• Note EIOPA stress test includes it Currency risk: counterintuitive to hold assets in

reporting currency instead of the liabilities Counterparty risk: too complicated and cash at

bank too penal relative to equivalent spread risk

Return Generating Assets

Market Risk SCR (Solos)

Other Equity forms part of Equity charge (exact % unspecified in EIOPA report)


Non-life: Undertaking Specific Parameters and Non-Proportional Adjustment

Approximate 20% reduction in underwriting volatility under non-proportional adjustment for liability and fire

Significant area of feedback:– Too complex, most undertakings did not complete– Not suitable for different types of non-proportional

reinsurance– Data requirements onerous

Undertaking Specific Parameters

Sample Size Sample Size

Non-Proportional Adjustment

USP’s submitted to supervisors under QIS 5 generally provide a significant reduction in volatility Especially for liability classes

Some concern about cherry-picking and USP’s not becoming an “internal model lite”


Section 3: Partial Internal Models for Catastrophe Risk

Who is planning an internal model for catastrophe risk? Is an Internal Model worth it? Do not underestimate the complexity ! Internal models could be the answer, but will they be?

Weighted average benefit from Internal Model 20%


Very high standard deviation of results: between 25% and 250% on 27 German insurers

Weighted average SCR via Internal Model 140% of Standard Formula result in Spain The average life firm’s internal model SCR was almost equal to their standard formula

SCR in the UK UK Internal Models:



Internal Models – too complex and worth the effort ?

For a model to be approved the following need to be satisfied:

– Use test: have to show that the model is used as a decision tool in daily risk management work

– Statistical quality standards

– Calibration standards

– Profit and Loss attribution

– Validation standards

– Documentation standards

– Internal Model governance

– Integration of external models needs to be understood In general: what regulators want to see is a controlled process around the internal

model, acknowledged and used by management Most popular use test example: reinsurance !

Do regulators have the capabilities or will they rely on outside consultants (like they are doing in Switzerland for the SST)


An example of a pre-application timetable (FSA)

Quarterly face to face meetings

Reviews and assessments of internal model

FSA Review

Application submission

SII requirements and contents of application

meetings

Completion of self assessment

Meetings to agree work-plan

Monthly reporting by company

2010 2011 2012

Scoping and planning

Experience shows that it takes at least 2 years from kickoff to approval (expect over 50 on-site visits from regulator)

Hundreds of documents Thousands of pages About 200 meetings About 100 employees involved (60% quantitative people) About 15 departments involved


Catastrophe Partial Internal Models

Area Considerations

Internal model approval process is currently very onerous required detailed documentation and validation of the science behind the catastrophe model

If the client cannot answer questions about the internal model (including the underlying external models), the model will not be approved

Potential issue for most commercial models, which are largely black boxes One regulator indicated preference for Impact Forecasting due to transparency

Clients fix the “model boundaries” at the outset If model changes fall within the boundaries, no need for renewed model approval

One regulator indicated that they prefer a multi-model approach Advantage: a change in one of the models would only partially impact the results No need for equal weighting of different models: is this ensuring best practice?

Some regulators indicated a pragmatic approach to facilitate the use of external commercial cat models and have the clients benefit from their data quality

Possible solution: simplified internal model approval process for cat (proposal submitted in February 2011 to EIOPA by Aon Benfield)

A simplified Internal Model approval process would be beneficial to insurers and to regulators and lower significantly the barrier for internal models as well as reduce the workload (and cost) for regulators

Focus for a simplified approval process should be on input data requirements and the process to correctly apply the catastrophe models

Model Approval Process

Model Change

Simplified Approval Process


QIS 5 as a precursor of Solvency II: The good, the bad and the ugly

Sufficient surplus capital on average

Better awareness of risk and the value of data quality

Quality of QIS 5 was quite poor in many aspects

Many results from the Standard Formula were wrong

Standard Formula overall much too complex

Resource requirements will come at a cost !


Advise from one of the EU regulators

Take the time for implementation !

Get used to market value and the corresponding volatility !


For more into, contact us locally or globally

Gareth Haslipt: +44 20 7522 8137e: [email protected]

Tessa Moultont: +44 20 7522 7137e: [email protected]

Jürgen Wielandtst: +32 2 661 7164e: [email protected]

Marc Beckerst: +44 7931 472 999e: [email protected]


mailto:[email protected]




solvency ii – the final test israel april 5 th, 2011 prepared by marc beckers of aon benfield...

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