What do you know about Solvency II? High-level introduction for interested parties from Non-EU regions February 2013

Transcription

1 What do you know about Solvency II? High-level introduction for interested parties from Non-EU regions February 2013

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3 Global trends in solvency modernisation are tending towards comprehensive riskand economic based regulatory regimes. The upcoming European Solvency II regime and the existing Swiss Solvency Test in Switzerland exemplify this trend. The new Solvency II regulation will promote an integrated, three pillar approach to risk management. All risks will be considered as part of the calculation for capital adequacy. Solvency II also has a qualitative aspect: it will create incentives for professional risk management by regulating the principles of internal risk management and of enhanced coordination among regulatory authorities.

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5 Table of contents Foreword 6 Introduction 7 Overview of solvency regulatory frameworks and evolution of Solvency II in Europe 8 Objectives of Solvency II 12 The three pillars of Solvency II 13 Key risk categories 17 Minimum Capital Requirements (MCR) and Solvency Capital Requirements (SCR) 21 Index/Bibliography 26 Swiss Re What do you know about Solvency II? 3

6 Foreword The insurance industry is undergoing profound regulatory reforms aimed at strengthening the stability of the financial sector. The modernization of the Solvency regimes is part of these reforms. Many countries and regions are bringing their regulations into line with the significant advances achieved in risk management and group supervision in recent years for the benefit of the consumer and the re/insurance industry as a whole. With Solvency II (SII) and the Swiss Solvency Test (SST), Europe and Switzerland have been working on strengthening the regulatory environment. Both regimes take an economic view and are risk-based, promote group supervision and create an environment in which the insurance industry can operate efficiently and promote financial stability and economic growth. Much more than that, the discussion around economic values has challenged the insurance industry to take a fresh look at their capital structure and assess all risk factors. As a major reinsurer, Swiss Re has engaged in a deep dialogue with clients and business partners and experienced a more holistic approach to reinsurance buying behaviors, which we want to share beyond the boundaries of Europe. This publication is a high-level introduction to SII for interested parties from Non-EU regions, designed to provide a flavour of what Solvency II is about and trigger discussions on solvency related topics. (We have also produced additional fact sheets with more detailed information on the topic, which you can find at solvency/solvency_ii_fact_sheets.html.) We are an active participant in shaping global and local regulatory reforms and work closely with our clients to support them when solvency related challenges and issues arise. Swiss Re is happy to share its knowledge and experience in Solvency II with its clients worldwide. Jean-Jacques Henchoz CEO Reinsurance EMEA 4 Swiss Re What do you know about Solvency II?

7 Introduction The Solvency I framework in Europe has proven to be insufficient in showing an insurer s true risk exposures and did not set adequate incentives for risk based management. Therefore, the European Commission launched the Solvency II project in Solvency II is a new regulatory framework for enhanced re/insurance solvency rules in the European Economic Area (EEA). It is based on an integrated three-pillar approach to risk management, similar to Basel II for the banking industry. It comprises rules on quantitative, qualitative and disclosure requirements. Furthermore, it is based on economic principles and encompasses the whole value chain of an insurance enterprise. However, it is still not clear when Solvency II will become applicable for all re/insurance companies, including captives established in the territory of the EEA. On 14th September 2012, an amendment of the Solvency II Framework Directive (2009/138/EC), the so-called Quick-Fix Directive had been completed, postponing the date for transposition in the member states to 30 June 2013 and still foreseeing enforcement for 1 January Since then there are again plans to further delay Solvency II1. It may be one or even two years that are needed to find a solution for the treatment of long-term guarantees which seems to be the key obstacle for a compromise on Omnibus II2 which currently causes the delay of the timetable of Solvency II implementation. 1 As of February 2013, Solvency II is not expected to be enforced before 2016 according to European Insurance and Occupational Pensions Authority (EIOPA). Press-Room/speeches/Carlos_Montalvo_-_Reactions_magazine.pdf 2 Omnibus II: The Solvency II Framework Directive (2009) on the financial position of insurance undertakings has had to be adapted in response to new architecture for its implementing measures introduced in the Lisbon Treaty (2009) and new financial supervision measures introduced in Regulation 1094/2010 establishing the EIOPA. These changes are implemented through the Omnibus II directive, currently in negotiations between Parliament and Council. Source: Swiss Re What do you know about Solvency II? 5

8 Overview of solvency regulatory frameworks and evolution of Solvency II in Europe Solvency regulations were first introduced in Europe (EU) in 1973 in the form of the first non-life insurance directive (followed by a life directive in 1979). Up to 2004 there were various national supervisory regulations in place to develop minimum asset management and solvency standards for life and non-life insurance companies. In 2004 the directive implementing Solvency I was adopted in the European Union and applicable for all EU-domiciled insurance enterprises (from December 2004 also for reinsurance companies), modifying the two existing directives. In 2005 the EU financial conglomerate directive was also implemented throughout the EU. Further developments with regard to Solvency II will be a big milestone in the relatively short history of a joint and consistent EU regulatory scheme. Solvency II timeframe The Solvency II project was launched in 2002; the following graph shows the steps undertaken so far: Milestones Timeframe Start of the Solvency II project by European Union Three different calls for advice to all stakeholders of the European insurance industry EU asked EIOPA to conduct Quantitative Impact Studies (QIS) QIS 1 QIS 2 QIS 3 QIS 4 QIS 5 Launch of the Solvency II Framework Directive 10 July 2007 Negotiation and approval of the Framework Directive by the EU Parliament and EU Council Work on implementation measures/delegated Acts (EC) Implementation of Delegated Acts in Companies Supervisory Guidelines Introduction of Solvency II expected from 2015/2016 Source: Swiss Re The key milestones so far were the launch of the Solvency II Framework Directive, the Quantitative Impact Studies (QIS) and the work on implementation measures. The EU Commission adopted the Solvency II Framework Directive on 10 July 2007, which was approved by the EU Parliament in March 2009 and by the EU Council in November It codifies and integrates 13 existing insurance directives into one coherent text. The implementation of Solvency II is outlined in 4 hierarchical levels and will be transposed in national law. 6 Swiss Re What do you know about Solvency II?

9 Under the four level implementation process, the EU institutions adopt framework legislation while detailed technical implementing provisions are the responsibility of the EU commission, assisted by specialist committees. The four levels of implementation are: Level 1: Framework Directive Level 2: Implementing Measures Level 3: Guidance by EIOPA to ensure consistent implementation and cooperation between member states Level 4: Rigorous enforcement of Community legislation by the commission. The main remaining obstacle to overcome is the treatment of long-term guarantees, which has become a key issue for life insurers. They are concerned Solvency II s market valuation approach might (temporarily) jeopardize their solvency ratio and lead to high risk capital costs due to market volatility and continued low yield environment. This concern has been taken up by the political stakeholders who aim at testing solutions in another impact assessment (QIS) before they can agree on Omnibus II. Once this has been adopted, Level 2 will enter the public consultation phase, and adjustments may be necessary, either because it needs to be aligned with the final Omnibus II text or driven by additional industry feedback.3 Decision making bodies: European Parliament European Commission EU co-decision process Council of Ministers Internal Markets Division EIPOC* (or permanent representative) Political advice Commission services Industry Technical advice Call for advice (CfA) EIOPA (same voting system than in the Council of Ministers) Expert groups Board Internal models Financial requirements Group supervision Supervisory review Consultative panel * EIPOC: European Insurance and Occupational Pensions Commitee Source: Swiss Re Key stakeholders Within the framework of the Lamfalussy approach 4, the European Union (EU) namely the European Parliament and the European Commission are the decision bodies with respect to Solvency II. The EU requested the Committee of European Insurance and Occupational Supervisors (CEIOPS) at the time (which was replaced by the European Insurance and Occupational Pension Authority (EIOPA) with effect of 1 January 2011)5 to advise on the development of a new solvency framework. 3 European Commission: 4 The aim of the Lamfalussy process is to simplify and speed up the EU legislative process in the area of financial services. Under the four-level process, the EU institutions adopt framework legislation, whilst detailed technical implementing provisions are the responsibility of the Commission, assisted by four specialist committees (former comitology procedure, *1.3.8), pdf 5 EIOPA (2011), Regulation, p. 83. Swiss Re What do you know about Solvency II? 7

10 Overview of solvency regulatory frameworks and evolution of Solvency II in Europe To test the practicability of the technical specification of Solvency II for calculating the new Solvency Capital Requirements (SCR) and the Minimum Capital Requirements (MCR), EIOPA conducted Quantitative Impact Studies (QIS) which were submitted by various insurance enterprises. The results of the QIS are crucial for the political discussion on the Framework Directive and the implementation process. From Solvency I to Solvency II The existing Solvency I framework is mainly based on a fixed formula approach, whereas Solvency II involves either a standard formula approach or an internal model, depending on the option chosen by the particular insurance company. The Solvency I approach takes only insurance risk (based on premium and reserve volume for non-life and based on technical provisions for life, not volatility) into account. It does not consider market risk, credit risk, operational risk, or an integrated risk management framework. Furthermore, with Solvency I, the statutory balance sheet is used to calculate the available capital, rather than an economic balance sheet. Finally, risk mitigation instruments such as reinsurance are less adequately reflected under Solvency I and disclosure requirements for public stakeholders are limited: The existing Solvency I regime Fixed formula approach determining capital requirements based on insurance risks held The anticipated Solvency II regime Economic framework taking into account the entire risk landscape and risk management framework Capital requirements: Life 4% of net gross provisions + 3 of net sum at risk Capital requirements: Non-life Premium index: 16/18% of net premiums earned or Claims index: 23/26% of net claims incurred The principles of Solvency II Pillar I Quantitative - MCR/SCR - Diversification - Risk mitigation - Assets/Liabilities Pillar II Qualitative - Risk governance - Supervision - Process/Control Pillar III Market disclosure - Supervisory disclosure - Public disclosure Key conclusions Volumes of business to drive capital requirements Only insurance risk considered Partial recognition of reinsurance solvency relief (eg. only up to 50% in P&C) Key conclusions Volatility of business to drive capital requirements Insurance, market, credit and operational risk considered Broader recognition of risk reduction techniques (reinsurance) The transition from a statutory capital approach to an economic framework will lead to a broader consideration of risk exposure as well as asks for decision to use either the Standard Formula or implement an internal model. Source: Swiss Re 8 Swiss Re What do you know about Solvency II?

11 The main deficiencies of Solvency I discussed above have been identified and were taken into account in Solvency II. Overall, Solvency II will lead to a more transparent, risk based, and thus economic view of a re/insurers risk landscape. Other solvency modernisation frameworks exist worldwide, for instance the RBC (Risk Based Capital) framework in the USA. In other parts of the world many regulatory initiatives are under way, eg in Australia a group supervision standard has been introduced already. Similarly, in Switzerland, the Swiss Solvency Test (SST) exists. A comparison of Solvency II and the Swiss Solvency Test (SST) is outlined as follows. Comparison of Solvency II and Swiss Solvency Test (SST) In Switzerland, the Swiss Solvency Test (SST) was launched in 2003 in cooperation with the insurance industry. Corresponding reporting requirements are in place since 2006 for large insurance companies and since 2008 for all insurance companies. As of 2011, all insurers are obliged to comply with the SST capital requirements.6 The SST is a risk-based economic solvency framework encompassing an integrated assessment of underwriting, financial market and credit risk based on expected shortfall 99% (TailVaR) plus a market value margin.7 Like Solvency II, SST is also based on the economic valuation of assets and liabilities. All on- and off-balance sheet assets and liabilities must be taken into account, reflecting a total balance sheet approach. The SST applies to all legal entities domiciled in Switzerland. Insurance groups, conglomerates and reinsurers are required to apply internal models down to a legal entity basis, also taking into account the interactions among them. Other insurance companies can apply the SST standard model. The key differences of SST to Solvency II are the risk categories, risk measurement, the levels of required capital, the group approach and disclosure, as illustrated below: Key differences SST Solvency II Quantified risk categories* Insurance Market Credit Insurance Market Credit Operational Risk measurement Expected shortfall 99% (TailVaR) VaR 99.5% Levels of required capital Group approach Disclosure Target capital (equals SCR plus Market Value Margin) MCR Legal entity basis, group interactions taken into account Towards regulatory authority only for the time being** * Operational risk under SST on quantitative basis only ** There are plans to disclose SST to the public as well Source: Swiss Re SCR MCR Modeling of group effects Towards regulatory authority and public 6 FINMA (2008), p Value at risk measures the risk of a loss of financial assets for a given portfolio, probability and time horizon. TailVaR is a measure of expectation only in the tail of the distribution. Swiss Re What do you know about Solvency II? 9

12 Objectives of Solvency II The overall objective of Solvency II is to establish a more transparent, professional and thus more secure insurance market by achieving a true picture of a re/insurer s solvency position. The main objective is to increase policyholder protection8. This can be broken down into the following: comprehensive risk assessment to enable the insurer s true risk landscape to be clearly identified consistency across the financial sectors and harmonisation of quantitative and qualitative supervisory methods across countries assessment of an insurer s overall solvency in a two level approach to capital requirements (MCR, SCR) prudent person principle for assets towards security, quality, liquidity and profitability enforcement of risk-adequate pricing and focus on economic value creation, ie strict enhancement of a risk/return focus To achieve the objectives of Solvency II, the following methods constitute part of the framework: economic principles based on market consistent valuation principle-based approach without undue complexity assets covering the technical provisions must be appropriate to the nature and duration of the liabilities (Asset liability management/alm) 8 Council of the EU (2009), Solvency II Framework Directive, p Swiss Re What do you know about Solvency II?

13 The three pillars of Solvency II The stabilisation of the financial services industry was the aim not only for Basel II, applicable for the banking industry, but also for Solvency II. Similar to Basel II, Solvency II takes a three pillar approach and is based on quantitative, qualitative and disclosure requirements: Pillar I Quantitative Requirements Pillar II Qualitative Requirements Pillar III Market Discipline Minimum capital requirements Solvency capital requirement Corporate governance Internal control Supervisory disclosure Standard approach Internal model Supervisory review process Supervisory powers Public disclosure Risk dependencies Safety measures Solvency control levels Risk mitigation Risk management function Asset & liability management Technical provisions Source: Swiss Re Pillar I Pillar I mainly determines the assessment of risks (including evaluation of technical provisions) and the related capital on the basis of minimum (MCR) and solvency capital requirements (SCR). It also takes into account risk dependencies and mitigation instruments. Pillar I constitutes all the quantitative requirements needed to identify all risks (insurance, market, credit and operational risk, described in more detail in the chapter Key risk categories ) an insurance company is exposed to. The risks are evaluated either via the standard approach or a (partial) internal model, and determine the required capital. Swiss Re What do you know about Solvency II? 11

14 The three pillars of Solvency II Available capital Solvency II requires that insurance companies back up their individual exposures by capital as a buffer for adverse developments. This buffer is referred to as available capital or own funds. Own funds are the financial resources at hand that can buffer financial losses. Own funds are essentially on- and off-balance sheet items or available capital used to cover the capital requirements (MCR, SCR) according to the Solvency II framework, which is based on an economic balance sheet as follows: Excess capital Solvency Capital Requirement (SCR) including Minimum Capital Requirements (MCR) = required capital Available assets to cover SCR/MCR Market value of assets Cash Fixed income instrument Property Equity Reinsurance assets Equity and retained earnings Hybrid capital risk margin 1 market-consistent valuation of hedgeable risks Discounted best estimate Own funds = available capital 1 for non-hedgeable risks Source: Swiss Re Required capital According to Solvency II, the required capital is determined by two components, the minimum (MCR) and the solvency capital requirements (SCR), which are calculated and need to be adhered to independently,as described in more detail in the chapter Minimum Capital and Solvency Capital Requirements. Pillar II Pillar II details all the qualitative aspects relating to an integrated risk management framework which cannot be taken into account in a model. Re/insurance companies are required to disclose the valuation principles for solvency purposes. The capital structure, risk management and governance system must reflect the nature, scale and complexity of the relevant undertaking business, particularly the risks inherent to that business. Furthermore, it must be accessible, complete in all material aspects, comparable, consistent over time, relevant and reliable.9 The robustness of the governance system is a prerequisite for an efficient solvency system which is compliant with the following requirements: fit and proper management body and key functions (Art. 42) proof of good repute (Art. 43) integrated risk management (Art. 44) own risk and solvency assessment (ORSA) (Art. 45) internal control (Art. 46) and internal audit (Art. 47) actuarial function (Art. 48) outsourcing (Art. 49) implementing measures (Art. 50) 9 Council of the EU (2009), Solvency II Framework Directive, p Swiss Re What do you know about Solvency II?

15 The governance and risk management system needs to be integrated into its organisational structure and value chain and is, therefore, an integral part of pillar II. It should comprise strategies, processes and reporting procedures to identify, measure, monitor, manage and report the risks which companies are exposed to: Value chain Productdevelopment Underwriting & pricing Marketing & distribution Admin of policies Asset Management Risk mitigation Claims management & reserving Integrated risk management (incl. ORSA) In order to benefit from the economic principles promoted under Solvency II, a risk management framework must be implemented across the entire value chain as well as risk landscape. Source: Swiss Re The own risk and solvency assessment (ORSA) is part of its risk management system. Every insurance or reinsurance undertaking shall conduct its own assessment. This should include at least the overall solvency needs, take into account the specific risk profile, approved risk tolerance limits and the business strategy of the undertaking. It should also be compliant with capital requirements and it should take into consideration the significance with which the risk profile of the undertaking concerned deviates from the assumptions underlying capital requirements. The results of ORSA shall be part of the information reported to the supervisory authorities. The supervisory review process constitutes an evaluation and review of the above-mentioned requirements. In the following cases the regulatory authority may set a capital add-on for re/insurance companies: standardised approach does not reflect risk profile material deficiencies in the internal model (full or partial) and material governance failure. The add-on capital is supposed to be reviewed at least once a year and be removed when the undertaking has remedied the deficiencies which led to its imposition.10 According to the Solvency II Framework Directive, senior management of re/insurance enterprises are responsible for compliance with the laws and regulations. If re/insurance companies use an approved partial or full internal model, the risk manage - ment function needs to fulfill additional tasks such as design, implementation, testing, documentation and performance analysis of the model. Overall, the integrated risk management system constitutes a key element of the Solvency II framework Council of the EU (2009), Solvency II Framework Directive, p EIOPA (2011), Work plan, p. 3 Swiss Re What do you know about Solvency II? 13

16 The three pillars of Solvency II Pillar III Pillar III ensures that all relevant solvency related information is disclosed to the public and reported to the regulatory authorities. Re/insurance undertakings need to annually disclose to investors and other stakeholders on solvency and financial conditions. The disclosures need to contain: a description of the business and its performance; the governance system and assessment of adequacy for the relating risk profile; a description of risk exposure per category and concentration; mitigation and sensitivity and the valuation basis for assets and liabilities. Furthermore, a description of capital management needs to be disclosed. The disclosures need to include an analysis explaining the deviations compared to the previous reporting period in order to explain the main differences. In addition, the following information needs to be reported to regulatory authorities: Definition of key principles for supervisory reporting and the details to follow the implementing measures. To ensure ongoing appropriateness of information submitted, companies need to have a policy for the disclosure procedures in place.12 The latest, more detailed reporting requirements are illustrated below: Contents of various Solvency II reports, including formats are not yet clear Report Solvency and Financial Condition Report (SFCR) public Regular Supervisory Report (RSR) Quantitative Reporting Templates (QRT) annual Quantitative Reporting Templates (QRT) quarterly ORSA supervisory report Supervisory reporting during phase-in (not legally binding) Due date (only valid for first year of SII) 20th week of the year (groups: 26th week) 20th week of the year (groups: 26th week) 20th week of the year (groups: 26th week) 8 weeks after quarter end (groups: 14 weeks) 2 weeks after concluding the assessment Not yet defined, it is expected that SII balance sheet, MCR, and SCR should be provided. Initial information requirements during the first year of application of Solvency II include the opening balance sheet (OBS), comparison of each class of assets and liabilities between figures set out in OBS with Sovency I figures. 12 Council of the EU (2009), Solvency II Framework Directive, p Swiss Re What do you know about Solvency II?

17 Key risk categories The new regulations will promote an integrated three pillar approach to risk management. All risks, ie insurance and financial market risks as well as risks associated with a company s operating business and their dependencies, will be considered as part of the calculation for capital adequacy. The following illustration shows the distribution of required capital amongst the risk categories for the market average: Diversified Basic solvency capital requirements (BSCR) structure All undertakings (solo calculation) All undertakings (group calculation) Market 56.5% Counterparty 6.9% Life 15.3% Health 4.3% Non-life 16.9% Intangible 0.2% Market 57.8% Counterparty 3.9% Life 17.3% Health 4.9% Non-life 15.8% Intangible 0.3% Non-life undertakings (solo calculation) Market 32.8% Counterparty 7.0% Life 0.5% Health 7.0% Non-life 52.4% Intangible 0.4% Source: EIOPA QIS 5 Report Life undertakings (solo calculation) Market 67.4% Counterparty 7.7% Life 23.7% Health 1.0% Intangible 0.1% Market risk Every investment of a primary insurer or reinsurer results in market risk, which applies for both P&C and L&H business. The actual risk is the mismatch between assets and liabilities which drives the market risk. Since the premium volumes received on the L&H side typically are larger than for P&C business, the impact of market risk is higher for the L&H business. Exposure to market risk is measured by the volatility of the market prices of financial instruments, ie: equity risk: impact of prices changes on assets and liabilities interest rate risk: impact of interest rate changes on fixed-income investments, insurance liabilities, financing instruments (loan capital) and interest rate derivatives property risk: change in real estate prices foreign exchange risk: impact of volatility on balance sheet spread risk concentration risk13 Unlike Solvency I, Solvency II takes market risk into consideration when calculating the required capital. In the standard formula, market risk is determined by the change in net asset value based on predefined stress scenarios. Liquidity risk is considered to be captured under pillar II (risk management). The various calculation requirements relating to the market sub risks can be obtained in the technical specification EIOPA (2010), Technical Specification, p EIOPA (2010), Technical Specification, p. 109 Swiss Re What do you know about Solvency II? 15

18 Key risk categories Underwriting risk Non-life premium and reserve risk Premium risk relates to future claims which arise from policies to be written (including renewals) during the period and to unexpired risks on existing contracts, and originates from claim sizes being greater than expected, differences in timing of claims payments from expected, and differences in claims frequency from those expected.15 Premium risk also includes the risk resulting from the volatility of expense payments.16 Reserve risk relates to incurred claims, ie existing claims (eg including IBNR and IBNER17), and originates from claims sizes being greater than expected, differences in timing of claims payments from expected, and differences in claims frequency from those expected.18 Non-life catastrophe risk Catastrophic risk is the risk of loss due to significant uncertainty of pricing and reserving caused by extreme or irregular events. According to the latest draft of Final Implementation Measures (31 October 2011), the non-life catastrophe risk module consists of the following sub-modules: the natural catastrophe risk sub-module, which includes windstorm, earthquake, flood, hail and the subsidence risk sub-modules the sub-module for catastrophe risk of non-proportional property reinsurance the man-made catastrophe risk sub-module, which includes motor third party liability, marine, aviation, fire, liability and credit & suretyship risk sub-modules the sub-module for other non-life catastrophe risk For natural catastrophe risks, the calculation of capital required for different perils varies. On the example of windstorm, it assumes two possibilities of a serious event of losses, ie an event generating 80% of total loss of one region, followed by another event generating 40% of total loss; or an event generating 100% of total loss, followed by another event generating 20% of total loss; and then the bigger of the above two is considered as the capital needed for this peril in this region, after any risk mitigation measures, such as reinsurance. Finally, the sums of capital required for all regions are calculated after taking into consideration the diversification effect through a predefined correlation matrix. For man-made catastrophe risks, the calculation considers certain parameters to reflect the exposure. For motor, for example, it considers the number of vehicles underwritten by the undertaking and sum insured of the vehicles as the major parameters for the portfolio s exposure. For aviation, the capital required equals the single maximum sum insured of aircrafts, including both hull and liability, underwritten by the undertaking. The calculation of catastrophe risk considers diversification among different geographical zones within one sub-module, eg diversification of all regions on windstorm risk; and it also considers diversification among different sub-modules. Since catastrophe risks are not correlated amongst themselves, this allows for a good degree of diversification. 15 Solvency II Glossary, source: impactassess/annex-c08d_en.pdf 16 EIOPA (2010), Technical Specification, p IBNR: claims that incurred but not reported; IBNER: claims that incurred but not enough reported 18 Solvency II Glossary, source: impactassess/annex-c08d_en.pdf 16 Swiss Re What do you know about Solvency II?

19 Life and health risk According to the SCR, L&H risk constitutes mortality, longevity, disability and morbidity, lapse, expenses revision and cat risk. The most significant categories are briefly described below:19 Mortality risk Mortality is the risk of loss or of adverse change in the value of insurance liabilities, resulting from changes in the level, trend, or volatility of mortality rates, where an increase in the mortality rate leads to an increase in the value of insurance liabilities. Longevity risk Longevity is the risk of loss or of adverse change in the value of insurance liabilities, resulting from changes in the level, trend, or volatility of mortality rates, where a decrease in the mortality rate leads to an increase in the value of insurance liabilities. Disability and morbidity risk Disability is the risk of loss or of adverse change in the value of insurance liabilities, resulting from changes in the level, trend or volatility of disability, sickness and morbidity rates. Lapse risk Lapse is the risk of loss, or of adverse change in the value of insurance liabilities, resulting from changes in the level or volatility of the rates of policy lapses, terminations, renewals and surrender. Credit or counterparty default risk Credit risk or counterparty default risk reflects possible losses due to unexpected default or deterioration in the credit standing of counterparties and debtors of insurance and reinsurance undertakings. Risk transfer instruments on the asset and liability side will be recognised in the SCR calculation and result in a reduction of required capital, but, at the same time, the required capital increases for the corresponding counterparty default risk. Reinsurance is one means of risk mitigation and, therefore, Solvency II requires holding required capital for a potential default of the reinsurer. The calculation components are the loss given default (LGD), which is the amount of basis own funds (reinsurance assets) which will be lost if the reinsurer defaults. The second component is the probability of default, which is directly related to the financial strength rating. It is, therefore, important for a reinsurance company to have a good financial strength rating. 19 Council of the EU (2009), Solvency II Framework Directive, p. 53 Swiss Re What do you know about Solvency II? 17

20 Key risk categories Swiss Re analysed the relationship between the number and rating of reinsurers as follows: 16% 14% 12% 10% 8% 6% 4% 2% 0% Solvency capital requirement in % 1 AAA 2 AAA 3 AAA 1 AA 2 AA 3 AA 1 A 2 A 3 A 1 BBB 2 BBB 3 BBB Source: Swiss Re In the SCR calculation the rating of the reinsurance company is considered to be a key driver of SCR. The impact on reducing required capital is much higher if the rating of the reinsurance company is of high quality. Thus, from a Solvency II capital requirement perspective, it is better to look for the best reinsurer and cede the entire portfolio to it, as the benefit of diversification is far outweighed by the impact of the credit quality of the high rated reinsurer. Meanwhile, counterparty default risk is not a main driver of SCR overall and, in most cases, the capital relief by using reinsurance as a risk mitigation instrument is greater than SCR from counterparty default risk. Operational risk Operational risk is the risk of losses resulting from inadequate or failed internal processes and systems, or losses caused by people or from external events - but excluding reputational risk or risks related to strategic decisions. Under Solvency I, operational risk was not taken into consideration in required capital determinations. Solvency II takes operational risk into account. Under the standard approach of Solvency II, the calculation method is factor-based EIOPA (2010), Technical Specification, p Swiss Re What do you know about Solvency II?

21 Minimum Capital Requirements (MCR) and Solvency Capital Requirements (SCR) Minimum Capital Requirements (MCR) The MCR is a simplified capital calculation approach which results in the absolute minimum threshold of required capital an insurance company needs to hold and is calculated on a quarterly basis. The basis for the evaluation of risks and the MCR is the determination of exposure to insurance, market, credit and operational risk. MCR needs to be adhered to in order to avoid any intervention of the regulatory authority. If the MCR is breached, the regulatory authority is allowed to withdraw the authorisation to operate as a re/insurance company. The MCR is to be calculated in line with the following principles: clear and simple calculation method corresponds to an amount of eligible basic own funds linear formula which takes into account technical provisions, written premiums, capital-at- risk, deferred taxes and administration expenses on a volume basis calibration to a value at risk at a confidence level of 85% over a one-year period floor of 25% and cap of 45% of SCR where calculated with the standard formula or internal model absolute floor of : EUR 2.3m for non-life (EUR 3.2 m if includes liability and credit business) EUR 3.2m for life EUR 3.2m for reinsurance undertakings EUR 1m for captives to be calculated quarterly; the result is to be reported to the supervisory authority.21 Solvency Capital Requirements (SCR) The SCR is the economic capital that an insurance undertaking needs to hold in order to limit the probability of ruin to 0.5%. The required capital needs to be calculated in line with the following principles: going concern consideration of all quantifiable risks, ie insurance, market, credit and operational risks are taken into account, covering existing and new business expected to be risk written within the next 12 months correspondence to a value at risk at a confidence level of 99.5% over a one-year period. 21 Council of the EU (2009), Solvency II Framework Directive, p. 60 Swiss Re What do you know about Solvency II? 19

22 Minimum Capital (MCR) and Solvency Capital Requirements (SCR) As already mentioned before, the capital requirements are mainly comprised of insurance, market, credit and operational risk, and can be calculated via the standard formula or an internal model22. SCR can be calculated by using the following approaches: Solvency capital requirements (SCR) Simplified solvency calculation Standard Formula Standard Formula with Undertaking specific parameters Complexity of SCR calculations Partial internal model Internal model * applies to the majority of companies; however some may have higher SCR with an internal model Source: Swiss Re Simplified approach Insurance and reinsurance undertakings may use a simplified calculation for specific sub-modules or risk modules, where the nature, scale and complexity of the risks they face justifies it and where it would be disproportionate to require all insurance and reinsurance undertakings to apply the standardised calculation or standard formula.23 Standard formula The standard formula is based on individual exposure data which outline the riskbearing capacity and define the required capital an insurance enterprise is supposed to hold, based on the risk profile to sustain any unexpected losses. The Solvency II risk measure will be based on a value at risk (VaR) level of 99.5%, which is equivalent to a 0.5% target default probability for a 1 in 200 year event, and specifies a time horizon of one year as a general basis for the solvency capital requirement and outlined as follows: VaR Likelihood Loss Profit 1 in 200 year loss Expected result (mean) Economic profit and loss distribution Source: Swiss Re The standard formula is structured as follows24: basic solvency capital requirement (BSCR) capital requirement for operational risk (Op) and adjustment for loss-absorbing capacity of technical provisions and deferred taxes (Adj) 22 Council of the EU (2009), Solvency II Framework Directive, p Council of the EU (2009), Solvency II Framework Directive, p EIOPA (2010), Technical Specification, p Swiss Re What do you know about Solvency II?

23 SCR Adj BSCR Op Market Health Default Life Non-life Intang Interest rate SLT Health CAT Non-SLT Health Mortality Premium Reserve Equity Mortality Premium Reserve Longevity Lapse Property Longevity Lapse Disability Morbility CAT Spread Disability Morbidity Lapse Currency Lapse Expences Concentration Expences Revision Illiquidity Revision CAT * Included in the adjustment for the loss-absorbing capacity of technical provisions under the modular approach Source: EIOPA (2010), Technical Specification, p. 90 The modular architecture of the basic SCR is based on linear aggregation techniques, ie adding up the capital required for individual risks by taking into account diversification effects. The design of the standard formula is relevant for all re/insurance companies. It is expected that the majority will use the standard formula when Solvency II will be introduced. Also companies that are using an internal model might be required to calculate SCR as per the standard formula on the request of the supervisor, eg during the approval process. The standard formula has some shortcomings in terms of recognising risk mitigation measures such as reinsurance. Although it adequately reflects proportional reinsurance solutions, non-proportional reinsurance solutions are not adequately considered. Therefore, insurance companies often do not receive adequate capital relief for a non-proportional solution. The QIS 5 has taken that into consideration and the results show that some improvements have been made. Diversification effects due to the spread of risk across risk modules, various lines of business and countries resulting in less required capital are taken into consideration under Solvency II. Under the standard formula, diversification is achieved by applying a correlation matrix within modules and among different modules. Undertaking specific parameters (USP) Subject to approval by the supervisory authorities, insurance and reinsurance undertakings may, within the design of the standard formula, replace a subset of its parameters by parameters specific to the undertaking concerned when calculating the life, non-life and health underwriting risk modules Council of the EU (2009), Solvency II Framework Directive, Article 104 (7) Swiss Re What do you know about Solvency II? 21

24 Minimum Capital (MCR) and Solvency Capital Requirements (SCR) Internal models Internal models are risk-based and future-oriented, using individual assumptions of the company compared to market averages used in the standard formula. They offer the opportunity to capture all interdependencies and risk transfer instruments, and are more specific to the risk profile of a certain re/insurance company. A major motivation for using an internal model is that the SCR might be lower compared to the standard formula, eg for well diversified portfolios. However the implementation of internal models will be more costly. A partial or full internal model needs to be approved by the regulator prior to its application. Article 113 of the Solvency II Framework Directive clarifies that the reason for the application of a partial internal model needs to be justified, the resulting capital charge needs to reflect the risk profile more adequately and the design needs to allow the partial model to be fully integrated into the standard formula. A partial or full internal model must meet the following requirements: use test (Art. 120): re/insurance companies must demonstrate that the internal model is embedded in their risk management process and that the solvency capital assessment and allocation process is continuously used and maintained statistical quality standards (Art. 121): the methods used to calculate the probability distribution forecast need to be based on adequate, applicable, relevant and consistent actuarial and statistical techniques and the data need to be accurate, appropriate and complete calibration standards (Art. 122): insurance and reinsurance undertakings are required to derive the solvency capital requirement directly from the probability distribution forecast generated by the internal model of those undertakings, using the value-at-risk measure validation standards (Art. 124): companies need to undertake model validations regularly. They must test the appropriateness of the probability distribution forecast compared to loss experience and analyse the stability of the internal model, including testing the sensitivity of the results of the internal model to changes in underlying assumptions documentation standards (Art. 125): the documentation needs to provide a detailed outline of the theory, assumptions, and mathematical and empirical basis underlying the internal model. There is a timeframe of up to six months within which the regulatory authority can approve the application. 22 Swiss Re What do you know about Solvency II?

25 Intervention measures in the event of non-compliance with MCR and SCR Non-compliance with MCR leads to an immediate intervention by the regulator which could result in the withdrawal of the authorisation to operate if the company concerned is unable to re-establish the amount of basic own funds at MCR level within a short period of time.26 A significant breach of SCR is defined as the earlier of the following events: own funds are equal to or less than 75% of SCR breach of SCR is not resolved within a two-month period. In both cases, the regulatory authorities have the right to intervene. No Breach (Adequate Capital) Breach of Adjusted SCR Breach of SCR Breach of MCR Additional Reporting Source: EIOPA, 2010, Technical Specification Financial Recovery Plan Closure to New Business Authorisation Withdrawn Not Required Not Required Not Required Not Required Required Possible Not Required Not Required Required Required Possible Not Required Required Required Required Possible 26 Council of the EU (2009), Solvency II Framework Directive, p. 7 Swiss Re What do you know about Solvency II? 23

26 Index/Bibliography Index Terminology Page Available capital 8 BSCR 15 Credit or counterparty default risk 17 Disability and mobidity risk 17 EIOPA 5 Internal model 8 Intervention measures 23 Lamfalussy process 7 Lapse risk 17 Life & Health risk 17 Longevity risk 17 Market risk 15 MCR 7 Mortality risk 17 Non-life catastrophe risk 16 Non-life premium and reserve risk 16 Omnibus II 5 Operational risk 18 ORSA 12 Pillar 1 8 Pillar 2 8 Pillar 3 8 QIS 6 Required capital 9 SCR 7 Simplified approach 20 Standard Formula 8 Undertaking Specific Parameters 21 Underwriting risk 16 Bibliography Council of the EU (2009), OJ L 335, , p , Solvency II Framework Directive, Brussels EIOPA Level 2 advice on SCR Standard Formula EIOPA (2010) Technical Specifications QIS 5 final version, Brussels EIOPA (2011) European Insurance and Occupational Pensions Authority, Medium- Term- Work-Plan SolvencyII- Medium-Term-Work-Plan pdf EIOPA (2011) European Insurance and Occupational Pensions Authority, Regulation: Regulation.pdf FINMA (2008) Rundschreiben 2008/44 Schweizer Solvenztest (SST), Swiss Financial Market Supervisory Authority; documents/fina-rs pdf J.P. Morgan (2010) Europe Equity Research, 29 January Swiss Re What do you know about Solvency II?

27 2013 Swiss Re. All rights reserved. Title: What do you know about Solvency II? Authors: Andrea Bär, Carol Liao (Co-Author), Martin Strassner (Technical Advisor) Editing and realisation: Sarah Davies De Paola, Katharina Fehr, Orla Harte Graphic design and production: Swiss Re Corporate Real Estate & Logistics/ Media Production, Zurich Visit to download or to order additional copies of Swiss Re publications. Disclaimer: The content of this brochure is subject to copyright with all rights reserved. The information may be used for private or internal purposes, provided that any copyright or other proprietary notices are not removed. Electronic reuse of the content of this brochure is prohibited. Reproduction in whole or in part or use for any public purpose is only permitted with the prior written approval of Swiss Re Ltd., and if the source reference is indicated. Courtesy copies are appreciated. Although all the information used was taken from reliable sources, Swiss Re does not accept any responsibility for the accuracy or comprehensiveness of the details given. All liability for the accuracy and completeness thereof or for any damage resulting from the use of the information contained in this brochure is expressly excluded. Under no circumstances shall Swiss Re or its Group companies be liable for any financial and/or consequential loss relating to this brochure. Order no: _13_en 06/13, 300 en

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