rv de septembre - 09/09/ XC

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1 rv de septembre - 09/09/ XC

2 Rendez-vous de septembre 9 September Monte Carlo RISK TRANSFER IN SOLVENCY II Xavier Cognat Fédération Française des Sociétés d Assurances rv de septembre - 09/09/ XC

3 PLAN Introduction The main goals of Solvency II Solvency II and the 2005 Reinsurance Directive The framework of Solvency II and risk transfer Main rules Technical provisions The Solvency Capital Requirement (SCR) The standard formula for the SCR The Minimum Capital Requirement (MCR) The case of accepting companies Consequences for the risk transfer industry

4 INTRODUCTION : THE MAIN GOALS OF SOLVENCY II Improve The protection of policy-holders The competitiveness of European industry The integration of the European single market Therefore: modernize and harmonize the prudentiel rules governing insurance in Europe, on the basis of an economic assessment of risks (and thus of risk transfer).

5 INTRODUCTION : THE PRUDENTIAL REVOLUTION OF SOLVENCY II Solvency I: evaluated risk through technical provisions with a lump-sum capital charge risk was thus measured through provisions (cost of settlement) Solvency II: is based on a market-consistent balance sheet evaluates risk though provisions ( best estimate and risk margin) and varies the capital charge according to volatility of risk (with a 99.5% decay threshold at one year) risk is thus measured both through provisions and through capital (which is linked to the volatility of insurance risks AND other risks mainly market risk).

6 INTRODUCTION : THE FRAMEWORK OF SOLVENCY II AND RISK TRANSFER The framework of Solvency II is more economic and leads overall to a transfer of security from provisions to capital (non-life insurance). Solvency II lays down a target capital requirement (SCR) and a minimum capital requirement (MCR). For the calculation of the target capital requirement, Solvency II allows insurers to use their own models as well as the standard formula. Solvency II allows the effects of diversification (by size, different lines of business, activity in different geographical zones) to be taken into account. All these factors represent opportunities for the risk transfer industry.

7 INTRODUCTION : SOLVENCY II AND THE 2005 REINSURANCE DIRECTIVE Directive 2005/68 relating to reinsurance set up an approval system with a European passport for reinsurers and introduced securitization vehicles into European law Concerning reinsurance, Solvency II: adopts the same approval system and the rules concerning the prohibition of the pledging of assets (art 171), prohibition of more favourable treatment for reinsurers from third countries (art 172), and possible agreements with third countries (art 173) adds a procedure for the recognition of equivalence (art 170) maintains a vigilant attitude to finite reinsurance treaties (art 208) with possible implementing measures Concerning securitization vehicles, Solvency II maintains authorization by the European Commission with possible implementing measures (art 209)

8 MAIN RULES : TECHNICAL PROVISIONS General principal (art 76-2) : Technical provisions are calculated gross of risk transfer in order to measure the insurer s total commitment A separate calculation is made for amounts recoverable from reinsurers or securitization vehicles as a result of these transfers

9 MAIN RULES : TECHNICAL PROVISIONS Amounts recoverable from reinsurers and securitization vehicles are assessed (art 80): According to the same principles as the technical provisions themselves, in particular with respect to dates of payment. The results of that calculation shall however be adjusted to take account of expected losses due to default of the counterparty, which should give rise to an implementing measure (art 85 g). The QIS 4 technical specifications (TS II B 21 to 31) give some indications for the calculation of this adjustment, which is problematic (difficulty of evaluation, possible double penalty resulting from overlap with the counterparty risk module of the SCR, doubtful utility in view of very low amounts involved): the QIS 4 results will be interesting.

10 MAIN RULES : SOLVENCY CAPITAL REQUIREMENT (SCR) STANDARD FORMULA INTERNAL MODELS The general principals for calculation of the SCR allow risk transfer to be taken into account both in the standard formula and in internal models (general art 101 5, repeated for internal models in art 119 6): When calculating the Solvency Capital Requirement, insurance and reinsurance undertakings shall take account of the effect of risk mitigation techniques, provided that credit risk and other risks arising from the use of such techniques are properly reflected in the Solvency Capital Requirement.

11 MAIN RULES : THE STANDARD FORMULA FOR THE SCR GENERAL In the standard formula, risk transfer is accounted for in the underwriting risk modules. This will give rise to qualitative and quantitative implementing measures (art 109 d e) that will be tested in QIS4. In particular QIS 4 offers qualitative criteria derived from the banking directive to ensure that in risk transfer: economic effect will take priority over legal form, legal certainty and enforcibility, liquidity and certainty over value, quality of supplier credit and the irrevocable and unconditional nature of the transfer. However useful they may be, these criteria should not be applied to insurance in exactly the same way as in banking. For example: liquidity constraints are much less severe in insurance; similarly under Solvency II European suppliers of insurance cover will benefit from an authorization which should automatically ensure adequate credit quality for risk transfer.

12 MAIN RULES : THE STANDARD FORMULA FOR THE SCR COUNTERPARTY RISK AND OPERATING RISK Quantitatively, as a counterparty to the acknowledgement of risk transfer: A specific capital charge will be made in a counterparty risk module (art 105 6), applicable to amounts recoverable from reinsurers and securitization vehicles. The calibration of this module in QIS 4 (TS X) poses two problems: o The effective loss following default is conservatively assessed as 50% of the amount recoverable, which seems disproportionate for amounts recoverable from technical provisions which represent 80% of the balance sheet of reinsurers protected by capital or for amounts recoverable from securitization vehicles. o The probability of default relies primarily on data from rating agencies even for European reinsurers who are all subject to authorization which should in itself guarantee a high level of security The operating risk module takes account of gross risks before transfer. Obviously the aim is to cover possible failures of risk transfer; however one may question the likelihood of such failure in cases where all the quality criteria are met.

13 MAIN RULES : THE STANDARD FORMULA FOR THE SCR NON-LIFE UNDERWRITING RISK In the non-life underwriting risk module of QIS 4: The component of the capital requirement linked to premiums and provisions is calculated as a percentage of net amounts: it therefore takes proportional reinsurance into account but scarcely reflects the importance of non-proportional reinsurance The component of the capital requirement linked to catastrophe risk is calculated either as a lump sum or on the basis of a scenario. Only this latter case enables non-proportional reinsurance to be taken into account appropriately, including possible recharging or management costs involved.

14 MAIN RULES : THE STANDARD FORMULA FOR THE SCR LIFE UNDERWRITING RISK In the life insurance underwriting risk module of QIS 4: The component of the capital requirement linked to premiums and provisions is calculated on the basis of net assets using mortality or longevity scenarios: the calculation is thus able to take into account both proportional and non-proportional reinsurance. The component of the capital requirement linked to catastrophe risks is (excluding simplifications) calculated on the basis of scenarios: the calculation is thus able to take into account both proportional and non-proportional reinsurance.

15 MAIN RULES : MINIMUM CAPITAL REQUIREMENT (MCR) The calculation of the minimum capital requirement (MCR) in QIS 4 (a linear function of premiums and provisions with upper and lower limits dependent on the SCR) is based on net premiums and provisions. The MCR therefore takes proportional reinsurance into account but scarcely reflects the importance of nonproportional reinsurance

16 MAIN RULES : THE CASE OF ACCEPTING COMPANIES Solvency requirements for accepting companies are in general calculated in the same way as for ceding companies However, in non-life insurance, the risk accepted in non-proportional reinsurance is classified in separate branches which for calculation of capital requirements have a greater weighting than direct insurance branches. The appropriate calibration needs to be found for this weighting which reflects the greater volatility of non-proportional risk.

17 CONSEQUENCES FOR THE RISK TRANSFER INDUSTRY With the tools to be developed for implementation of the standard formula for calculation of the SCR, Solvency II should enable everyone to make economic measurements of the costs and benefits linked to risk transfers. Solvency should also encourage the development of better economic models on the basis of complete or partial internal models (bearing in mind that the validation of these models by the supervisory authorities for prudential purposes implies that insurers themselves should make use of them for managerial decision-making)

18 CONSEQUENCES FOR THE RISK TRANSFER INDUSTRY This would allow ceding companies: To rationalize decisions to transfer risk while managing capital, thanks to quantitative evaluations directly linked to their prudential and economic requirements with respect to capital To organize competition more easily between solutionproviders To benefit from greater capacity that is more varied and better adapted.

19 CONSEQUENCES FOR THE RISK TRANSFER INDUSTRY It would enable accepting companies: To work in a market where emulation facilitates different types of risk transfer, which will encourage innovation in insurance and the development of new capacity. To offer solutions founded on proven economic logic, for example by enabling some players of medium size or who work on long, complex risks to benefit, via proportional reinsurance, from gains resulting from the sectorial or geographic diversification of the capacity provider.

20 CONSEQUENCES FOR THE RISK TRANSFER INDUSTRY For the whole of the risk transfer industry, and particularly for intermediaries and consultants: Solvency II will stimulate the search for exciting optimization strategies. Solvency II will create a market for quantitative modelling (pillar 1) and qualitative management (pillar 2) of risks. Analysis and quantitative modelling services should be closely associated with the provision of properly-adapted risk transfer solutions. In particular the development of internal models could lead to the creation of packages of services including the provision of risk transfer solutions. The services provided should be tailor-made and take into account the risk profile of each insurer, particularly the way its risks are diversified.

21 Thank you for your attention!

The Solvency II project and the work of CEIOPS

Thomas Steffen CEIOPS Chairman Budapest, 16 May 07 The Solvency II project and the work of CEIOPS Outline Reasons for a change in the insurance EU regulatory framework The Solvency II project Drivers Process