[ALL FACTORS USED IN THIS DOCUMENT ARE ILLUSTRATIVE AND DO NOT PRE-EMPT A SEPARATE DISCUSSION ON CALIBRATION]

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1 26 Boulevard Haussmann F Paris Tél. : Fax : Square de Meeûs, 29 B 1000 Bruxelles Tél. : Fax : Solvency II Cost of Capital CEA Note of 21 April 2006 [ALL FACTORS USED IN THIS DOCUMENT ARE ILLUSTRATIVE AND DO NOT PRE-EMPT A SEPARATE DISCUSSION ON CALIBRATION] 1. INTRODUCTION 1.1 The CEA supports a Total Balance Sheet for the determination of the Pillar I Solvency Capital Requirement ( SCR ). The details of the framework are provided in other publications 1. We however note that the market value of assets and liabilities play a central role in determining both the capital requirement and the available capital. 1.2 For many assets and liabilities there exist deep and liquid markets so that the market values are readily observed. However, we note that for some risks (the so called non-hedgeable risks) there is no readily observed market and in these cases the market value of the liabilities must be estimated, 1.3 For these liabilities, the starting point for the market value of the liability would be the present value of future cash flows, called Best Estimate Liability ( BEL ). We however recognise that the BEL would not necessarily correspond to a market value and an additional amount known as a Market Value Margin ( MVM ) should be added to the BEL. 1.4 One of the key elements in the Solvency II discussions is the appropriate approach for calculating the MVM. The discussions have thus far been centred on a Cost of Capital ( CoC ) approach as a proxy for the calculation of MVM. The cost of capital approach bases the risk margin on the theoretical cost to a third party to supply capital to the company in order to protect against risks to which it could be exposed. 1 Joint submission by the CEA and CRO Forum, Solutions to major issues for Solvency II. 10 January Comité européen des assurances,

2 1.5 An approach based on percentiles has also been proposed for the inclusion of a risk margin over best estimate liabilities. We believe that this type of approach is not consistent with an economic framework for the solvency assessment and cannot be considered as a proxy for a MVM. In particular the percentile approach would in lead many cases to arbitrary levels of the MVM. The percentile approach includes a pre defined risk margin based on the ability of the company to meet its liabilities with a defined confidence level (e.g. 75%) over the lifetime of the business. 1.6 The CEA has actively participated in the Solvency II discussions. The purpose of this paper is to: Describe potential differences between the economic framework supported by the CEA and CEIOPS and highlight certain issues and potential misconceptions (Section 2); Explain the reasons why the CEA believes the cost of capital approach is coherent and consistent with our intended framework. (Section 3); and Show how in practice a cost of capital approach could be used in a simple way under a standard approach like the European Standard Approach ( ESA ) proposed by the CEA. (Section 4) 2. CONSISTENCY OF THE FRAMEWORK 2.1 The economic framework is based on a Total Balance Sheet approach. Under this approach, the capital requirements and market consistent values of the liabilities for solvency purposes are clearly separated. 2.2 In the proposed framework, the SCR covers the risk that future market values vary from the current estimates reducing the available capital. The SCR should ensure that there are sufficient assets to cover the market consistent value of liabilities following adverse circumstances. This means that the company would have sufficient available capital in order to theoretically transfer its liabilities to a third party after the theoretical 1 in 200 event (99.5% confidence level). 2.3 In doing the calculation of the capital requirements we take into the account the impact of the risks arising over the one year as well as the potential impact of these risks on the run-off of the portfolio for example potential changes to trends within the portfolio. 2.4 This framework is coherent and should provide comfort to supervisors that the company could in theory transfer its liabilities to a third party with a 99.5% level of confidence over one year. Hence, no prudence in addition to the market consistent value of liabilities is required since all risks should be identified and incorporated to the capital requirement. Comité européen des assurances,

3 2.5 Some people have suggested that prudence should be incorporated to the market value of insurance liabilities to take into account uncertainty in the determination of the MVM. However we believe that this uncertainty would be better dealt with by the Minimum Capital Requirement ( MCR ). The MCR is a margin in excess of the market consistent value of the liabilities which takes into account both potential modelling errors and the potential time taken for a supervisor to intervene in the company. Hence no further prudence is needed in the market consistent valuation of the liabilities. 2.6 A framework using different time periods to assess the capital requirements and the risk margins within the technical provisions is not consistent with an economic framework. Using different time periods is somewhat complicated and is potentially open to interpretation. 2.7 For example one interpretation is that the technical provisions could be set at the 75 th percentile taking into account risks to run off but the capital requirements based on the impact observed within one year (but not taking into account the potential changes to run off). This example would be a weaker test than the economic framework supported by the CEA and the CRO forum and may explain why some supervisors are so keen on risk margins to be held within the technical provisions. 3. WHY A COST OF CAPITAL APPROACH? 3.1 In section 2 we described the economic framework for Solvency II. The CEA and others have expressed a desire for an alternative to the percentile approach promoted by CEIOPS. In this section we describe the reasoning behind the cost of capital approach as an alternative to the percentile approach. Consistency with Overall Framework 3.2 The economic framework, as described previously is based on market consistent valuation of assets and liabilities. 3.3 The Cost of Capital approach has a theoretical basis in determining the market consistent value of the liabilities. In theory shareholders of a company will need to provide capital to support the acquisition of a portfolio and shareholders would require compensation for the capital being supplied. 3.4 The Cost of Capital approach takes this into account. In addition the cost of capital approach can correctly distinguish between hedgeable and non hedgeable risks as modern financial theory indicates that shareholders would only require compensation for the non hedgeable elements. 3.5 As a result, the theoretical basis will provide correct directional movement of the MVM. For example portfolios which are more risky and where the risks persist for longer will require larger margins. Comité européen des assurances,

4 Transparency 3.6 We have previously described why the cost of capital approach is consistent with the proposed Solvency II framework. A key concern with other approaches (e.g. the percentile approach) is that it is less transparent as it mixes capital requirements within the technical provisions for solvency. 3.7 The main disadvantage of including arbitrary amounts of prudence within technical provisions for solvency is that the company is not encouraged to assess its true economic position. As a result, its management decisions will not be based on the underlying economic reality. Therefore the supervisors will also not have an adequate picture of the underlying risk profile of the company. This in the long run is detrimental to both shareholders and policyholders. Verification and Auditability 3.8 The cost of capital approach requires certain key assumptions (See Section 4). However these assumptions are clearly identified and are easily verifiable by supervisory authorities. 3.9 On the other hand, the percentile approach depends on key assumptions for distributions, stochastic models and input parameters. These inputs are potentially very subjective and may lead to a wide variation in the results of the percentile approach from company to company 2. As a result, the supervisory audit requirements for the percentile risk margins may be similar to those needed to validate internal models. Homogeneous application 3.10 The outcome of the cost of capital approach is less dependent on subjective assumptions, quality of data or sophistication of stochastic models that maybe company specific. This allows a greater consistency in its application It is relatively easy to implement both under a standard approach and internal models. It is suitable for companies of all sizes and levels of sophistication since it allows for the use of approximations for companies without cashflow models. Workable precedents 3.12 Companies have used a cost of capital approach in the European Embedded Value supplementary information to their published accounts. In addition, the cost of capital is an accepted component of transactions for both insurance portfolios and companies In addition, certain regulatory regimes for example The Swiss Solvency Test 3 uses a Cost of Capital approach in determining the MVM. 2 Australian Prudential Regulation Authority (APRA). General Insurance Risk Margins Industry Report, 30 June 2004 (issued October 2005) 3 Swiss Federal Office of Private Insurance (FOPI). The Swiss Experience with Market Consistent Technical Provisions Cost of Capital. Frebruary 24, 2006 Comité européen des assurances,

5 3.14 A percentile approach raises certain fundamental issues including the need for stochastic analysis, the reliance on judgement and the complexities of non proportionate reinsurance on the risk margins. Summary 3.15 The following table summarises the comparison between the CoC and percentile approaches. Relation to market value margin Precedents Cost of Capital Theoretical basis indicated previously Swiss Solvency Test, EV reporting, business transactions Percentile No clear connection to a market value margin; Most likely includes a significant element of prudence APRA but note practical problems identified in APRA Report 1 Workability Transparency and Auditability Can be tailored to make use of information readily available for solvency assessment Information requirements more manageable and auditable Requires significant data and analysis; major concern for small, medium and some large companies in QIS 1; More subjective so difficult to audit data and process used to calculate percentiles 4. USING THE COST OF CAPITAL TO CALCULATE THE MVM 4.1 In Section 3 we outlined the advantage in implementation of the cost of capital approach over the percentile approach. In this section we will explain the main components that form the basis for calculating the MVM. We will also demonstrate how MVM could be calculated in practice under the standard approach by using the proposed ESA 4 by the CEA. 4.2 Under a cost of capital approach the MVM is calculated as the present value of the cost of holding the SCR for non-hedgeable risks during the whole run-off period of the in-force portfolio. 4.3 Based on this definition, the items that will need to be estimated are: The SCR amount of capital relating to non-hedgeable risk ( SCR CoC ) that will need to be maintained in each of the periods until run-off. This will depend on: The non-hedgeable risk borne by the company on each year of the run-off The length and pattern of the run-off of liabilities 4 Comité Européen des Assurances. CEA Working Document on the Standard Approach for Calculating the Solvency Capital Requirement. Brussels, 22 March Comité européen des assurances,

6 The annual cost of holding that capital (CoC). The cost of capital in each year would be given by SCR t x CoC, by discounting these amounts we would obtain the MVM: MVM = CoC x SCR t x (1 + r t ) -t 4.4 In the following sections we will explain some possible approaches for the calculation of the different components and how they would be calculated under the ESA. IMPLEMENTATION UNDER THE ESA Under the ESA the calculation of the MVM with a cost of capital approach could be done in five steps: Step 1: Calculation of the SCR for non-hedgeable risks (SCR CoC )at time 0. Step 2: Calculation of the (SCR CoC ) for each point of the projection until run-off Step 3: Calculation of the capital charges for each year until run-off Step 4: Calculation of the present value of capital charges Step 5: The final step would be to incorporate the MVM to the BEL to obtain the market value of liabilities that would serve as one of the inputs for the calculation of available capital under the ESA. Calculation of SCR of non-hedgeable risks during run off 4.5 One of the inputs required for the cost of capital calculation is the SCR CoC to be held over the run-off period. This should be calculated net of full diversification benefits within all non-hedgeable risk types and can be determined in one of two ways. 4.6 The first method would be to calculate a SCR CoC at each year through internal models that would project assets, liabilities and non-hedgeable risks for each year. 4.7 The second method would be to calculate the SCR CoC at time 0 and relating it to a driver for the run-off of the risk. Under this approach the SCR CoC at time 0 can be calculated either through a standard approach or through an internal model. Within this paper and the ESA we illustrate the risk driver by using the run off of the BEL. In this context: Cash flow models can be used to provide the run-off pattern of the liabilities. For companies which may not have cashflow models prudent approximations could be used to estimate the pattern of the liabilities (i.e. a factor could be applied to the SCR CoC at time 0 based on the duration of the liabilities). Comité européen des assurances,

7 However, we also note that the driver may be chosen to best reflect the underlying risk. Other drivers are possible as indicated in Appendix C of the CRO Forum discussion paper The calculation of the SCR CoC could be done either at the portfolio level or at a product line level. The SST favours the calculation of the SCR CoC at the portfolio level while the CRO Forum favours the calculation at the product line level. The arguments favouring one and other approach are the following: The rationale behind the SST is that an insurer risks insolvency as a whole and there is an underlying assumption that the total portfolio is taken over by a third party. Therefore the MVM should be calculated on the total portfolio On the other hand the CRO Forum 5 favours the calculation of the MVM by line of business or products with similar risk profiles. This would favour transparency and would facilitate companies analysis of the risks they are taking. The MVL would then be aggregated to a company level. 5 The Chief Risk Officer Forum. A market cost of capital approach to market value margins. 17 March 2006 Comité européen des assurances,

8 IMPLEMENTATION UNDER THE ESA Under the ESA the projected SCR CoC could be calculated in a simple way by taking the SCR CoC at time 0 and projecting it in proportion to the BEL. No discussion has been yet made within the CEA regarding the level of aggregation in the calculation of MVM. In the examples below the calculation is made on a portfolio level, however this does not pre-empt further discussion within the CEA on the issue. The model taken for these examples is the Life ESA. For non-life, an additional example is provided in Appendix B. We will base our example on the following model company, and will use the ESA to calculate the MVM for liabilities (note that MVM are set to 0 for the moment). The model company is a Life company writing mostly savings products. Balance Sheet Step 1 Calculation of the SCR CoC at t=0 TOTAL MV of Assets 19,205 Best Estimate Liabilities 17,057 Market Value Margin 0 MV of Insurance Liabilities 17,057 Other liabilities 925 Available Capital 1,223 The SCR CoC could be calculated in a simple way under the ESA by setting the risk factors for market risk to 0. Market Risk PARAMETER SET PARAMETER SET Interest rate upward shift 1.50% Interest rate downward shift 1.00% Equity shares Europe 15.00% North America 20.00% Asia 25.00% Developing countries and other 30.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Comité européen des assurances,

9 In this way we would obtain an SCR CoC at time 0 that would only take into account non hedgeable risks: Company Summary SCR SCR Non-H Market risk SCR Underwriting risk SCR Credit risk SCR 43.9 Operational risk SCR Undiversified SCR Diversification effect SCR before risk absorption by liabs Risk absorbed by future profit sharing Total SCR Available capital 1,223.0 Capital Requirement coverage 207.7% Non-hedgeable SCR , % Step 2 Calculation of the SCR CoC for at each point of the projection By making the simplifying assumption that SCR CoC remains a constant proportion of the best estimate liabilities we can easily estimate the SCR CoC at each point in the projection. In our example this proportion amounts to 1.3% (219 / 17,057). In our example we assume that the business will run-off in ten years: BE Liabs Best estimate liability run-off Projection of best estimate technical reserve can be made by using a cash flow model Years Estimate of SCR for non hedgeable risk SCR Ratio = SCR(0) / BE(0) Projection of SCR = Ratio x BEL t Years Comité européen des assurances,

10 Circularity: One of the most frequent questions about the Cost of Capital approach for determining MVM is the circularity of the calculation. While in theory this is true, it can be easily avoidable in practice. Please note how in the example the SCR CoC has been calculated using BEL before incorporating any MVM. Under this assumption, the SCR CoC is related to the potential change in available capital over the one year period and the MVM impacts the amount of available capital. This approach is equivalent to making the assumption that the MVM will remain equal before and after the shock. As the MVM is a relatively small proportion of the market consistent liability, this simplifying assumption has only a second order impact on the results but means that circularity is completely avoided. Calculation of the MVM: Present Value of the capital charge 4.9 In theory, the capital charge amount for each year of the projection will be influenced by the rate in excess of the risk free rate that will be required by a potential purchaser to run-off the business (i.e. the cost of capital) In terms of the ESA, the actual cost to be used is likely to be determined in a practical fashion with input from both the industry and supervisors Once the cost is determined, then it could be applied to the previously calculated SCR CoC. The capital charge for each year is given by: Capital Charge t = CoC t x SCR CoC 4.12 The MVM is then calculated by discounting the capital charge at the Risk free rate: MVM = Capital Charge t x (1 + rfr t ) t Comité européen des assurances,

11 IMPLEMENTATION UNDER THE ESA Step 3 Calculation of the capital charges for each year Following our example we would obtain a capital charge for each year of the projection. For this example we have used a placeholder for the cost of capital of 4% 6. Cost of capital charge Period SCR n-hedge CoC Capital Charge % % % % % % % % % 0.9 Step 4 Calculation of the present value of capital charges The market value margin is calculated by discounting the capital charge at the risk free rate: Calculation of MVM Period Capital Charge RFR PV Capital Charge % % % % % % % % % 0.7 MVM 35 Step 5 Incorporating MVM to the calculation of available capital The final step would be to incorporate the MVM to the best estimate technical provisions in order to obtain the MVL. This MVL of liabilities including the MVM is the one used to assess the risk bearing capital of the company under the ESA. Balance Sheet TOTAL TOTAL MV of Assets 19,205 19,205 Best Estimate Liabilities 17,057 Market Value Margin 0 MVM 17, MV of Insurance Liabilities 17,057 Other liabilities 925 Available Capital 1,223 17, ,188 6 Joint CRO Forum/CEA paper Solutions to major issues for Solvency II, 17 February Comité européen des assurances,

12 Simplified approach for companies not being able to use cashflow models (potential replacement for steps 2 to 4) 4.13 One of the advantages of the CoC approach is that it can be tailored to suit both companies using sophisticated internal models as well as companies that are not able to produce cashflow analysis. In this way it provides a solution that is workable for large, small and medium sized companies Under the previous example we have assumed that the company could calculate the future development of the best estimate provisions through a cash flow model. Simplified prudent approaches could potentially be established for those companies who are not familiar with the use of cashflow models One such approach could be a simple factor depending on the weighted average duration. This factor could then be applied to the non-hedgeable SCR CoC determined as in Step 1 above. In cases where companies were not able to derive the duration of their liabilities, a predefined set of durations derived by the supervisors and the industry could be used. IMPLEMENTATION FOR COMPANIES THAT CANNOT PROJECT THE BEL For companies not being able to produce the development of their BEL by means of a cashflow model an alternative simple factor approach based on duration of the liabilities, the cost of capital and the impact of discounting may prove a workable solution. We have calculated a set of sample factors based on these three parameters. The factors on the table below would be applied to the SCR CoC at time 0 in order to arrive to the estimated MVM. In the case of our example the duration of liabilities was almost five years (18.1% is calculated as: 5 x 4% x 86% whereby the 86% is derived in step 4): Duration MVM Factor SCR CoC MVM 1 3.9% 2 7.6% % % X 219 = % X 219 = % X 219 = % % % % % % % Comité européen des assurances,

13 5. COMPARISON WITH THE SWISS SOLVENCY TEST 5.1 The Swiss Solvency Test uses the Cost of Capital approach for calculating MVM. According to pre test specification on QIS 2 released by CEIOPS on 22 March it will form the basis for the cost of capital approach. 5.2 It is therefore interesting to compare the SST approach to that described in this paper. 5.3 Methodology of calculation: The SST allows two methods for calculating the MVM. A more sophisticated approach that would consist on a full and complete SST calculation for each period, projecting assets, liabilities and risks. A simplified approach based on the SST at time 0 applied to the run-off technical provisions under the assumption that the relationship of the SCR with technical provisions remains constant throughout the run-off. 5.4 The approach described in this paper is consistent with the second alternative as demonstrated through the examples in section 4. However the ESA proposal would allow further simplification for those companies not able to use cashflow models as described in section SCR to be projected: The SCR that serves as a base for the calculation of MVM under the SST is calculated as the standard SCR (i.e. following the SST) and only for non-hedgeable risks. This is consistent with the process described for the ESA. 5.6 Hedgeable risks: To arrive to the future SCR the SST assumes that all hedgeable financial risk is reduced as far as possible by composing an optimal replicating portfolio. However the MVM under the SST incorporates some market risk as it is assumed that the asset portfolio may not be swapped instantaneously for the optimal replicating portfolio. Under the ESA it is assumed that the liability portfolio is hedged immediately following the transfer of the portfolio. 5.7 Cost of Capital: The cost of capital is set to 6% for the SST. This capital requirement is based on a company that would hold the SCR (estimated to be approximately a BBB company). A placeholder for this cost of capital has been used under the ESA (4%). Comité européen des assurances,

14 5.8 A summary of the main differences and similarities can be found below: SST ESA Calculation methodology SCR to project Hedgeable risks Allows : -Full valuation of the SCR in a each period. -Projection based on SCR at time 0 and run-off pattern SCR based on the the standard (SST) only for non hedgeable risks. Progressive reduction of ALM risk through an optimal replicating portfolio. Allows : -Projection based on SCR at time 0 and run-off pattern of liabilities - Simplified approach based on a factor dependent on duration. SCR based on the the standard (ESA) only for non hedgeable risks. Immediate hedging of ALM risk. No ALM risk is considered Cost of Capital Fixed at 6% Placeholder at 4% Comité européen des assurances,

15 APPENDIX A DIFFERENT VIEWS ON THE TIME PERIOD We note that there are some potential misconceptions on the intended framework, in particular, around the time frame of the risks considered in the SCR. The aim of this annex is to clarify these misconceptions Some have interpreted that the SCR was only capturing one year s worth of risk and have used this argument to support the inclusion of a risk margin (75 th percentile) that took into account risks arising until during run-off. This is an incorrect interpretation of what the SCR is intended to capture under the economic approach. Under the economic approach the SCR would take into account not only the impact of losses over the one year period but also the potential impact on future cashflows to the extent that the information arising over one year could be part of a trend impacting all future years. In this sense the SCR covers the impact until run-off of the liabilities of a worst case scenario (99.5th percentile) arising over one year. In order to highlight this point, we have illustrated what we believe to be the difference between a narrow view towards the time period and the wider view used to assess the SCR under the economic approach. A narrow view of the time period Under a narrow view of the time period the SCR would cover only losses that would arise during the risk assessment period of one year. A risk margin would then be introduced to cover risks arising over the following periods until the extinction of the liability. This would be accomplished by calculating the value of the liability using the 75 th percentile cashflows instead of using the best estimate cashflows. This approach is graphically depicted in the figure below: A narrow view on the time period SCR: 99.5th loss over 1yr Risk Margin at 75th 99.5th 75th BE Discount at risk free rate Best Estimate Liability Valuation Date Present Value LIABILITY CASH FLOWS Comité européen des assurances,

16 This framework may not be coherent as it mixes capital requirements within the technical provisions, could lead to double counting and it is not clear what the 99.5 th percentile loss over 1 year would mean for the overall policyholder protection. A wider view on the time period Under a wider definition of the time period, the SCR would capture not only the risk of losses arising over the next year but also the potential impact on the future cashflows of the company until run off. Hence items which represented a potential change in future trends would be captured. Hence the SCR based on a wider view together with the market value margin will provide comfort that with a 99.5% confidence level a company would be able to transfer their portfolio to a third party. No additional prudence is therefore needed in the valuation of liabilities. Conceptually, this approach is shown in the figure below: A wider view on the time period SCR: 99.5th impact over run-off Market Value Margin 99.5th Best Estimate Liability BE Discount at risk free rate Valuation Date LIABILITY CASH FLOWS Present Value Comité européen des assurances,

17 APPENDIX B EXAMPLE FOR NON-LIFE For the calculation of the MVM for Non-life companies, the same steps are carried out as for Life companies. Below, an example of a non-life portfolio is provided. The following adjustments are made for the purpose of the calculation of the SCR CoC in comparison to the calculation of the SCR. All market risk factors are set equal to 0, since market risk is assumed to be hedge-able. For premium risk, the volume measure is changed from net written premiums + net unearned premium reserves to net unearned premium reserves only. As a result, the inclusion of one year of new business is not incorporated in the calculation of the SCR CoC. Step 1 SCR SCR CoC Capital Requirements Reserve Risk Premium Risk Catastrophe Risk Diversification Benefit Total Insurance Risk Asset Risk Real Estate Interest Rate Risk Credit Risk Currency Risk Diversification Benefit Total Market Risk Operational Risk Reinsurance Credit Risk Diversification Benefit Total Risk Expected Value Created by 1 year of NB Solvency Capital Requirement Comité européen des assurances,

18 Steps 2-4 Assumed duration portfolio: 5 years ==> MVM factor: 18.1% SCR CoC 20.8 MVM 3.77 Step 5 Best MVM Market Liabilities Estimate Value Claims Provisions 69 Premium Provisions 19 Total Comité européen des assurances,