Solvency II Update. Latest developments and industry challenges (Session 10) Réjean Besner

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1 Solvency II Update Latest developments and industry challenges (Session 10) Canadian Institute of Actuaries - Annual Meeting, 29 June 2011 Réjean Besner

2 Content Solvency II framework Solvency II equivalence for non-eea countries Key outstanding issues for the industry Potential impact on the industry and QIS5 findings 2

3 Solvency II framework 3

4 The foundation of Solvency II is conceptually comparable to Basel II Pillar I Quantitative Requirements Pillar II Qualitative Requirements Pillar III Market Discipline Minimum capital requirement (MCR) Solvency capital requirement (SCR) Standard approach Internal model Risk dependencies and mitigation Corporate governance Internal control Supervisory review process Supervisory powers Safety measures Solvency control levels Supervisory disclosure Public disclosure Investments Risk management function Technical provisions Own risk and solvency assessment (ORSA) All pillars applicable to individual companies (solo entities) and groups 4

5 5 Market consistent valuation Economic view of utmost importance Market consistent valuation of assets and liabilities Cost of capital approach for Risk Margin Total balance sheet approach has to be followed Convergence with IFRS? Assets Liabilities Market value of total assets Available for SCR/MCR Excess capital Min. Capital Requirement (MCR) Risk margin Best estimate Solvency Capital Requirement (SCR) Market value of liabilities

6 Possibilities to calculate the SCR European standard approach (standard formula) calibrated through the different QISs Internal Model subject to a rigorous approval process outside of the UK only few entities are applying for a full Internal Model Partial Model combination of standard and internal model concern from the regulators about cherry picking Based on a one year time horizon VaR 99.5% confidence level 6

7 One of the key requirements of Pillar II is the introduction of ORSA Own Risk and Solvency Assessment Based on the own risk measure (reconciled to regulatory risk measure) The scope are all identifiable risks - also the risks the company may face in the longer term Solvency on continuous basis from an internal and regulatory perspective to be ensured Identification, assessment, monitoring and management based on strategic plan strategic decision planned factual to ensure solvency on continuous basis The assessment of risk and solvency provides a holistic view of the company's risk and enables the management and the board to shape and take appropriate decisions regarding its strategy A set of related processes guarantee good quality and ensure that the ORSA is useful for strategic planning and decision making Key results are reported to the supervisor ORSA is done regularly and at change of risk profile 7

8 ORSA links into Pillar I and provides to Pillar III Pillar I Quantitative Requirements Pillar II Qualitative Requirements Pillar III Market Discipline Corporate governance Risk management system Internal control system Internal audit function ORSA Actuarial function Internal model is used to conduct the ORSA ORSA assesses Ongoing solvency of the legal entity Compliance of technical provisions Deviation of risk profile from assumptions underlying SCR calculation Disclose a description of the ORSA process as part of public disclosure. Report ORSA results to the supervisors 8

9 Benefits from the ORSA process As a prerequisite for ORSA, a 3-5 year strategic plan for the legal entity needs to be provided / established, both, on a regular basis and at change of strategy ORSA will enable designing risk mitigating activities, like retrocession or hedges, and assessing their effectiveness under a variety of relevant scenarios. Consequently, it will enable planning of corresponding capital actions and assess their effectiveness It will thus provide a comprehensive assessment of the entity's risk and solvency capital position The ORSA report will provide a standard communication format discussing the impact of the legal entity's strategic plan on its risk and solvency ORSA is meant to be a central tool for the BoD in assuming its responsibilities regarding risk and solvency 9

10 Different governance requirements apply to 'Key Functions' versus 'Important or critical functions' "A function is an administrative capacity to undertake particular governance tasks. The identification of a particular function does not prevent the undertaking from freely deciding how to organise that function in practice save where otherwise specified in this Directive" 1) "The system of governance includes the risk-management function, the compliance function, the internal audit function and the actuarial function." 2) "The functions included in the system of governance are considered to be key functions and consequently also important and critical functions." 3) 1) Directive 2009/138/EC (Solvency II), Recital (31) 2) Directive 2009/138/EC (Solvency II), Recital (30) 3) Directive 2009/138/EC (Solvency II), Recital (33) The regulator's list of "key functions" is not closed. The entity must assess which other functions are Key Functions 10

11 Generic requirements for key functions (actuarial, risk mgmt, internal audit, compliance) Generic requirements for key functions include all persons who effectively run the undertaking or have other key functions should be fit and proper at all times 1) undertakings shall notify the supervisory authority of any changes to the identity of the persons who effectively run the undertaking or are responsible for other key functions 1) persons who effectively run the undertaking or have other key functions take into account the information reported as part of the risk management system in their decision making process 2) remuneration policy needs to comply with specific principles regarding key function holders 3) public disclosure of roles and responsibilities of key function holders, supplementary /early retirement schemes and process of assessment of fit and proper for key function holders 4) 1) Directive 2009/138/EC (Solvency II), Art 42 2) COMMISSION REGULATION (EU) DRAFT Delegated Acts (Level 2 text) March 2011 Art SG3 3) COMMISSION REGULATION (EU) DRAFT Delegated Acts (Level 2 text) March 2011 Art SG13 4) COMMISSION REGULATION (EU) DRAFT Delegated Acts (Level 2 text) March 2011 Art PDS 4 11

12 Pillar II also includes important requirements relating to outsourcing "Member States shall ensure that insurance and reinsurance undertakings remain fully responsible for discharging all of their obligations under this Directive when they outsource functions or any insurance or reinsurance activities" 1) "Outsourcing of critical or important operational functions or activities shall not be undertaken in such a way as to lead to any of the following: (a) materially impairing the quality of the system of governance of the undertaking concerned; (b) unduly increasing the operational risk; (c) impairing the ability of the supervisory authorities to monitor the compliance of the undertaking with its obligations; (d) undermining continuous and satisfactory service to policy holders." 1) "Insurance and reinsurance undertakings shall, in a timely manner, notify the supervisory authorities prior to the outsourcing of critical or important functions or activities as well as of any subsequent material developments with respect to those functions or activities." 1) "Undertakings shall disclose a description of their outsourcing policy including the rationale for the undertaking's outsourcing of any critical or important activities and critical or important operational functions and the jurisdiction in which the service provider is located" 2) 1) Directive 2009/138/EC (Solvency II), Art 49 2) COMMISSION REGULATION (EU) DRAFT Delegated Acts (Level 2 text) March 2011 Art PDS 4 12

13 Solvency II equivalence for non-eea countries 13

14 Third country equivalence under Solvency II Objectives of equivalence of third-country regulatory regimes Allow the regulator to rely on third-country supervisors and their rules Reduce regulatory burden for EEA and as well non-eea (re)insurers Use of local regulatory capital amounts in the Solvency II capital calculation Foster global regulatory governance, harmonize supervision and increase cooperation Equivalence of third-country regime to be assessed on three levels: Reinsurance transactions: Treatment of third-country reinsurance, specifically the need to collateralize arrangements within the EEA Group solvency calculation: Ability to use local regulatory capital amounts in the Solvency II capital calculation Group supervision: Reliance on third country for group supervision, i.e. European supervisors need only consider individual entities within their jurisdictions on a stand-alone basis 14

15 Latest developments on 3 rd country equivalence under Solvency II Situation The European Commission has asked CEIOPS to include Switzerland and Bermuda in a first wave to be assessed for all three types of equivalence Japan has been proposed to be assessed for equivalence on reinsurance supervision (Article 172) Currently the European Commission is considering to introduce a transitional regime for all three types of equivalence. To qualify for such a regime a third country will need to satisfy certain criteria that will be prescribed in the implementing measures. CEIOPS has published concrete principles and objectives regarding the assessment of third country equivalence, including transitional measures. Next steps on equivalence September 2011: July 2012: Publication of CEIOPS advise on equivalence Decision about the equivalence of first wave countries 15

16 Key outstanding issues for the industry 16

17 European supervisors have departed from the economic-based framework of the Solvency II Directive European Supervisors have become increasingly conservative and protectionist in the aftermath of the financial crisis, which is having negative implications on the implementing measures of the Solvency II Directive Regulatory developments Spill-over risks from banking requirements Conservative reactions due to the crisis New supervisory architecture Influence of central banks Ensure level playing field with banks Impact on Solvency II framework Own-funds debate Non-life capital calibration EIOPA and ESRB to be reflected in Omnibus II ECB pressure on reporting requirements Treatment of participations and hybrids Industry is increasingly concerned about the (i) capital impact of the Directive and (ii) regulatory uncertainty of expected requirements 17

18 Level 3 Level 4 starts in 2014 Time line for finalizing Solvency II is very tight unclear technical details of Level 2 and Level Level 1 Draft framework Directive (published 10 July 2007) Level 1 Directive adopted (approved 25 Nov 2009) Level 2 Draft implementing measures (expected by end 2010) Level 2 implementing measures & Omnibus II (expected by early 2012) Solvency II system in force QIS 1-3 ( ) QIS 4 QIS 4B QIS 5 QIS 6? Level 1: Level 2: Level 3: Level 4: Framework Directive setting out basic enduring principles Implementing Measures definition of detailed technical rules. Supervisory Standards setting out guidelines to ensure a consistent interpretation and application Evaluation enables the European Commission to monitor compliance and enforcement. Finalization of Omnibus II remains unchanged with formal adoption expected by early 2012 Transitional measures to be clarified in Omnibus II Level 3 still in early stages with some standards expected to be finalized after the launch of Solvency II European Commission remains committed to finalize informal discussions on Level 2 by end of June 2011 Some Supervisors mention privately that the Directive might be delayed 18

19 State of play of the Implementing Measures (Level 2) Implementing Measures being prepared based upon advice from EIOPA (following adoption of Framework Directive in May 2009) Discussion of drafts with Member States experts and with stakeholders (eg CEA, CRO Forum, CFO Forum) Consolidated version of Implementing Measures drafts prepared by Commission staff Impact assessment result on Level 2 was published early May 2011 Amendments to the Directive due to new EU regulatory architecture (eg EIOPA and ESRB) and transitional measure introduced through Omnibus II Council and Parliament to approve the Omnibus II Directive Intensive and challenging timeframe to ensure proper implementation of the Solvency II Directive on 1 January

20 Overall challenges going forward Finalising the regime Ensure that the Implementing Measures (Level 2) reflect the economic and principle-based approach of the Framework Directive (Level 1) Avoid unjustified spill over from banking regulation to Solvency II (e.g. CEIOPS report on comparison of own funds in Basel III and Solvency II) and from Solvency II to SST (e.g. treatment of expected profits and hybrids, approval of internal models) Define appropriate transitional measures to ensure smooth but effective introduction of the new regime SMEs concerns: (i) appropriate calibration of the standard formula, (ii) eliminate undue complexity in the standard formula and (iii) clarity on the principle of proportionality Avoid that large (re)insurance groups be required to apply the standard formula (some Member States may require to apply both standard formula and internal model) Implementing the regime Insurers have a lot to do in order to establish risk and economic-based tools, processes (high implementation costs) and new risk culture throughout their organizations National supervisors need to have adequate resources and expertise Above 70 companies in model pre-approval process in the UK and 10 in Germany 20

21 Key issues remaining at stake for the industry with regard to Level 2 implementing measures Key issues affecting the solvency coverage Available Financial Resources Expected future profit (EPiFP) Contract boundaries Discount rate for long term guarantee products Solvency Capital Required Calibration of non-life premiums and reserve risks Calibration non-life & health CAT risk Key issues affecting the level playing field Transitional provisions Equivalence regime/treatment non-eea Treatment of participation (versus Basel III) Interpretation by national supervisors

22 Details on key issues affecting the solvency coverage Expected Profits included in Future Premiums (EPiFP) Definition and treatment of EPFiP under discussion, raised by supervisors Industry does not currently support a separate tiering and requires full recognition in Tier I Contract boundaries EIOPA and Member States do not want to follow contract boundary definition of IFRS 4 Industry is in favour of single definition for accounting and regulatory issues Long term guarantees products Definition of discount rate (use max. of swap and government rate under discussion) Use of matching premium concept was introduced late by EIOPA Calibration non-life risk factors in the standard formula Recognition of diversification for non-eea cat risk exposure Appropriate LoB calibration Industry concerned due to deviation from market-consistent approach 22

23 Details on key issues affecting the level playing field Transitional provisions Omnibus II to provide legal basis for transitional provisions with a maximum period of 10 years However, transitional provisions will not be defined in all areas and will be as short as possible Expected "cooling off period" in year one: SCR not hard target and limited disclosure requirements Group supervision and third country equivalence Directive allows for group supervision of third countries if deemed equivalent Engage supervisors to clarify expected group supervision under Solvency II: avoid sub-group supervision Switzerland expected to receive full equivalence status in mid-2012 Transitional measures of equivalence recognition expected for large markets (eg US) Treatment of participations Favourable transitional measures for banks under Basel III (esp. bancassurers) Avoid competitive disadvantage and market distortions Supervisory interpretation Risk of market distortions in the approval process of internal models Clarity on the supervisory discretion 23

24 Potential impact on the industry and QIS5 findings 24

25 Solvency II is expected to change the European insurance landscape Market developments New wave of consolidation Larger groups favored versus SMEs Structure of insurance companies Legal model restructuring towards branches Head Office relocation depending on the portfolio/operational structure ERM more embedded in decision-making Business mix & asset allocation Companies to further consider size, geographical mix, lines of business, asset/liability matching Smaller insurers and mutuals to allocate more assets towards government bonds, or to reduce capital intense lines of business Products with guarantees will require higher levels of backing capital Products incorporating long term volatility will also be affected Product development Product development will increasingly incorporate capital considerations Capital bias towards short term lines Companies may wish to offload long tail risks Low frequency / high severity lines also hit

26 Standard Formula Partial internal model Internal model Solvency II expected to better recognise risk mitigation techniques as capital and risk management solutions Identify the individual capital drivers Examples: find the most efficient re/insurance solution Examples: value the capital benefit based on the model used Insufficient diversification Transfer of peak risks Natural catastrophe risk Insurance Linked Securities Large exposure to increasing life spans Longevity swap Volatility of reserve run-off Loss Portfolio Transfer & Adverse Development Cover Reinsurance is a powerful capital management tool under Solvency II 26

27 QIS5 provides some insights on the expected impact of Solvency II on the industry The 5 th Quantitative Impact Study (QIS5) was a test of the Solvency II standard formula under 2009 figures; results were released in March 2011 Results overview: Current regime Solvency I Solvency II Related to SCR Solvency ratio (in %) Surplus (in bn Euro) Requirements (in bn Euro) Eligible own funds (in bn Euro) Related to MCR Source: EIOPA EIOPA and European Commission comments on QIS5 Insurers and reinsurers are well positioned to meet Solvency II requirements Refinements still needed in technical provisions, own funds and calibration of the standard formula Changes needed to address volatility issues System too complex for small companies; simplifications required Targeted transition measures needed 27

28 Industry raised concerns as QIS5 results could provide a false sense of comfort QIS5 took into account many requests raised by the industry (eg illiquidity premium and treatment of own funds); results could be different if these critical points would be removed Industry to maintain intense level of dialogue with EIOPA and European Commission while finalizing the implementing measures Standard formula is too conservative (eg calibration of underwriting risks, notably at non-eea level) and not appropriate for large groups such as Swiss Re Ensure the use of undertaking Specific Parameters and promote (partial) internal models High volatility in the Solvency II framework needs to be addressed Further prepare the market (eg analysts and rating agencies) on the new regime Need for anti-cyclical mechanisms QIS5 results confirmed the importance to maintain certain elements that are key feature of a risk-based and economic regime 28

29 Composition of SCR for Groups under QIS 5 BSCR Structure (groups) Diversified Basic SCR structure All undertakings (groups) 10% 31% 46% 10% Non-Life 16% Market 58% 8% 34% 60% Health 5% 3% 113% 149% 100% Life 17% Counterpart y 4% 96% of the capital requirement stems from core insurance business 29

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