Christos Patsalides President Cyprus Association of Actuaries

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Christos Patsalides President Cyprus Association of Actuaries 1 Counter Party (Default) Risk Reinsurance Intermediaries Banks (cash at bank current ac/s only) Other

1 Christos Patsalides President Cyprus Association of Actuaries 1 Counter Party (Default) Risk Reinsurance Intermediaries Banks (cash at bank current ac/s only) Other Operational Risk Systems Risks Processes People Market Risk Interest rate risk Equity risk Property risk Spread risk Concentration risk Currency risk Illiquidity Premium Risk 2 1

2 Risk of suffering a loss from a potential default of a counterparty such as: Reinsurance arrangements, Securitizations and derivatives Receivables from intermediaries Cash at Bank (current a/cs) Any other credit exposures not covered in the spread risk sub-module Basic Parameters in Calculating SCR def Level of loss in case counterparty defaults (Loss Given Default LGD) Probability of Default PD Rating of Counterparty Risk mitigants 3 Two types of counterparty exposure, each subject to different treatment Type 1 = Exposures which may not be diversified and where the counterparty is likely to be rated: Reinsurance arrangements, Securitizations and derivatives, Any other risk mitigating contracts, Cash at bank, Deposits with ceding institutions (number of independent counterparties does not exceed 15) Capital, initial funds, letters of credit as well as any other commitments received by the undertaking which have been called up but are unpaid ( number of independent counterparties does not exceed 15) Guarantees, letters of credit, letters of comfort which the undertaking has provided as well as any other commitments which the undertaking has provided and which depend on the credit standing of a counterparty. 2

3 Type 2 = exposures which are usually diversified and where the counterparty is likely to be unrated. The class of type 2 exposure should consist of all exposures which are in the scope of this module and are not of type 1 Receivables from intermediaries, Policyholder debtors, including mortgage loans, Deposits with ceding institutions, if the number of independent counterparties exceeds 15, and Capital, initial funds, letters of credit as well as any other commitments received by the undertaking which have been called up but are unpaid, if the number of independent counterparties exceeds 15. Reinsurance/Securitisations: LGD i = max (50% * (Recoverables i + RM re, i - Collateral i ); 0) Derivatives: LGD i = max (90% * (Market Value i + RM fin, i - Collateral i ); 0) See QIS5 specifications for details on Collaterals 3

4 RM x,i = SCR hyp - SCR without SCR hyp Capital requirement for underwriting and market risk under the condition that the risk mitigating effect of the X of the particular counterparty is not taken into account in its calculation (determined solely for the purpose of the CPD risk module) SCR without Capital requirements for underwriting risk and market risk without any amendments (normal SCR) What does this mean? For example, for a r/i counterparty perform extra SCR calculation for u/w risk without taking into account its mitigating effect Type 1 exposures: SCR def, 1 = min ( i LGD i ; q * V); q є {3, 5} Type 2 exposures: SCR def, 2 = 15% * E (except those due more than 3 months) + 90% * E (due more than 3 months) SOS 1: 3 months period starts from the end of the credit period granted to the client or the intermediary SOS 2: E (except those due more than 3 months) = all Type 2 Exposures, except for below E (due more than 3 months) = Intermediary balances due for more than 3 months after contractual credit period 4

5 Unrated banks compliant with the Capital Requirements Directive (2006/48/EC) should be treated as if having a BBB rating. Exposures to each counterparty should be added together Counterparties which belong to the same group should be added together SCR def = {SCR 2 def, X SCR def, 1 X SCR def, 2 + SCR 2 def, 2 } 1/2 5

Rating Category Rating Default Probability Extremely strong AAA 0.002% Very strong AA 0.01% Strong A 0.05% Adequate BBB 0.24% Speculative BB 1.20% Very speculative B 6.

6 Rating Category Rating Default Probability Extremely strong AAA 0.002% Very strong AA 0.01% Strong A 0.05% Adequate BBB 0.24% Speculative BB 1.20% Very speculative B 6.04% Extremely speculative CCC 30.41% Unrated 30.41% Risk of loss to the Company that can result directly or indirectly from anywhere : Systems People Procedures SCR op is calculated based on: Premium Volumes Reserve Levels 12 6

7 Simplistic calculation will ultimately change Significant research in the area of quantification of operational risk No diversification benefits applied (not part of the overall Correlation Table) 13 Ignores Strategic Risk Formula driven one size fits all approach so far EU expects internal models to address many of these limitations 14 7

8 SCR op = MIN (30%BSCR, Op) + 25% Exp ul, where Op = max (Op provisions ; Op premiums ) Op provisions 0.45% on non-linked life and health reserves 3% on non-life reserves Op premiums 4% on non-linked life and health premiums 3% on non-life premiums (some additional allowance where premiums are growing more than 10% per annum). Exp ul = 25% of UL management expenses (excluding acquisition expenses) Market Risks Internal Risks As for other balance sheet items Risk that future benefits are no longer expected from the Intangible Asset Decrease of prices Risk that IA amount is reduced; Unexpected lack of market liquidity Linked to the commercialization of the intangible asset 8

9 SCRintangible = 0.8 IA IA = Value of Intangible Assets recognized by the Undertaking Recognized IA Future benefits to the Company are probable Cost of assets is measurable Requires evidence of exchange transactions for same or similar assets to value Goodwill has a zero economic value, thus we are talking about other Intangible Assets (see definition given in specifications Page 11) Equity / Stock prices Interest Rates Risk Spreads Property Values Foreign Exchange Illiquidity Premium Concentration Risk is also part of Market Risk 18 9

10 Participation: ownership, directly or by control, of 20% or more of the voting rights or capital of an undertaking Nature of participation Financial and credit institutions Participation excluded from scope of group supervision Participation in (re) insurance undertaking Other strategic related undertakings Other related undertakings (not included above) Treatment Deducted from own funds 100% market risk charge Standard equity charge for nonstrategic 22% adjusted equity charge for strategic 22% adjusted equity charge Standard equity charge (i.e. 30% for EEA/OECD listed, 40% for other) Separate Calculation for: (a) participations as defined in Article 92(2) of Directive 2009/138/EC in financial and credit institutions (subjected to zero market risk and carrying no value in Own Funds), (b) participations in related undertakings: (i) excluded from the scope of the group supervision under Article 214 (a) of Directive 2009/138/EC; or (ii) deducted from the own funds eligible for the group solvency in accordance with Article 229 of Directive 2009/138/EC; (c) other assets and liabilities. Equity holding in excess of 20% (Participation) in a related undertaking (falling under (b) above) carries no specific risk capital charge). Impacts Own Funds (deducted from Own Funds) 10

Introduction of Illiquidity Premium Two Correlation tables Linked to Interest Rate Scenario One UP and one DOWN scenario Scenario Based Calculations Market Risk consists of 7 different sub risks For

11 Introduction of Illiquidity Premium Two Correlation tables Linked to Interest Rate Scenario One UP and one DOWN scenario Scenario Based Calculations Market Risk consists of 7 different sub risks For each sub risk a separate solvency charge (solvency capital) calculation is performed Total market Risk Solvency Capital is produced from the separate sub risks after they are subjected to Correlation Matrix treatment SCR mkt = SCR i Diversification Benefit 22 11

For each risk sub-module, need to calculate capital charge both gross and net of loss absorbing effect of discretionary benefits Risk exposure of collective investment schemes should be allocated to

12 For each risk sub-module, need to calculate capital charge both gross and net of loss absorbing effect of discretionary benefits Risk exposure of collective investment schemes should be allocated to sub-modules on a look-through basis Risk of loss caused my movements in the level and volatility of interest rates Affects Assets and Liabilities whose NAV is sensitive to changes in the level of Interest rates (Interest Rate Volatility) Interest Sensitive Assets Fixed Income Investments (Bonds) Loan Capital (Financial Instruments) Policy Loans Interest Rate Derivatives Term Deposits Insurance Assets Liabilities Sensitive to Interest Rate Volatility Most Life Reserves (especially those with embedded options and guarantees) Non Life reserves calculated as Discounted Cash Flows Loans 12

Necessary Data Current Market Value of interest sensitive assets Coupons / Deposit rates Maturity date Maturity Value Liability Data (Policy Details and Assumptions) 25 Determine Δ NAV, the change in

13 Necessary Data Current Market Value of interest sensitive assets Coupons / Deposit rates Maturity date Maturity Value Liability Data (Policy Details and Assumptions) 25 Determine Δ NAV, the change in the value of assets and liabilities sensitive to this particular type of risk based on a particular scenario (shock) in the Term Structure of Interest Rates Different Shocks are applied to different maturities Both Assets and Liabilities are revalued 26 13

14 Under QIS 5: Δ NAV = Max {shock = % ; shock = %} where Max denotes worst result for the Company Δ NAV = (Assets - Revised Assets) (Liabilities - Revised Liabilities) How does the Shock lead to revised Assets and Liabilities? Assume 1 year interest rate of 4%. Assume upwards stress (UP Shock) of 40% Calculated Stressed Interest Rate (UP) = 5.56% {4 X (1.40)} Revalue all interest sensitive Assets and Liabilities using 5.56% as the 1 year interest rate. 27 Absolute change in the level of interest rates in a downwards scenario at least 1% If the unstressed rate happens to be < 1%, then the shocked rate becomes 0% Two correlation tables for Market Risk linked to Interest Rate Scenario Up Down 14

15 (α) Necessary Data Value of stock as at valuation date Location of stock market in which stock is listed (ΕΕΑ or Global) This will give the relevant Index to use Unlisted or listed in an emerging market 29 (β) Calculating SCR eq Determine Δ NAV, the change in the value of assets and liabilities sensitive to this particular type of risk based on a particular scenario (shock) in the Equities Market Different Shocks are applied to different markets (currently Local and Global Index). Δ NAV based on equity shock by Index Both Assets and Liabilities are revalued (where applicable) Calculate SCR eq through Correlation Matrix for the Indices 30 15

16 (β) Calculating SCR eq Under QIS 5: Δ NAV = f {Shock Index1 = -30% ; Shock Index2 = -40%} Index 2 Assets Invested outside Index 1 areas Index 1 Assets - Europe, USA, Japan and other developed markets (EEA and OECD countries) Only DOWN shocks Note: QIS5 introduces lower shock for strategic participations (22%) Correlation Matrix Index 1 100% Index 1 Index 2 Index 2 75% 100% 31 Risk of loss from movements in the value of property holdings of the Company (α) Necessary Data Property Type (posible future improvement) Geographical location (possible future improvement) Property Value (β) Calculating SCR prop Δ NAV = Shock -25% (QIS5) 32 16

(α) Necessary Data External rating of non government bonds (government bonds are excluded from this sub - module) Modified Duration of non government bonds Market Value of non government bonds Bank

17 (α) Necessary Data External rating of non government bonds (government bonds are excluded from this sub - module) Modified Duration of non government bonds Market Value of non government bonds Bank Deposits (Term Deposits that are not considered cash) 33 SCR sp = MV i X Mod Dur i X Risk Factor i i MV i ModDur i Risk Factor i Market Value of Bond Modified Duration of Bond Risk Capital Charge based on bond rating 34 17

Applicability Assets considered in Equity Risk sub module Assets considered in Spread Risk sub module Assets considered in Property Risk sub module (special case and treatment) 35 Exposures, subject

18 Applicability Assets considered in Equity Risk sub module Assets considered in Spread Risk sub module Assets considered in Property Risk sub module (special case and treatment) 35 Exposures, subject to Concentration Risk, belonging to the same Group are treated as One Assets covered under Counterparty Default Risk are excluded Participations in insurance or reinsurance undertakings subject to Solvency II Directive carry no Concentration Risk Charge Example Cash Held at bank are addressed in CPD risk and are excluded from Concentration Risk Any other concentration in Bank Assets is reflected here (including Term deposits covered under Spread Risk) 18

19 (XSi) Excess Exposure = The proportion that a Single Exposure to a Counterparty carries to the total assets in excess of the Concentration Threshold for the Counterparty XS i XS i = Max {E i /Assets xl CT ; 0} E i Exposure in Counterparty CT Counterparty Threshold Limit = f (rating) Aggregation assumes independence Mkt conc = i Conc 2 i Individual concentration charges Conc i = Assets xl * XS i * g i + ΔLiab ul Treatment of unrated insurance companies based on solvency status 19

20 a. Assets held for life contracts where investment risk borne by the policyholders; b. Assets covered in the counterparty default risk module c. Exposures to a counterparty belonging to the same group (as defined in Article 212 of Directive 2009/138/EC), provided that the following conditions are met: Counterparty is an insurance or reinsurance undertaking or a financial holding company, asset management company or ancillary services undertaking subject to appropriate prudential requirements; Counterparty included in same consolidation as the undertaking on a full basis; No material practical or legal impediment (current or foreseen) to the prompt transfer of own funds or repayment of liabilities from the counterparty to the undertaking Note: There is no Risk Capital Charge for Participation satisfying requirements under {c} above Government Bonds EEA government bonds have no risk capital charge Non-EEA government (lower than AAA-AA): g i based on credit quality Term Deposits (falling under Concentration Risk module) Can be exempted to the extent their full value is covered by an EEA government Guarantee is applicable unconditionally to the undertaking No double-counting of such guarantee with any other element of the SCR calculation. Property If Single Property exposure > 10% of Assets xl : 12% shock to exposure CT of Mortgage\Public sector covered bonds = 15% 20

21 Necessary Data Counterparty Rating of Counterparty Exposure Amount 41 Calculating SCR cnt The maximum allowed exposure (Concentration Threshold = CT) and the solvency capital charge for exposure in excess of the maximum are both a function of the rating of the Counterparty Asset Rating Indicative Rating Maximum Free Exposure Risk Charge on Excess Very strong or extremely strong AA - AAA 3% (5% in QIS4) 12% Strong A 3% (5% in QIS4) 21% Adequate BBB 1.5% (3% in QIS4) 27% Speculative or lower BB or Lower 1.5% (3% in QIS4) 73% Percentages applied on Assets xl (as defined before) 42 21

22 Asset Description Rating Asset Value % of Total Bonds Bank Omega Strong - A % Stock Company Zeta Adequate - BBB 150 5% Building n/a % Other Fixed Assets n/a % Current Account Bank B Strong - A % Other Assets n/a % Total % Asset Rating Max Free Exposure Excess Exposure Risk Charge Risk Capital Omega Strong 90 (3%) % Zeta Adequate 45(1.5%) % Building n/a 300 (10%) % Current a/c Strong - A 90 (3%) % Total If rated counterparties drop to BB, risk capital charge increases to Risk of loss caused by the movement in the value of other currencies to that of the currency used by the Company (α) Necessary Data Value of Assets and / or liabilities by currency (β) Calculating SCR fx Δ NAV = Max {Up shock; Down shock} Shock Levels 25% QIS5 (20% QIS4) 44 22

23 New market risk sub - module Illiquidity Premium Definition Increase in the discount rate applied in the calculation of the present value of future payments under certain long-term insurance contracts Illiquidity premium is designed to reduce the value of certain insurance liabilities (most obviously, annuities). Illiquidity Premium Issues Approach divides the spectrum of illiquidity into a series of buckets Illiquidity premium is scaled to each bucket based on its degree of illiquidity The illiquidity premium shock is the immediate effect on the net value of asset and liabilities expected in the event of a 65% fall in the value of the illiquidity premium observed in the financial markets Uncertain whether will end up as part of final Solvency II Applicable to all components of Market Risk Mkt ip = max {ΔTP illiquidity premium shock; 0} ΔTP = Change in the level of Technical Provisions caused by a change in the discount rates due to the illiquidity Premium shock Illiquidity Bucket Liability Characteristics 100% Contract exposed to longevity and expense risk only Contract has no surrender risk All contractual premiums have already been paid 75% Contracts with profit participation 50% All other business 23

Total Market Risk calculated after considering the correlation effects between the various market risk components as per the Market Risk Correlation Matrix Under QIS5 there are two correlation tables

24 Total Market Risk calculated after considering the correlation effects between the various market risk components as per the Market Risk Correlation Matrix Under QIS5 there are two correlation tables one for Up and one for Down Interest Rate stress tests). One producing highest SCR is yielding the SCR to use. SCRmkt = SCRi Diversification Benefit Upwards Scenario Int Eq Prop Sp Cur Conc Illiq Int 1 Eq 0 1 Pro Sp Cur Con Illiq Downwards Scenario Int Eq Prop Sp Cur Conc Illiq Int 1 Eq Pro Sp Cur Con Illiq Andreas Stylianou, KPMG Demetris Demetriou, Quantum Actuaries Marios Schizas, Quantum Actuaries For their useful comments, suggestions and review of the contents of this presentation. 24

25 Any Questions? Any Comments? 25

Introduction to Solvency II SCR Standard Formula for Market Risk. Erik Thoren 11 June 2015

Introduction to Solvency II SCR Standard Formula for Market Risk Erik Thoren 11 June 2015 Agenda Introduction to Solvency II Market risk module Asset allocation considerations Page 2 Introduction to Solvency