QIS5 planning. 26 August 2010 Page 2

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1 Disclaimer Please note that those slides are not part of the formal QIS5 documentation as issued by the European Commission. They are not intended to, and do not, replace the QIS5 Technical Specifications or any other part of the QIS5 documentation. They do not supersede the European Commission documentation. The seminar relied to a large extent on the QIS5 technical specifications, QIS5 spreadsheet, qualitative questionnaires as well as simplifications and helper tabs. Answers to questions raised of European relevance will be integrated in the Q and A document August 2010 Page 1

2 QIS5 planning 26 August 2010 Page 2

3 QIS5 - objectives Will require a high level of participation of solo undertakings and groups The main issues are The calibration of the standard formula Groups calculations Internal model Complexity But also to foster preparedness of industry and supervisors CEIOPS is committed to ensuring the success of QIS5 26 August 2010 Page 3

4 QIS5 versus QIS4 26 August 2010 Page 4

5 Aligning technical specification with level 2 implementing measures CEIOPS Design: ensure the inherent consistency of the proposals Quality: ensure that the proposals provide the appropriate level of financial soundness For example, what is the use of discussing the level of the capital requirements if these requirements are not supported by sufficient quality of capital? Calibration: regular review transparency and credibility of the process 26 August 2010 Page 5

6 Preparing and running QIS5 26 August 2010 Page 6

7 QIS 5 - timeline March CEIOPS provides draft technical specifications to EC 2010 July 2010 EC/EIOPC provide final technical specifications to CEIOPS August Nov QIS 5 exercise End of October for solo entities Mid November for Groups (analysis to be performed in a centralised database) April 2011 QIS 5 Report August 2010 Page 7

8 Pre-test and spreadsheets Aim of the pre-test is to debug the spreadsheets (highly involved but limited number of participants ideally) Pre-test spreadsheets can not be used to submit final results 6 Jul 12 Jul 19 Jul 26 Jul 2 Aug 9 Aug 16 Aug 23 Aug 30 Aug Publication of final technical specifications by EC Pre-test solo spreadsheets Solo+group spreadsheets available 26 August 2010 Page 8

9 Centralised databases Group centralised database Purpose: analysis of QIS 5 group results Non anonymised or anonymised To lead supervisor and then to CEIOPS / To lead supervisor and CEIOPS at the same time Calibration centralised database Purpose: refine non life and health underwriting calibration based on QIS 5 solo results Via solo supervisors Crypted containers and accessed using On-The-Fly-Encryption technology to ensure that the sensitive content will be never stored in a non-crypted form. 26 August 2010 Page 9

10 Spreadsheets and technical specifications but also CEIOPS Simplification Helper tabs QIS5 for beginner guide National guidance Centralised databases Q and A Training Qualitative questionnaires 26 August 2010 Page 10

11 Simplifications and helper tabs 26 August 2010 Page 11

12 National guidance 26 August 2010 Page 12

13 Q and A Escalation process at EEA level: if national supervisors can not answer the question Content of the specifications: started on 6 July EC included in the red flag procedure before the publication Spreadsheets: started on 23 August 26 August 2010 Page 13

14 Trainings CEIOPS seminars European workshops Sharing experience National initiatives from supervisors and trade associations 26 August 2010 Page 14

15 Qualitative questionnaires All undertakings Internal model users Group users 26 August 2010 Page 15

16 After QIS5 Further impact assessment based on data collected for fine tuning L2 and developing L3 process to be agreed in the November MM If needed, short and restricted QIS6 Implementation of Solvency 2!!! 26 August 2010 Page 16

17 To conclude QIS5 is crucial to test the system Therefore important not to make approximations (feasibility) To assess the impact QIS5 results will be use also to assess the needs and contents of L3 guidance linked to pillar 1 QIS5 is a major step in the preparedness to Solvency 2 26 August 2010 Page 17

18 Valuation of assets and other liabilities 26 August 2010 Page 18

19 The balance sheet Starting position for QIS5! Economic valuation 26 August 2010 Page 19

20 Valuation approach Economic, market consistent approach No subsequent adjustment for own credit risk IFRS as a proxy Only if reflects economic value! Materiality applies Valuation hierarchy Requirements for the valuation process 26 August 2010 Page 20

21 Guidance IFRS-SII adjustments (assets) Goodwill Other intangible assets Property, plant and equipment Inventories Finance leases Investment property Participations in subsidiaries, associates and joint ventures Financial assets Non-current assets held for sale or discontinued operation Deferred tax assets Current tax assets Cash and cash equivalents 26 August 2010 Page 21

22 Guidance IFRS-SII adjustments (liabilities) Provisions Financial liabilities Contingent liabilities Deferred tax liabilities Current tax liabilities Employee benefits and termination benefits 26 August 2010 Page 22

23 Market risk for non with profit business 26 August 2010 Page 23

24 Agenda Market risk in QIS 5 Look-through approach Market risk sub-modules Focus on spread risk 26 August 2010 Page 24

25 Market risk in QIS 5 Similar modular structure to QIS 4 but : One extra sub-module Calibrations adapted Some more detailed structural changes Scenario-based approach 26 August 2010 Page 25

26 Market risk in QIS 5 Correlation matrix New correlation parameters Up/Down correlation matrix 26 August 2010 Page 26

27 Look-through approach Substance over form principle => Economic substance rather than legal form of the investment determines its treatment Assets underlying collective investment vehicles/funds must be examined and would be subjected to the relevant sub-modules. Look-through approach required while risks are material 26 August 2010 Page 27

28 Equity 39% Global and 49% Other Symmetric ajustment : -9% in QIS 5 0,75 correlation between Global and Other Participations Strategic Financial and credit institutions Excluded from the scope of the group Duration dampener (article 304 of the Directive) 26 August 2010 Page 28

29 Interest rate Scenario-based approach Shocks applied to the risk free term structures (not to the illiquidity premium) Upward stress and downward stress for each maturity (SCR.5.21) Two sets of correlation 26 August 2010 Page 29

30 Property Scenario-based approach 25% charge Look-through approach for collective real estate vehicles Taking in account of gearing 26 August 2010 Page 30

31 Currency Worst of -/+25% charge for all foreign currency holdings Erratum of the EC for this submodule Lower for several currencies pegged to the euro : 26 August 2010 Page 31

32 Concentration Calculation per exposure: Exposures of the same group are not independent Charge depends on the rating Aggregation with zero correlation Special treatments: Sovereign bonds Covered bonds Property Participations Helper tab for this sub-module 26 August 2010 Page 32

33 Liquidity premium New sub-module Capture the illiquidity premium risk (increase of the value of TP due to a decrease of in the illiquidity premium) 65% fall in the value of the illiquidity premium Negatively correlated with spread risk 26 August 2010 Page 33

34 Focus on spread risk Scenario-based approach Separate treatment for: Bonds Structured products Credit derivatives Helper tab for this submodule Link with counterparty default risk 26 August 2010 Page 34

35 Focus on spread risk - Bonds Simplification: factor-based approach Special treatment for: Covered bonds Sovereign and supranational debts 26 August 2010 Page 35

36 Focus on spread risk Structured products Two scenarios: direct spread shock (level of the shock depends on the rating class and the duration of the credit exposure) shock on underlying assets Scenario-based approach => 0 < Shock < 100% of MV 26 August 2010 Page 36

37 Focus on spread risk Credit derivatives Scenario-based approach Only credit derivatives which are not part of undertaking s risk mitigation policy Upward shock (in absolute terms) and downward shock (in relative terms) 26 August 2010 Page 37

38 SCR- non life underwriting risk 26 August 2010 Page 38

39 Index Non life underwriting risk module General principles Catastrophe risk - natural cat scenarios (regional) - man made scenarios - factor based method Undertaking specific parameters Counterparty default risk Technical specification, the spreadsheet, the qualitative questionnaires, helper tabs New in QIS 5, from QIS 4 26 August 2010 Page 39

40 Non life underwriting risk general principles CEIOPS Premium and reserve risk- factor based approach: volume of the business * volatility News about premium & reserve risks Geographical diversification Adjustment for non-proportional reinsurance (premium risk) New factor in premium volume measure for existing contracts expected to be earned after the following year New lapse submodule New structure of cat risk 26 August 2010 Page 40

41 Non life underwriting risk cat risk new structure CEIOPS Method 1 (default one) regional scenarios for nat cat & man made, scenarios for perils/event (not LoB), brutto calculation nat cat & man made capital requirements aggregated (independency) Method 2 factor based approach if method 1 can not be applied and PIM is not appropriate outside EEA for miscellaneous LoB for non-proportional reinsurance Own reinsurances programme Aggregation of methods 1 & 2 (independency) 26 August 2010 Page 41

42 Non life underwriting risk cat risk method 1 nat cat CEIOPS Perils: windstorm flood earthquake hail subsidence Capital requirement is calculated for each peril and country separately, aggregation at first by countries then by perils For each zone (cresta, post-code) undertaking s exposure are required (total insured value) for each LoB affected by the peril (LoBs given in TS, for flood: Fire & other damages, MAT & MPD) 26 August 2010 Page 42

43 Non life underwriting risk cat risk method 1 nat cat CEIOPS Flood: WTIV = F * TIV ZONE ZONE ZONE CAT Flood _ ctry = QCTRY AGGr, c * WTIVZONE, r * WTIVZONE, where CAT flood_ctry capital requirement for flood and the country Q ctry factor for the country F ZONE factors for the zones rxc AGG r,c aggregation matrix for the country between the zones TIV ZONE exposure (total insured value) for each zone Multiple events: subsequent losses for windstorm, flood and hail capital requirement calculated as maximum from A and B type events A one large event and additionally one smaller event (for flood 1 i 0,1) B two moderate events (for flood 0,65 i 0,45) c 26 August 2010 Page 43

44 Non life underwriting risk cat risk method 1 man made cat CEIOPS The same events for all undertakings no differentiation between countries or zones Events: fire motor marine, aviation liability credit & suretyship terrorism Aggregation capital requirements from above events with the independence assumption 26 August 2010 Page 44

45 Non life underwriting risk cat risk method 1 man made catexample for the fire CEIOPS Option 1 CAT Fire = P* x where P- sum insured of the largest known concentration of exposures under the fire & other damages LoB in a 150m radius x- proportion of damages caused by the scenarios (100%) 26 August 2010 Page 45

46 Non life underwriting risk cat risk method 1 man made catexample for the fire CEIOPS Option 2 (simplification) CAT Fire = Max LSR, SI x * Fx sub lines where SI sum insured by sub-line of business (residential, commercial and industrial) LSR single largest risk across all sub-lines Fx market wide factors for each sub line 26 August 2010 Page 46

47 Non life underwriting risk cat risk method 2 CEIOPS For each event (storm, flood, earthquake, hail the affected LoBs are given with the factors Capital requirement based on the estimation of gross written premium in the following year in the relevant LoBs Aggregation of events with the independency assumption, the exception of direct insurance and reinsurance for the same LoB 26 August 2010 Page 47

48 Undertaking specific parameters Hierarchy: simplifications => standard formula => standard formula with USPs => standard formula with PIM => full internal model The approach based on the credibility factor mix with the market factors longer history => higher weight 100% for 10/15 years 26 August 2010 Page 48

49 Undertaking specific parameters Parameters to replace: σ prem,lob, σ res,lob, - in non life risk module and NSLT health For σ prem,lob and σ res,lob, there are 3 methods method can be chosen but the choice must be justified in the future (anty - cherry picking) Assumption of the methods should be checked, quality of data in the future is subject to the supervisory approval 26 August 2010 Page 49

50 SCR - counterparty default risk 26 August 2010 Page 50

51 Counterparty default risk QIS4 approach (V-H): Inconsistent capital requirement Laborious, impracticable and cumbersome method of calculation Not fulfilled Vasicek distribution assumptions Inadequate (too high) capital requirement for the unrated counterparties New structure of the module: Rated exposures, small numbers of counterparties (type 1) Unrated exposures, many diversified counterparties (type 2) Aggregation of capital requirements of both types - with the small diversification effect (0,75) 26 August 2010 Page 51

52 Counterparty default risk Type 1 (rated, may not be diversified) reinsurance arrangements securitisations and derivatives any other risk mitigating contracts Type 2 (unrated, diversified) receivables from intermediaries policyholder debtors, including mortgage loans cash at bank N<=15 N>15 deposits with ceding institutions commitments received by the undertaking, called up but are unpaid 26 August 2010 Page 52

53 Counterparty default risk type 1 SCR def,1 - theory CEIOPS Probablility of default of the counterparty i: PD i = bi PD ( S) = b + (1 b ) S i i i τ, where b basic probability of default of the counterparty i S the amount of the shock, common for all counterparties with the probability distribution α, τ-parameters α Pr( S s) = s, 0 < s < 1, 26 August 2010 Page 53

54 Counterparty default risk type 1 SCR def,1 - method of calculation CEIOPS SCR def,1 min 3 V 5% = LGDi ;5 V else, i i if V LGD i where Input: N N = j= 1 k = 1 Given in the TS: V ω LGD LGD, ω = ω( PD jk j LGD i rating or solvency ratio PD j - depending on rating or solvency ratio, coefficients ω jk k jk j, PD k, τ α), 26 August 2010 Page 54

55 Counterparty default risk type 1 SCR def,1 - LGD method of calculation CEIOPS Cash at bank Deposits with ceding institutions Unpaid but called up capital Guaranties letters of credit, etc. => LGD = Value according to Valuation section of the TS 26 August 2010 Page 55

56 Counterparty default risk type 1 SCR def,1 - LGD method of calculation CEIOPS Reinsurance, securitization, derivative => LGD i = max ( * 50% ) ( Recoverables + RM Collateral );0), i i i Collateral = * ( 100% ) ( ) MktValue Collateral MktRisk Collateral RM = hypothetical SCR (without taking into account RM contracts) real SCR for underwriting and market risk real SCR for those risk * Different percent values 26 August 2010 Page 56

57 Counterparty default risk type 2 SCR def,2 - method of calculation CEIOPS Scenario approach with the shock equal to where 15%* E + 90%* Epast due, E- Sum of the values of type 2 exposures, except for receivables from intermediaries which are due for more than 3 months E_ past-due Sum of the values of receivables from intermediaries which are due for more than 3 months 26 August 2010 Page 57

58 Counterparty default risk Simplifications of RM calculation (conditions!) Derivatives, which affect in RM one submodule of market risk only market risk For reinsurance: calculate the difference in non-life risk for all reinsurance counterparties and allocate them as follows SCR hyp nl SCR without nl SCRhyp nl SCR without nl *Rec i /Rec total where Rec i are the reinsurance recoverables towards counterparty (i) and Rec total the overall reinsurance recoverables Calculation by subsets not every single counterparty Collateral =85 * % Market Value of collateral Qualitative questionnaire 26 August 2010 Page 58

59 QIS5 for Life Insurers 26 August 2010 Page 59

60 Areas Covered This Morning Technical Provisions Best Estimate Discounting and Liquidity Premium Contract Boundaries This Afternoon SCR and MCR Life modules Loss absorbing capacity of technical provisions Op Risk MCR 26 August 2010 Page 60

61 Structure CEIOPS Theory (briefly) Spreadsheet Helper tabs Questionnaire Questions and discussion 26 August 2010 Page 61

62 Best Estimate Probably the fundamental part of the Solvency II calculation Best Estimate: corresponds to the probability-weighted average of future cash-flows, taking into account the time value of money (Article 77(2)) No margins Market consistent 26 August 2010 Page 62

63 Discounting and Liquidity Premium Risk free rate Swaps 10 bps Provided by CEIOPS Liquidity Premium for all products Three buckets Liquidity premium transitional 26 August 2010 Page 63

64 Contract Boundaries Very important for EPIFP TP 2.15 Only include cash flows within contract boundary: Where insurer has unilateral right to: terminate contract reject premiums Where insurer has unlimited ability to: amend premiums or benefits in future Unlimited ability - economic perspective Includes future policies exercised under options / guarantees 26 August 2010 Page 64

65 Risk margin 26 August 2010 Page 65

66 Principles from the technical specifications CEIOPS Section V.2.5: TP.5.3: COC of providing eligible own funds at the level of the futurs SCR over the lifetime of the (re)insurance obligations TP.5.4: futurs SCR with minimal market risk. Includes: Underwriting risk Unavoidable market risk Credit risk (reinsurance and SPV) Operational risk Loss absorbing capacity of TP, no loss absorbing capacity of deferred taxes Same future management actions 26 August 2010 Page 66

67 General formula (TP.5.9) 26 August 2010 Page 67

68 Calculation Risk free: without illiquidity premium TP.5.16: Futurs basic SCR should be calculated using the relevant SCR modules and sub-modules TP.5.20 : The calculation should be calculated on a best effort basis TP.5.25 : Calculation per line of business Calculation as a whole Allocation to the lines of businesses Simplifications TP.5.28 to TP August 2010 Page 68

69 Hierarchy of simplifications (TP.5.31) Level 1: full calculation without using simplifications Level 2: Approximations at the level of (sub)-risks Level 3: Approximation at the level of the whole SCR for each futur SCR Level 4: Approximation at once all futurs SCR Level 5: Percentage of the best estimate 26 August 2010 Page 69

70 Life modules 99.5% VaR over one year Seven modules: Mortality Longevity Morbidity Revision Lapse Catastrophe Expense Simplifications and USP available 26 August 2010 Page 70

71 Loss absorbing capacity of technical provisions CEIOPS SCR can be reduced to take account of the loss absorbency of technical provisions Before stress Post-stress, no actions taken Post-stress, with impact of management actions and deferred taxes Own Funds Own Funds Own Funds Assets Liabs Assets Liabs Assets Liabs 26 August 2010 Page 71

72 Approach 1 - Modular Three-step process: 1. Calculate modules assuming no actions taken ( gross calculation) and aggregate into a gross SCR 2. Calculate modules assuming loss-absorbing management actions are taken ( net calculation) and aggregate into a net SCR 3. The difference between these leads to the SCR adjustment The adjustment for deferred taxes is based on the difference in deferred taxes under the gross and net SCRs 26 August 2010 Page 72

73 Approach 2 Equivalent Scenario 3-step process: 1. Calculate undiversified capital charges for each risk (either gross or net) 2. Find the diversified capital requirement 3. Allocate the diversification benefit back to each risk to find the single equivalent scenario This is done by using the relative weights of risks and correlations Adjusted SCR is then calculated by running the single equivalent scenario stresses Adjustment for deferred taxes is calculated by looking at the value of deferred taxes under the single equivalent scenario 26 August 2010 Page 73

74 Loss absorbing capacity of technical provisions CEIOPS Modular approach Simpler to understand More extensively tested in QIS4 But Requires two calculations for each relevant risk module May not fully capture the effects of possible double counting of loss absorbency Single equivalent scenario Avoids double counting of loss absorbency Fewer calculations required More realistic treatment of management actions Easier to incorporate deferred taxes But More complex to understand the methodology 26 August 2010 Page 74

75 Financial Hedging 26 August 2010 Page 75

76 Agenda Scope Conditions for using of risk mitigation techniques Financial Risk Mitigation Basis Risk Rolling hedging Credit derivatives 26 August 2010 Page 76

77 Scope Purchasing or issuing of financial instruments which transfer risk to the financial markets Examples: Put options to cover the risks of falls in assets Credit derivatives to cover the risk of failure (or downgrade) of a counterparty Currency swaps to cover currency risk 26 August 2010 Page 77

78 Conditions for using in QIS 5 Legal certainty, effectiveness and enforceability Liquidity and certainty of the value Direct, explicit, irrevocable and unconditional features No double counting of mitigation effects Credit quality of the counterparty : at least BBB 26 August 2010 Page 78

79 Financial risk mitigation Basis risk Matching between underlying assets or references of the financial mitigation instrument and undertaking exposures is required When matching is not perfect, financial risk mitigation technique should be accepted in QIS 5 if: Correlation between hedged assets and assets underlying the derivatives is nearby 1 Correlation between hegded name and names referring to CDS is nearby 1 26 August 2010 Page 79

80 Financial risk mitigation Rolling hedging Pro rata temporis used for risk mitigation techniques which cover only a part of the next year Dynamic hedging : not a risk mitigation technique in QIS 5 Rolling hedge programme can be accepted under conditions => Taking into account of all the risks that can arise from the rolling over of the hedge 26 August 2010 Page 80

81 Financial risk mitigation Credit derivatives Applied procedures for the using of credit derivatives required Following credit events must be covered: Failure to pay the amounts due Bankruptcy or insolvency of the obligor Restructuring of the underlying obligation Mismatch between the underlying obligation and the reference obligation allowed if: Reference obligation is junior to the underlying obligation And same obligor shared 26 August 2010 Page 81

82 Operational Risk Straight forward factor based approach No diversification benefits 26 August 2010 Page 82

83 MCR Approximately 85% VaR over 1 year Straight forward factor based approach Subject to a window And to an absolute minimum 26 August 2010 Page 83

84 Main points to check when finalising solo undertakings submission 26 August 2010 Page 84

85 Elements Core spreadsheets.xls Participants tab!!!!!! (currency, internal model, ) Check all tabs are complete and right Use the overview tab and checks (true/false) that are in the spreadsheets) E.g. Balanced BS! Qualitative questionnaire Solo or group! -.doc Excel file (solo or group, information on transitional for own funds, internal models if relevant).xls Internal model if relevant.doc Additional request for refining calibration of non life and Health non SLT underwriting risks.xls Simplification and helper tabs.xls if asked by national supervisors or considered useful for the understanding of the results 26 August 2010 Page 85

86 Key points for solo undertakings Liquidity premium Transitional on discount rate Risk margin Equivalent scenario versus modular approach Internal model results Expected profits in future premiums Transitional on own funds 26 August 2010 Page 86

87 Post submission Be ready to answer questions from your supervisors! It will help improve quality of results and avoid misunderstandings 26 August 2010 Page 87

88 Thank you 26 August 2010 Page 88