Solvency II reporting: The three pillars

Solvency II reporting: The three pillars October 2012 For INSITUTIONAL AND PROFESSIONAL CLIENTS only not for Retail use or distribution.

3 Solvency II reporting: The three pillars

Solvency II reporting: The three pillars 3 Solvency II reporting: The three pillars With the rapidly approaching implementation of Solvency II, the focus of insurance companies investment teams is shifting from the much talked about financial impact of the regulation to the often ignored disclosure requirements. This paper discusses the reporting challenges viewed through the lens of the chief investment officer (CIO) and investment manager. Solvency II reporting means: Increased demand for investment data and governance Reassessment of current investment strategies and structures Need for an integrated operational framework between the asset management, insurance risk capital, actuarial and finance departments

4 Solvency II reporting: The three pillars Solvency II and the three pillars Solvency II is the new prudential regulatory framework being introduced in the European Union (EU). The measures will overhaul risk and capital management practices within the insurance industry, with the aim of harmonising the EU regulatory environment. Exhibit 1 Solvency II is designed around three pillars Pillar I Financial resources n Evaluation of the technical provisions, available capital, valuation of the assets and calculation of the minimum capital requirements (MCR) and the solvency capital requirements (SCR). n The MCR is the minimum capital an insurer needs to operate; calibrated to 1-year, 85% value at risk (VaR). n The SCR is the target level of capital to cover unexpected losses; calibrated to 1-year, 99.5% VaR. Pillar II System of governance n Defines governance requirements for risk management, internal controls, audit, outsourcing. n Allows regulator to impose additional capital requirements, depending on the assessment of a company s risk management and corporate governance, and whether the Pillar 1 measures adequately reflect the risk profile. Pillar III Public and regulatory disclosure n Information requirements for reporting to supervisors and public disclosure. n The so-called quantitative reporting template (QRT) will include: capital position, high level financials, assets, liabilities, revenue/expenses, business analysis, claims experience, reinsurance. n A subset of these items has to be reported to the supervisor on a quarterly basis. CIOs and investment managers should be aware that there are investment data requirements for all three pillars. In this paper, we define investment reporting within a wider context of the disclosure of investment asset data. Our definition goes beyond information transfer between insurer and regulator to include investment information processed from asset managers (internal or external), actuarial teams, enterprise risk management teams, data vendors and other third party investment accountants or administrators (see Exhibit 2). Until now, it has been reasonable for investment teams to operate with some degree of independence from other departments. Investment teams traditionally have the objective of ensuring that the insurance company can generate a reasonable return on its investments to meet its short-, medium- and long-term objectives within a predefined risk budget. Transparency of investment data for regulatory purposes and measurement of risk capital has not been a primary responsibility of the investment function, with most insurers relying on investment accountants for investment data aggregation and reporting. Under Solvency II there is a greater requirement for investment teams to have a closer understanding of regulatory investment risk. Further, failure to provide full investment risk disclosure could result in more severe implications resulting from the inability to provide detailed, consistent and continuous transparency of investments.

Solvency II reporting: The three pillars 5 Solvency II is extending the network of investment data flows Exhibit 2 Data requirements for all three pillars Asset management, investment accountant, third party administrator, economic scenario generator, data vendors Pillar I Data requirements are granular n Investment data wherever possible should be at security level. n No regulatory prescribed format. Pillar II Data requirements are continuous n Investment data here goes beyond Pillar 1 and could be required to ensure a more continuous track of investment risk exposure to the business. Pillar III Data requirements are comprehensive n Investment data needs to be reported by non standard instrument classifications. MCR / SCR ORSA QRT Solvency II regulatory reporting (Private and public disclosure) n Investment data must be consistent across all three pillars n Output from Pillar 1 (SCR and MCR) is reported in Pillar 3 n Output from Pillar 2 (ORSA) is partly reported in Pillar 3 Pillar 1 Measures investment risk SCR and MCR. The key data challenge here is the level of granularity needed to measure investment risk capital. Pillar 2 Investment data flow under this pillar provides an assurance that the insurance company is considering additional investment risk exposure on both assets and liabilities, beyond that accounted for under Pillar 1. There is also a suggestion of continuous risk capital monitoring. The output of Pillar 2 is a process and control report known as the Own Risk Solvency Assessment (ORSA). Pillar 3 Is the public and regulatory disclosure pillar, under which a predefined set of templates needed to be populated. These are the QRTs, which outline a set of data requirements including investment data. Disclosure under this pillar also includes information from Pillar 1 and 2 and therefore information flow between pillars needs to be consistent.

6 Solvency II reporting: The three pillars Solvency II data challenges to the investment process Solvency II introduces three core challenges to the CIO Increased data granularity: Wherever possible a full look-through must be performed; however, depending on the structure of the investment vehicle, this may be impracticable. Look-through is also required on unit-linked funds, although risk capital is not required to be held against this. Increased reporting frequency: Quarterly reporting is new for most EU member states, where regulatory reporting ranges widely from annually to triennially in some regions. ORSA introduces increased vigilance on the risk capital of insurance companies on an ongoing basis. Additional security classifications: Securities need to be classified more precisely under Solvency II. The traditional security classifications common to investment teams may not be permissible for regulatory disclosure. Security classification is via complementary identification code (CIC) and nomenclature generale des activites economiques dans les communautes europeennes (NACE) referencing. Pillar 1: Granular data requirements Under Pillar 1, the measurement of investment risk capital is the market risk SCR. The calculation is dependent on a range of inputs, and actuaries will be looking for detailed, accurate asset data and quantifiable credit and liquidity risk metrics. In order to generate this measurement, securitylevel holdings data is required from investment teams 1 ; however, there is no official data template between investment manager and insurance company for Pillar 1 purposes. The onus is on the insurer to source the necessary investment information accurately and on time. This introduces further considerations for external managers who may experience multiple insurers sending bespoke Pillar 1 data requests at varied levels of detail. Unfortunately, not all asset managers are well equipped to provide the level of detail required for a full look-through on investment risk SCR. The consequence of not providing full transparency under Pillar 1 for SCR calculations is a punitive risk capital charge of 49% ('other equity'). The challenge of Pillar 1 that arises as a result of the lack of a standard data template has been addressed by the European Insurance and Occupational Authority (EIOPA) in the June 2012 preconsultation paper on look-through 2. The proposals are encouraging as they suggest alternative methods for Pillar 1 look-through subject to the materiality of investments. Insurers that hold direct segregated investments are not in scope because, by default, such insurers have access to all investment information; however, insurers that invest in pooled investment vehicles would now be able to measure their SCR from aggregated holdings information 3. This, however, is subject to the prudent person principle. 4 1 Look-through approach: Treatment of investment funds and indirect exposure: see Article 144 MR3, (Art. 105 of Directive 2009/138/EC) The SCR shall be calculated on each of the underlying assets of collective investment vehicles and other investments packaged as funds. 2 Look-through ITS 22 June 2012. 3 Where a full look-through cannot be applied and a collective investment scheme strictly follows a mandate, reference shall be made to the investment mandate of the scheme, provided the fund manager can confirm the composition of the fund at the level of granularity required for the SCR calculation at the valuation date. 4 Prudent person principle is not yet explicitly defined under Solvency II. However it is expected to be a legal maxim restricting the discretion of an insurance company to that a prudent management team seeking business continuity, reasonable income and preservation of capital might make in the management of their insurance book of business.

Solvency II reporting: The three pillars 7 Aggregate data for Pillar 1 purposes is achievable by considering what information is required for each investment risk sub module. Asset managers might be inclined to adapt standard data aggregation formats for Pillar 1 purposes. Insurers must therefore ensure that asset managers can provide sufficient granularity through an aggregate approach. Exhibit 3 shows a sample of aggregate data that asset managers can provide to their insurers to help with Pillar 1 calibrations of collective investment schemes. Exhibit 3 Sample Pillar 1 aggregation methodology Investment risk sub-module Description Sample Pillar 1 aggregation Interest rate Up / Down shift in interest rates Effective duration, risk free curve, currency Equity Downward shift in equity prices Geographical location (OECD* / Non OECD) Property Downward shift in property prices Property exposure Spread Credit spread widening Duration, rating, bond type, local or external currency issue Currency Up / down shifts in exchange rates Currency exposure Concentration Dependent on single name exposure Market cap, sector, security type, country Counter cyclical premium Additional details expected * Organisation for economic co-operation and development Pillar 2 Integrated operational framework Pillar 2 is driven by the ORSA process which is a central component of Solvency II. The ORSA is an entity s economic view of the capital required to run its business, irrespective of the requirements set by the regulator, such as an economic capital framework. In addition to holding sufficient funds to meet the SCR, insurers must assess the adequacy of the capital position relative to their own risk profile, hold the funds appropriate to that profile and monitor it on a continuous basis. It is not a compliance exercise, but a process that gives real insight into the risks a firm faces. It is expected to be an ex-ante risk assessment linked to decision making, and so decisions using the ORSA should be based on reliable and relevant information. The ORSA brings together the risk management, capital management, strategic thinking, actuarial and finance departments. As a result, it is an important cultural element of insurers activities and should ensure that all parts of the entity work together effectively it should be impossible to have a sound ORSA process without cooperation across different parts of an insurer s business.

8 Solvency II reporting: The three pillars The ORSA is not all about capital it needs to include other risk management and mitigation techniques that have been used, particularly for non-quantifiable risks. Where a firm places reliance on a risk mitigation technique it should also assess the effectiveness of the technique and any secondary risks associated with it, in the same way as it assesses any other risk in the ORSA. The disclosure required for the ORSA will vary from insurer to insurer and, depending on the insurer s risk perception, could be over and above that required for Pillars 1 and 3. For example, data could be more granular and more frequent for the ORSA. Ad hoc data in abnormal circumstances 5, such as a crisis, is also expected by the regulator as part of a thorough risk management framework. The key challenges here are that, first, the trigger events are nonstandard, and second, the expected data quality for ad hoc information is the same as for other Solvency II data. While insurers are actively developing a framework for regular regulatory reporting and risk capital measurement, it is important that sufficient consideration is given to developing a reporting framework for unscheduled investment data requests that meets the ORSA requirements of Pillar 2. Pillar 3: Regulatory and public disclosure Currently, insurance reporting to regulators differs significantly across EU member states in terms of the detail of reporting and how often regulators require information (see Exhibit 4). Solvency II is changing this by introducing a standard reporting requirement for all insurers operating in Europe (see Exhibit 5). Investment teams across Europe need to be aware of the reporting changes and how they affect investment activity. Although Solvency II introduces a uniform burden of disclosure to all member states the extent of change differs significantly across member states, with some regions having to adapt to more drastic change than others. Exhibit 4 Current standard reporting Current Report Local regulatory report Description Significantly different across Europe in terms of disclosure, extend, type and time Demands for investment data are predominantly driven by the Pillar 3 public and regulatory disclosure requirements. 5 Solvency II consultation paper 56: in abnormal circumstances, especially in a crisis, it might be essential for both the undertaking and supervisory authorities that updates of data used in the calculation of the probability distribution forecast be performed at shorter notice and more frequently by the undertaking.

Solvency II reporting: The three pillars 9 Exhibit 5 Solvency II reporting changes the future of insurance reporting Solvency II report Name Submission Disclosure SFCR Solvency and Financial Condition Report Annually, 14-20 weeks after financial year Public disclosure Future RSR QRT Annual Regular Supervisory Report Quantitative Reporting Template Full report at least every three years; Material updates annually Annually, 14-20 weeks after financial year Private disclosure Private Full disclosure in RSR Public Partial disclosure in SFCR QRT Quarterly Quantitative Reporting Template Quarterly, 5-8 weeks after quarter end Private Full disclosure in RSR Public Partial disclosure in SFCR ORSA Own Risk and Solvency Assessment Regularly (at least annually), 2 weeks after completing the assessment Private disclosure Pillar 3 disclosure requirements cover all balance sheet items, including investments and technical provisions, off balance sheet items such as guarantees and commitments, and the solvency position. In the following paragraphs, we focus on the investment disclosure requirements. Insurers are required to prepare quantitative disclosures as part of the SFCR, RSR and ORSA. Qualitative information that needs to be included in these reports relates to: n performance of investment activities, comprising definition of investment performance, investment income and expenses, structured products and risk management procedures, and projections of the expected investment performance; n the basis, method and assumptions for the valuation of investments; and n prudent person principle. As part of the SFCR and RSR reports, insurers are required to prepare quantitative disclosures. The QRT prescribes a standardised format for the quantitative data and key data definitions (see Exhibit 6).

10 Solvency II reporting: The three pillars Exhibit 6 Asset templates within the QRTs relating to investment data Template Description Annual Quarterly Comments D1 Portfolio list D1Q Quarterly rolled up portfolio list D1S Structured products D2O Derivatives open positions Aggregated portfolio data excluding derivatives, requires eg average historical cost, CIC, credit rating and fair value information. Same fields as D1 rolled up. List of structured products such as asset-backed securities, collateralised debt obligations etc above an application threshold, more than 5% of total investments. Data required: capital protection, collateral, asset returns, loss given default and attachment and detachment point. Detailed list of derivative contracts once in relation to each portfolio both those are open and closed at reporting period. Data required: counterparty ID, credit ratings, delta, trigger value, unwind trigger, swaps inflows and outflows. D2T Derivatives closed positions see D20 D3 Return on investment assets Investment performance data by asset categories (based on CIC table). D4 Investment funds, look-through Look-through application on investment funds. D5 Security lending and repos Exposures to repurchase agreements and securities lending. Data required: collateral type, near/far leg amount and weight in total exposures. D6 Assets held as Collateral List of assets held as collaterals. Collateral amount helps in the SCR calculation and is therefore important to clients.

Solvency II reporting: The three pillars 11 Look-through has different interpretations under Pillar 1 and Pillar 3 The look-through approach is intended to help with the management and assessment of insurer's risk, particularly risks embedded in investment funds. With this approach, Solvency II requires granular investment data. The level of look-through is dependent on a number of factors and there is a difference between look-through at the Pillar 1 level and that required for regulatory disclosure under Pillar 3. Insurers are required to provide security-level detail of all holdings when completing the QRTs. The obvious look-through disclosure requirement relates to the QRT template D4 (look-through) where line-by-line disclosure is always provided for underlying assets of the collective investment funds, mutual funds, hedge funds, structured products and non-segregated mandates. The lookthrough requirement for this template goes into further iterations of fund of fund arrangements and shows granular security level wherever possible. For segregated mandates and direct investments, all other relevant templates need to be filled at a security level. This includes templates D1S structured products, D2 derivatives, D3 return on investment assets, D5 securities lending and repo and D6 assets held as collateral. For example, one of the key reasons why Pillar 3 matters to the CIO is because typically CIOs oversee a wide range of investment types, both for own funds and ring-fenced funds 6, and the level of granularity of data under Pillar 3 is dependent on the nature of the investment structure. Exhibit 7 shows a typical insurance CIO s investment coverage and highlights the various Pillar 3 templates required for each investment structure. CIO Exhibit 7 Investment structure influences the level of disclosure under Pillar 3 Unitlinked business Mutual funds Single manager Fund of funds Direct investment and segregated mandates Multiple Single managers managers Hedge funds Asset template -D1 Portfolio list Quantitative Reporting Templates Asset template -D1S Structured products Asset template -D2 Derivatives Asset template -D3 Return on investment assets Asset template -D4 Investment funds (look-through) Asset template -D5 Securities lending and repos Asset template -D6 Assets held as collateral Balance sheet and cover templates SCR templates Pillar 1 disclosure Security level detail wherever possible Pillar 3 disclosure (Segregated fund) Security level detail wherever possible Pillar 3 disclosure (Mutual fund) Security level at D4 one line item at D1 6 Ring fenced funds: eg unit-linked business and some with profit business. Own funds: eg mutual funds, segregated mandates and non transparent hedge funds.

12 Solvency II reporting: The three pillars Key considerations n Detailed investment disclosure from investment manager to insurer is needed to calculate the SCR under Pillar 1. Depending on the capital modelling methodology of the insurance company, this information could be of a different format and/or beyond the investment disclosure requirements under Pillar 3. n Ad-hoc data may be required in stressed events. This is intended to enable insurers to measure their risk exposure to the event (stressed events could be a large insurable event such as an earthquake or hurricane or a finance related event such as exposure to a distressed listed company). Data provided in the evaluation of ad-hoc investment risk capital is subject to the same quality and governance standards as required for regular regulatory reporting. This creates additional challenges for the investment team as investment data may not be readily available. n From the QRT perspective, the challenge in applying the look-through principle for investment/ mutual funds in form D4 is obtaining the underlying investment data of funds of funds, especially where a fund of funds invests in another fund of funds. Once the underlying investment data is obtained, the required disclosures under D4 themselves are relatively easy to source from data vendors. n Obtaining investment data for direct investments and segregated mandates is potentially difficult. As a result of the lack of data vendors that can source CIC, loss given default, attachment and detachment points and parent entity code, insurers (together with their asset managers) have to perform their own data classification mapping exercise. In addition, there are some data fields that will not be able to be automated. For example, capital protection related to derivatives and the risk factors related to structured products will require manual processes to classify them appropriately based on the intent of the holding. n In contrast to investments through segregated mandates, insurers are not required to disclose the detailed security or derivatives information mentioned above in the QRT related to the derivatives and structured products held by the investment funds. However, as discussed earlier, the insurers might still need this data for SCR calculation purposes.

Solvency II reporting: The three pillars 13 n The look-though principle is also applicable for unit-linked business. Although it is fair to say with unit-linked business the investment risk is ultimately borne by the individual end investor; however there is an element that is often overlooked. Insurance companies when calculating the liabilities for unit-linked business have to make assumptions related to the expected investment returns on their assets. This is essentially a projection of future management fees earned from their business technically known as value in force (VIF). By definition VIF is dependent on the underlying fund performance and hence is subject to market risk. Insurers that have a significant exposure here will therefore need to consider the investment risk SCR on their unit-linked funds to account for any balance sheet risk contribution. This implies a full look-through on unit-linked funds but is not a new requirement. The fiduciary responsibility that an insurer has to its clients already required it to disclose details of its unit-linked business. n Investing in opaque hedge funds, with an inability to apply look-through, will attract similar risk capital charges to non-developed equity ( other equity for the SCR calculation). Insurers could reduce risk capital by encouraging disclosure from their investment partners. n Consistency of security issuer hierarchy for the measurement of concentration risk is creating significant challenges for investment teams. Insurance firms using multiple managers to provide security information may not be consistent in determining the ultimate legal parent of a particular security. This means that firms will generate different Solvency II results for the same holding unless the same vendor source is chosen by all firms. This suggests that QRT reporting and look-through accuracy requires a consistent data source.

14 Solvency II reporting: The three pillars Checklist Engage with data providers, actuaries and chief risk officer with a common understanding Assess the level of look through available for all investments at security level Ensure a consistent Solvency II data source drives Pillars 1, 2 and 3 Ensure data quality and supervision meet regulatory Statement on Auditing Standards number SAS 70, Statement on Standards for Attestation Engagements (SSAE), or Service Organization Control (SOC) 2 Review most efficient investment structure, considering level of disclosure Ensure any new investments meet Solvency II data requirements Evaluate the potential data cost for sourcing investment data Ensure appropriate resources are allocated to Solvency II investment data management Ensure that all third-party asset managers can provide data: On time Accurately With sufficient level of granularity

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