Solvency Consulting Knowledge Series European insurers in the starting blocks Contacts: Martin Brosemer Tel.: +49 89 38 91-43 81 mbrosemer@munichre.com Dr. Kathleen Ehrlich Tel.: +49 89 38 91-27 77 kehrlich@munichre.com Dr. Norbert Kuschel Tel.: +49 89 38 91-43 49 nkuschel@munichre.com Lars Moormann Tel.: +49 89 38 91-36 65 lmoormann@munichre.com April 2010 1 European Commission for QIS5 Publication of the proposal for the fifth quantitative impact study (QIS5) has been eagerly awaited. Finally, on 15 April 2010, it happened the European Commission published its proposal for QIS5. 1 QIS5 is expected to be the last study officially carried out by the Commission with the support of CEIOPS that insurers can use to determine their future solvency requirements on a test basis before the new supervisory system finally comes into effect. Stakeholders have been given until 20 May 2010 to submit their comments on the proposal. The results of the last quantitative impact study, QIS4, demonstrated the need for further adjustments, both to the calibration of individual parameters and to some basic aspects of the formula. The financial crisis has given supervisors cause to consider that capital requirements need to be tightened and CEIOPS has put numerous proposals in this respect to the European Commission at Level 2 of the Lamfalussy process. This was preceded by a detailed consultation process, in which over 100 stakeholders submitted more than 30,000 comments. However, the proposal that has now been published by the European Commission differs 1 Cf. European Commission: http://ec.europa. eu/internal_market/insurance/solvency/ index_en.htm#hearing2010 in many aspects from the CEIOPS proposals following the last three waves of calls for advice (e.g. in the calibration of the standard formula and the interest-rate curve used for valuing technical provisions). The Commission shares the concerns of the industry that straight adoption of the proposals would lead to a disproportionate rise in capital requirements and has already announced that it would be proposing further adjustments to be prepared in the course of the consultation phase. 2 SCR using the standard formula according to QIS5 The purpose of companies having a certain level of own funds is to limit the risk of insolvency. The European standard approach is designed to reflect an insurance company s full risk spectrum. On introduction of the new supervisory rules, insurers will have to determine their solvency capital requirement (SCR) using either the standard formula or an internal model that will be subject to approval by the responsible supervisory authority. According to the Solvency II Directive, insurers risk situations are to be evaluated on a Value-at-Risk basis with a confidence level of 99.5% over a twelve-month period. 2 2 The requirements to be met for approval of an internal model should not be underestimated. Cf. Knowledge Series Internal models: European Supervisors prepare the approval process, online at www.munichre.com.
Page 2/6 Figure 1: Structure of the standard approach SCR Adj BSCR SCR op SCR market SCR health SCR def SCR life SCR non-life SCR intang Mkt fx Mkt prop Health SLT Health NonSLT Health CAT Life Mort Life Long Life CAT NL Prem&Res NL Lapse NL CAT Health Mort Health Prem&Res Health CAT Mkt int Life Dis/Morb Health Long Health NSLTLapse Mkt eq Life Lapse Health Dis/Morb Mkt sp Life Exp Health SLTLapse Mkt conc Health SLTExp Life Rev Adjustment for the risk-mitigating effect of future profit sharing Health SLTRev This will enable a loss from a prior period to be quantified at a predefined confidence level and indicate how much capital the company needs to have available in order to maintain the confidence level. The European standard approach is a bottom-up approach. Figure 1 essentially shows the individual modules that need to be calculated for QIS5. 3 As with QIS4, insurers must quantify capital requirements for the risk modules for underwriting risks (broken down into life, property-casualty and health), market risks and credit risks. New for QIS5 is an assessment of the risks arising out of intangible assets. Correlation and diversification effects are taken into account both within individual risk modules and across the various modules. In the case of investments, it is necessary to analyse dependencies between equities and fixed-interest investments and, for example, at riskmodule level also dependencies between life and property-casualty companies. The capital requirements for the individual risk submodules and modules then need to be aggregated, taking into account correlation effects in the basic solvency capital requirement (BSCR). Subject to certain conditions being met, insurers can use their own parameters to determine their capital requirements. Operational risk and any adjustments required 4 must be calculated separately. The total risk is obtained by adding together BSCR, operational risk and other adjustments; dependencies, however, are disregarded. 2.1 Underwriting risk for propertycasualty insurers Underwriting risk is extremely important for property-casualty insurers. It is the risk of an insurer s premiums and provisions being insufficient to cover its contractual liabilities for a given period. The method of calculating the solvency capital requirement for underwriting risk SCR non-life in QIS5 is similar to that used for QIS4; it is derived from the capital requirement for the premium and reserve risk NL Prem&Res, the lapse risk NL Lapse (new for QIS5) and the capital requirement for catastrophe risk NL CAT. It is assumed that there is no correlation between premium and reserve risk and lapse risk, so that full diversification is possible. The result correlates with the catastrophe risk module with a dependency factor of 3 Cf. European Commission: Draft QIS5 technical specifications, online at: http://ec.europa.eu/ internal_market/insurance/docs/solvency/qis5/ draft-technical-specifications_en.pdf. 4 For example, adjustments to take account of tax effects or future profit commissions.
Page 3/6 25%, in contrast to QIS4 where no correlation was applied. The capital requirement for this module may therefore rise substantially. Premium and reserve risk The term premium risk refers to the risk of the insurance premium for the following year being insufficient to cover future claims and other costs relating to the business in question (excluding catastrophes). The reserve risk is the risk of technical provisions established for past losses being insufficient to cover these claims. As with the premium risk, a period of one year is used as a basis. Both the premium risk and the reserve risk are initially calculated in accordance with an allocation by class of insurance prescribed for all companies in Europe and then aggregated taking account of dependencies and diversification effects. The Europe-wide standard deviations for each class of insurance are higher than for QIS4 (figures 2 and 3). Particularly affected are the marine, aviation and transport, and credit insurance classes, for which the risk factors have been increased by over 40%. The standard deviations for the other classes are up by 10% to 30% on the QIS4 values. Figure 2: Average market-wide prescribed standard deviations for the premium risk 30% 25% 20% 15% 10% 5% 0% Motor TPL Motor other MAT Property TPL Credit and suretyship Legal expenses QIS4 CP71 Final advice QIS5 Assistance Miscellaneous NP reins property NP reins casualty Figure 3: Average market-wide prescribed standard deviations for the reserve risk 30% 25% NP reins MAT 20% 15% 10% 5% 0% Motor TPL Motor other MAT Property TPL Credit and suretyship Legal expenses Assistance Miscellaneous NP reins property NP reins casualty NP reins MAT QIS4 CP71 Final advice QIS5
Page 4/6 A significant novelty in the QIS5 proposal is the improved recognition of non-proportional reinsurance through a factor used to adjust the capital requirements. In proposing this solution, the Commission has provided insurers with a simple method of calculating the effect of non-proportional reinsurance that reflects the change in risk considerably better than in QIS4. An insurer needs only the reinsurance structure to calculate the net-gross ratio. The Commission will provide a calculation tool developed by a working group. Lapse risk New for QIS5 is that lapse risks will also have to be taken into account in this module. The evaluation of lapse risks closely resembles that performed by life insurers. The capital requirement for the lapse risk NL Lapse is derived from the more capitalintensive scenario of increasing or declining lapse rates. Catastrophe risk Risks arising out of the high degree of uncertainty surrounding pricing and the assumptions applied to determine reserves for extreme and extraordinary events are to be taken into account separately in the catastrophic risk module. As with QIS4, for QIS5 insurers are given several alternatives for determining their capital requirements. At the time of publication of the QIS5 proposal, the standard scenario is still in its development phase. The scenarios, which are expected to be ready June 2010, are to cover natural catastrophes and man-made events. Aggregation will be based on the assumption that the two risks are not correlated. Natural catastrophe scenarios are to be defined by the national supervisory authorities, who have already developed their own approaches. Many of the EU countries are concentrating on the natural catastrophe risks resulting from windstorms, hail, floods and earthquakes. If the catastrophe risk determined using the standard approach appears inappropriate and a partial internal model is still being developed or itself appears to produce inappropriate results, companies should use a factor approach to calculate their capital requirements. This also applies to insurers that write primarily miscellaneous business, accept catastrophe exposure outside the EU, write non-proportional reinsurance business that cannot be appropriately depicted by a scenario. The capital requirements determined using this approach take account of correlation and diversification effects both between countries and between different natural hazards. Companies writing predominantly non-proportional reinsurance or catastrophe covers for regions primarily outside Europe are expected to use a (partial) internal model. 2.2 Underwriting risk for life insurers This risk module quantifies underwriting risks associated with the writing and managing of life business. It focuses on the uncertainty surrounding biometric expectations, expense ratios, assumptions relating to policyholders exercise of options and lapse expectations. In QIS4, all submodules were at the same level and correlated with each other. In the current QIS5 proposal, a life insurer s underwriting risk is obtained by aggregating the following two modules: Life UL/C : life underwriting risk excluding catastrophe risk Life CAT : Catastrophe risk There is a 25% correlation between the two modules. The risk capital, Life UL/C, is the aggregation of the risk capital figures for biometric risks and lapse and expense risks: Mortality risk (Life mort ) Longevity risk (Life long ) Disability (morbidity) risk (Life dis ) 5 Lapse risk (Life lapse ) Expense risk (Life exp ) Revision risk (Life rev ) The last submodule, Life rev, relates principally to annuities in non-life business. The correlation parameters for the aggregation of the submodules in Life UL/C are essentially the same as the QIS4 parameters. There is a change in the dependency between mortality risk and disability risk (reduced from 50% to 25%) and between expense risk and revision risk (increased from 25% to 50%). 5 Morbidity risk includes the biometric risks in occupational disability insurance and life covers for morbidity or sickness.
Page 5/6 Hence, two correlation matrices are to be used for the calculation of the total capital requirements for underwriting risk in life (SCR life ), which will result in risk capital requirements being somewhat lower than with the aggregation method used in QIS4. The submodules take account of trend, change and random-fluctuation risks arising in respect of the relevant actuarial assumptions. The catastrophe risk submodule includes extreme fluctuations in mortality that could be caused, for example, by pandemics or nuclear catastrophes. The simulation of the risks in the submodules is based on scenarios, with the changes only to be assumed in respect of the contracts covered by each risk. According to the current proposal, the following risk factors are to be used: Life mort : permanent increase of 15% in mortality rates for every age. Life long : permanent reduction of 25% in mortality rates for every age. Life dis : increase of 50% in disability (morbidity) rates for every age for the coming year with a permanent increase of 25% for every age with effect from the year after. There will also be a shock in rehabilitation rates, which are to be reduced by 20% for every age. Life lapse : the following must be quantified for the lapse risk: Scenario 1: A lasting fall of 50% in lapse rates for contracts with a current surrender value lower than their current best-estimate reserve. The lapse rate is reduced by a maximum of 20%. Scenario 2: A lasting rise of 50% in lapse rates for contracts with a current surrender value higher than their current best-estimate reserve. The lapse rate cannot exceed 100%. Scenario 3: To capture the risk of an extreme lapse event, all policies with a current surrender value in excess of their current best-estimate reserve should be taken into account. The differences between surrender value and best-estimate reserve are added together and the extreme lapse event is valued at 30% of the total. The factor is increased to 70% for non-retail business. The capital requirement for lapse risk (Life lapse ) is the highest of the figures produced by each of the three above scenarios. Life exp : the expense ratios assumed for the calculation of the best-estimate reserve are increased by 10% and the assumed inflation rate is increased by 1%. Life CAT : mortality increased by a loading of 1.5. In the case of disability covers, the extent to which it is appropriate to take account of the catastrophe scenarios defined in the health risk module should also be considered. Existing reinsurance covers are taken into account in the evaluation of each scenario. The risk-mitigating effect of reinsurance reduces the capital requirements in respect of the underwriting risk. 2.3 Market risk The QIS4 results showed that market risk is the main risk driver for life insurers. However, market risk is also important for property-casualty insurers, as they are generally in possession of substantial funds that need to be invested in a manner consistent with the company s goals. Market risk basically arises out of fluctuations in the market prices of financial instruments. Fluctuations in capital market prices are triggered, for example, by changes in interest rates, share prices, property prices or exchange rates. In the solvency balance sheet, fluctuations may directly impact the market value on the assets and liabilities sides of the balance sheet. In the case of liabilities, the discounting of technical provisions is mainly responsible for this. Like QIS4, QIS5 prescribes that the capital requirements for the following risk submodules must be determined separately: Interest-rate risk (Mkt int ), Equities risk (Mkt eq ), Property risk (Mkt prop ), Spread risk (Mkt sp ), Currency risk (Mkt fx ), Concentration risk (Mkt conc ). Compared to the evaluation of market risk in QIS4, for QIS5 there are changes in the aggregation of the sub-risks within market risk and in the shock factors for individual risk modules. Mkt int : there are reduced yield curves and a volatility shock for QIS5. Independently of the stress factors, the European Commission has also introduced minimum stress factors.
Page 6/6 Mkt eq : though the basic stress factors for both equities classes (global 39%, other 49%) are higher in QIS5 than in QIS4, there is to be a symmetrical adjustment, which for 2009 results in a reduction of 9% in the basic stress factors, making them lower than for QIS4. A stress factor of 22% is assumed for strategic participations. New for QIS5 is the introduction of a volatility shock. Mkt prop /Mkt fx : the stress factors for currency and property risks are 25% compared to 20% for QIS4. Mkt sp /Mkt conc : risks arising out of mortgage loans are to be taken into account in the calculation of capital requirements, which was not the case in QIS4. This is due not least to experience with the subprime crisis. There are also changes in the method of calculating the capital requirements for structured financial products. 2.4 Counterparty default risk The counterparty default risk is the risk arising from an unexpected default or deterioration in the credit standing of an insurance company s counterparties or debtors. The calculation of the counterparty default risk has changed fundamentally from QIS4. QIS5 distinguishes between two types of exposure (market value of receivables): Type 1 relates to exposures that are not necessarily diversified and where the counterparty usually has a credit rating. They include reinsurance agreements, cash at banks, guarantees and letters of credit. Type 2 comprises all other exposures, i.e. exposures that are usually diversified and where the counterparty does not have a credit rating. They include receivables from policyholders and insurance intermediaries. Capital requirements are calculated separately for each type. Diversification effects are recognised to a small degree when the figures are aggregated to obtain the total capital requirement. 2.5 Risks arising out of intangible assets For QIS5 risks arising out of intangible assets must also be evaluated. Examples are risks related to falling prices in the capital markets or unexpected shortages of liquidity in the capital markets, or internal risks, for instance that of a brand losing value or development projects not being completed on time. 2.6 Operational risk An insurer s operational risk is the risk of loss resulting from inadequate or failed internal processes, or from personnel or systems, or external events. Operational risks also include legal risks. Reputational risks and risks arising from strategic decisions are not deemed to be operational risks. The approach prescribed for QIS5 is based on similar simple assumptions to those tested in QIS4. A difference is that in the QIS5 proposal changes in premiums and reserves also flow into the calculation of the capital requirement. Furthermore, individual risk factors have been increased by 50% for property-casualty insurers and 25% for life insurers. The lack of risk sensitivity in the approaches continues to attract wide criticism. 3 Conclusion In its letter to the stakeholders, the European Commission has already referred to the continuation of work on the standard formula during the consultation phase. In any event, the QIS5 proposal already includes numerous adjustments to the calculation of capital requirements, most of which were announced with the publication of the final proposals for the implementing measures at Level 2 of the Lamfalussy process. Insurers should expect higher capital requirements than under QIS4. 2010 Münchener Rückversicherungs-Gesellschaft Königinstrasse 107, 80802 München, Germany Order number 302-06378