Solvency II: Implementation Challenges & Experiences Learned

Solvency II: Implementation Challenges & Experiences Learned Appointed Actuary Symposium Actuarial Society of Hong Kong (ASHK) Jonathan Zhao - Actuarial Services Practice Leader, Asia Pacific 3 November 2010

Agenda Solvency II introduction & recap Implementation procedures Experiences & lessons from QIS 5 Looking ahead Page 2

Solvency II introduction & recap Solvency II introduction & recap Implementation procedures Experiences & lessons from QIS 5 Looking ahead Page 3

Solvency II introduction & recap Background Solvency II is the proposed new Europe-wide framework for prudential supervision of insurance Aims to address problems with Solvency I - Outdated system - Insufficiently risk-sensitive - Does not reflect best practice - Difficulties in supervising multinational, diversified groups A fundamental change to Solvency requirements: - Principles based approach to supervision - Market consistent approach for valuing liabilities - Capital requirements linked to risk profile - Convergence of economic capital and regulatory capital - Major focus on risk management - Significant disclosure requirements - Capital add-ons for deficiencies - Links to other reporting measures Page 4

Implementation activity Regulatory timetable We are here Solvency II introduction & recap Regulatory timeline and implementation activities 2009 2010 2011 2012 European CEIOPS/ > EIOPA > May 2009 Framework Directive Approved Level 2 advice to Commission QIS5 QIS5 feedback Develop guidance under Level 3 October 2011 Level 2 Directive Approved Implementation 31 December 2012 L2 drafting (Commission and EIOPC) Impact study of L2 (Commission) Legislative process Internal Model Application Process (IMAP) submission Member States Planning for implementation in 30 countries and associated territories Transposition into domestic law and regulation UK Interactive firms & FSA IMAP dry run (June 2010 to October 2011) IMAP by April 2012 Full implementation Vision & Gap analysis Road Map design Detailed Implementation design Build and test Implementation Embed Page 5

Solvency II introduction & recap Frame work 3 Pillar Approach Risk Quantifications Pillar 1 Quantitative Capital Requirements Solvency Capital Requirements (SCR) Minimum Capital Requirements (MCR) Risk Management Pillar 2 Supervisory activities Risk Governance A risk oriented framework Risk Transparency Pillar 3 Supervisory reporting & public disclosure Transparency & Disclosure Page 6

Pillar 1 Pillar 1 Pillar 2 Pillar 3 Technical Provisions MCR Minimum Capital Requirement SCR Solvency Capital Requirement Model Approval Risk Management Own Risk and Solvency Assessment (ORSA) Supervisory powers & processes Disclosure- Solvency & Financial Condition Report Market Discipline Page 7

Solvency II Pillar 1 Market consistent balance sheet The starting point for Solvency II is an economic, market-consistent approach to the valuation of assets and liabilities. Alignment as far as possible between Solvency II and IFRS 4 Phase II. Solvency II Balance Sheet Assets are valued at market value Own Funds Assets Free Surplus MCR Risk margin SCR Technical provisions = BEL + Risk Margin Best Estimate Liability (BEL) Best estimate of all future cash flows discounted at a risk free rate with adjustment for illiquidity premium Risk free rate is derived from swap rates less an adjustment for credit risk (10bps), level of illiquidity premium various by contract type (50bps 100bps) + Risk Margin Cost of capital method will 6% factor used for QIS 5, IFRS 4 Phase II suggested 3 methods (CI, CTE and CoC) Best estimate liability Technical provisions Capital requirements SCR = first regulatory intervention point (VaR @99.5% CI over 1 year) Standard Formula or Internal Model MCR = final regulatory intervention point (VaR @85% CI over 1 year) Framework directive has also set MCR to a minimum of 25% and a maximum of 45% of the SCR Page 8

Solvency II Pillar I Structure of standard formula for SCR SCR = BSCR + Adj + Op Risk SCR intangibles risk module introduced for QIS 5. Adj BSCR Operational Risk SCR illiquidity premium sub-module introduced for QIS 5. Market Health Def ault Life Non-Life Intangibles Interest rate Equity SLT Health Mortality Health CAT Non-SLT Health Premium Reserve Mortality Longevity Premium Reserve Lapse Health risk module split between SLT (similar to life techniques) and NonSLT some reduction in QIS5 for certain correlations between sub-module risks. Health CAT risk introduced (as per Final Advice although the CAT risk is now aggregated across SLT and NonSLT). Property Spread Longevity Disability Morbidity Lapse Disability Morbidity Lapse CAT A lapse risk module for Non Life business has been introduced to recognise the impact if policy take-up rates were lower than expected. Basic SCR correlations Market Default Life Health Non-Life Currency Lapse Expenses Market 1 Concentration Expenses Revision Default 0.25 1 Life 0.25 0.25 1 Health 0.25 0.25 0.25 1 Illiquidity Revision CAT Non-Life 0.25 0.5 0 0 1 = included in the adjustment for the risk mitigating effect of future profit sharing Page 9

Solvency II - Pillar 2 Pillar 1 Pillar 2 Pillar 3 Technical Provisions MCR Minimum Capital Requirement SCR Solvency Capital Requirement Model Approval Risk Management Own Risk and Solvency Assessment (ORSA) Supervisory powers & processes Disclosure- Solvency & Financial Condition Report Market Discipline Page 10

Pillar 2 Requirements The key requirement of Pillar 2 is for firms to have a system of governance to provide for sound and prudent management of the business. This system of governance shall at least include an adequate transparent organisational structure with a clear allocation and appropriate segregation of responsibilities and an effective system for ensuring the transmission of information. Supporting this requirement are six key aspects based on conditions and functions which the Directive expects Firms to address and have in place: Conditions Fitness and Propriety Outsourcing Internal Control Functions Risk Management Function Internal Audit Function Actuarial Function Pillar 2 can be split in two Governance and ORSA Evidencing Successful Pillar 2 Implementation Governance Clear and documented delegation of authority cascading through the organisation with appropriate spans of control and suitable persons holding roles Suitable allocation of function responsibility that avoids duplication Clear articulation of committee responsibilities split between doing and oversight and assurance. Policies that set out how the business is overseen and controlled and that reflect the current reality Risk information to support individuals and committees in their roles across the lines of defence Own Risk and Solvency Assessment (ORSA) A demonstrable strategy and appetite for risk that is cascaded down through the organisation A process for identifying all the risks to the business, quantifying them across a range of outcomes controlling them and reporting within them within the governance arrangements set out A dynamic approach to using risk information within the business on a timely basis Page 11

Pillar 2 Own Risk and Solvency Assessment The ORSA is the regular practice of assessing overall capital needs with a view to the firm s specific risk profile that forms part of the risk management system. It is: an internal assessment process and as such should be embedded in strategic decisions, and a supervisory tool for the supervisory authorities. The ORSA can be defined as the entirety of the processes and procedures employed to identify, assess, monitor, manage, and report the short and long term risks that the business faces or may face and to determine the own funds necessary to ensure that its overall solvency needs are met at all times. The ORSA aims at enhancing awareness of the interrelationships between the risks the business is currently exposed to, or may face in the long term, and the internal capital needs that follow from this risk exposure. The ORSA needs to be supported by an effective and robust escalation process paying particular attention to Functional escalation Risk exposures and the linkages to decision making 3 lines of defence model a possible approach to meet Solvency II requirements 1 st Line Risk Ownership Executive Committee Supported by Risk Taking Business Units Board Strategy, risk appetite and policy 2nd Line Risk Control and Monitoring Oversight Committee Supported by Compliance, Actuarial, Risk Management and Risk Modelling Functions Risk Management Systems Own Risk and Solvency Assessment Internal Control Framework 3rd Line Independent Assurance Audit Committee Supported by Internal Audit The ORSA process for assessing and monitoring overall solvency builds on the Pillar I SCR calculation by articulating the firm s view of required capital. It should form an integral part of the business planning of the organisation. A key challenge will be integrating the appropriate modelling approaches into the risk framework and ORSA. Page 12

Solvency II - Pillar 3 Pillar 1 Pillar 2 Pillar 3 Technical Provisions MCR Minimum Capital Requirement SCR Solvency Capital Requirement Model Approval Risk Management Own Risk and Solvency Assessment (ORSA) Supervisory powers & processes Disclosure - Solvency & Financial Condition Report Market Discipline Page 13

Pillar 3 Overview Three aspects: Report to Supervisor RTS Information to submit to regulator Solvency and Financial condition report - SFCR Public disclosures at least annually Disclosures by regulators RTS and SFCR will contain a qualitative report, including quantitative data and quantitative reporting templates Proportionality principle: detail of information is in line with nature, scale and complexity of risks inherent in the business Need a written disclosure policy approved by the management body to ensure appropriate governance procedures and practices so that information is complete, consistent and accurate (on an ongoing basis) There are provisions to avoid competitors of the undertaking gaining significant undue advantage non-disclosure of information in specific cases need to be explicitly mentioned (along with reasons) in the SFCR In the SFCR, you may refer to or make use of equivalent information available elsewhere in the public domain (although CEIOPS do not consider it appropriate to refer through hyperlinks to other documents - rather reference if further information is provided elsewhere) Page 14

Implementation procedures Solvency II introduction & recap Implementation procedures Experiences & lessons from QIS 5 Looking ahead Page 15

Implementation activity Some key questions regarding your Solvency II implementation 2009 2010 2011 2012 May 2009 Framework Directive Approved QIS5 QIS5 feedback Internal Model Application Process (IMAP) submission Implementation 31 December 2012 Planning for implementation in 30 countries and associated territories Transposition into domestic law and regulation IMAP dry run (June 2010 to October 2011) IMAP by April 2012 Full implementation Vision & Gap analysis Road Map design Detailed Implementation plan and activities Build and test Implementation Embed What level of detail does your implementation plan go to? (e.g., high-level road map and detail activity plan) Does your plan build on the output from the gap analysis and identified solutions to mitigate all deficiencies? Has your plan been reviewed and approved by the governance committee, with agreed budget, headcounts, and timeline that are realistic? What do you plan to do next with your plan? Page 16

Enabling Illustrative SII governance and program structure making it happen A well defined SII governance/program structure will ensure rapid decision-making, and effective execution of the SII implementation plan Key Features Horizontal & vertical workstreams to drive aligned business requirements and a complete business case Dedicated technical challenge and support at all levels of the program Steering Committee Program Governance Technical Review Panel Program Management Program Management Office Program Directorate Design Authority Team Workstreams Internal Model Risk & ORSA Reporting & Disclosures Optimisation Product Pricing and Development Technology/Data and Tools Workstreams Process & Controls Change Management Documentation Page 17

Resourcing for SII and understanding its implications on existing headcount 30 25 20 15 10 5 0 6 4 15 3 1 12 5 2 16 Analyst Senior Analyst Assistant Manager Manager Senior Manager Director 3 10 1 3 4 SII headcount means a x% growth 2 Current team Open positions SII resources required Considerations on resourcing: Where to hire resources from? Internal vs. external use of resources and its cost implications? Impact on existing headcount and integrating new resources into business as usually activities? Speed at which resources can be obtained? Impact on SII programme? When do the resources need to be brought it? All at a point in time? Spread over time? Page 18

Phase 3 - Transition from Development to Production Phase 2 SII Reporting Implementation and Testing Phase 1 - Understand & Design SII Reporting Metrics & Modeling Requirements Example of Detailed Road Map Risk Modelling & Reporting 2H 2009 1H 2010 2H 2010 1H 2011 2H 2011 1H 2012 2H 2012 Business As Usual SII Reporting Methodology Overall SII Reporting Framework 1 Define and document required enhancement to models to meet requirements 2 ALM Model 3 Economic Scenario Generator (ESG) 4 Complete QIS5 QIS5 Solo delivery by Oct 2010 5 Asset Valuation Implementation 6 ALM Modeling 7 Implementation of the internal model ESG 8 Financial Reporting Infrastructures 9 Complete design and implement of valuation processes and reporting Validation, documentation & User Testing 10 Internal Finalisation of Models & External Model Audit SII Reporting Full Testing & Dry Runs SII Reporting System Go Live 11 External Audit Process being Carried Out 12 Parallel runs of Q1 ~ Q3 2012 System launched 13 Page 19

Review of ORSA Review of Governance Review of Risk Appetite & Tolerance Limits Example of Detailed Road Map Risk Management 2H 2009 1H 2010 2H 2010 1H 2011 2H 2011 1H 2012 2H 2012 Business As Usual Define and Determine Risk Appetite Set Risk Tolerances per Major Risk Category Define Management Response to Risk Identification and Appetite Define Control Activities to Address Risk Management requirements Assess / Update Governance Manuals, Terms of Reference and Role Definitions 5 1 2 3 4 Definition of Risk Appetite Completed Allocation of Risk Tolerances per Major Risk Category Completed Definition of Management Response to Risk Management Completed Definition of Control Activities Completed Annually review and update as required Build Process Catalogue Embed Risk Management Changes 6 7 Embedding Change Management Programs Completed Define and Design Process Identify and Assess Operational Risks Assessment of other Risk categories Build ORSA Report Formats Design of ORSA 8 Process Completed 10 Define Independent Review of ORSA 12 Use Test 11 9 Final Documentation of Operational Risks Completed Final Documentation of Other Risk Categories Completed Definition of Independent Review of ORSA Completed 13 Use Test Complete Page 20

The biggest issue/difficulty faced by company in its Solvency II implementation Resource, resource, resource!!! Understand the scale and complexity of the SII project and reflecting it realistically in the time, resource and cost estimate Deciding the appropriate detail action plans for both short term and medium to long term activities, including the key workstream leaders and SII program structure Allowing flexibility to cope with surprises arising from the Level 2 Implementing Measures and Level 3 Guidance Allowing for hand-offs and dependencies between workstreams and different department Other Page 21

Experiences & lessons from QIS 5 Solvency II introduction & recap Implementation procedures Experiences & lessons from QIS 5 Looking ahead Page 22

Experiences & lessons from QIS 5 QIS 5 Overview Overview The final QIS5 Technical Specification was issued on 6 July 2010 after discussions on the Draft Specification with selected stakeholders (CEA, AMICE, CRO Forum, CFO Forum, ECIROA, FERMA and Groupe Consultatif). The Commission has emphasized the importance of dealing with all areas of the exercise comprehensively, and is expecting high quality submissions from firms on which to base its decisions. A number of key changes from the draft technical spec: Changes in calibrations generally less favourable compared to QIS4, but more favourable compared to CEIOPS Consultation Papers / Final Advice. Changes in methodology additional sub-modules proposed and refinements in methodology for existing (sub)modules compared to QIS4. The technical specifications should not be seen as the final outcome as the intention is to publish the Level 2 implementing measures once the results of QIS5 are known. Results not required to be submitted to OCI. QIS5 objectives To provide detailed information on the quantitative impact of future Level 2 implementing measures. To encourage industry preparation and to: Identify areas where internal processes, procedures and infrastructure may need to be enhanced and encourage improvements to data collection processes To provide a starting point for an ongoing dialogue in preparation for the new supervisory system. QIS5 provides an ideal checkpoint for Solvency II programmes to: Educate stakeholders with quantitative evidence of the potential impacts, informing lobbying activity. Review and realign Solvency II plans based on your experience of performing QIS5. Extending the dialogue between local operating companies and European parent. Page 23

Experiences & lessons from QIS 5 Issues & Challenges - Overview Key issues and challenges encountered while carrying out QIS 5 exercise: Application of contract boundary condition. Calculation of expected profits in future premiums ( EPIFP ). Calculation of risk margin. Severity of standard formula currency risk stress. System and resource limitations. Page 24

Experiences & lessons from QIS 5 Issues & Challenges Contract Boundary Definition of contract boundary as per QIS 5 Technical Specifications: where an undertaking has the unilateral right to terminate the contract; or where an undertaking has the unilateral right to reject premiums; or where an undertaking has the unilateral right to amend premiums or benefits, at some point in the future, then any cash flows pertaining to time period after that date should not be included in the liability calculations. For insurers in the region, yearly renewable business likely to be affected. Likely to affect the BEL negatively as these business tend to have a negative BEL value. Current debate on application of contract boundary unit-linked contracts. Companies might calculate (submit) two set of results (one follow QIS 5 guidance exactly, and one follow their interpretation) given the definition of contract boundary is unclear Page 25

Experiences & lessons from QIS 5 Issues & Challenges EPIFP Calculation QIS 5 introduces the concept of expected profits in future premiums ( EPIFP ). Explicit recognition of expected profits built into future cash flows on best estimate basis. EPIFP value is to be included as Tier 1 capital for Own Funds calculations. Methodology for calculating EPIFP: Calculate technical provisions (ex-risk margin) using best estimate assumptions. [A] Calculate technical provisions (ex-risk margin) assuming no future premiums are received. [B] Technical provision (ex-risk margin) from [B] less that from [A] is the EPIFP value (if negative, EPIFP set to zero). In calculating [B], benefit levels are adjusted to be consistent with assumption of no future premiums. This adjustment not trivial as use of retrospectively or prospectively calculated surrender benefits will include elements of past or future profits. Severity of issue depend on reliance on EPIFP to meet the required capital requirements. Page 26

Experiences & lessons from QIS 5 Issues & Challenges Risk Margin Calculation Recall - risk margin calculation is a cost of capital approach, where the capital is the projected SCR. Projected SCR to include: unavoidable market risk; life underwriting risk; counterparty default risk relating to reinsurance and SPV reinsurance arrangements; and operational risk. Projection of the SCR requires nested stochastic calculations stresses to be applied for each future time period. Possible modeling solutions being explored include replicating portfolios and formula fitting techniques. Meanwhile, QIS 5 technical specifications set out a number of simplifications. Hierarchy of simplifications: full calculation of projected required SCR (no simplification used); approximate only certain risks in some of the required SCR; approximate whole SCR for each future year; approximate all future required SCR at once ; approximate risk margin as a percentage of the best estimate liabilities. In deciding simplification to be used, need to consider the information, resources and modeling capability available. May impact the capital position of the firm as risk margin could be a material value. Page 27

Experiences & lessons from QIS 5 Issues & Challenges Currency Risk Stress Standard formula stress for currency stress is an increase and decrease of 25% in net foreign currency exposure. This calibration may not be suitable for the Hong Kong dollar /United States dollar relationship given the close relationship of the two currencies in recent history. Some participants are viewing this as being too penal. Likely to have a significant impact on the SCR calculations. Page 28

Experiences & lessons from QIS 5 Issues & Challenges System and Resource System limitations: Data systems not able to support the extraction of data at the expected level of granularity required for Solvency II Pillar 1 compliance. Example historical and forecast premium information by line of business. Modeling capabilities not sufficiently refined to model key liability and asset portfolio features. Example dynamic policyholder behavior and equivalent scenario. Resource limitations: Lack of buy-in from management due to submission to OCI not required. Possible solutions: educate stakeholders; build relevant Solvency II features into business as usual activities. Lack of personnel with the relevant knowledge/experience. Possible solutions: tap knowledge of colleagues in European HQ; start recruiting and training now; engage consultants for specific modules. Page 29

Looking ahead Solvency II introduction & recap Implementation procedures Experiences & lessons from QIS 5 Looking ahead Page 30

Looking ahead Expected Implementation Challenges as SII Progress Use test This will be one of the most challenging areas of the new regime The impact will be far reaching and as a result the implementation challenges will be significant Significant business changes In the end state of Solvency II, there will be significant changes to the models, management information, data, infrastructure and procedures There are commercial and profitability implications arising out of implementation Links to other projects Solvency II can potentially link directly or impact on projects already ongoing. Ensuring that work done in these workstreams is leveraged appropriately to ensure no duplication of effort will be a key role of the Solvency II Steering Group. Implementation challenges Cultural changes Changes in the culture would be required to reflect new metrics and processes There is a necessity to manage the business to different metrics consistently across the group and to reward people on the basis of these new metrics. Page 31

Looking ahead Impact from IFRS 4 Phase II Page 32 3 September 2009 Training Materials

Thank You Appointed Actuary Symposium 3 November 2010