Solvency II Revealed. October 2011

Transcription

1 Solvency II Revealed October 2011

2 Contents 4 An Optimal Insurer in a Post-Solvency II World 10 Changing the Landscape of Insurance Asset Strategy 16 Capital Relief Through Reinsurance 21 Natural Catastrophe Capital Requirement Under Solvency II 27 Boosting Knowledge of Life Catastrophe Risk 32 Rating Agencies and Solvency II 35 Reinsurance Assets: Aggregate or Individual? 41 Risk and Capital Modelling for Solvency II: A Pillar of Strength

3 Aon Benfield Solvency II Revealed The insurance industry has seen an extraordinary rise to prominence for the proposed Solvency II regulation which will bring fundamental reform of insurance supervision across Europe. As the deadline for implementation approaches, and the economic environment continues to present significant challenges, the key is in understanding how and where to prioritise resource to not only achieve compliance but also make the most of the business opportunities that Solvency II offers. Aon Benfield, in collaboration with its clients, has made enormous progress in understanding the practical implications of the new regulatory landscape. Solvency II Revealed explores new ways of thinking about the regulatory challenges and practically addresses these through a series of in-depth articles and case studies. Aon Benfield identifies where Solvency II will have most impact on the industry, with advice on how best to plan ahead for all roles involved in managing the regulation from CFO and CRO to actuaries and catastrophe modellers. Seven key themes are explored in the report: After Solvency II implementation, what will a capital-efficient insurer look like? Taking a long-term approach, the article predicts how an insurer would structure its business to maximise capital efficiency under the Solvency II rules, considering both the asset and liability sides of the balance sheet. The insurance industry faces significant challenges transitioning to an economic framework for investments. The article reveals how Solvency II will impact insurance asset strategy and identifies the key considerations for the CFO and CIO in repositioning their portfolio to achieve capital efficiency and sidestep possible dislocations in the financial markets. This case study examines the potential impact of a non-proportional retention protection reinsurance on the non-life solvency capital requirements (SCR) for a notional company under the Standard Formula. The study demonstrates how such a contract can substantially reduce capital requirements as an additional benefit of the reinsurance protection. Internal models, despite requiring a significant investment, result in more accurate reinsurance recoveries and, consequently, net capital requirements, than the Standard Formula. The article delves into the alternatives to calculate insurers natural catastrophe SCR. Assessment of terrorism and pandemic risks has been taken to a new level through innovative developments in partial internal models. Case studies are used to illustrate the risk-mitigating effect of reinsurance. Not only are regulators focused on Solvency II, but to no surprise, so are the rating agencies. Reviewing recent feedback from rating agencies, the article helps reinsurers prepare for the potential impacts of rating agencies calculations of capital requirements. Calculating the fair value of a reinsurer s share of technical non-life liabilities could be a challenging task if the reinsurance programme has changed in recent years. This article examines Solvency II s framework directive requirements and presents two different approaches from a practical perspective. a pillar of strength: Companies using internal models need to ensure they satisfy each pillar of Solvency II. The article highlights how an internal model can deliver tangible benefits when completing the Own Risk and Solvency Assessment (ORSA) and help companies prove to regulators that risk is being effectively managed. Aon Benfield is helping insurers prepare for all pillars under Solvency II by identifying cost effective means of improving capital efficiency, by assisting with modelling of asset and underwriting risks and by validating (partial) internal models and ESGs. The firm offers expertise on both sides of the balance sheet and is advising clients on designing optimal insurance and asset strategies under Solvency II. Our Solvency II capabilities comprise asset management, reinsurance and capital market solutions covering life, non-life and health insurance. As the industry rapidly approaches implementation, Solvency II Revealed aims to provide insurers with a fresh view of Solvency II and empower firms to achieve both regulatory compliance and a level of capital efficiency that exceeds investors expectations. 3

4 Solvency II Revealed An Optimal Insurer in a Post-Solvency II World Uniting the management of insurance and asset risk provides a valuable opportunity for insurers to implement better management practices by viewing risk and capital holistically. This approach targets the overall balance sheet risk rather than insurance or investment risk as a silo. By leveraging the internal model framework, insurers can optimise business strategy across insurance and investment to improve both shareholder return and economic efficiency. Solvency II is changing the way regulatory capital is assessed for European insurers. The results of the latest impact assessment study, QIS 5, suggest that the average solvency ratio for non-life European insurers will drop from over 200% to around 165% (overall ratio since non-life ratio is not available separately). Additionally, unlike the existing Solvency I regime, Solvency II uses a risk-based approach to set the level of each individual insurer s solvency capital thus requiring more capital to be held for riskier insurance and investment activities. This means that insurers that take a higher level of risk, as measured by Solvency II, will suffer a far greater fall in solvency ratio than those with less risky portfolios, whose solvency ratio may even improve. Despite presenting clear challenges, Solvency II also offers insurers the opportunity to improve their business strategy through better allocation of risk and capital to target opportunities that provide the highest rate of return per unit of risk. Solvency II encourages firms to view risk, capital and value from a top-down perspective, rather than from a silo based approach. Insurers must set strategy in accordance with two sets of constraints simultaneously: the capital constraints imposed by regulators, and the economic constraints imposed by stakeholders, including shareholders, policyholders and management. To maximise performance, insurers must pursue a combined strategy for both sides of the balance sheet a strategy that comprehends the potential dependence between insurance and asset risk behaviour. To date, very few organisations have optimised their allocation of risk and capital across both insurance and asset risk under a consistent measurement framework. In practice, the two sides of the balance sheet have been managed by separate business functions and strategies are set without a full understanding of the impact on the overall level risk and capital. For example, credit insurance losses are highly correlated to economic risks and setting asset strategy without consideration of insurance risks may result in a strategy that actually increases overall risk for the firm. New approach for optimisation Aon Benfield has developed an optimisation process for setting consistent strategy across asset and liability risks, recognising all relevant economic and capital constraints. This process will support insurers to better manage their risk and capital under Solvency II. In a post-solvency II world, those insurers that can transform their business to maximise economic and capital efficiency will enjoy competitive advantages and improved shareholder returns. The process is outlined below, with sample exhibits for a hypothetical insurer Multi-line Plc. Figure 1 illustrates the process for optimising the firm s overall business strategy across insurance and asset risk. The initial strategy of Multi-line Plc is derived from the insurance and asset strategy of the average non-life company in Europe. The risk assessment of the existing business strategy has been carried out using the Aon Benfield Insurance Risk Study assumptions for 2011 for underwriting volatility and correlations and Aon Hewitt Capital Market Assumptions 2011 for asset risk. Additional assumptions for reserve risk and underwriting performance have been assessed using industry data. The Aon Benfield business strategy optimisation process for Multi-line Plc is illustrated on the next page: 4

5 Aon Benfield Figure 1: Aon Benfield Process for Insurance and Asset Strategy Optimisation 1 Insurance Asset Strategy Optimisation Articulate the firm s overall risk Identify optimal allocation of appetite, capital target and driver insurance risk under selected risk of shareholder value 2 and capital measure 3 Utilise remaining risk and capital budget to develop optimal investment strategy Risk Risk Insurance Classes Insurance Classes risks characteristics Asset Asset Classes & Classes Constraints & Constraints firm constraints Capital Capital e.g. 150% Solvency II ratio model Insurance Insurance Constraints Constraints current strategy Insurance Insurance & Asset Risk & Model Asset Risk Model asset risk Value Value earnings volatility combined Optimise Optimise Insurance Insurance Strategy Strategy Optimise Optimise Asset Asset Strategy Strategy to identify portfolios that budget and capital budget 1 Risk Appetite, Capital Target and Drivers of Value Overall risk for the firm will be quantified as the volatility of surplus, i.e. assets less liabilities, from all sources of insurance and asset risks. An internal model of the full balance sheet will be utilised to measure surplus volatility and to consistently allocate risk between insurance and asset risks. Aon Benfield s price-to-book regression study points to a volatility measure of risk as best capturing investor risk tolerances. The binding capital metric for Multi-line Plc is the Solvency II capital requirement (SCR) under the Standard Formula. Capital utilisation for insurance and asset risks will be measured by the contribution to the overall SCR from non-life insurance and market risk. This assumes that shareholders are motivated by optimal exposure to insurance risks, careful management of balance sheet volatility and attractive returns on equity. Following consultation with Multi-line Plc s management, the overall risk appetite for the company has been articulated as 10.0% surplus volatility across both insurance and asset risk, hence maintaining its existing level of overall balance sheet risk. Its existing Solvency II ratio of 165% has been judged an appropriate long term position and the strategy review should maintain this level of capital adequacy. 2 Identify Optimal Allocation of Insurance Risk The firm wants to improve its insurance strategy to generate improved returns for shareholders and achieve better risk characteristics. Shareholders of non-life insurers typically seek firms that offer exposure to a carefully selected portfolio of insurance risks, with an asset strategy that supports their liabilities and enhances risk-adjusted return within the overall risk and capital budget. Therefore, when optimising the insurance and asset strategy of a non-life insurer, the first stage is to optimise the insurance portfolio. Once the optimal allocation of insurance risks has been selected, the remaining risk and capital budget can be deployed to enhance shareholder returns through the asset strategy. Multi-line Plc has defined upper and lower bounds for premium volume by class of business and agreed that the total premium volume can vary between 85% and 100% of the current level ( 100m): by optimising the risk allocation it may be possible to achieve higher profitability at a lower premium volume. 5

6 Solvency II Revealed Table 1: Insurance Allocation Constraints LOB Allocation Initial Min Max 33% 28.0% 38.0% 18% 15.5% 21.0% 4% 2.5% 4.5% 30% 25.5% 34.5% General Liability 12% 8.5% 14.5% 4% 2.5% 4.5% An internal model of the insurer is created and, using Aon Benfield s proprietary optimisation framework, determines the economic and capital efficient frontiers of the insurance portfolios that provide the maximum expected profit for a specified level of economic volatility or Solvency II capital utilisation, respectively. Figure 2: Superimposition of Economic and Capital Efficient Frontiers Economic Capital B The Solvency II capital efficient frontier differs from the economic frontier, and capital allocations that are efficient under the proposed Standard Formula can be suboptimal from an economic perspective. This is because the proposed Standard Formula assesses capital based on prescribed volatilities and correlations for non-catastrophe underwriting risk and prescribed events for natural and man-made catastrophes these prescribed factors are not based on economic best estimates and are often conservative. The goal of optimisation is to identify portfolios of insurance risk that are efficient from both the economic and capital perspective. The identification of jointly efficient portfolios is achieved by comparing the economic and capital efficient frontier and seeking portfolios that lie on the intersection of the two frontiers. Figure 2 plots the economic and capital efficient frontiers on a single graph in volatility-return space. The economic and capital efficient frontiers coincide in locations A and B, which provide jointly optimal allocations. In order to decide which mix of insurance risk is preferable, it is necessary to consider performance metrics at the two candidate portfolios. Profit % A 8.1% 8.2% 8.3% 8.4% 8.5% 8.6% 8.7% 8.8% Economic Volatility Initial Portfolio In Figure 3, the insurance portfolio composition is shown along the economic efficient frontier and two performance metrics: the economic Sharpe ratio and return on capital. In comparing options A and B, the highest ratio of profit to risk and capital is sought: this will achieve the optimal allocation of insurance risk. The selected portfolio is at the left most point of the intersection of the economic and capital efficient frontier in region B, where both the economic Sharpe ratio and return on capital is higher than at region A, leading to greater profit per unit of risk and capital. This portfolio provides the best combination of economic and capital efficiency. 6

7 Aon Benfield Figure 2: Optimisation of Insurance Risk Under Economic Risk Measure 100% 40% 90% 35% Allocation 80% 70% 60% 50% 40% 30% 20% 10% A B 30% 25% 20% 15% 10% 5% 0% 8.04% 8.10% 8.20% 8.30% 8.35% 8.40% 8.45% 8.50% 8.55% 8.60% 8.65% 8.70% 8.75% Economic Volatility 0% Credit and Suretyship Marine, Aviation and Transport General Liability Fire and Other Damage to Property Motor and Vehicle Liability Motor, Other Classes Sharpe Ratio Return on Capital Optimal Portfolio Profit Initial Portfolio B % 8.2% 8.3% 8.4% 8.5% 8.6% 8.7% 8.8% 8.9% Economic Volatility 3 Optimisation of Asset Strategy Having selected the optimal insurance portfolio, the next stage is to investigate how the asset strategy can be improved within the remaining risk and capital budget for the firm. Overall, the level of insurance volatility has increased by 3 bps and the non-life Solvency II capital has increased by EUR0.1m. As the total budget for risk is 10.0% and the firm is targeting a 165% Solvency II ratio, this imposes two constraints on the asset portfolio: volatility must be such that overall surplus volatility does not exceed 10.0%. This will be computed as part of the optimisation as it is dependent on economic liability correlations be such that the overall SCR remains at the current level of EUR69.56m: through calculation this implies that the SCR_Mkt should be EUR29.86m In assessing the overall level of surplus volatility for the optimised insurance strategy alongside candidate asset portfolios, it is important to consider the impact that liability volatility has upon economic risk. 7

8 Solvency II Revealed Figure 2b: Optimisation of Insurance Risk Under Economic Risk Measure Portfolio Initial % 8.0% 8.2% 8.4% 8.5% 8.65% 8.77% Statistics Profit % 22.3% 30.6% 31.1% 31.1% 31.0% 31.0% 5.9% 4.8% 5.9% 6.2% 6.5% 6.7% 6.9% 33.2% 28.0% 28.0% 28.0% 28.0% 28.0% 28.0% 18.0% 18.0% 15.5% 15.5% 15.5% 15.5% 15.5% Allocation 3.7% 2.5% 4.5% 4.5% 4.5% 4.5% 4.5% 30.1% 25.5% 25.5% 26.9% 29.0% 31.1% 33.0% General Liability 11.5% 8.5% 8.5% 10.5% 12.1% 13.7% 14.5% 3.5% 2.5% 4.2% 4.5% 4.5% 4.5% 4.5% Total 100.0% 85.0% 97.3% 89.9% 93.6% 97.3% 100.0% In performing the asset strategy optimisation in the context of the overall insurance balance sheet, the following key characteristics are incorporated into the asset liability model: Interaction of liability uncertainty with economic risk: unavoidable market risk arises due to liability volatility interactions with interest rate risk. For example, if the liabilities increase by 50% then impact of interest movement will also increase by 50%. Economic liability correlation: some insurance risks, such as credit and surety, are highly correlated to the economy. Ignoring economic liability, correlation understates true level of overall risk, leading to incorrect allocations Using the asset liability model under our optimisation framework, a constrained efficient frontier of asset portfolios is determined for which the Solvency II market risk capital requirement does not exceed EUR29.86m. The optimal asset portfolio for the company is then determined by the portfolio lying on the efficient frontier that achieves an overall surplus volatility of 10.0%. However, while this portfolio will provide optimal return characteristics within the risk and capital budget, it lacks a number of desirable qualitative features. The asset strategy is refined by overlaying qualitative constraints for insurance: liquidity purposes (e.g. cat events) years at each key rate duration generating assets of 10% This will help ensure that the asset portfolio is robust during economic downturns and has good asset liability characteristics for non-life insurance. 8

9 Aon Benfield Figure 4: Optimal Asset Portfolio Composition Allocation 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Initial Em Eq AA Credit 5 FoHF (Hedged) Gov Bonds 3 Real Estate Cash A Credit 5 Private Equity Optimal Equities A Credit 10 AA Credit 10 Gov Bonds 5 2.6% 2.5% 2.4% 2.3% 2.2% 2.1% 2.0% 1.9% Gov Bonds 1 Excess Return Excess Return Statistics Portfolio Initial Optimal - 20% - ±1 year - 10% - 10% 10.0% % 2.50% 3.54% 3.46% % 43.06% 17.41% 20.02% The optimal asset strategy shown in Figure 4 has provided a 38 bps increase in return compared to the initial portfolio, while meeting quantitative constraints for risk and capital budgeting and insurance. Conclusion Multi-line Plc s economic and financial characteristics have been transformed under Aon Benfield s proprietary optimisation framework. Underwriting performance has been significantly enhanced by optimising premium volumes across each class of business, while applying realistic constraints to limit significant deviation from the initial underwriting strategy. The recommended insurance strategy was selected as the portfolio of insurance risks that: efficient frontier return on capital This portfolio provides the greatest profit per unit of risk and capital among all possible allocations of insurance risk within the specified constraints. After allocating risk and capital to the optimal insurance strategy, the remaining risk and capital budget was allocated to an optimal asset strategy. The selected asset strategy fully utilises the remainder of the risk and capital budgets and provides optimal return while meeting bespoke qualitative constraints specific to insurance. As shown in Figure 5, the overall financial and economic impact of the business strategy optimisation is an increase to expected profit of EUR1.4m, an improvement of shareholder return from 13.3% to 14.5%. In addition, there has been no increase in volatility or capital requirement under Solvency II. Figure 5: Overall Comparison of Initial and Optimal Business Strategy Profit Vol. SCR Sharpe Ratio ROE Optimised ROE of 14.45% Liabilities Assets Initial % % 2.91% % % 3.32% Initial % % 10.36% % % 11.13% Expected Profit Initial ROE of 13.27% Initial % 13.27% 9.97% % 14.45% % 9.00% 10.00% 11.00% 12.00% Volatility 9

10 Solvency II Revealed Insurance Asset Strategy Solvency II will change the investment behaviour of insurance companies. It introduces an economic balance sheet and capital charges for assets that reflect the degree of asset risk and asset liability matching. Under the Standard Formula, the calibration of some capital charges is inconsistent with an economic view of risk. It is important to understand what potential market dislocations could occur if a significant number of insurers choose to alter their investment strategy accordingly. Solvency II also encourages a holistic view of risk and capital across insurance and investment. Allocating risk and capital across underwriting and investment more dynamically provides an opportunity to deliver a more stable return to shareholders through the underwriting cycle. Introduction Solvency II is a major catalyst for insurance companies to revisit their asset strategy, driven by capital requirements that reflect the riskiness of each asset class and how well assets and liabilities are matched in a fair value accounting world. This is in contrast to the current state of play under Solvency I, where the same level of capital is required whether assets are held in cash or private equity and no consideration is given to the sensitivity of the firm s valuation to movements in economic variables such as interest rates and credit spreads. The capital charge under Solvency II for asset and economic risks is called the Market Risk Solvency Capital Requirement and represents the potential deterioration in the net asset value of the firm following a 1 in 200 year event over a one year time horizon across all asset and economic risks. This includes the potential loss in asset values and increase in liabilities due to changes in the discount rate. The market risk charge is decomposed into contributions from each underlying economic risk that drives changes in asset and liability valuation: this consists of a number of sub-modules that are described in Table 1. The capital charge for each sub-module is calibrated to the 1 in 200 year return period over a 1 year time horizon. The overall market risk charge is computed by aggregating together each sub-module using a prescribed correlation matrix to provide the 1 in 200 level of loss across all sources of market risk. The transition into Solvency II raises a number of important questions for insurance companies and this article reveals how these can be addressed: market risk relative to underwriting and reserve risk? strategy under Solvency II to achieve capital efficiency whilst targeting attractive returns? markets and what steps could be taken to avoid potential market dislocations? Capital Allocation at the Enterprise Level Historically non-life insurance companies have tended to manage underwriting risk and investment risk as silo activities under the Chief Underwriting Officer and the Chief Investment Officer without joined up measurement of risk and capital for the purposes of setting strategy. Solvency II changes the way insurers think about risk, capital, volatility and value generation through unified risk management processes. Many companies are introducing the role of Chief Risk Officer who is responsible for managing the overall level of risk and capital utilisation in the organisation across both sides of the balance sheet. Having a more holistic view of risk and capital provides the non-life insurance industry an opportunity to achieve more consistent levels of return on equity 10

11 Aon Benfield throughout the underwriting cycle by dynamically allocating capital between underwriting risk and investment risk. As illustrated in Figure 1, by continually monitoring and forecasting the pricing cycle, business plans can be adjusted to target business classes that provide maximum profit per unit of risk and capital. During soft markets, underwriting strategy can be more cautious and premium volumes reduced temporarily for less profitable lines. This will free-up risk bearing capacity that can be redeployed to support higher yielding investment strategies until the market turns, at which point investments can be de-risked and a more aggressive underwriting strategy can be followed. From this perspective, the objective of investment strategy for non-life insurance should be to enhance the firm s return on equity within the risk and capital budget remaining after following the optimal underwriting strategy. Table 1: Standard Formula: Overview of Market Risk Capital Changes Risk Capital Change Implications capital change Property Spread income assets Rating Duration Factor Capital Charge by Duration AAA 0.9% 0.9% 2.7% 4.5% 9.0% AA 1.1% 1.1% 3.3% 5.5% 11.0% A 1.4% 1.4% 4.2% 7.0% 14.0% BBB 2.5% 2.5% 7.5% 12.5% 25.0% BB 4.5% 4.5% 13.5% 22.5% 45.0% B or lower 7.5% 7.5% 22.5% 37.5% 60.0% Unrated 3.0% 3.0% 9.0% 15.0% 30.0% Solvency II bonds may increase premium markets assets for credit ratings A or above and 1.5% of total assets concentration threshold 11

12 Solvency II Revealed Figure 1: Dynamic Risk and Capital Allocation Capital Efficiency of Investment Strategies The capital requirements for different asset classes under Solvency II vary considerably and are not always set in line with economic principles. This creates inconsistencies between optimal strategies as viewed from an economic risk measure and the Solvency II Standard Formula capital requirements. It is important therefore to develop a framework for setting investment strategy that can incorporate the management s own view of risk alongside the constraint of the Solvency II capital requirements: while achieving capital efficiency is important, it should not override the importance of careful risk management. Where significant disparities exist between the Standard Formula and economic principles, one option is to develop a partial internal model covering market risk or specific asset classes where greater risk granularity is desired. For example, the Standard Formula assigns a capital charge of 49% to Other Equity which includes a wide range of alternative assets. In the case of risky flavours of private equity such as venture capital this is quite sensible but for a diversified fund of hedge funds, this would be overly cautious: hedge funds have historical levels of volatility significantly lower than listed equity. In setting investment strategy it is instructive to understand the relative capital efficiency of different asset classes. One approach for comparing the capital efficiency is to consider the return on capital achieved for each investment under current market conditions from a silo perspective (i.e. ignoring its contribution to diversification). This comparison can be helpful in identifying whether the existing strategy is overweight in less capital efficient assets. In Figure 2 key asset classes return on capital under the Standard Formula is compared to the economic view replicated using an internal model view (based on current market conditions). 12

13 Aon Benfield Figure 2: Comparison of Return on Capital Across Asset Classes 6.0% 5.0% 4.0% ROC 3.0% 2.0% 1.0% 0.0% Cash Gov Bonds 1 Gov Bonds 3 Gov Bonds 5 Gov Bonds 7 Gov Bonds 10 AA Credit 3 AA Credit 5 AA Credit 7 AA Credit 10 A Credit 3 A Credit 5 A Credit 7 A Credit 10 BBB Credit 3 BBB Credit 5 BBB Credit 7 BBB Credit 10 Equities Real Estate Private Equity FoHF (Hedged) Em Eq Asset Class ROC (Standard Forumla) ROC (Economic), Aon Hewitt The Standard Formula significantly overstates the risk bearing capital required for longer duration credit and hedge funds. It is also noteworthy that the riskiest asset classes provide the highest return on capital, despite having relatively high capital charges. Return generating assets can still make an important contribution to return on equity despite the 49% capital charge the impact of the additional expected yield is greater than the marginal increase in capital relative to less risky asset classes. For non-life insurers an important consideration under Solvency II is the capital charges for interest rate risk. Currently most categories of non-life insurance liabilities are accounted for on an undiscounted basis. This means that the management and investors of many non-life firms are focused on achieving positive investment return in their income statement, rather than considering the asset return achieved relative to the return of the liabilities. Solvency II is encouraging insurers to think about the economic balance sheet and has significant capital charges for interest rate duration mismatching. However, until IFRS 4 Phase 2 is implemented, the general accounting view will continue to be based on undiscounted liabilities. An important consideration will therefore be the trade-off between capital efficiency and managing earnings volatility on current accounting principles: will non-life insurance investors understand that negative investment returns do not necessarily represent an economic loss when assets and liabilities are matched? 13

14 Solvency II Revealed Impact of Solvency II on the Investment Market An important question is whether the new regulatory framework could itself have an impact on the investment market through changing the investment behaviour of the insurance industry. We have already seen that in many cases there is a disconnection between the basis on which the capital charges have been set under the Standard Formula and economic reality. The insurance industry plays a significant role in institutional investment and is a major participant in European bond markets. Changes in investment behaviour attributable to Solvency II may originate from a number of sources including: 1. Matching the components of the liability discount rate to reduce balance sheet volatility 2. Capital constrained insurers who need to improve their Solvency II ratio 3. Insurers who target an investment strategy that maximises their return on equity under the Solvency II Standard Formula for market risk 1. The Liability Discount Rate Under the current proposals, liabilities are discounted using a rate derived from the risk-free rate plus an illiquidity premium. The risk-free rate is swap based with an adjustment for credit risk and the illiquidity premium is variable depending on the level of illiquidity implicit in the liabilities: for annuities in payment which cannot be altered this will normally be 100% of the illiquidity premium and other more liquid liabilities will have a low percentage applied. The illiquidity premium itself is based on the observed spread between a basket of corporate bonds (using the iboxx index) and the swap rate that cannot be explained by credit risk. Some insurers will be motivated to invest the assets backing their technical provisions more closely to the liability discount rate under Solvency II as this will help to stabilise their Solvency II ratio. 2. Capital Constrained Insurers Under Solvency II, the capital constrained insurer s concern will be primarily to take steps to reduce the capital requirement. This means reducing exposure to return generating assets that attract the 39% and 49% charges and any other assets that have large capital charges. As illustrated in Table 1, long duration corporate bonds are capital intensive and for credit rating BBB or lower are in line with return generating assets. It is therefore likely that insurance companies will reduce their exposure to equities and longer duration bonds rated BBB or lower. In addition, there is an interesting secondary effect for life insurers. Currently, life companies will invest in long duration corporate bonds to match the duration of their liabilities (typically years). This works well as the strategy provides a good yield that enables competitive annuity pricing and the liability discount rate is usually asset based so there is no additional balance sheet volatility. As noted previously, under Solvency II the liquidity premium component of the discount rate is based on a basket of corporate bonds, which supports investment in matching bonds. However, under QIS 5, the calculation of the spread risk stress test has been disconnected to the illiquidity premium stress so assets and liability valuations are stressed separately. While an implicit link between spread risk and illiquidity risk has been maintained through a negative 50% correlation in the aggregation calculation, this acts as a disincentive to match the spread duration of the liabilities. The more capital efficient strategy is to invest in shorter duration corporate bonds which have a lower spread duration, and hence capital charge, and to utilise an interest rate swap to increase the rate duration of the assets to that of the liabilities. 14

15 Aon Benfield 3. Maximising Return on Equity As discussed earlier, the Standard Formula is not consistent with an economic perspective which means that firms aiming to maximise return on equity may design an investment strategy that differs substantially to their current asset allocation. In particular, Figure 2 shows that long duration credit BBB or lower is less capital efficient and hedge funds also do not achieve a good return on equity under the Standard Formula. In general, the Standard Formula will encourage holding assets classes that provide maximum yield for the capital category they fall into: for example, within Other Equity the most capital efficient assets will be risky forms of private equity investments. While many insurers are not expected to focus purely on capital efficiency, it is likely to be a consideration that will tilt the average insurance asset allocation away from less capital efficient asset classes such as high yield debt that feature low quality credit exposures. Conclusion Solvency II is driving non-life insurers to think holistically about risk, capital, volatility and value generation across insurance and investment. We believe that bringing together the management of insurance and investment risk through the Chief Risk Officer provides a valuable opportunity for insurers to: risk and capital holistically across both insurance and asset risk underwriting and investment more dynamically throughout the underwriting cycle to provide a more stable return to shareholders There are many challenges for European insurers during the transitional period to Solvency II and beyond to the new international accounting standards. To achieve attractive returns on equity under the new capital regime for market risk, significant changes to investment strategy will be required to manage asset liability risk. Moving to an economic view of the balance sheet has significant implications for companies who report on an undiscounted basis and careful communication with senior management and investors is required to carefully manage this transition. Finally, in the current draft of the Standard Formula, there are many areas of economic disconnect that could have broader implications for the investment market. Until the Standard Formula is finalised, it is difficult to judge at what point insurers will start to switch their portfolios, but it is important to be aware of the potential market dislocations and consider how to position your firm s investment portfolio to minimise the impact of the new regulatory framework. 15

16 Solvency II Revealed Capital Relief Through Reinsurance Insurers do not necessarily have to choose between a reinsurance programme which makes business sense and one which reduces capital requirements even if the company appears thinly capitalised under QIS 5. Non-proportional reinsurance often provides the best solution for the business by removing frequency risk and tail risks at a cost that makes economic sense. Under the Standard Formula significant capital relief can be obtained for non-proportional reinsurance, making it an attractive solution from both a business and capital perspective. Introduction Standard Formula risk mitigation techniques under Solvency II have already become a hot topic for actuaries, CROs and CFOs. For most companies, regulatory capital requirements have historically played a relatively small role in the decision to purchase a particular reinsurance contract, where managing the volatility of shareholder returns and economic and rating agency capital requirements have typically had the upper hand. However, QIS 5 indicated that regulatory capital requirements under Solvency II are likely to increase significantly for most non-life insurers. Although unlikely to become the dominant factor in a reinsurance purchasing decision, the impact of the reinsurance on Solvency II capital should be explored. In the Solvency II framework, an insurer can choose to use the Standard Formula or its own internal model to estimate its Solvency Capital Requirement (SCR). The Standard Formula is a non entity-specific risk-based formula designed by EIOPA, the European insurance regulator. Alternatively, the undertaking can build an internal model and submit it for approval by the regulator to determine their SCR. For the vast majority of companies the investment required to develop and submit an internal model is too great and so a good understanding of how the Standard Formula recognises the risk mitigation effect of reinsurance is essential. This case study uses the QIS 5 version of the Standard Formula to estimate the impact of a specific reinsurance structure on a notional company s non-life The non-life underwriting risk module comprises three This case study considers the impact of the reinsurance structure on both Premium Risk and Cat Risk which must be calculated separately and then combined together using a prescribed correlation coefficient. Under the Standard Formula, the premium risk by class of business is calculated as the product of a prescribed underwriting volatility and the company s premium volume. For proportional reinsurance, such as quota share, the capital relief can be easily determined by multiplying by the ceded percentage. For nonproportional reinsurance, the capital saving effect is less immediately apparent under Standard Formula. However, as this case study will demonstrate, nonproportional reinsurance can offer significant capital savings without requiring a partial or full internal model to be developed. Notional Insurer and Reinsurance Structure The case study is based on a notional Swedish monoline company whose property portfolio has a premium volume of EUR130m and is protected by existing risk attachment of a 12 year return period. The focus of the study is the capital benefit of adding an aggregate protection to the existing retention. Since the company has existing risk and catastrophe large individual and catastrophe claims, the additional 16

17 Aon Benfield structure they are interested in purchasing is a risk and catastrophe aggregate reinsurance to provide more sideways protection on their retention. With this new structure in place, the insurer is protected by the following reinsurance contracts: Table 1 shows the combined effect of these reinsurance protections for an example set of large individual claims: Table 1: Combined effect of reinsurance protections EURm Gross Loss Net of Risk XL Loss below Retention Presented to Aggregate Recovery from Aggregate Overall Net Undertaking Specific Parameters Under QIS 5, companies have the choice of two methods to estimate the impact of non-proportional reinsurance on their non-life insurance risk (on top of the effect of the reduced premium volume) both involve customisation of the volatility factor. The first approach is the Non-Proportional Adjustment Factor for reinsurance. Most insurers failed to apply this adjustment in their QIS5 submissions for a number of reasons, including: (1) it can only be applied for standard limits or deductibles are excluded, (2) the assumption made by the adjustment calculation that individual large loss severities follow a lognormal distribution may be of questionable appropriateness giving results which are hard to believe. The second method is known as Undertaking Specific Parameters (USPs). Non-life premium risk USPs allow insurers to determine the volatilities to apply in the premium risk calculation using their own historical losses and one of three prescribed methods. The final premium risk USPs are weighted averages of the insurer s calculation and the Standard Formula where the credibility weights depend primarily on the number of years of available data and the line of business. For example, for property (fire) the weighting is 100% for 10 years or more of data. To apply one of the USP methods, the historical losses are first adjusted for elements such as inflation and then the annual losses on an as-if basis. After all of these adjustments have been made, the volatility to use for the premium risk calculation is derived. The appeal of this method is that the impact of any reinsurance structure can be taken into account. Also, in comparison with approval by the supervisors. 17

18 Solvency II Revealed Historical Loss Data A credibility mechanism should be used when applying USPs. The credibility factors to be applied should be chosen according to the length of historical loss data. In this case study of USP on the Premium Risk, USP Method 3 will be applied to 10 years of historical loss data from the notional Swedish company. Premium Risk Results By applying the reinsurance programme to the 10 years of historical data, the USP method can estimate both the gross and net volatilities as a percentage of gross and net premiums respectively. Figure 1 shows the average large loss for each year before and after the reinsurance programme. Figure 1: Effect of Reinsurance Millions B Gross Net of XL Net of XL & AGG The volatility of the losses decreases significantly after the reinsurance programmes are applied. Table 2 shows the premium volatility and premium SCR charges obtained from applying the USP method to the loss Table 2: Premium Volatility and SCR Charges Using USP Method Net of XL Net of XL & Agg USP 9.1% 8.5% Both of these volatilities are lower than the 10% prescribed for property (fire) premium risk under QIS 5. Since, in this case, there is a property line with 10 years of data, a credibility weighting of 100% can be applied to the insurer s volatility calculation. The premium SCR decreases by approximately 9.5% due to the Aggregate Protection. 18

19 Aon Benfield Cat Risk Model Property catastrophe exposure in Sweden is purely Natural Catastrophe of which 100% is windstorm. In this case study the Catastrophe SCR is estimated based on real company data using Cat Method 1 of QIS 5 for this property exposure in Sweden. Using the Crestazone gross exposure data, the QIS 5 formula determines the 1 in 200 year event loss for the peril. To arrive at the 1 in 200 total peril loss (the CAT SCR) (Table 5), the Standard Formula requires two alternative hypothetical years to be created (Table 3). This is first done on a gross basis and each is then netted down for reinsurance, after which the maximum net annual total of the two is taken (Table 4). For the windstorm peril, the two hypothetical years are: 80% 20% of the 1 in 200 year event. Table 3: Two Hypothetical Years for Cat Scenario Cat Scenario (EURm) Table 4: The Cat Reinsurance Reinsurance (EURm) XL Agg Attachment Limit Table 5: The SCR Cat Results Before Agg After Agg Non-Life SCR Result Figure 2 shows the result after the aggregation of the Cat risk and Premium risk by using the QIS 5 correlation matrix. Figure 2: Aggregation of Cat and Premium Risks Millions CAT SCR Premium SCR Diversification Non Life SCR Before AGG After AGG 19

20 Solvency II Revealed Since the aggregate contract protects both premium risk and cat risk, some thought should be given to how the aggregate deductibles and limits are shared between the two risk categories. By applying the aggregate conditions separately to the premium risk calculation and cat risk calculation, as has been done in this study, a conservative assumption has been made due to the aggregate deductible being imposed twice. Conversely, allowing for the full aggregate limit in both calculations is an overly-generous assumption and therefore, a further condition is imposed: the total reduction in SCR contract, in this case EUR20m. A reduction of only no such cap is required. Therefore the aggregate reinsurance programme decreases the capital charge for Cat Risk by 38% and Premium Risk charge by 9% under the USP method. After diversification, the total Non-life SCR decreases by 22% from EUR49m to EUR38m. Conclusion This case study clearly demonstrates that, even for a reinsurance contract that is structured primarily to achieve very specific business benefits such as the sideways retention protection the risk-mitigation significant even under the Standard Formula where it may not be immediately apparent at first glance. As for proportional reinsurance, non-proportional reinsurance programmes with tailored characteristics can also significantly reduce the Solvency II Non-life underwriting SCR. This is due to a combination of reduction effects including the ability to fully recognise reinsurance in the calculation of non-life catastrophe risk, as well as the ability to capture the actual volatility of the company s net premium risk using the USP method. For companies for whom Solvency II capital is a key constraint, the reinsurance programme could be designed from more of a capital management perspective. This first requires a company to define its risk appetite for insurance underwriting risk, upon which an optimal reinsurance programme can be structured to help the company to meet these objectives, whilst achieving other desirable outcomes such as reducing ceded profit and retained volatility. Reinsurance has always been a valuable risk-mitigation instrument. Different reinsurance programmes provide different business and capital benefits, and this case study demonstrates that the two can go hand in hand under Solvency II without necessarily using an internal model. 20

21 Aon Benfield Natural Catastrophe Capital Requirement Under Solvency II A magnitude of difference can exist between the Standard Formula and an internal model to calculate solvency capital for catastrophe risk. The discrepancies are revealed in the case study which stresses the importance of making a strategic management leading Cat risk mitigation tool and proves to be a cost effective source of capital, which is now recognised by Solvency II. Catastrophe risk is a key driver for capital under Solvency II, with the benchmark to withstand a 1-in-200 year event for natural and man-made disasters. There is a basic calculation method that insurers can use to determine their Solvency Capital Requirement. However the methodology for the standardised scenarios for natural catastrophe modelling overlooks key data features. As such, natural catastrophe (Nat Cat) calculations are ignoring 15 years of critical evolution under the currently proposed Solvency II Standard Formula, which could lead to higher capital requirements for insurers when the regulation comes into force. Insurers need to choose between the Standard Formula and a partial internal model to assign a more appropriate capital charge. The article reveals the different outcomes through a detailed case study. Figure 1: Process Options to Calculate Nat Cat SCR NatCat SCR Standard Formula Standardised scenarios are defined per European country and peril. The Standard Formula approach is designed to be applicable to the majority of companies and will be a practical solution for smaller companies as internal models can be costly and require a complex regulatory approval process. Standard Formula parameters, such as damage factors and correlations, as well as peril selection depending on a country hazard profile, are based on the Catastrophe Task Force (CTF) guidance. The CTF is a working group which includes regulators, (re)insurance industry participants and catastrophe modelling agencies. The Nat Cat Standard Formula approach is currently under review after some criticism following the QIS 5 industry exercise. The factor-based method is used where standardised scenario is unavailable or non-applicable, including: Standard Formula (Partial) Internal Model Method 1: Standardised Scenarios Method 2: Factor based Use of Cat Models Internal model Internal models based on catastrophe modelling software output better reflect the risk profile of a company, which is particularly critical in producing results that reflect the company s potential exposure to Nat Cat risk. 21

22 Solvency II Revealed Table 1 outlines the differences between the data requirements and therefore data quality impacting risk sensitivity of the possible approaches used in QIS 5 for the Nat Cat SCR. Table 1: Impact of the Different Data Requirements for Nat Cat SCR Parameters and metrics Standardised scenario Factor based Internal model (cat model) Perils Subsidence Gross Written Premium Geographic resolution All levels of resolution Property coverage Interruption Line of business split other secondary characteristics Loss scenario Single event and Subsidence Loss calibration Due to significant differences in data granularity between Standard Formula and partial internal model, the output SCR will inevitably differ, with the former yielding a higher SCR in the majority of cases. Therefore companies will base their choice of method on the approach which provides the more accurate representation of their risk in their view. Significantly, an internal model offers several risk management applications in addition to the calculation of a Solvency II SCR, and provides the opportunity to fully recognise the benefit of complex mitigation structures. 22