International Financial Reporting for Insurers: IFRS and U.S. GAAP September 2009 Session 25: Solvency II vs. IFRS

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1 International Financial Reporting for Insurers: IFRS and U.S. GAAP September 2009 Session 25: Solvency II vs. IFRS Simon Walpole

2 Solvency II Simon Walpole Solvency II Agenda Introduction to Solvency II Background Overview of Solvency II Quantitative Requirements Pillar 2 Qualitative Requirements & Supervisory Review Pillar 3 Disclosures Position in Europe now: QIS4

3 Background Solvency I Before Solvency II, there was Solvency I Solvency I: All insurers must hold capital above local statutory reserves Local statutory reserves differed considerably between member states Solvency capital based on same principles across Europe, but with differences between countries according to local conditions Broad principles: Life insurers: % of reserves + % of sum at risk Non-life insurers: maximum of % of premiums and % of claims Adjustments for reinsurance Problems: Not risk-based Differences between countries Not integrated with other financial services industries 4%/0.3% 16%/18% Overview of Solvency II 3 Pillars Quantitative Technical provisions Capital Minimum Capital Requirement (MCR) Solvency Capital Requirement (SCR) Investment Tier 1, 2, 3 capital Pillar 2 Qualitative Internal control & risk management framework Add-on to Supervisory Review Process (SRP) Pillar 3 Disclosures Reporting & disclosures Life Non-Life Health Reinsurance

4 Overview of Solvency II Timetable Quantitative Impact Studies QIS3: April 2007 QIS4: April 2008 Results released November 2008 QIS5: unlikely (?) Directives Framework Directive Proposal: July 2007 Framework Directive: March 2009 (?) National Adoption Dry-run: 2010 (?) Full adoption: 2012 (?) Quantitative Requirements SOLVENCY II Embedding Solvency II in your business Insurance risk Quantitative requirements Pillar 2 Supervisory Review Market Discipline Market risk Credit risk Liquidity risk Operational risk Reserving Regulations on minimum capital requirements Investment Qualitative requirements Regulations on financial services supervision (Capabilities and powers of regulators, areas of activity) Transparency Disclosure requirements Competition related elements Implementation Control Disclosure

5 Main Concepts Asset side Valued across Europe on a standardised basis In line with IFRS (ie governed by IASB) Some quantitative limits to address liquidity & concentration risk Liability side Technical provisions Capital set aside by an insurer to fulfill its obligations to policyholders and beneficiaries Best estimate liability plus explicit margin for risk (market-based) MCR Absolute minimum floor in required capital SCR Capital that should be able to absorb unforeseen losses up to a ruin probability of 0.5% over one year Eligible capital Tiered classification of shareholder capital allowed to cover capital requirements Balance Sheet A L Assets at MV Free Surplus SCR MCR Free surplus > SCR Sufficiently capitalised Free surplus < SCR and Free surplus > MCR Early indicator that action needs to be taken Technical Provisions Free surplus < MCR Company is technically insolvent

6 Technical Provisions Fair value calculation with risk margins Cost of non-market Risk? Own credit Technical Provisions Best Estimate Liability (market consistent) Cost of Market Risk PV Cash Flow Risk Free Possible Future IFRS Fair value liability Best estimate liability Best estimate liability is part of technical provision Technical provision is key building block for Solvency II Used as foundation for SCR calculation Calculation of best estimate liability is highly complex Complex actuarial models required Explicit company-specific best estimate assumptions needed NOT prescribed under Solvency II Time consuming to perform, significant computing power needed Difficult to supervise Partly why Pillar 2 & 3 exist

7 Best estimate liability calculation steps: par Best estimate liability Risk free discount rate Projected cashflows Each scenario must be discounted with a probabilityadjusted rate, eg a state price deflator Cashflow model Expenses Projection assumptions Claim rates Policy data Dividends Approach: 1. Project future investment scenarios 2. For each period in each scenario, decide on a relevant dividend strategy Risk Margin Technical provision = best estimate liability + risk margin Risk margin Equal to discounted value of cost of capital of supporting the insurance obligations Capital to support insurance obligations defined to be SCR but only in respect of: Operational risk Underwriting risk (existing business only) Counter-party default risk in respect of reinsurance ceded Cost of capital prescribed to be 6% per annum Projection of relevant parts of SCR needed Certain approximations are allowed and put forward in QIS4

8 SCR Solvency Capital Requirement Equal to capital that should be able to absorb unforeseen losses up to a ruin probability of 0.5% over one year ie protected in 99.5% of cases over one year ie 1 in 200 year event Effectively a VaR ( Value at Risk ) approach using stress tests SCR: Calculation Approach (example 1) Step 1: Calculate base free surplus: {free surplus} base = {asset value} base {technical provision} base 10 = Step 2: Example: assume that 1 in 200 year event in respect of equity values is a stock market crash of 50% Apply this shock to the asset value and the technical provision This gives a new (lower) free surplus: {free surplus} equity = {asset value} equity {technical provision} equity 7 = Step 3: SCR equity = {free surplus} base {free surplus} equity = 10 7 = 3 Step 4: Repeat for each stress test, add up (but some diversification allowed)

9 SCR: Calculation Approach (example 2) Base scenario Interest rates down 1% Assets Net Free Assets Surp Liability Asset duration = short Current MV = 100 Stressed MV = 105 Liab duration = long Current MV = 90 Stressed MV = 99 Asset increase = 5 Liab increase = 9 Free surplus decrease by 4 SCR (interest rate fall) =4 SCR: QIS4 Risk Factors

10 SCR: QIS4 Example Risk Factors Market Value after Stress 100% Base case 80%Property stress test 68% global equity 55% hedge fund SCR: QIS4 Example Correlation Factors Mkt interest Mkt equity Mkt property Mkt spread Mkt fx Mkt interest Mkt equityt Mkt propertyt Mkt spread Mkt fx Example capital calculation for two risks: Mkt interest = 5 Mkt property = 3 SCR Mkt 2 = = 49 So SCR Mkt = 7 Diversification benefit = 1

11 MCR Minimum Capital Requirement Minimum floor in required capital Falling below this capital limit would trigger regulatory intervention MCR = Linear MCR subject to floor of 20% of SCR and cap of 50% of SCR Absolute minimum: Life business = Euro 2m Non-life business = Euro 1m Linear MCR: Life Similar to non-life, but for fewer lines of business 2 main factors: technical provision & sum at risk separately for guaranteed and discretionary benefits for par expenses element for certain unit linked contracts Similar to Solvency I

12 Position in Europe Now QIS4 & Group Supervision QIS4 QIS4 Participants

13 QIS4 Time Needed QIS4 Solvency II Ratio / Solvency I Ratio

14 QIS4 Firms not meeting SCR or MCR QIS4 Composition of Basic SCR: Life

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