Solvency II - Practical Implementation & Implications Nov 24, Richard Payne Regional Actuary Solvency II Prudential Corporation Asia

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1 Solvency II - Practical Implementation & Implications Nov 24, 2011 Richard Payne Regional Actuary Solvency II Prudential Corporation Asia

2 Solvency II: Practical Implementation & Implications 1. Principles 2. Solvency II Outputs 3. Implications 4. Benefits

3 Solvency II: Practical Implementation & Implications Health Warning: Rules/Regulations are subject to change

4 1. Solvency II Principles The European Commission outlined the following aims for a new solvency regime 1 : To increase policyholders protection by affording supervisors an adequate time window in which h to identify and remedy adverse experience or failings within an insurance company; To provide comparability and transparency thus creating a level playing field; To establish a solvency margin requirement that is better matched to the true risks; To establish principles and not be excessively prescriptive; Where possible to be based on common accounting practices so as to produce expenditure savings and avoid the duplication of financial reporting systems. 1 European Commission document titled Solvency II: Presentation of the proposed work dated 13 March

5 1. Solvency II Principles: 3 Pillars Pillar 1 Risk Measurement Pillar 2 Risk Management Pillar 3 Disclosure Harmonised Market consistent Balance Sheets Risk-Based Solvency Capital Requirement (SCR) Minimum Capital Requirement (MCR) Standard Formula or Internal Model approach System of Governance Supervisory review of firms processes, risk management system and capital adequacy Own Risk & Solvency Assessment (ORSA) Annual publicly-available Solvency & Financial Condition Report (SFCR) Quarterly/Annual l Quantitative Reporting Template (QRT) Annual Regulatory Supervisor s s Report (RSR) Market

6 Solvency II: Practical Implementation & Implications 1. Principles 2. Solvency II Outputs 3. Implications 4. Benefits

7 2. Solvency II Outputs - Balance Sheet Both assets and liabilities are to be fair valued (market value of assets and liabilities) Market Consistent Assets & Liabilities Valued at the amount for which they could be exchanged between knowledgeable willing parties in an arm s length transaction Assets Market Value Insurers must invest in assets according to the prudent person principle Contract Boundaries Significant outstanding issue 7 Assets at Market Value Excess of Assets Over Liabilities Other liabilities Risk Margin Best Estimate Liabilities Basic Own Funds Own funds is the Solvency II terminology for available capital Risk Margin: (for non-market risks) Margin to value technical provisions equivalent to the amount that another undertaking would be expected to require in order to take over and meet the insurance and reinsurance obligations Cost of Capital approach Reflects uncertainty in best estimate assumptions Best Estimate Liabilities (BEL): Probability-weighted average of future cashflows, taking account of expected present value of future cash-flows, using the relevant risk-free interest rate term structure Risk-Free Rate of Return/Discount Rate Best Estimate Assumptions Stochastic Valuation of Guarantees Technical Provisions (Value of Market Consistent Liabilities for fully hedgeable risks)

8 2. Solvency II Outputs: Balance Sheet Solvency Capital Requirement is regulatory Required Capital Assets at Market Value Own Funds Other liabilities Risk Margin Solvency Capital Requirement (SCR) Solvency Capital Requirement (SCR) SCR is the Solvency II terminology for required capital Own Funds must be greater than SCR otherwise regulator notified/recovery plan Minimum Capital Requirement (MCR) represents min level of resource & level of ultimate regulatory intervention Can be calculated by Standard Formula or by Internal Model Internal Model subject to regulatory approval much more than a capital calculation Best Estimate Liabilities Contract Boundaries Also an issue for SCR calculation l 8

9 2. Solvency II Outputs: SCR Standard Formula Approach Current Balance Sheet Shocked Balance Sheet Own Funds Apply Risk Driver Shock (e.g. equity) SCR Own Funds Assets Fall in Own Funds = (Equity) SCR Liabilities Assets Liabilities Calculated on Going-Concern basis SCR calc includes allowance for 12 months of New Business 9

10 2. Solvency II Outputs: SCR Standard Formula Approach Shock for each Risk Driver Equity Interest Rate (up & Down) Property Correlation Matrix Eq Int Prop Cred C/D Curr Etc Credit Spread Counterparty Default Concentration Currency Mortality Morbidity Lapse Up/Down/Mass Longevity Expense Eq Int x Prop Cred C/D Curr Etc =SCR Operational

11 2. Solvency II Outputs SCR: Prudential s Internal Model Internal Model Prudential can specify its own calibrations & risk profile, subject to meeting key principles in SII directive SCR is based on 1-in-200 shocks, uses a 1-year Value-at-Risk model Project all (100,000) possible scenarios of Solvency II balance sheets in 1 year 100, scenarios are multi-risk some good outcomes, some bad outcomes Calculate the Change in Own Funds for each scenario, and rank high to low Internal Model SCR is equal to the 500 th worst outcome (99.5 th percentile) Calculation of 100,000 projected balance sheets creates a practical problem 100,000 Possible Outcomes (Risk Scenarios) Balance Sheet Projection Model 100,000 ranked Balance Sheets (Change OF) SCR = 500 th worst outcome Risk Scenario Generator Lite Models 11

12 2. Internal Model SCR: Risk Scenario Generator Risk Driver Experience Investigations Risk Driver PDFs Risk Scenario Generator 100,000 Risk Scenarios Equity Interest Rate Credit Lapse Mortality Operational Etc Expert Judgement 100,000 Random Numbers 12

13 2. Internal Model SCR: Lite Models LM Calibration Scenarios Prophet Lite Model Calibration Lite Model Aggregator Equity Interest Rate Credit Lapse 250 Mortality 200 Etc % 50% 100% 150% 200% 250% Equity 13

14 2. Solvency II Outputs: Issues Fungibility Groups: deficit in one country supported by surplus in another But capital movements may be restricted by local regulations (inc. solvency) Treatment of Ring-Fenced funds (with-profits) Contract Boundaries (tbc) Removes future profits from BEL calculation for certain products Potentially significant impact on Medical, Unit Linked products May require tightening of policy conditions Not consistent with proposed p IFRS definition Regulations Still outstanding makes modelling and business decisions difficult BAU Timetable Extremely tight operating efficiencies necessary at year-end 14

15 Solvency II: Practical Implementation & Implications 1. Principles 2. Solvency II Outputs 3. Implications 4. Benefits

16 3. Solvency II Implications: What is an internal model? Solvency II is not just about Capital. It is a change of Behaviour. Thomas Steffen, Former Chairman of CEIOPS CULTURE DATA & TECHNOLOGY Group s definition is very specific the systems and processes used to quantify risks for the purpose of calculating the SCR and management s own assessment of economic capital requirements Holistic view of the firm s unique risk profile in order to identify, measure and manage risks on a continuous basis Must be fully integrated into day to day business and must demonstrably underpin a holistic cultural and behavioural approach to risk management Robust governance is essential & will be subject to approval and monitoring by the regulator Internal Model enables management to: The Internal Capital Model (ICM) the engine Assess impacts of business decisions on capital requirements Calculate Solvency Capital Requirement 16

17 3. Solvency II Implications: Internal Model Key Tests FSA are looking for 6 key tests to demonstrate that Internal Model is widely used in business and its outputs support key decisions Must be evidenced that business decisions are made with consideration of impact on the Group solvency position that have been informed by internal model and risk exposure against pre-defined risk appetite limits Business performance will be measured on a risk adjusted basis. Model will be regularly updated and improved, reflecting its significance to business 17

18 3. Solvency II Implications: Internal Model Use Test 1. Risk transfer - Reinsurance Currently, the assignment of new reinsurance is based on credit rating and rates competitiveness. Ascounterparty exposure limits are not used, we may be overly reliant on certain reinsurers for recovery, for example Swiss Re. Going forward, an explicit reinsurance strategy is required that takes into account counterparty exposure as well as any reduction ininsured risks. sit must also pass various prescribed tests in order to qualify for solvency credit, e.g. allowance for counterparty default, irrevocability Risk limits are to be set and monitored for each reinsurer; procedures are to be in place in the event that our exposure to a reinsurer exceeds risk limits 2. Capital management consideration of Risk Adjusted Rewards Currently, the allocation of capital to each LBU is based on local statutory requirements and marketing pressure. Little allowance is made to the risk-adjusted reward from the country (i.e. Return on Economic Capital), therefore countries with more stringent capital rules are allocated a larger share of the group s capital Going forward, Return on Solvency II capital will be used, which can take the form of new business value creation (on a Solvency II basis) over Solvency II capital. An LBU with a higher return will warrant greater capital allocation for business expansion 3. Business planning - stress testing SII surpluses Currently, the business plan focuses on IGD free surplus This will be replaced by Solvency II free surplus. Further, additional risk limits (e.g. NT$ interest rate exposure, Singapore morbidity exposure) may need to be observed. Thebusiness plan will need to be stress-tested to ensure that it remains resilient to changes in various risk factors (Group Risk Appetite tests), for example, PCA SII free surplus to fall by nomorethan x% when interest t rates fall by y% As with IGD, SII free surplus is likely to become a PCA KPI 18

19 3. Solvency II Implications: Internal Model Governance Strengthened Governance 3 lines of defence model enhanced Financial Risk Management Board Responsibilities Technical/Executive Risk Committees Regulatory Oversight Internal Model Approval Model Change Control including regulatory approval for major change Independent Model Validation Documentation Lots of it! Expert Judgement Justification of all modelling assumptions Data & Model Control Data quality requirements 19

20 3. Solvency II Implications: Own Risk Solvency Assessment (ORSA) Own Risk & Solvency Assessment (ORSA) Process Components Solvency position Risk profile Risk Governance Description of Risk Management Processes Capital Management and ORSA Business Components Planning Data Modelling assumptions and methodology Validation Integration of output into risk based decisions 20

21 3. Solvency II Implications: Risk Management Cycle Risk Appetite Groups and local companies appetite/limits for more or less risk Example: want to reduce exposure to lapse risk, increase exposure to longevity risk Risk Appetite applies similarly to profit & cashflow measures The EEV earnings should be resilient to withstand a 1-in-10 event with no more than x% fall Risk-Based Decision Making Application of Use Test Holistic Balance Sheet Management Product Design Product Mix Investment Strategy Capital Management Solutions Risk Monitoring Risk Monitoring Continuous Solvency Monitoring Regular Risk Monitoring activities Exposure Monitoring Asset Database Course of action when risk-limits are breached

22 Solvency II: Practical Implementation & Implications 1. Principles 2. Solvency II Outputs 3. Implications 4. Benefits

23 4. Solvency II: positives & negatives Positive Solvency Capital Requirement that reflects the risks we face as a business better protection for policyholders? More consistency between EU insurers Greater transparency into the Group s capital position and risk exposure, enabling better informed strategic decision-making - potentially leading to enhanced financial growth based on risk/reward balance Continuous Solvency Monitoring & Exposure Monitoring, plus modelling of What-if sensitivity analysis helps the business take preventative action Senior Management accountability Internal model option offers potential for a lower overall capital requirement than under the Standard Formula Additional control requirements reduces Operational Risk Goodwill with local regulators? Negative Regulations not finalised Standard Formula is the simple option, but it s far from simple! Internal model option comes with significant burden of documentation and governance requirements Lack of data availability means Internal Model approach requires significant ifi use of Expert Judgement Are these really 1-in-200 events? Over-reliance on the models by management/public? Complexity of models/volume of data Resource 23

24 Q&A

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