Fourth study of the Solvency II standard approach

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1 Solvency Consulting Knowledge Series Your contacts Kathleen Ehrlich Tel.: +49 (89) Dr. Rolf Stölting Tel.: +49 (89) You wish to receive regular information about Solvency II? You can find our Knowledge Series at > Business & Solutions > Solvency II > Knowledge Series December 28 CEIOPS carried out the fourth Quantitative Impact Study (QIS4) from April to July this year. To assess the practicality of future quantitative requirements, it was necessary to test a number of alternatives. In addition, the participants in the study were asked to complete questionnaires. The insurance companies were sent the instructions at the beginning of April 28 and the testing documents in mid-may. They were asked to prepare the Solvency II balance sheet at market values and to test future capital requirements using a European standard formula. On 2 October 28, CEIOPS submitted the first European findings in a stakeholder meeting. The final report was published in November 28. The final results are to be included at EU level in the final decision-making process before the proposal for the Directive is adopted by the European Commission. For the European insurance industry, par ticipation in the studies was an op portunity to look closely at the total balance sheet approach and its implications. CEIOPS: Overview of QIS4 results With a total of 1,313 insurers and reinsurers, 99 captives and 15 insurance groups taking part in the study, the European Commission achieved its participation target of at least 25% of all European insurance companies and 6% of all European insurance groups. Compared with QIS3, the participation rate was almost 4% up, even though the work involved in conducting the study increased significantly. For the first time since the test runs began, insurance companies from all EEA states (i.e. the member states of the European Union plus Iceland, Liechtenstein and Norway) took part in the study.

2 Page 2/6 Figure 1: Participation rate Number of participants per EU member state Austria Belgium Bulgaria Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Italy Latvia Liechtenstein Lithuania Luxembourg Malta Netherlands Norway Poland Portugal Romania Slovakia Slovenia Spain Sweden United Kingdom CEIOPS Report on its Fourth Quantitative Impact Study (QIS4) for Solvency II, p. 27 f., available online at: QIS3 QIS4 A large number of participants criticised the brief time-frame available for the study. At many companies, staff shortages proved to be a problem. As a result, some of the rather complex test calculations often could not be fully carried out. Another criticism raised concerned the fact that the test documents were not provided in the respective local languages, which necessitated the deployment of additional resources in a number of companies. Participants mentioned a few general practical difficulties, especially because of: Insufficient data at the company and/or high expenditure involved in producing the necessary data. Inadequate actuarial expertise at the company. Lack of practical QIS4 instructions. Some participants, for instance, indicated that they would prefer to receive specific rules regarding requirements, and that they especially expect clearer regulations concerning the revaluation of technical provisions, the determination of the solvency capital requirement and the calculation of own funds used to cover the capital requirement. QIS4 documentation: Participants particularly criticised the late publication of some of the documents and the numerous changes and updates throughout the course of QIS4. The following remarks summarise central elements of the QIS4 study for life and property-casualty insurers: 1 1 Cf. CEIOPS: Quantitative Impact Study 4. Summary results and main messages. Online at view/118/124/. Implications for the total balance sheet approachs The main aim of this study was to show whether the future quantitative solvency requirements could be implemented in practice. A comparison of all EEA states shows that there are hardly any differences in the balance sheet totals between the current Solvency I balance sheet and the new Solvency II balance sheet. The balance sheet composition, however, differs fundamentally. The results within the individual EEA states indicate clear differences between the individual items of the QIS4 solvency balance sheet and the current solvency balance sheet. The less the local accounting regulations are based on market value assumptions, the greater the difference.

3 Page 3/6 In the case of most companies, the investments on the assets side were revalued without difficulty at the market values of the Solvency II balance sheet. Difficulties were only encountered with the valuation of deferred taxes, participations, reinsurance receivables and intra-group transactions. The treatment of deferred taxes was not clearly defined, and participations were valued by some states at zero, whilst others recognised them at market value. A comparison of the results is therefore difficult. The greatest changes to be expected will involve the liabilities side of the future solvency balance sheet. Not all companies have been able to fully revalue their technical provisions yet. These provisions are especially important for determining the eligible capital components for covering the solvency capital requirement, since they have a direct impact here. In addition, these provisions are used to calculate the solvency capital requirement. On average, the value is lower than under Solvency I, mainly because the valuation system is different. The reasons given are essentially as follows: Higher discounting factor Consideration of an external risk margin (rather than an implicit risk margin) owing to the marketconsistent valuation required Recognition of future profits The majority of the participating companies faced the following difficulties in particular: Most participants were not yet able to carry out stochastic simulations for cash flows required to value future with-profits business, options and guarantees. A number of participants were un - able to value annuity payments separately. In many cases the data were insufficient. Other participants found it difficult to determine the net provisions. Some participants, especially property-casualty insurers, were still unable to break down best-estimate provisions into the segments required in QIS4. A large number of participants consider the required market-consistent valuation of the explicit risk margin as a part of the technical provisions to be difficult and complex. Most participants overcame these problems using the simplifications provided as an alternative. Impact on the capital requirement amount: Solvency and minimum capital requirement The results show that the capital requirements of all participating European companies tend to rise under Solvency II. But to conclude that this leads to a lower coverage ratio compared with the current system is wrong. Since the increase in a few countries in the own funds is stronger on average than the increase in capital requirements, those com panies actually have a higher coverage ratio. The solvency capital requirement can be calculated using a variety of different options. Only very few companies tested several alternative in parallel, however, mainly because of a lack of time. A comparison of the results is therefore subject to considerable uncertainty. From CEIOPS report on QIS4, the following conclusions were drawn with regard to the individual risk modules: Market risk: This risk module is the main risk driver for life insurers but it is also significant for propertycasualty insurers. The capital requirement for the equity risk could alternatively be determined using the dampening method proposed by France. Under this approach, the factor for a stress scenario is adjusted in relation to the duration of the liabilities and to the deviation of the equity values from the long-term average at the date of observation. For life insurance companies whose liabilities are generally of a long-term nature, this usually means a reduction in the equity risk. 25% of the QIS4 participants tested this approach. Figure 2: BSCR structure for life insurance companies 2 % The EU member states appear on the X axis. For reasons of confidentiality, no country names are listed on the X axis in the CEIOPS Report. Health Life Non-life Counterparty Market Diversification See reference under figure 1, page Cf. CEIOPS QIS4 presentation Quantitative Impact Study 4 Summary Results and Main Messages, available online at view/118/124/.

4 Page 4/6 Figure 3: Structure of the basic SCR for property-casualty insurers 3 % The EU member states appear on the X axis. For reasons of confidentiality, no country names are listed on the X axis in the CEIOPS Report Health Life Non-life Counterparty Market Diversification See reference under figure 1, page 174 The majority of the companies view it very critically, however: they claim it violates basic assumptions and harbours a risk of creating false incentives in risk management 4. Underwriting risk: This risk module is the greatest risk driver for property-casualty insurers. The requested segmentation into individual geographical areas does not appear to have any recognisable added value for many of the insurance companies that took part in the study, but it involves extra work and cost. The situation for groups and reinsurance companies is different. Here, the influence of geographical diversification on capital requirements is appreciable. Counterparty default risk: The capital requirement ranges between 3% for life insurers and 5% for property-casulty insurers. Many participants indicated that the evalu - ation of this risk module is very complex, in particular if the number of counterparties is high. Operational risk: On average, the capital requirement for this risk category ranges between 5 1% of the total solvency capital requirement. The approaches lack of risk sensitivity was widely criticised. In valuing QIS4 capital requirements, it is necessary to consider that the study s results are unbalanced in certain respects. The companies were requested to test several alternatives but not all companies were able to comply with this request. The calculation of the minimum capital requirement MCR was implemented in practice without difficulty. Most participates favoured the compact method for determining the MCR, i.e. the determination of the MCR as a percentage of the SCR. The linear approach was criticised by the majority of participants. They remarked that the method includes the same weaknesses as under Solvency I. The opinions about the use of the combined method 5, which was also tested, varied considerably. The regulators, however, regard this method as an acceptable compromise. Irrespective of the method tested, most participants have sufficient eligible own funds to cover the minimum capital requirement. Impact on the determination of eligible own funds Overall, eligible own funds under Solvency II rose by 27% on average. Own funds of the highest category (tier 1) account for 95%, tier 2 for 4% and tier 3 for only 1%, which permits the conclusion that the limitation approach will hardly lead to a restriction of the eligible own funds in Europe. Reasons for the increase can essentially be attributed to the change in the valuation system. For instance, equalisation reserves are allocated to own funds under Solvency II. Most participants were able to determine the eligible own funds without difficulty. 3 Cf. CEIOPS QIS4 presentation Quantitative Impact Study 4 Summary Results and Main Messages, available online at: view/118/124/. 4 See also our remarks in the section QIS4 results compared with those of internal models. 5 MCR equal to the higher of a fixed percentage either of the SCR or the technical provisions cf. CEIOPS DOC-22/7, page 14.

5 Page 5/6 Figure 4: Comparison of solvency coverage ratios % Solvency I QIS 4 Life insurers Propertycasualty insurers Multiline non-life insurers Reinsurers Captives See reference under figure 1, page 41 QIS4 results compared with internal models As part of this study, 141 companies from 16 EEA states reported on the results produced with their internal models. A comparison of the solvency capital requirements shows that the capital requirement when using an internal model tends to be lower than when using the standard approach. However, this does not apply to all risk modules: the capital module for the equity risk tends to be higher than when using the standard formula. This is largely because most companies base their models on an equity shock of over 4%, whereas the standard formula proceeds on an assumption of 32%. For life insurers that can use an internal model to determine their underwriting risk, the capital requirement for the mortality risk is 3% higher on average than when determined using the standard approach. Approximately half of the QIS4 participants have made qualitative disclosures regarding the topic block internal models. Somewhat more than 6% of these participants plan to use internal models. The developments in the European insurance market, however, are very heterogeneous. Even if the majority of companies claim they will not develop fully-fledged internal models, some are considering modelling individual risk modules. This decision is based primarily on the objective of improving risk and capital management. A large number of participants expect that capital requirements will tend to be lower since company-specific models better reflect the company s risk situation than a. However, the results of QIS4 show that the incentive to develop internal models is not yet sufficiently prevalent. Compared with the, the capital requirements for the risk modules equity risk, property risk and mortality risk tend to be higher. Of the QIS4 participants intending to develop an internal model, more than half plan to use a fully-fledged internal model to calculate capital requirements. Companies already in the process of developing an internal model preferred to begin by modelling the market risk above all with the interest rate, equity and property risk regardless of whether they transact life or non-life insurance business. Life insurers additionally need to model the mortality, longevity and lapse risks, in particular, and the property-casualty insurers the premium risk. Companies using the European standard formula indicated that developing an internal model of their own would be too cost-intensive and laborious. 9% of these insurers confirmed that they were happy with the. Group solvency Altogether, 111 groups from 16 EU member states participated in QIS4. Almost all companies that took part in the group part of the QIS4 study have more free assets available than under Solvency I. Most of them prefer segmentation according to geographical diversification but consider the standard method chosen to be unsuitable. Owing to the recognition of geographical diversification, the capital requirement for the premium and reserve risk could be reduced in some groups by up to 2% compared with the solo perspective per line of business. In some companies, the adjustments to the basic solvency capital requirement for future profit commissions and deferred taxes had a strong risk-mitigating effect on the capital held.

6 Page 6/6 Conclusion Solvency II is based on an approach that models an insurance undertaking s overall risk situation in a risk-oriented way and calls for the introduction of individual risk management. The scope and complexity of this fourth study has shown how important the future quantitative requirements are for the development of a risk-based solvency system. The range of results, however, remains very broad, which makes comparative evaluation difficult. But even if the results of this study can only be a conservative estimate of the effects of the new quantitative requirements on total capitalisation, they are a good opportunity for companies to deal in detail with the issue. The results also show, however, that further efforts will have to be made to master the future quantitative requirements in practice. The main focus of these efforts will have to be on matters relating to the consideration of deferred taxes and the further development of the group solvency perspective. Solvency consulting for your company Munich Re is actively involved in important national, European and international supervisory and technical bodies. Solvency Consulting has a wealth of experience in the development and use of stochastic risk models. Thanks to this experience, Munich Re provides its clients with extensive support in preparing for Solvency II, offering them tailor-made holistic reinsurance programmes and concrete and efficient assistance. Munich Re feels that the standard formula does not adequately take reinsurance into account in the Solvency II context. That is why, as the initiator and main sponsor of the open source project PillarOne, Munich Re offers all insurance companies access to modern risk management software. In this, it sees the greatest potential for developing and establishing (partial) internal models for all insurers. 28 Münchener Rückversicherungs-Gesellschaft Königinstrasse München Germany Order number 32-63