The standard formula requires further adjustments

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1 EIOPA publishes the results of the fifth quantitative impact study (QIS5) The standard formula requires further adjustments Authors Martin Brosemer Dr. Kathleen Ehrlich Dr. Norbert Kuschel Lars Moormann Radek Pavlis Dr. Tian Zhou-Richter Contact You can download the Knowledge Series at April 211 EIOPA 1 carried out the fifth quantitative impact study, QIS5, in the second half of 21. The primary purpose of the study was to review again the calibration of the parameters, test the impact of the future capital requirements on the insurance industry and in doing so obtain information on the state of readiness of companies and supervisory authorities. The main changes from QIS4 were the use of the illiquidity premium to discount reserves, taking account of diversification effects in the risk margin for solo companies, a revised credit default risk module, quantification of expected profits from future premium income and the valuation of intangible assets. Participants were also asked to answer general questions on valuation, internal models and, importantly, their ability to implement the new requirements in practice. The insurance companies were sent the instructions at the beginning of July 21 and the testing documents in August. They were asked to prepare the balance sheet at market values and to test future capital requirements using the QIS5 standard formula. EIOPA presented its report on the results on 14 March The results are to be included at EU level in the final decision process leading to approval of the implementing measures by the European Commission. Participation in the studies gave the European insurance industry what was probably a final opportunity to test the total balance sheet approach and its implications, though it is likely that there will be further tests for individual valuation modules. Overview of the results With a total of 2,52 insurers and reinsurers, and 167 insurance groups, taking part in the study, the European Commission achieved its participation target of at least 6% of European insurance companies and 75% of European insurance groups. 1 On 1 January 211, EIOPA (European Insurance and Occupational Pensions Authority) replaced CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors). 2 EIOPA Report on the fifth Quantitative Impact Study (QIS5) for, online at eiopa.europa.eu/publications/reports/index. html.

2 Page 2/8 Figure 1: QIS5 and QIS4 participants by size and sector 3 1,6 1,6 1,4 1,4 1,2 1,2 1, 1, Small 2 Large Nonlife Life Composite Captives Reinsurers Mediumsized QIS4 QIS5 This represents 68% of insurance companies covered by the Solvency II Directive, 95% of technical provisions and 85% of premium volume. Thus, participation was almost 8% higher than for QIS4, notwithstanding the fact that the study had to be completed within a short space of time and involved a not inconsiderable amount of work. Worthy of note in QIS5 was that for the first time many small and medium-sized insurance companies took part (Fig. 1). However, due to the degree of complexity and the short time frame, not all companies were able to carry out the instructions in full, so that the results may not fully reflect the true risk situation. Practicability and state of readiness 4 The majority of the participants reported that their preparations for implementation of the standard approach were still in course, with most working towards implementation by the end of 212. However, the fact that the implementing measures have still not been finalised continues to pose a problem. All countries have criticised the high degree of complexity of at least some of the test requirements. Apart from the measurement of the credit default risk 5 and the risk margin, 6 the following points were also considered to be too complex: 7 Depicting reinsurance treaties, especially for non-proportional reinsurance Measuring catastrophe risk for property-casualty and health insurers Valuing expected profits from future premium income Valuation of options and guarantees Using the look-through method for structured investments, and also for certain investment funds and unit-linked products Measuring lapse risk, especially calculation on a policy-by-policy basis Measuring concentration risk Cash-flow projection Valuation of premium reserves Measurement of spread risk (due to its calibration) Measuring currency risks Using undertaking-specific parameters The short time frame was also criticised. Furthermore, the demanding data requirements proved to be a problem for many companies 8, so that some of the rather complex test calculations could often not be fully carried out. Companies that have taken part in earlier studies clearly have an advantage. Many companies now have the following tasks on their agenda for the implementation of : Introduction of the processes and procedures required to produce the necessary data Increase in actuarial expertise at the company Building up a risk management system Training of staff at company level to increase their expertise and awareness of the importance of Gap analyses Detailed project planning 3 Cf. EIOPA QIS5 Report, p. 22 and CEIOPS QIS4 Report, p. 26, online at europa.eu/consultations/qis/index.html. 4 Cf. EIOPA QIS5 Report, p. 143 ff. 5 In particular determining the loss given default and the calculation of the risk-mitigating effect, and also the calculation of the credit default risk for a reinsurer and the hypothetical SCR. 6 The greatest challenge was calculating the future SCRs and valuing the residual market risk. 7 Cf. EIOPA QIS5 Report, p. 144 f. 8 Cf. EIOPA QIS5 Report, p. 145 f.

3 Page 3/8 However, some companies fear they may not be able to get everything done. Particularly critical is a lack of the resources needed to implement all of the requirements on time and smaller insurers are concerned that they may be heavily dependant on external consultants. Implications for the total balance sheet approach At the end of 29, surplus capital at companies was 5bn, substantially less than at the end of 27 before the financial crisis, when the figure was 6bn. 9 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 balance sheet. 1 The results within individual EEA states indicate clear differences between the individual items in the QIS5 solvency balance sheet and the Solvency I balance sheet. The less the local accounting regulations are based on market value assumptions, the greater the difference. It did not pose a problem for most companies to revalue the investments on the assets side at market value for the balance sheet, especially where they had already had experience of the IFRS valuation methodology. Difficulties only arose with the valuation of property, deferred taxes, intangible assets, participations, contingent liabilities, financial liabilities and employee benefits. 11 Figure 2: Solvency I and balance sheets compared Current SII Current SII balance balance balance balance Assets sheet sheet Liabilities and OF sheet sheet Unit-linked 19.1% 2.% Basic own funds Corporate bonds 22.5% 22.7% Non-life reserves 8.9% 6.7% Sovereigns 19.% 2.4% Health reserves 4.2% 4.% Equity 1.3% 1.8% Life reserves 46.5% 45.9% Mortgage 4.1% 4.% Unit-linked reserves 2.6% 2.7% Property 2.1% 2.8% Risk margin % 1.9% Cash 3.6% 3.8% Short-term liabilities 3.2% 3.% Reinsurance 6.6% 5.9% Deferred tax liabilities.2% 1.3% Investment funds 6.% 3.7% Other liabilities 3.9% 3.8% Deferred tax assets.2%.3% Total liabilities 6,714 6,491 Goodwill.1% % Total ( bn) 7,457 7,432 Other assets 6.4% 5.7% Total ( bn) 7,457 7,432 The greatest changes to be expected will involve the liabilities side of the future solvency balance sheet. Reserves are especially important for determining the own funds eligible for covering the solvency capital requirement and are used to calculate it. On average, the gross technical provisions are lower than under Solvency I, primarily because the valuation methodology is different. 12 The main causes are: 13 Discounting of the best estimate reserves on the basis of a risk-free interest-rate curve and application of an illiquidity premium Recognition of future premium income Use of more realistic assumptions for the best-estimate valuation Not all companies have been able to fully revalue their technical provisions yet. Life insurance companies have reported that they are having problems with the valuation of technical provisions on the basis of stochastic projections, the valuation of options and guarantees and the prescribed segmentation. Property-casualty insurers have reported difficulties in valuing reinsurance receivables. 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 of them overcame this problem using the approximation methods provided as a means of simplification. We summarise below the main elements of the QIS5 study for individual insurance companies. 9 Cf. EIOPA QIS5 Report, p. 6 f. 1 Cf. EIOPA QIS5 Report, p. 36 ff. and EIOPA QIS5 Results, p. slide admin/tx_dam/files/ consultations/qis/qis5/hearingqis5slides%2[compatibility%2mode].pdf. 11 Cf. EIOPA QIS5 Report, p The technical provisions are 25% lower for property-casualty insurers and slightly lower for life insurers (1%). Cf. EIOPA QIS5 Report, p. 44 f. 13 Cf. EIOPA QIS5 Report, p. 44.

4 Page 4/8 Impact on the solvency capital requirement and minimum capital requirement QIS5 has demonstrated that the capital requirements of all participating European companies tend to rise under (Fig. 3). At 227bn, capital requirements under Solvency I are considerably lower than the 547bn required for (SCR). Minimum capital requirements (MCR) for total 185bn (Fig. 4). However, it would not be correct to conclude from this that solvency ratios will be lower throughout the EU than with the current system, as the solvency ratios in some European countries have even risen as companies capital has increased by more than their capital requirement (e.g. in Austria, where around a half of the insurers have been able to improve their solvency ratio compared to Solvency I). 14 Figure 3: Capital requirements under Solvency I and compared % QIS5 Austria Belgium Bulgaria Cyprus Czech Republic Germany Denmark Estonia Spain France Finland Greece Hungary Ireland Iceland Italy Liechtenstein Lithuania Luxembourg Latvia Malta Netherlands Norway Poland Portugal Romania Sweden Slovenia Slovakia United Kingdom Figure 4: Capital requirements compared 1, Figure 6 shows the level of SCR cover (solvency ratio) by country. In Europe as a whole, only in Estonia did all participants have a solvency ratio in excess of 12%. In four EU countries, Slovakia, Finland and Lithuania, and in Liechtenstein, there was no participant with a solvency ratio below 75%. In the remaining EU countries, at least one participant had a solvency ratio below 75%. However, it is difficult to interpret these results because EIOPA did not provide information on the number of participants from each EU country. 4 2 Figure 5: Comparison in % of solvency ratios % Solvency I SCR 185 MCR 466 Capital requirement Eligible own funds Cf. FMA: : Wesentliche Ergebnisse der QIS5 (principal results of QIS5), online at data/6_sonderthemen/solvency_ii/qis%2 5%2Präsentation%222%23%2211.pdf. Solvency I SCR MCR

5 Page 5/8 Just under a half of the participants (48.3%) had solvency ratios of over 2% % of participants had a solvency ratio of between 12% and 2%. Around a quarter of European insurance companies (23.7%) showed a solvency ratio of less than 12%. 15% of QIS5 participants (QIS4 11%, QIS3 16%) had a solvency ratio of less than 1% and consequently insufficient eligible capital to cover their solvency capital requirement. EIOPA did not publish any results for the individual solvency ratios of the life, property-casualty and health business segments. Almost 5% did not even meet the minimum capital requirement (1.2% for QIS4). 17 Figure 6: SCR cover by country 15 % Figure 7 shows the QIS5 risk capital structure of solo property-casualty and life insurance companies. The report on the QIS5 results provides the following information on the individual risk modules: Market risk This risk module constitutes the largest risk component if the standard formula is used. This is particularly true of life insurance companies, where market risk accounts on average for 67%. At property-casualty insurance companies, market risk accounts for around a third of total risk. The main risk drivers within the market risk module are equity risk, spread risk and interest-rate risk. In their responses, participants proposed that complexity be reduced for the evaluation of the individual sub-risk modules and that the calibration be revised. 75 Less than 75% 75% to 12% 12% to 2% More than 2% European Economic Area Estonia Slovakia Liechtenstein Finland Lithuania Netherlands Czech Republic France Germany Portugal Romania Spain Austria Luxembourg Norway Denmark Cyprus Iceland Italy Hungary Belgium Bulgaria Slovenia United Kingdom Latvia Sweden Ireland Malta Poland Greece Figure 7: QIS5 risk capital structure by risk module (%) 18 % Non-life BSCR (diversified) Market risk Counterparty default risk Life Health Non-life Intangible assets BSCR % 1 8 Life BSCR (diversified) Cf. EIOPA QIS5 Report, p Cf. EIOPA QIS5 Report, p Cf. EIOPA QIS5 Report, p Cf. EIOPA QIS5 Report, p Market risk Counterparty default risk Life Health Non-life Intangible assets BSCR

6 Page 6/8 A major difference within market risk in comparison to QIS4 was the inclusion of a new risk module that measures the risk resulting from a reduction in the illiquidity premium. 19 The illiquidity premium risk accounted for 5.8% of the undiversified risk capital for the market risk at solo level, and 7.1% at group level. Some participants had problems using the illiquidity premium to discount their reserves. 2 Underwriting risk for PROPERTY-casualty insurers This risk module is the greatest risk driver for property-casualty insurers, accounting for 52.4% of total risk. Though the premium and reserve risks dominate within this risk module for solo companies, catastrophe risk is a significant risk driver (cf. Table 1). The predominant natural catastrophe risk across Europe is windstorm risk, followed by the earthquake scenarios, and the main man-made risks are the liability risks. Table 1: QIS5 risk capital structure for non-life underwriting risk Non-life Premium/reserve risk 75% Catastrophe risk 44% Lapse risk 1% Diversification effects 2% Many companies are looking for improvements in the measurement of catastrophe risks. Several participants found it difficult to depict their non-proportional reinsurance covers in full, also questioning the factor used in the premium and reserve risk module. A market-wide calibration with standard parameters would simplify measurement considerably. Problems were also experienced with the test instructions for the appropriate recognition of catastrophe risks. Participants criticised the prescribed catastrophe scenarios, the calibration, the complexity and the availability of data. EIOPA is currently working with the industry on suitable catastrophe scenarios. For QIS5, property-casualty insurers had to perform a valuation of lapse risks for the first time. This risk module was the subject of much criticism and many participants are demanding that the sub-module be taken out of the standard formula, not least because the lapse risk accounts in any case for only 1% of the underwriting risk. However, EIOPA is insisting on retaining it on the basis that it does not wish to create any undesired incentives in respect of the sale of insurance products in the propertycasualty area. Underwriting risk for life insurers At 23.7%, underwriting risk is the second-largest risk driver for life insurance companies after market risk (67.4%). Within the underwriting risk module, lapse risk and longevity risk are the major drivers, accounting for 46% and 44% respectively (cf. Table 2). Table 2: QIS5 risk capital structure for life underwriting risk Life Mortality risk 8% Longevity risk 44% Disability risk 6% Lapse risk 46% Expenses risk 22% Revision risk % Catastrophe risk 8% Diversification effects 35% The insurance industry evidently considers the structure of the underwriting risk for life to be appropriate except for the lapse risk. For QIS5, three scenarios had to be quantified at individual-contract level for lapse risk. It was only necessary to take account of those contracts causing a loss for each shock used. The main criticism concerned the calculation of the shock at individualcontract level. For the majority of companies, comparing surrender values with best-estimate reserves at individual-contract level involves a great deal of work or is not possible with their current systems. It was proposed that the methodology be simplified, for example by valuing the risk on the basis of model points. A further criticism related to the rigid financial behaviour ascribed to policyholders, who only make use of their right to cancel if it involves a loss for the insurance company. The failure to take account of the trend risk in the longevity risk module was criticised as well. Underwriting risk for health insurers As with property-casualty insurers, underwriting risk is also the largest risk driver for health insurers throughout Europe, accounting for 63% of total risk. 21 As can be seen from Table 3, the sub-module for health insurance by type of non-life insurance (non-slt health) dominates the underwriting risk. 19 Since illiquidity is taken into account in the discounting of best estimate reserves (through the use of a higher yield curve), the risk of economic capital decreasing in the event of a fall in the yield curve was also included. The fall was captured via a scenario in which it was assumed that the stress factors for the curve used decreased by 65%. 2 Cf. EIOPA QIS5 Report, p Underwriting risk accounts for 63% of the basic solvency capital requirement for insurers at which over 8% of technical provisions relate to health insurance business.

7 Page 7/8 Table 3: QIS5 risk capital structure for health underwriting risk Health SLT health 39% Non-SLT health 59% Health cat 11% Diversification effects 9% Non-SLT health consists primarily of premium and reserve risk the lapse risk was deemed by many insurers to be immaterial and hence not calculated. Within underwriting risk for health insurance by type of life insurance (SLT health), disability risk is the largest risk driver (76%), followed by lapse risk (19%), longevity risk (11%) and expense risk (11%). The catastrophe risk sub-module comprises three scenarios, arena, pandemic and concentration, of which the pandemic scenario is the most significant. Many changes were made to the module for health insurance underwriting risk following QIS4. Nevertheless, the following points were criticised: Allocation of business to the SLT health or non-slt health categories Calibration of the shocks for occupational disability insurance in the disability/morbidity module The appropriateness of the prescribed catastrophe scenarios Counterparty default risk There was considerable feedback from the participants on this risk module. Despite the fact that, at 7%, its average effect on overall SCR across Europe is modest, there were more responses than for any other risk module. Nevertheless, the exposure of certain insurance companies will be substantially higher. The valuation method used for the module was considered extremely complex. The valuation of risk-mit i- gating effects at individual-contract level and dependencies with other modules were criticised as involving too much work. For example, practical problems were encountered in the quantification of the risk-mitigating effect of special reinsurance solutions, such as coinsurance pools, reinsurance programmes with more than one partner and non-proportional reinsurance. Operational risk The factor approach tested in QIS5 hardly differed from that used in QIS4 the main change was that higher risk factors were applied for QIS5. The capital requirement for operational risk represents only 5.4% of the BSCR at individual-company level, so that overall it plays only a minor role. The simplified approach continues to be viewed critically, as it is not sensitive to risk and still bases the calculation on premiums and reserves. Moreover, the formula neither takes account of the quality of processes for the management of operational risk that have already been introduced nor provides a real incentive for companies to establish reasonable, individual risk management practices. It is therefore astonishing that a majority of the insurers questioned which notwithstanding the shortcomings mentioned intend to develop a partial/internal model would prefer to use the standard formula for measuring operational risks. It would appear that cost and benefit are not financially well balanced. Intangible assets A value can be attributed to intangible assets in the QIS5 balance sheet. Some insurers entered values for software, renewal rights and customer relationships, though most items were valued at nil. This risk module is of no significance for risk capital purposes, accounting for an average of.1% of basis SCR for life insurers and.4% for non-life insurers across Europe as a whole. QIS5 results compared with internal models 262 companies are already using their own model assumptions for their business model and 289 companies are currently working on introducing their own model. Analysis of the results has shown that individualcompany capital requirements calculated with the help of an internal model differed only marginally from those calculated using the standard formula The results are different for capital requirements at group level, which with internal models were on average only some 8% of those based on the standard formula.

8 Page 8/8 This might appear somewhat surprising at first, as the European Commission had intended that the prospect of capital relief would motivate companies to invest in their own models, but there are a variety of reasons for this result. One of the main reasons is that companies internal models evaluate risks that are disregarded in the standard approach. However, most internal models are still at the development stage, making comparison difficult. Many companies will be using partial models focusing on individual model assumptions for underwriting risks and market risk. Conclusion The basic objective of introducing a risk-based supervision system in Europe is viewed as absolutely necessary both by the insurance industry and by supervisors. EIOPA sees the risk situation of the insurance industry in Europe as being relatively positive compared to other areas in the financial sector, though the range of results remains very broad, making comparisons across country boundaries difficult. The market-oriented values used for the balance sheet directly affect solvency ratios, which will be subject to much greater fluctuations with the new supervision system than under Solvency I. If QIS5 were the standard, 15% of European insurers would have to improve their solvency ratio. In the course of QIS5, EIOPA received a lot of critical feedback from the industry on the standard formula. The participant feedback demonstrated that the preparations of many companies for calculating their solvency capital requirement are still far from complete. The frequent criticism that the standard formula is very complex relates not just to the method of valuation, but extends to the data required to perform the valuations at all. Thus, for many companies, the implementation of appropriate procedures and processes will be a key milestone on the road to producing the data needed to calculate their capital requirement. However, the uncertainty resulting from the fact that the implementing measures have not yet been completely defined continues to be per ceived as a problem by many companies, as they will only be able to implement the standard formula when the final implementing measures have been approved. So there is still a lot to be done and not just on the part of companies. The supervisors must now analyse the QIS5 results in detail and they will ultimately play an essential part in preparing the implementing measures. Numerous adjustments still need to be made to the standard formula to be defined in the course of the Level 2 deliberations, especially regarding the calibration of individual parameters and indeed the practicability of the formula in general. Solvency Consulting for your company Munich Re assists its clients in some areas of. Solvency Consulting already has a wealth of experience in dealing with the standard formula, the development and use of internal stochastic risk models and their relevance to value-based portfolio management. We also play an active role in industry committees looking at regulation and specialist issues and ensure that knowledge and expertise are transferred and translated into practical recommendations for action on the ground. We are thus able to offer our clients real and efficient help in preparing for. 211 Münchener Rückversicherungs-Gesellschaft Königinstrasse 17, 882 München, Germany Order number