Solvency II benchmarking survey

INSURaNce Solvency II benchmarking survey Life Insurers November 2011 kpmg.co.uk/solvencyii

2 SoLveNcy II benchmarking SURvey - LIfe INSUReRS

SoLveNcy II benchmarking SURvey - LIfe INSUReRS 3 Contents 1. Executive summary 4 2. The strategic view 6 3. The programme view 8 4. The actuarial view 12 5. The tax view 16 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International cooperative, a Swiss

4 SoLveNcy II benchmarking SURvey - LIfe INSUReRS Executive summary This summary report presents the highlights from our recent Life Insurers Technical Practices Survey. Good progress has been made by most respondents in their preparation for Solvency II. 78 percent feel that their programmes are on track and encouragingly 61 percent have seen their Solvency II budgets remain at the same level as originally forecast. The headlines form the survey are: Documentation ranks top of the implementation challenges. 27 percent are still in the early stages of meeting the internal model documentation requirements. This is a common theme across all three Pillars. 83 percent of those using an Internal Model (IM) believe they are on track. The main challenge highlighted was the technical build. 54 percent of respondents highlighted counterparty Risk as the most complicated Standard formula stress to compute. orsa is a key area of concern, ranking 3rd in the list of implementation challenges. 90 percent of respondents will produce a formal orsa report on an annual basis. 56 percent believe they still have significant work to do. Lack of guidance in some areas remains a problem and although the date change gives more time, firms urgently need clarity. Documentation, uncertainty over transitional arrangements and the ORSA top the list of issues to support differed tax asset recognition. There is some question over the level of independence being achieved in model validation and preparation of the validation report. Insurers are only now starting to focus on the wider business impacts of Solvency II such as corporate structures, product design and pricing and asset allocation strategies. We believe that although firms are generally making good progress, and there is now more time to achieve compliance, they should not be complacent. areas such as the orsa, documentation and inherent uncertainties still represent major challenges for most organisations. This summary report expands on these points and other issues arising from our more detailed survey report. If you would like a copy of this please contact me or view it on our website. www.kpmg.co.uk/solvencyii There are marked variances in the tax methodologies particularly around the assumptions used John Jenkins Partner, Life Actuarial

Fig 1.1 Challenges for Solvency II implementation Documentation 18 Uncertainty over transitional arrangements 17 ORSA 14 Governance and Compliance 13 Solvency Capital Requirement 12 Data 12 Group issues 10 IMAP 9 Assurance / validation 8 Pillar 3 7 Systems 7 Tax 6 Asset valuation 5 0 5 10 15 20 Number of respondents

6 SoLveNcy II benchmarking SURvey - LIfe INSUReRS The strategic view Solvency II impacts a range of business areas The results of the survey show that insurers are increasingly starting to deal with the wider business implications of Solvency II. The core themes of capital management, decision making processes and management information remain the priority areas for most programmes, but over the past six months many insurers have started to assess the wider business including: Approach to pricing yet to be determined To highlight one of these topics, the impact of Solvency II on pricing, a key consideration is the approach to allowing diversification benefits. although the majority of insurers are still undecided, several insurers have now confirmed their methodologies and, interestingly, have opted for divergent approaches. revising the corporate structure; adapting product designs and pricing; determining asset allocation strategies; clarifying the roles and responsibilities of the centre and divisions; and establishing business implications workstreams. Fig 1.2 Allowance for diversification in pricing between new and existing policies 4 1 1 3 No allowance for diversification Diversification across new business written within product group Diversification across new and existing business within product group 18 Diversification across new business written in all product groups Paul Merrey Director, Solvency II Strategy Undecided

Asset allocation is being reviewed another topic receiving increased attention is asset allocation. The Solvency II rules result in divergent treatment for asset classes, with government bonds and mortgages receiving more favourable treatment than corporate bonds. This has significant implications for insurers, particularly annuity providers that hold substantial bond portfolios. With the rules yet to be finalised, insurers are starting to develop a range of scenarios in order to respond effectively once the relative capital treatments are clarified. Insurers are starting to compete rather than merely comply as the impact of Solvency II becomes clearer and risk models provide better information, insurers will start to reassess the economics of their businesses and re-evaluate their strategies. Questions will be asked as to which markets and product lines to compete in and which parts of the value chain to focus on. This process provides insurers with a significant opportunity to compete effectively using a more sophisticated understanding of risks and returns, and reposition their businesses to be successful in the future. Fig 1.3 Impact of Solvency II on business areas capital management / allocation 72% 25% 3% corporate structure (eg de/merger of group entities) 16% 47% 38% Decision-making processes and management information 77% 16% 6% Product mix 13% 60% 27% Product pricing 38% 53% 9% Product design 22% 63% 16% 0% 20% 40% 60% 80% 100% Significant Impact Small Impact No Impact

8 SoLveNcy II benchmarking SURvey - LIfe INSUReRS The programme view On track but still under pressure While the majority of respondents indicated that Solvency II projects are on track, it s clear from the survey results that both timelines and resources remain under pressure. There is continued reliance on contractors to meet resourcing demands, particularly in the actuarial space. There are a number of specific areas where much work remains or, in some cases, is yet to begin. 27 percent of respondents are still in the early stages of meeting the IM documentation requirements. of some concern were the five percent that have yet to start. More than half of respondents also highlighted documentation as a major implementation challenge. This became apparent in a number of specific areas including the determination of best estimate liabilities. Lack of specific guidance is a challenge An ongoing theme is the lack of clarity around the final requirements. Until very recently IM firms were working towards making initial IMaP submissions in just 6 months time. The challenges posed by incomplete or limited guidance were highlighted by more than 50 percent of respondents in relation to both QIS 5 and the transitional arrangements, and no doubt this situation is in large part the reason for the effective date being pushed back. however, the issue has not gone away and firms programmes are still progressing without the necessary clarity from the Regulators. Fig 1.4 Proportion of Solvency II work carried out by internal staff, contractors and consultants, split by size of Peak I insurance liabilities plus WPICC Peak 1 insurance liabilities (plus WPIcc) over 1bn Peak 1 insurance liabilities (plus WPIcc) under 1bn 20% 1% 7% 13% 67% 92% David Kells Partner, Solvency II Assurance Internal staff contractors consultants

10 SoLveNcy II benchmarking SURvey - LIfe INSUReRS With the mechanics of many IMs well developed, thoughts are now turning to the challenges of Pillars 2 and 3. orsa was highlighted as a particular challenge by over a third of respondents. external reporting challenges arising from Pillar 3 were acknowledged, with 56 percent of respondents confirming significant work is still required. There is still much to do outside the IM. for example 34 percent of respondents have yet to consider the commercial implications of public disclosure. This was consistent with the limited level of engagement with stakeholders other than the regulators (63 percent). Timely engagement with analysts and ratings agencies will be critical, however the fact that many firms are yet to finalise their models and calculations makes it difficult to engage in a meaningful fashion. Timely engagement with all stakeholders will be critical, however many firms have so far only engaged with the regulator Fig1.5 Progress in key Pillar 2 and 3 aspects Risk management and identification 44% 53% 3% external reporting 56% 44% Internal reporting 34% 63% 3% Governance 6% 13% 72% 9% own Risk and Solvency assessment 41% 50% 9% 0% 20% 40% 60% 80% 100% Significant work required Some work required almost at required standard at required standard

SoLveNcy II benchmarking SURvey - LIfe INSUReRS 11 There are many instances where there are no clear preferences or standard practices emerging More than just models 56 percent of respondents are using some form of IM and a key theme emerging is the need for a robust framework of processes and controls over all aspects of Solvency II. With 37 percent of respondents confirming that remuneration will be linked to IM results, there is a real need for controls in this area, and the ability to demonstrate some level of independent review. A diverse range of practices and approaches increases risks The principles based approach to Solvency II has seen an incredibly diverse range of approaches and interpretations emerging in practice. Throughout the survey, there are many instances where there are no clear preferences or standard practice emerging, for example: While the majority of IM firms are enhancing their existing capital models, a significant number have built new models or leveraged economic models. The modelling of distribution portfolios required for each risk module of the IM saw a wide range of approaches. There was variation in the application of the proportionality principal. only 3% of respondents had not used some form of simplification in their calculation of the risk margin. Fig1.6 Communication to stakeholders Shareholders 13 7 12 Regulators 12 20 Policyholders 21 8 3 credit rating agencies 9 11 1 11 Market analysts 8 13 11 auditors 2 26 4 0 5 10 15 20 25 30 35 Number of respondents Detailed communication Some communication No communication Not applicable

12 SoLveNcy II benchmarking SURvey - LIfe INSUReRS The actuarial view Solvency II has posed a number of technical challenges for actuaries which extend across all areas of the Solvency II balance sheet. even the technical provisions calculation is not straightforward due to the Risk Margin ScR projection requirement. Technical Provisions progress The majority of firms have made significant progress with their best estimate liability methodology but, as would be expected, the progress on Risk Margin methodology is considerably less far advanced. Unsurprisingly, only one respondent was planning to calculate the Risk Margin by doing a full calculation of the Solvency capital Requirement (ScR) at each future point in time. Surprisingly, 16 percent of respondents were planning to use a different ScR projection approach for the Risk Margin to that used for the orsa and 34 percent remained undecided over the approach to take. Standard Formula challenges The most challenging risk module to calculate under the Standard formula was the counterparty risk module followed by interest rate, spread and Lapse risk. The main challenge in the overall Standard Formula SCR calculation was the assessment of the expected profits in future premiums. Fig1.7 Challenges on the use of an IM Documentation standards 16% 21% complying with the Use test Interaction with the regulator 32% 5% 5% Timescales Lack of management buy-in Technical build 5% 16% other John Jenkins Partner, Life Actuarial

SoLveNcy II benchmarking SURvey - LIfe INSUReRS 13 Solvency II means that actuaries have roles across all three pillars and we may see more actuaries involved in the Risk function in the future IM approach and challenges encouragingly, 83 percent of those using an IM believe they are on track with its development. other key points emerging from the survey responses included: The most challenging area of the IM was the technical build. Documentation also proved to be a challenge for a significant number of firms. The primary additional risks under the IM that were not captured under the Standard formula were equity, property and interest rate volatility. over 80 percent of firms had submitted their first self-assessment template at the time of completing the survey. only 42 percent of respondents had asset liability models in the scope of their IM. Initially the rules were interpreted by some to mean alm models should be included, however there is a general push to narrow the scope of IMs which may explain this finding. Actuarial input into Pillar 2 and Pillar 3 The actuarial function is shown to be playing an important role right across the 3 pillars. Most firms had at least partial involvement of actuaries in the Pillar 2 and Pillar 3 workstreams. The area with most actuarial input was the orsa, which is encouraging to see since this is where firms need to ensure there is adequate cross-functional collaboration. as expected, 41 percent of firms stated there was still significant work required on the orsa. The additional risks covered under the orsa that were not modelled as part the ScR included strategic, reputational and liquidity risk. 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International cooperative, a Swiss entity. all rights reserved. Printed in the United Kingdom.

14 SoLveNcy II benchmarking SURvey - LIfe INSUReRS With 37 percent of respondents confirming that remuneration will be linked to IM results, there is a real need for robust processes and controls, and the ability to demonstrate some level of independent review Internal Model Validation approach Given the validation of the IM has to be an independent process, it was surprising to see that out of the 18 respondents to this question, half indicated that their validation team belonged to the Production team. The other half indicated that the validation team belonged to the Risk function. Given the need to maintain independence, we believe it is prudent Fig 1.8 Attribution of responsibility of the validation tasks Who is responsible for carrying out IM validation? to separate validation and production of the IM. however, as long as it can be demonstrated that there is some level of independence in the process, for example different teams within the same function reviewing each other s work, then this requirement can be considered to have been met. The overwhelming majority of respondents to the survey had a separate IM validation team. (See fig 1.8) To which function does your IM validation team belong? 33% 50% 50% 67% Who is responsible for preparing IM validation report? 68% 6% Production team (1st line) Risk function (2nd line) Internal audit (3rd line) 26%

16 SoLveNcy II benchmarking SURvey - LIfe INSUReRS The tax view We have seen a wide variety of practices in the approach taken by insurers to calculating tax for Pillar 1 there is no clear consensus yet on what will be the industry norm Tax has to date been under-represented in Solvency II implementation, at both the firm and the regulatory levels, and this is something that requires addressing urgently. a great example of this is shown in the survey results. The tax relief which can be taken on the pre-tax ScR (the loss absorbing capacity of deferred tax) is a key driver of the overall capital requirement under Solvency II. however, there is a wide variance in practice when looking at the extent to which loss absorbency of deferred tax is recognised in the context of the 1 in 200 year shock loss (see fig 1.9). Fig 1.9 Extent to which loss absorbing capacity of deferred tax is recognised assumed to be nil 1 2 4 fully recognised, given the size of the deferred tax liability on the unstressed balance sheet 4 2 7 Recognised to the extent of the deferred tax liability on the unstressed balance sheet Supported by reference to future income or profits and / or prior year income or profits 9 Supported by reference to future / prior year income or profits, future management actions and future tax planning Recognised at the full tax rate but not fully tested other Stuart Secker Partner, Head of Insurance Tax

The level of variance in the implementation methodology should ring alarm bells right up to Board level a deferred tax asset can only be recognised where there is evidence of future profits to support it the most commonly identified source was release of risk margins, but only half of those surveyed had relied upon this. This highlights the lack of a common approach to tax across the industry. The source of the divergence of practice in the responses to our survey is clear - all of those surveyed did not feel the guidance from the regulator on tax was sufficient. There is an urgent need for this to be addressed. Tax is a key component of the stressed balance sheet for insurers. The level of variance in the implementation methodology should ring alarm bells right up to board level. What is acceptable practice needs to be established as a priority, as until this is done the validity of capital requirement projections will remain in doubt.

Contact us: If you would like more information on any of the results set out in this report please contact: John Jenkins Partner, Life Actuarial Tel: 020 7311 6199 john.a.jenkins@kpmg.co.uk Stuart Secker Partner, Head of Insurance Tax Tel: 020 7311 5366 stuart.secker@kpmg.co.uk David Kells Partner, Solvency II Assurance Tel: 020 7694 1995 david.kells@kpmg.co.uk Paul Merrey Director, Solvency II Strategy Tel: 020 7694 5276 paul.merrey@kpmg.co.uk Website www.kpmg.co.uk/solvencyii www kpmg.co.uk The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. Printed in the United Kingdom. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. RR Donnelley RRD 262091 November 2011