Transcript INTRODUCTION TO SOLVENCY II

Solvency II
Part 2: Pillar 1
(quantitative requirements)
Vesa Ronkainen
Insurance Supervisory Authority, Finland
30.11.2006
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Agenda
(based an a presentation in Finland by Raoul Berglund)
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Possible structure of the new solvency regime
Solvency II and IASB
Current approach to liability valuation (technical provisions)
Solvency II approach to liability valuation
Interaction between assets and liabilities (ALM)
Solvency capital requirement (SCR)
Adjusted solvency capital requirement (ASCR)
Internal models for SCR
Minimum capital requirement (MCR)
Eligible capital
Safety measures
Pillar I interaction with pillars II and III
Possible structure of the new solvency regime
Solvency structure in Solvency I and II (the height of the bars are fictive)
Required
minimum
margin
Solvency I
Capital held in excess
of regulatory capital
requirements
Regulatory capital
requirements
Minimum
guarantee
fund
Technical
provision with
prudential margins
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Solvency II
Capital held in excess
of regulatory capital
requirements
Regulatory capital
requirements
Risk margin
Best
estimate
liability
Adjusted
solvency
capital
Requirement
(ASCR)
Solvency
capital
requirement
(SCR)
Minimum
capital
requirement
(MCR)
Possible structure of the new solvency regime
(cont.)
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Solvency II and IASB
Realistic
economic
valuation
Bridge
Realistic
economic
valuation
Regulatory
purposes
(to ensure
insurance
consumers’
interest)
Financial
markets
International
Financial
Reporting
Standards
(IFRSs)
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Solvency II
Not equal
Current approach to liability valuation
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Some problems with the current EU approach to technical
provisions
a.
The risk of adverse deviation is addressed by building
conservatism into reported estimates;
b.
A prudent valuation is required, but limited guidance is
provided on how this should be arrived at or the degree of
protection that should result;
c.
Different valuation approaches and variability in the prudence
included in the calculation;
d.
For life insurance future bonuses, costs of options and
guarantees are commonly implicitly included (without taking
into account their financial nature) within the unknown and
variable level of prudence;
Current approach to liability valuation (cont.)
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e.
Fails to reflect changes in the underlying uncertainty associated
with the liability because the required margin fluctuates with
other variables (=> appropriate management responses and
regulatory intervention may be delayed, increasing the risk of
insolvency);
f.
Does not reflect the economic nature of the liability cash flows
(cannot be used for realistic reporting).
Solvency II approach to liability valuation
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The general liability valuation approach can be defined in the
following way:
a.
It should require a best estimate increased with a risk margin
for the uncertainty in the insurance liability
b.
The best estimate equals the expected present value
(probability weighted average) of all future potential cashflows (probability distributional outcomes), based upon current
and credible information and realistic assumptions.
c.
Where the benefits being valued contain options that may
potentially be exercised against the company, or the potential
liability outcomes have an asymmetrical distribution (e.g.
guarantees), then the best estimate liability must include an
appropriate value in respect of those options and/or
asymmetries.
d.
The risk margin should cover the risk linked to the future
liability cash-flows over their whole time horizon.
Solvency II approach to liability valuation
(cont.)
e. Best estimate
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–
–
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Biometric, expense, surrender assumptions etc should reflect
historical averages adjusted with future trends;
Applies an appropriate interest rate term-structure for discounting
the future payments (risk free interest rate);
Avoids inappropriate application of surrender value floors in life
insurance (realistic surrender rates);
–
Measures the costs of options and guarantees embedded in
insurance contracts in a market consistent way (explicitly taken
into account);
–
Includes constructive as well as contractual liabilities, where the
insurer has discretion over benefits – even if they have not been
allocated (principles for distribution of bonuses);
–
Allows possible management actions (regarding bonuses in withprofit life insurance business for instance)
Solvency II approach to liability valuation
(cont.)
 In order to achieve optimal market consistency the valuation is
divided into hedgeable and non-hedgeable components;
 If an exposure can be perfectly hedged or replicated on a sufficient
liquid and transparent market, the ”hedge or replicating portfolio”
provides a directly observable price (marked-to-market).
 The no arbitrage assumption implies that the market consistent value
of the hedgeable liability component should be equal to the market
value of the relevant hedge (replicating) portfolio.
 For the non-hedgeable liability component and for the remaining risk
on partial hedges, the valuation process would need to rely on
methodologies to deliver adequate proxies determined on a market
consistent basis, i.e. arbitrage-free mark-to-model techniques;
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Solvency II approach to liability valuation
(cont.)
 In each case where risks are non-hedgeable, a conservative valuation
based on the “best estimate plus uncertainty (risk margin) approach”
should be applied (the general valuation approach).
 This may also include financial risks, whenever these risks can not be
hedged in liquid and transparent markets or market prices tend not to
be reliable including an implicit additional uncertainty.
 Most insurance obligations needs to be marked-to-model because
there is no truly liquid secondary market in the contracts that could be
used as benchmarks for marking to market.
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Solvency II approach to liability valuation
(cont.)
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When setting this risk margin the following issues need to be
considered:
a.
b.
c.
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Any risk premium necessary to ensure the transferability of the
liabilities to a third party;
Achieving an appropriate level of policyholder protection over
the run-off period of the liabilities; and
Addressing uncertainty (model, parameter etc.) in the valuation
of the ‘best estimate’;
Thus, while market consistency is the appropriate guiding principle
for the risk margin, the determination of a risk margin should take
into account regulatory aspects;
Interaction between assets and liabilities
Simplified balance sheet
Equity risk
Equity risk
FX risk
FX risk
Interest rate risk
Real estate risk
Realistic
value
of
assets
Realistic
value
of
liabilities
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Real estate risk
Commodity risk
Credit risk
Commodity risk
Interest rate risk
Credit risk
Net asset
value
(NAV)
Aggregated NAV impact
Interaction between assets and liabilities (cont.)
 A deep understanding of the interaction is needed (ALM).
 Strongly related to management actions in life insurance (ALM).
 Possible management actions and their impact on the assets and the
liabilities (especially) should be carefully analysed and documented.
 Should take into account policyholders’ expectation and the duty to
treat insurance customers fairly.
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Solvency capital requirement - SCR
 The SCR should be a capital requirement which guarantees the
minimum capital strength to maintain appropriate policyholder
protection and market stability;
 Can be determined either by a standard approach or by internal
models;
 SCR should in principle be sufficiently larger than the MCR;
 Should be risk-based and based on the going-concern principle
 The EU Commission has suggested a 99.5 percent confidence level
(percentile, VaR) over a one-year time horizon as a working
hypothesis for the calibration of the SCR;
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Solvency capital requirement - SCR (cont.)
 Thus prudential regulation of insurance can be seen to be based on a
non-zero failure regime and is broadly consistent with the levels of
capital associated with a ”BBB” rating.
 In practise each risk is calibrated to this level
 The dependencies among the different risks should be taken into
account
 Reinsurance and other mitigation effect should be taken into account
 The calibration of the SCR should not be influenced by the existence
of any guarantee schemes.
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Adjusted solvency capital requirement - ASCR
 Solvency II should provide a mechanism to deal with situations where
the standardized approach underestimates (due to a unrecognized or
recognized risk in the standard approach) the capital required given
the firm’s risk profile.
 Two possible approaches:
- Require higher capital as part of Pillar II or
- Require the firm to develop an internal model.
 The supervisory review process in Pillar II should also allow Pillar I
capital requirements to be adjusted for risks that cannot be quantified.
(e.g. adequacy of internal control)
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Internal models for SCR
 All firms will have the option of using their internal models in place
of all or parts of the standard approach;
 Changing parameters in the standard approach is not considered to be
an internal model;
 Internal models should have references to full probability
distributions;
 Regulatory approval will be required to help ensure that it is
reasonable to rely on a firm’s model for regulatory capital purposes;
 The purpose of the validation criteria is to enable a regulatory
judgment about the extent to which the models’ results provide
accurate view of the firm’s risks;
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Internal models for SCR (cont.)
 Both qualitative and quantitative aspects should be include, which
could for instance be
- Model governance;
- Model inputs;
- Model structure and
- Model output.
 The models selected should be used by the firm’s management to run
the business;
 Selecting internal models solely to minimize capital requirements –
”cherry picking” – should be in a regulatory control;
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Minimum capital requirement - MCR
 Given that SCR is the risk-based capital requirement and the key
solvency control level, a logical role for the MCR is to facilitate runoff when breached.
 Thus, the MCR will not be fully risk-based
 There should not be an option for firms to estimate their MCR
 Should not be seen as a driver for capital requirement
 The MCR should provide capital as a buffer against the risk that the
firm’s financial strength deteriorates during the process of run-off
(MCR has already been breached)
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Eligible capital
 Solvency II will need to specify the types of capital that
are eligible to meet solvency requirements.
 A Basel II tier-type approach is under consideration,
where the capital is categorized according to the extent to
which they meet the regulatory purposes of capital.
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Safety measures
 The EU directive should set out a sliding scale of supervisory
actions with respect to the solvency control levels, providing
regulators with more discretion in their responses to breach of the
adjusted SCR than for a breach of Pillar I SCR and MCR.
 This is illustrated in the table below:
Additional
reporting
Breach of adjusted SCR
Breach of SCR (pillar I)
Breach of MCR
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Required
Required
Required
Financial
Closure to new Authorisation
recovery plan
business
withdrawn
Possible
Required
Required
---------Possible
Required
------------------Possible
Pillar I interaction with Pillar II and III
 Pillar II should provide a framework to deal with any
simplifications and assumptions required to capture risks in Pillar I
as well as those risks not covered by Pillar I SCR.
 The interaction of Pillar III information with Pillar I and II needs
also to be given appropriate considerations.
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