Emerging European Issues Accounting and Solvency September 21, 2007 Susan Witcraft, St. Paul, Minnesota

Emerging Accounting Issues

2 Guy Carpenter IFRS – Concept  The International Accounting Standard Board (IASB) issues the International Financial Reporting Standards (IFRS, formerly IAS)  From 2005 onwards, all companies listed in the EU have to report according to IFRS for their consolidated financial statements  Generally, local GAAP still stays effective for financial statements of single entities (stand-alone)  Local taxation is in general not based on IFRS  IASB tries to harmonize accounting standards world-wide  IFRS rules are influenced by U.S. accounting rules (U.S. GAAP)

3 Guy Carpenter IFRS – Concept Investments IAS 39 Equity (net asset value) AssetsEquity and Liabilities Other Assets Insurance Reserves IFRS 4 Other Liabilities

4 Guy Carpenter Financial Instrument Categories CategoryMeasurementChanges in carrying amount TradingFair valueIncome statement Available-for-saleFair valueAmortized cost-income Fair value-equity Held to maturityAmortized costIncome statement Loans and receivablesAmortized costIncome statement Designated at fair valueFair valueIncome statement IFRS – Investments

5 Guy Carpenter IFRS – Insurance Contracts IFRS Phase I (interim) “Non-fair value accounting” -No equalization reserve -Unbundling of embedded derivatives, deposit elements 2010? Phase II “fair value accounting”

6 Guy Carpenter IFRS – Insurance Contracts Accounting Mismatch Phase I (2005 – 2010?) Investments (partially) at fair value Assets Equity & Liabilities Insurance Reserves not at fair value Accounting mismatch Volatile net income + equity Equity

7 Guy Carpenter IFRS – Insurance Contracts Phase II  Exposure draft published in 2007; adoption of Phase II in 2010 or later  Phase II will most likely implement a market value approach (“fair value accounting”) to recognize assets and liabilities arising from insurance contracts  Market value approach likely to result in higher volatility of net income and equity

8 Guy Carpenter  If fair value accounting is adopted, consensus appears to be that: – Premium and expenses will be recognized at contract inception – Deferred expenses and premiums will be eliminated (e.g. deferred acquisition costs) – Reserve estimations are based on present value of expected cash flows – Present value will include some form of risk margin IFRS – Insurance Contracts Phase II

Emerging Solvency Issues

10 Guy Carpenter Solvency II Overall Objective Establish a solvency system that is matched to the true net risks of an insurance company EU flag

11 Guy Carpenter Solvency II Structural Approach Harmonisation among European supervisors. Pillar I: Quantitative method for determining solvency capital requirement. Pillar II: Supervisors intervention powers. Possible solvency capital add-on in addition to the quantitative requirement. Pillar III: Harmonised reporting requirements. Increases transparency and makes comparison of companies in different regions easier. SOLVENCY II Pillar I Pillar II Pillar III 3-Pillar Approach

12 Guy Carpenter Solvency II Time Table ?

13 Guy Carpenter ASSETSLIABILITIES MVA SCR AC MVL Solvency II Economic Balance Sheet Market values Full balance sheet Recognition of risk mitigation Two solvency levels, solvency capital requirement (SCR) and minimum capital requirement (MCR) ASSETSLIABILITIES MVA SCR MVL ASSETSLIABILITIES MVA SCR MVL MCR

14 Guy Carpenter ASSETSLIABILITIES MVA SCR MVL Solvency II Economic Balance Sheet Market values Full balance sheet Recognition of risk mitigation Two solvency levels, solvency capital requirement (SCR) and minimum capital requirement (MCR) ASSETSLIABILITIES MVA SCR AC MVL ASSETSLIABILITIES MVA SCR MVL MCR

15 Guy Carpenter ASSETSLIABILITIES MVA SCR MVL Solvency II Economic Balance Sheet Market values Full balance sheet Recognition of risk mitigation Two solvency levels, solvency capital requirement (SCR) and minimum capital requirement (MCR) ASSETSLIABILITIES MVA SCR AC MVL ASSETSLIABILITIES MVA SCR MVL MCR

16 Guy Carpenter Solvency II Non-hedgeable Liabilities – Market Value Margin (MVM) Market Value of Liabilities = Best Estimate + Market Value Margin LIABILITIES MVL BE MVM

17 Guy Carpenter Solvency II Market Value Margin (MVM) AL SCR Company A: Solvent AL SCR Company B: Solvent AL Company A: Technical insolvency AL SCR Company B: Solvent SCR t=0t=1 t = n Additional SCR required by B for run-off of A’s liabilities MVM = Cost of capital for this extra SCR t=n

18 Guy Carpenter QIS 3 Standard Model Solvency Capital Requirement Framework Methodology for standard formula Bottom up approach [1] Risk categories identified [2] Capital allocated to each subcategory VaR, 99.5%, 1 year solvency and risk assessment period [3] Total company SCR calculated Aggregate Consider diversification Risk silos combined into overall company risk – bottom up approach UW Market Health Credit Life Operation Prem/Res CAT F/X Property Interests Equity Spread Concen- tration Health sub risks Life sub risks BSCR SCR

19 Guy Carpenter QIS 3 Standard Model Market Risk Module Purpose of SCR mkt Measure impact of movements in the level of financial variables, such as stock prices, interest rates, real estate prices and exchange rates. Modules in SCR mkt Mkt int – Interest Rate risk. Upward and downward shocks to yield curve. Mkt eq – Equity risk. Downward shock.Taking account of the offsetting effect on the value of derivaties and short positions. Mkt prop – Property risk. Downward shock to the market value of property exposures. Mkt sp – Spread risk. Widening of credit spreads. Mkt conc – Risk Concentrations. Mkt fx – Currency Risk. Shock to exchange rates.

20 Guy Carpenter QIS 3 Standard Model Market Risk Module - Mkt int - Market interest rate risk stress test Current yield curve Upward shocked curve Downward shocked curve Evaluate effect of interest rate changes on both assets and liabilties

21 Guy Carpenter QIS 3 Standard Model Counterparty Credit Default Risk Module SCR def The risk of default of a counterparty to risk mitigating contracts like reinsurance and financial derivatives. Data requirements Replacement cost - Difference between gross and net technical provisions plus the extra premium minus recoveries Probability of default Default risk in standard formula requires replacement cost estimation Rating i PD i AAA0.002% AA0.01% A0.05% BBB0.24% BB1.20% B6.04% CCC or lower and NR 30.41% Probability of default

22 Guy Carpenter Demand for high securitized reinsurance might increase Low rating  increased counterparty default risk Few reinsurers  increased counterparty default risk QIS 3 Standard Model Counterparty Credit Default Risk Module

23 Guy Carpenter QIS 3 Standard Model Non-life Underwriting Risk Module Purpose of SCR nl Cover excess losses that might occur due to existing insurance provisions and new business. Both for CAT and Non-CAT losses. NL pr Capital charge for the premium and reserve risk. NL cat Capital charge for the losses arising from Catastrophes Scenarios defined by local supervisors (local). Scenarios defined by CEIOPS (trans-regional). Individual CAT scenarios (if more severe than prescribed above). independence assumed

24 Guy Carpenter QIS 3 Standard Model Operational Risk Module  Capital charge: Factors applied to gross premium and gross technical provisions – Approximative approach (due to lack of operational loss data)  Currently no recognition of risk management or mitigation Operational risk model in QIS 3 - simplistic approach

25 Guy Carpenter SCR calculation QIS 3 Standard Model Total SCR Formula Aggregation Aggregation to SCR – Bottom up approach Step 1: Combine risks from sub-categories to major category (SCR mkt, SCR def, SCR life, SCR nl ) Step 2: Combine major risk categories using prescribed correlation matrix (BSCR) Step 3: Add operational risk capital charge SCR = BSCR + SCR op Correlation between risk categories Undiversified companies are generally penalised Diversification is a key issue

26 Guy Carpenter Internal Models Scope  Full Internal Model (long term goal) – Model and simulate all important aspects of the business – Take correlation between risks into account (cause-effect) – Derive Net Operating Income distribution – SCR = 1 in 200 year negative result  Partial Internal Model (valuable starting point) – Model and measure risk using Partial Internal Models – Clearly identify what are the main capital drivers of the SCR standard formula and focus on these risks first – Aggregate capital requirements to total capital requirement  Correlation needs to be considered Metarisk XMR suitable for partial and full internal modeling

27 Guy Carpenter Internal Models Regulatory Approval Actuarial Model Test 1: Statistical Quality Internal Risk Management Test 2: Use Regulatory Capital Requirement Test 3: Calibration Preapproval required to use internal model for regulatory solvency assessment