PAM 22 March Susanne Kaske-Taft Solvency II – Capital drivers & reinsurance solutions FIAR May 22-26, 2011 Alexandra Storr

Solvency II | Example: Capital drivers & reinsurance solutions Required capital Capital drivers under Solvency II Under Solvency I a lot of fundamentals of the insurance business model have been neglected in the regulatory regime Under Solvency II the real risk landscape of an insurance company should be considered in the calculation of the solvency capital requirements Therefore the solvency capital requirements under Solvency II are influenced by a number of capital drivers compared to Solvency I Insufficient diversifcation Counterpartyd efault risk Volatility of reserve run-off Exchange rate mismatch Highly volatile peak risks Duration mismatch (ALM) Equity & property price risk Embedded options & guarantees Frequency Unexpected widening of bond spreads Availabke capital Ability to increase capital

Solvency II | Example: Capital drivers & reinsurance solutions Summary Solvency II & reinsurance Volatility of reserve run-off Insufficient diversification Standard Formula Partial internal model Internal model Loss Portfolio Transfer & Adverse Development Cover Transfer of peak risks Insurance Linked Securities Large exposure to increasing life spans Longevity swap Identify the individual capital drivers … Examples: … find the most efficient reinsurance solution … Examples: … value the capital benefit based on the model used Reinsurance is a powerful capital management tool under Solvency II Natural catastrophe risk

Solvency II | Example: Capital drivers & reinsurance solutions Solvency II Examples of Capital drivers and Reinsurance solutions Capital driversReinsurance solutions P&C Volatility of reserve run-off Insufficient diversification High volatile peak risks Standard FormulaPartial Internal Model Internal Model (Structured) Quota share / LPT & ADC / Run off (Structured) Quota share (Structured) Excess of Loss Frequency (Structured) Aggregate XL

Solvency II | Example: Capital drivers & reinsurance solutions Insufficient diversification and quota share 5

Solvency II | Example: Capital drivers & reinsurance solutions Insufficient diversification will lead to an increase in solvency capital requirement compared to Solvency I (Missing) diversification on the asset side will be a capital driver, too Better diversified insurers are able to deal with financial consequences of risks relatively easier and therefore more efficiently Most affected: Captives Monoliners Small local players Niche players Capital driver under Solvency II– Insufficient diversification

Solvency II | Example: Capital drivers & reinsurance solutions Value proposition of a Quota Share under Solvency II: Gross situation: BSCR (99.5 % VaR): 12.7 mio EUR UW risk 10.2 mio EUR Market risk 2.5 mio EUR Credit risk Reinsurance: 20 % Quota Share / 23 % Commission Net situation: BSCR (99.5 % VaR) 10.6 mio EUR UW risk 8.2 mio EUR Market risk 2.1 mio EUR Credit risk 0.3 mio EUR = Capital relief of the 200-year event = EUR 2.2 m P&C Quota Share under Solvency II The quota share reduces the Solvency Capital Requirement (SCR) for the insurance risk under Solvency II according to the proportion ceded to the reinsurer Insurer’s share (retention) ) 80 % Reinsurer’s share (cession) ) 20 % Loss

Solvency II | Example: Capital drivers & reinsurance solutions Example: Highly volatile peak risk and Excess of Loss covers 8

Solvency II | Example: Capital drivers & reinsurance solutions Portfolio A contains only low risks Portfolio B contains only high risks Solvency II will require insurers to back their book of business with solvency capital that reflects the economic risk In contrast to Solvency I where often only the premium volume is decisive Portfolios with the same premium volume can have a totally different capital requirement If one of the portfolios (Portfolio B) contains high volatile peak risks where the resulting aggregate claims distribution is more skewed to the right than for a Portfolio A of risks with low volatility VaR 99.5% Claims amount VaR 99.5% Capital driver under Solvency II– Highly volatile peak risk Claims amount Probability Premium volume Portfolio B Premium volume Portfolio A

Solvency II | Example: Capital drivers & reinsurance solutions Value proposition of an Excess of Loss under Solvency II: For a given safety level the ratio of net premiums relative to required risk capital after reinsurance will increase considerably with a XL treaty. Risk mitigationNoneQuota share (50 %) WXL Gross premium R/I premium Net premium Capital requirement Net premium / Capital requirements 57 % 164 % P&C XL per risk under Solvency II number of losses amount of losses loss burdenreinsurance covernot covered An XL reinsurance treaty reduces not only the absolute variability of the reinsured’s retained losses but also their relative variability. The premium ceded to the reinsurer is in relative terms considerably smaller compared to the reduction of required capital through a non- proportional reinsurance treaty. Indicator: Recognition as reinsurance = 0.28 < 0.82

Solvency II | Example: Capital drivers & reinsurance solutions Example: Frequency risk and Aggregate-XL 11

Solvency II | Example: Capital drivers & reinsurance solutions Capital driver under Solvency II– Exposure to frequency risk Primary insurers are normally well protected against losses from a severity perspective ( vertical protection ) through the core Catastrophe Excess of Loss (CXL) programme A growing risk-taking ability often implies a growing deductible for the CXL programme which exposes the insurer to frequency risk below the deductible Often, there is no protection against frequency risk below the deductible (missing horizontal protection ) Within Solvency II, the required solvency capital is determined by the distribution of the overall aggregate annual loss This in turn is the result of the combination of the distribution of the claims amount (severity) and of the distribution of the claims frequency Probability Number of losses The aggregate claim is the result of the combination of the distribution of the claims amount (severity) and of the distribution of the claims frequency The more dangerous the claims frequency for any given severity, the more capital required to back the portfolio  Portfolio B requires more capital than Portfolio A

Solvency II | Example: Capital drivers & reinsurance solutions Value proposition of a Structured Stop Loss & Aggregate XL & under Solvency II: Insurance risk: Level of the capital relief determined by the design of the cover and the additional structural elements Especially if the structured elements influence the risk mitigation or utilize the diversification in time or over lines of business Qualitative aspects: Multi-year covers are providing certainty regarding price and capacity for a specified future periods This could be used as a qualitative argument for the regulator (Pillar 2) P&C Aggregate XL under Solvency II Loss ratio per year / % 140% Year 1Year 2Year 3 Term limit 400 mio EUR 200 mio EUR 150 % 200 mio EUR 160 %

Solvency II | Example: Capital drivers & reinsurance solutions Example: Volatility of reserve run-off and LPT & ADC 14

Solvency II | Example: Capital drivers & reinsurance solutions While the final payments to a policyholder or a beneficiary will not yet be precisely known, the run-off contributes to the absolute volatility of an insurer’s result This implies that the client will need, from an economic perspective, risk capital in order to support the run-off of a portfolio of liabilities The inclusion of the volatility of reserve run-off may decrease or (more likely) increase the capital requirement 1. Timing risk 2. Reserving Risk Claims incurred (one AY) 100% estimate at end AY Time Total claims amount to be paid Time Capital driver under Solvency II– Volatility of reserve run-off

Solvency II | Example: Capital drivers & reinsurance solutions Loss Portfolio Transfer (LPT) & Adverse Development Cover (ADC) under Solvency II Value proposition of a LPT/ADC under Solvency II: Insurance risk: LPT removes the timing risk ADC removes the reserving risk =>both consequently remove the necessity to set aside regulatory capital Market risk: Reduction of market risk due to the reduction of investments Reserve risk (a) Timing risk (b) Time “Adverse Development” Cover (a) Claims Expected claims (Claims provision on balance sheet) Investment risk (c) “Loss Portfolio Transfer” Cover (b+c) “Loss Portfolio Transfer” premium (Net present value of claims provision) Run-Off solution Remarks: Normally the capital relief from transferring the LPT part will be lower than the relief achieved by reinsuring adverse claims (ADC) So far in some European countries the LPT is not recognized as reinsurance

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