1 Federal Office of Private Insurance Philipp Keller Research & Development Toronto, 28 March 2007 The Swiss Solvency Test

2 Contents The Swiss Solvency Test Methodology The SST Principles Economic Valuation The Standard Model Internal Models

3 The Swiss Solvency Test The market Crash showed exposure of insurance industry to equity risk, statutory valuation and Solvency 1 were inadequate SST being developed during Field-tested in 2004 and 2005 In force since 1 January 2006 As of 2006, all large life and P&C companies have to do the SST As of 2008, all companies (direct insurers, reinsurers and insurance groups) will have to do the SST The SST has to be done on a legal-entity level and on group-level Insurance groups, reinsurers and all companies for which the standard model is not applicable have to use internal capital models for the SST  approx. 80 companies will use (partial) internal models The SST is risk- and principles-based The SST is based on an economic and realistic valuation framework

4 The Swiss Solvency Test: Development The SST was developed together with the Swiss Insurance Association, insurers and reinsurers and consulting companies Participants in the different working groups encompassed mathematicians, actuaries, accountants, CROs, CFOs, capital management specialists, life-, P&C- and reinsurance-specialists, … FOPI defined the overarching regulatory aims and was responsible for all design decisions Regulatory aims: Giving incentives for risk management Transparency on the real economic position of companies Level playing field FOPIs regulatory aims were understood and accepted by industry, although there were discussions and controversies regarding specific points Differences in opinions were always discussion in public and could all be resolved eventually

5 Risk-Based Solvency Frameworks The main purpose of risk-based solvency (and of risk management) is to achieve transparency on the insurers’ exposure to risk Control and mitigation of risk are secondary objectives which are better achieved via transparency Incorporating implicit prudence via valuation, restrictions on eligibility of capital, investments and risk transfers will make the system less transparent and will lead to the transfer of insurers’ risk management and responsibility to the supervisor. The rigidity of such a system can even cause insolvencies Using aggressive parameters or neglecting major risks (e.g. equity risk) in order to perpetuate a given business model or to achieve political aims will also make the system intransparent and will ultimately lead to a loss of confidence in the solvency system and the insurance industry The core of a solvency framework are the underlying methodology and principles, not the standard models Internal models must be assessed with reference to the methodology of the solvency framework not with reference to the standard model

6 Rules vs. Principles However, principles-based supervision is more challenging both for the supervised and for the supervisors There is pressure by some (among senior management, appointed actuaries, supervisors, etc.) that regulation becomes more prescriptive and rules-based It is essential that both the supervisors and senior management accept that the price of freedom is responsibility The responsibility for the SST lies with senior management and the board of directors not with the Responsible Actuary “Liberty means responsibility. That is why most men dread it”, George Bernard Shaw To give incentive for risk and capital management and to put responsibility to senior management and the board of directors, it is essential that the approach to supervision is principles-based

7 The Economic Balance Sheet The economic balance sheet gives a realistic picture of a company’s financial position now Cost of Capital Margin SCR: Required capital for 1-year risk Free capital Market consistent value of liabilities Available Capital Discounted Best Estimate

8 Risk as Change of Available Capital t=0 t=1 Balance sheet at t=0 Hypothetical balance sheets at t=1 The Solvency Capital Requirement (SCR) captures the risk that the economic balance sheet of the company at t=1 differs from the economic balance sheet at t=0 The economic balance sheet at t=1 differs from the one at t=1 due to: Changes in the financial markets (interest rates, real estate prices, …) Losses and catastrophes New information leading to a revaluation of the liabilities (e.g. asbestos) Capital received from or transferred to the group, reinsurers,… Hybrid instruments switching from a liabilities to equity Dividends paid, profit participation for policyholders …

9 The SST Principles 1.All assets and liabilities are valued market consistently 2.Risks considered are market, credit and insurance risks 3.Risk-bearing capital is defined as the difference of the market consistent value of assets less the market consistent value of liabilities, plus the market value margin 4.Target capital is defined as the sum of the Expected Shortfall of change of risk-bearing capital within one year at the 99% confidence level plus the market value margin 5.The market value margin is approximated by the cost of the present value of future required regulatory capital for the run-off of the portfolio of assets and liabilities 6.Under the SST, an insurer’s capital adequacy is defined if its target capital is less than its risk bearing capital 7.The scope of the SST is legal entity and group / conglomerate level domiciled in Switzerland 8.Scenarios defined by the regulator as well as company specific scenarios have to be evaluated and, if relevant, aggregated within the target capital calculation Defines Output 9.All relevant probabilistic states have to be modeled probabilistically 10.Partial and full internal models can and should be used. If the SST standard model is not applicable, then a partial or full internal model has to be used 11.The internal model has to be integrated into the core processes within the company 12.SST Report to supervisor such that a knowledgeable 3rd party can understand the results 13.Public disclosure of methodology of internal model such that a knowledgeable 3rd party can get a reasonably good impression on methodology and design decisions 14.Senior Management is responsible for the adherence to principles Defines How-to Transparency

10 Market Consistent Valuation Market Consistent Value of Liabilities: Best Estimate + MVM: =market value (if it exists); or =value of a replicating portfolio of traded financial instruments + cost of capital for the remaining basis risk Replicating portfolio: a portfolio of financial instruments which are traded in a deep, liquid market, with cash flow characteristics matching either the expected cash flows of the policy obligations or, more generally, matching the cash flows of the policy obligations under a number of financial market scenarios (IAIS Structure Paper) The replicating portfolio has to match the company specific cash flows, depending on the company specific expenses, claims experience etc. The cost of capital margin is defined as the cost for future regulatory capital which has to be set up for the liabilities. The cost of capital is set for 2007 as 6% over risk-free

11 Years t=1t=2t=3 Cost of Capital Margin t=0 Future SCR entering calculation of CoCM at t=0 SCR(0) SCR(1) SCR(2) SCR(1) Market and credit risk Run-off risk Premium risk Market and credit risk assuming asset portfolio corresponds to the optimal replicating portfolio SCR(T)

12 Statutory vs Market Consistent Valuation The following graph shows the relationship between statutory and market consistent technical provisions for a (randomized) sample of Life and P&C companies participating in the field tests 2005 and If the bars exceed 1, then the statutory values are lower than the market consistent values Over the whole life insurance market, the total value of statutory and market consistent technical provisions are approx. equal. For the P&C market, statutory provisions exceed market consistent provisions by ~ 15% Discounted best estimate Cost of Capital Margin Life P&C

13 Standard vs. Internal Models Risk Quantification: Using standard models for life, P&C and health companies, if the standard models capture the risk the companies are exposed to appropriately Using internal models for reinsurers, insurance groups and conglomerates and all companies for which the standard model is not appropriate (e.g. if they write substantial business outside of Switzerland) The use of an internal model is the default option, the standard models can only be used if they adequately quantify the company‘s risks

14 SST Standard Model Scenarios Standard Models or Internal Models Mix of predefined and company specific scenarios Target CapitalSST Report Market Consistent Data Market Risk Credit Risk Life P&C Market Value Assets Risk Models Valuation Models Best Estimate Liabilities MVM Output of analytical models (Distribution) Health Aggregation Method

15 SST Standard Model The standard model is quite complex and demands from insurers to analyze their cash flows, claims experience, claims triangles, … The standard model is able to take into account most commonly used reinsurance contracts (QS, XL, SL per LoB) and risk mitigation can easily be taken into account The model allows the analysis of different risks within the company (e.g. different LoBs, reserve and premium, parameter and stochastic,…) Companies receive information on their parameterization and SST results in comparison to their peers Many small companies think that the complexity of the model is more than compensated with the additional insight into the risk structure of their business The work load for a small company is approx. 1-3 person months (PM), for mid sized companies 9-15 PM and for large companies PM Some small companies expanded their business volume based on the results of the SST Field Test

16 Scenarios Company specific scenarios: Allow senior management and the board to have an informed discussion on strategic decisions For supervisors, the quality of company specific scenarios is a good indication on the quality of the company’s risk management Predefined scenarios: Allow the analysis of the risk exposure of the company For supervisors, they allow a discussion with senior management and the board on the actual risk exposure of the company Both company specific and predefined scenarios are important tools for supervisors to assess the quality of risk management and the company’s internal processes. They are the basis of an informed dialog of supervisors with senior management and the board of directors

17 Impact of Scenarios Total Impact of Scenarios on the Life Market No Scenario Longevity Invalidity Pandemic Financial Distress Loss of Reinsurer Terrorism Equity drop -60% Real estate crash Stock market crash (1987) Nikkei crash (1990) European currency crisis (1992) US interest rate crisis (1994) LTCM (1998) Stock market crash (2000/2001) Global deflation Lapse Level 1Level 2 Example of Scenarios

18 Internal Models Internal Models are an essential part of the SST Insurance groups and conglomerates, reinsurers and all companies for which the standard model is not applicable have to use internal capital models for the SST  approx. 80 companies will use (partial) economic capital models All life insurers for which the standard model is not suitable (e.g. all insurers writing substantial embedded options) will need to develop internal models Many companies are already using full or partial internal models (e.g. for market and credit risk, to quantify risk of special lines of businesses etc.)

19 Internal Models: Review Even worse than having a bad model is having any kind of model – good or bad – and not understanding it If internal models are used for regulatory purposes, it will be unacceptable if the model is not understood within the company There needs to be deep and detailed knowledge by the persons tasked with the upkeep and improvement of the model Knowledge on the underlying assumptions, methodology and limitations by the CRO, appointed actuary etc. Sufficient knowledge to be able to interpret the results and awareness of the limitations by senior management and the board Senior management is responsible for internal models and the review process. The review of internal modes will be based on 4 pillars Internal Review; External Review; Review by the Supervisor; Public Transparency. The regulator is responsible for ascertaining that the review process is appropriate Companies using internal models have to disclose publicly the methodology, valuation framework, embedding in the risk management processes etc.

20 SST Implementation Rule based mindset of some companies Some senior management pushing for desired results Lack of seriousness by some companies for which the SST was already mandatory Sometimes not enough know-how (only weakly correlated to the size of the companies) or not enough resources assigned The evaluation of scenarios is spotty The modeling of optionalities is uneven Lack of peer review Lack of appropriate documentation Data quality Risk culture: Willingness to know about risks and acceptance that strategy has to be aligned with the company’s risk bearing capacity, engaged board of directors Open dialogue within the company (e.g. departments communicate well, in particular CRO, CFO, Actuary and CIO) Direct reporting line of the CRO to the CEO Integrity of responsible persons Risk management and capital management aligned Deep know-how of model experts, know-how and support of senior management and the board Key Success Factors Modelling Deficiencies

21 Outlook A consistent quantification of all risks will demand that many functions within a company work together: actuaries, underwriter, claims managers, RI specialists, CROs, CIOs, CFOs,… An economic view of business will demand deeper quantitative skills Companies will have to optimize their economic performance  optimization of asset liability mismatch, coherent reinsurance programs, securitization of risks, optimization of diversification via coinsurance, geographical spread, etc. Mid-sized companies might become being squeezed between smaller, specialized and nimble insurers and large, well diversified insurance groups Large companies will have to optimize their risk and capital allocation to maximize diversification Consequences of an economic and risk based view: Prediction is very difficult, especially about the future Niels Bohr