Solvency II and the Swiss Solvency Test János Blum Casualty Loss Reserve Seminar San Diego, 11 September 2007

Contents Swiss Solvency Test Industry Engagement -Test Runs Intro State of play in largest insurance markets North America Japan, Asia Europe UK Australia, NZ, South Africa (no guarantee products) Summary: Fragmentation Move away from traditional products More sophisticated Increased customer choice Ability of IFA to tailor solutions – no longer using only blunt tools such as total asset class returns Pre-retirement savings vehicles Strong demand for guarantees FRM enabling new business opportunities VA / EIA Example hedge costs Small amount of FRM process (put most in appendix) Distribution channel sales Client list detail Wealth management? **************************************** Alternative format UK Wealth Management customer needs / demands Needs: Retirement savings Personal savings Wants: Upside exposure Downside protection – customers desire guarantees Tailored to meet specific personal financial situation Industry dynamics: People have been burned in the market crash – much more focused on downside People need to save more Low expected market returns – real rates, inflation are at historical lows Wealth management competition How to differentiate from relatively homogenous products How to stop against competitors copying new products How to meet customer wants and needs The gap is…… this is what can fill it - Examples of products / how other markets have meet this need Customer value proposition Types of products: VA / EIA US / Japan Europe / Asia / Australia / NZ / Sth Africa UK – historically have failed badly (e.g. Equitable). Hartford Life have now entered the market with a WB. Other banking products include capital guaranteed stock market bonds (similar to NAL GSB / GIB). E.g. National Savings and Investment; L&G. Outline limitations of these products How are these products managed? 5 choices – historically only Product design FRM techniques Advantages this brings Milliman FRM is the industry standard – dominates the US and Japan, expanding throughout Europe / UK and Asia How would these products fit into a wealth management / banking institution Segmentation of risks enables different parts of the value chain to manage and profit from each Given NAGE is a manufacturer of investment product but not insurance product – how can it best offer such product? Target market analysis – e.g. HNW, middle income, low income earners Other applications of FRM for managing guarantees (one slide): DB pensions – inflation guarantees Existing blocks of business – GAOs, With Profits Equity release mortgages – guarantees linked to property and mortality Products with real return rather than nominal return guarantees – use inflation derivatives to hedge exposures Products with exposure to pure credit risks – synthesise through the credit derivatives market Supporting Information / Detail in appendices

Swiss Solvency Test

Swiss Solvency Test Switzerland is not member of the European Union, but Swiss companies have pivotal interest in EU regulation Compatibility to EU is a main objective of SST Swiss Federal Office of Private Insurance designed, tested and partially implemented the new solvency system between 2002 and 2006 New Insurance Supervisory Law effective since 2006 Full implementation of SST beginning 2011

Old Insurance Supervision Rule based Product and Tariff Approval Restrictions on products, investments and pricing No consideration of asset risks

Old Insurance Supervision - Problems Overexposure to risky assets Underpriced long term guarantees Accounting and regulatory arbitrage Compliance culture Abrogation of responsibility to the regulator

New Insurance Supervision Act of 1.1.2006 No restrictions on products (except for some mandatory life and health products) Less restrictions on investments Corporate governance and risk management requirements Appointed Actuary for all insurers and reinsurers

New Insurance Supervision Act of 1.1.2006 Supervision of groups and conglomerates Consistent requirements for insurers and reinsurers Responsibility with senior management Principle based

The SST Principles Output – Methodology – Transparency - Responsibility All assets and liabilities are valued market consistently Risks considered are market, credit and insurance risks 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 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 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 Under the SST, an insurer’s capital adequacy is defined if its target capital is less than its risk bearing capital 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 9. All relevant probabilistic states have to be modeled probabilistically 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 The internal model has to be integrated into the core processes within the company SST Report to supervisor such that a knowledgeable 3rd party can understand the results Public disclosure of methodology of internal model such that a knowledgeable 3rd party can get a reasonably good impression on methodology and design decisions Senior Management is responsible for the adherence to principles

Timetables EU Switzerland Political Decision 2002 Project Start 2003 Consulting Phase 2003 to 2009 2003 to 2005 Quantitative Impact Studies / Field Tests 2005 to 2008 (?) 2004 to 2007 New Legislation 2007 to 2011 2006 Mandatory Reporting 2012 2008 New Intervention Regime 2011

Some Differences SST – Solvency II 99% TVar vs. 99.5% Var confidence level Cost of Capital approach for Market Value Margin EU has not yet decided between i) 75th percentile and ii) Cost of Capital approach Minimum Capital Requirement 60% of Solvency Capital Requirement EU has not yet decided between i) percentage of SCR and ii) separate calculation for MCR, i.e. 90% confidence level Operational Risk taken into account, but not part of Pillar I, as not sufficiently quantifiable No restrictions on eligibility of capital – no tiers

Cost of Capital Approach SCR absorbs risks with 1 year time horizon At the end of year 1, portfolio is assumed to be taken over by another company New company provides regulatory capital to absorb run-off risk Market Value Margin is the NPV of the future cost of capital at risk free rate + 6%

Internal Models If standard model not applicable, internal models mandatory reinsurance, groups, entities with foreign branches estimated 80 entities will have to develop internal models Internal models encouraged, as they demonstrate high risk management skills and provide relevant company specific information High technical standards: stochastic modelling required. Building and validating internal models is resource intensive. Consistency: same model should be used for all external reporting (regulator, rating agencies) and internal steering purposes

Groups Incentive to simplify complex group structures SST required both on entity level and group level Detailed internal model for groups Diversification benefit on group level Explicit modeling of Capital and Risk Transfer Instruments internal reinsurance loans participations guarantees capital mobility

Small Companies Increased consolidation pressure Complexity of Solvency II is a challenge for small entities: limited availability of resources and data low participation in test runs indicates lack of awareness loss mitigation relatively expensive standard model leads to high capital requirements, building more favourable internal models not viable

Risk Management & Risk Mitigation Risk Management will become key competence Data quality Capital adjusted pricing and product structuring Modelling capabilities Demand for Risk Mitigation will increase Hedging financial risk for life insurers Reinsuring or securitizing cat risk for P&C insurers

Industry Engagement -Test Runs

Quantitative Impact Studies 2005: QIS 1 compared reserves under Solvency I and Solvency II measured existing levels of prudence tested Cost of Capital approach increased awareness in the insurance industry 2006: QIS 2 tested methods for calculating provisions, asset values, SCR and MCR gathered information on practicability, data issues and resource requirements measured changes of overall level of solvency ratio 2007: QIS 3 calibrates risk and correlation matrices tests impact on groups tests internal vs standard models results to be published in fall 2007 2008: possibly QIS 4 to back test draft directives

Quantitative Impact Study 2 514 companies (out of 4‘000) from 23 countries participated 237 P&C, 161 Life, 81 Composite, 22 Health, 13 Reinsurance Overall market share 65% for Life, 56% for P&C vary from 11% to 94% from country to country Generally lower participation by small companies Data quality inhomogeneous Results published on a no name basis

QIS 2 – Impact on Solvency Assets valuated higher Liabilities valuated lower > Resulting Available Capital higher Required Capital much higher > Solvency Ratios decrease in general Most Companies still with Solvency Ratios > 100%

Swiss Field Tests Facultative in 2004 and 2005 (before new legislation) Mandatory for large companies in 2006 and 2007 46 (out of 150) entities participated in 2006, 29 of them on a voluntary basis. >90% market share covered. Mandatory reporting for all companies starting 2008 Intervention based on new regime starting 2011, i.e. three year transition period

SST - Solvency Ratios Solvency Ratios lower, but mostly still sufficient (similar to QIS results) Life: low correlation between old and new Solvency Ratios (R2 = 12%) P&C: no correlation between old and new Solvency Ratios (R2 < 1%) i.e. completely new situation for most companies

SST - Breakdown of Balance Sheets Approximative Numbers Life Health P&C Reserves at Best Estimate 90% 50% Solvency Capital Required 8% 25% 7% Market Value Margin 2% 0% Excess Capital 3% Solvency Ratio 100% 200% 150%

SST - Breakdown of SCR & MVM Approximative Numbers Life Health P&C Market Risk 70% 80% 30% Credit Risk 5% 10% Insurance Risk 15% 25% 90% Scenarios 0% Diversification (SCR reduction) -20% -25% Expected Profit -10% Market Value Margin 20%

SST – Historic Scenarios - Life Approximative Numbers Solvency drops from 100% to... Market Crash 2000/2001 < 60% European Currency Crisis 1992 70% Market Crash 1987 75% LTCM 1998 Real Estate Crash 1994 80%

Breakdown of Insurance Risk – P&C Approximative Numbers Normal Claims 45% Large Claims 15% Reserves 40% Diversification 0%

Key findings Life insurers sufficiently, P&C insurers well capitalized Assets main risk for life insurers, balance sheets vulnerable to historic economic scenarios Insurance (underwriting incl. cat) main risk for P&C insurers, balance sheets resistant to scenarios Market Value Margin (reserve risk beyond 1 year) almost negligible for P&C insurers, more important for life companies