Solvency II – A view from the US Casualty Loss Reserve Seminar – 2008 Robb W. Luck Insurance & Actuarial Advisory Services Ernst & Young LLP 19 September 2008

Agenda General background Solvency I vs. Solvency II Solvency II readiness survey summary Summary results from Quantitative Impact Studies Specifications of QIS 4 Key differences between Solvency II and current solvency measures in the US Illustrative case study results Difference in solvency ratios under RBC, Solvency II QIS 4 formula, and other estimated rating agency formulas Difference in technical provisions for reserves – nominal versus discounted with risk margin What could this mean for the US market and the reserving actuary?

Solvency I versus Solvency II balance sheet Solvency I balance sheet Solvency II balance sheet BV assets BV liabilities MV assets MV liabilities Free surplus Free surplus Free surplus Free surplus Solvency capital requirement Capital requirement MCR Best estimates Risk margin Risk margin Best estimates Technical provisions with implicit risk margins Technical provisions

Timeline for Solvency II 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Definition of the general form of the solvency system Phase I Three calls for advice Preparation of the draft Level 1 directive (major principles) QIS 1 Phase II QIS 2 Consulting documents Level 2 Implementing measures Level 3 Application guidelines QIS 3 Level 1 process for directive approval by the Parliament and European Council QIS 4 QIS etc. Transposition of the directive into local law Entry into force of the new Solvency II prudential system

Solvency II readiness survey Measuring performance in relation to risk We have indicators based on accounting data We have some additional indicators on performance We have some additional indicators on performance and risk management (e.g., return on risk capital) We have already converged towards economic value-based criteria (e.g., return on economic capital)

Solvency II readiness survey Economic capital models Statutory measures only Rating agency formulas Developed EC models but will require significant enhancements to comply with Solvency II Existing EC models will comply with Solvency II

Solvency II readiness survey The systems challenge Current systems will be sufficient Minor changes needed Major changes needed Haven’t analyzed the issues

Solvency II readiness survey Current level of expertise Current actuarial and risk management expertise fall far short Some expertise but will require upgraded skill and additional risk management professionals Some upgrade of skills needed for actuaries and risk management professionals Current have necessary expertise

Quantitative Impact Studies Technical provisions QIS 1 Discounting in non-life leads to a reduction of 10-15% In most cases: best estimate + MVM (75% quantile) < current technical provisions QIS 2 Cost of capital vs. quantile approach for MVM: results heterogeneous QIS 3 Industry asks for guidance on the assessment of best estimates Cost of capital approach for risk margins Proxies allowed for risk margins (fixed % of best estimates)

Quantitative Impact Studies Financial impact on balance sheets – QIS 3 Technical provisions tended to decrease, with the release of the prudence margin in Solvency I being greater than the additional risk margin under Solvency II. This tended to be more than offset by an increase in the capital requirements, the overall solvency ratio tended to decrease. Most significant for nonlife companies 98% of companies met the MCR and 84% met the SCR, a large scale capital injection is unlikely. However there could be significant reallocation of capital. Results for MCR were consistent with 80-90% value at risk over one year time horizon. Formula SCR tended to be higher than internally modeled SCR, approximately 25% driven by insurance risk.

Quantitative Impact Studies Solvency Capital Requirement (SCR) – QIS 3 Provisions for expected profit and loss was removed Factor based approach for nonlife underwriting risk vs. scenario approach for life companies CAT risk in specified regional scenarios Operational risk added at top level, function of technical provisions and premium Diversification effect from correlation between segments and risk modules was about 20% Underwriting risk dominated the overall SCR for non-life companies, 75% Results: Internal models produce significantly lower SCR than standard approach (around 25%), mainly due to underwriting risk Decrease in solvency ratios: 19.5% of nonlife companies would need additional capital to meet SCR Significant fluctuations in available surplus for non-life companies, 40% would decrease by 50% or more, 20% would increase by 50% or more

QIS 4 highlights Key changes in response to QIS 3 issues QIS 4 solution Nonlife issues QIS3 technical specification was ambiguous about premium provisions (also referred to as stand-ready obligation or preclaims liabilities). In consequence most nonlife insurers did not use QIS3 as an opportunity to recast their balance sheet onto a full economic basis as Solvency II requires (most introduced discounting but did not rework the traditional unearned premium provision UPR). Proposed QIS4 specification is clearer and proposed simplification is consistent in that combined ratio approximates for estimate of future cash flow. Nonlife technical provisions

QIS 4 highlights Key changes in response to QIS 3 issues QIS 4 solution Nonlife issues Calibration of NL underwriting risk module of standard formula SCR regarded as unsatisfactory. Some changes to calibration proposed for QIS4. A simple formula (Layer 1) will apply in QIS4 if regional scenarios (now referred to as Layer 2) are not available. QIS4 also introduces Layer 3 where insurers will calculate capital based on the personalized catastrophe scenarios which are regarded as appropriate to their business. Nonlife underwriting risk Nonlife catastrophe

Key differences between Solvency II and current US solvency measures Solvency II focus is on capitalizing to a level such that the probability of insolvency over a one year time horizon is remote, 0.5% Solvency II is intended to be more aligned with the individual risk profile of a company Formula vs. internal model vs. partial internal model More recognition of risk diversification benefit Line of business and risk module correlations Zero correlation between life and nonlife entities Technical provisions for loss reserves are comprised of a discounted best estimate and an explicit risk margin Question around nominal vs. discounted + risk margin

Risk margin Based on a Cost-of-Capital methodology Cost of providing amount of eligible own funds equal to SCR, necessary to support obligations over their lifetime Cost-of-Capital rate = 6.0% For QIS 4 purposes, SCR calculations performed on the basis of the standard formula Net of reinsurance SCR calculation only considers operational risk, underwriting risk and counterparty default risk QIS 4 specifies benchmark risk margins as a percent of technical provisions for use if the company cannot determine based on internal data

Cost-of-capital methodology (1) Steps to calculate the risk margin Step 1: Calculate SCR for t=0 and for each future year * for each segment * throughout the lifetime of obligations in that segment * SCR(0) corresponds to today’s capital requirement of the firm * but only part of the risks is considered: operational, underwriting and counterparty default t=0 t=1 t=2 t=3 ……………… t=T

Cost-of-capital methodology (2) Steps to calculate the risk margin Step 2: Multiply each of the SCR’s by the Cost-of-Capital rate * determination of cost of holding future SCR’s * CoC rate = 6% (return above risk free) t=0 t=1 t=2 t=3 ……………… t=T

Cost-of-capital methodology (3) Steps to calculate the risk margin Step 3: Discount the amounts calculated in Step 3 * using the risk free yield curve at t=0 * sum of discounted values is risk margin (for this segment) Step 4: Total risk margin is sum of risk margins in all segments t=0 t=1 t=2 t=3 ……………… t=T

Case studies Case studies were prepared using US Statutory information to look into three areas of impact under Solvency II Calibrated companies to 250% RBC and measured solvency ratios under Solvency II QIS 4 formula and estimated rating agency formulas Authorized Control Level RBC compared to Minimum Capital Requirement (MCR) Difference between nominal loss reserves and discounted with risk margin using the Solvency II cost of capital method for industry aggregate Schedule P lines of business

Case study Solvency ratios Multiline companies Large long-tailed company Midsize short-tailed company

Case study Solvency ratios Monoline companies Monoline medical malpractice Monoline work comp

Case study Authorized control level RBC vs. MCR Large long-tailed company Midsize short-tailed company Monoline medical malpractice Monoline work comp

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry HO/FO Risk margin Best estimate Change = 0.3%

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry Private passenger auto liability Risk margin Best estimate Change = (3.5)%

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry Commercial auto liability Risk margin Best estimate Change = (4.5)%

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry Commercial multiperil Change = (3.8)% Risk margin Best estimate

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry General liability Risk margin Best estimate Change = (5.0)%

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry Workers’ compensation Risk margin Best estimate Change = (9.8)%

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry Medical malpractice Risk margin Best estimate Change = (4.1)%

Case study Nominal reserves vs Case study Nominal reserves vs. discounted with risk margin for US industry Special property Change = (0.3)% Risk margin Best estimate

What does this mean for the US market? Changing competitor behavior from companies based in Solvency II regulated countries New capital structures and solvency levels How different are nominal reserve levels from discounted with risk margin? “Use Test” will require the framework to be embedded in the business process, driving strategic decision making Pricing differences Convergence with IFRS Question of when, not if Changing reinsurance market in Bermuda BMA is currently in the process of adopting solvency measures expected to be similar to Solvency II Increased M&A activity and group structure

What does this mean for the US market? Emphasis is on enhancing economic capital modeling and strengthening enterprise risk management frameworks Results from the QIS show significant decreases to required capital when modeled internally Companies face upward capital adjustments under Solvency II Pillar 2 based on risk management capabilities US rating agencies are continuing to emphasize ERM as a factor in assigning ratings Initial bar was set and will continue to be raised

What does this mean for the reserving actuary? Increased focus on the overall distribution of loss reserves vs. range of reasonable estimates Increased need to understand the correlations between reserve segments Need to analyze the timing of reserve variability emergence Ultimate variability vs. one-year time horizon