A Global Framework for Insurer Solvency Assessment A Discussion of Working Party Positions IAA Solvency Working Party May 19, 2003

2 Total Company Considerations Time horizon Available capital Confidence level Reflection of the Cost of Capital Integration/Diversification/Correlation Liquidity (Lessons from Past Failures) Unintended Uses of Solvency Capital

3 Introduction Global trends affecting insurers Governance - impact of various recent corporate scandals Risk management - ERM expected by Boards and supervisors Financial sector convergence - integrated sector supervisors International harmonization of supervisory approaches - IAIS, BIS International standards for insurance accounting - IASB, IAA Consolidation and globalization - common meaningful reporting Increased market discipline and disclosure

4 Introduction International supervisory trends More risk sensitivity testing; less rules-based regulation Strengthening of supervisory oversight & capacity Increased reliance on market discipline (i.e., changes in the insurer/supervisor relationship) Integrated supervision More international supervisory cooperation System stability viewed from both macro (system-wide) and micro (insurer) perspectives Increased focus on insurer capital requirements and the need for changes in approach (e.g. IAIS, EC, UK FSA, Dutch DKV, Malaysian Bank Negara, Canadian OSFI, US NAIC etc.)

5 Future Structure for Solvency Assessment Multi-pillar approach to supervision A set of capital requirements is necessary for solvency assessment but not sufficient by itself (Pillar 1) – Provide a snap-shot of financial position of insurer – No information about impact of various adverse circumstances – Factor-based requirements may not even help to understand an insurer’s actual risks or their management of them Supervisory review of insurer is therefore also needed (Pillar 2) – To better understand the risks faced by the insurer and the way they are managed – To consider multi-period and multi-scenario modelling of the risks Market disclosure measures (Pillar 3) – To disclose insurer risks & methods to manage & provide for them

6 Future Structure for Solvency Assessment All types of risk to be included All types of risks to be considered within the 3 Pillars Within Pillar 1, capital requirements should provide for – Underwriting risk – Credit risk – Market risk Any risks not covered within Pillar 1 (e.g., strategic risk, operational risk and liquidity risk) should be examined within Pillar 2 as part of supervisory review

7 Future Structure for Solvency Assessment Use appropriate risk measures Use consistent (e.g., coherent) measures such as TailVar (also known as Conditional Tail Expectation)

8 Future Structure for Solvency Assessment Allow for risk management Risk reduction - Limiting exposure to certain risks Risk integration - Managing assets and liabilities in an integrated way - ALM Risk diversification - Increasing number of policies reduces relative risk Risk hedging - Offsetting transaction reduces risk – Natural mortality hedge between annuities and life insurance – Reinsurance Risk transfer - Sale or securitization Risk disclosure - Requirements support better risk management

9 Proposed Working Party Position Total Balance Sheet Requirement Total Assets needed for solvency protection= expected value + capital for each risk - adjustment to reflect interactions of these risks Solvency Capital = Total Needed Assets - Accounting Book Value of the Risks Total Company Risk Risk Type Products Risk Aggregation Total Risk Market Risk Value CAT Risk Underwriting Risk Operating Risk Credit Risk Produc t 1 Produc t 2

10 Rationale Total Balance Sheet Requirement – Capital available to an insurer includes conservative margins embedded in conservative accounting conventions – e.g the discount ing U.S. GAAP non-life loss reserves – Economic Capital is All that Matters – Flexible with Country-Specific Accounting Conventions

11 Proposed Working Party Position Time horizon One year is an appropriate time horizon for assessing the current financial position of an insurer for purposes of Pillar 1 (capital requirements) of an insurer multi-pillar supervisory framework. A multi-year (2-5 yr for example) time horizon is appropriate for the assessment of the future financial condition of an insurer for purposes of Pillar 2 (supervisory review). A 2 year time horizon may be appropriate for insurers writing short term (e.g., one year) insurance liabilities, while a longer time horizon such as 5 years would be appropriate for insurers writing long term (e.g. longer than a couple of years) insurance liabilities. Stress the Definition of Time Horizon: – Solvency assessment time horizon refers to the period of time required for a supervisor to gain control of a troubled insurer commencing with the point of time when the solvency position was measured.

12 Rationale Time horizon – Given the long term nature of insurance, typical banking VaR holding periods of weeks or months are two short. A longer TH of 2 years has been discussed but has been rejected due to the complications of including new business risks and the availability of multi-year Pillar 2 assessments. – The above rationale recognizes the fundamental need of supervisors for Pillar 1 capital requirements. These requirements must provide for non-systematic risks to a very high confidence level and also systematic risks that could weaken the insurer during the TH period. – Recognizes the potential for changing liquidity potential that severely spirals downward the ability for the supervisor to aid in any rehabilitation effort.

13 Proposed Working Party Position Available capital The PV of an insurer’s obligations at a selected confidence level must include all policyholder and external obligations (i.e., debt) of the insurer. The PV of such external obligations will be included based on their “permanency” in the event of financial distress (e.g., short term debt and cumulative preferred shares included 100%; long term debt and non-cumulative preferred shares excluded). The assets included in the TCM calculation are limited to those with a reasonably liquid cash flow stream.

14 Rationale Available capital – A TCM which only compares the MV/FV of assets to best estimate policy liabilities ignores other external obligations for which there is a legal obligation to pay. – The value of assets in the TCM calculation must ignore those assets which afford no cash flow to pay for policyholder or external obligations. – These types of adjustments are very similar in nature to the various “available capital” adjustments adopted by many national supervisors.

15 Proposed Working Party Position Confidence level The confidence level assumed in the determination of Pillar 1 capital requirements should be set at a level consistent with a very high degree of confidence that the insurer’s obligations will be met. Default data by rating category for insurers can be used to help set the confidence level. The confidence level should go beyond the historical perspective of “How much capital would I have to lose to be insolvent” under normal going-concern conditions but rather reflect “How much capital can I lose and not prevent me from rapid liquidity decline”. The proposed confidence level or proposed guide to its selection should be guided by this notion.

16 Rationale Confidence level – Rating agencies have compiled significant ratings transition and default data on the companies they rate. Once a company falls below a certain level, it becomes very difficult to continue with normal business activity. – The key threshold level for insurers would seem to be the transition from A to BBB. For those insurers dependent on maintaining higher credit ratings to attract and maintain business (especially annuity business and non-life business), this threshold may occur at a higher level.

17 Rationale Confidence level The essential regulatory, and rating agency, task is to: – Determine when a company is in danger of ceasing to be a going concern, but… – Do so without actually ending the going concern status incorrectly Example: capital markets trading companies – The most significant element of being a going concern in the capital markets is market confidence & trust – Once lost, a liquidity crisis can result and ends the ability of the company to be a going concern Hence, a confidence Level should reflect this.

18 Future Structure for Solvency Assessment Appropriate time horizon & confidence level WP proposes two tests: – One is short term, determined for all risks at a very high confidence level (say 99% CTE), which includes at the end of one year the value of future obligations, including a margin (or perhaps at a moderate confidence level such as 75% CTE) – The other is long term, determined for all risks at a high confidence level (say 90-95% CTE) for a longer time horizon. The slightly lower confidence level (although applied over longer period) for this second test is appropriate since the insurer has the opportunity to take risk management action throughout the lifetime of the business.

19 Proposed Working Party Position Reflection of the Cost of Capital Expected Profitability or non-profitabiloity during the proposed time horizon is a critical element of solvency capital determination. Having enough capital to support the risks facing a company important at time 0. The ability to maintain and attract capital is as important.

20 Rationale Reflection of Cost of Capital – Take two companies each with a needed solvency capital of 100. Both with a cost of capital of 15%. – Company A expects a profit of 10 during the upcoming year and has an available capital of 110, while Company B expects a profit of 40 during the year while it’s available capital is 90. Which Company is in a better solvency position? – The US NAIC RBC formula would say Company B is weaker. Is it?

21 Proposed Working Party Position Integration/Diversification/Correlation The following needs to be reflected: – Simple diversification that results from independent (or close to independent) risks. – Hedging that occurs for systematic risks – Diversification Between Systematic Risks – Superadditivity Risk – Tail Correlations Suggested Pillar 1 Factor- Based Formula

22 Rationale Integration/Diversification/Correlation Capture Domino Effects – No one risk usually is the cause of an insolvency, but rather a chain reaction of one or more causes – Not reflecting diversification reduces a company’s reward for diversifying their risks

23 Proposed Working Party Position Should Study Lessons from Past Failures Our proposed solvency capital requirements, whether factor-based or internal model based should be tested with actual financials of past company failures These tests are intended to gauge the responsiveness of a proposed solvency capital formula in providing Insurance Supervisors an early enough warning for effective supervisory involvement Separate reviews – Life Companies – Non-Life Companies

24 Rationale Should Study Lessons from Past Failures Gauge Domino Effects – No one risk usually is the cause of an insolvency, but rather a chain reaction of cause – Methods of Addressing Changing Liquidity e.g. Reliance – Multi-line non-life writer in the US – Business is rating sensitive – Heavily leveraged by reinsurance and heavily leveraged by holding company debt – Unicover – Reserve deficiencies – Downgraded – Liquidity, liquidity, liquidity

25 Proposed Working Party Position Unintended Uses of Solvency Capital Regulation Should be Stressed Factor-Based Approaches should not be an end-all in disciplined capital management. It’s purpose is for early warning differentiation by insurance supervisors – Intended Uses  Minimum Capital Requirements  Solvency Monitoring  Legal Authority – Unintended Uses  Marketing  Rate justification  other Factor based approaches for insurance company groups should be additive and not be included under the square-root rule under factor based approaches. Reflect both the numerator (profit=return) as well as the denominator (capital=risk)

26 Rationale Unintended Uses of Solvency Capital Regulation Should be Stressed Minimize “Gaming” the System Minimize erroneous Business Decisions By the Company – Examples  Less investment in equities to avoid capital charges goes against effective investment portfolio management  benefits of reinsurance vs. capital charge on counterparty risk  Double Whammy - Underreported reserves and hence, low capital risk charges  In non-life, it is prudent to asset/liability mismatch for higher returns per the risk taken vs. avoidance of mismatch risk charge.

27 Current WP progress (March 2002 to May 2003): – Meetings; numerous conference calls plus 3 face-to-face meetings of entire WP + many calls involving WP assignment groups – Presentation to EC in Brussels (with GC) June 25 and Dec 7, 2002 – Presentation to IAIS Technical Sub-Committee Nov 20, 2002 – Presentation to EU insurance supervisors April 8, 2003 – Draft incomplete report with case studies and appendices (May 2003) – Sought input on our progress from various parties and obtained broader member association input (on-going effort in this regard)

28 Next Steps – Complete remaining sections of report (focus on standardized versus advanced approaches; case study illustrations etc.) – Consider input from IAA Insurance Reg’n Committee and interested supervisory bodies (e.g. IAIS, EC, etc.) in May and June – Issue “discussion” draft report to Insurance Regulation Committee on July 31 for discussion – Issue revised “exposure” draft report to Insurance Regulation Committee on September 30 for Berlin meeting – Identify follow-on initiatives required by the IAA and member associations