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

2. 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?
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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

3. Swiss Solvency Test

4. 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

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

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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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%

13. 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

14. 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

15. 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

16. 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

17. Industry Engagement -Test Runs

18. 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

19. 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

20. 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%

21. 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

22. 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

23. 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%

24. 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%

25. 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%

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

27. 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