1. An Introduction to Solvency II Philadelphia Actuaries Club May 13, 2010 John C. Knauss, FSA, MAAA Vice President and Corporate Actuary London Life Reinsurance Company

2. May 13, 2010 An Introduction to Solvency IISlide 2 Key Objectives What is it? Why did it come about? What are the basics? What does it mean? Why should we care?

3. May 13, 2010 An Introduction to Solvency IISlide 3 Outline Brief History – US vs. Europe What’s so bad about Solvency I? Structure of Solvency II Regime Implications of Solvency II

4. May 13, 2010 An Introduction to Solvency IISlide 4 Some History – U.S. vs. Europe United StatesEurope Early 1990’sCurrent RBC Regime Introduced 1970’sSolvency margin requirements introduced 1986NY Regulation 126 2000C3 Phase I2002Solvency I 2005C3 Phase II 2009VA CARVM2007Solvency II Proposal Adopted 2010Risk-Focused Examinations 2011?C3 Phase III2012Solvency II effective

5. May 13, 2010 An Introduction to Solvency IISlide 5 Abbreviations and Definitions CEIOPS: Committee of European Insurance and Occupational Pensions Supervisors IFRS: International Financial Reporting Standards QIS: Quantitative Impact Study SCR: Solvency Capital Requirement MCR: Minimum Capital Requirement VaR: Value at Risk SRP: Supervisory Review Process

6. May 13, 2010 An Introduction to Solvency IISlide 6 Solvency I – The Basics Simple factor-based model Focuses on the liability side of the balance sheet Regulatory capital requirement –P&C: function of written premiums and loss reserves –Life: function of amount at risk –Basically “RBC-extra light”

7. May 13, 2010 An Introduction to Solvency IISlide 7 So what’s wrong with Solvency I? Simple formula approach disregards actual risk profile of the business Leads to unintended incentives (e.g., lower reserves = lower required capital) Applied to legal entity – no consolidation for groups of companies Limited disclosure requirements Need for more comprehensive approach was clear even during development

8. May 13, 2010 An Introduction to Solvency IISlide 8 So what’s wrong with Solvency I? “Sharma Report 1 ” (2002) showed that vast majority of insolvencies were preceded by internal management or governance shortcomings or some external trigger events. Report further noted that there was a period of time between such events and insolvency, suggesting that better information may have prevented the insolvency. Thus was born the Solvency II project. 1. Prepared under the leadership of Paul Sharma, head of the Prudential Risks Department of the UK Financial Services Authority

9. May 13, 2010 An Introduction to Solvency IISlide 9 Solvency II – Essence Promote a robust, forward-looking risk management framework to guide both insurance company management and regulators Require implementation of risk practices appropriate for size, nature and complexity of the insurer’s business Reduce reliance on capital requirements as an exclusive early warning tool

10. May 13, 2010 An Introduction to Solvency IISlide 10 Solvency II – Advantages Market-consistent valuation of assets and liabilities Identify and quantify risks and their interdependence Prospective risk management focus “Ladder of interventions” – upper threshold (plan for corrective action) to lower threshold (regulator takes over) Group supervision

11. May 13, 2010 An Introduction to Solvency IISlide 11 Solvency II – Basic Structure Introduces economic risk-based solvency requirements across all EU member states Total balance sheet approach 3 pillars: –Quantitative requirements –Supervisory review –Supervisory reporting and public disclosure

12. May 13, 2010 An Introduction to Solvency IISlide 12 Solvency II Balance Sheet Total Assets MCR RM Best- Estimate Liability Free Surplus Technical Provisions = Best-Estimate + Risk Margins (RM) Solvency Capital Requirement (SCR) ( MCR is a subset of the SCR)

13. May 13, 2010 An Introduction to Solvency IISlide 13 Pillar 1: Quantitative Requirements Addresses the following: Calculation of technical provisions (i.e., reserves) –Valued according to IFRS definition of fair value –QIS4: discount rates are term-dependent risk-free rates at time of valuation (revisited in QIS5) Calculation of solvency capital requirements Investment management

14. May 13, 2010 An Introduction to Solvency IISlide 14 Solvency II Capital Requirements SCR: capital such that the probability of ruin within one year = 0.5% (i.e., 99.5% VaR) –In other words, holding 100% of calculated SCR would result in becoming insolvent once in every 200 years –Calculated using standard formula, internal models, or combination MCR: floor below which a company will not be permitted to operate Between MCR and SCR, company subject to supervisory action

15. May 13, 2010 An Introduction to Solvency IISlide 15 Standard Formula Linear, factor-based approach Intended to be conservative approximation of the 99.5% VaR objective Specific structure not yet finalized and factors not yet calibrated –Final calibration to be completed by October 2011 to allow 12 months’ lead time for full implementation –Will likely include market, counterparty, mortality, morbidity, catastrophe, and operational risks

16. May 13, 2010 An Introduction to Solvency IISlide 16 Use of Internal Models Solvency II encourages firms to use internal models under the premise that it will result in –a better alignment between firm risk and capital requirements –Stronger risk management culture in the firm Use of internal models should lead to reduced required capital relative to the standard formula Regulatory approval required for use (must satisfy number of standards for calibration, validation, documentation, etc.)

17. May 13, 2010 An Introduction to Solvency IISlide 17 Pillar 2: Supervisory Review Focus: provide supervisors with means of identifying firms that have a higher risk profile, and the ability to intervene Qualitative aspects: Internal controls Risk management processes Corporate governance

18. May 13, 2010 An Introduction to Solvency IISlide 18 Pillar 2: Supervisory Review Requires firms to conduct an Own Risk and Solvency Assessment (ORSA) ORSA is responsibility of the Chief Risk Officer (not an actuarial function) Objectives of ORSA –Tool for firm’s own decision making –Tool for supervisors to better understand the risk profile of the firm

19. May 13, 2010 An Introduction to Solvency IISlide 19 Pillar 3: Reporting and Disclosure Supervisory Reporting Public Disclosure Focus: increasing the transparency of the insurer’s risks and capital position Group Supervisor – a single regulator will oversee a group of companies operating in multiple jurisdictions

20. May 13, 2010 An Introduction to Solvency IISlide 20 Implications Risk Management Practices Insurers must have an actuarial function and a risk management function Insurers will be required to have “adequate and transparent governance system” Increased use of ERM “I would not position it as having to be ready for Solvency II. Instead, we have to be ready for proper enterprise risk management and Solvency II is part of that.” –Jeroen Potjes, Chief Insurance Risk Officer, ING

21. May 13, 2010 An Introduction to Solvency IISlide 21 Implications “Third-Country Insurers” Specific rules exist for European branches of non-EU insurers Solvency II contains provisions that enable the equivalence of a third-country solvency regime to be assessed. Equivalence with U.S. may be difficult without federal charter (i.e., single regulator)

22. May 13, 2010 An Introduction to Solvency IISlide 22 Implications Insurers’ Capital Requirements Per Industry: As currently proposed, required capital will increase dramatically Per Regulators: Required capital will now be at an appropriate level

23. May 13, 2010 An Introduction to Solvency IISlide 23 Implications Impact on Products Will affect EU companies (including U.S. companies with EU parent) QIS4: Long-term products likely to suffer –due to risk-free discounting (This was changed in QIS5). –Longevity: immediate mortality improvement of 25% –Mortality: mortality deteriorates 15% CEIOPS: Consumers will have a more uniform and enhanced level of protection, and increased competition will put downward pressure on prices

24. May 13, 2010 An Introduction to Solvency IISlide 24 Industry Reactions “Why Excessive Capital Requirements Harm Consumers, Insurers and the Economy” –Published by CEA (“Euro-ACLI”) in March 2010 –Written in response to requirements of QIS4 Increase in required capital could be “65- 75%” while sources of available capital are reduced “25-50%”

25. May 13, 2010 An Introduction to Solvency IISlide 25 Industry Reactions (con’t) “The price of many life products would go up by up to 20-30% due to higher capital requirements…” “…non-life product prices would increase on average by 5-10% for more capital-intense products… or those with a long tail… due to higher capital costs…”

26. May 13, 2010 An Introduction to Solvency IISlide 26 Implications U.S. Regulation Continued convergence of insurance accounting regimes (IFRS) – are capital requirements far behind? Risk-focused examinations introduced by NAIC for year-end 2010 NAIC is examining models-based catastrophe charges for RBC NAIC is re-examining asset RBC charges NAIC to consider some measure of operational risk? NAIC to require something similar to the ORSA?

27. May 13, 2010 An Introduction to Solvency IISlide 27 Questions?