0. 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

1. 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?

2. 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

3. 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

4. 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)

5. 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

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

7. 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

8. 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)

9. 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.

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

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

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

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

22. 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%

23. 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)%

24. 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)%

25. 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

26. 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)%

27. 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)%

28. 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)%

29. 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

30. 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

31. 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

32. 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