1. Global Life Actuarial INTERNAL USE ONLY ASSAL-IAIS Training Seminar: Risk Margin in the Swiss Solvency Test 22nd November 2012 Alex Summers

2. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 2 Important note The views expressed in this presentation are the presenter’s own and do not necessarily represent the views of either Zurich Insurance Group (Zurich), or FINMA I am very grateful to colleagues within Zurich and at FINMA for their assistance in preparation Further information from FINMA on the Swiss Solvency Test can be found on FINMA’s website at http://www.finma.ch

3. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 3 Agenda Purpose and relevance of the SST risk margin Key principles and conceptual framework Calculation including simplifications Comparison against alternative approaches

4. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 4 The risk margin helps SST protect policyholders by giving a high probability of orderly run-off of the business SST identifies insurers* at risk of being unable to honour their existing obligations A ladder of intervention allows appropriate actions to be taken when insurers run into difficulties SST sets capital requirements so that there is high probability after one year of 1. Still being solvent (Expected shortfall SCR) 2. Having enough capital to fund future SCRs over the life time of the business (Risk margin) Risk margin should thus give just enough capital to allow orderly run-off of the business, whether internally or via transfer of liabilities to a third party if necessary Both fulfilment and transfer value concepts are relevant for risk margin in the SST Risk Total required 0 margin capital SST ladder of intervention Based on FINMA SST technical document p8 *: The term “Insurers” has been used throughout to indicate both insurance and reinsurance undertakings

5. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 5 Overview of risk margin in the SST Risk margin is the extra amount needed above best estimate of liabilities to cover the cost of supporting risks the liabilities bring Non-hedgeable risks only Present value of opportunity cost of regulatory capital needed to support risks over the lifetime of the liabilities Simplifications are needed in practice SST risk margin is similar in nature to Solvency II risk margin Details differ slightly

6. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 6 Relevance of SST risk margin can vary significantly across insurers Source: FINMA Report on the Swiss Insurance Market, SST 2012 Charts show % total Market Value of Liabilities + required capital (BEL + ES SCR + Risk Margin) “MVM” (Market Value Margin) is another name for risk margin in SST

7. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 7 Even though risk margin is small relative to total liabilities, it can have a very significant effect on SST solvency ratio… Source: FINMA Report on the Swiss Insurance Market, SST 2012 Charts shows weighted averages for Swiss Industry, expressed as % total Market Value of Assets Risk margin is particularly important in stressed markets Nevertheless risk margin is small enough to be a rounding error in BEL Accurate assessment of BEL is important, considering materiality of impact on target capital

8. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 8 …as can be seen from consideration of different components of SST target capital Source: FINMA Report on the Swiss Insurance Market, SST 2012 Charts shows weighted averages for Swiss Industry, expressed as % total required capital (Expected Shortfall SCR + Risk Margin)

9. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 9 Agenda Purpose and relevance of the SST risk margin Key principles and conceptual framework Calculation including simplifications Comparison against alternative approaches

10. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 10 The SST risk margin is the expected amount of capital needed today to be able to support regulatory capital requirements over the lifetime of the business

11. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 11 SST risk margin is based on projected regulatory SCR, allowing for own diversification For SST the principles defining how risk margin is calculated are based on both transfer and fulfillment value considerations Inputs mix regulatory and company specific aspects Solvency II is more strictly motivated by transfer value concept Benefits of allowing consideration of company specific aspects include Consistency of balance sheet Improved incentives for good risk management, including diversification Aspects supplied by FINMA Undertaking- specific aspects Consistent with both transfer value and fulfilment concepts Consistent with fulfilment concept Risk measure for regulatory capital 6% cost of capital rate Non-hedgeable risk exposures Diversification Assumptions consistent with best estimate Company policy for going concern management actions

12. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 12 Only non-hedgeable risks need to be considered in SST risk margin Practical policyholder protectionTheoretical robustness Relevance of risk margin increases in a stressed solvency position Considering non-hedgeable risks only is consistent with possible outcomes under ladder of intervention Good value safeguarding industry competitiveness: minimum needed for policyholder protection In market consistent framework, only compensated for risks that can’t be hedged or diversified Consistent with view of total market value of liabilities as corresponding to value of an optimal replicating portfolio No double counting No penalty for market risk associated with free surplus

13. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 13 SST risk margin is consistent with other elements of the balance sheet, and required capital Same assumptions should be used for valuing risk margin and best estimate discounted liabilities In particular there should be a consistency of assumptions pertaining to Own business policies Settling own portfolio Diversification Own expense risk Client behaviour This prevents distortions from artificial shortening of run-off period through inconsistencies in lapse assumptions, or assumption of aggressive run-off rather than treatment as a going concern

14. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 14 6% Cost of Capital rate corresponds to BBB credit rating Derived considering opportunity cost of capital in excess of risk-free Steady “through the cycle” assumption BBB credit rating consistent with 99% Expected Shortfall risk measure Higher credit rating would give lower CoC rate, offsetting higher SCR Using the same 6% rate for all insurers is consistent with a transfer value concept Disproportionate effort for each company to calibrate a specific rate Using same rate for all improves transparency Other rates can be used e.g. lower rates used for MCEV Cost of Residual Non- Hedgeable Risks

15. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 15 Company-specific diversification is a key advantage of SST risk margin Allowing for company-specific diversification recognises that diversification is at the heart of good risk management practice for insurance So it’s not a disadvantage that company-specific diversification leads to a different “market” value of liabilities for different insurers Consistent with fulfilment value concept Hopefully this should be more often relevant than transfer value!

16. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 16 Agenda Purpose and relevance of the SST risk margin Key principles and conceptual framework Calculation including simplifications Comparison against alternative approaches

17. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 17 Calculating SST risk margin is generally relatively simple in practice… Brute force multi-year stochastic-on-stochastic-on-stochastic approach to projecting the required capital is not generally feasible A simplification can be used: The contribution to the ES SCR for each risk driver is assumed to follow an appropriate run-off pattern, starting from the initial ES SCR e.g. sum at risk for mortality A simple aggregation method can then be used to give the overall projected ES SCR for each time period Expert judgment as to choice of run-off pattern needs careful consideration

18. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 18 … although distinguishing non-hedgeable component of market risks can be a challenge Non-hedgeable risks relate to components of the liabilities for which there is no liquid market Expert judgment is needed in determining an optimal replicating portfolio Good documentation needed Non-market risks are often not hedgeable at low cost However if replicating portfolios used for Internal Models, these can also be set up to consider only candidate assets for which there is a liquid market Comparison with full “theoretical candidate asset” replicating portfolio across many real world scenarios can then inform estimate of non- hedgeable proportion of market risk

19. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 19 Agenda Purpose and relevance of the SST risk margin Key principles and conceptual framework Calculation including simplifications Comparison against alternative approaches

20. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 20 Risk Margins for Solvency II and SST are similar in concept but differ in some details “Story“Transfer to empty shell companyBoth transfer value and fulfilment value concepts are relevant ApproachCost of Capital Cost of capital rate 6% Risks coveredInsurance risk, operational risk, counterparty risk and non- hedgeable market risks excluding interest rate risk All non-hedgeable risks, including interest rate risk Operation risk excluded DiversificationLegal entity but not between life and non-life Whole company specific TaxPost-tax, but no loss absorbency of deferred taxes Pre-tax

21. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 21 IFRS Phase 2 approach to risk adjustment will probably give some flexibility Cost of capital, VaR, tail VaR and replicating portfolio approaches all potentially acceptable Accounting purpose is different But synergies from allowing a consistency of approach would save effort Less allowance for diversification Risk margin vs. residual margin: to split or not to split?

22. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 22 Overview of risk margin in the SST Risk margin is the extra amount needed above best estimate of liabilities to cover the risks the liabilities bring Non-hedgeable risks only Present value of opportunity cost of regulatory capital needed to support risks over the lifetime of the liabilities Relevant for both transfer and fulfilment value concepts Simplifications are needed in practice SST risk margin is similar in nature to Solvency II risk margin Details differ slightly

23. © Zurich Insurance Company Ltd. INTERNAL USE ONLY 23 Thank you for your attention Any further questions?