1. 1 Use test Izabela Sabała Insurance and Pension Inspection Department KNF O ffi ce TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

2. Disclaimer Any views and opinions expressed in this presentation or any material provided with it wholly express only the personal views of the author and not necessarily exactly reflect the common position of the speaker’s employer, namely the KNF (Polish Financial Supervision Authority) O ffi ce (Urząd Komisji Nadzoru Finansowego). The information, views, opinions or any other material are provided without any warranty, including but not limited to, warranties of correctness, of completeness or of validity. 2 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

3. General framework Art. 120 of SII Directive IM use IM is widely used in and plays an important role in the system of governance, in particular in the risk management system and ORSA Frequency of calculation frequency of calculation of SCR consistent with the frequency with which it is used for the other purposes at least annually Responsibility of the administrative, management and supervisory body ensuring the ongoing appropriateness of the design and operations of IM ensuring that IM continues to appropriately reflect the risk profile 3 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

4. Use test philosophy 4 If an undertaking does not trust its IM sufficiently to use it, why should the supervisor? IM should be used in a way that creates incentives to improve its quality. Fit to the business Support for decision-making Integration with RM Understanding of IM TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

5. Fit to the business  The modelling approaches reflect the nature, scale and complexity of the risks inherent in the business of the undertaking which are within the scope of IM.  The outputs of IM and the content of the internal and external reporting of the undertaking are consistent.  IM is capable of producing outputs that are sufficiently granular to play an important role in the relevant management decisions of the undertaking –as a minimum, the outputs of IM shall differentiate between material lines of business, between risk categories and between major business units.  The policy for changing IM foresees that IM is adjusted for changes in the scope or nature of the business of the undertaking. 5 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

6. Support for decision-making  IM shall be used to support the relevant decision- making processes in the insurance or reinsurance undertaking, including the setting of the business strategy.  IM shall be used to assess the impact of potential, material decisions including the impact on expected profit or loss and the variability of the profit or loss resulting from those decisions.  IM and its results shall be regularly discussed and reviewed in the administrative, management or supervisory body of the insurance or reinsurance undertaking. 6 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

7. Integration with risk management  All material quantifiable risks identified by the risk management system are covered by IM.  The outputs of IM, including the measurement of diversification effects, are taken into account in formulating risk strategies, including the development of risk tolerance limits and risk mitigation strategies.  The relevant outputs of IM are covered by the internal reporting procedures of the risk management system.  The quantifications of risks and the risk ranking produced by IM trigger risk management actions where relevant.  The policy for changing IM foresees that IM model is changed, where relevant, to reflect changes in the risk management system. 7 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

8. Understanding of IM  The administrative, management or supervisory body of the insurance or reinsurance undertaking and the other persons who effectively run the undertaking shall be able to demonstrate an overall understanding of IM: –the structure of IM and the way the model fits to the business and is integrated in the risk-management system of the insurance or reinsurance undertaking; –the scope and purposes of IM and the risks covered by IM, as well as those not covered; –the general methodology applied in IM calculations; –the limitations of IM; –the diversification effects taken into account in IM.  The persons who effectively run the undertaking shall be able to demonstrate a sufficiently detailed understanding of the parts of IM used in the area for which they are responsible. 8 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

9. Use test assessmnet  Indication on the areas where IM should be used,  Concrete examples of decisions where IM has been used supported by analysis made for this purpose,  Description of the decision-making process with defining the roles of persons involved,  Indication on variables analysed on a regular and ad hoc basis,  Report (and reporting templates) with IM outputs and explanation why the elements covered by the report are analyzed,  Documents indicating on an active use of IM in risk analysis (risk management policy, ORSA),  Indication when IM is run and assessment if it is consistent with the period when main (including strategic ones) decisions are made,  Catalogue of trainings on IM, including participants or target audience,  Minutes from meetings of the board and relevant committees. 9 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

10. Strategic management Performance measurement Economic Value Added (EVA) MCEV RoRAC Limit systems Risk bearing capacity Risk tolerance Risk limits Strategic asset allocation and investment decisions Analysis of ALM positions Implications of various SAA options Setting investment related limits Product development and pricing ALM position (CF models) Cost of capital Reinsurance optimization Analysis of various re-insurance structures 10 Examples of IM use TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

11. Example 1: risk surplus determination (1/4) 11 To ensure that sufficient eligible own funds are hold in order to cover the solvency need from its risk position equaling SCR. SCR increasing to an extent that own funds available do no longer cover the Solvency needs from its risk position Own funds decreasing by an extent that existing SCR can no longer be covered. TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

12. Example 1: risk surplus determination (2/4) 12 Determination of the starting position for the risk appetite as the amount of the eligible own funds Definition of an initial risk appetite based on the volatility of SCR Definition of an intial risk tolerance based on the defined solvency buffer Calculation of the available surplus TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

13. Example 1: risk surplus determination (3/4) 13 SCR SCR volatility Initial risk appetite Initial risk tolerance Solvency buffer Surplus Risk appetite the amount of the eligible own funds TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

14. Example 1: risk surplus determination (4/4) 14 SCR SCR volatility Initial risk appetite Initial risk tolerance Solvency buffer Surplus Risk appetite the amount of the eligible own funds Add-on The amount of add-on allocated individually per risk category. TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

15.  Risk-adjusted Return on Capital – the relative performance of business segments that have different levels of risk, which are reflected in the denominator  Return on Controllable Assets - the performance of business in relation to the capital hold  Economic Value Added – the amount of earning generated above and beyond the cost of capital employed to generate those earnings (stakeholders must earn return that compensates for the risk taken) Example 2: Performance measures 15 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

16. Example 3: Market Consistent Embedded Value (MCEV)  Net Asset Value (NAV)= +Required capital (RC) + Free Surplus (FS)  Value of in-force portfolio of life policies (ViF) = + Present value of future after tax profits (PVFP) -Time value of financial options and guarantees (TVFOG) -Cost for non-hedgeable risk (CNHR) -Frictional cost of required capital for the in-force business (FCRC) 16 RC FS PVFP TVFOG CNHR FRCR VIF NAV MCEV TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

17. Example 4: Investment Management GOAL: To create an asset mix that will provide the optimal balance between expected risk and return for a long term investment horizon Limit framework The target weights for the asset classes consistent with the limits Verified at the levels on which limits are applicable Duration of the fixed income portfolio ALM 17 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

18. 18 TAIEX Workshop on Solvency II Requirements Baku, December 17 ‒ 18, 2013

19. Thank you! Izabela Sabała +48 (22) 262 53 42 izabela.sabala@knf.gov.pl 19