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Solvency II – The Final Test Israel April 5 th, 2011 Prepared by Marc Beckers of Aon Benfield Analytics.

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Presentation on theme: "Solvency II – The Final Test Israel April 5 th, 2011 Prepared by Marc Beckers of Aon Benfield Analytics."— Presentation transcript:

1 Solvency II – The Final Test Israel April 5 th, 2011 Prepared by Marc Beckers of Aon Benfield Analytics

2 Solvency II: Executive Summary  Harmonizes insurance regulation across Europe, replacing Solvency I (est. 1973) and local regimes (e.g. UK ICAS)  Start date January 2013 + transitional period of up to 5-10 years  Capital charges under Solvency II will be finalised in Dec 2011  Risk-based approach to required capital that demands insurers to develop robust risk management practices  Risk and capital mitigation effect of reinsurance only allowed if the reinsurance counterparty has a Solvency II ratio above 100% or a rating of at least BBB  The average non-life solvency ratio expected to decrease from about 200% under Solvency I to 165% under Solvency II  Captives and mono-lines are at a significant disadvantage as the standard formula penalises those writing less diverse portfolios – both geographically and in terms of class of business.  The capital charges for counterparty default risk may drive a flight to quality for reinsurance counterparties (rating A or better)  Catastrophe risk is a key concern within the Solvency II Standard Formula  The local catastrophe scenarios under QIS 5 often lead to a materially higher result than the commercial catastrophe models 1 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

3 Topics for discussion Section 1Summary Conclusions QIS 5 Section 2Life, Non-Life and Health within QIS 5 Section 3Partial Internal Models in QIS 5 2 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

4 Section 1: Summary Conclusions QIS 5  Solvency Ratio from 310% in Solvency I to 165% under QIS 5 !  Diversification for composite solo submissions 32% and 46% for groups  Quality of QIS 5 submission debatable  Significant issues with the QIS 5 requirements for some key risks  Time is running out

5 Summary: Surplus falling under QIS 5 but still acceptable on average Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 4 Surplus: Solvency I to QIS 5  Overall 2009 level of surplus for European industry has decreased by 30% representing a €120bn reduction (from €480m to €360m)  The margin under the MCR has increased by €200bn  Industry wide solvency ratio falls from 310% to 165% under QIS 5 SR = 310% 165% 466% Valuation Adjustment Effect +99% Analysis of Surplus Movement  Market consistent valuation of assets under QIS 5 reduces solvency ratio by 14%  Technical provisions assessed at fair value increases solvency ratio by 107%  Risk based capital requirements are the key driver for the reduction in solvency ratio Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

6 Are diversification and loss absorbing mechanisms too large ? Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 5 Source: EIOPA QIS 5 report  32% diversification for solo composites and 46% for groups versus a diversification benefit by S&P of below 10% ! Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

7 Groups – Key Observations  Under Standard Formula, average group surplus reduces by 43% vs Solvency I, but using internal model surplus increases by 6%  Average group diversification 20% under accounting consolidation  Significant adjustment for loss absorbency and deferred taxes  Equal balance between life and non-life insurance risk  Market risk is substantial at 57% of BSCR –Equity risk and spread risk are significant –High interest rate charge suggests poor ALM  Counterparty charge large relative to other risk categories Diversified Group SCR 6 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

8 UK: Acceptable quality except for USPs and SCR Underwriting Risk ! Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 7 Source: FSA QIS 5 report Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

9 What issues transpired in QIS 5 ?  Ireland difficulties: 1.Complexity, especially counterparty default risk module and non-life cat risk 2.Non-Life underwriting risk calibration 3.Life contract boundaries and Expected Profits in Future Premiums (EPIFP)  France difficulties: 1.Asset risk fair value very different from today 2.Complexity SCR, especially non-life cat and non-proportional reinsurance 3.Calculating technical provisions, eg. contract boundaries and illiquidity premium 4.EPIFP  Spain: 1.Complexity counterparty default risk (need to run the model twice !) 2.Catastrophe risk for non-life and life, eg. consorcio not taken into account in life Cat  Other observations: poor data “quality control” Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 8

10 Solvency II implementation to cost in excess of €3m on average Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 9 Source: FSA QIS 5 report Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

11 Was QIS 5 “only” a test ? Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 10 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

12 Solvency II implementation by 2013 2005 2006 2007 2008 2009 2010 2011 2012 2013 Directive Development (Commission) Directive Adoption (Council & Parliament) Level 1 Implementation in member states Solvency II Start Date 1 Jan 2013 Level 2 Implementation Measures (CP’s) Level 3 Guidelines by Regulators Proposal expected in June 2011 Final measures by end 2011 Expected before March 2012 (depends on Level 2) QIS Omnibus II QIS 1 QIS 2 QIS 3QIS 4 QIS 5 QIS5 results expected by March 2011 Transitional Phase? QIS = Quantitative Impact Studies Key Dates for 2011 July 2011 Sept 2011 Q3 2011 Nov 2011 Dec 2011 EC finalise technical standards for Solvency II Pan European Stress Test EIOPA Advice on assessment of Switzerland, Bermuda, Japan 3 rd country assessment methodology EC confirm transitional measures for Solvency II 11 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

13 ? Transitional measures under “Draft” Omnibus II 2013201420152016 2017 2018 201920202021 2022 Valuation of Assets & Liabilities  Requirement for fair value assessment of assets and liabilities delayed for up to 10 years  Existing member state rules as at 31 December 2012 will apply during transitional period Calculating Technical Provisions  Requirement for calculation of technical provisions delayed for up to 10 years  No requirement to be as best estimate with discounting and risk margin,  Existing Solvency I directives will apply during transitional period Tiering of Own Funds  Requirement for criteria by which funds classified into various tiers delayed for up to 10 years  Existing Solvency I directives for classification of own fund items will apply during transitional period Public Reporting  Delayed for up to 3 years  Higher level reporting in Solvency II directive required from 2013 SCR  Requirement for SCR calculation delayed for up to 10 years  Calculation of ‘transitional SCR’ may include modifications to standard formula calculations  Insurers must comply with a transitional SCR that is no higher than the SCR and no lower than the sum of the MCR and 50% of the difference between the SCR and the MCR. Governance  Delayed for up to 3 years  Existing Solvency I directives will apply during transitional period  Draft Omnibus II directive published by European Commission on 19 January 2011  Solvency II start date confirmed as 1 January 2013  Omnibus II provides maximum transitional periods  EC will publish delegated acts in 3 rd quarter 2011 confirming actual transitional measures – likely to be shorter than the maximum time periods Equivalence of third countries  Criteria for equivalence delayed up to 5 years  Decisions would be made on case by case basis under delegated acts of law Supervisory Reporting and Governance  RSR is delayed for up to 3-5 years (including supporting systems and governance)  Existing Solvency I reporting applies 12 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

14 Section 2: Life, Non-Life and Health in QIS 5 QIS 5 shows that key challenges remain before the implementation of Solvency II

15 Underwriting risk is the key SCR component for non-life insurers Non-Life Solo SCR  Average capital requirement for non-life insurers is higher than life insurers under Solvency II –This is driven by the loss absorbency of life mathematical provisions  Greater diversification in the BSCR for non-life insurers  Underwriting risk is the key component for non-life insurers  Market risk is largest component of life insurance capital requirement * Adjustment for tax is estimated for non-life SCR based on group value provided in EIOPA report on QIS 5. ** Diversification is estimated using QIS 5 correlations and non-life / life individual risk SCR’s post-diversification Life Solo SCR 14 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

16 QIS 5: Life and Health Cat Risk 11% of U/W risk pre-diversification LIFE CAT RISK1.5 per mille on capital at risk HEALTH CAT RISK  Arena risk (50% of stadium) +  Concentration risk (100% + 300m around) +  Pandemic risk (0.075 per mille) Accidental Death10% Permanent total disability1.5% Long term disability5% Short term disability13.5% Medical / Injuries30% 15 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

17 QIS 5 results show the importance of EQ risk (net of reinsurance)  Overall reinsurance is a key aid to reduce the exposure to NatCat risks  Overall (net) EQ exposure within a local Cypriot non-life insurer would be about 25% of the total capital requirement  “The CTF recommends a more accurate and appropriate estimation of the undertaking's catastrophe risk through the use of a partial internal model” 16 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

18 NatCat: Earthquake Calculate the gross 1/200 OEP per country Total Insured Value per Cresta Vulnerability factor (quake) “Aggregation” Matrix (quake) 1 in 200 OEP factor Parameters-non-life-catastrophe-risk_en.xls EQ_CRESTA_CY Provided by company 17 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

19 Evaluating catastrophe models – components Exposure Vulnerability Hazard Loss Industry Exposure database Geocoding Resolution Occupancy Type Vulnerability Regions Construction Type Post-Loss Amplification Loss by Geographical Region Deductibles Losses by LoB / Coverage Regional Correlation Business Interruption Line of Business Hazard EP Curves / RPs Several steps along the catastrophe modelling chain where we can evaluate and compare models 18 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

20  Potentially significant difference in output between Standard Formula approach and cat models  Scenario testing vs cat model by client  Negative percentage = cat model lower than scenario  For over 80% of clients the standard formula for natural cat is unacceptable Standard Formula Nat Cat – Cat Models vs Scenario France Comparison with Cat Models  Damage by Cresta zone is going back more than 15 years in time  Munich Re / Swiss Re approach prior to cat models?  Almost all clients have data more granular than Cresta  All commercial cat models have finer granularity  Data quality is ignored  No impact for location granularity  No differentiation by occupancy  No impact for construction, age, height  Single damage function  No differentiation by buildings, contents, BI  No application of limits, excess, original deductibles Issues with Standard Formula Our Recommendation: Catastrophe Partial Internal Model PML QIS 5 > PML vendor models PML QIS 5 < PML vendor models 19 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

21 Non-Life Solos – Key Observations  Non-life cat risk has significant issues with calibration under Standard Formula  Health care component relatively small but complex to compute –Segmentation into SLT and non-SLT of workers comp difficult –Similar to life (SLT) only 2.5% of BSCR for non-life firms Is the complexity justified?  Life risk close to nil  Market risk smaller for non-life companies reflecting lower risk investment strategies –Equity risk largest component Diversified Non-Life Solo BSCR 20 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

22 Non-life SCR (Solos) Manmade Cat Natural Cat Method 1 28%  Premium risk largest driver of non-life capital –Most entities did not use USP’s or NP adjustment  Cat risk split fairly evenly between Method 1 and 2 –Non-EEA cat risk carries significant capital charge  Manmade cat charge similar to Nat cat –Does this make sense for a risk not currently explicitly modelled?  Lapse assumed nil by most companies Non-Life SCR (Solos) 21 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

23 Health SCR (Solos) Health Cat Similar to Life (SLT)  Disability is the largest risk within SLT (76%) –Income protection disability charge too penal  Lapse risk also significant, many reported difficulties to identify +ve and –ve surrender strains  Health cat does not factor in medical expenses for pandemics –Also difficult to calculate and inconsistent with life cat  Cat scenarios too generic for local markets and insurers Health SCR (Solos) 39% 11% 22 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

24 Life SCR (Solos)  Lapse risk and longevity risk are most material life risks –Feedback on longevity risk critical of it only being a shock on level, rather than accounting for trend risk –Lapse risk calculation was criticised as too onerous on a policy by policy basis  Revision risk is nil –Surprising result: possible error in report? (in appendix to EIOPA report = 2.9%) –Or indicator that calculation is too complex for most companies? Life SCR (Solos) 23 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

25 Market Risk SCR (Solos) Credit Quality  Equity and spread risk are most significant –Both criticised as too penal –Spread risk excludes Sovereign risk Note EIOPA stress test includes it  Currency risk: counterintuitive to hold assets in reporting currency instead of the liabilities  Counterparty risk: too complicated and cash at bank too penal relative to equivalent spread risk Return Generating Assets Market Risk SCR (Solos) Other Equity forms part of Equity charge (exact % unspecified in EIOPA report) 24 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

26 Non-life: Undertaking Specific Parameters and Non-Proportional Adjustment  Approximate 20% reduction in underwriting volatility under non-proportional adjustment for liability and fire  Significant area of feedback: –Too complex, most undertakings did not complete –Not suitable for different types of non-proportional reinsurance –Data requirements onerous Undertaking Specific Parameters Sample Size Non-Proportional Adjustment  USP’s submitted to supervisors under QIS 5 generally provide a significant reduction in volatility  Especially for liability classes  Some concern about cherry-picking and USP’s not becoming an “internal model lite” 25 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

27 Section 3: Partial Internal Models for Catastrophe Risk  Who is planning an internal model for catastrophe risk?  Is an Internal Model worth it?  Do not underestimate the complexity !  Internal models could be the answer, but will they be?

28 Weighted average benefit from Internal Model 20% Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011 27  Very high standard deviation of results: between 25% and 250% on 27 German insurers  Weighted average SCR via Internal Model 140% of Standard Formula result in Spain  The average life firm’s internal model SCR was almost equal to their standard formula SCR in the UK  UK Internal Models: Source: FSA QIS 5 report Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

29 Internal Models – too complex and worth the effort ?  For a model to be approved the following need to be satisfied: –Use test: have to show that the model is used as a decision tool in daily risk management work –Statistical quality standards –Calibration standards –Profit and Loss attribution –Validation standards –Documentation standards –Internal Model governance –Integration of external models needs to be understood  In general: what regulators want to see is a controlled process around the internal model, acknowledged and used by management  Most popular use test example: reinsurance ! Do regulators have the capabilities or will they rely on outside consultants (like they are doing in Switzerland for the SST) 28 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

30 An example of a pre-application timetable (FSA)  Experience shows that it takes at least 2 years from kickoff to approval (expect over 50 on-site visits from regulator)  Hundreds of documents  Thousands of pages  About 200 meetings  About 100 employees involved (60% quantitative people)  About 15 departments involved 29 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

31 Catastrophe Partial Internal Models AreaConsiderations  Internal model approval process is currently very onerous required detailed documentation and validation of the science behind the catastrophe model  If the client cannot answer questions about the internal model (including the underlying external models), the model will not be approved  Potential issue for most commercial models, which are largely black boxes  One regulator indicated preference for Impact Forecasting due to transparency  Clients fix the “model boundaries” at the outset  If model changes fall within the boundaries, no need for renewed model approval  One regulator indicated that they prefer a multi-model approach  Advantage: a change in one of the models would only partially impact the results  No need for equal weighting of different models: is this ensuring best practice?  Some regulators indicated a pragmatic approach to facilitate the use of external commercial cat models and have the clients benefit from their data quality  Possible solution: simplified internal model approval process for cat (proposal submitted in February 2011 to EIOPA by Aon Benfield)  A simplified Internal Model approval process would be beneficial to insurers and to regulators and lower significantly the barrier for internal models as well as reduce the workload (and cost) for regulators  Focus for a simplified approval process should be on input data requirements and the process to correctly apply the catastrophe models Model Approval Process Model Change Simplified Approval Process 30 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

32 QIS 5 as a precursor of Solvency II: The good, the bad and the ugly  Sufficient surplus capital on average  Better awareness of risk and the value of data quality  Quality of QIS 5 was quite poor in many aspects  Many results from the Standard Formula were wrong  Standard Formula overall much too complex  Resource requirements will come at a cost ! 31 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

33 Advise from one of the EU regulators Take the time for implementation ! Get used to market value and the corresponding volatility ! 32 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011

34 For more into, contact us locally or globally  Gareth Haslip t: +44 20 7522 8137 e: gareth.haslip@aonbenfield.comgareth.haslip@aonbenfield.com  Tessa Moulton t: +44 20 7522 7137 e: tessa.moulton@aonbenfield.comtessa.moulton@aonbenfield.com  Jürgen Wielandts t: +32 2 661 7164 e: jurgen.wielandts@aonbenfield.comjurgen.wielandts@aonbenfield.com  Marc Beckers t: +44 7931 472 999 e: marc.beckers@aonbenfield.commarc.beckers@aonbenfield.com 33 Aon Benfield | Israeli Market presentation Proprietary & Confidential | 5 April 2011


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