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1 Potential Rating Implications of Solvency II London 15 March, 2012 Catherine ThomasDirector, Analytics
2 Key Issues: –Diversification benefits –Investment strategies –Available regulatory capital –Use of internal capital models
3 Diversification benefits enhanced BEST’S PERSPECTIVE Well diversified groups will be able to realise substantial reductions to their capital requirements Larger groups more likely to seek internal model approval – potential for even greater diversification benefits Internal models increasingly used to support strategic decisions Diversification benefits from acquisitions that increase product offering or extend geographical reach RATING IMPLICATION Diversification benefit applied consistently across the global insurance market through BCAR Credit in BCAR for line of business diversification and economies of scale Correlations increase during periods of extreme financial stress Diversification for diversification’s sake viewed unfavourably M&A - underwriting, execution and integration risk are key rating drivers
4 Investment strategies BEST’S PERSPECTIVE Individual asset classes will be examined to determine if returns support cost of capital Equities, as well as longer dated and lower rated corporate bonds, are relatively capital intensive EEA government bonds currently classified as risk free Shift from long term to short term debt and towards higher rated corporate and government bonds Alternative assets incur fixed 49% charge unless possible to “look through” to underlying assets RATING IMPLICATION Continue to independently assess the risk profile of each rated insurer’s investment portfolio Required capital to support investment risk calculated using BCAR Capital charges based on risk of default, illiquidity and market-value declines Do not differentiate between government and corporate bonds Additional stress testing owing to European economic uncertainty
5 Available regulatory capital BEST’S PERSPECTIVE 3 tiers based on 5 criteria: –subordination –loss absorption –permanence –perpetuity –interest deferral Tier II and III capital will allow insurers to increase financial leverage RATING IMPLICATION AM Best has its own methodology on equity credit for hybrid securities Key characteristics – permanency of capital, ability to defer interest or dividend payments and subordination in an insurer’s capital structure No change in methodology – allows for global consistency Will monitor how companies respond to guidelines, in particular if this leads to further innovation in respect of hybrid instruments
6 Credit for economic capital models BEST’S PERSPECTIVE Customised model fit to company’s unique risk profile Regulator reviews and approves the model Development of an internal ECM generally viewed positively – company is exploring another way to quantify and manage its risk Concerns regarding over-reliance RATING IMPLICATION Difficult to compare company ECMs because of little standardisation Insurers encouraged to share ECM output Credit for ECM versus BCAR required capital No change in methodology Proven strong ERM + ECM capability = lowering of capital requirement over time
7 Risk Management and BCAR – Best’s Approach LOWHIGH EXPOSURE TO EARNINGS and CAPITAL VOLATILITY BCAR BCAR Guideline Weak Risk Management Strong Risk Management Enhanced ERM
8 Conclusion Rating implications will depend on the final structure and calibration of Solvency II Uncertainty remains –timing of implementation –transitional arrangements –final capital charges –equivalence –group supervision –internal capital model approval Response of management will determine the impact on an insurer’s credit worthiness
9 Catherine Thomas Director, Analytics A.M. Best Europe – Ratings Services Ltd email@example.com
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