Solvency II: Future Regulatory Capital Requirements CAS CARE Seminar, June 2005 Susan Witcraft

2 Guy Carpenter Agenda Changing Financial Environment Changing Regulatory Standards  Concept of Solvency II  Determination of Solvency Capital Requirement (SCR)  Reinsurance Implications of Solvency II Alignment of Regulatory and Economic Capital

3 Guy Carpenter Changing Financial Environment Financial Conglomerate Bank entities Insurance entities Solvency II Basel II Regulatory Environment Interdependencies IFRS Accounting Environment Broad Conclusions: Higher minimum capital likely Transparency Robust risk management system crucial Consistency Transparency More volatility

4 Guy Carpenter Changing Regulatory Standards Solvency II – Background Current Solvency I inadequately reflects risk profile of insurers = establishment of new complex solvency system Solvency II applicable for EU domiciled (re-)insurers Solvency II is interlinked with developments of IASB – Consistent definition of capital resources available Solvency II will likely shift risk management approach in the insurance industry – Burden placed on company to defend its capital adequacy Solvency II moves toward a more risk-based architecture encouraging companies to properly measure and manage risks

5 Guy Carpenter Impact of IFRS on future Solvency Rules Main areas IFRS will influence Solvency II regulations: – Determination of capital resources available – Measurement of insurance reserves – Increased transparency Investments (partially) at fair value Assets Equity & Liabilities Insurance Reserves fair value? Capital

6 Guy Carpenter Comite Europeen des Assurances (CEA) published comparative study on solvency regimes March 2005 – CEA: The European Federation of National Insurance Associations Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) published third-wave call in Spring 2005 – CEIOPS: European umbrella organisation for national regulators EU publishing framework based on CEIOPS and CEA recommendations, targeted for 2006 European Framework Directive published Q2 2006? – Framework Directive will determine first substantial results as guideline for insurance industry Directive finalised and agreed 2008? Implementation of Directive in local regulations 2009/10? Solvency II - Timetable

7 Guy Carpenter Solvency II – 3-Pillars Pillar III Transparency Disclosures Reporting requirements Pillar II Supervisory review process Internal control & risk management Intervention powers and responsibilities of supervisors 3-Pillar Approach Within Solvency II framework, determination of SCR will be one of the major issues Pillar I Quantitative requirements Quantification insurance reserves Investment rules Capital Requirement Minimum Capital Requirement (MCR) Solvency Capital Requirement (SCR) Standardized model Internal model

8 Guy Carpenter Influence: Internal: BOD / Management External: Rating / Regulatory / Stock Analyst Insurance Risk Management Framework Risk Environment Risk Categories

9 Guy Carpenter Solvency II – Determination of SCR SCR likely follows a risk-based capital approach covering all major risk categories of an insurer, not only underwriting risk Calculation of SCR will be most likely based on – Standardized model or – Internal model or – Combination of both standardized and internal model (partial internal model)

10 Guy Carpenter Solvency II – Calculation of SCR Current approaches to anticipate calculation of SCR vary across Europe UK, Swiss and Dutch most recently reformed their domestic regimes – ECR calculations have shown that majority of UK non-life insurers are faced with significantly higher capital requirements German Regulator (BaFin) and Insurance Association (GDV) currently working on a standard model to anticipate Solvency II (expected mid 2005) Guy Carpenter Recommendation: – Insurers that have not yet started to assess future capital adequacy are advised to benchmark with existing regulatory capital adequacy measures – Capital Adequacy Projector

11 Guy Carpenter (net-) Premiums (net-) reserves Credit risk (reinsurance recoverables) investment / asset risk Possibly other risks such as operational risk Standardised model lines of business Solvency I (net-) Premiums (net-) claims/ -reserves Solvency II- solvency capital (Standardised Model) Other risks or risk categories are not addressed Solvency II Anticipated Standardized Factor Based Model

12 Guy Carpenter Solvency II Evaluation of Capital Requirements Approximation of regulatory capital benchmarks…: Approximation of rating agencies’ capital requirements….:

13 Guy Carpenter Solvency II – FSA (UK) – Approach Minimum Capital Requirement (MCR) (Solvency I) Enhanced Capital Requirement (ECR) Internal Capital Assessment (ICA) Actual Capital Resources Individual Capital Guidance (ICG) BASED ON FSA REVIEW OF ICA AND ECR Hard Test Soft Test Company Calculation / FSA Review Comparison of ICG to Actual

14 Guy Carpenter Solvency II – Internal Models An internal model is a risk-based capital model developed by the management (DFA-concept) Development of full-scale and partial internal models will be likely encouraged by regulators Partial internal models would ease the move from standardized models to full-scale internal models Both full-scale and partial internal models are subject to regulatory approval – Will regulators be prepared? Internally modeled capital will likely be benchmarked with risk capital based on standardized model by regulator

15 Guy Carpenter Solvency II – Reinsurance Implications Reinsurance constitutes exchange of insurance risk (primarily underwriting & accumulation) for asset risk – Asset risk carries a lower capital charge than insurance risk, thus reinsurance can be an effective way to manage regulatory capital needs Factor based models do not distinguish between proportional and non- proportional reinsurance Risk mitigating effect of non-proportional reinsurance compared to ceding of profits are reflected more adequately within simulation based models Accumulation risk reduction impact of reinsurance has most likely to be considered in both standardized and internal models

16 Guy Carpenter Treatment of Accumulation Risk Current regulatory guidelines as to ability to withstand catastrophic events – Australia Prudential Requirements  Internal model: reduce probability of default to 1 in 200 year  Prescribed method: add net 1 in 250 PML to minimum capital – U.K Internal Capital Adequacy Standards  Internal model: reduce probability of default to 1 in 200 year – U.S. Risk-Based Capital  No specific requirements – Revised German model (BaFin/GDV) will most likely require additional capital for NATCAT exposure (1 in 200 storm) Will there be pressure to raise limits under Solvency II?

17 Guy Carpenter Credit Risk under Solvency II Concentration in credit risk to be considered – FSA (UK) monitors annual premiums ceded to one reinsurer (group) to 20% – FSA (UK) monitors total recoverables from any one insurance group not to exceed 100% of capital resources Rating of reinsurers to be factored in – The higher the rating of a reinsurer the lesser capital is needed – Increasing tendency to cover credit risk arising from reinsurance recoverables  Retrospective and prospective coverage reinsurance solutions Diversification and quality of reinsurance recoverables will become more important

18 Guy Carpenter Dual Effect of Reinsurance on Solvency Rules Reinsurance provides: – Capital relief in MCR and especially SCR as discussed – Protection of capital resources available defined as  Equity according to balance sheet (local GAAP or IFRS) adjusted by items such as ­Non-admissible assets ­Hybrid capital ­Off-balance sheet items When evaluating impact of reinsurance both risk capital relief and coverage of capital resources available have to be taken into account

19 Guy Carpenter Adequate Capitalization: Competing Interests of Stakeholders Companies generally start with management view and compare against views of other interested parties

20 Guy Carpenter Economic Capital Covers Unexpected Losses Potential Losses Unexpected Losses Taken into account in pricing and valuation decisions Expected Losses Projection of expected result Require capital to protect policyholder interests Avoids cyclical pricing behaviour Capital requirements Solvency II The starting point for Solvency II is that financial strength should only cover unexpected losses. Expected losses should be included in pricing and valuation decisions. Henrik Bjerre-Nielsen, Chairman of CEIOPS, 18 June 2004

21 Guy Carpenter Regulatory Capital based on Economic Capital Economic capital as realistic measure for required regulatory capital – Commensurate with risk-based capital Companies using internal DFA based models are better able to align internal management goals with regulatory requirements – Prerequiste: internal models are approved by regulator Companies having no internal models in place – Application of standardized model – most likely factor-based - to fulfill regulatory requirements – Factor-based models are conceptually inadequate for internal management purposes – Companies are faced with co-existence of regulatory and management capital perspectives

Solvency II: Future Regulatory Capital Requirements CAS CARE Seminar, June 2005 Susan Witcraft