CAS CARE Seminar, June 2005
Solvency II:
Future Regulatory Capital Requirements
Susan Witcraft
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
Guy Carpenter
2
Changing Financial Environment
Financial
Conglomerate
Broad Conclusions:
Bank entities
Insurance entities
Regulatory Environment
Basel II
Solvency II
• Higher minimum
capital likely
• Transparency
• Robust risk
management
system crucial
Interdependencies
• Consistency
Accounting Environment
IFRS
Guy Carpenter
IFRS
• Transparency
• More volatility
3
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
Guy Carpenter
4
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
Assets
Equity & Liabilities
Capital
Investments
(partially)
at
fair value
Guy Carpenter
Insurance
Reserves
fair value?
5
Solvency II - Timetable

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?
Guy Carpenter
6
Solvency II – 3-Pillars
3-Pillar Approach
Pillar II
Pillar I
Pillar III
Supervisory
review process
Quantitative requirements
Transparency
Internal control
& risk
management
Intervention powers
and responsibilities
of supervisors
Quantification
insurance
reserves
Investment rules
Capital Requirement
• Minimum Capital
Requirement (MCR)
• Solvency Capital
Requirement (SCR)
• Standardized
model
• Internal model
Disclosures
Reporting
requirements
Within Solvency II framework, determination of SCR will be one of the major issues
Guy Carpenter
7
Insurance Risk Management Framework
Influence:
Internal: BOD /
Management
External: Rating /
Regulatory / Stock
Analyst
Goals Based Capital Structure
(1. Adequacy and 2. Predictable and Sustainable Results)
Risk
Environment
Risk
Categories
Insurance
Asset
Operational
1. Underwriting
4. Credit (Counterparty)
7. Admin / Compliance
/ Governance
2. Accumulation / Cat
5. Market
8. Strategic
3. Reserve Deterioration
6. Liquidity (ALM)
9. Technology /
Infrastructure
Guy Carpenter
8
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)
Guy Carpenter
9
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
Guy Carpenter
10
Solvency II
Anticipated Standardized Factor Based Model
Solvency I
Solvency II- solvency capital
Standardised
(Standardisedmodel
Model)
(net-)
Premiums
(net-)
Premiums
(net-) claims/
-reserves
(net-) reserves
Credit risk
(reinsurance
recoverables)
Other risks or
risk categories
are not addressed
investment / asset
risk
Possibly other risks
such as
operational
risk
Guy Carpenter
11
Solvency II
Evaluation of Capital Requirements
Approximation of regulatory capital benchmarks…:
Risk category
Model
ECR (UK)
MCR (AUS)
RBC (US)
GDV (Germany)
Investment Reserve Premium
Risk
Risk
Risk
Credit
Risk
Operating
Risk
Covariance
Adj
Net 250
year PML
Total
X
Approximation of rating agencies’ capital requirements….:
Risk category
Investment Reserve Premium
Risk
Risk
Risk
Credit
Risk
Operating
Risk
Covariance
Adj
Net 250
year PML
Model
A.M.Best*
S&P
* A.M. Best does not make CAT adjustments to calculate the risk capital but deducts the greater of
1/100 wind or 1/250 quake from available capital resources
Guy Carpenter
Total
12
Solvency II – FSA (UK) – Approach
Company Calculation / FSA Review
Soft Test
Hard Test
Minimum
Capital
Requirement
(MCR)
Enhanced
Capital
Requirement
(ECR)
Internal
Capital
Assessment
(ICA)
Individual
Capital
Guidance
(ICG)
Comparison of
ICG to Actual
Actual Capital
Resources
BASED ON
FSA REVIEW
OF ICA AND
ECR
(Solvency I)
Guy Carpenter
13
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
Guy Carpenter
14
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 nonproportional 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
Guy Carpenter
15
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?
Guy Carpenter
16
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
Guy Carpenter
17
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
Guy Carpenter
18
Adequate Capitalization:
Competing Interests of Stakeholders
Interested
Parties
1 Management
Directional
Pressure on
Capital
Related Internal Metrics
Potential Objectives
Maintain capital adequacy
Allocate capital to profit centers and measure
based on internal measures to volatility around profitability and capital adequacy Optimize Based
support current business and
on Business
expected growth
Plans
2 Shareholders / Predictable, acceptable return Probability of achieving return targets
Analysts
on optimal invested capital
Reduce to
Optimum
3 Regulators
Capital adequacy
Probability of available capital resources falling
Increase to
below target risk-based capital (internal or external
Achieve Cushion
models)
over Regulatory
Target
4 Rating
Capital adequacy
Probability of achieving target S&P and A.M. Best
Capital Adequacy Ratios (SPCAR, BCAR)
Agencies
Increase to
Exceed Rating
Agency Target
Companies generally start with management view
and compare against views of other interested parties
Guy Carpenter
19
Economic Capital Covers Unexpected Losses
Potential Losses
Expected
Losses
Unexpected
Losses
Taken into account in
pricing and valuation
decisions
Require capital to
protect policyholder
interests
Projection of expected
result
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
Guy Carpenter
20
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
Guy Carpenter
21
CAS CARE Seminar, June 2005
Solvency II:
Future Regulatory Capital Requirements
Susan Witcraft