An Introduction to Solvency II
Philadelphia Actuaries Club
May 13, 2010
John C. Knauss, FSA, MAAA
Vice President and Corporate Actuary
London Life Reinsurance Company
Key Objectives
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What is it?
Why did it come about?
What are the basics?
What does it mean?
Why should we care?
May 13, 2010
An Introduction to Solvency II
Slide 2
Outline
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Brief History – US vs. Europe
What’s so bad about Solvency I?
Structure of Solvency II Regime
Implications of Solvency II
May 13, 2010
An Introduction to Solvency II
Slide 3
Some History – U.S. vs. Europe
United States
Europe
Early 1990’s
Current RBC Regime
Introduced
1986
NY Regulation 126
2000
C3 Phase I
2005
C3 Phase II
2009
VA CARVM
2010
Risk-Focused
Examinations
2011?
C3 Phase III
May 13, 2010
1970’s
Solvency margin requirements
introduced
2002
Solvency I
2007
Solvency II Proposal Adopted
2012
Solvency II effective
An Introduction to Solvency II
Slide 4
Abbreviations and Definitions
• CEIOPS: Committee of European Insurance
and Occupational Pensions Supervisors
• IFRS: International Financial Reporting
Standards
• QIS: Quantitative Impact Study
• SCR: Solvency Capital Requirement
• MCR: Minimum Capital Requirement
• VaR: Value at Risk
• SRP: Supervisory Review Process
May 13, 2010
An Introduction to Solvency II
Slide 5
Solvency I – The Basics
• Simple factor-based model
• Focuses on the liability side of the balance
sheet
• Regulatory capital requirement
– P&C: function of written premiums and loss
reserves
– Life: function of amount at risk
– Basically “RBC-extra light”
May 13, 2010
An Introduction to Solvency II
Slide 6
So what’s wrong with Solvency I?
• Simple formula approach disregards actual
risk profile of the business
• Leads to unintended incentives (e.g., lower
reserves = lower required capital)
• Applied to legal entity – no consolidation for
groups of companies
• Limited disclosure requirements
• Need for more comprehensive approach was
clear even during development
May 13, 2010
An Introduction to Solvency II
Slide 7
So what’s wrong with Solvency I?
• “Sharma Report1” (2002) showed that vast
majority of insolvencies were preceded by
internal management or governance
shortcomings or some external trigger events.
• Report further noted that there was a period
of time between such events and insolvency,
suggesting that better information may have
prevented the insolvency.
• Thus was born the Solvency II project.
1. Prepared under the leadership of Paul Sharma, head of the Prudential Risks
Department of the UK Financial Services Authority
May 13, 2010
An Introduction to Solvency II
Slide 8
Solvency II – Essence
• Promote a robust, forward-looking risk
management framework to guide both
insurance company management and
regulators
• Require implementation of risk practices
appropriate for size, nature and complexity of
the insurer’s business
• Reduce reliance on capital requirements as
an exclusive early warning tool
May 13, 2010
An Introduction to Solvency II
Slide 9
Solvency II – Advantages
• Market-consistent valuation of assets and
liabilities
• Identify and quantify risks and their
interdependence
• Prospective risk management focus
• “Ladder of interventions” – upper threshold
(plan for corrective action) to lower threshold
(regulator takes over)
• Group supervision
May 13, 2010
An Introduction to Solvency II
Slide 10
Solvency II – Basic Structure
• Introduces economic risk-based solvency
requirements across all EU member states
• Total balance sheet approach
• 3 pillars:
– Quantitative requirements
– Supervisory review
– Supervisory reporting and public disclosure
May 13, 2010
An Introduction to Solvency II
Slide 11
Solvency II Balance Sheet
Free
Surplus
Solvency Capital
Requirement (SCR)
Total
Assets
MCR
RM
BestEstimate
Liability
May 13, 2010
(MCR is a subset of the SCR)
Technical Provisions =
Best-Estimate + Risk
Margins (RM)
An Introduction to Solvency II
Slide 12
Pillar 1: Quantitative Requirements
Addresses the following:
• Calculation of technical provisions (i.e.,
reserves)
– Valued according to IFRS definition of fair value
– QIS4: discount rates are term-dependent risk-free
rates at time of valuation (revisited in QIS5)
• Calculation of solvency capital requirements
• Investment management
May 13, 2010
An Introduction to Solvency II
Slide 13
Solvency II Capital Requirements
• SCR: capital such that the probability of ruin
within one year = 0.5% (i.e., 99.5% VaR)
– In other words, holding 100% of calculated SCR
would result in becoming insolvent once in every
200 years
– Calculated using standard formula, internal
models, or combination
• MCR: floor below which a company will not
be permitted to operate
• Between MCR and SCR, company subject to
supervisory action
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An Introduction to Solvency II
Slide 14
Standard Formula
• Linear, factor-based approach
• Intended to be conservative approximation of
the 99.5% VaR objective
• Specific structure not yet finalized and factors
not yet calibrated
– Final calibration to be completed by October 2011
to allow 12 months’ lead time for full
implementation
– Will likely include market, counterparty, mortality,
morbidity, catastrophe, and operational risks
May 13, 2010
An Introduction to Solvency II
Slide 15
Use of Internal Models
• Solvency II encourages firms to use internal
models under the premise that it will result in
– a better alignment between firm risk and capital
requirements
– Stronger risk management culture in the firm
• Use of internal models should lead to
reduced required capital relative to the
standard formula
• Regulatory approval required for use (must
satisfy number of standards for calibration,
validation, documentation, etc.)
May 13, 2010
An Introduction to Solvency II
Slide 16
Pillar 2: Supervisory Review
Focus: provide supervisors with means of
identifying firms that have a higher risk
profile, and the ability to intervene
Qualitative aspects:
• Internal controls
• Risk management processes
• Corporate governance
May 13, 2010
An Introduction to Solvency II
Slide 17
Pillar 2: Supervisory Review
• Requires firms to conduct an Own Risk and
Solvency Assessment (ORSA)
• ORSA is responsibility of the Chief Risk
Officer (not an actuarial function)
• Objectives of ORSA
– Tool for firm’s own decision making
– Tool for supervisors to better understand the risk
profile of the firm
May 13, 2010
An Introduction to Solvency II
Slide 18
Pillar 3: Reporting and Disclosure
• Supervisory Reporting
• Public Disclosure
• Focus: increasing the transparency of the
insurer’s risks and capital position
• Group Supervisor – a single regulator will
oversee a group of companies operating in
multiple jurisdictions
May 13, 2010
An Introduction to Solvency II
Slide 19
Implications
Risk Management Practices
• Insurers must have an actuarial function and
a risk management function
• Insurers will be required to have “adequate
and transparent governance system”
• Increased use of ERM
• “I would not position it as having to be ready
for Solvency II. Instead, we have to be ready
for proper enterprise risk management and
Solvency II is part of that.”
– Jeroen Potjes, Chief Insurance Risk Officer, ING
May 13, 2010
An Introduction to Solvency II
Slide 20
Implications
“Third-Country Insurers”
• Specific rules exist for European branches of
non-EU insurers
• Solvency II contains provisions that enable
the equivalence of a third-country solvency
regime to be assessed.
• Equivalence with U.S. may be difficult without
federal charter (i.e., single regulator)
May 13, 2010
An Introduction to Solvency II
Slide 21
Implications
Insurers’ Capital Requirements
• Per Industry: As currently proposed, required
capital will increase dramatically
• Per Regulators: Required capital will now be
at an appropriate level
May 13, 2010
An Introduction to Solvency II
Slide 22
Implications
Impact on Products
• Will affect EU companies (including U.S.
companies with EU parent)
• QIS4: Long-term products likely to suffer
– due to risk-free discounting (This was changed
in QIS5).
– Longevity: immediate mortality improvement of
25%
– Mortality: mortality deteriorates 15%
• CEIOPS: Consumers will have a more
uniform and enhanced level of protection,
and increased competition will put
downward pressure on prices
May 13, 2010
An Introduction to Solvency II
Slide 23
Industry Reactions
• “Why Excessive Capital Requirements Harm
Consumers, Insurers and the Economy”
– Published by CEA (“Euro-ACLI”) in March 2010
– Written in response to requirements of QIS4
• Increase in required capital could be “6575%” while sources of available capital are
reduced “25-50%”
May 13, 2010
An Introduction to Solvency II
Slide 24
Industry Reactions (con’t)
• “The price of many life products would go up
by up to 20-30% due to higher capital
requirements…”
• “…non-life product prices would increase on
average by 5-10% for more capital-intense
products… or those with a long tail… due to
higher capital costs…”
May 13, 2010
An Introduction to Solvency II
Slide 25
Implications
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U.S. Regulation
Continued convergence of insurance
accounting regimes (IFRS) – are capital
requirements far behind?
Risk-focused examinations introduced by
NAIC for year-end 2010
NAIC is examining models-based
catastrophe charges for RBC
NAIC is re-examining asset RBC charges
NAIC to consider some measure of
operational risk?
NAIC to require something similar to the
ORSA?
May 13, 2010
An Introduction to Solvency II
Slide 26
Questions?
May 13, 2010
An Introduction to Solvency II
Slide 27