Casualty Actuaries of Greater New York
CAGNY
December 2012
Perspectives on Solvency II
Ira Robbin, Principal
P&C Actuarial Analysts, LLC
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 No statements about the views or proprietary
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Agenda
 Solvency II Overview
 Accounting Changes
 Capital Requirements
 Standard Formula
 Internal Model
 Perspectives
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Overview
Sliced Bread or Epic Fail
Three Pillars
Accounting Changes
Technical Provisions
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Solvency II – Best Thing Since Sliced Bread !
 Institutes uniform accounting rules and
solvency regulations across Euro zone
 Replaces hodgepodge of outmoded regulations
 Moves to principles-based, market-consistent
accounting
 Superior to rules-based accounting
 Promotes use of internal models to
determine required capital
 Sophisticated models
 Better at capturing real risk
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Solvency II – Epic Fail !
 Overly ambitious- grandiose
 Breaks with existing P&C accounting
 Requires huge IT effort
 Transition/ new scorekeeping may confuse market
 Less priority given to policyholder protection
 Inadequate understanding of P&C risk
 Push to internal models impractical
 Imposes burden on regulators
 Makes results non-transparent
 Very costly
 Repeatedly delayed
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Three Pillars
Pillar 1
Pillar 2
Pillar 3
Quantitative
Qualitative
Reporting, disclosure,
and market discipline
Balance sheet (including
Technical Provisions
Governance, risk management
and required functions
SFCR and RSR
Min Capital Req’ment (MCR)
ORSA
Transparency
Solvency Capital Req’ment (SCR)
Supervisory review process
Support of supervision through
market mechanisms
Market –consistent valuation
Business governance
Disclosure
Risk-based requirements
Internal Control processes
Transparent markets
Disclosure
Risk-based supervision
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SII Accounting Changes
 ‘Market-based’ Valuation

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
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Mark to model
Removal of prudential margins
Explicit discounting
Explicit risk margin
No accrual

Eliminates UEPR
 Pre-up front recognition= date obligation is made
 Contract boundary
 different from UWY and AY
 EPIFP - Expected Profits Included in Future
Premiums
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SII P&C Loss Provision
 Technical Provisions (Liability)

TP= BE + RM
 BE = Best Estimate
 RM = Risk Margin
 Loss Provision (TP2.47-2.48)

Best Estimate is Discounted Mean of Scenarios
 Discounted with loaded risk –free rates
 Loaded with illiquidity premium
 Duration matched

Risk Margin based on Cost of Capital
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Risk Margin for Loss Reserves
 Risk Margin = discounted Cost of Capital
 r = needed additional return = 6.0%
 SCR = Solvency Capital Requirement
 Cost of capital for each year of runoff
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Capital Requirement
Categories
SCR for Unpaid Loss
Standard Formula and Internal Models
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Non-Life Risk Categories
 Underwriting risk
 Premium risk
 Reserve risk
 Lapse risk
 A new type of P&C risk
 Risk pre-up front profits not realized
 CAT risk
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Solvency Capital Requirement for Unpaid Loss
 SCR = 99.5% Percentile excess of the mean
 One-year Risk
 Retrospective look at Best Estimate
 Except for discounting, one-year risk would be a
measure of how much projected ultimate has
changed over one year.
 Viewed by many as inadequate for long-tail LOBs
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Standard Formula or Internal Model
 SCR can be computed via SF or IM
 IMs expected to lead to reduced SCR
 IM must be approved by supervisor
 Extensive documentation required
 IM algorithms and parameters not specified
 IM does not change conceptual calibration
 99.5% excess of mean on one-year risk
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Standard Formula
Coefficients of Variation (CVs) by LOB
Aggregation and Calibration
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Standard Formula – QIS5
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EIOPA ~10 LOBs w Lognormal CVs
Complicated but practical
Premium and Reserve correlation
LOB Correlation matrix
Volume measures
 Credit for geographic diversity
 Lognormal assumption for aggregation
 CAT Capital
 “Factor” based - factors applied to premiums
 “Scenario” based – factors applied to TIVs
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SF CVs for Premium and Reserve Risk
SF CVs
Segment
Motor vehicle liability
Other motor
Premium risk - gross
JWG
QIS5
Rec
10.0%
9.6%
Reserve risk - net
JWG
QIS5
Rec
9.5%
8.9%
7.0%
8.2%
10.0%
8.0%
Marine, aviation & transport
17.0%
14.9%
14.0%
11.0%
Fire / property
10.0%
8.2%
11.0%
10.2%
General liability
Credit and suretyship
15.0%
21.5%
13.9%
11.7%
11.0%
19.0%
11.0%
Legal expenses
6.5%
6.5%
9.0%
12.3%
Assistance
5.0%
9.3%
11.0%
13.0%
12.8%
15.0%
20.0%
Medical expenses
Income protection
4.0%
8.5%
5.0%
8.5%
10.0%
14.0%
5.3%
13.9%
Workers' compensation
5.5%
8.0%
11.0%
11.4%
Miscellaneous financial loss
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LOB Reserve CV Calibration – SF
 Heterogeneity within an LOB
 Size of portfolio and process risk
 JWG
 “… volatility factors for … reserve risks are typically
impacted by the size of the portfolio… the SCR will
be too large for the larger portfolios and too small
for the smaller ones”.
 Diversification across LOBs
 How real are observed correlations?
 Comparison
 Rating agencies used fixed factors
 RBC adjusts benchmarks for company experience.
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Internal Models
Use test
Statistical quality standards
Challenges and concerns
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Internal Models under SII
 SII encourages use of IM instead of SF
 “Big Bang” approach
 Expected to reduce capital required
 Requires regulator approval
 Exact form or type of model not specified.
 Many companies using giant simulation models.
 IM reduces transparency
 Firms unlikely to disclose IM details to public
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IM Documentation – Use Test
 Use Test (decision making process)
 “ … provide evidence … your internal model is widely
used and plays an important role in your decision-making
processes …”
Source: G2 – FSA Solvency II Internal Model Approval
Process document – Pre-application process p8 July 2010
 Does anyone use such a model “widely” in P&C?
 How does the SII IM relate to existing CAT,
reserving, pricing, and M&A models?
 The more complicated it gets, the less likely it can
be used for anything other than showing SII
compliance.
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IM Documentation – Stat Quality Standards
 Statistical quality standards


confirmation … methods are based upon current …
information…
Please identify … differences in the actuarial …
techniques used and the underlying assumptions ...”
 Why should methods (not parameters?) be based
on current information? What does it mean for
techniques to be different from assumptions?
 Different documentation standard than ASOP 41?
 “sufficient clarity…that another actuary qualified in
the same practice area could make an objective
appraisal…”
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IM Challenges and Concerns
 Cost in € and time
 Firms need to hire consultants and new staff
 Documentation requirements
 Huge (some say excessive) effort
 Changes will require justification
 Management sign-offs
 IM too technical for leaders to understand
 IMs reduce transparency
 Overwhelming regulatory burden
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Perspectives
RBC Highlights
Regulatory considerations
Life vs PC
Basel II - Banking
NAIC
Insurance Industry - Negative Comments
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RBC Required P&C Capital Highlights
 Specified Formula
 Industry based premium and reserve risk factors
 adjusted for company avg vs Industry avg
 Reductions for CM and Loss Sensitive business
 Square root of sum of squares for aggregating
 Investment risk
 detailed by asset class and instrument
 Non-diversification penalties
 assets and insurance risk
 No CAT risk
 Transparent and accessible to the public
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Regulatory Considerations
 Cost to regulator and the regulated
 Ease of compliance
 Equal treatment – fairness
 Effectiveness – does it work?
 Induced motivations and side effects
 Transparency and public access
 Market confidence and acceptance
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Approaches to Regulation
Constrained Free Market
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Post-Modern Bureaucratic
Regulatory State
Gov’t intervention in response Gov’t intervention the norm
to defined need
Attempts to be cost-effective
Costly
Rules and details
Principles, models, and process
Compliance
Go beyond compliance exercise
Regulator as umpire
Regulator as coach
Minimize opportunities to
game the system
Assumes cooperative
relationships
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Life vs PC Risk
Risk
Life
PC
Severity
Known
Highly variable depending on
the LOB and coverage
Claim count
Known
Highly variable – subject to
CAT, contagion, mass torts
Lapse rate risk
Important
Does not exist in US GAAP,
STAT
Ultimate Risk
Low
High
One-year risk
Relatively large
Relatively small for long-tail
lines
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Basel II – Banking Experience With IMs
 Basel II – always more cautious in use of IMs
 Internally derived parameters could be approved for use
in regulatory algorithm
 Limited diversification benefits
 2012 - Further reduced role of IMs
 “Risk was not being properly captured by the models…”
--Adkins FSA
 Floor - Use 80% or 100% of standard approach
 Implications for modeling
 “ If.. sophisticated modeling means you end up with
more capital, … why would banks do this?” “Bye,
robot”, Risk July 2012
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Summary of US Regulator Views
 No appetite for switching to SII accounting
 Continue to use IMs on limited add-on basis
to supplement standard approach in life
 Keep focus on protecting policyholders
 Support for key components of US system
 liquidation approaches in STAT accounting
 current US IRIS, RBC capital requirements
 Proud of system performance in latest crisis
 NAIC is continuing to improve - SMI
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US Regulator Comments
- Leonardi and Vaughn
 CT Commissioner Leonardi Aug 2011
 “… well-intended but untested European regulatory
changes, known as “Solvency II” … could weaken
consumer protections …”
 “Solvency II is a much-needed effort to modernize
an …outmoded European regulatory regime…”
 NAIC CEO Vaughn
Nov 2011
 “ Our system is one that we're quite comfortable
with… equivalence should be assessed on an
outcomes basis. On that basis, we should be found
equivalent.”
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US Regulator Comments
- McCarty
 NAIC President McCarty Mar 2012, May 2012
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“ We’re not interested in taking our system and
putting it through the ..analysis undertaken by…
Switzerland, Bermuda and Japan”
 “No disrespect to the EU but …at best, they would
want to make a comparison to a system [Solvency
II] that isn't in place yet. .. It's kind of silly to even
consider that an equivalence process."
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Industry Commentary – ACE Annual Report 2011 –
Evan Greenberg on Solvency II
 “…simply wrong-headed…overly
bureaucratic, process-oriented, costly …
 … I am not sure what problem we are trying
to solve.
 Solvency II-…would do great harm.
 a framework of minimum standards ….that
results in similar outcomes is far more
practical and effective…”
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Commentary – European Insurance Industry
 Insurer groups tell EC to calm down on
Solvency II or face ‘dire consequences’
Commercial Risk Europe, April 7, 2011
 “At the very time that Europe is experiencing
significant economic, financial and social
challenges, … the draft Solvency II implementing
measures…risk driving insurers out of their longterm business” Letter from PEIF, CEAA, CFO
Forum. …
 The group said …publication of QIS5 intensified
rather than assuaged their fears …their ‘valid
concerns’ have been consistently ignored.
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Solvency II – Latest Delay
 “EU may now delay Solvency II till 2015
following proposal from EU Commissioner
Barnier” - Commercial Risk Europe, Sept 20, 2012
 final agreement should wait until the latest study
into Solvency II is completed in March 2013.
 Chief executive of Hiscox, agreed. "I'd rather it
be delayed and made better than have it
rammed through and have to be changed
later”.
 October 2012: plenary vote on Omnibus 2 in the
European Parliament was rescheduled from
November 2012 to March 2013
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Solvency II – EIOPA Response to SII Delay
 EIOPA chairman Gabriel Bernardino WRIN TV Oct 5, 2012
 “blames political maneuvering for delays…
 “ ‘delay undermining EU credibility’ …”
 " ‘still no clear and credible timetable…’ ”
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Solvency II – BaFin Response to SII Delay
 “BaFin considers Solvency 1.5” - Solvency II Wire
Nov 15, 2012
 President of BaFin Dr. Elke Konig
“ Having debated something for such a long time
and having had the brightest minds of the industry
…means you have created a massively complex
system which is probably only fully understandable
for those that have created it.”
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Solvency II – Summary Observations
 P&C concerns about SII
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One-year reserve risk
Discounting with rate including illiquidity premium
CAT risk calculation
Overreliance on IMs
 SII delay is being driven by concerns from Life
 With exception of CAT, P&C issues not high on radar
 US NAIC has staked out position against
submitting to SII equivalence process
 Some form of SII is probably inevitable
 not as inevitable as it was last year
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Solvency II – Closing Remarks
 US actuaries should become familiar with SII
 In increasingly interconnected world, need to be
aware of developments in EU
 Many of the accounting concepts may be
adopted in some form in IFRS
 Actuaries may be best able to bridge gap
between modelers and insurance executives
 View EU regulatory change as opportunity
 What loopholes in SII can be legally exploited?
 What markets will EU insurers abandon/ become
more aggressive in due to SII?
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