ASSAL-IAIS Training Seminar: Swiss
Solvency Test
Market Consistent Balance Sheet
21st November 2012
Alex Summers
Global Life Actuarial
INTERNAL USE ONLY
Important note
The views expressed in this presentation are the presenter’s own and
do not necessarily represent the views of either Zurich Insurance Group
(Zurich), or FINMA
I am very grateful to colleagues within Zurich and at FINMA for their
assistance in preparation
© Zurich Insurance Company Ltd.
Further information from FINMA on the Swiss Solvency Test can be
found on FINMA’s website at http://www.finma.ch
INTERNAL USE ONLY
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Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
© Zurich Insurance Company Ltd.
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options
and Guarantees
INTERNAL USE ONLY
3
The SST protects policyholders by requiring a
high probability of orderly run-off of business
SST identifies insurers* at risk of being
unable to honour their existing
obligations
A ladder of intervention allows
appropriate actions to be taken when
insurers run into difficulties
SST ladder of intervention
Risk
0 margin
Total required
capital
© Zurich Insurance Company Ltd.
SST sets capital requirements so that
there is high probability of orderly run-off
of business
Internally
Transfer of liabilities to a third party if
necessary
Both fulfilment and transfer value
concepts are thus central to the SST
Based on FINMA SST technical document p8
INTERNAL USE ONLY *: The term “Insurers” has been used throughout to indicate both insurance and reinsurance undertakings
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The economic balance sheet is the foundation
on which the entire SST is built
Market Consistent Data and
Best Estimate Assumptions
Mix of predefined
and company
specific scenarios
Standard Models
or Internal Models
Valuation Models
Risk Models
Market Risk
Scenarios
Market Value
Assets
Credit Risk
Life
P&C
Best Estimate
Liabilities
Health
Risk margin
© Zurich Insurance Company Ltd.
Output of analytical models (Distribution)
Aggregation Method
Target Capital
INTERNAL USE ONLY
SST Report
Source: FOPI, 2007
5
Principles of market consistent
valuation for SST
All assets and liabilities are to be valued in accordance with economic
principles in a market-consistent manner
“In accordance with and not at variance with information that can be gleaned
from trade in liquid financial markets”
IFRS (fair value) valuations may be used where compatible
Mark-to-market where possible, otherwise mark-to-model
© Zurich Insurance Company Ltd.
Market-consistent value “such that knowledgeable business partners
would purchase or sell the positions at this price in an arm’s length
transaction”
“Plausible” methods and estimates should be used in stressed markets
Own credit risk should not be taken into consideration except for hybrid
instruments
Often requires mark to model adjustments to market values
INTERNAL USE ONLY
Source for quotations: FINMA Circular 2008/44
6
No allowance for own credit risk in SST, so
best estimate of liabilities is typically greater
than market value
Suppose an insurer
1. Issues USD 100MM 10 year zero coupon bonds
2. Writes single premium pure endowments with guaranteed maturity
values* totalling USD 100MM
Suppose the 10 year risk-free rate is 5%, and there is a 2% credit
spread above risk-free for debt issued by the insurer
Market value of the bonds is 100 x (1+5%+2%)-10 = USD 51MM
© Zurich Insurance Company Ltd.
However in the SST MCBS, the bonds and pure endowments should
each be valued at 100 x (1+5%)-10 = USD 61MM
This creates an asymmetry for debt internal to groups
Symmetric treatment can be permissible on application to FINMA
INTERNAL USE ONLY
*: For purposes of this example, ignoring all cash flows other than maturity payment, and assuming 100% survival
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Ideal characteristics of market data for use in
SST
Price is what you pay, value is what you get
Warren Buffet
Either sufficient transactions for an asset or liability take place at arm’s
length between knowledgeable business partners, or
A sufficient number of securities traders or brokers quote prices in the
capacity of business partners for a potential transaction, in good faith
and in a binding manner, and for significant volumes
Market data can still be used if these conditions aren’t met subject to
test of plausibility
© Zurich Insurance Company Ltd.
Testing adherence to these conditions proportionate to significance
No explicit link to “deep, liquid & transparent” requirements
Inherited criteria from IFRS
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Marking-to-model in the SST
Only if marking-to-market not possible
Apply “sound finance mathematics and actuarial methods for assets and
liabilities”
Principle of proportionality can allow simplifications
Models and parameters calibrated as much as possible on the basis of
objectively observable data
© Zurich Insurance Company Ltd.
Documentation must be sufficient
INTERNAL USE ONLY
9
Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
© Zurich Insurance Company Ltd.
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options
and Guarantees
INTERNAL USE ONLY
10
SST Market Consistent Economic
Balance Sheet
The economic balance sheet gives a realistic picture of a
company’s financial position at a given point in time
Free capital
Required
capital for
1-year risk
Available Capital
Total
required
capital
Risk Margin
© Zurich Insurance Company Ltd.
Market value
of assets
INTERNAL USE ONLY
Market
consistent
value of
liabilities
Time Value of
Options and
Guarantees
Certainty
equivalent
best estimate
of discounted
liabilities
11
Cash flows to be considered in discounted
best estimate value of liabilities
Life
In-flows
© Zurich Insurance Company Ltd.
Premiums
Other
revenue
INTERNAL USE ONLY
Out-flows
Non-Life
General
Discounted best
estimate
Death benefits
Discounted best estimate of Bonds issued
future claims and expense Planned dividends
Maturity benefits
payments related to claims Contractual profit
Annuity benefits
incurred before the
sharing with
Surrender benefits
valuation date, whether or
policyholders
Other benefits
not reported
Own shares
Commissions
Unearned premium reserve
Tax provisions
Administrative costs,
Pensions
including investment
costs
12
Valuation of life insurance liabilities for
SST (1)
Best estimate: no loadings for safety, fluctuation or anything else
Projection all the way to run-off
Model points at policy level
Grouping permissible
In force business only – future new business is excluded
© Zurich Insurance Company Ltd.
Going concern basis for calculating expenses
FINMA circular states that employee benefit schemes are in scope, and
should be valued according to same principles as insurance liabilities
INTERNAL USE ONLY
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Valuation of life insurance liabilities for
SST (2)
Pre-tax: deferred tax assets are not to be valued
© Zurich Insurance Company Ltd.
Net of reinsurance
Can show liabilities gross, with a corresponding asset for reinsurers’
share of liabilities
Only contractually guaranteed benefits in SST standard model
Other approaches can be considered in SST internal models e.g. as
for MCEV, future discretionary benefits are included
Extra accuracy and usefulness but considerable extra complexity for
insurers
Consistent treatment of loss absorbency in risk calculations is
important
INTERNAL USE ONLY
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Does exclusion of future discretionary
benefits (FDB) matter?
If the aim is only to calculate solvency ratio, ignoring FDB gives a
prudent view to extent that FDB are fully loss absorbing
R1. SST standard formula ratio 1: (MVA – BEL) / (SCR + RM)
© Zurich Insurance Company Ltd.
R2. Internal models: (MVA – BEL – FDB) / (SCR + RM – LAC)
If FDB are fully loss absorbing, LAC = FDB, so R2>R1*
However, understanding the nature of policyholders’ reasonable
expectations of future discretionary benefits can be very helpful in
managing the business
Consistency with other reporting metrics e.g. MCEV
Use test
INTERNAL USE ONLY
*: Assuming R1>100%; LAC = Loss Absorbing Capacity
15
© Zurich Insurance Company Ltd.
Risk margin is a key part of the balance sheet,
and will be discussed tomorrow morning
INTERNAL USE ONLY
16
Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
© Zurich Insurance Company Ltd.
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options
and Guarantees
INTERNAL USE ONLY
17
Different yield curves are proposed for
different purposes
SST offers flexibility in the choice of risk-free yield curve used so long
as it is clearly documented, with shadow impact analysis
EUR yield curves Q411
FINMA SST
MCEV
(Zurich used as example)
Other MCEVs – guide to SII?
German
Government Bonds
Swap
Swap
Deduction for credit risk
No
No
Yes
Adjustment added to
underlying curve
No
Illiquidity premium (bucketed) in
line with MCEV principles
Yes – discussions ongoing on CounterCyclical Premium and Matching
Adjustment
Smith-Wilson
Smith-Wilson
Smith-Wilson used in QIS5
Entry to extrapolation
30 yr
50 yr
Considering even earlier extrapolation
than QIS5 30yr
Ultimate forward rate
3.9%
Longest market spot rate (ie.
2.6%)
Stable 4.2%UFR used in QIS5
Moderate
Irrelevant given full use of
market data and moving UFR
Moderate for QIS5; under discussion
Underlying risk free
yield curve data
© Zurich Insurance Company Ltd.
YC interpolation/
extrapolation
Speed of convergence
INTERNAL USE ONLY
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Recent FINMA proposals for
“lightening” of SST
FINMA has proposed a further update to SST yield curve methodology,
prompted by
Low interest rates observed in Europe; possible distortions in Swiss
govies
Developing Solvency II package to address the challenges to
business with Long Term Guarantees (LTG) posed by full market
consistency
Details uncertain, but appear to allow Solvency II QIS5 yield curves to
be used for a transitional period of 3 years
© Zurich Insurance Company Ltd.
Shadow calculations on govies would still be required
New business would need to be separated for purposes of calculation
INTERNAL USE ONLY
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Careful consideration is needed before
applying QIS5 proposals designed for Europe
to Latin America
Speed of convergence has substantial impact if working with fixed UFR and
market data available only to 5 years e.g. BRL Q411
14.00%
Annually compounded interest rate
Where there is little market data e.g.
10 years or less, early extrapolation
and fast convergence to a low, fixed
ultimate forward rate can lead to
unintended consequences
Real yield curve may be more
relevant than nominal
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0
10
20
30
40
50
60
Term
UFR moves with market data Q411 alpha 0.1 1 year fwd rates
UFR moves with market data Q411 alpha 0.2 1 year fwd rates
Stable 4.2% UFR Q411 alpha 0.1 1 year fwd rates
Stable 4.2% UFR Q411 alpha 0.2 1 year fwd rates
Smith-Wilson approach can work well
given appropriate parameters
UFR has substantial impact if market data available only to 5 years e.g. BRL Q411
18.00%
16.00%
Annually compounded interest rate
© Zurich Insurance Company Ltd.
A more plausible solution would be to
keep forward rates flatter
Slower convergence, and/or
Allow some movement in UFR
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0
10
20
30
40
50
60
Term
UFR moves with market data Q411 +500bps 1 year fwd rates
UFR moves with market data Q411 -100bps 1 year fwd rates
Stable 4.2% UFR Q411 +500bps 1 year fwd rates
Stable 4.2% UFR Q411 -100bps 1 year fwd rates
INTERNAL USE ONLY
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“Smith-Wilson” approach can give smooth
curves passing exactly through the market
data
USD annually compounded spot rates Q410
7.00%
Annually compounded interest rate
Smith-Wilson curves pass exactly
through market data
Necessary for market consistency
Works well with swap market data
Pre-smoothing needed for govies
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
0
5
10
15
20
25
30
The smoothness of the forward rate
curve is important for correct
behaviour of actuarial cash flow
models
Simple linear interpolation of spot
rates would not be good enough for
use in cash flow models
Zurich 0% LP Swap spot rates
Linear interpolation spot rates
Reasonable looking spot rates can
hide problems with forward rates
USD 1 year forward rates Q410
7.00%
Annually compounded interest rate
© Zurich Insurance Company Ltd.
Term
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
0
5
10
15
20
25
30
Term
INTERNAL USE ONLY
Zurich 0% LP Swap 1 year fwd rates
Linear interpolation 1 year fwd rates
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Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
© Zurich Insurance Company Ltd.
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options
and Guarantees
INTERNAL USE ONLY
22
Discounted cash flow models for life
business require projections of
economic variables
Bond prices
Inflation
© Zurich Insurance Company Ltd.
Cash index
Equity and
property
indices
INTERNAL USE ONLY
© 2010 The Actuarial Profession  www.actuaries.org.uk
Movements in economic assumptions are
often the single biggest driver of changes
in market consistent valuation
Fund-based
policyholder
benefits and
fees
Inflation linked
benefits
Cash
flow
model
Dynamic
policyholder
actions e.g.
lapses
Discounting
Best
estimate
liabilities
Dynamic
management
actions e.g.
bonus crediting
23
Different types of stochastic economic
scenarios can be used for SST Internal
Models
Proxy
representation
of liabilities
Market risk
capital
requirement
Risk neutral
economic
scenarios
Fitting and
validation
scenarios
Real world
economic
scenarios
© Zurich Insurance Company Ltd.
Best estimate
liabilities and
sensitivities
© 2010 The Actuarial
INTERNAL
USE Profession
ONLY  www.actuaries.org.uk
24
We need stochastic modelling for valuation
because the future is uncertain, and good
outcomes don’t always average out bad ones
Time Value of Options & Guarantees
(TVOG) = Stochastic BEL –
Deterministic BEL
Value of an interest rate floor with 5% strike for
different initial levels of interest rates
TVOG is the impact on valuation of
considering uncertainty
© Zurich Insurance Company Ltd.
Stochastic modelling is needed when
TVOG is material due to asymmetries
Value of option
Deterministic modelling is often good
enough
Deterministic value
(price with zero
volatility)
Stochastic value
(price with nonzero volatility)
TVOG
3.0%
5.0%
7.0%
Initial interest rate
TVOG is greatest when guarantees are
on the point of biting
INTERNAL USE ONLY
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Time Value of Options and Guarantees (TVOG),
Risk Margin and “SCR” all arise from different
aspects of uncertainty
TVOG is the extra component within the best estimate liabilities arising due to uncertainty
across an asymmetric range of possible outcomes
Allowance needed even for hedgeable risks
Required capital for one year risk (SCR) is the increase to market value sufficient to
ensure high probability of solvency in one year’s time
Risk margin is the minimum extra amount needed to give high probability of orderly run-off
by giving just enough capital to fund future SCRs
Free capital
Required
capital for
1-year risk
Available Capital
Total
required
capital
© Zurich Insurance Company Ltd.
Risk Margin
Market value
of assets
INTERNAL USE ONLY
Market
consistent
value of
liabilities
Time Value of
Options and
Guarantees
Certainty
equivalent
best estimate
of discounted
liabilities
26
Ideal characteristics of risk-neutral
economic scenarios from diverse
sources
Ideal characteristics of asset models:
Reproduce market price of assets
No arbitrage
Consistency with prescribed yield
curve
GBP market swaption volatilities Q411
40-45
35-40
30-35
25-30
20-25
15-20
10-15
5-10
0-5
45
It is not always possible in practice to
achieve all of these simultaneously
40
35
SST does not impose specific generic
requirements for stochastic modelling of
assets
30
Volatility
25
© 2010 The Actuarial
INTERNAL
USE Profession
ONLY  www.actuaries.org.uk
15
1
10
6
5
25
15
9
7
5
0
Tenor
15
3
Many sources of requirements for
economic scenarios apart from regulation
Industry standards e.g. CFO-F
MCEV Principles
Auditors
Internal need for high quality
management information
1
© Zurich Insurance Company Ltd.
20
Term
27
Market-consistent Economic Scenario
Generator calibration
• Three stages:
– Market prices (or substitutes)
– Calibrate model to the data
– Simulate scenarios from the model
Simulation of the
© Zurich Insurance Company Ltd.
Observable
market prices
Model of the
Model of the
Observable
market prices
Observable
market prices
Source: Towers Watson
INTERNAL USE ONLY
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A feedback loop can help to quantify
materiality of impacts and define
relevant tolerances
1. Define targets,
tolerances and
number of
scenarios, based
on materiality
© Zurich Insurance Company Ltd.
4. Analyse liabilities and
model results to assess
limitations of ESG and
which market data are
most relevant
© 2010 The Actuarial
INTERNAL
USE Profession
ONLY  www.actuaries.org.uk
2. Gather data
and produce
scenarios
3. Test
scenarios
against targets
and tolerances
before release
for model runs
29
SST Market Consistent Balance Sheet:
Summary
SST MCBS is the foundation for all other parts of SST
All assets and liabilities are to be valued in accordance with economic
principles in a market-consistent manner
Market-consistent value “such that knowledgeable business partners
would purchase or sell the positions at this price in an arm’s length
transaction”
Mark-to-model often needed
© Zurich Insurance Company Ltd.
SST risk-free rate methodology based on govies
Alternatives are possible
Choice of appropriate risk-free rate methodology and consequences for
long term business need careful thought for LATAM
TVOG can be a key component of the SST balance sheet
Stochastic valuation challenging where market data limited, but solutions
can be found
INTERNAL USE ONLY
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Thank you for your attention
© Zurich Insurance Company Ltd.
Any further questions?
INTERNAL USE ONLY
31
© Zurich Insurance Company Ltd.
Standard SST MCBS in full
INTERNAL USE ONLY
32
APPENDIX: Tiering of available capital is not a
central concept for SST
SST tiering aims for transparency without fixed limits and restrictions
Fixed limits not consistent with principles based framework
Tiering of available capital distinguishes contribution to available capital from
“hybrid instruments” but unlike SII, tiering has no impact on solvency ratio
© Zurich Insurance Company Ltd.
Hybrid instruments assessed on substance rather than form
Ability to buffer risks
Availability in case of need
Guarantees and contingent capital can be acceptable
Clear wording, legally binding, embedded within the risk and capital
management processes of companies
Adequate and consistent modeling needed
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