The Swiss Solvency Test
Federal Office of Private Insurance
Philipp Keller
Research & Development
Toronto, 28 March 2007
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Contents
•The Swiss Solvency Test Methodology
•The SST Principles
•Economic Valuation
•The Standard Model
•Internal Models
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The Swiss Solvency Test
• The market Crash 2001-2003 showed exposure of insurance industry
to equity risk, statutory valuation and Solvency 1 were inadequate
• SST being developed during 2003 - 2005
• Field-tested in 2004 and 2005
• In force since 1 January 2006
• As of 2006, all large life and P&C companies have to do the SST
• As of 2008, all companies (direct insurers, reinsurers and insurance
groups) will have to do the SST
• The SST has to be done on a legal-entity level and on group-level
• Insurance groups, reinsurers and all companies for which the
standard model is not applicable have to use internal capital models
for the SST  approx. 80 companies will use (partial) internal models
• The SST is risk- and principles-based
• The SST is based on an economic and realistic valuation framework
3
The Swiss Solvency Test: Development
• The SST was developed together with the Swiss Insurance
Association, insurers and reinsurers and consulting companies
• Participants in the different working groups encompassed
mathematicians, actuaries, accountants, CROs, CFOs, capital
management specialists, life-, P&C- and reinsurance-specialists, …
• FOPI defined the overarching regulatory aims and was responsible for
all design decisions
• Regulatory aims:
• Giving incentives for risk management
• Transparency on the real economic position of companies
• Level playing field
• FOPIs regulatory aims were understood and accepted by industry,
although there were discussions and controversies regarding specific
points
• Differences in opinions were always discussion in public and could all
be resolved eventually
4
Risk-Based Solvency Frameworks
The main purpose of risk-based solvency (and of risk
management) is to achieve transparency on the insurers’
exposure to risk
Control and mitigation of risk are secondary objectives which
are better achieved via transparency
The core of a solvency framework are the underlying methodology and
principles, not the standard models
Internal models must be assessed with reference to the methodology of
the solvency framework not with reference to the standard model
Incorporating implicit prudence via valuation, restrictions on eligibility of capital,
investments and risk transfers will make the system less transparent and will
lead to the transfer of insurers’ risk management and responsibility to the
supervisor. The rigidity of such a system can even cause insolvencies
Using aggressive parameters or neglecting major risks (e.g. equity risk) in order
to perpetuate a given business model or to achieve political aims will also make
the system intransparent and will ultimately lead to a loss of confidence in the
solvency system and the insurance industry
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Rules vs. Principles
“Liberty means responsibility. That is why most men dread it”, George
Bernard Shaw
To give incentive for risk and capital management and to put
responsibility to senior management and the board of directors, it is
essential that the approach to supervision is principles-based
• However, principles-based supervision is more challenging both for the
supervised and for the supervisors
• There is pressure by some (among senior management, appointed
actuaries, supervisors, etc.) that regulation becomes more
prescriptive and rules-based
• It is essential that both the supervisors and senior management
accept that the price of freedom is responsibility
• The responsibility for the SST lies with senior management and the
board of directors not with the Responsible Actuary
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The Economic Balance Sheet
The economic balance sheet gives a realistic picture of a
company’s financial position now
Free capital
Available Capital
SCR: Required
capital for 1-year
risk
Cost of Capital Margin
Market
consistent
value of
liabilities
Discounted Best Estimate
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Risk as Change of Available Capital
The Solvency Capital Requirement (SCR) captures the
risk that the economic balance sheet of the company at
t=1 differs from the economic balance sheet at t=0
Hypothetical balance
sheets at t=1
Balance
sheet at t=0
t=1
t=0
The economic balance
sheet at t=1 differs from
the one at t=1 due to:
• Changes in the financial
markets (interest rates, real
estate prices, …)
• Losses and catastrophes
• New information leading to a
revaluation of the liabilities
(e.g. asbestos)
• Capital received from or
transferred to the group,
reinsurers,…
• Hybrid instruments switching
from a liabilities to equity
• Dividends paid, profit
participation for policyholders
• …
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The SST Principles
Defines Output
4. Target capital is defined as the sum of the
Expected Shortfall of change of risk-bearing
capital within one year at the 99% confidence
level plus the market value margin
5. The market value margin is approximated by
the cost of the present value of future
required regulatory capital for the run-off of
the portfolio of assets and liabilities
6. Under the SST, an insurer’s capital adequacy
is defined if its target capital is less than its
risk bearing capital
7. The scope of the SST is legal entity and group
/ conglomerate level domiciled in Switzerland
Defines How-to
2. Risks considered are market, credit and
insurance risks
3. Risk-bearing capital is defined as the
difference of the market consistent value of
assets less the market consistent value of
liabilities, plus the market value margin
9.
Transparency
1. All assets and liabilities are valued market
consistently
All relevant probabilistic states
have to be modeled probabilistically
10. Partial and full internal models can
and should be used. If the SST
standard model is not applicable,
then a partial or full internal model
has to be used
11. The internal model has to be
integrated into the core processes
within the company
12. SST Report to supervisor such that
a knowledgeable 3rd party can
understand the results
13. Public disclosure of methodology of
internal model such that a
knowledgeable 3rd party can get a
reasonably good impression on
methodology and design decisions
14. Senior Management is responsible
for the adherence to principles
8. Scenarios defined by the regulator as well as
company specific scenarios have to be
evaluated and, if relevant, aggregated within
the target capital calculation
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Market Consistent Valuation
Market Consistent Value of Liabilities: Best Estimate + MVM:
= market value (if it exists); or
= value of a replicating portfolio of traded financial
instruments + cost of capital for the remaining basis risk
Replicating portfolio: a portfolio of financial instruments which are
traded in a deep, liquid market, with cash flow characteristics matching
either the expected cash flows of the policy obligations or, more
generally, matching the cash flows of the policy obligations under a
number of financial market scenarios (IAIS Structure Paper)
The replicating portfolio has to match the company specific cash flows,
depending on the company specific expenses, claims experience etc.
The cost of capital margin is defined as the cost for future regulatory
capital which has to be set up for the liabilities. The cost of capital is set
for 2007 as 6% over risk-free
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Cost of Capital Margin
CoCM= CoC  SCR(t)
t 1
SCR(0)
Premium risk
Run-off risk
Market and credit risk
SCR(1)
Market and credit risk assuming asset portfolio
corresponds to the optimal replicating portfolio
SCR(2)
SCR(1)
SCR(T)
t=0
t=1
t=2
t=3
Years
Future SCR entering calculation of CoCM at t=0
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Statutory vs Market Consistent Valuation
The following graph shows the relationship between statutory and market
consistent technical provisions for a (randomized) sample of Life and P&C
companies participating in the field tests 2005 and 2006. If the bars exceed 1,
then the statutory values are lower than the market consistent values.
Discounted best estimate
0
1.2
Cost of Capital Margin
P&C
Life
0.2
0.4
0.6
0.8
1
0
1.2
0.2
0.4
0.6
0.8
1
Over the whole life insurance market, the total value of statutory and market consistent
technical provisions are approx. equal. For the P&C market, statutory provisions exceed
market consistent provisions by ~ 15%
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Standard vs. Internal Models
Risk Quantification:
• Using standard models for life, P&C and health companies, if
the standard models capture the risk the companies are
exposed to appropriately
• Using internal models for reinsurers, insurance groups and
conglomerates and all companies for which the standard model
is not appropriate (e.g. if they write substantial business
outside of Switzerland)
The use of an internal model is the default
option, the standard models can only be used if
they adequately quantify the company‘s risks
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SST Standard Model
Market Consistent Data
Mix of predefined
and company
specific scenarios
Standard Models
or Internal Models
Valuation Models
Risk Models
Market Risk
Credit Risk
Life
Scenarios
Market Value
Assets
P&C
Best Estimate
Liabilities
Health
MVM
Output of analytical models (Distribution)
Aggregation Method
Target Capital
SST Report
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SST Standard Model
•The standard model is quite complex and demands from insurers to
analyze their cash flows, claims experience, claims triangles, …
•The standard model is able to take into account most commonly used
reinsurance contracts (QS, XL, SL per LoB) and risk mitigation can
easily be taken into account
•The model allows the analysis of different risks within the company
(e.g. different LoBs, reserve and premium, parameter and
stochastic,…)
•Companies receive information on their parameterization and SST
results in comparison to their peers
•Many small companies think that the complexity of the model is more
than compensated with the additional insight into the risk structure of
their business
•The work load for a small company is approx. 1-3 person months
(PM), for mid sized companies 9-15 PM and for large companies 12-24
PM
•Some small companies expanded their business volume based on the
results of the SST Field Test
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Scenarios
Company specific scenarios: Allow senior management and the
board to have an informed discussion on strategic decisions
For supervisors, the quality of company specific scenarios is a good
indication on the quality of the company’s risk management
Predefined scenarios: Allow the analysis of the risk exposure of the
company
For supervisors, they allow a discussion with senior management and
the board on the actual risk exposure of the company
Both company specific and predefined scenarios are important tools
for supervisors to assess the quality of risk management and the
company’s internal processes. They are the basis of an informed
dialog of supervisors with senior management and the board of
directors
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Impact of Scenarios
Total Impact of Scenarios on the Life Market
Level 2
Level 1
Lapse
Global deflation
Stock market crash (2000/2001)
LTCM (1998)
US interest rate crisis (1994)
European currency crisis (1992)
Nikkei crash (1990)
Stock market crash (1987)
Real estate crash
Equity drop -60%
Terrorism
Loss of Reinsurer
Financial Distress
Pandemic
Invalidity
Longevity
No Scenario
Example of Scenarios
0
0.2
0.4
0.6
0.8
1
1.2
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1.4
Internal Models
• Internal Models are an essential part of the SST
• Insurance groups and conglomerates, reinsurers and all companies for
which the standard model is not applicable have to use internal capital
models for the SST  approx. 80 companies will use (partial)
economic capital models
• All life insurers for which the standard model is not suitable (e.g. all
insurers writing substantial embedded options) will need to develop
internal models
• Many companies are already using full or partial internal models (e.g.
for market and credit risk, to quantify risk of special lines of
businesses etc.)
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Internal Models: Review
Even worse than having a bad model is having any kind of
model – good or bad – and not understanding it
If internal models are used for
regulatory purposes, it will be
unacceptable if the model is not
understood within the company
Senior management is responsible for
internal models and the review process.
The review of internal modes will be
based on 4 pillars
There needs to be
• Internal Review;
• deep and detailed knowledge by the
persons tasked with the upkeep and
improvement of the model
• External Review;
• Review by the Supervisor;
• Public Transparency.
• Knowledge on the underlying
assumptions, methodology and
limitations by the CRO, appointed
actuary etc.
The regulator is responsible for
ascertaining that the review process is
appropriate
• Sufficient knowledge to be able to
interpret the results and awareness
of the limitations by senior
management and the board
Companies using internal models have
to disclose publicly the methodology,
valuation framework, embedding in the
risk management processes etc.
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SST Implementation
Key Success Factors
Modelling Deficiencies
• Risk culture: Willingness to
know about risks and
acceptance that strategy has to
be aligned with the company’s
risk bearing capacity, engaged
board of directors
• Open dialogue within the
company (e.g. departments
communicate well, in particular
CRO, CFO, Actuary and CIO)
• Direct reporting line of the CRO
to the CEO
• Integrity of responsible persons
• Risk management and capital
management aligned
• Deep know-how of model
experts, know-how and support
of senior management and the
board
•Rule based mindset of some
companies
•Some senior management pushing
for desired results
•Lack of seriousness by some
companies for which the SST was
already mandatory
•Sometimes not enough know-how
(only weakly correlated to the size
of the companies) or not enough
resources assigned
•The evaluation of scenarios is
spotty
•The modeling of optionalities is
uneven
•Lack of peer review
•Lack of appropriate documentation
•Data quality
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Outlook
Prediction is very difficult, especially about the future
Niels Bohr
Consequences of an economic and risk based view:
• A consistent quantification of all risks will demand that many functions
within a company work together: actuaries, underwriter, claims
managers, RI specialists, CROs, CIOs, CFOs,…
• An economic view of business will demand deeper quantitative skills
• Companies will have to optimize their economic performance 
optimization of asset liability mismatch, coherent reinsurance
programs, securitization of risks, optimization of diversification via
coinsurance, geographical spread, etc.
• Mid-sized companies might become being squeezed between smaller,
specialized and nimble insurers and large, well diversified insurance
groups
• Large companies will have to optimize their risk and capital allocation
to maximize diversification
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