Risk Based Supervision and the Swiss
Solvency Test
Federal Office of Private Insurance
Philipp Keller, Philipp.Keller@bpv.admin.ch
Zurich, 1 December 2006
1
Contents
• Global Regulatory Tendencies
• The Impact of the Old Supervisory Framework
• SST Principles
• Risk
• Valuation
• Risk Management
• Internal Models
2
Global Regulatory Tendencies
There are costs and risks to a program of action, but they are far
less than the long-range risks and costs of comfortable inaction
John F. Kennedy
In the past, insurance supervisors but also insurance companies often
were not sufficiently aware of economic reality
• The valuation of assets and liabilities was not adequate for an analysis of risk
• The artificial smoothing of results often made companies and supervisors
inclined to comfortable inaction
• An adequate risk quantification was perceived by some as to be too complex
and too onerous
The financial crisis of 2000-2002 has shown to all that the insurance
industry was more exposed than previously thought and both insurers
and regulators saw the need for a more adequate, risk based
supervisory framework  many regulators (UK, NL, CH,…) and the EU
have started initiatives to develop more risk based supervisory models
3
Purpose of Insurance Regulation
Insurance is often a long term contract: A policy
bought today can be a promise of the insurer to
pay at a random future date - up to 50 years later
- a random amount. During the contractual
period, it is often difficult to sell the product (e.g.
only at a loss, replacing a policy might be
impossible due to the health state of insured,…)
The world about 50 years ago:
Churchill was still premier minister
Eisenhower finished his first term
as US president
No man-made object orbited Earth
Peak speed of the fastest computer
(MIT TX0) was 83kOPS, which is
approx. 100bn times slower than
today's fasted computer
Market Imperfections:
Information asymmetry: Policy holders know less about products than
insurers, the products are complex and abstract
Lack of transparency: Accounting information is often not very relevant
to assess the financial situation of a insurer
Products are not freely tradable: Once bought, it is often impossible to
sell a policy or only at a large loss
4
Current Regulatory Initiatives
2000
2005
2010
ICAS* (UK)
Solvency 2
SST* (CH)
IAIS
Current regulatory initiatives
are all based on market
consistent valuation,
quantification of all relevant
risks and the use of internal
models
While some frameworks
(Solvency 2, IFRS) will be
implemented only in 2010+,
they are already influencing
the industry’s business model
Implementation
Projected Implementation
IFRS
ICAS: Internal Capital Adequacy Standards
SST: Swiss Solvency Test
Basel II
IAIS: International Association of Insurance
Supervisors
5
New Swiss Insurance Regulation
Main Aims
• Policy holder protection from fraud
• Policy holder protection from the
consequences of insurance failures
• Functioning and innovative
insurance market
Preconditions
• Pervasive responsibility culture
• People act with integrity
• Existence of a risk culture
• Transparency
The strategy of FOPI
promotes the necessary
preconditions to achieve
its main aims:
• Risk based supervision
• Principles based
supervision
• Enabling competition
within the market
• Being professional,
efficient and
transparent
• Rule of Law
6
Contents
• Global Regulatory Tendencies
• The Impact of the Old Supervisory Framework
• SST Principles
• Risk
• Valuation
• Risk Management
• Internal Models
7
Supervision in the Past: Statutory Valuation
“The actuarial convention according to which the composition of the assets
determines the size of the liabilities is one of the weirdest emanations of the
human mind. It's a metaphor - like saying that the advent of jet planes made the
Atlantic narrower - and metaphor has a limited place in finance”
Speech given by Martin Taylor to the National Association of Pension Funds
conference
• Discount rate for liabilities was
set with reference to an
expected asset profit based on
past experience
• Implicit - often unknown prudence in liabilities
• No explicit valuation of
embedded options and
guarantees
• Amortized cost for bonds
• Solvency 1: No capital
requirement for market and
credit risk
• High risk assets resulted in reduction
of liabilities
• Sales-forces pushed for adding high
guarantees to life policies
• Foreclosing of investment
opportunities due to amortized cost
approach for bonds
• Cash flow underwriting
• Downward spiral when business
contracts
• Underwriting cycles are exacerbated
8
Old Supervisory Framework
• Statutory valuation and Solvency 1 were not adequate for defining risk
adequate capital requirements
• Statutory valuation is (barely) adequate in a stable economic
environment where interest rates do not move and business neither
contracts nor grows
• As interest rates fell during the 90s, the situation of life insurers
worsened
• The steering of companies with regard to statutory valuation only led
to uneconomic incentives for management
• Solvency 1 and statutory valuation were hiding the true economic
situation of insurers, leading to a postponement of necessary changes
in strategy, making problems much worse when they finally had to be
dealt with when share market crashed in 2001/2002
The new risk assessment is based on a market consistent valuation
and an appropriate quantification of risk  Swiss Solvency Test
The responsibility for the adequate quantification lies with senior
management  principles based approach to supervision
9
Contents
• Global Regulatory Tendencies
• The Impact of the Old Supervisory Framework
• SST Principles
• Risk
• Valuation
• Risk Management
• Internal Models
10
Rule- vs. Principles-Based Supervision
Underlying most arguments against the free market is
a lack of belief in freedom itself, Milton Friedman
Regulation: A system of laws, decrees, rules, principles, implicit and explicit
conventions and expectations, incentives, rewards and punishments, etc.
Rule Based Approach
A system trying to define
and micro-manage the
insurance market
Principles Based Approach
Regulator
The complexity grows over
time, the system needs to
be adapted continuously to
new products
Dirigistic
Insurance Market
 The “5-year plan” approach to regulation
A system promoting a
free and liberal market
Regulator
The system needs to
promote competition,
punish collusion and create
a level playing field via risk
based capital requirementsLiberal Insurance
and transparency
Market
The market decides which companies
succeed or fail
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Principles Based Supervision
The more laws and order are made prominent, the more
thieves and robbers there will be, Lao-tzu
Principles based standards describe the objective sought in general
terms and require interpretation according to the circumstance
Companies tailor their approach such
that a clearly stated objective is attained
The objective can be attained if the
companies interpret principles faithfully
Principles based
Objective
Rule-based
Objective
A rule based approach does not
allow a truly company specific risk
assessment (or the set of rules
becomes huge and Byzantine)
e.g. company
specific risk-based
= solvency
assessment
The attained result likely deviates from the
objective (e.g. a true company specific solvency
requirement) since the rules will not capture the
specific situation of the insurer sufficiently well
12
The SST Principles
9.
Defines How-to
1. All assets and liabilities are valued market
consistently
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
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
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
10.
11.
12.
Transparency
Defines Output
Those are my principles. If you don't like them I have others, Groucho Marx
13.
14.
All relevant probabilistic states
have to be modeled
probabilistically
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
The internal model has to be
integrated into the core processes
within the company
SST Report to supervisor such
that a knowledgeable 3rd party
can understand the results
Public disclosure of methodology
of internal model such that a
knowledgeable 3rd party can get
a reasonably good impression on
methodology and design decisions
Senior Management is responsible
for the adherence to principles
13
Contents
• Global Regulatory Tendencies
• The Impact of the Old Supervisory Framework
• SST Principles
• Risk
– Principle 1:
The Economic View
– Principle 3:
The Economic Balance Sheet
– Principle 2 & 4: Risk Quantification
• Valuation
• Risk Management
14
The Economic View
The measurement of risks: Accounting risk or economic risk?
Reported earnings follow the rules and principles of accounting. The
results do not always create measures consistent with underlying
economics. However, corporate management’s performance is
generally measured by accounting income, not underlying
economics. Therefore, risk management strategies are directed at
accounting, rather than economic performance.
Enron in-house risk-management handbook
For a risk-based solvency system, risks need to be measured
objectively and consistently
15
The Economic Balance Sheet
The market consistent (economic) balance sheet
Assets
Risk bearing
capital
Market value of assets
Liabilities
Free capital
Available
Capital
Wherever possible, marketconsistent valuation is based
on observable market prices
(marking to market)
If such values are not available,
a market-consistent value is
determined by examining
comparable market values,
taking into account liquidity and
other product-specific features,
or marking to model
Market-consistent means that up
to date values are used for all
parameters
SCR: Required
capital for 1-year
risk
Market Value
Margin
Market
consistent
value of
liabilities
Best estimate of liabilities
Best-estimate = Expected
value of liabilities, taking into
account all information from
financial and insurance
market
All relevant options and
guarantees are valued.
No explicit or implicit margins
Discounting with risk-free
interest rate
16
Risk Quantification
Risk quantification via standard
models or internal models
Available capital changes
due to random events
Year 0
Year 1
Revaluation of
liabilities due to
new information
Available
capital
Market Value
New business
Margin
during one year
Probability < 1%
Claims
Change in market
Catastrophes
value of assets
Market value
of assets
Market consistent
value of liabilities
Best estimate
of liabilities
Economic balance sheet
at t=0 (deterministic)
Probability density of
the change of available
capital
Average value of
available capital in
the 1% ‚bad‘ cases =
TailVaR = -SCR
Economic balance sheet
at t=1 (stochastic)
17
Risk Quantification
Most capital models consist of two basis components:
• A valuation V(.) is a mapping from the space of financial
instruments (assets and liabilities) in R:
V: A * L  R, where A * L is the space of all assets and
liabilities
• A risk measure rm(.) of a random variable (e.g. VaR, TVaR,…)
AC(t) = V(A(t))-V(L(t)), t=0,1
SCR = - rm( AC(1) – AC(0) )
Available capital at
time t: random variable
For the SST:
Available capital at
time 0: known
Valuation:
Market consistent
Risk Measure: Expected Shortfall
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Contents
• Global Regulatory Tendencies
• The Impact of the Old Supervisory Framework
• SST Principles
• Risk
• Valuation
– Requirements on the Valuation
– Principle 1 & 5: Market Consistent Valuation
• Risk Management
• Internal Models
19
Requirements on the Valuation
实事求是, We must seek truth from facts
邓小平, Deng Xiaoping
• Consistency across assets and liabilities and across products: Without
consistency, arbitrage and pure ‘valuation’ volatility will result (e.g. a
IFRS phase 2 situation)
• Uniqueness: There should not be choice in the sense that one can
switch a valuation scheme arbitrarily (e.g. amortized cost or market
value for bonds, discounting or not discounting liabilities)
• Codifiability: The valuation scheme must be such that it can be
codified (e.g. via principles or rules or a mix thereof)
• Approximating observable prices: A valuation scheme should not
result in prices which are far off observation, at least for a reasonably
efficient market
• Accepted and used by market participants: Without acceptance by the
market (not only by actuaries!), the valuation can not become
embedded within the companies
For FOPI, market consistent valuation of assets and liabilities
optimally satisfies the requirements on an appropriate valuation
20
Market Consistent Valuation
Market Consistent Value of Liabilities: Best Estimate (future cash flows
discounted with risk free interest rate) + MVM (cost of capital approach)
= market value (if it exists); or
= value of a replicating portfolio of traded financial instruments + cost
of capital margin for remaining basis risk as a proxy for the MVM,
For life insurance liabilities: the complexity lies with the projection of future cash
flows, which have to take into account all relevant optionalities and guarantees
- Options of the company: profit participation features,…
- Options of policy holders: lapse options, annuity vs lump sum options,…
•Optionalities can not easily be replicated using traded
instruments, policy holder behavior is often not strictly
financially rational
•Options of the company imply the formulation and coding of
management rules; in case of profit participation features,
the modeled future economic (and statutory) performance of
the company effects the valuation of liabilities
•The long duration of many contracts implies modeling of
long-term economic parameters
Review: Supervisors
need comfort that the
management rules
correspond to actual
strategy; requirement
on technical
sophistication of
companies increases
massively
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Contents
• Global Regulatory Tendencies
• The Impact of the Old Supervisory Framework
• SST Principles
• Risk
• Valuation
• Risk Management
– Principle 11:
Risk Management
– Principle 11 & 14: Elements of Supervision
– Principle 11 & 14: Expectations on the Board
• Internal Models
22
Risk Management
Warren Buffett‘s three key principles for running a successful insurance business:
• They accept only those risks that they are able to properly evaluate (staying within their
circle of competence) and that, after they have evaluated all relevant factors including
remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share
considerations and are sanguine about losing business to competitors that are offering
foolish prices or policy conditions.
• They limit the business they accept in a manner that guarantees they will suffer no
aggregation of losses from a single event or from related events that will threaten their
solvency. They ceaselessly search for possible correlation among seemingly-unrelated
risks.
• They avoid business involving moral risk: No matter what the rate, trying to write good
contracts with bad people doesn't work. While most policyholders and clients are
honorable and ethical, doing business with the few exceptions is usually expensive,
sometimes extraordinarily so.
February 28, 2002, Warren E. Buffett
An insurance regulator should set incentives such, that good risk
management practices are rewarded:
• setting transparent requirements
• putting responsibility to the board and senior management
• Enforce requirements consistently
23
Elements of Supervision
Principles based supervision
will depend on a web of
relationships between the
company, professional bodies
and the supervisor
For a liberal, principles based
approach to function, all have
to see to it that the system of
checks and balances works
Implications for
supervision: closer
contact and dialogue
with the board,
professional bodies
and all relevant
functions within the
company
Supervisor
Direct supervision
and check that
oversight
responsibilities
are implemented
Indirect supervision to ascertain
that professional standards are
defined and in-line with
regulatory expectations
Actuarial
Profession
Accounting
Profession
Professional
guidance and
enforcement of
code of conduct
Board of
Directors
Senior
Management
Risk
Management
Responsible
Actuary
Internal
Audit
24
Expectations on the Board
The Board of Directors is responsible for:
• the governance, guidance and oversight responsibilities that are
critical to an effective internal control structure
• defining necessary board committees (e.g. audit committee,
nomination and compensation committee,…)
• The Board as a whole needs to have sufficient technical as well as
strategical insurance know-how to be able to supervise and guide the
company as well as the necessary stature and mindset
• A Board must be prepared to question and scrutinise management’s
activities, present alternative views and have the courage to act in the
face of obvious wrongdoing
• The Board and management need to know how adverse a risk must be
for it to impair the insurer’s financial position. This should include all
risks arising from the insurer’s assets and liabilities
• The members of the Board need to satisfy fit and proper requirements
and have to minimize conflict of interests
• The Board needs to define the risk appetite and see to it that it is in
line with the actual risk capacity of the company
25
Reality vs Potentiality
The Need for Probabilistic Thinking
For a risk culture to develop, senior management, the board and supervisors
must be able to understand the probabilistic nature of the world
Example: A CRO hedges the risk of interest rates falling since the company is
short in duration. Interest rates then increase and the hedge expires
worthless. Senior management then criticizes the CRO for „destroying“ profit
Example: A CRO models the exposure to hurricane risk according to industry
best-practice but the actual loss is a multiple of the predicted loss. The
supervisor then assume wrong-doing and an intentional optimistic assumption
to minimize required regulatory capital
In insurance, reality can – and often will be – different from prediction.
While only one of the possible outcomes will be realized, there
nevertheless are many a-priori potentialities, which the company and
risk management have to consider
26
Contents
• Global Regulatory Tendencies
• The Impact of the Old Supervisory Framework
• SST Principles
• Risk
• Valuation
• Risk Management
• Internal Models
– Principle 10:
Internal Models
– Principle 10:
Internal Model Review
– Principle 9, 11 & 14: Modelling Deficiencies
27
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
When allowing
internal models for
regulatory capital
calculation, the
problems a
supervisor faces are
• How to ensure that the results are comparable
between different companies?
• How to ensure, that a company is not punished if it
models risks more conscientiously than its peers?
• How to be able to distinguish between acceptable
and not acceptable models?
• How to be certain that a model is deeply
embedded within a company?
28
Internal Model 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, the
responsble actuary, etc.
The regulator is responsible for
ascertaining that the review process is
appropriate
• sufficient knowledge to be able to
interpret the results and an
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.
29
Internal Model Review
If reality turns out differently from the prediction: How can a
supervisor distinguish between
a) an appropriate model which explains the outcome, but the event
was rare and extreme by coincidence;
b) a model which has shown itself to be inappropriate but not due to
an error of the modeller (e.g. reality might have changed due to
global warming,…);
c) a model which has shown itself to be inappropriate and the
modeller was responsible for the error (e.g. using Black Scholes for
unhedgeable options,…); and
d) a model intentionally chosen in order to reduce regulatory capital
requirement?
How can the supervisor give the modeller confidence that
• in case a) and b), she will not suspect stupidity or fraud;
• in case c) she will not assume a) and b) but also not foul play; and
• in case d) she will not be fooled in believing a), b) or c)?
30
Internal Model Review
The supervisor has to send the right signals such that there is
trust that she will accept the random nature of reality but that
she will sanction incompetence and fraud
Is it better to err on the optimistic side (e.g. make some errors
where incompetence or fraud models are not detected) or to err
on the pessimistic side (e.g. identify some honest modelers with
incompetent or fraudulent ones)?
• To be too pessimistic is dangerous, since it destroys the trust
of honest modelers
• To be too optimistic emboldens fraudulent companies and will
make incompetence acceptable
• When incompetence or fraud have been clearly identified, the
sanctions have to be swift
31
Modelling Deficiencies
Observations based on three field tests of the SST:
• A rule based mindset of some companies
• Some companies do not deviate from standard model methodologies
and parameters
• Risk management is not always sufficiently embedded with the
companies
• Some models are not adequately embedded within risk management
• Senior management sometimes is pushing for desired results
• State dependent parameters are often calibrated to ‘normal’
experiences (e.g. correlations)
• Data quality
32
Principles Based Supervision
I believe we are on an irreversible trend toward more
freedom and democracy - but that could change
Dan Quayle
The success of principles based supervision will depend crucially on:
• Trust and an open and informed dialog between the industry and the
supervisor
• Development of a responsibility culture  the willingness to do the
right thing rather than purely complying with a minimal set of rules
• Adequate self-governance of the industry and relevant professional
associations (actuaries, accountants,…)
The ultimate responsibility for ascertaining adherence to principles lies
with the supervisor but a principles based supervisory framework will
depend on devolving responsibility for implementing the principles away
from the supervisor to the board of directors, senior management and
professional organizations
33