Solvency II – A view from the US
Casualty Loss Reserve Seminar – 2008
Robb W. Luck
Insurance & Actuarial Advisory Services
Ernst & Young LLP
19 September 2008
Agenda
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General background
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Solvency I vs. Solvency II
Solvency II readiness survey summary
Summary results from Quantitative Impact Studies
Specifications of QIS 4
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Key differences between Solvency II and current solvency measures
in the US
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Illustrative case study results
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Difference in solvency ratios under RBC, Solvency II QIS 4 formula, and
other estimated rating agency formulas
Difference in technical provisions for reserves – nominal versus
discounted with risk margin
What could this mean for the US market and the reserving actuary?
Page 1
Solvency II – A view from the US
Solvency I versus Solvency II balance sheet
Solvency I
balance sheet
BV assets
Solvency II
balance sheet
BV liabilities
Free
surplus
MV assets
Free surplus
MV liabilities
Free
surplus
Free surplus
Solvency capital
requirement
Capital requirement
MCR
Risk margin
margin
Risk
Best
estimates
Page 2
Technical provisions
with implicit risk margins
Solvency II – A view from the US
Best
estimates
Technical provisions
2003
Phase I
Timeline for Solvency II
Definition of the general form of the solvency system
2005
2006
Phase II
2004
Three calls for advice
Consulting documents
2007
2008
2009
QIS 1
QIS 2
Preparation of
the draft
Level 1 directive
(major principles)
QIS 3
Level 2
Implementing
measures
Level 3
Application
guidelines
QIS 4
QIS etc.
Level 1 process
for directive approval
by the Parliament and
European Council
2010
Transposition of the
directive into local law
2011
2012
Page 3
Entry into force of the new Solvency II prudential system
Solvency II – A view from the US
Solvency II readiness survey
Measuring performance in relation to risk
45%
40%
We have indicators based on
accounting data
35%
We have some additional
indicators on performance
We have some additional
indicators on performance and risk
management (e.g., return on risk
capital)
30%
25%
20%
We have already converged
towards economic value-based
criteria (e.g., return on economic
capital)
15%
10%
5%
0%
Page 4
Solvency II – A view from the US
Solvency II readiness survey
Economic capital models
50%
Statutory measures only
45%
Rating agency formulas
40%
Developed EC models but will
require significant enhancements
to comply with Solvency II
35%
30%
Existing EC models will comply
with Solvency II
25%
20%
15%
10%
5%
0%
Page 5
Solvency II – A view from the US
Solvency II readiness survey
The systems challenge
45%
Current systems will be sufficient
40%
Minor changes needed
35%
Major changes needed
Haven’t analyzed the issues
30%
25%
20%
15%
10%
5%
0%
Page 6
Solvency II – A view from the US
Solvency II readiness survey
Current level of expertise
60%
Current actuarial and risk
management expertise fall far
short
50%
Some expertise but will require
upgraded skill and additional risk
management professionals
40%
Some upgrade of skills needed for
actuaries and risk management
professionals
30%
Current have necessary expertise
20%
10%
0%
Page 7
Solvency II – A view from the US
Quantitative Impact Studies
Technical provisions
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QIS 1
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QIS 2
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Discounting in non-life leads to a reduction of 10-15%
In most cases: best estimate + MVM (75% quantile) < current technical
provisions
Cost of capital vs. quantile approach for MVM: results heterogeneous
QIS 3
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Page 8
Industry asks for guidance on the assessment of best estimates
Cost of capital approach for risk margins
Proxies allowed for risk margins (fixed % of best estimates)
Solvency II – A view from the US
Quantitative Impact Studies
Financial impact on balance sheets – QIS 3
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Technical provisions tended to decrease, with the release of the
prudence margin in Solvency I being greater than the additional risk
margin under Solvency II.
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This tended to be more than offset by an increase in the capital
requirements, the overall solvency ratio tended to decrease.
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Most significant for nonlife companies
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98% of companies met the MCR and 84% met the SCR, a large scale
capital injection is unlikely. However there could be significant
reallocation of capital.
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Results for MCR were consistent with 80-90% value at risk over one
year time horizon.
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Formula SCR tended to be higher than internally modeled SCR,
approximately 25% driven by insurance risk.
Page 9
Solvency II – A view from the US
Quantitative Impact Studies
Solvency Capital Requirement (SCR) – QIS 3
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Provisions for expected profit and loss was removed
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Factor based approach for nonlife underwriting risk vs. scenario approach for life
companies
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CAT risk in specified regional scenarios
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Operational risk added at top level, function of technical provisions and premium
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Diversification effect from correlation between segments and risk modules was about
20%
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Underwriting risk dominated the overall SCR for non-life companies, 75%
Results:
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Internal models produce significantly lower SCR than standard approach (around 25%), mainly due
to underwriting risk
Decrease in solvency ratios: 19.5% of nonlife companies would need additional capital to meet
SCR
Significant fluctuations in available surplus for non-life companies, 40% would decrease by 50% or
more, 20% would increase by 50% or more
Page 10
Solvency II – A view from the US
QIS 4 highlights
Key changes in response to QIS 3 issues
QIS 3 issue
QIS 4 solution
Nonlife issues
Nonlife
technical
provisions
Page 11
QIS3 technical specification was ambiguous about premium
provisions (also referred to as stand-ready obligation or
preclaims liabilities). In consequence most nonlife insurers
did not use QIS3 as an opportunity to recast their balance
sheet onto a full economic basis as Solvency II requires
(most introduced discounting but did not rework the
traditional unearned premium provision UPR). Proposed
QIS4 specification is clearer and proposed simplification is
consistent in that combined ratio approximates for estimate
of future cash flow.
Solvency II – A view from the US
QIS 4 highlights
Key changes in response to QIS 3 issues
QIS 3 issue
QIS 4 solution
Nonlife issues
Nonlife
underwriting
risk
Nonlife
catastrophe
Page 12
Calibration of NL underwriting risk module of standard
formula SCR regarded as unsatisfactory. Some changes to
calibration proposed for QIS4.
A simple formula (Layer 1) will apply in QIS4 if regional
scenarios (now referred to as Layer 2) are not available.
QIS4 also introduces Layer 3 where insurers will calculate
capital based on the personalized catastrophe scenarios
which are regarded as appropriate to their business.
Solvency II – A view from the US
Key differences between Solvency II and
current US solvency measures
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Solvency II focus is on capitalizing to a level such that the probability
of insolvency over a one year time horizon is remote, 0.5%
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Solvency II is intended to be more aligned with the individual risk
profile of a company
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Formula vs. internal model vs. partial internal model
More recognition of risk diversification benefit
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Line of business and risk module correlations
Zero correlation between life and nonlife entities
Technical provisions for loss reserves are comprised of a discounted
best estimate and an explicit risk margin
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Page 13
Question around nominal vs. discounted + risk margin
Solvency II – A view from the US
Risk margin
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Based on a Cost-of-Capital methodology
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For QIS 4 purposes, SCR calculations performed on the
basis of the standard formula
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Cost of providing amount of eligible own funds equal to SCR,
necessary to support obligations over their lifetime
Cost-of-Capital rate = 6.0%
Net of reinsurance
SCR calculation only considers operational risk,
underwriting risk and counterparty default risk
QIS 4 specifies benchmark risk margins as a percent of
technical provisions for use if the company cannot
determine based on internal data
Page 14
Solvency II – A view from the US
Cost-of-capital methodology (1)
Steps to calculate the risk margin
Step 1: Calculate SCR for t=0 and for each future year
* for each segment
* throughout the lifetime of obligations in that segment
* SCR(0) corresponds to today’s capital requirement of the firm
* but only part of the risks is considered: operational, underwriting and
counterparty default
t=0
Page 15
t=1
t=2
t=3
Solvency II – A view from the US
………………
t=T
Cost-of-capital methodology (2)
Steps to calculate the risk margin
Step 2: Multiply each of the SCR’s by the Cost-of-Capital rate
* determination of cost of holding future SCR’s
* CoC rate = 6% (return above risk free)
t=0
Page 16
t=1
t=2
t=3
Solvency II – A view from the US
………………
t=T
Cost-of-capital methodology (3)
Steps to calculate the risk margin
Step 3: Discount the amounts calculated in Step 3
* using the risk free yield curve at t=0
* sum of discounted values is risk margin (for this segment)
Step 4: Total risk margin is sum of risk margins in all segments
t=0
Page 17
t=1
t=2
t=3
Solvency II – A view from the US
………………
t=T
Case studies
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Case studies were prepared using US Statutory
information to look into three areas of impact under
Solvency II
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Page 18
Calibrated companies to 250% RBC and measured solvency ratios
under Solvency II QIS 4 formula and estimated rating agency
formulas
Authorized Control Level RBC compared to Minimum Capital
Requirement (MCR)
Difference between nominal loss reserves and discounted with risk
margin using the Solvency II cost of capital method for industry
aggregate Schedule P lines of business
Solvency II – A view from the US
Case study
Solvency ratios
Multiline companies
300%
Large long-tailed company
250%
Midsize short-tailed company
200%
150%
100%
50%
0%
RBC
Page 19
Rating Agency #1 Rating Agency #2
Solvency II QIS 4
Solvency II – A view from the US
Case study
Solvency ratios
Monoline companies
300%
Monoline medical malpractice
250%
Monoline work comp
200%
150%
100%
50%
0%
RBC
Page 20
Rating Agency #1 Rating Agency #2
Solvency II QIS 4
Solvency II – A view from the US
Case study
Authorized control level RBC vs. MCR
120%
Large long-tailed company
100%
Midsize short-tailed company
Monoline medical malpractice
80%
Monoline work comp
60%
40%
20%
0%
MCR %
Page 21
Solvency II – A view from the US
Case study
Nominal reserves vs. discounted with risk margin for US industry
HO/FO
25,000,000
Risk margin
Change = 0.3%
20,000,000
15,000,000
10,000,000
5,000,000
0
Nominal
Page 22
Solvency II QIS 4
Solvency II – A view from the US
Best estimate
Case study
Nominal reserves vs. discounted with risk margin for US industry
Private passenger auto liability
100,000,000
90,000,000
Change = (3.5)%
Best estimate
80,000,000
70,000,000
60,000,000
50,000,000
40,000,000
30,000,000
20,000,000
10,000,000
0
Nominal
Page 23
Risk margin
Solvency II QIS 4
Solvency II – A view from the US
Case study
Nominal reserves vs. discounted with risk margin for US industry
Commercial auto liability
30,000,000
Change = (4.5)%
25,000,000
Best estimate
20,000,000
15,000,000
10,000,000
5,000,000
0
Nominal
Page 24
Risk margin
Solvency II QIS 4
Solvency II – A view from the US
Case study
Nominal reserves vs. discounted with risk margin for US industry
Commercial multiperil
40,000,000
Change = (3.8)%
35,000,000
Best estimate
30,000,000
25,000,000
20,000,000
15,000,000
10,000,000
5,000,000
0
Nominal
Page 25
Risk margin
Solvency II QIS 4
Solvency II – A view from the US
Case study
Nominal reserves vs. discounted with risk margin for US industry
General liability
140,000,000
Change = (5.0)%
120,000,000
Best estimate
100,000,000
80,000,000
60,000,000
40,000,000
20,000,000
0
Nominal
Page 26
Risk margin
Solvency II QIS 4
Solvency II – A view from the US
Case study
Nominal reserves vs. discounted with risk margin for US industry
Workers’ compensation
120,000,000
Change = (9.8)%
100,000,000
Best estimate
80,000,000
60,000,000
40,000,000
20,000,000
0
Nominal
Page 27
Risk margin
Solvency II QIS 4
Solvency II – A view from the US
Case study
Nominal reserves vs. discounted with risk margin for US industry
Medical malpractice
35,000,000
Change = (4.1)%
30,000,000
Best estimate
25,000,000
20,000,000
15,000,000
10,000,000
5,000,000
0
Nominal
Page 28
Risk margin
Solvency II QIS 4
Solvency II – A view from the US
Case study
Nominal reserves vs. discounted with risk margin for US industry
Special property
14,000,000
Change = (0.3)%
Risk margin
12,000,000
Best estimate
10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
0
Nominal
Page 29
Solvency II QIS 4
Solvency II – A view from the US
What does this mean for the US market?
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Changing competitor behavior from companies based in Solvency II
regulated countries
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New capital structures and solvency levels
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Question of when, not if
Changing reinsurance market in Bermuda
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“Use Test” will require the framework to be embedded in the business
process, driving strategic decision making
Pricing differences
Convergence with IFRS
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How different are nominal reserve levels from discounted with risk margin?
BMA is currently in the process of adopting solvency measures expected
to be similar to Solvency II
Increased M&A activity and group structure
Page 30
Solvency II – A view from the US
What does this mean for the US market?
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Emphasis is on enhancing economic capital modeling and
strengthening enterprise risk management frameworks
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Results from the QIS show significant decreases to required capital when
modeled internally
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Companies face upward capital adjustments under Solvency II Pillar 2
based on risk management capabilities
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US rating agencies are continuing to emphasize ERM as a factor in
assigning ratings
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Page 31
Initial bar was set and will continue to be raised
Solvency II – A view from the US
What does this mean for the reserving
actuary?
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Increased focus on the overall distribution of loss reserves vs. range
of reasonable estimates
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Increased need to understand the correlations between reserve segments
Need to analyze the timing of reserve variability emergence
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Page 32
Ultimate variability vs. one-year time horizon
Solvency II – A view from the US