Casualty Actuaries of Greater New York CAGNY December 2012 Perspectives on Solvency II

Casualty Actuaries of Greater New York CAGNYDecember 2012 Perspectives on Solvency II

Ira Robbin, PrincipalP&C Actuarial Analysts, LLC

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Disclaimers and Cautions

No statements about the views or proprietary practices of prior employers will be made or should be inferred.

No liability whatsoever is assumed for any damages, either direct or indirect, that may be attributed to use of any of the material in this presentation.

Whatever you allege I said, either I never said it, I said the opposite, I was just joking, or I was quoted out of context.

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Agenda

Solvency II Overview Accounting Changes Capital Requirements Standard Formula Internal Model Perspectives

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Sliced Bread or Epic FailThree PillarsAccounting ChangesTechnical Provisions

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Overview

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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 PillarsPillar 1

Quantitative

Balance sheet (including Technical ProvisionsMin Capital Req’ment (MCR) Solvency Capital Req’ment (SCR)

Market –consistent valuationRisk-based requirements

Pillar 2Qualitative

Governance, risk management and required functionsORSASupervisory review process

Business governanceInternal Control processesRisk-based supervision

Pillar 3Reporting,

disclosure, and market discipline

SFCR and RSRDisclosureTransparencySupport of supervision through market mechanisms

Disclosure Transparent markets

SII Accounting Changes

‘Market-based’ Valuation 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

Premiums9

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 Capital10

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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CategoriesSCR for Unpaid LossStandard Formula and Internal Models

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Capital Requirement

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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Coefficients of Variation (CVs) by LOBAggregation and Calibration

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Standard Formula

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Standard Formula – QIS5

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

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SF CVsSegment QIS5

JWG Rec

QIS5JWG Rec

Motor vehicle liability 10.0% 9.6% 9.5% 8.9%

Other motor 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 15.0% 13.9% 11.0% 11.0%

Credit and suretyship 21.5% 11.7% 19.0%

Legal expenses 6.5% 6.5% 9.0% 12.3%

Assistance 5.0% 9.3% 11.0%

Miscellaneous financial loss 13.0% 12.8% 15.0% 20.0%

Medical expenses 4.0% 5.0% 10.0% 5.3%

Income protection 8.5% 8.5% 14.0% 13.9%

Workers' compensation 5.5% 8.0% 11.0% 11.4%

Premium risk - gross Reserve risk - net

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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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Use testStatistical quality standards Challenges and concerns

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Internal Models

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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RBC HighlightsRegulatory considerations Life vs PCBasel II - BankingNAICInsurance Industry - Negative Comments

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Perspectives

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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

Post-Modern Bureaucratic Regulatory State

Gov’t intervention in response to defined need

Gov’t intervention the norm

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 29

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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 “ 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 long-term 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 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 40

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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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