Solvency 2

Udaipur- 08.01.2011Udaipur- 08.01.2011 11

Solvency II –Lessons for Solvency II –Lessons for IndiaIndia

Dr. R. KannanDr. R. Kannan

Member (Actuary)Member (Actuary)

IRDAIRDA

Udaipur- 08.01.2011Udaipur- 08.01.2011 22

Solvency I

Decision to Solvency II

Solvency II DirectiveEuropean Commission

DecisionEuropeanCouncil & Parliament

Implementation

Member states

Answers to Calls for Advice CEIOPS

QISI QIS2 QIS3 More QISI

Various consultation papers

Preparation of solvency II, participation to QISRespond to consultation papers

Insurance industry

2001 2011

Timing of Solvency II process

33 Udaipur- 08.01.2011Udaipur- 08.01.2011

Changing role of Risk management ?Changing role of Risk management ?

The insurance industry has undergone a process of de-regulation which enabled The insurance industry has undergone a process of de-regulation which enabled them to take more risk and explore competitive edges of the market.them to take more risk and explore competitive edges of the market.The drive for competitive forces led to fall in premiums which had to be compensated The drive for competitive forces led to fall in premiums which had to be compensated by taking on investment risk. In the life segment unit linked products becoming more by taking on investment risk. In the life segment unit linked products becoming more popular.popular.Capital markets have become more volatile. Part could be attributed more efficient Capital markets have become more volatile. Part could be attributed more efficient and linkage to globalized markets. and linkage to globalized markets. Investment strategies have become a more important source of income. This places Investment strategies have become a more important source of income. This places additional importance on investment strategy as a source of risk. additional importance on investment strategy as a source of risk. In late 1990s and early 2000s the number of insurers becoming insolvent grew In late 1990s and early 2000s the number of insurers becoming insolvent grew significant world over especially in Europe.significant world over especially in Europe.The difference between bank and an insurance company and hence the risk The difference between bank and an insurance company and hence the risk management principles have to recognize the nature of insurance business:management principles have to recognize the nature of insurance business:– Cash on handCash on hand– Liability estimationLiability estimation– Duration of assets and liabilitiesDuration of assets and liabilities

Udaipur- 08.01.2011Udaipur- 08.01.2011 44

Their novelty compared with the current best practices.Their novelty compared with the current best practices.The strategic nature of the problems.The strategic nature of the problems.Huge level of investment likely to be required to comply with the Huge level of investment likely to be required to comply with the coming Solvency II framework.coming Solvency II framework.The European Commission asked CEIOPS to launch a wide The European Commission asked CEIOPS to launch a wide consultation process with the industry players. The result:consultation process with the industry players. The result:A first wave of 12 consultation papers was published on 26 March A first wave of 12 consultation papers was published on 26 March 2009.2009.A second wave of 24 CPs was published on 2 July 2009.A second wave of 24 CPs was published on 2 July 2009.A third wave of 17 CPs was published on 2 November 2009.A third wave of 17 CPs was published on 2 November 2009.The outcomes from these consultations assisted CEIOPS in issuing The outcomes from these consultations assisted CEIOPS in issuing final advices to the Commission.final advices to the Commission.The European Commission published QIS5 technical specifications The European Commission published QIS5 technical specifications on 6 July 2010.on 6 July 2010.

Background for Sol IIBackground for Sol II

Udaipur- 08.01.2011Udaipur- 08.01.2011 55

Three pillar approach Three pillar approach

Pillar - IIIPillar - I Pillar - II

Financial Requirement

Supervisory review process

Disclosure & Market discipline

Valuation of technical provisions

and solvency requirements (SCR / MCR)

Supervisory powers governance guidelines

Disclosure requirements and

supervisory reporting

66 Udaipur- 08.01.2011Udaipur- 08.01.2011

Risk CategoriesRisk Categories

RiskRisk

Investment riskInvestment risk Underwriting Risk

Underwriting Risk

Non- financial risk

Non- financial risk

NonLife Risk

NonLife Risk

Life Risk

Life Risk

Credit RiskCredit RiskMarket risk(Incl. ALM)

Market risk(Incl. ALM) Operational

Risk

OperationalRisk

Business

Risk

Business

Risk

77 Udaipur- 08.01.2011Udaipur- 08.01.2011

Basic forms of Risk ManagementBasic forms of Risk Management Risk Management Risk Management

Risk reductionRisk reductionRisk financingRisk financingRisk controlRisk control

Safety Control,

prevention measures

Safety Control,

prevention measures

Risk retentionRisk retention

Risk TransferRisk Transfer

HedgingHedging

WithdrawalWithdrawal

DiversificationDiversification

88 Udaipur- 08.01.2011Udaipur- 08.01.2011

Role of capitalRole of capital

Why capital is required? Why capital is required? – Capital is required to absorb extreme unexpected Capital is required to absorb extreme unexpected

losses caused by various risks. losses caused by various risks. – Capital guarantees long term continuity. Without Capital guarantees long term continuity. Without

continuity the insurer could not obtain future profits.continuity the insurer could not obtain future profits.– When rating established by the rating agencies they When rating established by the rating agencies they

also look at financial aspects of the insurer and the also look at financial aspects of the insurer and the amount of capital. amount of capital.

– When their capital falls below certain limits it could When their capital falls below certain limits it could have negative consequences for rating.have negative consequences for rating.

– Capital is also required to protect policyholders’ Capital is also required to protect policyholders’ interest and thus protect the stability of the economic interest and thus protect the stability of the economic system. system.

Udaipur- 08.01.2011Udaipur- 08.01.2011 99

Guiding PrinciplesGuiding Principles

The guide is based on six main themes:The guide is based on six main themes:Economic balance sheetEconomic balance sheetData managementData managementStandard formula (SCR solo and SCR Standard formula (SCR solo and SCR group)group)Internal modelInternal modelRisk governance and supervisory reviewRisk governance and supervisory review DisclosureDisclosure

Udaipur- 08.01.2011Udaipur- 08.01.2011 1010

Economic Balance Sheet Economic Balance Sheet

In addition to the methods of valuation of the different In addition to the methods of valuation of the different components of the balance sheet, it is important to components of the balance sheet, it is important to highlight an important principle reinforced in the first highlight an important principle reinforced in the first wave of consultation:wave of consultation:– Convergence of the regulatory environment: CEIOPS has Convergence of the regulatory environment: CEIOPS has

chosen a pragmatic approach by defining the economic chosen a pragmatic approach by defining the economic valuation of the different components of the Solvency II balance valuation of the different components of the Solvency II balance sheet according to the IFRS principles. sheet according to the IFRS principles.

Udaipur- 08.01.2011Udaipur- 08.01.2011 1111

Although Solvency II and IFRS Phase II contain similar Although Solvency II and IFRS Phase II contain similar principles, there are a number of important differences in principles, there are a number of important differences in the technical provisions and other elements of insurance the technical provisions and other elements of insurance company balance sheets.company balance sheets.– Predominance of the balance sheet approach in IFRS, Solvency Predominance of the balance sheet approach in IFRS, Solvency

II focuses on defining the valuation principles of assets and II focuses on defining the valuation principles of assets and liabilities. liabilities.

– the balance sheet approach will ultimately lead insurance the balance sheet approach will ultimately lead insurance companies to adopt new key performance indicators which are companies to adopt new key performance indicators which are more relevant within this new environment. A Solvency II more relevant within this new environment. A Solvency II implementation plan, based on a thorough gap analysis, would implementation plan, based on a thorough gap analysis, would identify more appropriate measures of the company's identify more appropriate measures of the company's performance (or evolution of value over time), e.g. via an performance (or evolution of value over time), e.g. via an embedded valueembedded value..

Economic Balance Sheet Economic Balance Sheet

1212 Udaipur- 08.01.2011Udaipur- 08.01.2011

Issues on Economic CapitalIssues on Economic Capital

Wide variation between statutory liability and Wide variation between statutory liability and economic liability economic liability

Various risk parameters--standardizationVarious risk parameters--standardization

Diversification effectDiversification effect

Concentration effectConcentration effect

Issues on estimating operational riskIssues on estimating operational risk

The link between EC and Embedded value The link between EC and Embedded value

Udaipur- 08.01.2011Udaipur- 08.01.2011 1313

Technical provisionsTechnical provisions

The Solvency II framework directive will lead to major changes in The Solvency II framework directive will lead to major changes in the valuation of the balance sheet items compared to the current the valuation of the balance sheet items compared to the current local GAAP and, in particular, in the valuation of insurance liabilities local GAAP and, in particular, in the valuation of insurance liabilities which will need to be undertaken on a market-consistent basis.which will need to be undertaken on a market-consistent basis.

Technical provisions will typically be estimated on a proxy to a Technical provisions will typically be estimated on a proxy to a market value, i.e., a best-estimate basis allowing for the time value market value, i.e., a best-estimate basis allowing for the time value of money supplemented by a risk margin. It will now become of money supplemented by a risk margin. It will now become important that companies focus on the projection of future cash important that companies focus on the projection of future cash flows. In projecting cash flows, companies need to bear in mind that:flows. In projecting cash flows, companies need to bear in mind that:

Cash flows should be estimated taking into account gross amounts Cash flows should be estimated taking into account gross amounts recoverable from reinsurance contracts.recoverable from reinsurance contracts.

Cash flows should account for the full lifetime of existing insurance Cash flows should account for the full lifetime of existing insurance contracts and reflect policyholder behavior and management contracts and reflect policyholder behavior and management actions.actions.

Udaipur- 08.01.2011Udaipur- 08.01.2011 1414

Technical ProvisionsTechnical Provisions

CEIOPS has retained a cost-of-capital approach for the CEIOPS has retained a cost-of-capital approach for the estimation of the risk margin with a rate of at least 6%.estimation of the risk margin with a rate of at least 6%.It is important to note that in QIS5, the risk margin is It is important to note that in QIS5, the risk margin is calculated at an undertaking level and not at a line-of-calculated at an undertaking level and not at a line-of-business level. This means that undertakings will enjoy business level. This means that undertakings will enjoy the diversification benefits between lines of business the diversification benefits between lines of business within the risk margin. within the risk margin. Should an undertaking decide to transfer a line of Should an undertaking decide to transfer a line of business, the contribution of each line of business to the business, the contribution of each line of business to the risk margin can be allocated separately risk margin can be allocated separately

Udaipur- 08.01.2011Udaipur- 08.01.2011 1515

Internal ModelsInternal Models

The analysis of all measures relating to internal models The analysis of all measures relating to internal models (or models used for the parameterization of the standard (or models used for the parameterization of the standard formula) is a central element of the path towards formula) is a central element of the path towards Solvency II. Features of internal model include :Solvency II. Features of internal model include :– Assumptions for future management actionsAssumptions for future management actions– Process to be followed for the approval of an internal modelProcess to be followed for the approval of an internal model– Tests and standards for internal model approvalTests and standards for internal model approval– Partial internal modelsPartial internal models– Treatment of future premiumsTreatment of future premiums– Segmentation for the calculationsSegmentation for the calculations

Udaipur- 08.01.2011Udaipur- 08.01.2011 1616

Main challenges for internal modelsMain challenges for internal modelsThe need to have the internal model approved before being allowed to use it The need to have the internal model approved before being allowed to use it for regulatory solvency requirements is a major development for the teams for regulatory solvency requirements is a major development for the teams working on capital models working on capital models

Use testUse test Statistical qualityStatistical quality CalibrationCalibration

The need to show The need to show that the internal that the internal model is clearly model is clearly relevant and relevant and integrated into daily integrated into daily risk management and risk management and decision-making decision-making process process

The settings of the The settings of the internal model internal model (data, assumptions, (data, assumptions, methods, tools) methods, tools) must be accurate must be accurate and credible and credible

The internal model The internal model must be consistent must be consistent with SCR framework with SCR framework (i.e., at least a 99.5% (i.e., at least a 99.5% confidence level over confidence level over a one-year time a one-year time horizon) horizon)

Udaipur- 08.01.2011Udaipur- 08.01.2011 1717

Steps to follow for the completion of an Steps to follow for the completion of an approval applicationapproval application

Based on the experience of developing actuarial Based on the experience of developing actuarial models, the documentation for the approval process models, the documentation for the approval process needs to be produced along with the development needs to be produced along with the development and the validation of the model. The documentation and the validation of the model. The documentation would also include information gathered during would also include information gathered during discussions with the supervisor in the context of the discussions with the supervisor in the context of the pre-application process.pre-application process.

Udaipur- 08.01.2011Udaipur- 08.01.2011 1818

Governance and supervisory Governance and supervisory reviewreview

Adequate and operational structureAdequate and operational structureClear allocation of tasks and responsibilitiesClear allocation of tasks and responsibilitiesTransparency of the organizationTransparency of the organizationEfficient information systems on all business activities.Efficient information systems on all business activities.Internal control and internal audit are largely defined and Internal control and internal audit are largely defined and required in the current regulatory environment in a required in the current regulatory environment in a similar way to that set out in the Solvency II directive.similar way to that set out in the Solvency II directive.Risk management and actuarial functions already exist Risk management and actuarial functions already exist but are not properly defined; hence there should be but are not properly defined; hence there should be some significant changes with Solvency II.some significant changes with Solvency II.

Udaipur- 08.01.2011Udaipur- 08.01.2011 1919

The main changes within the Solvency II The main changes within the Solvency II directive in terms of governance are:directive in terms of governance are:Requirement of formal governance in order to Requirement of formal governance in order to implement efficiently policies decided by the implement efficiently policies decided by the management body.management body.Requirement of a full system of governance Requirement of a full system of governance ensuring:ensuring:– Identification, assessment and management of risksIdentification, assessment and management of risks– Efficient communication of informationEfficient communication of information– Reporting of a consolidated view of the risks.Reporting of a consolidated view of the risks.

Governance and supervisory Governance and supervisory reviewreview

Udaipur- 08.01.2011Udaipur- 08.01.2011 2020

Risk management and actuarial Risk management and actuarial functions - ambiguous rolesfunctions - ambiguous roles

For the risk management function, CEIOPS prescribes (for For the risk management function, CEIOPS prescribes (for large companies) the creation of a chief risk officer (CRO) large companies) the creation of a chief risk officer (CRO) who will be responsible for:who will be responsible for:Leading the risk management functionLeading the risk management functionReporting the risk exposure to the administration and Reporting the risk exposure to the administration and business operationbusiness operationMaintaining a consolidated view of the risks through the Maintaining a consolidated view of the risks through the ORSA (own risk and solvency assessment)ORSA (own risk and solvency assessment)CEIOPS recommends that the risk management function CEIOPS recommends that the risk management function has leadership of the internal model in terms of conception, has leadership of the internal model in terms of conception, maintenance and management of results. The actuarial maintenance and management of results. The actuarial function contributes to the implementation of the internal function contributes to the implementation of the internal model.model.

Udaipur- 08.01.2011Udaipur- 08.01.2011 2121

These recommendations do not remove the ambiguities and These recommendations do not remove the ambiguities and difficulties of implementation:difficulties of implementation:CEIOPS defines the actuarial function as the role of controlling and CEIOPS defines the actuarial function as the role of controlling and reporting technical provisions by means of an actuarial report:reporting technical provisions by means of an actuarial report:Coordination and control of the technical provisions valuationCoordination and control of the technical provisions valuationStatement of opinion regarding underwriting and reinsurance policies Statement of opinion regarding underwriting and reinsurance policies –the actuarial function should express an opinion independently from –the actuarial function should express an opinion independently from any other administration or business operation department.any other administration or business operation department.This is another point where there are ambiguities in the roles of the This is another point where there are ambiguities in the roles of the risk management function and the actuarial function, in particular for risk management function and the actuarial function, in particular for the leadership on the best estimate reserves computation in the SCR the leadership on the best estimate reserves computation in the SCR calculation:calculation:The ownership of the model and the consolidated vision of the risks The ownership of the model and the consolidated vision of the risks would mean that the calculation of the SCR (and hence of the best would mean that the calculation of the SCR (and hence of the best estimate reserves under Solvency II) should be the responsibility of estimate reserves under Solvency II) should be the responsibility of the CRO. This would appear to restrict the role of the actuarial the CRO. This would appear to restrict the role of the actuarial function.function.

Risk management and actuarial Risk management and actuarial functions - ambiguous rolesfunctions - ambiguous roles

Udaipur- 08.01.2011Udaipur- 08.01.2011 2222

Own risk and solvency assessment Own risk and solvency assessment (ORSA) principles(ORSA) principles

The overall solvency needs taking into account the The overall solvency needs taking into account the specific risk profile, approved risk tolerance limits and specific risk profile, approved risk tolerance limits and the business strategy of the undertaking.the business strategy of the undertaking.The compliance with the capital requirements and with The compliance with the capital requirements and with the requirements regarding technical provisions.the requirements regarding technical provisions.The extent to which the risk profile of the undertaking The extent to which the risk profile of the undertaking deviates significantly from the assumptions underlying deviates significantly from the assumptions underlying the SCR, calculated with the standard formula or with the SCR, calculated with the standard formula or with its partial or full internal model.its partial or full internal model.The ORSA principles should be applied in a The ORSA principles should be applied in a proportionate manner having due regard to the nature, proportionate manner having due regard to the nature, scale and complexity of the activities of the scale and complexity of the activities of the undertaking concerned.undertaking concerned.

Udaipur- 08.01.2011Udaipur- 08.01.2011 2323

Lessons from Solvency II exercise for Lessons from Solvency II exercise for IndiaIndia

Solvency II is unquestionably the most significant regulatory change Solvency II is unquestionably the most significant regulatory change for the insurance industry that is happening right now and continues for the insurance industry that is happening right now and continues to be widely reported in the industry press. to be widely reported in the industry press. We have started the We have started the process of estimating economic capital and yet a long way to go for process of estimating economic capital and yet a long way to go for risk mapping and risk reporting.risk mapping and risk reporting.One benefit of moving the effective start date to 1 Jan 2013 would One benefit of moving the effective start date to 1 Jan 2013 would be to align the rules to the effective financial reporting year for most be to align the rules to the effective financial reporting year for most European insurers. This would make life a bit easier for most firms European insurers. This would make life a bit easier for most firms but the reality remains that firms must be fully compliant from day but the reality remains that firms must be fully compliant from day one and implementation should already have started in all firms. one and implementation should already have started in all firms. We are working on IFRS and this issue need to be addressed in We are working on IFRS and this issue need to be addressed in future.future.Solvency II is needed to strengthen the regulatory framework for Solvency II is needed to strengthen the regulatory framework for insurers in Europe and enable both supervisors and firms to move insurers in Europe and enable both supervisors and firms to move on from the confines of an outdated European regime that stands in on from the confines of an outdated European regime that stands in the way of the adoption of modern methods and the spread of best the way of the adoption of modern methods and the spread of best practice. practice. Our solvency regime is robust but there is no Our solvency regime is robust but there is no complacency in examining the alignment with accounting disclosure.complacency in examining the alignment with accounting disclosure.

Udaipur- 08.01.2011Udaipur- 08.01.2011 2424

Solvency II will fundamentally transform the capital adequacy and Solvency II will fundamentally transform the capital adequacy and risk management regime for the European insurance industry. The risk management regime for the European insurance industry. The requirements for delivering and demonstrating the standards of risk requirements for delivering and demonstrating the standards of risk management and governance will be challenging, and especially so management and governance will be challenging, and especially so for groups that operate in multiple countries. for groups that operate in multiple countries. We have already We have already initiated this exercise. initiated this exercise. It will require greater disclosure and transparency, together with It will require greater disclosure and transparency, together with additional and more frequent reporting. additional and more frequent reporting. We have already initiated We have already initiated disclosures and this will be strengthened in the light of our disclosures and this will be strengthened in the light of our experienceexperienceit puts robust risk management firmly at the centre of the new it puts robust risk management firmly at the centre of the new regime; insurers will be required to focus on the early identification, regime; insurers will be required to focus on the early identification, quantification and management of the risks that they face, or will quantification and management of the risks that they face, or will face in the future, through the forward-looking Own Risk and face in the future, through the forward-looking Own Risk and Solvency Assessment. Solvency Assessment. We have already developed “early warning We have already developed “early warning system” for life and this needs to be strengthened. Shortly we will system” for life and this needs to be strengthened. Shortly we will be finalizing the guidelines for non-life industry also.be finalizing the guidelines for non-life industry also.

Lessons from Solvency II exercise Lessons from Solvency II exercise for Indiafor India

Udaipur- 08.01.2011Udaipur- 08.01.2011 2525

One consequence of the market consistent approach to the One consequence of the market consistent approach to the valuation of liabilities is that there will be no arbitrary prudence in valuation of liabilities is that there will be no arbitrary prudence in technical provisions. technical provisions. This needs a closer examination. This needs a closer examination. Solvency II is also very clear that the responsibility for the running of Solvency II is also very clear that the responsibility for the running of the firm rests firmly on the shoulders of senior management. This the firm rests firmly on the shoulders of senior management. This means that senior management and the Board must be able to means that senior management and the Board must be able to demonstrate they are fully in control of their firm and that they fully demonstrate they are fully in control of their firm and that they fully understand the risks that the firm is running, or might face in the understand the risks that the firm is running, or might face in the future. future. We have already positioned “corporate governance We have already positioned “corporate governance principles” and they need to be strengthened.principles” and they need to be strengthened.Another big shift in the regulatory landscape as a result of Solvency Another big shift in the regulatory landscape as a result of Solvency II means that there will be an increased focus on groups and the II means that there will be an increased focus on groups and the joint supervision of groups. The supervisory colleges will play an joint supervision of groups. The supervisory colleges will play an increased role and this will mean an adjustment of the mindsets for increased role and this will mean an adjustment of the mindsets for supervisors under Solvency II. supervisors under Solvency II. This is not a pressing issue now, This is not a pressing issue now, however we are addressing this. however we are addressing this.

Lessons from Solvency II exercise Lessons from Solvency II exercise for Indiafor India

Udaipur- 08.01.2011Udaipur- 08.01.2011 2626

Insurers will also need to report more information, more frequently Insurers will also need to report more information, more frequently to their supervisors. For example, under the new regime, it is likely to their supervisors. For example, under the new regime, it is likely that firms will need to report all their individual asset exposures to that firms will need to report all their individual asset exposures to their supervisor every quarter. This is a big change and the bigger their supervisor every quarter. This is a big change and the bigger the firm, and the more complex the investment strategy, the more the firm, and the more complex the investment strategy, the more work there will be to get this up and running. work there will be to get this up and running. We have already We have already moved on thismoved on this..It is a fundamental precondition for the proper understanding of risks It is a fundamental precondition for the proper understanding of risks that they are measured on an objective and consistent basis. It will that they are measured on an objective and consistent basis. It will be a big step forward for Europe to move to a common valuation be a big step forward for Europe to move to a common valuation basis. It is absolutely necessary that the solvency capital basis. It is absolutely necessary that the solvency capital requirement (SCR) and the minimum capital requirement (MCR), or requirement (SCR) and the minimum capital requirement (MCR), or internal models – will be based on the Solvency II balance sheet. internal models – will be based on the Solvency II balance sheet. We have to initiate our own work on internal models. We have to initiate our own work on internal models.

Lessons from Solvency II exercise Lessons from Solvency II exercise for Indiafor India

Udaipur- 08.01.2011Udaipur- 08.01.2011 2727

Thank youThank you