Lecture STK 4540 University - PowerPoint Presentation

1. Lecture STK 4540University of Oslo28th of October 2015Tord Kopland EidSolvency II1

2. AgendaWhat is Solvency II?Why regulate the insurance industry? Why Solvency II?Pilar I: Capital requirementsPilar II: ORSA and System of GovernancePilar III: Quantitative reporting and Public disclosureSolvency II: The political process

3. Solvency II is a law (an EU Directive)Main aim: avoid bankruptcies in the EU insurance industryTimeline2000-20132014-201520162016-?DevelopmentInterim phaseImplementationmany transitional measures will still be in place in the coming years

4. Most EU life- and non-life insurers are obliged to implement Solvency IIOnly insurers with a premium income of less than €5m or provisions less than €25 millioner are exemptedReinsurers are subject to Solvency IIPension funds are not, but will face similar regulations as they are in direct competition with life insurers

5. The number of insurance companies in Europe is in decline – Solvency II will probably accelerate this trendSource: Insurance Europe

6. Why regulate the insurance industry?

7. The main driver of financial regulation is to avoid bankruptcies and systemic risk

8. Regulation is costly – is it worth it?It is very costly to create and implement Solvency Hence, it is fair to ask whether it is worth itWhat are the gains from regulation?Usually regulation is about making a market work wellIn insurance (and banking) the main priority is rather to avoid bankruptcyThe market mechanism does not work well when the claims are very long tailed  very hard to know what the right price is, and thus whether a company is profitable, until a long time has passedThe consequences of bankruptcies in the financial industry are potentially very severe  E.g. retired people who lose their pensionWhy European-wide regulations?Having one regulatory system is more efficient than having 30More transparent and easy for customers and companies to move across bordersLesson from financial crisis: The risks do not stop at borders

9. Why Solvency II?Solvency I is being replaced and updated in order to give the insurance industry a modern regulatory frameworkSolvency I is….

10. Pillar I

11. 11Solvens IIPillar I: QuantitativeBalance sheet valuationSolvency Capital Requirements (SCR)Minimum Capital Requirements (MCR)Standard formulaInternal modelPillar II: QualitativSystem of governanceThree lines of DefenseOwn Risk and Solvency Assessment (ORSA)Pillar III: ReportingSolvency and Financial Condition Report (SFCR)Report to Supervisor (RTS) Quantitative Reporting Templates (QRT)

12. Typical Solvency II balance sheet of a (Non-Life) insurance companyAssetsLiabilitiesFinancial assetsSharesBondsPropertyReceivables from customers and reinsurersPremium & Claims provisionsOwn FundsRisk MarginEquityTechnical Provisions (Debt)Own funds ≡ Assets - Debt

13. Through Solvency II, the insurer is maintained to keep the level of Own Funds above the capital requirementsAssetsLiabilitiesFinancial assetsSharesBondsPropertyReceivables from customers and reinsurersPremium & Claims provisionsOwn FundsRisk MarginCapital requiredMCRSCROwn funds = Assets - Debt > SCRSCR value is based on Value-at-Risk calculation:Time horizon: 1 yearConfidence level: 99,5 %I.e. an insurer is expected to deplete its own funds once every 200 years

14. SCRAdjBSCROpMarketHealthDefaultLifeNon-lifeIntangInterest rateCon-centrationCurrencySpreadPropertyEquitySLT HealthH CATNon-SLT HealthMortalityLongevityDisabilityMorbidityLapseExpensesRevisionLapsePremium ReservePremium ReserveNL CATLapseMortalityLongevityDisability MorbidityLapseExpensesRevisionL CATNat CatNP Reins.Man madeNL CAT otherMass accidentAccident conc.Pandemic163043Standard modelhttps://eiopa.europa.eu/Publications/Standards/A_-_Technical_Specification_for_the_Preparatory_Phase__Part_I_.pdf

15. Non-life: Non-life risk is most significantLife: Market risk is most significantSource: EIOPA report on the 5th quantitative impact study

16. Main rule of Solvency II: Level of Own Funds > SCRThe standard model calculates the SCR as well as the own funs the ratio of which must be greater than one:A low solvency margin implies that the risk exposure of the insurance company is too high relative to the buffer (i.e. the level of own funds) 16

17. There are three main types of risk affecting insurers17

18. Market risk affecting liability side of balance sheet: Low interest rate is a major risk for a Life insurer under a defined benefit scheme - typical Cash-out flow of claims for such a companyDiscounting effect is very important when valuing long-term provisions:Low interest rate  Low discounting of future claims  Increased provisions and capital requirement  Low risk-adjusted return  ProblemsSource: BaFin report

19. The SCR Non-life is driven by volatility in the loss ratio:Norwegian private industrySource: FNO

20. Non-Life risk in the standard formula: The volatility (i.e. measure of risk/capital requirement) varies between lines of businesshttps://eiopa.europa.eu/Publications/Standards/A_-_Technical_Specification_for_the_Preparatory_Phase__Part_I_.pdf

21. Non-life insurance risk is also affected byCatastrophy riskSeparated from underwriting risk in the standard modelDistinction between Man-made Cat and Nature CatSuch large claims are harder to predict (shortage of data)  Appears to be more randomReinsurance: Bought by the insurer to offload such risksAlso taken into account in the model

22. Market risk: The asset allocation of the insurer comes with different levels of capital requirementSource: The EconomistInsurers have significant investments of reserves (Claims & Premium provisions)Risky investments, such as stocks, comes with a higher capital charge than lending money to governments (as the latter is assumed to imply low risk)Clearly, this is important. It does not matter that an insurer sets aside sufficient amounts of reserves if all was invested – and lost - in a stock market crash“Solvency II will transform not just insurance but capital markets, too” -The Economist, 7.april 2012

23. The standard model is really not very good (i.e. accurate): It is only the beginning of the ladder of models for SCR-calculationComplexityExpected capital requirementHighLowLowHigh

24. Summing up Pillar I: There are many differences between Solvency I and Solvency IIIssueSolvency ISolvency IIValuation of assets and liabilitiesValued at (historic) book valueValued at (current) discounted market valueCapital requirementsCalculated as a percentage of the insurance liabilitesStatistical calculation taking more risks into accountStandard model or internal modelMarket riskNo impact on capital requirementsCapital requirements depending on risk of asset portfolioOperational-, Counterparty-, and disaster riskNo impact on capital requirementsIncluded in capital requirements calculationRisk management and regulatory reportingLimitedExtensiveLife and non-life insurance regulationSeparate regulationJoint regulationInsurance liabilities – Level of detailHomogeneous: Limited variation between lines of businessHeterogeneous: Risk exposure varies with the line of business

25. Pillar II

26. 26Solvens IIPillar I: QuantitativeBalance sheet valuationSolvency Capital Requirements (SCR)Minimum Capital Requirements (MCR)Standard formulaInternal modelPillar II: QualitativSystem of governanceThree lines of DefenseOwn Risk and Solvency Assessment (ORSA)Pillar III: ReportingSolvency and Financial Condition Report (SFCR)Report to Supervisor (RTS) Quantitative Reporting Templates (QRT)

27. System of Governance - Organization: Three lines of defenceBusiness operations (Risk ownership)The business operation units are to measure and manage business performance, implement internal control and risk management frameworkRisk mgmt functionFacilitate the Risk Management system: System of governance, ORSA, SCR calculation123Internal and external auditProvide independent and objective assurance over the effectiveness of corporate standards and business compliance, including that the risk management system functionsActuarial functionCoordinate calculation of provisionsContribute to risk management systemCompliance functionFacilitate and evaluate internal control processesContribute to risk management systemRisk and control functions

28. System of governance – A structure of documents connecting business strategy to risk decision and operational processesSource: EIOPA guideline on system of governance

29. The Own Risk and Solvency Assessment (ORSA) process should be integrated with the strategy process and results in an ORSA-report to the supervisor29

30. Key aspect of ORSA: Risk appetite – How much risk does the insurer want to be exposed to? Type målBreach of risk appetite limitsTolerable, but not within risk appetite limitsAim – Within the risk appetiteEconomic profit< 10 % Return on equity10 % -18 % eller > 40 %Return on equity18 % - 40 % Return on equityGrowth< 1 % or > 10 % av total volume1 % - 2 % or 7 % - 10 %of total volume2 % - 7 % of total volumeSolvency Margin< 105 % of SCR105 % - 115 % of SCR > 115 % of SCR

31. Pillar III

32. 32Solvens IIPillar I: QuantitativeBalance sheet valuationSolvency Capital Requirements (SCR)Minimum Capital Requirements (MCR)Standard formulaInternal modelPillar II: QualitativSystem of governanceThree lines of DefenseOwn Risk and Solvency Assessment (ORSA)Pillar III: ReportingSolvency and Financial Condition Report (SFCR)Report to Supervisor (RTS) Quantitative Reporting Templates (QRT)

33. The reporting requirements of Solvency II surpass anything the insurance industry has had to deal with before:Quantitative reporting (QRT):Extensive reporting packages to be submitted four times per yearXBRL formatHigh standard for data quality and consistencySpecific reports are to be published on the company website for increased transparencyHas required significant implementation costs for the industryFirst full scale report will be based on status 31.12.2016Qualitative reporting:Solvency and Financial Condition Reports (SFCR) – published yearlyReport to Supervisor (RTS) – delivered to supervisor at least every 3rd year SFCR to contain information on the company’s risk profile, risk management system, Solvency II balance sheet and the capital management of the companyRTS will contain all that is necessary for the purpose of supervisionThe structure of SFCR and RTS will be similar, but the latter will contain more detail and strategic information

34. DataSCR and MCR capital requirementSolvency II Balance sheet and Own FundsQRT’s reported to regulatory supervisor in XBRL formatDetails on provisions and assetsTechnical provisionsFinancial assetsReinsuranceData from the same source is to be submitted in different reports  Consistency is a challenge

35. The total set of Quantiative Reporting Templates is significant

36. SOLVENCY II: POLITICAL PROCESS

37. Solvens II was developed in the EU according to the Lamfalussy process (later on the this has been altered by the Lisbon process):

38. EIOPA – The Supervisor for the European Insurance Industry

39. 39The early phases of Solvency II development was marked by significant involvement from experts and from the industry

40. Insurance companies from all around Europe took part in the studies on which the standard formula for the capital requirement is based

41. Later on, the development process became very political and there has been a lot of bargaining, lobbying and compromises

42. The financial crisis: Low interest rates implied that many life insurers were no longer able to satisfy the projected solvency capital requirement (SCR)

43. The Omnibus II process amended Solvency II: The main issue was how the low interest rates were to affect the discounting of long-term liabilitiesDilemma: Should short-term fluctuations in the long-term interest rate lead to volatility in current balance sheets?Yes: If the market is right about these interest rates, this is the true value of the liabilitiesNo: Short term volatility may be excessive and should not have full effectThe Omnibus II process: Purpose was rather straight foward amendments of the Solvency II directiveThe interest rate issue caused significant lobbying; Long-Term Guarantee package increased the discounting effect  reduced provisions for life insurersSignificant delays and a less prudent regulatory regime

44.