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ASSAL-IAIS Training Seminar: Overview of the Swiss Solvency Test

ASSAL-IAIS Training Seminar: Overview of the Swiss Solvency Test. 21st November 2012 Alex Summers. Important note. The views expressed in this presentation are the presenter’s own and do not necessarily represent the views of either Zurich Insurance Group (Zurich), or FINMA

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ASSAL-IAIS Training Seminar: Overview of the Swiss Solvency Test

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  1. ASSAL-IAIS Training Seminar: Overview of the Swiss Solvency Test 21st November 2012 Alex Summers

  2. Important note • The views expressed in this presentation are the presenter’s own and do not necessarily represent the views of either Zurich Insurance Group (Zurich), or FINMA • I am very grateful to colleagues within Zurich and at FINMA for their assistance in preparation • Further information from FINMA on the Swiss Solvency Test can be found on FINMA’s website at http://www.finma.ch

  3. Agenda • Context and history • Key principles and conceptual framework • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  4. FINMA’s objectives* • "FINMA's mandate is to protect creditors, investors and policy holders and ensure the smooth functioning of the financial markets. • Through consistent supervision and predictable regulation, we make an important contribution to safeguarding the stability and good reputation of the Swiss financial centre, and consequently to enhancing its competitiveness.“ Prof. Anne Héritier Lachat, Chair of the Board of Directors, FINMA *: FINMA is the Swiss regulator for banking, insurance and other financial services

  5. SST ladder of intervention Risk Total required 0 margin capital Based on FINMA SST technical document p8 The SST protects policyholders by requiring a high probability of orderly run-off of business • SST identifies insurers* at risk of being unable to honour their existing obligations • A ladder of intervention allows appropriate actions to be taken when insurers run into difficulties • SST sets capital requirements so that there is high probability of orderly run-off of business • Internally • Transfer of liabilities to a third party if necessary • Both fulfilment and transfer value concepts are thus central to the SST *: The term “Insurers” has been used throughout to indicate both insurance and reinsurance undertakings

  6. The SST aims to be based more on principles than rules Liberty means responsibility. That is why most men dread it. George Bernard Shaw • Principles encourage responsible management behaviour for good risk and capital management • Principles are more challenging than rules both for the supervised and for the supervisors • Principles must be powerful and general. • Rules give less incentive for thoughtful risk management • Innovation discouraged, reducing long term competitiveness • Increased systemic risk

  7. History of the SST: successful launch despite challenging conditions • Developed 2003-2005 • Field-tested in 2004 and 2005 • In force since 1 January 2006 • Larger companies first • Results not binding initially • As of 2008, all companies calculated SST • 1.1.2011 SST capital requirements binding • 2012 FINMA propose temporary lightening of SST in context of extreme financial markets and Solvency II uncertainty • Internal model approval process is ongoing for many companies • So far no requirement for public disclosure of results for individual insurers Source: FINMA, 2012

  8. Swiss Solvency Test and Solvency II are broadly equivalent • FINMA has applied for recognition of the SST as equivalent to SII • Defining principles of both risk-based framework are the same • Based on a holistic market consistent balance sheet • Requirements for good governance and transparent disclosure • Uncertainty SII measures for Long Term Guarantees may cause differences • FINMA has proposed temporary adjustments to SST in response • EIOPA advice on Switzerland’s equivalence under Article 172, 227 and 260: • Switzerland meets the criteria set out in EIOPA’s methodology for equivalence assessments under Solvency II… • …but caveats around looser public disclosure requirements, captives and compliance / internal audit functions

  9. Agenda • Context and history • Key principles and conceptual framework • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  10. The SST Principles in full • All assets and liabilities are valued market consistently • Risks considered are market, credit and insurance risks • 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 • 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 • 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 • Under the SST, an insurer’s capital adequacy is defined if its target capital is less than its risk bearing capital • The scope of the SST is legal entity and group / conglomerate level domiciled in Switzerland • Scenarios defined by the regulator as well as company specific scenarios have to be evaluated and, if relevant, aggregated within the target capital calculation • 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 • Regulatory 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 Defines How-to Defines Output Transparency Governance Source: FOPI, 2007

  11. SST principles aim for a sound, consistent and transparent framework • Risk based • Principles based • Holistic market consistent balance sheet giving economic view of both assets and liabilities • Available capital = market value of assets – best estimate liabilities • Required capital based on risk margin* + potential change in available capital over 1 year time horizon, using 1 in 100 expected shortfall as a risk measure, incorporating scenarios • Applies both to legal entities and groups *: For SST, also referred to as Market Value Margin (MVM)

  12. Risk based framework for calculating SST Market Consistent Data and Best Estimate Assumptions Mix of predefined and company specific scenarios Standard Models or Internal Models Scenarios Valuation Models Risk Models Market Risk Market Value Assets Credit Risk Life Best Estimate Liabilities P&C Risk margin Health Output of analytical models (Distribution) Aggregation Method Target Capital SST Report Source: FOPI, 2007

  13. Agenda • Context and history • Key principles and conceptual framework – BALANCE SHEET • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  14. SST Market Consistent Economic Balance Sheet The economic balance sheet gives a realistic picture of a company’s financial position at a given point in time Free capital Required capital for 1-year risk Available Capital Total required capital Risk Margin Market consistent value of liabilities Market value of assets Best estimate of discounted liabilities

  15. SST ladder of intervention Risk Total required 0 margin capital Based on FINMA SST technical document p8 Holistic market consistent balance sheet gives a complete and transparent view A little light dispels a lot of darkness. Rabbi Schneur Zalman • Consistent with transfer value concepts • Valuation benchmark is price at which knowledgeable business partners would purchase or sell the positions in an arm’s length transaction • Where these conditions are not satisfied in stressed markets, plausible methods and parameter estimates are to be selected. • Pro-cyclical effects need to be considered • Not necessarily aligned to existing accounting standards • Materiality concept vital

  16. Overview of risk margin in the SST • Risk margin is the extra amount needed above best estimate of liabilities to cover the risks the liabilities bring • Non-hedgeable risks only • Present value of opportunity cost of regulatory capital needed to support risks till the liabilities run off • Relevant for both transfer and fulfilment value concepts • SST risk margin is similar in nature to Solvency II risk margin • Details differ slightly • SST Treatment of risk margin aims to avoid circularity • Simplifications are needed in practice

  17. Agenda • Context and history • Key principles and conceptual framework – RISK CALCULATIONS • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  18. As a risk-based framework, SST aims for transparent view of insurers’ exposure to risk Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true. Demosthenes • Control and mitigation of risk are secondary objectives which are better achieved via transparency • SST aims to avoid prudence, restrictions on eligibility of capital, investments and risk transfers • These would reduce transparency and transfer responsibility for risk management to supervisor • SST also aims for an appropriate parameterisation, considering all material, quantifiable risks • Not seeking to perpetuate a given business model or distort transparent economic view for political aims

  19. Hypothetical balance sheets at t=1 Balance sheet at t=0 t=1 t=0 Risk as Change of Available Capital • SST required capital covers the risk of adverse changes in the economic balance sheet over the next year • The total capital requirement is set so that even after adverse experience, it should still be possible to transfer business to a third party Source for illustration: FOPI, 2007

  20. All material, quantifiable risks are covered in the SST • Market risk • Interest rates, spreads, foreign exchange, equity, alternative investments, volatilities • Insurance risk • Reflecting both parameter and random risk • Non-life: settlement, new claims and accumulation risks • Life: mortality, longevity, disability/morbidity, recovery, expenses, lapse and other options and accumulation risks • Health insurance risks • Impact of reinsurance has to be modelled separately (waiver possible) • Credit risk • Complete or partial default • Migration: change in creditworthiness or rating • For groups: changes in value of intra-group loans and other Capital and Risk Transfer Instruments

  21. Other risks • Risk concentrations are considered within SST scenarios • Operational risk is currently not explicitly included in SST in the context of self-assessment by Swiss insurers • Systematic quantitative assessment of operational risks considered for investigation by FINMA • Liquidity risks have to be taken into account in insurers’ risk management outside of SST • Model risks need to be taken into account in risk management • Parameter risks incorporated into SST quantification • Impact of other model shortcomings needs to be recognised • FINMA can ask for explicit quantification in serious cases

  22. One year time horizon consistent with transfer value concept • One year time horizon allows for ladder of intervention while keeping calculation efforts reasonable for a given level of accuracy • Choice of time horizon is a key decision which for SST then determines many areas of the framework • SST volatilities are then set consistently with one year view • Mean reversion does not play a role • Treatment of business with long term guarantees remains consistent with one year time horizon

  23. Year 0: known Year 1: uncertain Available capital changes due to random events Probability density of the change in available capital Revaluation of liabilities due to new information Available Capital New business during one year Probability < 1% Claims Change in market value of assets Average value of available capital in the 1% “bad” cases = Expected shortfall Catastrophes Market value of assets Best estimate of liabilities Economic balance sheet at t=0 (deterministic) Economic balance sheet at t=1 (stochastic) Risk measure is 99% expected shortfall

  24. Expected shortfall risk measure prevents tail risks from being ignored • Results for 99.5% Value at Risk as used for SII are typically not too different from 99% Expected Shortfall • Expected shortfall requires more thought when extrapolating risks into extremes of the tail • In practice ES is typically a more stable measure than Value at Risk • Other useful mathematical properties such as coherence Probability density of the change in available capital Probability < 1% Average value of available capital in the 1% “bad” cases = Expected shortfall

  25. SST requires use of Internal Models except where Standard Model is adequate The core of the SST framework are the underlying methodology and principles, not the standard models Methodology of the Solvency Test Valuation, risk measure, time horizon,… Implicit and explicit prudence, limits, etc. to take into account the approximations used for the standard model Company specific approach and simplifications Internal models are assessed with reference to the methodology of the SST framework Internal Models Standard Models

  26. Standard Model and SST SST Standard Model Realistic Internal Model based on SST Methodology • Functional dependence of P&L on risk factors is linear • Specified distributions (Normal except GI) • Time 0 sensitivities • Focus only on guaranteed cash flows gives disconnect with industry Embedded Value • Realistic dependence of P&L on risk factors • Dependency between risk factors can be modeled more flexibly (e.g. tail dependency) • Risks can be assessed via generation of scenarios of the economic state of the company in one year’s time • Valuation and one year risk consistent • Conceptually more consistent with EV • Model can map better company’s internal view of business  embedding of the model easier Standard model is adequate for “simple” companies with few optionalities and stable business Realistic model is adequate also for companies with optionalities in both assets and liabilities Source: After FINMA 2007

  27. Some SST Standard Model simplifications • The following simplifications are applied consistently to both available and required capital in the SST Standard Model • PRE (policyholders reasonable expectations) are fully risk bearing • Future discretionary benefits are excluded from calculations with focus only on guaranteed cash flows • Tax liabilities are fully risk bearing • All calculations are done pre-tax

  28. Agenda • Context and history • Key principles and conceptual framework – AGGREGATION • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  29. SST does not specify an approach to aggregation in calculating required capital • SST standard model makes use of mixture of correlation matrices, convolutions and other simplifications for aggregation • Copula approach can also work well for internal models, but is not a requirement

  30. Agenda • Context and history • Key principles and conceptual framework – SCENARIOS • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  31. Scenarios are a key element of the SST to capture extreme risks and combinations of events • Scenarios in the SST are events or combinations of events that cause a severe reduction in available capital but with low probability • Help ensure model gives adequate weight to tail risks and tail dependencies • Standard Model scenarios are defined by FINMA • Insurers must provide additional specific scenarios relevant to their business • Two types of scenarios in SST: • Type 1: Scenarios to be aggregated into SST required capital • Type 2: Scenarios to be evaluate but to avoid double counting, not aggregated into SST required capital • Holistic impact must be considered, not only insured claims amount • E.g. market risk impacts from a pandemic or terrorist attack • For each scenario, expected effect must be quantified

  32. Aggregation of scenarios into SST required capital is based on simplifying assumptions • Assumed no more than one such extreme event each year, and they are independent • Distribution in risk models assumed unchanged in event of extreme event • Impact and probabilities define discrete point distributions which can then be summed together with continuous distribution resulting from non-scenario risk calculations • Simple formula for Standard Model resulting from assumed Normal distribution for non-scenario risk calculations • Monte Carlo simulation if using Internal Model

  33. Scenarios in the SST Standard Model • The historical market stress scenarios cover: Stock Market Crash 1987, Nikkei Crash 1989, European Currency Crisis 1992, US Interest Rates 1994, Russia / LTCM 1998, Stock Market Crash 2000 • The list keeps growing and now includes additional synthetic market scenarios Source: FINMA SST Technical Document, 2006

  34. The crisis could have been much worse! Impact of Scenarios, SST 2009: Swiss life insurers prompted to further mitigate interest rate risk thanks to SST Source: FINMA SST report 2009

  35. Agenda • Context and history • Key principles and conceptual framework • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  36. Principles of Group Solvency Testing under SST • Groups are defined by legal entities and the web of ownership relations and Capital and Risk Transfer Instruments (CRTIs) between them • Therefore one number is not enough to assess a group’s risk: it is first necessary to analyze the solvency of the legal entities of the group • Consolidated view can then offer useful additional insight • Group supervisor needs to ensure consistent risk quantification across legal entities • Review the web of CRTIs and ensure that quantitative and qualitative requirements on the CRTI are satisfied • In case of a group’s financial distress • The group supervisor should ensure capital mobility, and that capital flows according to the CRTI in such a way that all the group’s policyholders are protected optimally

  37. Intra-group retrocession, contingent capital issued and received, etc. Fungible capital Legal Entity 3 Parent Company Market Value Margin Legal Entity 1 Legal Entity 2 Group Analysis of CRTIs allows understanding of how risks are spread within groups • Intra Group Capital and Risk Transfer Instruments can only be considered if they are legally binding and accepted by the regulators involved • A wide variety of CRTIs are possible, including intra-group reinsurance / retrocession, guarantees, participations, dividends, loans, issuance of surplus notes, securitization of future cash flows / earnings

  38. Setting SST capital requirements for groups • All (material) legal entities have to be modeled as per standalone SST but taking into account the web of CRTI • Symmetric valuation of CRTI permissible • Group’s required capital is then identical to that for parent company based on a economic, realistic framework • The value of a subsidiary for the parent company is its economic value • Independent of regulatory or accounting conventions the subsidiary is domiciled in • SST allows economic value to be floored at zero • The one-year risk of a subsidiary for the parent is defined as the potential change of the economic value of the subsidiary within a year • In practice group modeling for SST requires very considerable effort

  39. Group SST allows a consistent treatment and allocation of diversification • Group Level Diversification • A parent company benefits from group-level diversification since the random change of its assets and liabilities is not fully correlated to the changes of the economic value of its participations • Restrictions on capital mobility have to be taken into account • Group level diversification is effected via web of ownership • ‘Down-streaming’ of Diversification • A parent can down-stream group diversification to its subsidiaries via CRTIs e.g. legally binding parental guarantees • A parental guarantee lowers the SCR of the subsidiary but increases the SCR of the guarantor • Restrictions on capital mobility have to be taken into account

  40. Agenda • Context and history • Key principles and conceptual framework • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  41. Introducing SST required a lot of effort on all sides… • FINMA SST team consists almost of 20quantitative specialists • Each company is assigned a team out of these 20 people. • Each internal model is assigned a team out of these 20 specialists. • SST team evaluates approximately 130 annual SST reports, producing feedback to insurers regarding: • Solvency ratio (SST ratio) • Quality of calculations • Quality of documentation • SST team evaluates approximately 80 (partial) internal models

  42. … but the effort was worthwhile • When SST was field tested there was no meaningful correlation between SST results and those of the previously existing Solvency 1 framework • This could indicate simple factor based Solvency 1 results gave little insight into economic reality indicated by risk based solvency testing

  43. Agenda • Context and history • Key principles and conceptual framework • Groups & Capital and Risk Transfer Instruments • Experiences • Selected practical aspects

  44. FINMA has been an enthusiastic supporter of equivalence between SST and Solvency II • Equivalence should not compromise consistency of framework for regulation • It brings many benefits • Sharing of best practice • Less wasted effort • Less regulatory arbitrage • Improved competitiveness of local market • Improved appeal to multinationals, bringing capital and expertise • Policyholders benefit in the end

  45. Explicit concept of materiality is vital • For regulation to be feasible to implement and enforce, a concept of materiality is needed • In the SST, documented non-significant positions and non-relevant risks can be omitted or presented in a simplified manner if the overall impact of all simplifications is no more than either • 10% of available capital • 10% of required capital • 10% of solvency ratio • The lower the threshold, the higher the cost • The key is being able to spot companies close to trouble • FINMA can ask for more detailed calculations if solvency ratio close to or below 100%

  46. Effort for internal model approval on all sides should not be underestimated • High quality documentation helps • Unlike SII, SST IMAP is not time bound • No pre-approval phase • Model changes during review period can be a challenge • Special attention is needed for keeping decisions on models and calculations consistent over companies and over time • By early 2012, FINMA had completed 27 model reviews Source: FINMA, 2012

  47. Risk quantification is only one part of a successful framework for insurance regulation • SST applies a Use Test and requires regular validation, thorough documentation and senior management responsibility for adherence to SST principles • Clearly defined requirements for regular regulatory reporting, as well as reporting of losses or changes in risk-profile • The Swiss Solvency Test is also complemented by the Swiss Quality Assessment (SQA) • SQA considers Corporate Governance, Risk Management and Internal Control Systems for Swiss Insurers • Restrictions on quality of “Tied Assets” backing liabilities

  48. Overview of SST • Risk based • Principles based • Holistic market consistent balance sheet giving economic view of both assets and liabilities • Available capital = market value of assets – best estimate liabilities • Required capital based on risk margin + potential change in available capital over 1 year time horizon, using 1 in 100 expected shortfall as a risk measure, incorporating scenarios • Applies both to legal entities and groups

  49. The SST has established itself as an essential supervisory tool for FINMA • Introduction of SST motivated Swiss insurers to address their solvency situation • Companies took necessary capital increasing and risk reducing measures • Companies improved their risk management  • With the SST, FINMA has access to an effective solvency testing instrument • Solvency problems are identified in a timely fashion  • Conservative measures can be taken based on a ladder of intervention Source: FINMA 2012

  50. Despite a baptism of fire, the SST has given a clear and helpful view in tough times

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