Solvency II

1. Solvency II Ian Marshall Cape Town, 5 March 2010

2. What is Solvency 2? • Solvency 2 will set out new, strengthened EU-wide requirements on capital adequacy and risk management for insurers with a view to reducing the likelihood of an insurer failing. • Implemented across all 30 EEA countries on 1 November 2012. • Will apply to almost all insurers and reinsurers: • Excluded due to size, if annual premium income does not exceed €5m; and • Insurance liabilities do not exceed €25m. • Group application (all EEA, non EEA branches, group supervision). “Solvency 2 is a fundamental review of the solvency and risk management standards for the European insurance industry aiming to strengthen the prudential regulation of the insurance sector.”

3. Lamfalussy process Process for producing EU financial services legislation that can cope with rapidly changing technical standards Four-level approach: Level 1: framework principles – instrument that sets out essential framework principles, including implementing powers for detailed measures at Level 2 Level 2: implementing measures – this involves making more detailed implementing measures (prepared by commission) Level 3: cooperation – CEIOPS works on joint interpretation recommendations, consistent guidelines and common standards (incl. peer reviews and comparisons of regulatory practices) Level 4: enforcement – ensuring consistent application of the regime across the community

4. Solvency II – Where are we? The EU process for implementing regulation in financial services Approved2009 Level 1 Framework Principle (Directive)  CEIOPS advice given Level 2 Implementation of principles (regulation) () Next step Level 3 Guidelines and recommendations  After 2012 Level 4 Enforcement  CEIOPS has given final advice to the European Commission – Waiting for EC to adopt implementing measures

5. Solvency II – Implementation plan Level 1 = Framework of overarching principles Level 2 = Detailed measures to implement the principles Political agreement on detailed requirements Technical advice provided by supervisors Level 3 = Guidance and interpretation of Level 1 & 2 Process is around here

6. Requirements3 Pillar Approach

7. Quantitative capital requirements • Technical provisions • Minimum capital requirement (MCR) • Solvency Capital Requirement (SCR) • Investment rules Qualitative supervisory review • Principles for internal control and risk management • Supervisory review process Market discipline • Transparency • Disclosure • Support of risk-based supervision through market mechanisms Pillar 1: Pillar 2: Pillar 3: Market-consistent valuation Validation of internal models New focus for supervisor Level of harmonisation More pressure from capital markets More pressure from rating agencies 3 Pillar approach Three-pillar approach

8. Quantitative capital requirements • Technical provisions • Minimum capital requirement (MCR) • Solvency Capital Requirement (SCR) • Investment rules Qualitative supervisory review • Principles for internal control and risk management • Supervisory review process Market discipline • Transparency • Disclosure • Support of risk-based supervision through market mechanisms Pillar 1: Pillar 2: Pillar 3: Market-consistent valuation Validation of internal models New focus for supervisor Level of harmonisation More pressure from capital markets More pressure from rating agencies Pillar 1 Three-pillar approach

9. fornon-hedgeable riskcomponents Pillar 1 – Adequacy of Capital Resources Free assets • SCR reflects risk of total balance sheet • Market Risk • Counterparty default risk • Life underwriting risk • Non-life underwriting risk • Health underwriting risk • Operational risk SCR MCR Assets covering technical provisions, MCR and SCR Riskmargin - assets Bestestimate Technicalprovisions Market consistent valuationfor hedgeableriskcomponents

10. Pillar 1 – Capital Resources Valuation • Market Consistent • Distinction between insurance (TP) and non-insurance liabilities Own Funds • Basic own funds consist of the excess of (regulatory) assets over (regulatory) liabilities plus subordinated liabilities and ancillary own funds • Classed in 3 tiers reflecting differences in loss absorbency • Restrictions as to which tiers of capital are eligible to meet solvency requirements Investments • Prudent person principle (not ruled based)

11. Pillar 1 – Minimum Capital Requirement (MCR) • Lowest level of supervisory intervention • Standardised pan-European factors for all life insurers • Calculated by simple formula using basic quantities • Includes adjustment for discretionary benefits, i.e. participating business • Result a proportion of SCR - constrained within corridor of 25% - 45% of SCR

12. Pillar 1 – Solvency Capital Requirement (SCR) • Risk sensitive approach to calculate the capital requirement • 99.5% 1-year VaR measure of “Basic Own Funds” • Can use a standard formula, internal model or a combination

13. Pillar 1 – SCR Standard Formula Structure • Each module and sub-module designed to capture the 1 in 200 VaR for that risk • Aggregation done through correlation matrices with set parameters • Calibration done for average firm in the EEA • Calibration takes into account 2008 experience

14. Pillar 1 – SCR standard formula equity stress • Basic stress is 45% fall in equities • Includes dampener to decrease countercyclicality: as markets fall, the level of stress decreases. Range for equity stress is 35% to 55% • Includes volatility stress: most onerous of 50% increase or 15% decrease. • Correlation of 75% between volatility and level stresses

15. Pillar 1 – SCR standard formula interest rate stress • Two-sided test, considers most onerous of up and down stress • Term dependant stress • Stress includes an increase in the volatility of interest rates

16. Pillar 1 – SCR standard formula mortality stresses • Long term mortality stress: increase in all mortality rates of 15% • Mortality catastrophe stress of 1.5 per mille

17. Pillar 1 – SCR standard formula non-life underwriting stresses • Due to recalibration, final advice to EC not submitted • Catastrophe factor based v scenario based • Other non-life underwriting risk is still being calibrated

18. Pillar 1 – SCR standard formula correlation matrices

19. Pillar 1 – SCR standard formula correlation matrices (cont)

20. Pillar 1 – SCR standard formula correlation matrices (cont)

21. Pillar 1 – Internal Models • To be discussed this afternoon

22. Quantitative capital requirements • Technical provisions • Minimum capital requirement (MCR) • Solvency Capital Requirement (SCR) • Investment rules Qualitative supervisory review • Principles for internal control and risk management • Supervisory review process Market discipline • Transparency • Disclosure • Support of risk-based supervision through market mechanisms Pillar 1: Pillar 2: Pillar 3: Market-consistent valuation Validation of internal models New focus for supervisor Level of harmonisation More pressure from capital markets More pressure from rating agencies Pillar 2 Three-pillar approach

23. Pillar 2 – Qualitative review • Quantitative requirements (capital) not sufficient on their own • Qualitative standards that insurers must meet include: • General governance (incl. remuneration policy) • Effective risk management systems Including the firm’s own assessment of risks within its business and corresponding solvency needs • Internal audit • Actuarial Function • Supervisory Review Process (SRP) harmonised across Europe: • Developing the risk-assessment framework, monitoring tools and early warning indicators • Process for taking supervisory action (including Capital Add-ons)

24. Pillar 2 – System of Governance Articles on which Level 2 advice was provided • Solvency 2 will require every insurer to have 4 functions: Risk management, Internal audit, Compliance, Actuarial.

25. Pillar 2 – Risk Management Risk to be include in the risk management system (at a minimum) Underwriting and reserving Inadequate reserving and pricing, risk limits, concentrations, reinsurance, back testing, data, timing of premiums, processes and procedures Asset-liability management Interdependence between assets and liabilities, correlations, Off-balance sheet exposures, stress scenarios Investments Risk tolerance, solvency positions, Investment strategy (long term and short term), Derivatives, Financial instruments, liquidity risk, quantitative risk limits, control systems Liquidity and concentration risk management Liquidity contingency plan, limits and thresholds, monitoring, stress testing Operational risk management Internal integrated system to identify, document and monitor exposure to operational risk and track relevant operational risk data, including near miss losses. Includes regulatory risk Reinsurance Credit risk, limits, procedures, concentration, politic, control system Strategic and reputation Strategic goals, business strategies (quality and resources), economic condition of the market surrounding it, Correlation, image, communication, social responsibility

26. Pillar 2 – Own Risk and Solvency Assessment (ORSA) No Level 2 advice but Level 3 guidance is now being developed. Definition: CEIOPS Issues Paper – May 2008 • “the entirety of the processes and procedures employed to identify, assess, monitor, manage and report the short and long term risks a (re)insurance undertaking faces or may face and to determine the own funds necessary to ensure that the undertaking’s overall solvency needs are met” Some Key principles • Part of risk management (not an actuarial exercise) and should encompass all material risks • Does not require an undertaking to develop an internal model • Responsibility of the insurer (understood by administrative / management body) and should be regularly reviewed and approved. • It is firm's own assessment – explain what they do (Economic capital level) • Integral part of the business strategy • Forward looking - the risks an undertaking is currently exposed to or may face in the long term.

27. Free Assets C SCR A Initial Intervention P I T A L MCR Ultimate Regulatory Action Pillar 2 – Supervisory review framework • SRP being developed at Level 3 • Importance of on-site visits • But framework a continuous process based on intervention ladder. • 1) Periodic (reporting) • 2) Ad-hoc • Early warning indicators (Economic capital) • Breach of SCR / MCR triggers supervisory intervention • 3) Supervisory Enquiry

28. Quantitative capital requirements • Technical provisions • Minimum capital requirement (MCR) • Solvency Capital Requirement (SCR) • Investment rules Qualitative supervisory review • Principles for internal control and risk management • Supervisory review process Market discipline • Transparency • Disclosure • Support of risk-based supervision through market mechanisms Pillar 1: Pillar 2: Pillar 3: Market-consistent valuation Validation of internal models New focus for supervisor Level of harmonisation More pressure from capital markets More pressure from rating agencies Pillar 3 Three-pillar approach

29. Pillar 3 – Reporting and Disclosure 1) Private Report to Supervisors (RTS) • Annual submission will highlight any material changes over the year • Other reporting includes quarterly submissions of ‘core’ information to supervisors (including detailed information on investments) • SFCR plus material not suitable for public disclosure 2) Public Annual Solvency and Financial Condition Report (SFCR) - Exemptions permitted if undertaking would be at a competitive disadvantage - materiality - Major change, market discipline

30. Pillar 3 – Main features/concepts • Contents of SFCR and RTS (to include SFCR information) • Quantitative reporting templates included within SFCR and RTS • Consistent structure: • Executive summary • Business and performance • System of governance • Risk profile • Regulatory balance sheet • Capital management • Quantitative reporting templates

31. Pillar 3 – Reporting review Relationship between SFCR and RTS Public SFCR Qualitative, harmonised structure, annual Can also include extra qualitative detail Quantitative disclosures determined at Level 3 Private RTS Includes SFCR detail – annual More qualitative data, detail (or changes), harmonised structure, annual Quantitative data, harmonised – annual and quarterly – or national specific

32. Estimating the Impact Insurance undertakings have been invited by CEIOPS Members to voluntarily participate: • ‘best effort’ basis, reasonable approximations, simplifications possible, focus on material risks Both acquaints insurers with framework and promotes better refinement CEIOPS Quantitative Impact Studies • QIS1 – QIS4 from 2005 to 2008 • QIS5 scheduled for summer 2010 QIS 3 (Spring 2007) • Issues - MCR design, simplification of calculations, non-life catastrophe risk QIS 4 (Summer 2008) • Outcome - practicability, refinement of methodology and calibration, broad support for approach valuation and technical provisions.

33. Estimating the Impact – QIS 5 • QIS 5 to take place during 2010 • Final results to be delivered to European Commission in Q1 2011 • Final significant opportunity for testing impact of Solvency 2 before Commission finalises Level 2 measures • QIS5 will include all quantitative aspects of Solvency 2 as well as issues such as reporting • Follows completion of Level 2 advice by CEIOPS • Will therefore incorporate developments in methodology and calibration since QIS4 • Will provide an invaluable “post-crisis” view

34. Questions?