Swiss Group Capital Requirements

1. Swiss Group Capital Requirements Federal Office of Private Insurance Philipp Keller Beijing, 17 October 2006

2. Contents • Consistency Requirements • Two Methodologies • Consolidated Approach • CRTI Approach • The CRTI Approach • Implication for Holding and Parent Company Group Structures • Quantification of Risks and the Limited Liability Put Option • Diversification • Group Level Diversification • Down-streaming of Diversification • Risk Management Requirements • Capital Mobility • Implementation

3. The Importance of Being Consistent con·sis·tent (k&n-'sis-t&nt): marked by harmony, regularity, or steady continuity : free from variation or contradiction Merriam-Webster Online Dictionary For a regulatory framework, consistency between the requirements at group and at subsidiary level is key • Without consistency, • If requirements for groups and legal entities are inconsistent, then in case of a parent company owning subsidiaries it will experience the situation of having two contradictory capital requirements: One for the group and one for solo solvency • groups will have to develop different models for group level solvency requirements and for solo level requirements for the different subsidiaries. Different models will make embedding within companies questionable • a layer of economically irrelevant arbitrage instruments will be developed to exploit regulatory inconsistencies • Further objectives: • Assessing the risk situation of the investment in major legal entities (respectively sub-groups) of a group is essential for competent capital and risk management • Future risk based capital requirements in different jurisdiction will necessitate either the development of many stand-along capital models or – preferably – a group model able to capture capital requirements of solo entities

4. FOPI’s Approach: CRTI A group is defined not only by its legal structure but also by its web of intra-group capital and risk transfer instruments CRTI: Capital and Risk Transfer Instruments Intra-group retrocession, contingent capital issued and received, etc. CRTI Approach: Explicit modeling of all relevant CRTIs and taking into account the legally limited liability structure Fungible capital Legal Entity 3 Parent Company Market Value Margin Legal Entity 1 Legal Entity 2 Group Intra-Group Capital and Risk Transfer Instruments: Intra Group Capital and Risk Transfer Instruments can only be considered if they are legally binding and accepted by the regulators involved • Intra-group Retrocession • Guarantees • Participations • Dividends • Loans • Issuance of surplus notes • securitization of future cash flows / earnings

5. The Consolidated Approach Group Test: Assumes unrestricted capital transfer between the legal entities of the group even if no formal capital and risk transfer instruments are in place consolidated calculation • For the solo test of a subsidiary of a group to be consistent with a group level consolidated approach, capital flows to and from the group need to be taken into account, even if there are no formal CRTI in place • Group level diversification can only be allocated exogenously to the subsidiary • The consolidated approach might be realistic if the economic situation of a group is good. However, in case of financial distress, the assumptions likely break down Solo Test: Assumes unrestricted risk and capital transfer in case of financial problems in the rest of the group even if no formal capital and risk transfer instruments are in place group risk Formal capital and risk transfer instruments Assumed unrestricted capital transfer

6. The CRTI Approach Group Test: Assumes capital transfer only via formal capital and risk transfer instruments • The CRTI approach for groups is consistent with FOPI‘s solo solvency test: Only formal CRTI are considered, non-legally enforceable promises by the group to support a subsidiary are not quantified within the solo SST • The CRTI approach requires modeling of (major) legal entities, thereby giving incentives for appropriate capital management according to legal entities economic capital needs • The CRTI approach better captures the options and strategy of a group in case of financial distress than the consolidated model • FOPI decided to choose the CRTI approach for the group solvency test Solo Test: Assumes capital transfer only via formal capital and risk transfer instruments Formal capital and risk transfer instruments

7. Main Reasons for Choice of CRTI Approach Consistency between Individual- and Group-Level Solvency Requirements A group‘s non-formal promise to a support a subsidiary will not be taken into account in the subsidiary‘s individual solvency assessment  Consistency requirement implies taking into account only formal promises Without consistency, a parent company will have two different capital requirements, one seen as an legal entity having to satisfy an individual solvency requirement, and one seen as a group, having to satisfy also a group-level solvency requirement Realistic Modeling of a Group’s Behavior in Case of Financial Distress Realistic modeling of group support to subsidiaries has to take into account the possible financial state of the group. In normal cases, a group will likely support its subsidiaries even without a formal CRTI in place, in case of financial problems, a group is likely to revert to a more legalistic interpretation of its rights and obligations

8. The CRTI Approach in a Nutshell 1 • The CRTI approach is methodologically consistent between the solo and the group level solvency test • For a parent company, the group level solvency requirement equals the solo solvency requirement • Owning a subsidiary is an asset • The value of a subsidiary for the parent company is the economic value (independent of regulatory or accounting conventions the subsidiary is domiciled in) • All relevant formal capital and risk transfer instruments have to be modeled • The risk of a subsidiary for the parent is defined as the potential change of the economic value of the subsidiary within one year • The option of a parent company to let a subsidiary go into run-off is taken into account ( the value of a subsidiary for the parent company is never less than 0 if there are no CRTI)

9. The CRTI Approach in a Nutshell 2 • The parent company is assumed to be able to unlock economic value of a subsidiary by selling it for its economic value • However, remaining fungibility restrictions and liquidity need to be modeled • The group level model needs to be able to quantify the risk of the different legal entities • Simplifications can be acceptable (e.g. sub-consolidation instead of modeling of all legal entities individually) • But the group model needs to be able to map the major sub-groups/legal entities • Calculation of available funds with a view on double-gearing along accounting standard consolidation methods • A parent company benefits endogenously from group level diversification by taking into account the dependency structure between the risks in its subsidiaries and the risks of the parent company • A subsidiary can benefit from group level diversification by taking into account CRTIs between the subsidiary and other legal entities of the group

10. CRTI Approach Properties: Group Structures Holding Company Structure Parent Company Structure Holding Insurer Non- insurers Non- insurers Insurer Insurer Insurer Insurer Insurer Insurer The holding company owns insurers, some supervised by FOPI, some supervised in other jurisdictions Assuming no holding company guarantees exist, the risk based capital requirement is always satisfied (maximal loss is equal to the value of its participations  VaR, TailVaR is always less than available capital) Capital requirements need to be attached to a legal entity  FOPI puts capital requirement on the holding but demands SST compatible valuation and risk quantification of all relevant legal entities owned by the holding The parent company owns subsidiaries, some supervised by FOPI, some supervised in other jurisdictions The SST capital requirement for the group equals the individual capital requirement of the parent company Holding company Insurance company supervised by FOPI Insurance company not supervised by FOPI

11. CRTI Approach Properties: Risks The risk of a subsidiary for the parent company is emanating from the change in economic value of the subsidiary and – potentially – from CRTI which will be implemented during a time horizon of one year No CRTI in place: The subsidiary is in default, the economic value of the subsidiary for the parent is zero. The CRTI approach takes into account the legally limited liability structure: The model assumes that in case of financial distress, the group will not support a subsidiary if no CRTI are in place Adverse event impacting the subsidiary’s balance sheet, subsidiary is insolvent Subsidiary Parent A L A L Subsidiary Parent A L A L A L A L An insolvency protection guarantee from the parent to the subsidiary is in place: The subsidiary is in run-off, the value of the subsidiary for the parent is zero and capital is further depleted due to payout of guarantee Economic value of subsidiary as asset of the parent Missing capital of subsidiary is replenished with assets from the parent

12. CRTI Approach Properties: Diversification Group Level Diversification:A parent company benefits endogenously from group level diversification by taking into account the dependency structure between the risks of its subsidiaries and the risks of the parent company Down-streaming of Diversification: A parent company can down-stream group level diversification via capital and risk transfer instruments (e.g. intra-group retrocession, guarantees, etc.) to its subsidiaries. A guarantee from the parent to a subsidiary allows a subsidiary to reduce the economic capital requirement but increases the capital requirement for the parent If there is no formal instrument from the parent to the subsidiary which ensures that the parent will support the subsidiary, then the subsidiary cannot benefit from being part of a group Parent Company Subsidiary1 Subsidiary2 Parent Company Subsidiary1 Subsidiary2 Assets exceeding technical provisions and debt Within the SST, diversification is not seen as a (virtual) asset but as the fact that required capital is reduced due to a legal entity being part of a group SCR Effect of Diversification SCR without taking into account diversification

13. Group Level Diversification The subsidiary's economic value is an asset to the parent company The 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 Random changes of the economic value of assets and participations Parent Company Group level diversification is effected via the ownership relation between the parent and its subsidiaries Random changes of liabilities Assets Liabilities Assets Available Capital of Subsidiary 1 Subsidiary1 Available Capital of Subsidiary 2 Liabilities Random changes of the economic value of assets and participations Subsidiary2 Random changes of liabilities Economic balance sheet at t=0 (deterministic) Economic balance sheet at t=1 (stochastic)

14. Down-streaming of Diversification A: Capital Requirements without Guarantee B: Capital Requirements with Guarantee SCR Assets Liabilities Parent Company Parent Company Guarantee SCR SCR Subsidiary1 Subsidiary1 Subsidiary2 Subsidiary2 B: • The parent company issues a guarantee to subsidiary 1 • The capital requirement for the parent increases due to the risk that the guarantee will be invoked by subsidiary 1 • The capital requirement for subsidiary 1 decreases due to the fact that the parent has to transfer capital if the guarantee will be triggered • The capital requirement for subsidiary 2 is unchanged • The ability of the parent company to issue guarantees to its subsidiaries is constrained by its capital situation • Guarantees, intra-group retrocession, etc. allow subsidiaries in a ‚natural‘ way to benefit from being part of a group without resorting to artificial, exogenous capital allocation schemes

15. CRTI and Diversification Implications of Group Structures on Diversification SCR Parent Company Parent Company Parent Company SCR SCR Subsidiary1 Subsidiary1 Subsidiary1 Subsidiary2 Subsidiary2 Subsidiary2 Parent company has only ownership relation with its subsidiaries. Group diversification is concentrated in the parent company, subsidiaries do not benefit from being part of the group Unlimited guarantees between the parent company and its subsidiaries. The group structure is effectively that of a consolidated group. Diversification is spread over parent and subsidiaries Unlimited guarantee from the parent company to subsidiary 1, no guarantee to subsidiary 2. Part of group diversification has been down-streamed to subsidiary 1, subsidiary 2 does not benefit from being part of a group Assets exceeding technical provisions and debt Effect of Diversification SCR without taking into account diversification SCR

16. Risk Management Requirements Allowing for CRTI in the calculation of SCR implies risk management requirements for the company receiving the CRTI Example of a misuse of a CRTI: B: Excess Capital of Subsidiary is Used C: Guarantee is Revoked by Parent A: Capital Requirements with Guarantee SCR Excess capital is transferred out of subsidiary and spent Assets Liabilities Parent Company Parent Company Guarantee SCR Subsidiary1 Subsidiary1 Subsidiary1 The parent issues a guarantee to its subsidiary. The capital requirement of the subsidiary is reduced Excess capital of the subsidiary is transferred out. The subsidiary is still solvent due to the guarantee by the parent The parent cancels the guarantee, SCR of the subsidiary increases and the capital of the subsidiary is not sufficient anymore

17. Risk Management Requirements For a CRTI to be allowed to reduce the required capital for the SST, quantitative and qualitative preconditions have to be met: • The instrument has to valued appropriately • The risk of the instrument has to be quantified and taken into account appropriately (e.g. credit risk of the guarantor) • The instrument needs to be legally binding • The wording of the contract needs to be unambiguous • The company receiving the instrument needs to have adequate risk management: Sufficient know-how, adequate processes, etc. The company needs to have a strategy in place to take into account the possibility that the CRTI will be cancelled. The strategy is the responsibility of the senior management of the company receiving the CRTI and having reduced the economic solvency requirement (e.g. the subsidiary receiving a parental guarantee)

18. CRTI vs Consolidated Approach CRTI Approach Consolidated Approach Diversification is down-streamed to subsidiaries within the model by CRTIs, and no exogenous allocation scheme needs to be used Subsidiaries can only benefit from being part of a group if group-level diversification is allocated using an exogenous, arbitrary allocation scheme The group level model is consistent with the individual models for the group’s legal entities and can be used for local solvency calculations The group level model is inconsistent with individual models. The legal entities of the group have to develop specific models for individual capital calculations The model can be used for a group’s capital management since legal entity risks and capital requirements are captured The consolidated model cannot be used for capital management since it gives no information on legal entity capital requirements The model is complex since the relevant legal entity of the group as well as all relevant CRTI need to be mapped The model is simpler since intra-group CRTIs cancel out and legal entities need not be captured

19. Restriction of Capital Mobility Subsidiary Parent Subsidiary Parent A A L L A A L L Adverse event impacting the subsidiary’s balance sheet Assume that the local supervisor of the parent company restricts capital mobility. This causes the default of the subsidiary although the group as a whole could survive without problem if the parent were allowed to inject capital in the subsidiary. The acceptance of CRTI across jurisdictions is key to allow subsidiaries to benefit potentially from being part of a group.

20. Restriction of Capital Mobility Restricted fungibility of capital is an issue when a group is in financial distress, not when things are going well For FOPI, one of the main question for group supervision will be the treatment of the policy holders in different jurisdictions in case of financial distress of a group • If local regulators agree on capital flows also in case of financial distress, all policy holders suffer (potentially) equally  this approach allows policy holders to benefit from group diversification and more efficient allocation of capital • Otherwise, when capital fungibility is being restricted in case of financial problems within a group, group diversification is limited and policy holders in other jurisdictions might suffer disproportionately  this situation leads to high premiums and inefficiencies and might even lead to insolvent run-offs of distressed legal entities while other legal entities of the group are still solvent FOPI strongly supports a harmonized treatment of policy holders, irrespective of their nationality and a harmonization of requirements of regulators

21. Implementation All insurance groups supervised by FOPI need to have an acceptable internal model by 2008 To achieve the successful development and implementation of internal models satisfying the requirements of FOPI, regular contacts and meetings between companies and FOPI will take place between 2006 and 2008 Draft for future transparency of the internal model* Formulation/evaluation of scenarios Approval of internal model * Discussion of the project plan together with senior management* Results from prototype (if feasible) Pre-Approval of internal model 2007 2006 2008 Kick-off Meeting Discussions on conceptual and technical issues Discussions on conceptual and technical issues Results from the internal model* Initial discussion, identification of issues and way forward Depending on the size and complexity of the company, the frequency of the meetings can vary (monthly or quarterly) * With senior management