SOLVENCY II Part 4: Quantitative impact studies

1. SOLVENCY IIPart 4: Quantitative impact studies Vesa Ronkainen Insurance Supervisory Authority, Finland 30.11.2006

2. Contents 1. Background 2. QIS2 excercise – the main results 3. References for Solvency II

3. 1. Background of QIS calculations • CEIOPS has carried out so far 3 exercises to tentatively test Solvency II quantitative impacts, namely the Preparatory Field Study, the QIS1 and the recent QIS2 • These and forthcoming QIS rounds are part of a continuous dialogue between CEIOPS, the European Commission, insurance industry and other stakeholders that increase the knowledge and help to shape the future solvency system for the EU. • So called Preparatory Field Study that took place in April and May 2005 only concerned life insurance, and its main goal was to test the infrastructure and to prepare for Quantitative Impact Studies.

4. 1. Background - QIS1 exercise • QIS1 calculations were done during the last 3 months of 2005. Here the focus was solely on the technical provisions. • The findings are discussed in the QIS1 summary report, which is available on the CEIOPS website. • In general QIS1 achieved its 2 main goals, namely giving a rough indication of the levels of prudence in the current technical provisions by benchmarking them against different explicit percentiles (75% and 90% level of prudence), and secondly giving insight to practicability of this type of calculations. • QIS1 paved the way for QIS2 and its main results will be discussed in that context

5. 1. Background - QIS2 exercise • QIS2 project in 2006 includes all the elements of Pillar 1 quantitative requirements => a tentative, crude overall quantitative picture of Solvency II can be formed: • The technical provisions (best estimate, 75%, and the Cost of Capital approach advocated by the industry) • Capital requirements (incl. alternative methods): the Solvency Capital Requirement SCR (new feature) and the Minimum Capital Requirement MCR (cf Solvency 1) • Assets are marked to market • Eligible elements of capital are based on the current Solvency 1 rules with some necessary QIS2 adjustments (for hidden reserves / deficits) • Calibration was crude and tentative in QIS2 and will be refined in QIS3 for 2007

6. 2. QIS2 exercise • Over 500 firms from 23 countries participated in QIS2, compared with 312 firms from 19 countries in QIS1. • The market share of the respondents in these 23 countries is generally above 50%. There is still a size bias present in QIS2 towards medium and large sized firms, though less than in QIS1

7. General economic results 1 • In general the capital requirements increased but on the other hand the technical provisions decreased and the available capital increased. The overall effect was that the ratio of available capital to required capital (SCR) decreased (compared to Solvency I) for most life and non-life participants, but still remained above 100%. • In many countries, a number of undertakings would need more capital according to QIS2 formulae, but many things, including calibration, may still change for the final SCR formula.

8. General economic results 2 • The MCR solvency position is also above 100% for most undertakings in the sample. • In some cases SCR and MCR were quite close to each other due to methodological differences when calculating SCR and MCR. This inconsistency was generally considered to be problematic.

9. Suitability of methodology • A number of useful comments were received from undertakings and supervisors, particularly in relation to the further development of the underwriting risk modules • Although calibration was not in focus in this exercise, still many critical comments were received. Their general message was that some risk modules and correlations seem too prudent (e.g. market risk, non-life underwriting risk and size factor). • It was also noted that the level of prudence in placeholder and alternative methods were not always equal. Some information and comparative figures of internal models were also received.

10. Practicality of the exercise • In many respects the findings are similar as in the earlier QIS1 exercise. Technical provisions remain the main challenge for most undertakings. Resource issues were again severe (lack of time, data, people, knowledge, and guidance). • On average it took a couple of person months to complete the study. However, it was difficult for undertakings to estimate at this stage the level of initial investment that Solvency II regime would ultimately require.

11. Technical provisions • In most countries, the differences between the 75th percentile provision and the cost-of capital provision were not significant. • Although the answers provided may not form a representative sample, in most countries a majority of participants seems to prefer the CoC provision to the percentile provision because of its simplicity (in life insurance in particular) and economic interpretation. • Approximative methods for the CoC calculation that did not require stochastic modelling were generally available, while this was not usually the case for the percentile approach. • Practicability and harmonisation of the assessment (in particular in life insurance with regard to hedgeable risks and future bonuses) continue to pose a challenge to the Solvency II process.

12. The components of SCR in QIS2

13. QIS 2 technical specifications • Solvency Capital Requirement SCR is based on 1-year 99,5 % VaR (or in theory 99 % TailVaR), but in QIS2 the calibration was very crude and tentative • Risk classification follows the proposal of the IAA • Usually both a factor- and a scenario-based alternatives were tested • The placeholder was usually the simpler factor-based methods except for the interest rate risk • Dependencies were addressed via correlation coefficients

14. QIS 2 technical specifications (cont) • Interest rate risk (includes both assets and technical provisions) • 5 duration buckets and shocks (see below) • Equity risk 40 % shock for both methods (hedging was taken into account)

15. QIS 2 technical specifications (cont)

16. QIS 2 technical specifications (cont) • Real estate risk 20 % shock • Currency risk 25 % shock • Credit risk = sum of the products of rating-weights, effective durations and market values:

18. QIS 2 technical specifications (cont) • Life insurance underwriting risk – several submodules • Non-life insurance underwriting risk – 3 submodules • Operational risk was simply approximated as a percentage of premiums and technical provisions • Internal model based results were also welcome

19. QIS 2 technical specifications (cont) • Minimum Capital Requirement MCR • 2 options: ‘transitional’ and ‘post-transitional’ • ‘post transition MCR’ was calculated in principle as the SCR except for calibration • ‘transitional MCR’ is based on Solvency I (50% or 100%) • Run off costs

20. Risk profiles in QIS2 • In life insurance the market risk was usually dominant • In non-life insurance the underwriting risk was the most important, and then the market risk • There was a wide dispersion between different insurance companies and markets • Risk components are of course sensitive to the parameters chosen, which will be adjusted for QIS3

21. Other findings 1 • There was a fairly wide dispersion noted in the number of medium and large sized, life and non-life, undertakings in each country that provided comparative figures from their internal models for part or all of the SCR calculation, and in the results derived from these models. However, the following features were observed in most countries. • the life underwriting risk charges measured by the internal models consistently exceeded the corresponding risk module of the SCR • for non-life underwriting risk, the internal models generally give lower outcomes than the placeholder SCR • for credit risk, the internal models almost all give higher values for credit risk than the SCR

22. Other findings 2 • Where figures from different entities within a group were combined, then most groups took the consolidated balance sheets as a starting point for the assessment of both provisions and the SCR. • The reported reductions of group risk capital - including diversification effects - show a wide range of values

23. 3. References • There is a large amount of publicly available papers about the Solvency II project. Some interesting websites are: • European Commission (http://ec.europa.eu/internal_market/insurance/index_en.htm) • CEIOPS (www.ceiops.org) • Groupe Consultatif (www.gcactuaries.org) • CEA (www.cea.assur.org) • IAIS (www.iaisweb.org) • IAA (www.actuaries.org) • CFO Forum (www.cfoforum.nl)