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Emerging European Issues Accounting and Solvency

September 21, 2007. Emerging European Issues Accounting and Solvency. Susan Witcraft, St. Paul, Minnesota. Emerging Accounting Issues. IFRS – Concept. The International Accounting Standard Board (IASB) issues the International Financial Reporting Standards (IFRS, formerly IAS)

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Emerging European Issues Accounting and Solvency

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  1. September 21, 2007 Emerging European Issues Accounting and Solvency Susan Witcraft, St. Paul, Minnesota

  2. Emerging Accounting Issues

  3. IFRS – Concept • The International Accounting Standard Board (IASB) issues the International Financial Reporting Standards (IFRS, formerly IAS) • From 2005 onwards, all companies listed in the EU have to report according to IFRS for their consolidated financial statements • Generally, local GAAP still stays effective for financial statements of single entities (stand-alone) • Local taxation is in general not based on IFRS • IASB tries to harmonize accounting standards world-wide • IFRS rules are influenced by U.S. accounting rules (U.S. GAAP)

  4. IFRS – Concept Assets Equity and Liabilities Investments IAS 39 Equity (net asset value) Insurance Reserves IFRS 4 Other Assets Other Liabilities

  5. Trading Fair value Income statement Available-for-sale Fair value Amortized cost-incomeFair value-equity Held to maturity Amortized cost Income statement Loans and receivables Amortized cost Income statement Designated at fair value Fair value Income statement IFRS – Investments Financial Instrument Categories Category Measurement Changes in carrying amount

  6. 2005 Phase I (interim) • “Non-fair value accounting” • No equalization reserve • Unbundling of embedded derivatives, deposit elements 2010? Phase II “fair value accounting” IFRS – Insurance Contracts IFRS 4

  7. Accounting mismatch Volatile net income + equity IFRS – Insurance ContractsAccounting Mismatch Phase I (2005 – 2010?) Assets Equity & Liabilities Investments (partially) at fair value Equity Insurance Reserves not at fair value

  8. IFRS – Insurance ContractsPhase II • Exposure draft published in 2007; adoption of Phase II in 2010 or later • Phase II will most likely implement a market value approach (“fair value accounting”) to recognize assets and liabilities arising from insurance contracts • Market value approach likely to result in higher volatility of net income and equity

  9. IFRS – Insurance ContractsPhase II • If fair value accounting is adopted, consensus appears to be that: • Premium and expenses will be recognized at contract inception • Deferred expenses and premiums will be eliminated (e.g. deferred acquisition costs) • Reserve estimations are based on present value of expected cash flows • Present value will include some form of risk margin

  10. Emerging Solvency Issues

  11. Solvency IIOverall Objective EU flag Establish a solvency system that is matched to the true net risks of an insurance company

  12. SOLVENCY II Pillar III Pillar II Pillar I Solvency IIStructural Approach 3-Pillar Approach Harmonisation among European supervisors. Pillar I:Quantitative method for determining solvency capital requirement. Pillar II:Supervisors intervention powers. Possible solvency capital add-on in addition to the quantitative requirement. Pillar III: Harmonised reporting requirements. Increases transparency and makes comparison of companies in different regions easier.

  13. Solvency IITime Table ?

  14. Solvency IIEconomic Balance Sheet ASSETS ASSETS LIABILITIES LIABILITIES ASSETS LIABILITIES • Market values • Full balance sheet • Recognition of risk mitigation • Two solvency levels, solvency capital requirement (SCR) and minimum capital requirement (MCR) SCR SCR SCR AC MCR MVA MVA MVA MVL MVL MVL

  15. Solvency IIEconomic Balance Sheet ASSETS ASSETS LIABILITIES LIABILITIES ASSETS LIABILITIES • Market values • Full balance sheet • Recognition of risk mitigation • Two solvency levels, solvency capital requirement (SCR) and minimum capital requirement (MCR) SCR SCR SCR AC MCR MVA MVA MVA MVL MVL MVL

  16. Solvency IIEconomic Balance Sheet ASSETS ASSETS LIABILITIES LIABILITIES ASSETS LIABILITIES • Market values • Full balance sheet • Recognition of risk mitigation • Two solvency levels, solvency capital requirement (SCR) and minimum capital requirement (MCR) SCR SCR SCR MCR AC MVA MVA MVA MVL MVL MVL

  17. MVM BE Solvency IINon-hedgeable Liabilities – Market Value Margin (MVM) LIABILITIES MVL Market Value of Liabilities = Best Estimate + Market Value Margin

  18. Additional SCR required by B for run-off of A’s liabilities t = 1 2 3 ... n MVM = Cost of capital for this extra SCR Solvency IIMarket Value Margin (MVM) Company A: Company A: A L A L SCR Solvent Technical insolvency t=0 t=1 t=n Company B: Company B: A L A L SCR SCR SCR Solvent Solvent

  19. QIS 3 Standard ModelSolvency Capital Requirement Framework SCR • Methodology for standard formula • Bottom up approach • [1] Risk categories identified • [2] Capital allocated to each subcategory • VaR, 99.5%, 1 year solvency and risk assessment period • [3] Total company SCR calculated • Aggregate • Consider diversification Operation BSCR Health Credit Market Life UW Prem/Res F/X Life sub risks Health sub risks CAT Property Concen- tration Interests Equity Spread Risk silos combined into overall company risk – bottom up approach

  20. QIS 3 Standard ModelMarket Risk Module • Purpose of SCRmkt • Measure impact of movements in the level of financial variables, such as stock prices, interest rates, real estate prices and exchange rates. • Modules in SCRmkt • Mktint – Interest Rate risk. Upward and downward shocks to yield curve. • Mkteq – Equity risk. Downward shock.Taking account of the offsetting effect on the value of derivaties and short positions. • Mktprop – Property risk. Downward shock to the market value of property exposures. • Mktsp – Spread risk. Widening of credit spreads. • Mktconc – Risk Concentrations. • Mktfx – Currency Risk. Shock to exchange rates.

  21. Upward shocked curve Current yield curve Downward shocked curve QIS 3 Standard ModelMarket Risk Module- Mktint - Market interest rate risk stress test Evaluate effect of interest rate changes on both assets and liabilties

  22. QIS 3 Standard ModelCounterparty Credit Default Risk Module • SCRdef • The risk of default of a counterparty to risk mitigating contracts like reinsurance and financial derivatives. • Data requirements • Replacement cost - Difference between gross and net technical provisions plus the extra premium minus recoveries • Probability of default Probability of default Default risk in standard formula requires replacement cost estimation

  23. QIS 3 Standard ModelCounterparty Credit Default Risk Module Few reinsurers  increased counterparty default risk Low rating  increased counterparty default risk Demand for high securitized reinsurance might increase

  24. QIS 3 Standard ModelNon-life Underwriting Risk Module • Purpose of SCRnl • Cover excess losses that might occur due to existing insurance provisions and new business. Both for CAT and Non-CAT losses. • NLpr • Capital charge for the premium and reserve risk. • NLcat • Capital charge for the losses arising from Catastrophes • Scenarios defined by local supervisors (local). • Scenarios defined by CEIOPS (trans-regional). • Individual CAT scenarios (if more severe than prescribed above). • independence assumed

  25. QIS 3 Standard ModelOperational Risk Module • Capital charge: Factors applied to gross premium and gross technical provisions • Approximative approach (due to lack of operational loss data) • Currently no recognition of risk management or mitigation Operational risk model in QIS 3 - simplistic approach

  26. QIS 3 Standard ModelTotal SCR Formula Aggregation • Aggregation to SCR – Bottom up approach • Step 1: Combine risks from sub-categories to major category (SCRmkt, SCRdef, SCRlife, SCRnl) • Step 2: Combine major risk categories using prescribed correlation matrix (BSCR) • Step 3: Add operational risk capital charge • Correlation between risk categories • SCR calculation SCR = BSCR + SCRop Diversification is a key issue Undiversified companies are generally penalised

  27. Internal ModelsScope • Full Internal Model (long term goal) • Model and simulate all important aspects of the business • Take correlation between risks into account (cause-effect) • Derive Net Operating Income distribution • SCR = 1 in 200 year negative result • Partial Internal Model (valuable starting point) • Model and measure risk using Partial Internal Models • Clearly identify what are the main capital drivers of the SCR standard formula and focus on these risks first • Aggregate capital requirements to total capital requirement • Correlation needs to be considered Metarisk XMR suitable for partial and full internal modeling

  28. Internal Risk Management Test 2: Use Actuarial Model Regulatory Capital Requirement Test 1: Statistical Quality Test 3: Calibration Internal Models Regulatory Approval Preapproval required to use internal model for regulatory solvency assessment

  29. www.guycarp.com

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