1 Federal Office of Private Insurance Zurich, 3 July 2006 SST for Small Entities

2 Contents Swiss Solvency Test: Principles Standard Formulae vs. Standard Models Work Load Impressions from the Industry

3 Principles vs Rules.. in designing Solvency 2 our principal aim should be to incentivise insurance firms to use, and reward them for using, modern risk management practices appropriate to the size and nature of their business. Speech by John Tiner, Chief Executive, FSA, ABI conference on Solvency II and IASB Phase II, 6 April 2006 A risk based solvency system has to rely on principles rather than rules if it is to give incentives for risk management Principle-based standards describe the objective sought in general terms and require interpretation according to the circumstance. A rule-based approach is not be possible if internal models are to be used for regulatory purposes A principle based approach however only works within a responsibility culture but not with a compliance culture

4 The Importance of Being Consistent Without consistency: results are intransparent, prudence will be implicit a layer of economically irrelevant arbitrage instruments will be developed to exploit regulatory inconsistencies 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 the Swiss regulator, consistency of the SST is key Main requirements on consistency: between valuation of assets and liabilities between valuation and risk quantification between individual and group level solvency tests between insurers and reinsurers between life and nonlife

5 Valuation Coyle & Sharpe © Mal Sharpe Actuaries of the PastActuaries of the Future Prediction of future asset returns and banking conjectured gambling profits by using high discount rates for the valuation of liabilities Injection of ambiguity into the predictions by using prudent parameters Never going back to past predictions and forever using parameters used in the past Using recognized mathematical and financial models Having transparency on prudence by using an explicit risk margin Regularly reassessing and updating the valuation and using most recent information David Hilbert

6 Swiss Solvency Test: Principles 1.All assets and liabilities are valued market consistently 2.Risks considered are market, credit and insurance risks 3.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 4.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 5.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 6.Under the SST, an insurers capital adequacy is defined if its target capital is less than its risk bearing capital 7.The scope of the SST is legal entity and group / conglomerate level domiciled in Switzerland 8.Scenarios defined by the regulator as well as company specific scenarios have to be evaluated and, if relevant, aggregated within the target capital calculation Defines Output 9.All relevant probabilistic states have to be modeled probabilistically 10.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 11.The internal model has to be integrated into the core processes within the company 12.SST Report to supervisor such that a knowledgeable 3rd party can understand the results 13.Disclosure of methodology of internal model such that a knowledgeable 3rd party can get a reasonably good impression on methodology and design decisions 14.Senior Management is responsible for the adherence to principles Defines How-to Transparency

7 SST Standard Models SST Standard Model: Standard Scheme rather than Standard Formula The standard scheme is similar to companies internal model: Financial market Risk: RiskMetrics type approach (Covariance matrix of market risk factors) Credit Risk: Basel 2 or Credit risk portfolio models, credit risk of reinsurers via scenario P&C Insurance Risk: Distribution based (small, large and cat claims) Life Insurance Risk: Covariance approach for life insurance risk factors Companies have to determine sensitivities of assets and liabilities to financial market risk factors Analyze life and P&C insurance risk, determine company specific parameters Aggregate risk using convolutions etc. gives incentives for risk management corresponds closely to the thinking of the user of the model (e.g. actuaries, investment specialists, CROs,…) Allows easy use of partial internal models allows easy and consistent mapping of reinsurance (business ceded)

8 Contents Swiss Solvency Test: Principles Standard Formulae vs. Standard Models Work Load Impressions from the Industry

9 Standard Formulae vs. Standard Models Standard Formula: A simple formula which uses easily obtainable accounting or other values to arrive at a (more or less good) proxy for necessary economic capital (SCR). If the calculation can be done by a HR manager, then it is a standard formula. Example: Solvency 1, GDV model Standard Model: An algorithm or a description of a sequence of calculation steps ending the desired results and allowing company specific adaptations. If the user needs know-how of the underlying model and risks and expert judgment, it is a standard model. Example: Internal Models, ICA, SST Standard Formula Standard Model Pros Simple Easy to check Very little work needed The way of calculation is comparable Cons Not risk sensitive Not company specific Often allows arbitraging against Gives no incentive for risk management Underlying assumptions often not clear Partial internal model are difficult to integrate Financial and reinsurance risk mitigation can not be captured adequately Introduces systemic risk Pros Incentivizes risk management Result is company specific Financial and reinsurance risk mitigation fully reflected The results are comparable Underlying assumptions are clear Result is more than just a number Cons More work intensive Needs educated users

10 Standard Formula vs. Standard Model FOPI decided in an early phase of the development of the SST to develop a standard model rather than a standard formula. There is no simple standard formula for small companies, all insurers and reinsurers, irrespective of size, have to calculate the SST using either the standard model or an internal model: The main aim of Swiss risk based regulation is to incentivize insurers to implement adequate risk management. This can not be achieved with a standard formula approach Risk mitigation (reinsurance, guarantees, etc.) are difficult or impossible to be taken into account by a standard formula. This puts small insurer, which cede relatively more risks to reinsurers at a disadvantage The parameterization of a standard formula is intransparent and there is the danger, that parameters and risk factors will not be adapted to a changing risk environment (example Solvency 1) It is difficult or impossible for a company to use a partial internal model (e.g. for market risk) within a standard formal framework. This puts a great hurdle to small companies for using company specific internal models In a standard formula, the steps of a calculation are comparable between different companies, not however the results. In a standard model, the results are comparable, not necessarily however the way of calculation. FOPI prefers comparability of results rather than comparability of form.

11 SST for Small Entities: Comparability It is imperative that regulatory capital requirements are comparable between different companies, i.e. that companies with similar risks have similar capital requirements With a standard formula, the calculation steps are comparable, not necessarily however the resulting capital requirement. A standard formula is difficult or impossibly to make sufficiently risk sensitive such that it can capture the risks of companies with varying and heterogeneous risk exposures. For example, Solvency 1 is comparable in the sense that the calculations different companies make can easily be compared. However, the results are not comparable Using a standard model the results rather than the calculation steps become comparable and there is a level playing field between insurers

12 SST for Small Entities: Reinsurance Small companies transfer a substantial part of their risk (often up to 80%) to reinsurers, allowing a substantial reduction in necessary economic risk capital. A simple standard formula would not be able to capture this risk transfer appropriately, putting small companies at a great disadvantage compared to larger companies using internal models. If small entities want to take advantage of risk transfer to reinsurers in a standard formula regime, they would have to develop or buy a full internal model The SST standard model is sufficiently complex to be able to capture most common reinsurance deals without small companies having to develop an internal model

13 SST for Small Entities: Know-How It is not FOPIs observation, that competence is correlated to the size of companies. Small companies often have people knowing a lot about all aspects of the business (insurance, assets, etc.) whereas in large companies, the know-how tends to be much more fragmented A sufficiently complex standard model can be the kernel for a full internal model for a small companies. A standard model as the SST allows the stepwise transition and incremental adaptation of the standard model to a company specific internal model via integration of partial models. With a standard formula, small companies are forced to develop a full internal model in a single step

14 SST for Small Entities: Complexity Often, small companies have less complex business than large insurers. The complexity of calculation is then also reduced. This is often the case for smaller P&C companies which sell only a small number of products or specialized life companies. This is however sometimes not always the case for small life insurers which often also sell complex, long dated products with embedded options (e.g. interest rate guarantees). FOPI considers that adequate risk management, understanding and quantification of risks is essential for these types of products, irrespective of the size of the insurer due to policy holder protection FOPI expects risk management and know how of companies to be commensurate to the complexity of their business

15 SST for Small Entities: Systemic Risk The use of many insurers of the same standard formula leads to the danger of systemic risks. All models have shortcomings and if all insurers use the same formula, they will all be exposed to the same mistakes and blind spots. Solvency 1 is an example of a standard formula which is leading to systemic risk in the market. The lack of charges for market risk led many companies in Europe to go into risky assets which all dropped in value at the same time in 2001/2002, causing insurers to sell shares at the same time, depressing prices further. A risk based regulatory system which relies on internal models and a standard model which can be adapted to the company specific risk situation reduces the danger that all insurers will make the same mistake at the same time.

16 Contents Swiss Solvency Test: Principles Standard Formulae vs. Standard Models Work Load Impressions from the Industry

17 Experiences from Field Test 2005 Field test 2005: approx 15 life, 15 nonlife and 15 health insurers participated Some companies have also include their branches into their calculations The field test included all large and most mid-sized Swiss insurers as well as a number of smaller companies The participants of the field test comprise approx. 93% of the provision in life and approx 85% of premiums in nonlife The main result was that the standard model can be used even by small companies. The work load ranged from 1 month for small companies to more than one year for international groups The additional information gained by the standard model was perceived by most as worth the extra work compared to a simple factor model

18 Work Load Result of the Field test: Total Work Load in Person Months (PM) Based on initial feedback from a part of the field test participant Split for field test on average: 20% - 30% for internal education, communication 30% - 40% for developing valuation methodology, preperational work (data, IT),… 20% - 30% for actual calculation

19 Work Load Life initial Life later Nonlife initial Nonlife later Total workload for life and nonlife companies, split into work for field test 2005 (initial) and estimates for work for SST during later years Y-axis: person days of work X-axis: logarithmic scale for size of company (assets) LargeMid-SizedSmall Contains build-up of valuation methodology and software Contains modelling of branches Company using already existing partial models Branches

20 Contents Swiss Solvency Test: Principles Standard Formulae vs. Standard Models Work Load Impressions from the Industry

21 Impressions from the Industry In einer breit angelegten Feldstudie, an der 2005 rund 45 schweizerische Versicherungen freiwillig teilgenommen haben, wurden die Ergebnisse vom BPV analysiert und in verdichteter Form publiziert. Die Befürchtungen einer generellen Unterkapitalisierung haben sich ebenso wenig bewahrheitet wie der Vorwurf, dass der Aufwand für kleine und mittelgrosse Versicherer nicht vertretbar ist. Offene Fragen im Zusammenhang mit der Einführung des SST werden in entsprechenden Arbeitsgruppen angegangen und in Rundschreiben und Verfügungen des BPV gefasst. Swiss Insurance Association, Jahresbericht 2005/06

22 Impressions from the Industry Wir haben diesen Sommer viel gelernt über unser Versicherungsgeschäft und über die Bedeutung von einzelnen Zahlen. Es gab viele Diskussionen über Kennziffern usw. welche zu einem Wissensaufbau in unserer Geschäftsführung führten und dazu beitragen werden, dass wir die Gesellschaft mit noch besseren Entscheidungsgrundlagen führen können. Die Ergebnisse aus dem SST-Testlauf nutzen wir auch für Diskussionen mit dem Verwaltungsrat (es gibt eine zusätzliche Sicht auf den Vermögensstand und den Geschäftsverlauf). Ich bin überzeugt, dass der SST die Führung von unserer Gesellschaft zukünftig unterstützen wird. Die Aufsicht lieferte uns dementsprechend ein weit ausgebautes Führungshilfsmittel. Comment by Martin Rastetter from the Metzgerversicherung a small-to-midsized nonlife company with approx CHF 160 Mio tech. provisions Implementation of the SST for small companies: Days of work used approximately: Initially: Internal: days, External: days Afterwards:Internal: days, External: days

23 Impressions from the Industry Das per revidierte Versicherungsaufsichtsgesetz (VAG) sieht u. a. eine Verstärkung der Aufsichtsinstrumente vor. Als weiteres bringt es eine Verfeinerung der Solvenzkontrolle mittels des neu geschaffenen SST-Verfahrens (Swiss Solvency Test), das nach einer dreijährigen Übergangsfrist definitiv vorliegen muss. Der Zweck des SST ist nicht nur das Zielkapital der einzelnen Versicherer zu bestimmen, sondern auch das Riskmanagement und das Risikobewusstsein der Gesellschaft zu fördern. Zusammen mit aussenstehenden Aktuaren haben wir die notwendigen, aufwendigen Arbeiten frühzeitig in Angriff genommen und erachten sie als Fitnesstest. Zudem sehen wir die Chance, optimale Beurteilungsgrundlagen für unsere neue Rückversicherungslösung zu erhalten. Die bisherigen Zwischenresultate bestätigen die gute Solvabilität und Risikofähigkeit der emmental. Geschäftsbericht 2005, Emmental Versicherung Emmental Versicherung: Mutual insurer with policy holder and approx. 40 Mio premiums

24 Impressions from the Industry Effiziente Risikopolitik dank Swiss Solvency Test (SST). Kapital ist eine knappe Ressource, die effizient gesteuert und optimal verteilt werden muss. Zum besseren Schutz der Versicherungsnehmer wird 2006 der vom Bundesamt für Privatversicherungen (BPV) entwickelte Schweizer Solvenztest eingeführt. Der Test ist Teil der verbesserten Aufsicht und ermittelt die Fähigkeit eines Versicherungsunternehmens, die eingegangenen Risiken aus der gesamten Geschäftstätigkeit zu tragen. innova arbeitete an der Entwicklung des schweizerischen Solvenztests in der Projektgruppe des BPV mit und hat diesen bereits zweimal freiwillig durchgeführt. Das Ergebnis des Tests zeigt, dass wir die hohen Anforderungen klar übertreffen. Geschäftsbericht 2005, Innova Innova: Health insurer with policy holders and 117 Mio premiums

25 Impressions from the Industry For our risk and investment strategy we need to be able to quantify the cash flow structure and the risk bearing capacity of our portfolios. For this the SST is a good (although in many aspects still to be modified and enhanced) basis. In addition, we can use the SST to test capital requirements for alternative investment strategies. As we have not yet an equally well suited internal model, the SST is for us of great benefit. We see it as an integral part within our ALM process. Comment by René Bühler from the National Versicherung, a mid-sized insurance group. Implementation of the SST for midsized companies: Days of work used approximately: Initially: Internal: 220 days for life, 170 days for nonlife Afterwards:Internal: ~180 days for life, 150 days for nonlife

26 Impressions from the Industry Swiss Solvency Test (SST) unternehmensweit eingeführt. Die Visana garantiert ihren Kunden jederzeitige Zahlungsfähigkeit. Mit dem Inkrafttreten des neuen Versicherungsaufsichtsgesetzes (VAG) sorgt ein neu entwickeltes Instrument, der Swiss Solvency Test (SST), für noch mehr Sicherheit und Transparenz im Bereich der Zusatzversicherungen nach VVG. Die Versicherer müssen sich intensiv mit verschiedenen Risikoszenarien auseinandersetzen und der Aufsichtsbehörde deutlich mehr Informationen hierzu liefern. Der SST ist von Gesetzes wegen nur für Versicherungen nach Versicherungsvertragsgesetz (VVG) verbindlich, der Bereich der obligatorischen Krankenpflegeversicherung untersteht dem Krankenversicherungsgesetz (KVG). Die Visana überprüft jedoch die Auswirkungen der diversen Risikosimulationen auch auf die Grundversicherung und betreibt somit ein unternehmensweites Risk Management. Visana, Geschäftsbericht 2005

27 Impressions from the Industry "Die Winterthur Gruppe unterstützt grundsätzlich die Einführung des Swiss Solvency Test. Im Gegensatz zum heute gültigen Solvenzregime gibt der Swiss Solvency Test ein präziseres Bild über die Risikoexposition einer Versicherungsgesellschaft. Das ist im Interesse der Versicherten und der Versicherer. Das Risk Management der Winterthur arbeitet intern schon seit einigen Jahren mit vergleichbaren Risikomodellen und hat seine Erfahrungen in den SST eingebracht. Im Rahmen von Solvency II entwickelt sich in der EU ein vergleichbares Solvenzregime. Wichtig ist, dass der schweizerische Versicherungsregulator den Versicherungsgesellschaften eine angemessene Übergangsfrist bei der Erfüllung der neuen Anforderungen einräumt, und die Entwicklungen im Rahmen von Solvency II bei der weiteren Ausgestaltung des SST angemessen berücksichtigt." Implementation of the SST for large companies: Joachim Oechslin, Chief Risk Officer Winterthur Group

28 For More Information Philipp / Thomas Mark Web-Links: