QIS5 : SOLVENCY II NEARS THE FINISHING LINE

1. QIS5 : SOLVENCY II NEARS THE FINISHING LINE Istanbul, 1st October 2010 David Simmons, Managing Director, Head of ERM, Willis Re September 2010

2. Agenda • Solvency II:Background and highlights • QIS4 and QIS5:Details and consequences • Internal models:Should you or shouldn’t you? • ORSA:Implications and issues • Solvency II and you:Impacts and solutions

3. QIS5 : SOLVENCY II NEARS THE FINISHING LINE Solvency II:background and Highlights

4. What is Solvency II? • Solvency II is the European Union’s new insurance regulatory regime • It applies to the European Economic Area (EEA), the EU plus Norway and Iceland • It is inspired by the Basel II banking regulatory regime • It is risk based, the riskier the business you write, or assets you hold, the more capital you have to hold • It encourages companies to identify, understand, manage and mitigate the risks they face – an ERM framework • Standard capital formulae may be replaced by approved internal models

5. Solvency II timeline Standard Formula QIS2 QIS3 QIS4 QIS5 2006 2007 2008 2009 2010 2011 2012 2013 Bureaucracy (Consultation Process) Draft Level 1 Adopt Level 1 Draft Level 2+3 Adopt Level 2+3 S2 in force Action UK Pre- approval Dry-run S2 in use

6. Three pillars Solvency I • Quantitative – no qualitative element • Simple calculation based on ratio of premium and reserves Solvency II • Risk - based quantitative and qualitative elements Quantification - SCR • Capital Required to stay solvent to 1 in 200 year confidence level over a one year period QIS 5 QIS 3, QIS4 • Calculated by “ Standard Formula ” (MS Excel), Internal Model, or blend of both • QIS 5 is very close to final calculation

7. Quantitative impact studies • QISsare designed to develop Standard Formula approach through iterative improvement to address fairly industry and regulator concerns Closest approximation to final capital impact of Solvency 2 • QIS 2 response was mainly from larger companies • QIS 3 ran from April to June 2007 • QIS 4 ran from April to June 2008 • 1,400 firms, 75% Life & 69% Non-Life participation by premium volume • 11% of companies failed to meet Solvency Capital Requirement • QIS 5 runs from August to October 2010 • Larger participation sought, 60% of companies in EEA • Although reduced from earlier proposals, QIS5 will produce higher solvency capital requirements for most insurers, perhaps 20% to 30% higher than QIS4 although very company specific

8. Solvency capital • SCR = Solvency Capital Requirement • Capital needed to stay solvent to 1 in 200 year confidence level • QIS 4 Results • 10.9% of all firms (11.2% of Non-Life) failed to meet Standard Formula SCR • 28.3% of captives failed to meet Standard Formula SCR • Lloyd’s of London estimated QIS4 SCRs were 57% higher than ICA (the UK’s early precursor of Solvency II) • Internally modelled SCR on average 80% of the standard formula (but internal models not formally approved) SCR

9. Solvency II calculation SCR Operational “Basic” SCR Non-Life U/W Default Market (Asset) Health U/W Life U/W

10. QIS5 : SOLVENCY II NEARS THE FINISHING LINE QIS4 and QIS5:Details AND Consequences

11. QIS 4 results Underwriting 58% Market 31% Default 5% Operational 6% General Insurance company average risk split:

12. Underwriting risk Catastrophe Premium & Reserving Average Captive Average Non-Life Premium: Risk that future premiums less than future claims Reserve: Risk that current reserves less than existing liabilities Catastrophe: Impact of natural and man-made catastrophes 58% Average Captive Average Non-Life

13. Underwriting risk QIS Key Risk Drivers Underwriting Risk Net Premium 58% Netclaims reserve Net Catastrophe Risk Number LoBs Number Regions

14. Underwriting risk Premium & Reserving Risk 58% • QIS5: • Premium & Reserve factors can be adjusted using historical data. • NP is factor used to estimate positive impact of reinsurance • Inclusion of Health and Non-Life Lapse Risk • Correlation between P&R and Cat increased from 0% to 25% • Correlation between lines of business unchanged from QIS4

15. Underwriting risk Premium & Reserving Risk 58% • QIS5: • Premium & Reserve factors can be adjusted using historical data. • NP is factor used to estimate positive impact of reinsurance • Inclusion of Health and Non-Life Lapse Risk • Correlation between P&R and Cat increased from 0% to 25% • Correlation between lines of business unchanged from QIS4 Overall

16. QIS5 Geographical diversification • Segmentation is based on "macro-geographical regions" developed by the United Nation Statistics Division • World split into 18 zones • USA split into 4 zones • All other countries are part of a continental zone • Turkey with Israel, Asian Arab Countries, ex-Soviet Asian Republics

17. Underwriting risk Catastrophe Risk QIS4 % applied to net written premium by LoB Tend to be conservative e.g. “Fire” catastrophe charge = 75% Level 1 “Factor” 58% National Regulators provide cat scenarios Firms estimate loss based on market share 25% “Materiality Threshold” Level 2: “Scenario” Firms define their own cat scenarios Catastrophe modelling results can be used Level 3: “Partial” Model”

18. Underwriting risk CEIOPS has developed gross aggregate cat models by peril and country using TIV by CRESTA. Reinsurance & correlations applied Where the proposed scenarios are irrelevant for firms (e.g. wording explicitly excludes risk) firms may use factor to estimate gross cat & apply R/I Own scenario option still available but is now classified as a partial internal model with a formalised approval process Catastrophe Risk QIS5 Level 1 “Scenario” 58% Level 2: “Factor” Level 3: “Partial” Model”

19. Underwriting risk CEIOPS has developed gross aggregate cat models by peril and country using TIV by CRESTA. Reinsurance & correlations applied Where the proposed scenarios are irrelevant for firms (e.g. wording explicitly excludes risk) firms may use factor to estimate gross cat & apply R/I Own scenario option still available but is now classified as a partial internal model with a formalised approval process Overall? Catastrophe Risk QIS5 Level 2: “Scenario” 58% Level 1: “Factor” Level 3: “Partial” Model”

20. Market (asset) risk • More important for Life than Non-Life firms – we have already seen defensive strategic moves away from annuities business on the Life side • On the Non-Life side many firms were reducing their equity portfolio before the financial crisis in advance of Solvency II • Methodology remains very similar, although in QIS5 we now have a market risk correlation relating to upwards and downwards interest rate shock 31% Equity Property Currency Interest Conc. Spread

21. Market (asset) risk equity risk 31% YE09 Dampener is an attempt to take the financial losses from the recent crisis into consideration Equity Property Currency Interest Conc. Spread

22. Market (asset) risk equity risk 31% Overall YE09 Dampener is an attempt to take the financial losses from the recent crisis into consideration Equity Property Currency Interest Conc. Spread

23. Market (asset) risk property and currency risk 31% Equity Property Currency Interest Conc. Spread

24. Market (asset) risk property and currency risk Overall 31% Equity Property Currency Interest Conc. Spread

25. Market (asset) risk interest rate risk 31% Equity Property Currency Interest Conc. Spread

26. Market (asset) risk interest rate risk QIS4 31% Equity Property Currency Interest Conc. Spread

27. Market (asset) risk interest rate risk QIS5 up/down 31% Equity Property Currency Interest Conc. Spread

28. Market (asset) risk interest rate risk Overall QIS5 up/down 31% Equity Property Currency Interest Conc. Spread

29. Market (asset) risk concentration risk Greater concentration of assets Better credit rating 31% Equity Property Currency Interest Conc. Spread

30. Market (asset) risk concentration risk Overall? Greater concentration of assets Better credit rating 31% Equity Property Currency Interest Conc. Spread

31. Duration of option Value of assets Better credit rating Market (asset) risk spread of credit risk 31% Equity Property Currency Interest Conc. Spread

32. Market (asset) risk spread of credit risk 31% Equity Property Currency Interest Conc. Spread

33. Market (asset) risk spread of credit risk Overall 31% Equity Property Currency Interest Conc. Spread

34. Default (counterparty credit) risk Reinsurance provides the simplest and most effective way of reducing the capital charge, and only incurs a relatively small increase in capital charge. The Solvency 2 Standard Formula Default risk calculation is driven by; Exposure; 50% × • Expected annual recoveries from reinsurance, • Dependence on reinsurance to mitigate 1 in 200 year loss Risk • Credit rating of the reinsurers used, and • Spread of reinsurance panel. 5%

35. Default (counterparty credit) risk QIS4 • Assumes independence between reinsurer defaults. QIS5 • Assumes correlation between reinsurer defaults 5%

36. Default (counterparty credit) risk Overall QIS4 • Assumes independence between reinsurer defaults. QIS5 • Assumes correlation between reinsurer defaults 5%

37. Operational risk Either… Gross Written Premium Or… Gross technical reserves Whichever is higher QIS 4 6% 2% Factor applied

38. Operational risk Either… Gross Written Premium Annual increase in GWP (>10%) Or… Gross technical reserves Annual increase in reserves (>10%) Whichever is higher QIS 5 6% 3% Factor applied – a 50% increase

39. Operational risk Annual increase in GWP (>10%) Annual increase in reserves (>10%) Overall QIS 5 Either… Gross Written Premium 6% Or… Gross technical reserves Whichever is higher 3% Factor applied – a 50% increase

40. Overall expected QIS5 impact for major risk types

41. QIS5 : SOLVENCY II NEARS THE FINISHING LINE Internal Models:Should you or shouldn’t you?

42. Why use an internal model • Standard models are invariably • Crude • Conservative • Inflexible • An internal model can: • Be designed to reflect your business • Be designed to reflect your reinsurances • Be the core of an ERM programme • Reduce your capital requirement (under QIS4 internal models were 20% lower, will be more under QIS5)

43. Why not model? • Cost • Actuaries are not cheap • A continuing cost: models must be constantly updated and upgraded • Time • Requires buy-in and understanding by ALL senior staff • Heavy documentation requirement • Approval process with regulator may be time-consuming • You may not be regulatory capital constrained • Most large, diversified companies will not by constrained by regulatory capital • BUT rating agencies will also welcome an approved SII capital model as part of a strong Enterprise Risk Management Programme

44. Requirements for an internal model • Use test • The model must be ‘widely used’ and ‘plays an important role in their system of governance’. • Statistical quality standards • Statistical methods used in modelling must be ‘adequate, applicable and relevant’. Data used in modelling must be ‘accurate, complete and appropriate’. • Calibration standards • The model must be able to produce output consistent with defined Solvency Capital Requirements. • Profit and loss attribution • The firm must demonstrate that it regularly reviews causes of profit and loss. The model must be structured to be consistent with this review. • Validation standards • The model and its assumptions must be subject to regular review in light of experience. • Documentation standards • Model design and operational details must be documented including ‘the theory, assumptions and mathematical and empirical basis underlying the internal model’.

45. Internal model options • Full model • Every part of standard formula replaced by a model • The “big bang” approach, bigger companies only? • Partial Model • Review standard calculation to see where biggest problems lie • Selectively replace those element of the calculation that are the most problematic/inaccurate • Eg if Catastrophe risk is a problem, perhaps as you write a larger commercial property portfolio than average, then use broker’s cat modelling to replace that element of the model • BUT if an external model is used for an “internal” model, all the model requirements still apply, eg you need to be able to show why model was selected, its sensitivities and its limitations

46. QIS5 : SOLVENCY II NEARS THE FINISHING LINE ORSA:Implications and issues

47. ORSA: Own Risk and Solvency Assessment • ORSA is the risk management framework for Solvency II • Every firm must carry out a regular assessment of its solvency needs and its compliance with those needs, and submit the results to the supervisor. • Firms must have robust processes for identifying and quantifying risks in a coherent framework. • They must also show that the assessment is used in the firm’s strategic decision making • Clearly the ORSA is an indirect encouragement to develop internal models • One requirement is to demonstrate a measurable set of business objectives • All actions and strategies are judged against these objectives • This includes reinsurance strategy • Solvency II is not just about capital protection, appropriate reinsurance may also be required to support shorter-term objectives

48. QIS5 : SOLVENCY II NEARS THE FINISHING LINE Solvency II and you:Impacts and solutions

49. Solvency II: home truths • Solvency II will be introduced in 2013 • Unless there is a political or economic earthquake • Many companies will now be concerned about regulatory capital for the first time • Particularly smaller, less diversified ones • Many companies will be unprepared • Too few qualified staff • Many regulators will be unprepared • Too few qualified staff

50. Solvency II: potential implications • Growth in demand for reinsurance • Not just catastrophe covers (most already buy to 1 in 200) but may be switch to paid reinstatements for example • Many will find reserve risk is a major issue, growth in demand for Adverse Development Covers? • Increase in mergers and acquisitions • Smaller companies merge to gain diversification benefits • Costs of compliance high for smaller concern • Little scope to introduce internal models, so stuck with punitive standard formula for SCR • Regulatory shopping? • Will all regulators have the same appetite to approve internal models • Will all regulators have the same ability to approve internal models • Will all regulators vet internal models to the same standard?