Solvency II –Lessons for India

Solvency II –Lessons for India Dr. R. Kannan Member (Actuary) IRDA Udaipur- 08.01.2011

Solvency II Directive European Commission Solvency I Decision European Council & Parliament Implementation Member states 2001 2011 Decision to Solvency II Answers to Calls for Advice CEIOPS QISI QIS2 QIS3 More QISI Various consultation papers Preparation of solvency II, participation to QIS Respond to consultation papers Insurance industry Timing of Solvency II process Udaipur- 08.01.2011

Changing role of Risk management ? • The insurance industry has undergone a process of de-regulation which enabled them to take more risk and explore competitive edges of the market. • The drive for competitive forces led to fall in premiums which had to be compensated by taking on investment risk. In the life segment unit linked products becoming more popular. • Capital markets have become more volatile. Part could be attributed more efficient and linkage to globalized markets. • Investment strategies have become a more important source of income. This places additional importance on investment strategy as a source of risk. • In late 1990s and early 2000s the number of insurers becoming insolvent grew significant world over especially in Europe. • The difference between bank and an insurance company and hence the risk management principles have to recognize the nature of insurance business: • Cash on hand • Liability estimation • Duration of assets and liabilities Udaipur- 08.01.2011

Background for Sol II • Their novelty compared with the current best practices. • The strategic nature of the problems. • Huge level of investment likely to be required to comply with the coming Solvency II framework. • The European Commission asked CEIOPS to launch a wide consultation process with the industry players. The result: • A first wave of 12 consultation papers was published on 26 March 2009. • A second wave of 24 CPs was published on 2 July 2009. • A third wave of 17 CPs was published on 2 November 2009. • The outcomes from these consultations assisted CEIOPS in issuing final advices to the Commission. • The European Commission published QIS5 technical specifications on 6 July 2010. Udaipur- 08.01.2011

Pillar - I Pillar - II Financial Requirement Supervisory review process Disclosure & Market discipline Valuation of technical provisions and solvency requirements (SCR / MCR) Supervisory powers governance guidelines Disclosure requirements and supervisory reporting Three pillar approach Pillar - III Udaipur- 08.01.2011

Risk Investment risk Non- financial risk Underwriting Risk BusinessRisk Market risk (Incl. ALM) Credit Risk Life Risk Operational Risk NonLife Risk Risk Categories Udaipur- 08.01.2011

Risk Management Risk control Risk financing Risk reduction Safety Control, prevention measures Withdrawal Risk retention Diversification Risk Transfer Hedging Basic forms of Risk Management Udaipur- 08.01.2011

Role of capital • Why capital is required? • Capital is required to absorb extreme unexpected losses caused by various risks. • Capital guarantees long term continuity. Without continuity the insurer could not obtain future profits. • When rating established by the rating agencies they also look at financial aspects of the insurer and the amount of capital. • When their capital falls below certain limits it could have negative consequences for rating. • Capital is also required to protect policyholders’ interest and thus protect the stability of the economic system. Udaipur- 08.01.2011

Guiding Principles The guide is based on six main themes: • Economic balance sheet • Data management • Standard formula (SCR solo and SCR group) • Internal model • Risk governance and supervisory review • Disclosure Udaipur- 08.01.2011

Economic Balance Sheet • In addition to the methods of valuation of the different components of the balance sheet, it is important to highlight an important principle reinforced in the first wave of consultation: • Convergence of the regulatory environment: CEIOPS has chosen a pragmatic approach by defining the economic valuation of the different components of the Solvency II balance sheet according to the IFRS principles. Udaipur- 08.01.2011

Economic Balance Sheet • Although Solvency II and IFRS Phase II contain similar principles, there are a number of important differences in the technical provisions and other elements of insurance company balance sheets. • Predominance of the balance sheet approach in IFRS, Solvency II focuses on defining the valuation principles of assets and liabilities. • the balance sheet approach will ultimately lead insurance companies to adopt new key performance indicators which are more relevant within this new environment. A Solvency II implementation plan, based on a thorough gap analysis, would identify more appropriate measures of the company's performance (or evolution of value over time), e.g. via an embedded value. Udaipur- 08.01.2011

Issues on Economic Capital • Wide variation between statutory liability and economic liability • Various risk parameters--standardization • Diversification effect • Concentration effect • Issues on estimating operational risk • The link between EC and Embedded value Udaipur- 08.01.2011

Technical provisions • The Solvency II framework directive will lead to major changes in the valuation of the balance sheet items compared to the current local GAAP and, in particular, in the valuation of insurance liabilities which will need to be undertaken on a market-consistent basis. • Technical provisions will typically be estimated on a proxy to a market value, i.e., a best-estimate basis allowing for the time value of money supplemented by a risk margin. It will now become important that companies focus on the projection of future cash flows. In projecting cash flows, companies need to bear in mind that: • Cash flows should be estimated taking into account gross amounts recoverable from reinsurance contracts. • Cash flows should account for the full lifetime of existing insurance contracts and reflect policyholder behavior and management actions. Udaipur- 08.01.2011

Technical Provisions • CEIOPS has retained a cost-of-capital approach for the estimation of the risk margin with a rate of at least 6%. • It is important to note that in QIS5, the risk margin is calculated at an undertaking level and not at a line-of-business level. This means that undertakings will enjoy the diversification benefits between lines of business within the risk margin. • Should an undertaking decide to transfer a line of business, the contribution of each line of business to the risk margin can be allocated separately Udaipur- 08.01.2011

Internal Models • The analysis of all measures relating to internal models (or models used for the parameterization of the standard formula) is a central element of the path towards Solvency II. Features of internal model include : • Assumptions for future management actions • Process to be followed for the approval of an internal model • Tests and standards for internal model approval • Partial internal models • Treatment of future premiums • Segmentation for the calculations Udaipur- 08.01.2011

Main challenges for internal models • The need to have the internal model approved before being allowed to use it for regulatory solvency requirements is a major development for the teams working on capital models Udaipur- 08.01.2011

Steps to follow for the completion of an approval application • Based on the experience of developing actuarial models, the documentation for the approval process needs to be produced along with the development and the validation of the model. The documentation would also include information gathered during discussions with the supervisor in the context of the pre-application process. Udaipur- 08.01.2011

Governance and supervisory review • Adequate and operational structure • Clear allocation of tasks and responsibilities • Transparency of the organization • Efficient information systems on all business activities. • Internal control and internal audit are largely defined and required in the current regulatory environment in a similar way to that set out in the Solvency II directive. • Risk management and actuarial functions already exist but are not properly defined; hence there should be some significant changes with Solvency II. Udaipur- 08.01.2011

Governance and supervisory review • The main changes within the Solvency II directive in terms of governance are: • Requirement of formal governance in order to implement efficiently policies decided by the management body. • Requirement of a full system of governance ensuring: • Identification, assessment and management of risks • Efficient communication of information • Reporting of a consolidated view of the risks. Udaipur- 08.01.2011

Risk management and actuarial functions - ambiguous roles • For the risk management function, CEIOPS prescribes (for large companies) the creation of a chief risk officer (CRO) who will be responsible for: • Leading the risk management function • Reporting the risk exposure to the administration and business operation • Maintaining a consolidated view of the risks through the ORSA (own risk and solvency assessment) • CEIOPS recommends that the risk management function has leadership of the internal model in terms of conception, maintenance and management of results. The actuarial function contributes to the implementation of the internal model. Udaipur- 08.01.2011

Risk management and actuarial functions - ambiguous roles • These recommendations do not remove the ambiguities and difficulties of implementation: • CEIOPS defines the actuarial function as the role of controlling and reporting technical provisions by means of an actuarial report: • Coordination and control of the technical provisions valuation • Statement of opinion regarding underwriting and reinsurance policies –the actuarial function should express an opinion independently from any other administration or business operation department. • This is another point where there are ambiguities in the roles of the risk management function and the actuarial function, in particular for the leadership on the best estimate reserves computation in the SCR calculation: • The ownership of the model and the consolidated vision of the risks would mean that the calculation of the SCR (and hence of the best estimate reserves under Solvency II) should be the responsibility of the CRO. This would appear to restrict the role of the actuarial function. Udaipur- 08.01.2011

Own risk and solvency assessment (ORSA) principles • The overall solvency needs taking into account the specific risk profile, approved risk tolerance limits and the business strategy of the undertaking. • The compliance with the capital requirements and with the requirements regarding technical provisions. • The extent to which the risk profile of the undertaking deviates significantly from the assumptions underlying the SCR, calculated with the standard formula or with its partial or full internal model. • The ORSA principles should be applied in a proportionate manner having due regard to the nature, scale and complexity of the activities of the undertaking concerned. Udaipur- 08.01.2011

Lessons from Solvency II exercise for India • Solvency II is unquestionably the most significant regulatory change for the insurance industry that is happening right now and continues to be widely reported in the industry press. We have started the process of estimating economic capital and yet a long way to go for risk mapping and risk reporting. • One benefit of moving the effective start date to 1 Jan 2013 would be to align the rules to the effective financial reporting year for most European insurers. This would make life a bit easier for most firms but the reality remains that firms must be fully compliant from day one and implementation should already have started in all firms. We are working on IFRS and this issue need to be addressed in future. • Solvency II is needed to strengthen the regulatory framework for insurers in Europe and enable both supervisors and firms to move on from the confines of an outdated European regime that stands in the way of the adoption of modern methods and the spread of best practice. Our solvency regime is robust but there is no complacency in examining the alignment with accounting disclosure. Udaipur- 08.01.2011

Lessons from Solvency II exercise for India • Solvency II will fundamentally transform the capital adequacy and risk management regime for the European insurance industry. The requirements for delivering and demonstrating the standards of risk management and governance will be challenging, and especially so for groups that operate in multiple countries. We have already initiated this exercise. • It will require greater disclosure and transparency, together with additional and more frequent reporting. We have already initiated disclosures and this will be strengthened in the light of our experience • it puts robust risk management firmly at the centre of the new regime; insurers will be required to focus on the early identification, quantification and management of the risks that they face, or will face in the future, through the forward-looking Own Risk and Solvency Assessment. We have already developed “early warning system” for life and this needs to be strengthened. Shortly we will be finalizing the guidelines for non-life industry also. Udaipur- 08.01.2011

Lessons from Solvency II exercise for India • One consequence of the market consistent approach to the valuation of liabilities is that there will be no arbitrary prudence in technical provisions. This needs a closer examination. • Solvency II is also very clear that the responsibility for the running of the firm rests firmly on the shoulders of senior management. This means that senior management and the Board must be able to demonstrate they are fully in control of their firm and that they fully understand the risks that the firm is running, or might face in the future. We have already positioned “corporate governance principles” and they need to be strengthened. • Another big shift in the regulatory landscape as a result of Solvency II means that there will be an increased focus on groups and the joint supervision of groups. The supervisory colleges will play an increased role and this will mean an adjustment of the mindsets for supervisors under Solvency II. This is not a pressing issue now, however we are addressing this. Udaipur- 08.01.2011

Lessons from Solvency II exercise for India • Insurers will also need to report more information, more frequently to their supervisors. For example, under the new regime, it is likely that firms will need to report all their individual asset exposures to their supervisor every quarter. This is a big change and the bigger the firm, and the more complex the investment strategy, the more work there will be to get this up and running. We have already moved on this. • It is a fundamental precondition for the proper understanding of risks that they are measured on an objective and consistent basis. It will be a big step forward for Europe to move to a common valuation basis. It is absolutely necessary that the solvency capital requirement (SCR) and the minimum capital requirement (MCR), or internal models – will be based on the Solvency II balance sheet. We have to initiate our own work on internal models. Udaipur- 08.01.2011

Thank you Udaipur- 08.01.2011

Solvency II –Lessons for India