Group Level SST

1. Group Level SST Philipp Keller, Federal Office of Private Insurance Basle, 19 May 2006

2. Contents • Group Solvency Requirements in Switzerland • The Reason for the Choice of the Swiss Approach • Discussion of the Swiss Approach • Summary and Challenges

3. Group Requirements in Switzerland • As of 1 January 2006, all supervised groups and conglomerates in Switzerland need to satisfy risk based capital requirements group level SST • For the group level SST, groups and conglomerates need to use internal models satisfying SST principles • Groups and conglomerates have to have internal models approved by FOPI by 2008 to determine group level SST for year 2008 • FOPI supervises approx. 10 groups and 70 subsidiaries of insurance groups • During 2006 and 2007, FOPI will meet monthly with all groups involved in order to achieve market wide consistency in implementation of SST requirements

4. The Importance of Being Consistent 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 FOPI, consistency between the requirements on a group and on a subsidiary of a group is key • Without consistency, • If requirements for groups and legal entities are inconsistent, then in case of a parent company owning subsidiaries it will experience the situation of having two contradictory capital requirements: One for the group and one for solo solvency • groups will have to develop different models for group level solvency requirements and for solo level requirements for the different subsidiaries. Different models will make embedding within companies questionable • a layer of economically irrelevant arbitrage instruments will be developed to exploit regulatory inconsistencies • Further objectives of FOPI: • Assessing the risk situation of the investment in major legal entities (respectively sub-groups) of a group is essential for competent capital and risk management • Future risk based capital requirements in different jurisdiction will necessitate either the development of many stand-along capital models or – preferably – a group model able to capture capital requirements of solo entities

5. FOPI’s Approach: CRTI A group is defined not only by its legal structure but also by its web of intra-group capital and risk transfer instruments CRTI: Capital and Risk Transfer Instruments Intra-group retrocession, contingent capital issued and received, etc. CRTI Approach: Explicit modeling of all relevant CRTIs and taking into account the legally limited liability structure Fungible capital Legal Entity 3 Parent Company Market Value Margin Legal Entity 1 Legal Entity 2 Group Intra-Group Capital and Risk Transfer Instruments: Intra Group Capital and Risk Transfer Instruments can only be considered if they are legally binding and accepted by the regulators involved • Intra-group Retrocession • Guarantees • Participations • Dividends • Loans • Issuance of surplus notes • securitization of future cash flows / earnings • sale / liquidation of a business

6. Contents • Group Solvency Requirements in Switzerland • The Reason for the Choice of the Swiss Approach • Discussion of the Swiss Approach • Summary and Challenges

7. The Consolidated Approach Group Test: Assumes unrestricted capital transfer between the legal entities of the group even if no formal capital and risk transfer instruments are in place consolidated calculation • For the solo test of a subsidiary of a group to be consistent with a group level consolidated approach, capital flows to and from the group need to be taken into account, even if there are no formal CRTI in place • Group level diversification can only be allocated exogenously to the subsidiary • The consolidated approach might be realistic if the economic situation of a group is good. However, in case of financial distress, the assumptions likely break down Solo Test: Assumes unrestricted capital transfer in case of financial problems in the rest of the group even if no formal capital and risk transfer instruments are in place group risk Formal capital and risk transfer instruments Assumed unrestricted capital transfer

8. The CRTI Approach Group Test: Assumes capital transfer only via formal capital and risk transfer instruments • The CRTI approach for groups is consistent with FOPI‘s solo solvency test: Only formal CRTI are considered, promises by the group to support a subsidiary are not quantified within the solo SST • The CRTI approach requires modeling of (major) legal entities, thereby giving incentives for appropriate capital management according to legal entities economic capital needs • The CRTI approach better captures the options and strategy of a group in case of financial distress than the consolidated model • FOPI decided to choose the CRTI approach for the group solvency test Solo Test: Assume capital transfer only via formal capital and risk transfer instruments Formal capital and risk transfer instruments

9. Contents • Group Solvency Requirements in Switzerland • The Reason for the Choice of the Swiss Approach • Discussion of the Swiss Approach • Summary and Challenges

10. The CRTI Approach in a Nutshell 1 • The CRTI approach is methodologically consistent between the solo and the group level solvency test • For a parent company, the group level solvency requirement equals the solo solvency requirement • Owning a subsidiary is an asset • The value of a subsidiary for the parent company is the economic value (independent of regulatory or accounting conventions the subsidiary is domiciled in) • All relevant formal capital and risk transfer instruments have to be modeled • The risk of a subsidiary for the parent is defined as the potential change of the economic value of the subsidiary within one year • The option of a parent company to let a subsidiary go into run-off is taken into account ( the value of a subsidiary for the parent company is never less than 0 if there are no CRTI)

11. The CRTI Approach in a Nutshell 2 • The parent company is assumed to be able to unlock economic value of a subsidiary by selling it for its economic value • However, remaining fungibility restrictions and liquidity need to be modeled • The group level model needs to be able to quantify the risk of the different legal entities • Simplifications can be acceptable (e.g. sub-consolidation instead of modeling of all legal entities individually) • But the group model needs to be able to map the major sub-groups/legal entities • Calculation of available funds with a view on double-gearing • A parent company benefits endogenously from group level diversification by taking into account the dependency structure between the risks in its subsidiaries and the risks of the parent company • A subsidiary can benefit from group level diversification via taking into account CRTIs between the subsidiary and other legal entities of the group

12. CRTI Approach Properties: Diversification Capital and Risk Transfer Instruments allow downstreaming of group level diversification to subsidiaries With a guarantee from the parent to the subsidiary Without CRTI SCR of the parent is increased due to the risk that the guarantee issued will be invoked SCR of the subsidiary is reduced due to the guarantee of the parent RBC SCR RBC SCR RBC SCR RBC SCR Subsidiary Parent Subsidiary Parent Risk bearing capital of the subsidiary is unchanged since the economic value of the guarantee is offset with the transaction cost RBC of the parent is unchanged since the fee for the guarantee paid by the subsidiary compensates for the economic cost of the guarantee issued The ‚allocation‘ of group level diversification to subsidiaries is not achieved via an arbitrary, exogenous allocation method but endogenously via CRTI. This however only works if CRTI are accepted across jurisdictions. CRTIs are also the responsibility of the subsidiary, and the subsidiary needs to have strategy for dealing with the situation if the CRTIs are revoked by the parent

13. CRTI Approach Properties: Group’s Put Option Subsidiary Parent Subsidiary Parent A A L L A A L L Adverse event impacting the subsidiary’s balance sheet If no CRTI exist between the parent and the subsidiary, the parent can exercise the put option to let the subsidiary go into default Economic value of subsidiary Economic value of the parent = Economic value of own business + economic value of subsidiary The economic value of the subsidiary is negative The CRTI approach takes into account the legally limited liability structure: The model assumes that in case of financial distress, the group will not support a subsidiary if no CRTI are in place

14. CRTI Approach Properties: Risks The risk of a subsidiary for the parent company is emanating from the change in economic value of the subsidiary and – potentially – from CRTI which will be invoked during a time horizon of one year Adverse event impacting the subsidiary’s balance sheet, subsidiary is insolvent Subsidiary Parent A L A L Subsidiary Parent No CRTI in place: The subsidiary is in default, the economic value of the subsidiary for the parent is zero A L A L A L A L An insolvency protection guarantee from the parent to the subsidiary is in place: The subsidiary is in run-off, the value of the subsidiary for the parent is zero and capital is further depleted due to payout of guarantee Economic value of subsidiary as asset of the parent Missing capital of subsidiary is replenished with assets from the parent

15. Contents • Group Solvency Requirements in Switzerland • The Reason for the Choice of the Swiss Approach • Discussion of the Swiss Approach • Summary and Challenges

16. CRTI Approach: Pros and Cons • Advantages of the CRTI Approach • Group level model can (theoretically) be used for different legal entities • Realistic assumptions • Consistency between legal entity and group level requirements • Risks within different legal entities are captured • The model can be changed easily to full-consolidation assumptions (by adding unlimited guarantees between the legal entities of the group) • The model can be implemented gradually, using initially simplified approaches (e.g. sub- consolidations). Then it can be gradually enhanced to take explicitly those subsidiaries into account where regulators require risk-based solvency calculation • Allocation of diversification is endogenous within the model (via capital and risk transfer instruments) rather than exogenous as in the consolidated approach) • Disadvantages of the Approach • Existing groups’ internal models often follow a full consolidation approach • Not as close to the Solvency 1 approach for groups as the consolidated model • More complex to model than consolidated approach, more expensive since group internal capital and risk transfer instruments do not cancel; legal entities need to be mapped within the model • CRTIs need to be formally accepted across jurisdictions

17. Restriction of Capital Mobility Subsidiary Parent Subsidiary Parent A A L L A A L L Adverse event impacting the subsidiary’s balance sheet Assume that the local supervisor of the parent company restricts capital mobility. This causes the default of the subsidiary although the group as a whole could survive without problem if the parent were allowed to inject capital in the subsidiary. The acceptance of CRTI across jurisdictions is key to allow subsidiaries to benefit potentially from being part of a group.

18. Restriction of Capital Mobility [Nationalism] is the last refuge of the scoundrel Samuel Johnson For FOPI, one of the main question for group supervision will be the treatment of the policy holders in different jurisdictions in case of financial distress of a group • If local regulators consider only their own policy holders and restrict capital fungibility in case of financial problems within a group, group diversification is limited and policy holders in other jurisdictions might suffer disproportionately  this situation leads to high premiums and inefficiencies and might even lead to insolvent run-offs of distressed legal entities while other legal entities of the group are still solvent • If local regulators agree on capital flows also in case of financial distress, all policy holders suffer (potentially) equally  this approach allows policy holders to benefit from group diversification and more efficient allocation of capital FOPI strongly supports a harmonized treatment of policy holders, irrespective of their nationality and a harmonization of requirements of regulators