Lessons learned from the crisis: Solvency II and beyond

1. Lessons learned from the crisis: Solvency II and beyond Carlos Montalvo – Secretary General, CEIOPS ASSAL-EU dialogue Mexico 27 April 2009

2. FINANCIAL CRISIS “ The best of prophets of the future is the past “.

3. CEIOPS Contents • Introduction to CEIOPS activities • The current crisis… and CEIOPS role • Lessons for Solvency II • Lessons beyond Solvency II • What about Occupational Pensions?

4. Introduction to CEIOPS activities

5. Members´ Meeting ManagingBoard Chair: Thomas Steffen, Germany ConsultativePanel Solvency II: Financial StabilityCommittee Kajal Vandenput, Belgium Financial RequirementsExpert Group Pauline de Chatillon, France Occupational PensionsCommittee Tony Hobman, United Kingdom Internal Governance,Supervisory Review and Reporting Expert Group Gabriel Bernardino, Portugal Consumer Protection Committee Victor Rod, Luxembourg W o r k i n g G r o u p s Internal ModelsExpert Group Paul Sharma, United Kingdom ConvergenceCommittee Raffaele Capuano, Italy Insurance Groups Supervision Committee Petra Faber-Graw, Germany Review Panel Michel Flamée, Belgium S e c r e t a r i a tSecretary General: Carlos Montalvo CEIOPS Structure

6. example CEIOPS Work Input Procedures Results Balanced views Calls for Advice Meetings, deskwork, braimstormings… Additional mandates Consultation with stakeholders Workable solutions CEIOPS’ own work plan

7. The current Crisis… and CEIOPS role

8. The current crisis From the Subprime crisis in 2007… • US originated, contagion through Financial sector • Banking sector: exposures to mortgage related debt and ABS. Write downs and losses • Role of Rating Agencies • Insurance sector: reduced exposures, positive results, high solvency buffers • Insurance sector, Monoliners: downgrades, exposures, losses.

9. The current crisis … to an unprecedented Global Turmoil in 2008 • Global dimension, contagion from Financial sector to the rest of the Economy. • Banking sector: big losses, share prices fall, rescue plans and default (Lehman). • Insurance sector: smaller exposures, less positive results (even losses), high solvency buffers “used”. AIG. • Insurance sector, Monoliners: downgrades, exposures, losses. End of business model?

10. The current crisis A closer look to Insurance… • Deterioration in Solvency positions • Reduction of profits (upcoming losses?) • Asset side of the business (decreases) • Liability side • Lapse risk • Low interest rates • Cat events in 2008

11. Lessons for Solvency II

12. FINANCIAL CRISIS “ Experience is the name we give to our mistakes “.

13. THE SOLVENCY II PROJECT • Solvency I • Framework dates from the 1970s • ‘Prudent’ valuation of liabilities reflect local accounting practices • Relatively simplistic ‘volume-based’ capital requirements • Asset risk managed by quantitative restrictions rather than capital • No provision for risk review • Solvency II • A risk oriented approach • Unified legislative basis for prudential regulation of insurers & reinsurers • Non-zero failure regime • Three pillar structure, based on Basel II • Link to IASB work • Employs Lamfalussy arrangements

14. CEIOPS Lessons learned for Solvency II • Overall architecture is sound… • …but still needs some refinement. • Need to strengthen Governance and Controls • Need to take a holistic approach to exposures and structures. • Procyclicality has to be dealt with. NEED OF A RISK ORIENTED SYSTEM (SOLVENCY II)

15. Treatment and calibration of risks

16. Credit risk • Definition: the risk of a change in the value due to actual credit losses deviating from expected credit losses due to the failure to meet contractual debt obligations. • Asset side: increased PDs and LGDs (standard formula) • Liability side: credit insurers pricing policies (procyclicality) • Role of Credit Rating Agencies (reliance? Mis-use?) • Alternative Risk Transfer: effective transmission of the risk, and underlying risks. ILS?

17. Liquidity risk • Definition: the risk derived from the lack of sufficient cash or other liquid assets to meet the insurer’s liabilities. • Outside the standard formula… inside the turmoil drivers. Pillar 2 treatment • Lapse risk • AIG case (liquidity constraints due to downgrading) • Liquidity flows from Insurance to Banking LIQUIDITY RISK ALSO IMPACTS INSURANCE SECTOR

18. Market risk • Definition: the risk of changes in values caused by market prices or volatilities of market prices differing from their expected values. • Pillar 1 treatment (quantifiable risks): submodules • Calibration needs refinement (e.g. Derivatives or Equities) • Correlations should be reviewed • Pillar 2: investment policies and plans (internal limits) • Concentration risks (asset and liability side). Internal limits RIGHT CALIBRATIONS AND CORRELATIONS NEEDED

19. Operational risk • Definition: The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. It includes legal risks as well, but this definition (Basel II) excludes business risk, strategic risk or reputational risk. • Pillar 1 and 2 joint treatment • Are there right incentives in force to make undertakings advance in this area? MAIN ROLE IN THE CURRENT CRISIS

20. Stress testing • Assessment of the ability of undertakings to cope with events or changes in the economic conditions to be faced. • Supervisory power under Solvency II (art. 34) • Operating debate should not interfere on the use. BASIC TOOLKIT IN A RISK ORIENTED FRAMEWORK

21. Governance systems • Internal Controls and Risk Management systems have failed during the crisis. • Direct attribution of responsibilities in the Directive. • Remuneration has been an issue to end up where we are now. Long term views needed. SOLVENCY II INCENTIVES SOUND RISK MANAGEMENT

22. Loss absorbing capacity of own funds • Purpose of capital requirements: absorb losses. • Basel II like approach to own funds: Tiers (based upon quality). • What has happened in the Banking sector? • We need to ensure sufficient quality of capital, to guarantee its loss absorbing capacity. • Solvency II text… no limits in Level 1. CAPITAL QUALITY MATTERS… WHEN IT REALLY MATTERS

23. Internal Models • Gradual implementation in Insurers. • Cornerstone of a risk oriented system. • Doubts and critics for banks models… • Quality of data should improve. • Lack of appropriate testing and challenging of models results (reverse testing). • Use test still an issue. PUT INTO QUESTION, BUT STILL VALID… AND NEEDED!

24. Contingent Liabilities (and SPVs) • Significant increase in securitisations (until 2008). Capital incentives? • Pricing issue regarding structured products; Liquidity risk. • Additional risks embedded… and not always effective risk transfer! • Reliance on CRAs. • Transparency problems. Risk Management gaps. • What about ILS? Need of a holistic approach to undertakings

25. Fair Valuation in Inactive Markets • Solvency II: Solvency requirements should be based on an economic valuation of assets and liabilities. • Lack of disclosure, transparency and inappropriate valuation of complex products. • Flexibility within local GAAP to deal with procyclicality. • Valuation not only relevant for accounting reasons, also for Risk Management purposes (overpayments, underestimation of risks…) • Illiquid and non active markets. Don’t buy/sell an asset you cannot understant or value

26. Lessons beyond Solvency II

27. Lessons beyond Solvency II • Insurance Guarantee Schemes • Information to Policyholders • Common reporting formats

28. Occupational Pensions and the Crisis

29. Occupational pensions and the crisis • Short term loss in asset values across the board • Long term horison means long term approach • Need to differentiate between DB and DC

30. Occupational pensions and the crisis - DB • Finding gaps to remedy over time, but retirement benefits, in principle, unaffected • Review of recovery plans balanding the needs of the sponsoring employer and the pension scheme • Avoid procyclical measures

31. Occupational pensions and the crisis - DC • Impact dependent on asset allocation and members’ age • Older members can suffer permanent income loss • Younger workers may benefit • Effective communications essential!

32. MY VIEW OF THE CRISIS… El traje nuevo del Emperador. H. C. Anderssen

33. Thank you carlos.montalvo@ceiops.eu