Swiss Solvency Test and Skandia Group Economic Capital at 31 December 2004

1. Swiss Solvency Test and Skandia Group Economic Capital at 31 December 2004 Fredrik Galschiödt For Finansinspektionen, 15 March 2006 Confidential draft. For discussion purposes only. This document is incomplete without the accompanying oral commentary and discussion.

2. Disclaimer • The following material is confidential and not for public disclosure. • Tillinghast has reviewed Skandia's implementation of the Swiss Solvency Test framework (prior to including allowance for operational risk) and has found that the methodology and assumptions used were appropriate and prudent.

3. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

4. European Solvency DevelopmentsBackground • Tillinghast article in December 2004: "Regulatory update on european life insurance: Mark-to-market through the regulatory back door?" SUMMARY [ ]... The UK,Switzerland and the Netherlands have introduced, or are in the process of introducing, market-consistent techniques for valuing assets and liabilities of insurance companies. In our opinion, these models are likely to set the standard for Solvency II and forward looking companies would be well advised to take a close look at these new supervisory rules in preparation for Solvency II. Not only do they have a number of characteristics in common, but they could also be considered current best-practice in risk management and measurement requiring: ■ An assessment of available capital based on market-consistent valuations of assets and liabilities including the financial options and guarantees inherent in much long-term life insurance business; and ■ An assessment of required capital based on the impact on the balance sheet of stress and scenario testing a range of adverse scenarios. • Analysis by Mercer Oliver Wyman in 2005 on behalf of CEA (p 35) shows that SST aligns most completely with the Solvency II key principles put forward by the IAA, the IAIS and the EU Commission

5. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

6. Economic Capital in General • Economic Capital is the capital required to be held within the Skandia Group to protect our customer liabilities from risk events at a given tolerance level • Risk events considered include: • Market risks: Interest Rate, F/X, Equity, Credit • Insurance risks: Mortality, longevity, morbidity, recovery rates, lapses, costs • Operational and legal risk • The tricky part is in the detail of the calculations • Crucial - makes an enormous difference to the results

7. Economic Capital in General • Economic Capital is not a standard concept • In theory Economic Capital should include all risks entailed by the company such as • Market • Insurance • Credit • Operational • Legal • Political • Regulatory • Strategic • Other off-balance sheet items (e.g. Skandia Liv suing SICL) • etc Swiss Solvency Test is the sum of these plus a risk margin. The others are excluded for simplicity and because there are no theoretically sound methods to account for them (it can be argued differently for operational risks). Additionally we have calculated Operational and Legal risk according to Basel II

8. Economic Capital in General • Modern approach is to think about Economic Capital as a cash equivalent • What is this thing worth if I sell it today? • What is this thing worth if I sell it next week? • What is this thing worth if I sell it next week after an equity market crash? • So what is the minimum I need today to survive that market crash? • Discounted cash-flow techniques are widely adopted to estimate these values

9. What strain does Economic Capital have to meet? • Concept is that Economic Capital is needed • to help pay losses arising from the risk event until such time that solvency is secured once more • How soon can solvency be secured once more? • Most insurers, professional advisors, regulators use a 1 year horizon for insurance business • Banks use a variety from 1 day to 1 year depending on segment • Basel I stipulates 10 days for market risks

10. What strain does Economic Capital have to meet? Risk Event Available Risk-bearing Capital Must not be negative! Actually must be sufficient to secure against risk events in later years 1 year

11. What strain does Economic Capital have to meet? Risk Event Available Risk-bearing Capital To be sufficient to secure against risk events in later years. This must exceed required EC at this time. 1 year

12. What strain does Economic Capital have to meet? Risk Event Excess Capital Available Risk-bearing Capital To be sufficient to secure against risk events in later years. This must exceed required EC at this time. REC0 REC1 1 year

13. What strain does Economic Capital have to meet? Risk Event What if REC is larger than available capital after a risk event? Available Risk-bearing Capital REC0 REC1 1 year

14. Risk Event What if REC is larger than available capital after a risk event? Available Risk-bearing Capital Then we need to hedge out more risk until available once again exceeds required capital (and this has implications for how we calculate REC0) REC0 REC1 1 year What strain does Economic Capital have to meet?

15. What strain does Economic Capital have to meet? • The Required Economic Capital, derived according to published Swiss Solvency Test, includes an allowance for the unfavourable scenario of having to hedge out all possible risks to enable a secure run-off of the portfolio • The allowance, referred to as "risk margin", includes an assumed cost for hedging and a cost for running off the portfolio over the following 30+ years

16. What strain does Economic Capital have to meet? The Required Economic Capital is the amount neccessary to withstand the following scenario: • Severe risk occurs this year - Insurance, market, credit and/or operational/legal • During the year, to the maximum extent possible, all remaining risks are hedged to secure run-off of customer promises. (Either voluntarily or as a consequence of intervention by authorities.) • The customer promises are run-off • Closed to new business

17. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

18. For one sample risk event, the Available Risk-bearing Capital dropped from y to yA Risk Event Available Risk-bearing Capital y yA 1 year

19. The Available Risk-bearing Capital is calculated as the excess of the market value of assets over the market value of the liabilities Today After risk event A Available Risk-bearing Capital today Available Risk-bearing Capital after risk event A y yA

20. Many possible risk events • Hence many yA values So how do we combine these results into a single measure? • Economic Capital could be based on... ...summation of the losses due to risk events • But that is too strong – it assumes that all events will occur in the same year ...the worst loss due to a risk event • But that is too weak – it assumes that only one risk can occur in a year, when in fact some risks are correlated

21. Many possible risk events • Therefore, Economic Capital is based on an aggregation of the losses due to risk events allowing for diversification, that is • the likelihood that not all risk events will occur in the same year is taken into account • the outcome from risk events in many years can be considered normal while some are extreme

22. Economic Capital in General • The concept of Economic Capital • Required Economic Capital • Available Risk-Bearing Capital Excess Capital Market & Insurance Risk Available Risk-Bearing Capital Required Economic Capital Credit Risk Operational Risk Risk Margin Today

23. Economic Capital in General • Economic capital assumptions *) Swiss Solvency Test **) Individual Capital Assessment ***) Nordea and peers

24. Economic Capital in General • Risk of ruin - Probability • 1% using risk measure Expected Shortfall corresponds to roughly • 0.3%-0.4% using risk measure Value at Risk • BBB corporate corresponds to 0.6% default rate per annum • AAA corporate corresponds to 0.04% default rate per annum • Source Standard & Poor's* *) The default rate above is the average over the last 15 years. See table 10 in Standard & Poor's "Annual Global Corporate Default Study: Corporate Defaults Poised to Rise in 2005", published January 2005

25. Shaded area = 1% Value at Risk Loss Expected Shortfall Expected shortfall v VaRTime horizon 1 year and a 1% risk of ruin • Expected shortfall* = The average one-in-a-hundred-year loss In other words: The average outcome of the worst 1% scenarios in a year. That is, if you have 1 000 scenarios of the future then Economic Capital is the amount necessary to cover the average outcome of the worst 10 scenarios. • VaR = the amount necessary to cover the 10th worst scenario *) Note that Expected Shortfall is also known as Conditional Tail Expectation or Tail Value at Risk

26. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

27. Swiss Solvency Test in General • Professional development by B&W Deloitte, Ernst & Young, Mercer Oliver Wyman, Tillinghast, 2 professors and Swiss Supervisor (FOPI*) • Principle based approach • Complete Balance Sheet Approach • Market consistent valuation • Including insurance contracts where surplus values may arise • Including a Risk Margin based on a cost of capital approach • Including Reinsurance • Including diversification effects • Excluding Operational, Political, Regulatory and Strategic Risks • (Basel II includes allowance for operational risk) *) Federal Office for Private Insurance (Swiss FSA)

28. The concept is based on the following worst-case scenario: Severe risk occurs this year - Insurance, market and/or credit During the year, to the maximum extent possible, all remaining risks are hedged to secure run-off of customer promises. (Either voluntarily or as a consequence of FOPI intervention.) The customer promises are run-off Closed to new business Target Capital is the sum of: Market and Insurance Risks (Expected Shortfall over 1 year) Credit Risks (Basel II) Risk Margin Swiss Solvency Test - The Concept

29. General Framework • Stochastic models: for ‘normal’ situation where statistical data exists, normality assumption etc. are valid • Scenarios: to supplement stochastic models (e.g. 50% equity drop and thereafter extra 20% surrenders p.a. for 2 years) • To model additional risks • To reduce model risk • To take into account extreme events where model assumptions break down • Aggregation: weighted (quantile-adjusted) average of scenarios with results from stochastic model* * See published paper by Damir Filipovi´c in July 2004: "Ubersicht SST-Standardrahmen fur das Nichtlebengeschäft"

30. General Framework Standard Models or Internal Models Mix of predefined and company specific scenarios SST Concept Model Scenarios Total Balance Sheet Impact Insurance Risks Financial Risks Aggregation Method Credit Risk (Basel II) Risk Margin Target Capital

31. REC = ES[ ΔC] + CR + RM Required Economic Capital (=Target Capital) Risk MarginCovers risk after 1-year time-horizon Expected Shortfall of Change of Risk-Bearing Capital: Captures 1-period market and insurance risk I.e. covers risks during the 1-year time-horizon Credit Risk using Basel II

32. Interest rate sensitivity would be given by the sum of sensitising loans, liabilities, bonds etc Modelling in Practice E.g. 10 MSEK of equity in B/S using 10% sensitivity gives 1 MSEK output. • In practice the calculation is usually performed separately for market and insurance risk to keep it simple. Otherwise the correlation matrix would need to be expanded with all insurance/market correlations. • The example to the right shows the steps to derive an overall variance relating to the specific risk category in question. Balance Sheet sensitivities for the risk factors are calculated: F The sensitivity is normalized: Fn The normalized sensitivity is multiplied with the risk factor volatility resulting in the annual standard deviation: Fn * σ Normalization gives 10 MSEK = 1 MSEK / 10% Correlation between risk factors: FnT∑f Fn σ2 Multiplied by volatility gives annual standard deviation: 20 MSEK = 10 MSEK * 20% Results in a variance for the group of risk factors Vf

33. Assumptions • For Skandia, financial volatilities and correlations are based on RiskMetrics data except for equity volatility which was increased to be in line with SST standard model • Insurance volatilities and correlations are based on data prescribed by FOPI • Main assumptions • Equity volatility 20% (FOPI) • SEK/GBP volatility 8.62% (RiskMetrics) • Surrender volatility 25% (FOPI) • Diversification and correlation assumptions • No correlation between market, insurance and credit risk • Correlation within market risks e.g. SEK and Euro has 0.92 correlation while SEK and GBP has 0.73 • Correlation within insurance risks are zero for those risks applicable to Skandia

34. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

35. Swiss Solvency TestFramework and Principles for life business • Principle based approach • Complete Balance Sheet Approach • Market consistent valuation • Including insurance contracts where surplus values may arise • Including a Risk Margin based on a cost of capital approach • Including Reinsurance • Including diversification effects • Excluding Operational, Political, Regulatory and Strategic Risks • (Basel II includes allowance for operational risk)

36. CEA Basis for Discussion Feb/Mar 2005Framework and Principles for life business • The current basis for discussion* within CEA contains the following: • Principle 1: Market Consistent Total Balance Sheet Approach • Principle 6 and 15: Market Consistent Valuation of UL implies that the liability may be less than face value, i.e. like EV but market value • Principle 10: Include reinsurance • Principle 11: Include diversification effects • CEA principles 5, 6,7 and 8 gives the possibility to use approximations as long as they are prudent. E.g. allowing use of statutory liabilities instead of market consistent if it can be shown to be more prudent. • Thus, the general principles are in line with the SST. • But CEA proposes to include operational risk while the SST does not. • In terms of the standard template the framework at large is the same with the exception of CEA having a correlation matrix for the different risk types (market, insurance, credit and operational) while the SST assumes zero correlation between market and insurance and 100% with credit. *) to be sent to CEIOPS for QIS2

37. CRO Forum and CEASolutions to major issues for Solvency II, 17 February 2006 • Principle based approach • Complete Balance Sheet Approach • Market consistent valuation • Including insurance contracts where surplus values may arise* • Including a Risk Margin based on a cost of capital approach • Including Reinsurance • Including diversification effects • Deviates in general to the SST only in the following areas • Proposes to include Operational Risk according to Basel II whereas the SST excludes Operational Risk* • Proposes Value at Risk at 99.5% as risk measure which is similar to Expected Shortfall 99% but not equivalent *) Additional details can be found in CRO Forum presentation "Principles for Regulatory Admissibility of Internal Models", 10 June 2005

38. IAA, IAIS and EUKey Solvency II principles • Analysis* by Mercer Oliver Wyman in 2005 on behalf of CEA shows that SST aligns most completely with the Solvency II key principles put forward by the IAA, the IAIS and the EU Commission. *) "Solvency Assessment Models Compared" by Mercer Oliver Wyman and the CEA in early 2005

39. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

40. Trafikljuset • ES using 1% probability roughly corresponds VaR using 0.4-0.3% • Assuming normal distribution and 0.5% risk of ruin per annum: • VaR = Quantile(0.5%) * Annual Standard Deviation => Using standard deviation of equity used in Skandia EC 20% • VaR = 2.58 * 20% = 52% • Roughly comparable to Trafikljuset 40% equity drop • Thus Skandia EC can serve as a prudent comparison to Trafikljuset

41. Trafikljuset • Trafikljuset for Skandia happens to show a risk bearing capital and capital at risk in the same magnitude as the Economic Capital approach but it does not reveal the sources of risk appropriately since it is not on a look-through basis. • Deviation to SST and proposed approaches by CEA, CRO Forum, Group Consultatif etc are the following • Only market risks are included • No diversification/correlation effects taken into account except for within interest rates • Rule based rather than principle based • Not based on a look-through basis (i.e. shares in subsidiaries are treated as a stock market investment while the subsidiaries in fact have a completely different risk exposure)

42. TrafikljusetPreliminary Outcome 2005

43. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

44. Solvency II Issues • Market Value of Liabilities - Approach for determining a market value needs to be agreed. MVM based on cost of capital or percentile or something else? • MVM based on cost of capital - What methodology and what cost of capital rate should be used? • Diversification - How should one include diversification and fungibility between subsidiaries in different markets?

45. Economic Capital Issues • How to model the rational strategy for a group • Optimizing structure of a group - branches v subsidiaries, risk and capital transfer agreements • Develop a consistent firm-wide economic model - central model or local model • Allocation of capital - A group wishes to run its subsidiaries as capital efficient as possible and not tie up capital in every jurisdiction • As the models become more complex communication and understanding will become more burdensome

46. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

47. Credit risk • Credit risk capital was derived by using the Basel II standard approach • The standard approach is the most simple one out of three possible methods • According to this method, credit risk capital is 8% of the risk weighted capital • The risk weighted capital is derived using prescribed risk weights, different for different categories of credits, multiplied by the capital at risk

48. Operational and Legal risk • Operational risk capital was derived by using the Basel II basic indicator approach • The basic indicator approach is the most simple one out of three possible methods • According to this method, operational risk capital equals 15% of the average annual positive gross income over the last three years

49. Agenda Slide • Background • Introduction to the concept • Introduction to the calculations • Introduction to the Swiss Solvency Test • Comparison SST, CEA, CRO Forum etc • Trafikljuset • Solvency II/Economic Capital - Issues • Skandia’s Available and Required Economic Capital • Conclusions • Appendices 3 5 17 26 34 39 44 47 62 66

50. Conclusions • Donald Rumsfeld: "...there are things we know, and we know we know them -- the known knowns. There are things we know that we don't know -- the known unknowns. And there are unknown unknowns; the things we do not yet know that we do not know."* • But it does provide a sound way of comparing solvency of insurance companies and we believe that Skandia is strong * Donald Rumsfeld in October 2002, source: United States Department of Defense (http://www.defenselink.mil/transcripts/2002/t10172002_t1017sd.html)