Casualty Actuaries of Greater New York CAGNY December 2012 Perspectives on Solvency II

1. Ira Robbin, Principal P&C Actuarial Analysts, LLC Casualty Actuaries of Greater New York CAGNYDecember 2012 Perspectives on Solvency II

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4. Agenda • Solvency II Overview • Accounting Changes • Capital Requirements • Standard Formula • Internal Model • Perspectives

5. Overview Sliced Bread or Epic Fail Three Pillars Accounting Changes Technical Provisions

6. Solvency II – Best Thing Since Sliced Bread ! • Institutes uniform accounting rules and solvency regulations across Euro zone • Replaces hodgepodge of outmoded regulations • Moves to principles-based, market-consistent accounting • Superior to rules-based accounting • Promotes use of internal models to determine required capital • Sophisticated models • Better at capturing real risk

7. Solvency II – Epic Fail ! • Overly ambitious- grandiose • Breaks with existing P&C accounting • Requires huge IT effort • Transition/ new scorekeeping may confuse market • Less priority given to policyholder protection • Inadequate understanding of P&C risk • Push to internal models impractical • Imposes burden on regulators • Makes results non-transparent • Very costly • Repeatedly delayed

9. SII Accounting Changes • ‘Market-based’ Valuation • Mark to model • Removal of prudential margins • Explicit discounting • Explicit risk margin • No accrual • Eliminates UEPR • Pre-up front recognition= date obligation is made • Contract boundary • different from UWY and AY • EPIFP - Expected Profits Included in Future Premiums

10. SII P&C Loss Provision • Technical Provisions (Liability) • TP= BE + RM • BE = Best Estimate • RM = Risk Margin • Loss Provision (TP2.47-2.48) • Best Estimate is Discounted Mean of Scenarios • Discounted with loaded risk –free rates • Loaded with illiquidity premium • Duration matched • Risk Margin based on Cost of Capital

11. Risk Margin for Loss Reserves • Risk Margin = discounted Cost of Capital • r = needed additional return = 6.0% • SCR = Solvency Capital Requirement • Cost of capital for each year of runoff

12. Capital Requirement Categories SCR for Unpaid Loss Standard Formula and Internal Models

13. Non-Life Risk Categories • Underwriting risk • Premium risk • Reserve risk • Lapse risk • A new type of P&C risk • Risk pre-up front profits not realized • CAT risk

15. Solvency Capital Requirement for Unpaid Loss • SCR = 99.5% Percentile excess of the mean • One-year Risk • Retrospective look at Best Estimate • Except for discounting, one-year risk would be a measure of how much projected ultimate has changed over one year. • Viewed by many as inadequate for long-tail LOBs

16. Standard Formula or Internal Model • SCR can be computed via SF or IM • IMs expected to lead to reduced SCR • IM must be approved by supervisor • Extensive documentation required • IM algorithms and parameters not specified • IM does not change conceptual calibration • 99.5% excess of mean on one-year risk

17. Standard Formula Coefficients of Variation (CVs) by LOB Aggregation and Calibration

18. Standard Formula – QIS5 • EIOPA ~10 LOBs w Lognormal CVs • Complicated but practical • Premium and Reserve correlation • LOB Correlation matrix • Volume measures • Credit for geographic diversity • Lognormal assumption for aggregation • CAT Capital • “Factor” based - factors applied to premiums • “Scenario” based – factors applied to TIVs

19. SF CVs for Premium and Reserve Risk

20. LOB Reserve CV Calibration – SF • Heterogeneity within an LOB • Size of portfolio and process risk • JWG • “… volatility factors for … reserve risks are typically impacted by the size of the portfolio… the SCR will be too large for the larger portfolios and too small for the smaller ones”. • Diversification across LOBs • How real are observed correlations? • Comparison • Rating agencies used fixed factors • RBC adjusts benchmarks for company experience.

21. Internal Models Use test Statistical quality standards Challenges and concerns

22. Internal Models under SII • SII encourages use of IM instead of SF • “Big Bang” approach • Expected to reduce capital required • Requires regulator approval • Exact form or type of model not specified. • Many companies using giant simulation models. • IM reduces transparency • Firms unlikely to disclose IM details to public

23. IM Documentation – Use Test • Use Test (decision making process) • “ … provide evidence … your internal model is widely used and plays an important role in your decision-making processes …” Source: G2 – FSA Solvency II Internal Model Approval Process document – Pre-application process p8 July 2010 • Does anyone use such a model “widely” in P&C? • How does the SII IM relate to existing CAT, reserving, pricing, and M&A models? • The more complicated it gets, the less likely it can be used for anything other than showing SII compliance.

24. IM Documentation – Stat Quality Standards • Statistical quality standards • confirmation … methods are based upon current … information… • Please identify … differences in the actuarial … techniques used and the underlying assumptions ...” • Why should methods (not parameters?) be based on current information? What does it mean for techniques to be different from assumptions? • Different documentation standard than ASOP 41? • “sufficient clarity…that another actuary qualified in the same practice area could make an objective appraisal…”

25. IM Challenges and Concerns • Cost in € and time • Firms need to hire consultants and new staff • Documentation requirements • Huge (some say excessive) effort • Changes will require justification • Management sign-offs • IM too technical for leaders to understand • IMs reduce transparency • Overwhelming regulatory burden

26. Perspectives RBC Highlights Regulatory considerations Life vs PC Basel II - Banking NAIC Insurance Industry - Negative Comments

27. RBC Required P&C Capital Highlights • Specified Formula • Industry based premium and reserve risk factors • adjusted for company avgvs Industry avg • Reductions for CM and Loss Sensitive business • Square root of sum of squares for aggregating • Investment risk • detailed by asset class and instrument • Non-diversification penalties • assets and insurance risk • No CAT risk • Transparent and accessible to the public

28. Regulatory Considerations • Cost to regulator and the regulated • Ease of compliance • Equal treatment – fairness • Effectiveness – does it work? • Induced motivations and side effects • Transparency and public access • Market confidence and acceptance

29. Approaches to Regulation

30. Life vs PC Risk

31. Basel II – Banking Experience With IMs • Basel II – always more cautious in use of IMs • Internally derived parameters could be approved for use in regulatory algorithm • Limited diversification benefits • 2012 - Further reduced role of IMs • “Risk was not being properly captured by the models…” --Adkins FSA • Floor - Use 80% or 100% of standard approach • Implications for modeling • “ If.. sophisticated modeling means you end up with more capital, … why would banks do this?” “Bye, robot”, Risk July 2012

32. Summary of US Regulator Views • No appetite for switching to SII accounting • Continue to use IMs on limited add-on basis to supplement standard approach in life • Keep focus on protecting policyholders • Support for key components of US system • liquidation approaches in STAT accounting • current US IRIS, RBC capital requirements • Proud of system performance in latest crisis • NAIC is continuing to improve - SMI

33. US Regulator Comments-Leonardi and Vaughn • CT Commissioner Leonardi Aug 2011 • “… well-intended but untested European regulatory changes, known as “Solvency II” … could weaken consumer protections …” • “Solvency II is a much-needed effort to modernize an …outmoded European regulatory regime…” • NAIC CEO Vaughn Nov 2011 • “ Our system is one that we're quite comfortable with… equivalence should be assessed on an outcomes basis. On that basis, we should be found equivalent.”

34. US Regulator Comments - McCarty • NAIC President McCarty Mar 2012, May 2012 • “ We’re not interested in taking our system and putting it through the ..analysis undertaken by… Switzerland, Bermuda and Japan” • “No disrespect to the EU but …at best, they would want to make a comparison to a system [Solvency II] that isn't in place yet. .. It's kind of silly to even consider that an equivalence process."

35. Industry Commentary – ACE Annual Report 2011 – Evan Greenberg on Solvency II • “…simply wrong-headed…overly bureaucratic, process-oriented, costly … • … I am not sure what problem we are trying to solve. • Solvency II-…would do great harm. • a framework of minimum standards ….that results in similar outcomes is far more practical and effective…”

36. Commentary – European Insurance Industry • Insurer groups tell EC to calm down on Solvency II or face ‘dire consequences’ Commercial Risk Europe, April 7, 2011 • “At the very time that Europe is experiencing significant economic, financial and social challenges, … the draft Solvency II implementing measures…risk driving insurers out of their long-term business” Letter from PEIF, CEAA, CFO Forum. … • The group said …publication of QIS5 intensified rather than assuaged their fears …their ‘valid concerns’ have been consistently ignored.

37. Solvency II – Latest Delay • “EU may now delay Solvency II till 2015 following proposal from EU Commissioner Barnier” - Commercial Risk Europe, Sept 20, 2012 • final agreement should wait until the latest study into Solvency II is completed in March 2013. • Chief executive of Hiscox, agreed. "I'd rather it be delayed and made better than have it rammed through and have to be changed later”. • October 2012: plenary vote on Omnibus 2 in the European Parliament was rescheduled from November 2012 to March 2013

38. Solvency II – EIOPA Response to SII Delay • EIOPA chairman Gabriel Bernardino - WRIN TV Oct 5, 2012 • “blames political maneuvering for delays… • “ ‘delay undermining EU credibility’ …” • " ‘still no clear and credible timetable…’ ”

39. Solvency II – BaFin Response to SII Delay • “BaFin considers Solvency 1.5” - Solvency II Wire Nov 15, 2012 • President of BaFin Dr. ElkeKonig “ Having debated something for such a long time and having had the brightest minds of the industry …means you have created a massively complex system which is probably only fully understandable for those that have created it.”

40. Solvency II – Summary Observations • P&C concerns about SII • One-year reserve risk • Discounting with rate including illiquidity premium • CAT risk calculation • Overreliance on IMs • SII delay is being driven by concerns from Life • With exception of CAT, P&C issues not high on radar • US NAIC has staked out position against submitting to SII equivalence process • Some form of SII is probably inevitable • not as inevitable as it was last year

41. Solvency II – Closing Remarks • US actuaries should become familiar with SII • In increasingly interconnected world, need to be aware of developments in EU • Many of the accounting concepts may be adopted in some form in IFRS • Actuaries may be best able to bridge gap between modelers and insurance executives • View EU regulatory change as opportunity • What loopholes in SII can be legally exploited? • What markets will EU insurers abandon/ become more aggressive in due to SII?