Quantitative Challenges of Solvency 2.

Bruce Porteous, Standard Life.

Challenges in Quantitative Risk Management for Insurance,ICMS, 14 India Street, Edinburgh.29 November 2007.

Agenda.

Solvency 2 Objectives Recap.

“Summary” of Directive Proposals.

Quantitative Challenges.

Questions.

Solvency 2 Objectives Recap.

Solvency 2. “Solvency 2 should enhance this confidence [in the capacity of the

industry to honour its commitments] by improving risk management and by setting capital requirements that are directly based on the level of risk taken.”

“Within this new system, supervisors will have to co-operate more closely and independently. The possibilities for further integration of the insurance industry largely depend on this supervisory convergence.”

“Solvency 2 is already having a positive effect on the way companies are being run. More emphasis is being put on modern risk management, and I am happy to see that.”

Speech by Commissioner Charlie McCreevy, LIMRA Conference, Warsaw, 15 September 2006.

What are Solvency 2’s Objectives?

• Based on same (Basel 2) principles as FSA reforms:• 3 pillar framework.

• Risk management.

• Market consistent valuation.

• Risk-responsive capital requirements.

• Encouragement of internal models.

• Greater convergence in requirements across EU.

• Deepen the Single Market in insurance.

• More stream-lined supervision of Groups.

Source: FSA.

“Summary” of Directive Proposals.

Solvency 2: Proposed Pillar 1.Key principle is fair values and exit values.

SCR – Draft Directive Text. The Solvency Capital Requirement shall be calibrated so as to ensure that all quantifiable risks to

which an insurance or reinsurance undertaking is exposed are taken into account. With respect to existing business, it shall cover unexpected losses.

It shall correspond to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level of 99.5% over a one-year period.

The Solvency Capital Requirement shall cover at least the following risks:

a) non-life underwriting risk;

b) life underwriting risk;

c) health underwriting risk;

d) market risk;

e) credit risk;

f) operational risk

When calculating the Solvency Capital Requirement, insurance and reinsurance undertakings shall take account of the effect of risk mitigation techniques, provided that credit risk and other risks arising from the use of such techniques are properly reflected in the Solvency Capital Requirement.

Source: Draft Directive, Article 100

Structure for the Calculation of the SCR.Modular Structure

As per QIS3

Internal Model SCR.

Concept subject to great uncertainty.

Expectation that internal model SCR < standard SCR?

Subject to approval by supervisory authorities. Use test. Statistical quality standards. Calibration, validation standards. Documentation standards.

UK ICA is a good starting point. But no UK ICA meets Solvency 2 internal model standards - FSA.

Other.

Capital add ons.

Own risk and solvency assessment.

Group supervision, including diversification benefits and Group support.

Own funds. Tiering. Eligibility constraints.

Quantitative Challenges.

Key Outstanding Issues. Calibration of standard SCR.

Imperative that there is a commercial incentive for internal models. MCR.

Technical provisions. Risk margin. What is risk free?

Surplus funds issue. Germany.

Groups. Diversification benefits. Non EU entities. Group support. Legal issues.

Key Outstanding Issues.

Own funds. Complex?

Interactions with other “big ticket” initiatives.

Questions?