Grasping the reins of fundamental change

Ernst & Young’s comments on Solvency II draft directive

Solvency II introduces a risk-based, forward-looking approach that will alter the way insurers are supervised

competitive and innovative global insurance market. In a fundamental change from the current Solvency I framework, the most recent draft directive sets forth an economic, market consistent valuation of assets and liabilities. Ernst & Young believes Solvency II’s wide reaching governance, risk management, control and

for the management of insurers and will reward insurers for managing their businesses well.

Executive summary

In this document, we look at the main components of the latest draft directive. In offering our own observations

in the proposed requirements and key issues that companies need to address. The eight items for discussion include:

Market-consistent Solvency II balance sheet p4

Risk-absorbing elements p5

Own funds p6

The solvency capital requirement p7

The minimum capital requirement p8

Key elements from Pillars II and III p8

Internal models p9

Group requirements p9

Setting the stage for a new regimeIn introducing Solvency II, the main purpose is to achieve transparency on an insurer’s value and risk. This is accomplished by several means through a three-pillar approach that aligns risk measurement, management and disclosure requirements:

Quantitative requirements (Pillar I) define a valuation framework that is consistent with how a deep and liquid market would value assets and liabilities. This allows for comparability and consistency of valuation between insurers in much the same way that the Solvency Capital Requirement (SCR) quantifies the risk embedded within an insurer on a consistent basis.

Sound corporate governance and effective risk and capital management requirements (Pillar II) will enhance transparency within an insurance company on both its own value and

are permanent internal audit and actuarial functions, efficient internal control systems

is to foster a risk culture within insurance companies where there is transparency on

is aligned with effective risk tolerance.

both towards the public and supervisory authorities, will enhance transparency. In particular, the requirements for public disclosure of relevant information on value and risk will allow policyholders, shareholders and other stakeholders to better assess the financial strength of insurers.

The three pillars of Solvency II should not be viewed in isolation, but as a mutually supporting

the topic of information, Pillar I makes sure that it is relevant; Pillar II ensures that it is appropriately acted upon “through the eyes of management”; and Pillar III focuses on how it is disseminated. The ultimate goal is protecting policyholders, creating a competitive advantage

and allocating the capital resources of European Union insurers.

risk and valuation. However, key components of Solvency II, as currently drafted, show certain inconsistencies. While inconsistencies can be

give rise to arbitrary and unequal treatment of insurers by supervisors who have different and

Comments on achieving consistency

consistent as possible. This also applies to the methodological aspects of Solvency II, where

through implementation measures or ad hoc decisions by the supervisory authorities.

Solvency II should strive to remain as far removed as possible from arbitrary limits on

In many cases, risks are better dealt with

management than by regulatory limitations. If limits are introduced, it should be clearly stated that they are a function of the model and risk management framework of an insurer.

Consistency is a key issue in the SCR, which is determined by the value at risk of the change of own funds over a one-year time horizon on a

directive concerned with the SCR calculation can elaborate on, but should not contradict,

articles state requirements for the treatment of balance sheet items (e.g., for subordinated liabilities) which are not consistent with the

the risk-absorbing attributes of elements such

liabilities reduce the SCR. While subordinated loans, surplus funds and ancillary own funds are added in the assessment of own funds, limitations in the shock-absorbing attributes are not consistently considered.

3 Grasping the reins of fundamental change

Market-consistent Solvency II balance sheet

available economic solvency capital (or own funds) and how risks are measured.

of own funds over one year—meaning that the balance sheet also determines the SCR.

balance sheet, and highlights two items: assets

knowledgeable willing parties in an arm’s length transaction. This corresponds to observable market prices for assets that are traded in a deep and liquid market. For other assets, the valuation is more or less mark-to-model, depending on the relevancy of observable market prices. Liabilities, on the other hand, are valued at the amount for which they could be transferred or settled between knowledgeable willing parties in an arm’s length transaction. It is important to note that a company’s credit standing cannot be taken into account in determining the liabilities.

Market-consistent value of insurance liabilitiesThe focus of our discussion centers on insurance liabilities. Where no deep and liquid

based on current and credible information,

be incurred in servicing the liabilities. This

contractual options, but also other payments to

discretionary bonuses. It is important to take into account whether or not these payments are contractually guaranteed.

When viewing policyholder behavior, assumptions need to be based on realistic, current and credible information. The impact

should also be considered. For instance, if it can

valuation of the liabilities.

settlement value of insurance liabilities by a market consistent valuation, which comprises

insurance liability into two components: one that can be replicated with deeply traded

be replicated, the market consistent value is simply the market value of the replicating

if the insurer invests its assets in the replicating

be replicated gives rise to risks that cannot be hedged and must be covered by an additional risk margin. In summary, the market consistent value of the insurance liabilities is the market value of the replicating portfolio, plus the risk margin.

The risk margin is calculated using the cost

for providing an amount of eligible own funds equal to the SCR over the entire lifetime of the liabilities. The cost of capital rate is the same for all insurers. Therefore, the risk margin

regulatory capital required to support risks within the insurance liabilities that cannot be hedged.

Comments on market-consistent value of insurance liabilities

market consistent value of liabilities as either the best estimate of insurance liabilities, plus the risk margin; or in the case where the future

issue for many P&C liabilities. When there are no substantial embedded options and liability cash

factors, the portfolio consists of government

Ownfunds

Excessownfunds

Reduction of SCR due to shock absorbing elements

Solvencycapital

requirement

Best estimate

Other liability

Risk margin

Surplus funds

Subordinatedloans

Shareholder’sequity

Assets Liabilities

Source: Ernst & Young

(or own funds) and how risks are measured.

4Ernst & Young comments on Solvency II draft directive

Figure 1

replicating portfolio is the best estimate.

In other instances, the decomposition into a best-estimate and a risk margin will be less straightforward. Depending on the replicating portfolio used, it might not be possible to arrive at a best estimate, since the market value of the replicating portfolio already contains part of the risk margin. In article 75 paragraph 4 of the draft directive, it is indicated that no separate risk margin needs to be calculated for insurance obligations that can be fully replicated by

consistent value of insurance liabilities as the sum of the market value of the replicating portfolio and the risk margin for the remaining

In this special case then, the market value would be given as the sum of the present value of the

risk-free rate) and the risk margin.

Whatever the direction, it is important to

the replicating portfolio.

In addition, as stated in the draft directive, the risk margin has to be determined for each

homogeneous risk group. This requires either a stand-alone calculation of an SCR for each risk group or the allocation of the total SCR to different risk groups. The separate calculation of the risk margin for each risk group makes sense if transferred to a third party. If the insurer’s entire portfolio were transferred to a third party, the risk margin would be determined on the total portfolio only.

The calculation of the risk margin for separate

SCR associated with each homogeneous group has to be determined. On the other hand, insurers are faced with issues like allocation of

when they are pricing their products according

principles to meet the Solvency II requirements

Risk-absorbing elementsInsurance liabilities may include certain components that absorb shocks in adverse

shock absorbance capacity leads to a reduction of the SCR. Certain balance sheet elements have the ability to buffer insurance company

Source: Ernst & Young

Figure 2

5 Grasping the reins of fundamental change

The insurer may be able to cease paying coupons of hybrid debt if it is close to insolvency

Discretionary policyholder benefit liabilities

cover losses in certain situations

Surplus funds, where presented as liabilities, may be used to cover losses

treatments for various balance sheet elements:

The SCR can take into account the loss-

deferments and discretionary policyholder benefits

Under certain conditions, surplus funds may not be considered as insurance and

these surplus funds may be used to cover potential losses

Subordinated liabilities are taken into account as basic own fund elements, a treatment which assumes that the full amount of the subordinated liabilities will be loss-absorbing

Conceptually, risk-absorbing elements and own funds like surplus funds, ancillary funds and subordinated loans should be treated equally. No matter what the case, all or part of the liabilities can be used to buffer risks in

deteriorate over a one-year time horizon, all of the above elements reduce the SCR. The

of the different elements. For instance, the loss-absorbing capacity of subordinated debt is

particular, how deeply it is subordinated and how

or stopping payment of the coupons. One also needs to consider whether such an action would not trigger an insolvency.

Comments on risk-absorbing elements: comparability and realitiesErnst & Young believes that it is important that the Solvency II directives are consistent in treating liabilities that have loss-absorbing

capacity. It is essential that the amount of loss-

relevant measures.

While conceptually the loss-absorbency should

to include certain items like surplus funds in the amount of own funds available. Ernst & Young thinks that no matter what the approach, two key aims of Solvency II should be considered:

Comparability: Whatever approaches different insurers use, they must reflect the loss-absorbency of these elements; the net effect to the solvency ratios should be neutral.

Realities: The loss-absorbency should be reflected realistically. This might entail cash flows modeling of these elements, taking into account the future projected financial state of the insurer, or it might necessitate the use of partial internal models. However, either disregarding or overstating the loss-absorbency of these elements would not result in a realistic picture of the actual financial position.

Own fundsIn a discussion of own funds, there are two central topics: the balance and off-balance sheet items and shareholder value. Own funds

to an insurer to buffer risks emanating during the time horizon considered by Solvency II.

criteria to cover Minimum Capital Requirement

eligible. They are assigned to different tiers: Tier 1 items have the highest ability to absorb losses; Tier 2 and Tier 3 items have a lower ability to buffer risks. The grouping into tiers is

loss-absorbency, permanence, perpetuality and absence of servicing costs.

Tier system challengesOwn funds are split into on-balance sheet items (basic own funds) and off-balance sheet items (ancillary own funds). Basic own funds consist

taking into account own shares that are directly held by the insurer) over the market consistent

value of insurance liabilities and subordinated

other than basic own funds which can be called up to absorb losses (e.g., unpaid share capital, letters of credit or other commitments

limits on how much of basic and own funds can be covered by Tier 2 and Tier 3 elements.

Insurers will be required to group their on- and off-balance sheet items into the different tiers according to a list supplied by the European

directive). If an own fund item is not on the list, the insurer has to classify that item according

further divide own fund items into subtiers if that is necessary to ensure the overall quality of own funds and cross-sector consistency

Comments on tier system challengesIn the actual implementation of Solvency II, the consistent assignment of own fund items to tiers or subtiers will be a major task. The current Solvency I ratios in Europe are hard to compare between insurers in diverse jurisdictions not because the Solvency I capital requirements are calculated differently, but because there

items (for Solvency I) are eligible and which are not. To decide whether an own fund item

Tier 1, 2 or 3 elements will be a challenge.

In effect, the tier system will inherit from Solvency I limits for investment and capital management possibilities of insurers. Ernst & Young believes that it might be preferable in

and capital management requirements. Only in those cases where insurers do not have an adequate risk and capital management

(and thus cannot measure the actual shock absorbance capacity of these instruments), should the limit come into play. For instance, the nonpermanence of a capital instrument (e.g., of a hybrid loan or a guarantee received) could be dealt with by requiring the insurer to have a strategy of how to replace the instrument or—if that were not possible—of handling the situation

6Ernst & Young comments on Solvency II draft directive

incentives for insurers to manage their business beyond the one-year time horizon on which the SCR of Solvency II is based.

Own funds and shareholder value

Solvency II balance sheet is an economic balance sheet, but the own funds do not represent the tangible shareholder value or the (market consistent) embedded value. Figure 3 outlines the main differences and lends itself to some observations.

Comments on own funds and shareholder value

own funds minus SCR) is not necessarily fully attributable to shareholders. It is possible that policyholders’ dividends from surplus funds, redemptions to subordinated loans or cancellations of guarantees and other ancillary funds need to be completed before funds can be distributed to shareholders.

On the other hand, own fund instruments like subordinated loans, surplus funds, etc. will add value for the shareholder because they may:

Reduce frictional costs since interest and policyholders’ dividend payments are often

Create an “optional” value for the shareholder, because while the payoffs of such instruments are generally capped, they are fully at risk under stressed circumstances.

Reduce cost of capital, since the market yield of the other own fund instruments under review may be lower than the cost of shareholders’ equity.

To summarize, in order to reconcile the Solvency II balance sheet to an economic balance sheet based upon Market Consistent Embedded Value (MCEV), the shareholders’ share in own funds needs to be carved out from total own funds.

The solvency capital requirementThe SCR is a buffer for market, credit, operational, non-life underwriting, life

underwriting and health underwriting risk emanating during a time horizon of one year. It is set at such a value that it is able to buffer the largest yearly loss that occurs with a probability higher than 0.5%, or, generally speaking, a one in 200 year event.

The calculation of the SCR can take into account risk mitigation techniques (e.g., business ceded to reinsurers or management actions that are

that also credit and other risks associated with these measures are taken into account.

Assumptions and approachesSince the purpose of the SCR is to buffer the risks emanating during a one-year time horizon,

as the possibility that the own funds change during that period. The value of own funds

value of insurance liabilities.

adapt it by using partial internal models or use a full internal model to calculate the SCR. The supervisory authority can require an insurer to use an internal model for the SCR calculation if the standard formula does not

submodules for market, credit, life, P&C and health insurance risks. The required capitals for the different risks are then aggregated using

SCR. Operational risk can be added to that

Comments about assumptions and approachesIn our opinion, the framework directive could

loss distributions. The Solvency II draft directive

basic own funds of an insurance or reinsurance

99.5% over a one-year period. This does not mean that the modeling is restricted to that time horizon. It requires a comprehensive estimation of the potential change in the

Req

uir

ed s

olv

ency

Ancillary funds

Shareholders’ funds

Subordinated loan

Surplus funds

Source: Ernst & Young

Figure 3

7 Grasping the reins of fundamental change

stressed circumstances, including all embedded options and guarantees. The latter must be viewed over the total contract period.

If an insurer would like to simplify the calculation, then an approach from the current draft directive might be used. However, this

and only be allowed with the approval of the supervisory authority.

different subrisks implies strong assumptions

they assume that the distributions are part of the Elliptical family. While this assumption

necessary for a standard formula, it is important to keep in mind that for many insurers, their

different distribution law. In addition, the assumption used in the standard formula fails to take into account the tail dependency of different risks (i.e., the fact that in case of large losses, dependencies tend to increase). It is likely that for internal models supervisors will require more realistic assumptions on the dependencies of risk. There is always the danger that for some insurers, an internal model will lead to a substantially higher capital requirement than the standard formula.

The minimum capital requirementThe MCR is calibrated to a level that corresponds to value at risk, calculated on a

For many insurers, this corresponds to about one-third to one-half of the SCR. MCR is at the minimum EUR 1 Mio for nonlife companies and EUR 2 Mio for life companies. While SCR is calculated annually, the MCR has to be calculated and reported to the supervisory

the MCR calculation method is not yet clearly

own funds falling below the MCR will trigger strong supervisory actions, in which case, the MCR calculation should be unambiguous.

Comments about the minimum capital requirementErnst & Young believes that the level of the MCR should follow from its intended function. When an insurer’s level of capital drops below the MCR, it will not be allowed to operate. Therefore, the MCR must supply the necessary capital to ensure that administrative and legal costs associated with the withdrawal of license are covered. It is not evident that such frictional costs are linked to the SCR, either via

in the draft directives.

Since the difference between MCR and SCR can be covered by parental support for subsidiaries

The closer MCR is to SCR, the less group

The requirement to determine the MCR on a quarterly basis has far reaching consequences.

necessitate the calculation of a full or partial SCR. In any case, the test on capital adequacy against the MCR might demand the quarterly calculation of insurance liabilities. In particular for life insurers, where liabilities are often tightly

will require a recalculation of all embedded options and guarantees on a quarterly basis. For this to be possible, the insurers’ information systems and data warehouses need to complete the necessary calculations and audits in a timely manner. The recommendation is to not rely on

intervention.

Key elements from Pillars II and IIIMarket disciplineFostering market discipline through public disclosure is perhaps the most important

precondition for the functioning of market forces, it will allow all stakeholders to base their decisions on relevant data regarding the

based on Solvency I could be considered

irrelevant or even misleading. Within Solvency II, transparent insight in developments of value and risk will be relevant and provide a good indication of an insurer’s economic strength. In addition, the requirement to publish the valuation basis, sensitivities to risks and the amount and quality of own funds will allow a comparison and minimize the danger of regulatory arbitrage.

publish a Report on Solvency and Financial Condition. This report is subject to approval by the administrative or management body of the insurer and is issued only after that approval. This requires senior management to take responsibility for the report and its content.

The reporting requirements are far reaching and include descriptions of the SCR, MCR, capital management, and structure, amount and quality of own funds. They also address:

Business and overall performance

Governance and an assessment of its

Sensitivity and mitigation employed for each category of risk

The valuation basis for assets and liabilities

Main differences between current internal models and the standard formula

Reasons for noncompliance with the MCR and SCR during the reporting period

If there are material changes during the

information disclosed, insurers have to provide

apply if a company is noticeably noncompliant with the SCR and unable to submit a viable recovery plan to the supervisory authority within two months or noncompliant with the MCR and unable to submit a viable recovery plan to the supervisory authority within one month. In these cases, the supervisory authority will require an immediate disclosure of such noncompliance, including the amounts, reasons and the remedial actions to be taken.

the partial internal models or use a full internal model to calculate the SCR.

8Ernst & Young comments on Solvency II draft directive

Internal models

model for the calculation of the SCR if it is approved by the supervisory authority. For the approval, the company needs to show that it meets the use test, as well as statistical quality, calibration, validation and documentation standards. The supervisory authority needs

approve the model.

If the standard formula is not appropriate for a

authority can require the insurer to use an internal model for the calculation of the SCR. If a company obtains the approval to use a partial or full internal model, it has to estimate the SCR determined in accordance with the standard formula for two years.

model can also use a partial internal model. This would constitute either replacing one or more risk or submodules of the Basic Solvency Capital Requirement, a model for operational risk or a

loss-absorbing capacity of technical provisions

Once a company has obtained approval to use a partial internal model, it cannot revert to the

supervisory authority. In this way, the opportunity for cherry picking is minimized. However, if the company does not satisfy the requirements for the use of a partial internal model, the company needs to submit a plan to the supervisory authority on how to restore compliance within a reasonable time (or show that the effects of its non-compliance are immaterial). If the company fails to implement the plan, the supervisory authority can then revoke permission to use the internal model and the insurer has to revert to using the standard formula.

If a company uses a model from a third party, all the requirements for an internal model developed in-house still hold. While a company can use a partial internal model, the supervisory

scope of the model over time.

Comments about internal models: need to start the process nowThe supervisory authority has to decide whether or not to approve an internal model

in Switzerland, where internal models have to be approved by the supervisory authority have shown that this supervisory assessment

or reinsurers) is a multi-year process. It can

Solvency II, a rather large number of insurers will be required or choose to use their own internal models. It will be important for these insurers to start the model approval process in a timely manner before 2012 and to enter into a formal or informal dialogue with the relevant supervisory authorities as soon as possible.

In reality, most insurers will use at least partial

draft directives, an internal model can be used to calculate the SCR. However, the valuation of many assets and liabilities, in particular those that are not traded in a deep and liquid market, is done through models. The requirement for a market-consistent valuation will necessitate the use of more sophisticated valuation models than many insurers have used in the past.

Group requirementsThe approach to group supervision is one of the major changes of Solvency II. In contrast to the old Solvency I framework, group supervision is not an adjunct of solo supervision, but will

Young has made additional comments on the Solvency II approach to group supervision in the

Solvency II for Insurance Groups.

For Solvency II, a group supervisor will be appointed for insurance groups and will have both coordinating and decision making powers. The group supervisor will have primary responsibility for group solvency, intragroup transactions, risk concentrations, risk management and internal control. These responsibilities will involve cooperation,

9 Grasping the reins of fundamental change

consultation and building strong relationships with local supervisors. There are new provisions that require all supervisors to share relevant information and to consult with each other regarding important decisions.

Normally, group supervision should be undertaken only at the top European Union level. However, after consultation with the group supervisor and the insurance group, a local supervisor can supervise the subgroup domiciled in the local supervisor’s jurisdiction. The method of calculating the group solvency requirement is binding to the local supervisor. That means, that if an insurance group has received permission to use an internal model for determining its solvency requirements, the local supervisor can then not insist on another method of calculating the solvency requirement on a national level. However, if the internal

require a capital add-on.

of a larger group that is not domiciled in the European Union (EU). In that case, the group supervisor can assess whether the supervisory regime in the non-EU jurisdiction is at least equivalent to the Solvency II regime. If that is the case, the calculation can take into account the own fund and SCR calculations of that supervisory system. If the supervisory system is not seen as equivalent, then a full Solvency

made by the subgroup domiciled in the EU.

To verify the prudential equivalence of a non-EU

that is also politically contentious. Supervisory systems can differ substantially while still offering similar protection to policyholders.

To better understand the process, it should be noted that there are two methods for calculating group solvency:

consolidation-based method

and aggregation method

In method 1, the group SCR is calculated based on the consolidated balance sheet of the group. It has to be at least the sum of the parent company’s MCR and the separate MCR of each subsidiary or insurers in which the group holds participation. In method 2, the group SCR is the sum of the parent company’s SCR and the SCR of the subsidiary or insurers in which the group has participation.

To determine own funds, irrespective of whether method 1 or 2 is used, the double-use of eligible own funds and the intragroup creation of capital has to be eliminated.

asset that is used by the:

Participating insurer to cover the SCR of a related insurer (e.g., a subsidiary)

Related insurers (e.g., subsidiaries) to cover their SCR

Related insurers to cover the SCR of the participating company

In addition, all own funds eligible for covering

between different legal entities of the group

holding company, then the calculation has to be done at the holding company level.

Of great importance is the fact that subsidiaries of insurance groups can take into account support received from the parent company. The decision whether to allow either an increase in a subsidiary’s own fund eligible to cover SCR or to decrease the SCR has to be taken by the group supervisor in consultation with all supervisory authorities concerned. The permission can only be given if:

The group support is legally binding, i.e., eligible own funds will be transferred when necessary

The risk management and internal control processes of the parent company cover the subsidiary

The group can ask for permission to use group support to cover all or part of the difference between the MCR and the SCR of

its subsidiaries. Such group support would be treated as an ancillary own fund item. It has the form of a declaration to the group supervisor and has to be a legally binding document constituting a commitment to transfer eligible own funds. Permission to use declarations of group support to cover part of a subsidiary’s capital can only be given if the

funds could actually be transferred if necessary.

cover its SCR, the supervisory authority can call on the parent company to increase its group support such that SCR is covered again.

Comments about group requirements: diversification and flexibilityThe Solvency II option to take into account group support allows a group to move its structure from a subsidiary to a branch structure. The primary difference between having a subsidiary versus a branch is that, under the subsidiary structure, the group has the option to let the subsidiary go into run-off. Its value for the group – if there are no guarantees or other contractual obligation—can not drop below zero.

It is likely that some groups will choose

other groups might prefer to keep a subsidiary structure in place. This allows a group to

catastrophic events, these groups would have

while letting some subsidiaries go into run-

disadvantage of making the group more brittle in the sense that a large loss in a legal entity will have repercussions throughout the group and a ring-fencing of the losses will no longer be possible.

10Ernst & Young comments on Solvency II draft directive

Ernst & Young

About Ernst & Young

services. Worldwide, our 130,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve potential.

For more information, please visit www.ey.com.

Ernst & Young refers to the global organization of member firms of Ernst & Young Global

Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK

company limited by guarantee, does not provide services to clients.

www.ey.com/solvencyii

© 2008 EYGM Limited.

EYG No. EG0022

About Ernst & Young’s Global Insurance Center

issues that challenge their risk management approaches, operations and financial reporting practices. Ernst & Young’s Global Insurance Center brings together a worldwide team of professionals to help you achieve your

trends, identify the implications and develop points of view on relevant industry issues. Ultimately it enables us to help you meet your goals and compete more effectively. It’s how Ernst & Young makes a difference.