5 kpmg

Reducing Uncertainty, Creating Values

Leveraging Actuarial Insight: Solvency II and You

23 September 2011 / Herb Desson

Solvency II - background

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Solvency II has a long history

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Began as an effort to quantify risk instead of relying on “rules of

___thumb” and unquantified conservatism

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Initial efforts were in the US 20 years ago: • Risk Based Capital was discussed, but not implemented • Dynamic Financial Analysis stated to be discussed – now called Enterprise Risk Management

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Solvency II - background

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Solvency II has been discussed in Europe for about 10 years

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Initially was supposed to be implemented in 2005 and has

___been implemented “next year” every year since

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A major impediment has been that every time they test the

___effect of implementing the proposed standards several big ___companies appear to have problems.

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Solvency II: a three pillar approach Three-pillar approach – solo and group Pillar 1 Quantitative capital requirements ■ Market-consistent valuation ■ Own funds ■ Economic risk based capital requirements – Minimum (MCR)

Pillar 2 Qualitative supervisory review

Pillar 3 Market discipline

■ Internal control and risk management

■ Transparency

■ Required functions

■ Disclosure

■ Supervisory review

■ Solvency and financial condition report (SFCR)

■ Capital add-ons

– Solvency (SCR)

Own risk and solvency assessment (ORSA)

Market-consistent valuation Validation of internal models

New focus for supervisors Maximum level of harmonisation ‘Use test’

More pressure from capital markets More pressure from rating agencies

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

Solvency II is all encompassing Financial and Strategic Objectives

Core Business Processes

ORSA

Risk management

Markets and Competition Internal control

Governance Every pillar involved Fit and Proper Propositions and Brands

Internal audit Actuarial function

Operational Infrastructure and Technology

Organisation Structure, Governance and Risk Controls

Outsourcing People and Culture

Clients and Distribution

Measures and Incentives

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

Understanding the ORSA requirements The UK FSA defines the ORSA as: “the name given to the entirety of processes and procedures employed by a (re)insurance undertaking to identify, assess, monitor, manage and report the short and long term risks it faces or may face and to determine the own funds necessary to ensure that the undertaking’s overall solvency needs are met at all times”

■ The new Solvency II and IAIS requirements will require fundamentally firms to understand how much capital they think the need to adequately meet their obligations.

Return

■ Insurers will also need to demonstrate that they have met their regulatory requirements over the year and to what process they have used to ensure such requirements have been met.

Capital, performance and risk management

■ Other significant issues which firms need to ensure is – do they have the right SCR? ■ Can they meet the capital requirements in the future?

■ Have they involved the right people internally to undertake this assessment?

Risk

Solvency

■ When and how often do ORSA assessments need to be undertaken? © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

Capital

Managing the ORSA components 1st Line Business Processes Risk identification

Business processes

Risk monitoring

Technical provisions

Risk assessment

Feedback loop

Forward looking assessment Stress and scenario testing

Strategic planning

Standard formula SCR

Risk control

Internal model SCR

Risk reporting

Solvency monitoring

Identify areas of weaknesses in business processes supporting risk and capital assessment

Own view of capital

Business planning

Strategy

Business environment

Determine internal view of capital requirements now and the future

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

Solvency II - background

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Solvency Capital Ratio – 0.5% chance of being bankrupt in 1 year

• • • •

Minimum Capital Ratio 15% chance of being bankrupt in 1 year Own Risk and Solvency Assessment (ORSA) All Calculations consider cash flows and time value of money Key innovation of Solvency II and ORSA is looking carefully at variability of results

•

Point estimate is no longer sufficient

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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How useful is the Solvency Capital Ratio?

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Solvency Capital Ratio (SCR) is 0.5% chance of bankruptcy in 1 year.

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Assuming independence that means :

• • • •

5 years - 2.5% 10 years - 5% 50 years - 22% 100 years - 39%

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components

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Reserve Risk

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Underwriting Risk

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Market (Asset) Risk

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Operations Risk

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Correlations

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Simulation

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Critical Paths

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components Reserve Risk

• Determine mean and standard deviation of reserves by line • Can use Mack or Bootstrapping from Chain Ladder library of R • Select distribution – lognormal is common (and never negative)

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components Underwriting Risk

• The risk in the unearned premium • Select mean losses (loss ratio) by line and standard deviation • Should be consistent with reserve risk selections • Select distribution – lognormal is common (and never negative) • Catastrophe Risk • Change in premium • Reinsurance © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components Market (Asset) Risk

• The risk in value of assets and the amount of investment income • • • • • •

Interest Rate risk Reinvestment risk Equity risk Foreign Exchange risk Liquidity risk Concentration risk

• Select distributions, mean and standard deviation for each component

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components Operations Risk

• Risk that arise from operating the business • • • • •

Fraud Exceeding underwriting authority Rogue trader Industrial espionage Business interruption due to riot, flood, tsunami, etc.

• Select distributions, mean and standard deviation for each component

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components Correlations

• Most risks have significant correlations • • • • •

Interest rate risk and claim severity Claim severity between lines Reserve risk and underwriting risk Equity risk and interest rate risk Investment yield and bond value

• Correlation matrices add greatly to the complexity of simulations and the computing power required

• Sign of the correlation is more important than the amount − e.g., bond value should be negatively correlated with interest rates © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components Simulation

• ORSA is too complex for analytical solutions so must be simulated • Should incorporate conclusions from reserve, underwriting and market risk analysis as well as correlations

• Outputs should be key financial statement parameters by percentile rankings, e.g., percentiles of shareholders equity

• Usually too complex for a spreadsheet, so needs an programming tool or language

• Based on transformation of uniform random variables over many iterations – usually need at least 10,000 iterations to give reliable results

− e.g., at the 99.5% level need 6,000 iterations to get a sample of 30 in the tail © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Outline of ORSA components Critical paths • Most companies are not significantly impaired by a single event or bad results in one line of business – basic diversification should ensure it

• A combination of events is usually what causes a big problem • The simulation results can be used to find the combinations or events that cause serious problems (or opportunities)

• Critical paths are those combinations of events over time that lead to unusual results

• Identifying these combinations can greatly reduce uncertainty and create

value

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Tools Many different tools available

Dynamo – developed by Pinnacle Actuarial Consulting in Excel in the early 90’s

RAT – developed by Arium in the UK

Obsolete now, but free still available and useful for learning

Useful for understanding relationships, but not stochastic

Igloo – developed by EMB

Widely used in the US and UK

Risk Explorer – Developed by URS

R – an open source programming language

Popular with universities in many areas – not just insurance

Excellent technical support

A cool tool

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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R A

general use statistical programming language

Actuarial

Chain

libraries available

Ladder library

− Chain Ladder , Cape Cod Methods − Mack and Bootstrapping volatility analysis Easy

to use simulation functions

Available

free from http://www.r-project.org/

© 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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R – a simple simulation example (1 year, 1 line,

no correlation)

iterations <- 100 assets <- 100 equity <- 50 liabilities <- assets - equity # premium_mean <- 100 premium_standard_deviation <- 10 loss_ratio_mean <- .6 loss_ratio_standard_deviation <- .06 investment_income_rate_mean <- .05 investment_income_rate_standard_deviation <- .005 expenses_mean <- .4 expenses_standard_deviation <- .04 # premium <-rnorm(iterations, premium_mean, premium_standard_deviation) loss_ratio <- rnorm(iterations, loss_ratio_mean, loss_ratio_standard_deviation) investment_yield <- rnorm(iterations, investment_income_rate_mean, investment_income_rate_standard_deviation) expenses <- rnorm(iterations, expenses_mean, expenses_standard_deviation) * premium losses <- premium * loss_ratio underwriting_result <- premium - losses - expenses investment_income <- rnorm(iterations, investment_income_rate_mean, investment_income_rate_standard_deviation) * assets operating_result <- underwriting_result + investment_income ending_equity <- operating_result + assets - liabilities ending_equity © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with © 2011 KPMG Phoomchai Business Advisory Ltd., a Thai limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved. Printed in Thailand.

KPMG International Cooperative (“KPMG International”) a Swiss entity. All rights reserved.

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Thank You Presentation by Herb Desson