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					The Swiss Solvency Test

Federal Office of Private Insurance
Philipp Keller
Research & Development
Toronto, 28 March 2007

•The Swiss Solvency Test Methodology
•The SST Principles
•Economic Valuation
•The Standard Model
•Internal Models

The Swiss Solvency Test
• The market Crash 2001-2003 showed exposure of insurance industry
  to equity risk, statutory valuation and Solvency 1 were inadequate
• SST being developed during 2003 - 2005
• Field-tested in 2004 and 2005
• In force since 1 January 2006
• As of 2006, all large life and P&C companies have to do the SST
• As of 2008, all companies (direct insurers, reinsurers and insurance
  groups) will have to do the SST
• The SST has to be done on a legal-entity level and on group-level
• Insurance groups, reinsurers and all companies for which the
  standard model is not applicable have to use internal capital models
  for the SST  approx. 80 companies will use (partial) internal models
• The SST is risk- and principles-based
• The SST is based on an economic and realistic valuation framework

The Swiss Solvency Test: Development
• The SST was developed together with the Swiss Insurance
  Association, insurers and reinsurers and consulting companies
• Participants in the different working groups encompassed
  mathematicians, actuaries, accountants, CROs, CFOs, capital
  management specialists, life-, P&C- and reinsurance-specialists, …
• FOPI defined the overarching regulatory aims and was responsible for
  all design decisions
• Regulatory aims:
   • Giving incentives for risk management
   • Transparency on the real economic position of companies
   • Level playing field
• FOPIs regulatory aims were understood and accepted by industry,
  although there were discussions and controversies regarding specific
• Differences in opinions were always discussion in public and could all
  be resolved eventually
Risk-Based Solvency Frameworks
The main purpose of risk-based solvency (and of risk
management) is to achieve transparency on the insurers’
exposure to risk
Control and mitigation of risk are secondary objectives which
are better achieved via transparency

The core of a solvency framework are the underlying methodology and
principles, not the standard models
Internal models must be assessed with reference to the methodology of
the solvency framework not with reference to the standard model

Incorporating implicit prudence via valuation, restrictions on eligibility of capital,
investments and risk transfers will make the system less transparent and will
lead to the transfer of insurers’ risk management and responsibility to the
supervisor. The rigidity of such a system can even cause insolvencies
Using aggressive parameters or neglecting major risks (e.g. equity risk) in order
to perpetuate a given business model or to achieve political aims will also make
the system intransparent and will ultimately lead to a loss of confidence in the
solvency system and the insurance industry
Rules vs. Principles
                 “Liberty means responsibility. That is why most men dread it”, George
                                                                        Bernard Shaw

To give incentive for risk and capital management and to put
responsibility to senior management and the board of directors, it is
essential that the approach to supervision is principles-based
• However, principles-based supervision is more challenging both for the
  supervised and for the supervisors
• There is pressure by some (among senior management, appointed
  actuaries, supervisors, etc.) that regulation becomes more
  prescriptive and rules-based
• It is essential that both the supervisors and senior management
  accept that the price of freedom is responsibility
• The responsibility for the SST lies with senior management and the
  board of directors not with the Responsible Actuary

The Economic Balance Sheet
The economic balance sheet gives a realistic picture of a
company’s financial position now

                                     Free capital

 Available Capital
                                     SCR: Required
                                     capital for 1-year

                                     Cost of Capital Margin

                       value of      Discounted Best Estimate

Risk as Change of Available Capital
The Solvency Capital Requirement (SCR) captures the
risk that the economic balance sheet of the company at
t=1 differs from the economic balance sheet at t=0
                                             The economic balance
                     Hypothetical balance
                                             sheet at t=1 differs from
                        sheets at t=1
                                             the one at t=1 due to:
                                            • Changes in the financial
                                              markets (interest rates, real
                                              estate prices, …)
                                            • Losses and catastrophes
                                            • New information leading to a
 Balance                                      revaluation of the liabilities
sheet at t=0                                  (e.g. asbestos)
                                            • Capital received from or
                                              transferred to the group,
                                            • Hybrid instruments switching
                                              from a liabilities to equity
                                    t=1     • Dividends paid, profit
                                              participation for policyholders
               t=0                          • …

   The SST Principles
                 1. All assets and liabilities are valued market                         9.   All relevant probabilistic states
                    consistently                                                              have to be modeled probabilistically

                                                                        Defines How-to
                 2. Risks considered are market, credit and                              10. Partial and full internal models can
                    insurance risks                                                          and should be used. If the SST
                 3. Risk-bearing capital is defined as the                                   standard model is not applicable,
                    difference of the market consistent value of                             then a partial or full internal model
                    assets less the market consistent value of                               has to be used
                    liabilities, plus the market value margin                            11. The internal model has to be
                 4. Target capital is defined as the sum of the                              integrated into the core processes
Defines Output

                    Expected Shortfall of change of risk-bearing                             within the company
                    capital within one year at the 99% confidence                        12. SST Report to supervisor such that
                    level plus the market value margin

                                                                                             a knowledgeable 3rd party can
                 5. The market value margin is approximated by                               understand the results
                    the cost of the present value of future                              13. Public disclosure of methodology of
                    required regulatory capital for the run-off of                           internal model such that a
                    the portfolio of assets and liabilities                                  knowledgeable 3rd party can get a
                 6. Under the SST, an insurer’s capital adequacy                             reasonably good impression on
                    is defined if its target capital is less than its                        methodology and design decisions
                    risk bearing capital                                                 14. Senior Management is responsible
                 7. The scope of the SST is legal entity and group                           for the adherence to principles
                    / conglomerate level domiciled in Switzerland
                 8. Scenarios defined by the regulator as well as
                    company specific scenarios have to be
                    evaluated and, if relevant, aggregated within
                    the target capital calculation

Market Consistent Valuation
Market Consistent Value of Liabilities: Best Estimate + MVM:
  = market value (if it exists); or
  = value of a replicating portfolio of traded financial
    instruments + cost of capital for the remaining basis risk

Replicating portfolio: a portfolio of financial instruments which are
traded in a deep, liquid market, with cash flow characteristics matching
either the expected cash flows of the policy obligations or, more
generally, matching the cash flows of the policy obligations under a
number of financial market scenarios (IAIS Structure Paper)

The replicating portfolio has to match the company specific cash flows,
depending on the company specific expenses, claims experience etc.
The cost of capital margin is defined as the cost for future regulatory
capital which has to be set up for the liabilities. The cost of capital is set
for 2007 as 6% over risk-free

Cost of Capital Margin

                        CoCM= CoC  SCR(t)
                                 t 1

                                                                  Premium risk

                                                                  Run-off risk

                                                                  Market and credit risk

                                           Market and credit risk assuming asset portfolio
                                           corresponds to the optimal replicating portfolio


   t=0     t=1      t=2        t=3                                                     Years

                    Future SCR entering calculation of CoCM at t=0

Statutory vs Market Consistent Valuation
The following graph shows the relationship between statutory and market
consistent technical provisions for a (randomized) sample of Life and P&C
companies participating in the field tests 2005 and 2006. If the bars exceed 1,
then the statutory values are lower than the market consistent values.
                                                                         Discounted best estimate
                                                                         Cost of Capital Margin
  Life                                              P&C

 1.2     0.2   0.4    0.6     0.8    1              0
                                                    1.2    0.2    0.4    0.6      0.8        1

Over the whole life insurance market, the total value of statutory and market consistent
technical provisions are approx. equal. For the P&C market, statutory provisions exceed
market consistent provisions by ~ 15%

Standard vs. Internal Models
Risk Quantification:
• Using standard models for life, P&C and health companies, if
  the standard models capture the risk the companies are
  exposed to appropriately
• Using internal models for reinsurers, insurance groups and
  conglomerates and all companies for which the standard model
  is not appropriate (e.g. if they write substantial business
  outside of Switzerland)

    The use of an internal model is the default
    option, the standard models can only be used if
    they adequately quantify the company‘s risks

SST Standard Model
                                     Market Consistent Data

Standard Models                                                          Mix of predefined
or Internal Models                                                       and company
                                                                         specific scenarios

             Risk Models                 Valuation Models    Scenarios
                     Market Risk            Market Value
                     Credit Risk              Assets
                        Life                Best Estimate
                        P&C                   Liabilities
                       Health                   MVM

                Output of analytical models (Distribution)

                               Aggregation Method

                 Target Capital            SST Report

SST Standard Model
•The standard model is quite complex and demands from insurers to
 analyze their cash flows, claims experience, claims triangles, …
•The standard model is able to take into account most commonly used
 reinsurance contracts (QS, XL, SL per LoB) and risk mitigation can
 easily be taken into account
•The model allows the analysis of different risks within the company
 (e.g. different LoBs, reserve and premium, parameter and
•Companies receive information on their parameterization and SST
 results in comparison to their peers
•Many small companies think that the complexity of the model is more
 than compensated with the additional insight into the risk structure of
 their business
•The work load for a small company is approx. 1-3 person months
 (PM), for mid sized companies 9-15 PM and for large companies 12-24
•Some small companies expanded their business volume based on the
 results of the SST Field Test
Company specific scenarios: Allow senior management and the
board to have an informed discussion on strategic decisions
For supervisors, the quality of company specific scenarios is a good
indication on the quality of the company’s risk management

Predefined scenarios: Allow the analysis of the risk exposure of the
For supervisors, they allow a discussion with senior management and
the board on the actual risk exposure of the company

 Both company specific and predefined scenarios are important tools
 for supervisors to assess the quality of risk management and the
 company’s internal processes. They are the basis of an informed
 dialog of supervisors with senior management and the board of

Impact of Scenarios
Total Impact of Scenarios on the Life Market
                                                        Level 2         Level 1

                   Global deflation
   Stock market crash (2000/2001)
                      LTCM (1998)
      US interest rate crisis (1994)
   European currency crisis (1992)
               Nikkei crash (1990)
        Stock market crash (1987)
                 Real estate crash
                 Equity drop -60%
                Loss of Reinsurer
                Financial Distress
                      No Scenario

                                        0   0.2   0.4     0.6     0.8      1      1.2   1.4
Example of Scenarios

Internal Models
• Internal Models are an essential part of the SST
• Insurance groups and conglomerates, reinsurers and all companies for
  which the standard model is not applicable have to use internal capital
  models for the SST  approx. 80 companies will use (partial)
  economic capital models
• All life insurers for which the standard model is not suitable (e.g. all
  insurers writing substantial embedded options) will need to develop
  internal models
• Many companies are already using full or partial internal models (e.g.
  for market and credit risk, to quantify risk of special lines of
  businesses etc.)

Internal Models: Review
Even worse than having a bad model is having any kind of
model – good or bad – and not understanding it

If internal models are used for         Senior management is responsible for
regulatory purposes, it will be         internal models and the review process.
unacceptable if the model is not        The review of internal modes will be
understood within the company           based on 4 pillars
There needs to be                         • Internal Review;
• deep and detailed knowledge by the      • External Review;
  persons tasked with the upkeep and
                                          • Review by the Supervisor;
  improvement of the model
                                          • Public Transparency.
• Knowledge on the underlying
  assumptions, methodology and          The regulator is responsible for
  limitations by the CRO, appointed     ascertaining that the review process is
  actuary etc.                          appropriate
• Sufficient knowledge to be able to    Companies using internal models have
  interpret the results and awareness   to disclose publicly the methodology,
  of the limitations by senior          valuation framework, embedding in the
  management and the board              risk management processes etc.

SST Implementation
Key Success Factors                  Modelling Deficiencies
• Risk culture: Willingness to       •Rule based mindset of some
  know about risks and                companies
  acceptance that strategy has to    •Some senior management pushing
  be aligned with the company’s       for desired results
  risk bearing capacity, engaged     •Lack of seriousness by some
  board of directors                  companies for which the SST was
• Open dialogue within the            already mandatory
  company (e.g. departments          •Sometimes not enough know-how
  communicate well, in particular     (only weakly correlated to the size
  CRO, CFO, Actuary and CIO)          of the companies) or not enough
• Direct reporting line of the CRO    resources assigned
  to the CEO                         •The evaluation of scenarios is
• Integrity of responsible persons    spotty
• Risk management and capital        •The modeling of optionalities is
  management aligned                  uneven
• Deep know-how of model             •Lack of peer review
  experts, know-how and support      •Lack of appropriate documentation
  of senior management and the       •Data quality
                         Prediction is very difficult, especially about the future
                                                                       Niels Bohr

Consequences of an economic and risk based view:

• A consistent quantification of all risks will demand that many functions
  within a company work together: actuaries, underwriter, claims
  managers, RI specialists, CROs, CIOs, CFOs,…
• An economic view of business will demand deeper quantitative skills
• Companies will have to optimize their economic performance 
  optimization of asset liability mismatch, coherent reinsurance
  programs, securitization of risks, optimization of diversification via
  coinsurance, geographical spread, etc.
• Mid-sized companies might become being squeezed between smaller,
  specialized and nimble insurers and large, well diversified insurance
• Large companies will have to optimize their risk and capital allocation
  to maximize diversification