Benefits and challenges of using an internal model for Solvency II

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Principle

Capital is a scarce resource

And

It flows to the highest returns

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Agenda

1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements Internal Model Approval Criteria Documentation 5. How to get there: Key features to be taken into account when designing an internal model 6. Where is the market?: ERM Survey 2008 7. Challenges and Opportunities

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Do the right things and do the things right

We do not need a lot of regulation but relevant one Transparency is not the art of producing telephone books full of information, but rather concise and relevant information for transparency It is key that the new regulation is developed in coordinated efforts between regulators and industry. Only by this Regulation becomes relevant and applicable Is accepted by all parties Can enhance the value creation of the sector

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Benefits of internal models vs. Standards formula

Under Solvency II firms can choose using the standard formula approach or building an there own internal model Advantages of internal models vs. Standards formula: Improved management and understanding of the business and its capital requirements. Improve the risk management, governance and strategic decision making of the company and therefore in a more efficient use of the companys capital. Improved quality of documentation and use in the Own Risk Solvency Assessment (ORSA) Disadvantages: Costly to develop (time, actuarial resources and software) Stringent regulatory review and compliance Onerous data and documentation requirements.
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Agenda

1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements Internal Model Approval Criteria Documentation 5. How to get there: Key features to be taken into account when designing an internal model 6. Where is the market?: ERM Survey 2008 7. Challenges and Opportunities

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Solvency II timetable
Internal Model approval

Dear CEO letter

Plan to seek approval of Internal Model 06/09 Europe Implementation plan 06/10 to 11/10 Internal Model Dry run submission 10/12 Internal Model approval

04/09 UK Implementation plan Approval of the SII Framework Directive

Solvency II Implementation Internal Model Dry run submission

QB1, Participate to QIS4 exercise

Aviva / FSA Dialogue

QB2, Made substantial progress towards documentation QB3, Prepared a Solvency II implementation plan to get internal model, risk management and associated systems embedded QB4, Be able to calculate the EC on a regular basis

2009

2010

2011

2012

The implementation of Solvency II is likely to involve the development of new internal models or the enhancement of existing ones in order to carry out the measurement, management, and mitigation of their risks.
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Agenda

1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements Internal Model Approval Criteria Documentation 5. How to get there: Key features to be taken into account when designing an internal model 6. Where is the market?: ERM Survey 2008 7. Challenges and Opportunities

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Risk Landscape

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Aviva target operating model

Drivers for integrated risk and capital management

Regulatory drivers
Management Information Governance
Strategy & Plans Risk Appetite Roles & delegated authorities

Business drivers
D I S C L O S U R E

Solvency II

Incidents & Loss events LEARN FROM PAST Risk profiles & quantification analysis PRESENT Predictor events FUTURE Line management & Reporting

Efficient use of capital

FSA

Risk Management

Policies Risk Identification & Assessment Committees

Decision Making

Standard & Poor's

Monitoring & Controls

Maximising risk reward trade off through managing upside risk

Systems and Tools

Other international work

Communication, Education Training and Guidance

Maximising adverse risk exposure/ managing downside risk

Internal Model

Market drivers
Hardening insurance market
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Extreme events

Market turbulence

Competitor activity

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Agenda

1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements Internal Model Approval Criteria Documentation 5. How to get there: Key features to be taken into account when designing an internal model 6. Where is the market?: ERM Survey 2008 7. Challenges and Opportunities

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Solvency II Requirements
Internal Model Approval Criteria

The internal model approval process requires firms to demonstrate compliance with the tests outlined in the Framework Directive.
Art. 119 Statistical quality standards Art. 118 Use test Art. 122 Validation standards Art. 44

Art. 120 Calibration standards

Internal Model Approval

Art. 123 Documentation standards

O R S A

Art. 121 Profit and loss attribution

Art. 124 External models and data

The purpose of the use test is to ensure that the internal model, its methodologies and results are fully embedded into the risk strategy and operational processes of the firm. The firm should demonstrate that the internal model is widely used within the business, and plays an important role in the system of governance, in particular: The risk management systems and decision making processes The economic and solvency capital requirement and allocation processes The model also needs to be updated regularly to ensure that it remains appropriate to ongoing risk profile.
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Solvency II Requirements
Documentation of internal model and risk management processes

Solvency II relevant texts Art 123: The documentation shall indicate any circumstances under which the internal model does not work effectively Art 123: The documentation shall demonstrate compliance with Article 118 to 122 Art 123: Insurance and reinsurance undertakings shall document all major changes to their internal model as set out in Article 113. Art 123: The documentation shall provide a detailed outline of the theory, assumptions, and mathematical and empirical basis underlying the internal model Art 123: Applying proportionality

Documentation should increase with the complexity of the internal model, we could imagine for example: Minimum common standards A Second level of standards A Third level of standards

Documentation

Complexity of the model

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Agenda

1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements Internal Model Approval Criteria Documentation 5. How to get there: Key features to be taken into account when designing an internal model 6. Where is the market?: ERM Survey 2008 7. Challenges and Opportunities

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Why is Capital so important

Problem: How to model the different risks to what extent? Which risks are dependent resp. independent? Some risks are relatively easy: Asset risks (eg Geometric brownian motion) Other risks are more difficult Bonus rates Disability Longevity
50 150

100

Some risks are almost inaccessible Operational Legislation

0 -6 150 -4 -2 0 2 4 6

100

50

0 -6

-4

-2

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Sweden

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Capital model allocate capital

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Balance sheets and Risk Capital

Statutory balance-sheet
Assets Liabilities
statutory valued insurance liabilities

Fair value balance-sheet for control of risk capital

Assets Liabilities
fair / marketnear valued insurance liabilities

A/L management focuses on Statutory view and Mark to market view

Therefore the balance sheet need to be recalculated

Probability Density
Provisions at Fair Value Median (Best Estimate) Confidence Interval

In a second step the corresponding risk capital needs to be evaluated

Required Capital

Provisio ns 50%

Additional Available Capital 50%

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Value

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Design of an Internal Model that can be used in dayto-day business: Key features to be taken into account
KEY FEATURES Frequency of calculations COMMENTS Need to define the required frequency of the reporting and calculation in order to support the decision making process Sufficiently fast model to accommodate and facilitate internal management use Design a good estimation model that produces credible results in between reporting periods Dependencies: Closing processes should be adapted to the above required frequency IT systems should allow for information to be adequately aggregated, reported and analysed Appropriateness of calibrations Use of internal model in decision making The model should allow for different calibrations to be used in decision making (1 in 10, 1 in 50, 1 in 200) Correlations should be adjusted to each calibration The model should be used for decision making on a number of areas: Reinsurance, underwriting, investment management, management information, strategy/planning, corporate finance and finance function Demonstrate integration between capital measurement systems and capital management Board /Senior management implication
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Board /Senior management need to understand: High level principles, assumptions and limitations Commercial implications

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Practical applications to make better decisions

AREAS Reinsurance Underwriting Investment Management Product Development Management Information Strategy & Planning

PRACTICAL APPLICATIONS Analysis, design and purchase of the reinsurance programme Pricing of the business through the allocation of capital to lines of business and linking to the plan targets Determining the possible effects of investment decisions Understanding the potential impact of new products Understanding the risk in the plan and sensitivities to key assumptions Assessing the possible impact on the risk and capital of the business of various strategies Assessing the possible impact on the risks and capital profile of the business of potential M&A Risk based performance reporting using measures such us return on risk adjusted capital

Corporate Finance

Finance Function

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Models in General Scylla and Chaybdis

Reality Model

Observable Parts of the world: 1) Share Prices 2) Discount Rates 3) Forward rates 4) etc.

Observable Parts in the model: 1) Share prices 2) Discount rates 3) Forward rates 4) etc.

Real Questions: 1) Value of an entity 2) Cost of a product 3) Required risk capital 4) etc.

Deductions and solved questions in the model: 1) Value of an entity 2) Cost of a product 3) Required risk capital 4) etc.

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Agenda

1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements Internal Model Approval Criteria Documentation 5. How to get there: Key features to be taken into account when designing an internal model 6. Where is the market?: ERM Survey 2008 7. Challenges and Opportunities

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ERM Survey 2008

Use of Internal Model

Where are you compared to your peers?

The use test requires the insurer to demonstrate that there is sufficient discipline in its internal model development and application such that it is widely used in and plays an important role in the management of the firm. In the survey most insurers admitted they have significant work to do before they will be able to use economic capital (EC) in performance management and decision making. However most highlighted that this was their key priority. Use of EC for decision making: 44% of respondents indicated they were already using their EC results for capital management, 36% for asset strategy and 28% for product design and pricing

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Agenda

1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements Internal Model Approval Criteria Documentation 5. How to get there: Key features to be taken into account when designing an internal model 6. Where is the market?: ERM Survey 2008 7. Challenges and Opportunities

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Treats and Opportunities 1/2

Severity
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Treats and Opportunities 2/2: Manage the business Sensible MIS to enhance returns

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Consequences

Always

keep the purpose in mind

No mathematical woo do! No Eulenspiegel No Baron von Munchhausen But solve open problems and be pragmatic

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Risk Management Process Do you know where YOU stand?

Identify all relevant risks and allocate them to risk categories

Identification

Monitor Compliance with Limits Review the risk/return rations

Mo n

Risk Management Process

Measurement

itor Monitoring ing

Measure the assumed risks

Define the measurement methodology Measure the individual risk factors Aggregate the risk exposures

Management

Fix the limits / maximal allowable risk exposures Evaluate the existing and required risk capital Actively manage risk exposures
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The floor is open!

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