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Global Life Actuarial
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ASSAL-IAIS Training Seminar: Swiss Solvency TestMarket Consistent Balance Sheet21st November 2012Alex Summers
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Important note
The views expressed in this presentation are the presenter’s own and do not necessarily represent the views of either Zurich Insurance Group (Zurich), or FINMA
I am very grateful to colleagues within Zurich and at FINMA for their assistance in preparation
Further information from FINMA on the Swiss Solvency Test can be found on FINMA’s website at http://www.finma.ch
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Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options and Guarantees
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The SST protects policyholders by requiring a high probability of orderly run-off of business
SST identifies insurers* at risk of being unable to honour their existing obligations
A ladder of intervention allows appropriate actions to be taken when insurers run into difficulties
SST sets capital requirements so that there is high probability of orderly run-off of business
InternallyTransfer of liabilities to a third party if necessary
Both fulfilment and transfer value concepts are thus central to the SST
Risk Total required 0 margin capital
SST ladder of intervention
Based on FINMA SST technical document p8
*: The term “Insurers” has been used throughout to indicate both insurance and reinsurance undertakings
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The economic balance sheet is the foundation on which the entire SST is built
Scenarios
Standard Models or Internal Models
Mix of predefined and company specific scenarios
Target Capital SST Report
Market Consistent Data and Best Estimate Assumptions
Market Risk
Credit Risk
Life
P&C
Market Value Assets
Risk Models Valuation Models
Best Estimate Liabilities
Risk margin
Output of analytical models (Distribution)
Health
Aggregation Method
Source: FOPI, 2007
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Principles of market consistent valuation for SST
All assets and liabilities are to be valued in accordance with economic principles in a market-consistent manner
“In accordance with and not at variance with information that can be gleaned from trade in liquid financial markets”IFRS (fair value) valuations may be used where compatible
Mark-to-market where possible, otherwise mark-to-model
Market-consistent value “such that knowledgeable business partners would purchase or sell the positions at this price in an arm’s length transaction”
“Plausible” methods and estimates should be used in stressed markets
Own credit risk should not be taken into consideration except for hybrid instruments
Often requires mark to model adjustments to market valuesSource for quotations: FINMA Circular 2008/44
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No allowance for own credit risk in SST, so best estimate of liabilities is typically greater than market value
Suppose an insurer1. Issues USD 100MM 10 year zero coupon bonds2. Writes single premium pure endowments with guaranteed
maturity values* totalling USD 100MM
Suppose the 10 year risk-free rate is 5%, and there is a 2% credit spread above risk-free for debt issued by the insurer
Market value of the bonds is 100 x (1+5%+2%)-10 = USD 51MM
However in the SST MCBS, the bonds and pure endowments should each be valued at 100 x (1+5%)-10 = USD 61MM
This creates an asymmetry for debt internal to groupsSymmetric treatment can be permissible on application to FINMA
*: For purposes of this example, ignoring all cash flows other than maturity payment, and assuming 100% survival
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Ideal characteristics of market data for use in SST
Either sufficient transactions for an asset or liability take place at arm’s length between knowledgeable business partners, or
A sufficient number of securities traders or brokers quote prices in the capacity of business partners for a potential transaction, in good faith and in a binding manner, and for significant volumes
Market data can still be used if these conditions aren’t met subject to test of plausibility
Testing adherence to these conditions proportionate to significance
No explicit link to “deep, liquid & transparent” requirementsInherited criteria from IFRS
Price is what you pay, value is what you get
Warren Buffet
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Marking-to-model in the SST
Only if marking-to-market not possible
Apply “sound finance mathematics and actuarial methods for assets and liabilities”
Principle of proportionality can allow simplifications
Models and parameters calibrated as much as possible on the basis of objectively observable data
Documentation must be sufficient
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Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options and Guarantees
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SST Market Consistent Economic Balance Sheet
The economic balance sheet gives a realistic picture of a company’s financial position at a given point in time
Risk Margin
Required capital for 1-year risk
Free capital
Market consistent value of liabilities
Available Capital Total required capital
Market value of assets Certainty
equivalent best estimate of discounted liabilities
Time Value of Options and Guarantees
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Cash flows to be considered in discounted best estimate value of liabilities
Life Non-Life General
In-flows Out-flowsDiscounted best
estimate
Premiums
Other revenue
Death benefitsMaturity benefitsAnnuity benefits
Surrender benefitsOther benefitsCommissions
Administrative costs, including investment
costs
Discounted best estimate of future
claims and expense payments related to
claims incurred before the valuation date,
whether or not reportedUnearned premium
reserve
Bonds issuedPlanned
dividendsContractual
profit sharing with
policyholdersOwn shares
Tax provisionsPensions
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Valuation of life insurance liabilities for SST (1)
Best estimate: no loadings for safety, fluctuation or anything else
Projection all the way to run-off
Model points at policy levelGrouping permissible
In force business only – future new business is excluded
Going concern basis for calculating expenses
FINMA circular states that employee benefit schemes are in scope, and should be valued according to same principles as insurance liabilities
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Valuation of life insurance liabilities for SST (2)
Pre-tax: deferred tax assets are not to be valued
Net of reinsuranceCan show liabilities gross, with a corresponding asset for reinsurers’ share of liabilities
Only contractually guaranteed benefits in SST standard modelOther approaches can be considered in SST internal models e.g. as for MCEV, future discretionary benefits are includedExtra accuracy and usefulness but considerable extra complexity for insurersConsistent treatment of loss absorbency in risk calculations is important
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Does exclusion of future discretionary benefits (FDB) matter?
If the aim is only to calculate solvency ratio, ignoring FDB gives a prudent view to extent that FDB are fully loss absorbing
R1. SST standard formula ratio 1: (MVA – BEL) / (SCR + RM)
R2. Internal models: (MVA – BEL – FDB) / (SCR + RM – LAC)
If FDB are fully loss absorbing, LAC = FDB, so R2>R1*However, understanding the nature of policyholders’ reasonable expectations of future discretionary benefits can be very helpful in managing the business
Consistency with other reporting metrics e.g. MCEVUse test
*: Assuming R1>100%; LAC = Loss Absorbing Capacity
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Risk margin is a key part of the balance sheet, and will be discussed tomorrow morning
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Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options and Guarantees
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Different yield curves are proposed for different purposes
FINMA SST MCEV(Zurich used as
example)
Other MCEVs – guide to SII?
Underlying risk free yield curve data
German Government
Bonds
Swap Swap
Deduction for credit risk
No No Yes
Adjustment added to underlying curve
No Illiquidity premium (bucketed) in line with MCEV
principles
Yes – discussions ongoing on Counter-Cyclical Premium and
Matching Adjustment
YC interpolation/ extrapolation
Smith-Wilson Smith-Wilson Smith-Wilson used in QIS5
Entry to extrapolation
30 yr 50 yr Considering even earlier extrapolation than QIS5 30yr
Ultimate forward rate
3.9% Longest market spot rate (ie. 2.6%)
Stable 4.2%UFR used in QIS5
Speed of convergence
Moderate Irrelevant given full use of market data and moving UFR
Moderate for QIS5; under discussion
EUR yield curves Q411
SST offers flexibility in the choice of risk-free yield curve used so long as it is clearly documented, with shadow impact analysis
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Recent FINMA proposals for “lightening” of SST
FINMA has proposed a further update to SST yield curve methodology, prompted by
Low interest rates observed in Europe; possible distortions in Swiss goviesDeveloping Solvency II package to address the challenges to business with Long Term Guarantees (LTG) posed by full market consistency
Details uncertain, but appear to allow Solvency II QIS5 yield curves to be used for a transitional period of 3 years
Shadow calculations on govies would still be required
New business would need to be separated for purposes of calculation
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Careful consideration is needed before applying QIS5 proposals designed for Europe to Latin America
Where there is little market data e.g. 10 years or less, early extrapolation and fast convergence to a low, fixed ultimate forward rate can lead to unintended consequences
Real yield curve may be more relevant than nominal
A more plausible solution would be to keep forward rates flatter
Slower convergence, and/orAllow some movement in UFR
Smith-Wilson approach can work well given appropriate parameters
UFR has substantial impact if market data available only to 5 years e.g. BRL Q411
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UFR moves with market data Q411 +500bps 1 year fwd ratesUFR moves with market data Q411 -100bps 1 year fwd ratesStable 4.2% UFR Q411 +500bps 1 year fwd ratesStable 4.2% UFR Q411 -100bps 1 year fwd rates
Speed of convergence has substantial impact if working with fixed UFR and market data available only to 5 years e.g. BRL Q411
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UFR moves with market data Q411 alpha 0.1 1 year fwd ratesUFR moves with market data Q411 alpha 0.2 1 year fwd ratesStable 4.2% UFR Q411 alpha 0.1 1 year fwd ratesStable 4.2% UFR Q411 alpha 0.2 1 year fwd rates
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“Smith-Wilson” approach can give smooth curves passing exactly through the market data
Smith-Wilson curves pass exactly through market data
Necessary for market consistencyWorks well with swap market dataPre-smoothing needed for govies
The smoothness of the forward rate curve is important for correct behaviour of actuarial cash flow models
Simple linear interpolation of spot rates would not be good enough for use in cash flow models
USD annually compounded spot rates Q410
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Zurich 0% LP Swap spot rates Linear interpolation spot rates
USD 1 year forward rates Q410
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Zurich 0% LP Swap 1 year fwd rates Linear interpolation 1 year fwd rates
Reasonable looking spot rates can hide problems with forward
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Agenda
SST MCBS Context, Purpose and Principles
Elements of the SST MCBS
Risk-free rate: technicalities and implications
Case study: risk-neutral stochastic scenarios for Time Value of Options and Guarantees
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Discounted cash flow models for life business require projections of economic variables
Fund-based policyholder benefits and
fees
Dynamic policyholder actions e.g.
lapses
Inflation linked benefits
Dynamic management actions e.g.
bonus crediting
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Bond prices
Inflation
Cash index
Equity and property indices
Movements in economic assumptions are often the single biggest driver of changes
in market consistent valuation
Best estimate liabilities
DiscountingCash flow
model
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Different types of stochastic economic scenarios can be used for SST Internal Models
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Best estimate
liabilities and sensitivities
Proxy representation of liabilities
Market risk capital
requirement
Real world economic scenarios
Risk neutral economic scenarios
Fitting and validation scenarios
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We need stochastic modelling for valuation because the future is uncertain, and good outcomes don’t always average out bad ones
Time Value of Options & Guarantees (TVOG) = Stochastic BEL – Deterministic BEL
Deterministic modelling is often good enough
TVOG is the impact on valuation of considering uncertainty
Stochastic modelling is needed when TVOG is material due to asymmetries
TVOG is greatest when guarantees are on the point of biting
Value of an interest rate floor with 5% strike for different initial levels of interest rates
3.0% 5.0% 7.0%
Initial interest rate
Val
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f opt
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Deterministic value(price with zerovolatility)Stochastic value(price with non-zero volatility)TVOG
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Time Value of Options and Guarantees (TVOG), Risk Margin and “SCR” all arise from different aspects of uncertainty
TVOG is the extra component within the best estimate liabilities arising due to uncertainty across an asymmetric range of possible outcomes
Allowance needed even for hedgeable risks
Required capital for one year risk (SCR) is the increase to market value sufficient to ensure high probability of solvency in one year’s time
Risk margin is the minimum extra amount needed to give high probability of orderly run-off by giving just enough capital to fund future SCRs
Risk Margin
Required capital for 1-year risk
Free capital
Market consistent value of liabilities
Available Capital Total required capital
Market value of assets Certainty
equivalent best estimate of discounted liabilities
Time Value of Options and Guarantees
Risk Margin
Required capital for 1-year risk
Free capital
Market consistent value of liabilities
Available Capital Total required capital
Market value of assets Certainty
equivalent best estimate of discounted liabilities
Time Value of Options and Guarantees
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Ideal characteristics of risk-neutral economic scenarios from diverse sources
Ideal characteristics of asset models:Reproduce market price of assetsNo arbitrageConsistency with prescribed yield curve
It is not always possible in practice to achieve all of these simultaneously
SST does not impose specific generic requirements for stochastic modelling of assets
Many sources of requirements for economic scenarios apart from regulation
Industry standards e.g. CFO-F MCEV PrinciplesAuditorsInternal need for high quality management information
© 2010 The Actuarial Profession www.actuaries.org.uk
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Volatility
Tenor
Term
GBP market swaption volatilities Q411
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Market-consistent Economic Scenario Generator calibration
• Three stages:– Market prices (or substitutes)– Calibrate model to the data– Simulate scenarios from the model
Observable market prices
Model of the
Observable market prices
Simulation of the
Model of the
Observable market prices
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Source: Towers Watson
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A feedback loop can help to quantify materiality of impacts and define relevant tolerances
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1. Define targets, tolerances and
number of scenarios, based
on materiality
2. Gather data and produce
scenarios
4. Analyse liabilities and model results to assess limitations of ESG and which market data are
most relevant
3. Test scenarios
against targets and tolerances before release for model runs
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SST Market Consistent Balance Sheet: Summary
SST MCBS is the foundation for all other parts of SSTAll assets and liabilities are to be valued in accordance with economic principles in a market-consistent mannerMarket-consistent value “such that knowledgeable business partners would purchase or sell the positions at this price in an arm’s length transaction”Mark-to-model often needed
SST risk-free rate methodology based on goviesAlternatives are possibleChoice of appropriate risk-free rate methodology and consequences for long term business need careful thought for LATAM
TVOG can be a key component of the SST balance sheetStochastic valuation challenging where market data limited, but solutions can be found
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Thank you for your attention
Any further questions?
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APPENDIX: Tiering of available capital is not a central concept for SST
SST tiering aims for transparency without fixed limits and restrictionsFixed limits not consistent with principles based framework
Tiering of available capital distinguishes contribution to available capital from “hybrid instruments” but unlike SII, tiering has no impact on solvency ratio
Hybrid instruments assessed on substance rather than formAbility to buffer risksAvailability in case of need
Guarantees and contingent capital can be acceptableClear wording, legally binding, embedded within the risk and capital management processes of companiesAdequate and consistent modeling needed