Proposal by Swiss Re and Deloitte

Philipp Keller

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Global Insurance Capital Standard Interaction with BCR and HLA

HLA (Higher loss absorbency requirements) for non-traditional and noninsurance activities. In the absence

of a global capital standard as a basis, these will be built upon straightforward, basic capital requirement for

all group activities, including non-insurance subsidiaries. HLA requirements will need to be met by the

highest quality capital.

BCR: straightforward, basic capital requirement to apply to all group activities, including non-insurance

subsidiaries,

ICS

BCR

HLA

Insurance Capital

Standard, for

IAIG

Basic Capital

Requirement,

for G-SII

Higher Loss

Absorbency,

for G-SII

BCR

HLA

BCR

HLA

Less likely options

G-SII specific

risk based

capital

standard

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Regulatory models Typology

Linear function A simple combination of factors applied to balance sheet elements or other

volume measures. Diversification between different risks cannot be taken into

account except implicitly by reducing the factors.

Pure scenarios Predefined scenarios for whose the impact has to be evaluated. The capital

number is then a function of the impacts, e.g. the maximum or average of the

losses.

Factor formula A straightforward formula, based on the modeling of underlying risk factors,

taking into account diversification and that is transparent in which risks are

quantified and which are not.

Standard formula A complex set of equations for different risk classes that are combined using a

correlation matrices and other approaches and that aims to capture all risks.

Standard model A stochastic model that can capture dependencies naturally on the level of the

underlying events or risk factors.

Level of

Com

ple

xity

Internal Models Approaches relying on the use of (partial) internal models to determine the

capital requirements, where the models have to follow principles that ensure

consistency and comparability of results

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Regulatory models Typology

Linear

function

Pure

scenarios

Factor

formula

Standard

formula

Standard

model

Internal

Models

SPAN by

the CBOT

SST

Solvency I RiskMetrics

Solvency II

HK DST

SST for

reinsurers and

insurance

groups

Basel II

market risk APRA

Basel II

Credit Risk

BCR

ICS

proposal

HLA?

MCT

MCCR

US-RBC

J-RBC

Lloyds RDS

S&P

CreditMetrics Fitch

FFF

Risk Classes Risk Factor

based, complex

Risk Factor

based, simple

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Insurance Capital Standard Desirable key characteristics

The global insurance capital standard (ICS) should

• Satisfy IAIS core principles (ICP) 14 and17 and be aligned with ComFrame

considerations on capital assessment (M2E5) to ensure consistency with economic and

risk-based capital standards

• Be based on a clear, transparent and public underlying methodology

• Be extendable and adaptable over time

• Reflect the risk-sensitivity, legal diversity and economic reality of IAIGs (including total

balance sheet considerations)

• Be consistent with and extendable from group to legal entity requirements

• Give relevant and useful information to management and to supervisors

• Allow for the analysis of global and market-wide exposures to risk

• Give incentives for appropriate risk management

• A well-defined, risk-based capital standard for IAIGs will be an improvement for the

insurance industry and provide for a level playing field

• The proposed approach has been developed by Swiss Re's experts, based on the

Group's global experience, with the support of Deloitte

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Elements of Capital Standards Events, Exposures, Impact and Framework

Events

Possible future states of the

world impacting the balance

sheet of groups or

conglomerates. A state of the

world is given by the state of

the financial market, natural

and man made catastrophes

occurring, pandemic events,

operational risk events, etc.

Exposure to risks, due to

insurance policies, other

liabilities, investments,

operations etc.

The impact of events on an

IAIGs balance sheet, given by

the exposures and the

valuation standards being used

to measure the impact

The implemented framework

(standard formula, standard

model, factor based approach,

etc.) quantifies the potential

change in available capital

over a given time horizon and

assesses capital needed to

cover risks

Exposures Impact Integrated framework

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Development and Calibration Key steps

• The proposed approach is feasible and allows for adaptations and extensions. It builds on

existing regimes without undermining tested approaches

• The use of tested capital regimes in combination with scenarios for calibration ensures a risk-

sensitive and robust factor formula

• The use of scenarios for the calibration allows for the consistent assessment not only of the

risks of IAIGs, but also of market-wide exposures to risk and the potential interconnectedness of

IAIGs

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Define a set of realistic, possible and adverse states of the world (scenarios) covering events

impacting IAIGs

Define principles to extend the set of scenarios to take into account local events and risks, or

update scenarios in a consistent way

Define a set of base-case and adjusted balance sheets for calibration and consistency

Evaluate impacts of scenarios on actual, base-case and adjusted balance sheets

Define the structure of the factor formula based on tested regulatory approaches (e.g. APRA

capital standard, EU Solvency II standard model, Swiss Solvency Test, US RBC, etc.)

Calibrate the factor formula using the evaluation of scenarios and other parameters

Compare results of factor formula with existing methodologies (standard formulae and internal

models) - adjust scenarios and calibration if necessary to arrive at a robust result

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Development and Calibration Illustration

Framework methodology

Adjusted and base-

case balance sheets

for consistency and

calibration

Calibration

Realistic, possible

states of the world Original balance

sheets

Output of impact of scenarios,

allowing in-depth analysis of specific risks of

IAIGs, analysis of market-wide exposures to

risk, supporting macro-prudential surveillance

Internal models

Regulatory frameworks

Historical data

Ca

lib

rati

on

Testing • Company-specific scenarios

• Regional / National scenarios

• Global scenarios

Insurance Capital Standard

Structure of the Factor Formula

Final calibration of

Factor Formula

Factor Formula

Evaluation of the impact of scenarios

based on a common or local valuation

standards

Actual Balance Sheets

from Field Test

Participants

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1

3

4 5

6

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Comparing the calibration

Principles for formulating

states of the world

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More details on the aggregation of the scenarios'

evaluation under the proposed Factor Formula

Event Scenario Impact on

Adjusted Balance

Sheet

Initial Adjusted

Balance Sheet

Qualifying

capital

resources

Initial qualifying

capital resources:

QCR(0)

QCR1

QCR2

QCR3

QCRn

f(QCR1, QCR2,…, QCRn) = PCR

Factor formula, combining the

results of the evaluation of the

scenario to the prescribed

capital requirement (PCR)

The factor formula takes into

account dependencies between

scenarios and allows for the

calibration of the PCR, based on

existing risk-based solvency

frameworks (e.g. from APRA,

Solvency II, US-RBC, SST…)

and internal models

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Principles

Principle 1: Assets and liabilities are valued using an economic valuation standard and a total balance

sheet approach, reflecting also the long-term nature of the insurance business;

Principle 2: IAIGs initial balance sheets (which can be regulatory or accounting balance sheets) are

adjusted using principles derived from the economic valuation standard, to arrive at comparable balance

sheets;

Principle 3: Qualifying capital resources are defined with reference to the adjusted balance sheet;

Principle 4: A state of the world is a description of a joint realization of risk factors describing the world;

Principle 5: The capital resources in a state of the world are quantified based on the economic valuation

standard;

Principle 6: The ICS is defined such that the IAIG has a given positive amount of capital resources with a

given confidence level at the end of a given time horizon;

Principle 7: IAIG determine the impacts of scenarios on the adjusted balance sheet in a transparent

manner;

Principle 8: The impacts of scenarios are aggregated using a specified factor formula to arrive at the

capital requirement.

Principle 9: Scenarios are to be chosen such that they cover all material market, credit, underwriting and

operational risks for the given confidence level.

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Factor Formula Framework The structure of the factor formula

• The factor formula is to be based on a clear separation of events that impact an insurer‘s

balance sheet and the valuation standard on which the balance sheet is determined. This

allows for flexibility with respect to the valuation being used and easy adaptation of the

factor formula to different valuation standards.

• The separation implies that the factors are to be derived as far as possible on the events

rather than on insurer’s balance sheet elements, premia etc.

• These factors can then be applied to the balance sheet, e.g. via sensitivities, the

calculation of losses, or other approaches.

• For example, rather than to calculate 3 per mille times Sum at Risk to determine

mortality risk, the factor would be linked to the mortality (e.g. an increase in mortality of

20%) and the impact then assessed by the insurer. The results of the impacts are then

combined, taking into account the inter-dependencies between the different risk factors.

• In other words, the factors are applied to underlying risk factors that describe a given

event, and then the impact on the insurer’s balance sheet is determined. In this way, the

calibration of the factors does not depend on the valuation being used.

• This has the additional advantage that diversification is taken into account on the level of

underlying risk factors and its impact for the insurers is determined then via the valuation.

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Factor Formula Framework The structure of the factor formula

• If there is a complete separation between events and valuation, then the factor formula

framework would be a truly global standard, in the sense that it could be applied to any

valuation standard being used. This would allow comparison of internal models, and

national risk-based solvency standards against a global standard.

• Such a complete separation between external events and the valuation standard is likely

not possible. It is achievable for financial market risk and for life insurance and annuities

as well as for part of non-life insurance.

• Other risk, e.g. operational risk might be modeled differently. However, the aggregation of

the capital requirements emanating from these other risks can be done in such a way that

the factor formula remains predominantly valuation independent and would still serve as a

truly global standard.

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Factor Formula Framework The structure of the factor formula

Market Risk Credit Risk Underwriting Risk Operational Risk

Group Risk

Liquidity Risk

Market liquidity

Funding liquidity

Monetary liquidity

People

Systems

Processes

Interest rates

Spreads

Volatilities

Equities

FX

Counterparty default

Sovereign

Intra-group credit

Reinsurer default

Life Insurance

General Insurance

Mortality trend

Mortality level

Morbidity

Reserve

Nat Cat

Man Made Cat

Currency mismatch

Translation

Pandemic

Concentration Risk

Cash flow liquidity

Capital mobility

Taken into account by the factor formula ORSA, capital

quality, etc.

Ris

k

Cate

go

ries

Ris

k S

ub

-Cate

go

ries, Illu

str

ati

ve

Quantitative Elements Qualitative

Elements

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Design Criteria Summary

Straightforward factor

formula

Clear methodology,

separating risks,

exposures and valuation

Calibration based on

scenarios and tested

regulatory regimes

A straightforward factor formula allows the ICS to be regularly

assessed for each IAIG and recalibrated to changing global and

national risks. The use of scenarios as an additional means for

assessing risks more than compensates the potential shortcomings of

a straightforward but transparent factor formula.

The proposed approach will allow the ICS to be updated and internal

models to be used as a means for testing and improving the factor

formula. It allows for flexibility for the use of the valuation standard(s),

either globally or locally.

Using a combination of scenarios and global parameters in

conjunction with tested regulatory capital approaches will result in a

stable and robust calibration.

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Development

• The separation of the events impacting an insurer’s balance sheet and the valuation standard to be

used to measure the impact allows for an efficient development of the factor formula framework. The

calibration of the risk factors can be done independently of the choice of valuation.

• The structure of the factor formula depends mainly on the events chosen and risk factors used to

describe and parameterize the scenarios. There is also some dependency on the valuation

standards, but a major part of the structure of the factor formula can be defined with reference to the

events and risk factors only.

Choice of

Events

Calibration of

risk factors and

dependencies

Development of the balance

sheet adjustments

Main structure

of the factor

formula

Evaluation of

the impact of

events

Overall structure

of the factor

formula

Further development of the

balance sheet adjustments

Evaluation of

the impact of

events

Overall structure

of the factor

formula (update)

Events

Valuation

2014 2015 2016 2017 2018 2019+

Dec: Consultation on design of ICS

First ICS test Second ICS test ICS reporting

to supervisors

(all IAIGs)

ICS reporting

to supervisors

+ public

disclosure (?) Adoption of

ComFrame by IAIS

including ICS

ICS full

implementation

2013

Initial Development Improvements and Extensions

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Conclusion

• Developing a global insurance capital standard by 2016 is challenging but possible

• There is a wide variety of IAIGs, with different exposures to risks, legal structures,

business models and valuation bases. The ICS needs to be able to address this diversity

• A factor formula framework can be developed that is

• relatively straightforward and transparent

• based on adjusted and base-case balance sheets to achieve comparability and

consistency

• calibrated based on scenarios further ensuring comparability

• using the experience of tested regulatory capital frameworks

• supplemented with scenarios as additional risk governance measures

• Creating incentives for appropriate risk management

• Flexible and adaptable to different valuation standards and risk profiles

• consistent with ICP 14 and 17, and aligned with ComFrame capital considerations

(M2E5)

• Tested regulatory regimes should be utilised to define the structure and improve the

calibration of the factor formula framework.

• ComFrame should facilitate the recognition of economic and risk-based capital regimes

aligned with the proposed factor formula framework

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Diversification and Dependencies

• Diversification is at the core of insurers business models. By having heterogeneous

portfolios with different exposures to risk, insurers aim to be in a situation where no one

single event can endanger their solvency.

• If an insurance capital standard were not to consider diversification, it would give a

comparative advantage to insurers that take on risk concentration. These insurers are

often able to earn more than their better diversified competitors, but tend to fail

catastrophically.

• Diversification is the fact that not all events that can cause losses occur at the same time.

The amount of diversification that can be actually be used by the insurer depends on its

exposures to these events.

• The factor formula framework takes diversification into account where it objectively occurs:

at the level of events impacting the insurer’s balance sheets. This is quantified via the

evaluation of the impact of scenarios and sensitivities to risk factors.

• The factor formula approach – by its clear separation of events and exposures – allows for

a IAIG-specific quantification of diversification

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Diversification and Dependencies

Two main approaches of modeling diversification

Risk class approach

Risk factor approach

• First capital charges for major classes of risks are determined (e.g.

market, credit, underwriting and operational risks)

• Then diversification is taken into account by aggregating these

separate capital charges using a correlation matrix

• Typical examples of this approach are the US RBC, the S&P

model, or the Solvency II standard formula

• Diversification is taken into account on the level of events that

impact the insurer’s balance sheet

• Dependencies between equity prices, spreads, interest rates,

mortality and morbidity, natural catastrophes etc. are modeled

• Examples of this approach are the RiskMetrics covariance

approach for financial market risk and a number of internal models

by banks and insurers

• The advantage of the risk class approach is its simplicity. It requires merely a

small correlation matrix to arrive at a total capital requirement

• However, the calibration of the correlation matrix is highly subjective and cannot

be based on historical data

• In addition, diversification changes with the insurer’s exposures. The correlations

depend on the insurer’s exposures and they are dependent on the specific IAIG.

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Diversification and Dependencies Modeling approaches

Examples

Pandemic

scenario

Historical

financial market

risk scenario

Market risk

factors

Life insurance

risk factors

Abstract nat cat

scenario

{S│P(S)<α}

Nat Cat

Market Risk Credit Risk Underwriting Risk Operational Risk Liquidity Risk

quantitative qualititative

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Events, Scenarios and States of the World

• Risk is defined as the (random) change of the qualifying capital resources over a given

time horizon. The qualifying capital resources at the end of the time horizon t are

determined by the specific state of the world that has been realized. A state of the world is

described by risk factors (e.g. the value of shares, yield curves, magnitudes of

earthquakes, etc.).

• A future state of the world at time t is arrived at from a given initiation state of the world

now (at time t=0) via the occurrence of events during the time interval from zero to t.

• At time t=0, the events that will occur until time t are not known and have to be modeled.

Different events require different techniques of modeling. A scenario is a more formal

definition of the concept of an event that can capture the different types of events.

State of the

World at time 0 State of the

World at time t

Events

Risk factors

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Events

For the purpose of the factor formula

framework, a scenario can describe:

A single event, e.g. a specific

earthquake in Los Angeles, a stock

market crash, etc.

An implicit event that is defined

implicitly. Examples are reverse

scenarios that are defined as ‘events

that lead to a given loss’ or ‘an

earthquake event to which a specific

insurer has highest exposure’, etc.

A set of events. In some

circumstances, the distribution and

dependency of risk factors can be

modeled sufficiently reliably. This model

then describes a set of potential events

with relative weights. Examples are

certain financial market risk events, life

insurance risk events, etc.

Implicit

Events

Set of

Events {E│P(E)<α}

{E│Capital(E)<0}

X ~ LN(x,α,β)

Events

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Types of Scenarios

Possible, internally

consistent events,

parameterized by a

set of risk factors

Scenarios AKG Photo

Global Events

Regional / National Events

Company Specific Events

Events that have

global reach and that

impact all IAIGs, e.g.

global financial

market events or

pandemics.

Events that have regional or

national reach and that impact

those IAIGs that have

exposures to the specific

region. Examples are a

regional financial market

event, a SARS epidemic, etc.

Scenarios that are

tailored to the risk

exposure of a specific

IAIG, defined either by

the supervisory

authorities or by the

insurer.

Historical Events

Events that are patterned after

historical events. Risk factors are

calibrated based on historical data,

but taking into account possibly

changes in the environment.

Examples are past financial crisis

(e.g. the credit crunch, the global

recession, pandemic)

Conceivable Events

Events that have not

occurred before, e.g. EU

split-up, USD default, legal

liabilities due to

nanotechnology, etc.

{S│P(S)<α}

Implicit Events

Events that are described

implicitly, e.g. ‘an earthquake

event to which a specific

insurer has maximal exposure

and that occurs with a

likelihood of less than 1 in 100.

Set of Events

A set of events with relative

weights, e.g. financial

market risk factors with joint

distribution function defining

an (infinite set) of possible

financial market risk events

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Proposed principles for defining scenarios

• Principles for defining scenarios ensure that the set of global scenarios can be extended

and adapted over time and company specific and national scenarios can be formulated

consistently

• Given the experience of insurance supervisory authorities (e.g. Australia, Belgium,

Bermuda, Canada, EIOPA, Germany, Hong Kong, Japan, Singapore, Switzerland, USA

and others) as well as the industry with stress testing and scenario analysis, a framework

can be implemented that ensures both a stable calibration and relevant information on

the impacts of scenarios on IAIGs.

• The principles for defining scenarios could include:

• Adequate documentation (reasons for choice of the scenario, narrative, data basis,

etc.)

• Range of likelihoods of the event considered

• Time frame over which events take place

• Effects to be included (initial event(s), secondary effects, ripple effects)

• Granularity of the numerical specification of the event

• Specification for the evaluation of the impact of the scenario (e.g. granularity, valuation

basis, management actions to be taken into account, etc.)

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Choice of Scenarios for IAIG

Global Scenario

Regional Scenario

National Scenario

Company Specific

Extensions

Regional and national

scenarios derived from global

scenarios. Detailed

specification of regional and

local risk factors, based on a

high-level, global event.

National

scenarios

derived from

regional but not

global events

Company specific scenarios

formulated to target specific

vulnerabilities

Adaptations and extensions of the scenario

descriptions to take into account company-specific

exposures and relevant risk factors

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Scenarios

Scenarios

Core set of global

scenarios, defined

by the IAIS

Local / National

scenarios, defined by

supervisory authorities

Company specific

scenarios

Realistic, adverse

possible states of the

world, covering major

global and regional

events impacting IAIGs.

Scenarios covering

financial market risk

events, pandemic,

natural catastrophes etc.

Local and national event,

consisting of more detailed

global events with local

impacts and additional events

tailored to the local situation

Company specific

events, targeting

exposure to risk of

single companies for

additional information

National calibration Base calibration

Global scenarios,

detailed for

national effects

National scenarios

Capital requirement Capital requirement

Impact of

scenarios

Calibration

A scenario is defined by

values taken on by a set of

risk factor that describe the

relevant state of the world

given a realistic, adverse

event occurs. Risk factors are

for example interest rates,

equity prices, mortality rates,

loss ratios etc.

Risk factors

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Events impacting IAIGs Examples

Global Events

Regional or

market wide

events

Scenarios that potentially

affect most or all IAIGs

Company-

Specific Events

Scenarios that potentially

affect a few IAIGs

Scenarios that are

specific to a single IAIG

Pandemic, Global financial market events (e.g. impacting

global interest rates, global credit crunches, etc.)

Regional war between major powers (?)

Sovereign defaults impacting a major currency

Default of a G-SIFI with ripple effects

Global high inflation

Regional financial market events (e.g. due to central bank

policies, regional collapse of economy), large natural

catastrophe (e.g. earthquake California, Tokyo, etc.)

Default of a regional or local sovereign

Events impacting entire business classes leading to

under-reserving

Specific products incurring catastrophic losses, specific

assets holding

Under-reserving

Default of the home jurisdiction (minor economy)

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Philipp Keller

Head Financial Risk Management

Philippe Brahin

Head Governmental Affairs & Sustainability

Managing Director

Deloitte AG

General-Guisan Quai 38

8022 Zurich

Switzerland

Swiss Reinsurance Company Ltd

Mythenquai 50/60

8022 Zurich

Switzerland

Tel: +41 58 279 6290

Fax: +41 58 279 6600

Mobile: +41 79 874 2575

Email: phkeller@deloitte.ch

Direct: +41 43 285 7212

Fax: +41 43 282 7212

Mobile: +41 79 777 9835

E-mail: Philippe_Brahin@swissre.com

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