1

Consequences of Solvency II for Insurers’Administrative Costs

CEA, March 2007

2

Executive SummaryRequest from the Commission

The European Commission has requested that CEA assists in estimating the impact of Solvency II on administrative costs

In this summary, CEA considers two potential scenarios:Scenario 1: Solvency II follows a risk based economic system (Key assumptions provided in following slide)Scenario 2: Solvency II leads to an inappropriate Solvency framework

The analysis indicates that admin. costs would be manageable if Solvency II follows a risk based economic approach (scenario 1) but can be significantly greater if Solvency II results in an inappropriate framework (scenario 2)

3

The impact on administrative costs will be determined by the final outcome of the SolvencyII texts. This is not yet known and as such, we have made certain assumptions in performing this work including:

Solvency II will be based on a risk based economic approachPillar I Solvency Capital Requirement (“SCR”) will be based on a market-consistent, total balance sheet approach

No prudence required in excess of the market value of liabilities It is the purpose of the SCR to cover the risk that the future values vary from the current market value estimates (considering market prices of risks; costs of options and guarantees)

Solvency II will encourage proper risk control; risk mitigation will be fully recognised in both Pillar I and IISolvency II is sufficiently harmonised (across all Pillars) so that the risks in different locations and companies are treated consistently Diversification as a basis for sound risk management will be recognised in both the solo and group solvency requirementsThe SCR can be determined either by a standard approach or by an approved (partial) internal model with the standards for approval being achievablePillar 2 requirements are clearly articulated and achievableThe SCR acts as an important target level of capital

Executive Summary Assumptions underlying a risk based economic approach

(Scenario1)

Our assumptions are part of a coherent package and it is not clear that the current CEIOPS advice and QIS 3 specifications are consistent with the above assumptions. If Solvency II does not follow the above assumptions, then the costs (admin. and otherwise) will be significantly

higher for the industry.

4

Executive SummaryScenario 1: A risk based economic system

As part of the preparatory work on the Directive on Solvency II, the European Commissionrequested CEA to assist in estimating the administrative costs associated with Solvency II (i.e. the extra costs solely attributed to Solvency II)

Our analysis indicates the following:

0.3 – 0.52.0 – 3.0Estimated reduction for work already planned/done

€ 0.3 – 0.5 bn€ 2.0 – 3.0 bnNet estimate 1

0.6 – 1.04.0 – 6.0Gross estimate

Ongoing (p.a.) admin costsInitial admin costsCosts in Billion Euro

The results are based on two different approaches (top down and bottom up) withconsistent results from both approaches.

The analysis shows that the costs would be managable only if Solvency II reflects the underlying economics that companies use to manage their business. Failure to do so willresult in the loss of synergies and lead to significantly higher costs and double work for

companies.

1 The impact of tax relief on the associated expenses is not included as this will vary by type of business and jurisdiction

5

Failure of Solvency II to follow a risk based economic approach will impact the associated admin costs. In this scenario:

Many companies would still incur the costs of a risk based economic approach as this is in line with industry best practice on risk management. Solvency II will simply mean double work. There would be no reduction for work already planned/done.

In such a case, the extra admin cost would be at least equal to the € 4.0 to € 6.0 billion previously indicated and indeed could be higher particularly, if the system was prescriptive and significantly out of line with the economics of the business (potential admin costs could exceed € 10.0 billion).

However, the true cost to the industry if Solvency II did not follow an economicapproach cannot be measured in monetary terms:

The system would provide inappropriate incentives for companies in managing their risks, thereby allowing companies to accept risks on non-economic terms.

This will be to the longer term detriment of both policyholders and investors There will be no incentive for companies to improve their risk measurement and risk management processesThe resultant system would be capital inefficient and insurance companies would be unable to perform the key function of accepting and spreading risk to detriment of the European Insurance industry, policyholders and the wider economy

Executive SummaryScenario 2: An inappropriate Solvency framework

6

Executive SummaryImpact on capital raising

The European Commission also asked CEA to help assess the potential impact of Solvency II to the cost of raising capital. The potential benefits of a well designed Solvency II include:

Increases in transparency and disclosure for investors and consumers Encouraging companies to better manage their businesses (towards more efficient economic capital structures, and reducing inappropriate risks)Improving investors’ confidence by better understanding of the company’s risk (reduces risk premiums for the industry)Improving customer choice by facilitating competition and product innovation among insurersGreater confidence in the insurance sector by preventing of potential future industry crises

Capital raising is just one area where a properly designed Solvency II could provide benefits:Capital raising by European Insurance companies has averaged ca € 25 billion per annum over the last few years. We expect increased transparency and better recognition of recent capital market innovations such as hybrid debts might decrease the cost of raising capital for companiesIn addition, current Solvency I requirements are in the order of € 300 billion. A risk sensitive Solvency II framework will allow companies to tailor their risk strategy and only small changes in capital consumption is required in order to compensate for the associated admin costs

There is however a risk as over 80% of companies responding to the CEA Impact Assessment survey indicated that if Solvency II does not follow economic principles or the capital requirements are higher than economically justified or if the requirements conflict with good risk management (scenario 2) then the resulting system will be complex and inefficient potentially damaging investor confidence and their willingness to supply capital to

the insurance industry.

7

Executive SummaryImpact on Capital raising

Quantification of the effects on capital raising is more complex and more assumptions-based. This requires more in-depth analyses.

If the European Commission would like to pursue a quantitative analysis, we propose the European Commission to approach an independent expert (e.g. economist firm) to assist with the analysis.

8

Contents

Executive Summary

Admin costs: Request, Assumptions and Approach

Admin costs: Top-down approach

Admin costs: Bottom-up approach (CEA questionnaire)

Capital raising and Solvency II benefits

9

Request from European Commission

The European Commission has requested that CEA assists in estimating the impact of Solvency II on administrative costs and the cost for insurance companies to raise capital

The European Commission request included the following questionsWhat would be the net impact on insurers’ administrative costs associated with Solvency II, distinguishing between initial costs and ongoing costs?What would be the potential benefits associated with Solvency II?What would be the impact of Solvency II on costs for insurance companies to raise capital in the future?

Administrative costs are defined as the costs incurred in meeting legal obligations to provide information to public authorities or to private parties.

Net change in the cost of on-going reporting (i.e. the difference of reporting under Solvency I and Solvency II)Information is to be taken in a broad sense, including costs of reporting, and monitoring to provide the information and registrationAn administrative action required by law but corresponding to what an entity would normally do in the absence of any legal obligation should not be regarded as an administrative obligation.

10

Analysis of administrative costs are based on two approaches

Top-down approachWe have analysed publicly available data that relates to Solvency II and / or other examples of regulatory change

This includes QIS2, CEA Impact Assessment Survey, ICAS, SST, Basel II, ANIA survey, and Dutch legal reforms

This information has been used to derive a high level quantitative assessment

Bottom-up approachWe have executed a questionnaire covering the potential impact of Solvency II on companies:

initial and ongoing costsRelationship between internal and external costsPlanned and additional Solvency II costs

We received over 90 responses out of 17 countries covering a representative sample of the European market

This reflects substantial interest from companies considering the very short timeframe for the survey (less than three weeks)

11

Contents

Executive Summary

Admin costs: Request, Assumptions and Approach

Admin costs: Top-down approach

Admin costs: Bottom-up approach (CEA questionnaire)

Capital raising and Solvency II benefits

12

Top-down approach:Analysing multiple publicly available sources

Analysing available data on the foreseen Solvency II regimeCEIOPS’ QIS 2 ReportCEA Impact Assessment Survey

Analysing publicly available data on regimes that have undergone significant regulatory changes

UK (ICAS regime)Switzerland (SST) Italy (ANIA-survey)Netherlands (WFT)

Banking industry (Basel II, Capital Requirements Directive)

The information above has been used to derive a quantitative assessment with qualitative comments as to the potential differences with the intended Solvency II regime.

13

The Top-Down approach

Base case

Assumed European equivalent

Costs incurred by actual or planned risk management

activities

Assumed total (gross) Solvency II

costs

Extrapolate

Scale up

Net down

Identified by country-specific regimes such as SST, ICAS, etc.

Estimate costs if base case would be implemented Europe-wide(e.g. ratio-up to 5,000 companies)

Assess difference between base case and Solvency II (e.g. include efforts for Pillars II & III)

Estimate proportion of costs that would have been incurred anyway

Admin costs of Solvency II

(net costs)Step 1

Step 2

Step 3

14

Key assumptions used in the top-down approach

Annual total costs (incl. overhead) per person year: € 240kThis is based on average salary of scarce, highly skilled technical expertise such as actuaries and risk managers (€ 75k)It includes a loading for non-salary costs such as overhead expenses, pension contributions and other statutory benefits (100%)It further assumes that part of the initial Solvency II work will require external support (30% for initial costs and 7.5% for ongoing costs)

Information provided on comparative regimes normally covers the risk measurement information

The results therefore need to be scaled up to reflect additional costs of embedding the system into the company and Pillar 2 and 3 requirementsWe have therefore made an assumption that the overall Solvency II framework requires an effort of 200% on top of the risk modelling work*. The CEA Impact Assessment shows that regulatory change is not the only driver for companies to upgrade risk management and management processes.Other reasons include shareholder and rating agency pressure, good business practice and competitive pressuresOur questionnaire to companies indicates that if Solvency II follows a risk based economic approach then companies are expected to have done roughly 50% or more of the required work for Solvency II in an attempt to individually improve their risk management frameworks

* Please note that this does not intend to make any implicit assumptions on the distribution of costs among the 3 Pillars, but rather an a overall estimation of the cost of a future holistic approach to Solvency II.

15

An example of our top-down approach:CEIOPS’ QIS 2 report (1/2)

Base case: Estimate the number of person-months to do the QIS 2 calculations from the QIS 2 feedback

Initial requirements are “4 person months to 3 person years”Annual ongoing costs are “couple of person months on average“. We assume 2 person months

Step 1: Recognise that efforts differ for small, medium-sized and large companiesExtrapolate these estimates to the European market by multiplying by the number of companies in each segmentThis provides a preliminary estimate of the risk modelling work required

Step 2: Scale this up to include other non-risk modelling workThis includes areas such as governance, validation and reporting work. Also this includes the work required for more permanently embedding the risk modelling workThis provides an estimate of the total costs of embedding Solvency II functions within the company

Step 3: net down the gross cost to recognise that part of the work will be done because of companies’ individual efforts to improve their risk management activities

16

An example of our top-down approach:CEIOPS’ QIS 2 report (2/2)

€ 370 m€ 1,575 m€ 40 m€ 720 m€ 11 m€ 360m

Total ongoing costs

€ 14 m

€40 k

2

Ongoing costs

2624248Person months

€ 40 k€120 k €480k€40 k€960 kCosts

4375500125Number of comps

Step 1: Assumed European Equivalent of QIS2 (5.000 companies)

€ 125 m€ 525 m€ 240 m€ 4.0 m€ 120 m

Step 2: Scale up for other Solvency II costs

€ 421 m€ 2.7 bnTotal initial costs

Ongoing costs

Initial costsInitial costsOngoing costs

Initial costsPer company

Small companiesMid-size companiesLarge companies

Based on this, Solvency II would costs: € 2.7 bn (initial) and € 0.4 bn (ongoing)This estimate should be treated as a lower band of our estimates

QIS 2 was only a partial test including simplifying shortcutsInherent bias: QIS 2 participants are likely to be the more advanced companies

17

Although Basel II is a useful reference point,the industry believes Solvency II should be less onerous

Initial (one-off) implementation costs for Basel II:1)

ca. € 32.5-47.5 bn pre-tax

The insurance industry is substantially smaller than the banking industry Insurance is ca 1/5th the size of banking (Assets under Management: € 25’000 bn vs. 5’000 bn)

This would lead to initial (one-off) costs: approx. € 6.5 to 9.5 bn

While Solvency II is more advanced than Basel II, Solvency II could be less costly because:

Solvency II can benefit from progression within the area of risk management since the introduction of Basel IIBasel II drills down to individual product level, whereas Solvency II is more high-level without requiring fundamental redesign the underwriting processesLarge IT expenses by larger banks up to € 150m implementation costs per bankBasel II is also more prescriptive than our assumption for Solvency IIMany insurance companies are already investing ahead of Solvency II in order to improve their risk measurement and management in line with a risk based economic approachHence, above figures could be at the upper range for a risk based Solvency II

1) Source: ”Study on the financial and macroeconomic consequences of the draft proposed new capital requirements for banks and investment firms in the EU (markt 2003/02/F)” (PWC, 2004)

18

Results from the top-down analysis (1/2)

Step 2 results€ 0.6 – 1.0 bn€ 4.0 – 6.0 bnSubjective estimate1

0.4 – 1.2

n/a

1.2

0.7

1.0

0.4

Annual ongoing costs

1.7 – 9.5Range overall

ANIA estimated only ongoing costsn/aANIA

Basel II less comparable, outcome at upper range6.5 – 9.5Basel II

Swiss market is small and advanced market – outcome is lower bound1.7SST

ICAS aimed at internal model building4.8ICAS

QIS2 was partial test, on “best efforts”basis - outcome at lower range2.7QIS 2

CommentsInitial costsCosts in Billion Euro

1 Excluding extreme values

19

Results from the top-down analysis (2/2)

Step 3: ”Netting down” takes into account that part of the Solvency II costs would be incurred by companies who have already made an effort of improving their risk management

As stated before, the netting down is based on the assumption that Solvency II is based on a risk based economic approach which is aligned with the principles that companies already use for their internal risk management frameworks (Scenario 1)

0.3 – 0.52.0 – 3.0Reduction work already planned/done: 50%

€ 0.3 – 0.5 bn€ 2.0 – 3.0 bnNet estimate1

0.6 – 1.04.0 – 6.0Gross estimate

Ongoing (p.a.)admin costs

Initial admin costsCosts in Billion Euro

1 The impact of tax relief on the associated expenses is not included as this will vary by type of business and jurisdiction

20

Contents

Executive Summary

Admin costs: Request, Assumptions and Approach

Admin costs: Top-down approach

Admin costs: Bottom-up approach (CEA questionnaire)

Capital raising and Solvency II benefits

21

Methodology for bottom-up approach

A questionnaire was sent out to members accompanied by a guidance document explaining the background

The guidance document made certain assumptions that Solvency II would follow a risk based economic approach

Participants were asked to estimate:Initial costs of implementing a risk management framework and the additional cost of Solvency II complianceOngoing risk management costs and the additional administrative cost of Solvency II External support requirements

Over 90 companies responded to the questionnaire, from 17 countries. This represents an excellent result given the short time frame for the survey (less than 3 weeks)

The response is a good representation of the EU insurance industry, including large/small companies, stock-listed/mutual insurers, multi-/mono-liners, etc

Respondents indicate that at least 50% of the initial costs of Solvency II would be already planned or incurred

22

The Bottom-up results are aligned with the top-down estimates

Based on the data from the questionnaire, companies have indicated the total and the additional work due to Solvency II

€ 0.5 bn€ 2.3 bnNet estimate1

0.52.3Reduction for work that would be done/has been done (50%)

€ 1.0 bn€ 4.5 bnTotal costs (gross)

0.20.8125Large

0.20.9500Midsize

0.62.84375Small

Ongoing (€ bn)Initial (€ bn)Number Comp.’s

This is based on the assumption that Solvency II will follow a risk based economic approach (Scenario 1)

Respondents clearly underline that an inappropriate design of the Solvency II framework will significantly increase costs (Scenario 2)

1 The impact of tax relief on the associated expenses is not included as this will vary by type of business and jurisdiction

23

Qualitative feedback from companies1

“I assume that our internal risk modelling work will be accepted under Solvency II”

“Economic capital models are getting more and more important. Maintaining separate models next to each other will be confusing and will lead to even more complex decision making processes “

“Assumption is an efficiently working Solvency II system (group supervision, internal vs. standard models, benchmark portfolio). If this is not the case costs may increase exponentially.”

“We are a small non-life firm. Too strong requirements, towards the means of a small firm, could urge us to retain only a partial internal model”

“To a large extent the additional costs of Solvency II depend on the degree that we are required to provide information at a different level or in different ways than what is currently used internally”

“We have assumed that there will be a lead supervisor approach …, else the additional of Solvency II compliance will be much higher”

“We expect the additional cost of Solvency II compliance to be negligible because the Solvency II requirements will be an integral part of the internal model currently being developed.”

“Our national supervisor would request that we run both the standard and our internal models…We would (aim) to prevent such situations that might definitely increase our technical workload

without actually enhancing our SCR adequacy.”

1 Source: qualitative comments to CEA questionnaire

24

The CEA Impact Assessment highlights dangers of not following a risk based approach for Solvency II

This work has been based on the assumption that Solvency II will follow a risk-based economic approach. Failure to do so (for example Scenario 2) would result in the following:

Solvency II will not follow the ongoing industry trend towards a risk-based economic approach and hence it will be likely for companies to maintain their current efforts (improved risk management) while being forced to use in parallel a regulatory model which would not be in line with economic realitySolvency II will result in increased work for companies if it gives rise to parallel reporting linesIt would provide inappropriate incentives for companies in managing their risks, thereby allowing companies to accept risks on non-economic terms. This will be to the longer term detriment of both policyholders and investors

Over 80% of the insurance companies indicated that Solvency II will be complex and inefficient if:

the framework does not follow clear economic principlesthe capital requirements are greater than economically justifiedthe requirements are in conflict with good risk management

This is likely to damage the confidence of investors and their willingness to supply capital to the insurance industry.

25

Contents

Executive Summary

Admin costs: Request, Assumptions and Approach

Admin costs: Top-down approach

Admin costs: Bottom-up approach (CEA questionnaire)

Solvency II benefits and impact on capital raising

26

The benefits of Solvency II will extendbeyond capital management

The European Commission also asked CEA to help assess potential changes in the cost of raising capital due to Solvency II.

It is difficult to quantify in euro amounts the benefits of the intended SolvencyII framework (particularly in the limited time available). However, the potential qualitative benefits of a well designed Solvency II include:

Increases in transparency and disclosure for investors and consumersIncreased competition in European Insurance MarketsSharper and fairer pricing of insurance productsBetter incentives to insurance product developmentA better functioning internal market for insurance servicesProviding also regulatory incentives to companies to better manage their businesses (towards more efficient economic capital structures, and reducing inappropriate risks)Improving investors’ confidence by better understanding of the company’s risk (reduces risk premiums for the industry)Greater confidence in the insurance sector by preventing of potential futureindustry crisisAll stakeholders, including consumers, will ultimately benefit from a Solvency II regime that is based on a risk based economic framework

27

Impact of Solvency II on the cost of raising and holding capital

Capital management is just one area where a properly designed Solvency II could provide benefits.

Over past years the European insurance industry raised capital of the order of approximately € 25 billion per annum

This has been roughly divided equity 25%, hybrid capital 35%, bonds/debt 40%We might expect that increased transparency and better recognition of recent capital market innovations such as hybrid debts should theoretically decrease the cost of raising capital for companies

However, the other benefit of Solvency II will be in the ability of the companyto actively manage its capital requirements regardless of size and corporatestructure,

Current Solvency I requirements are in the order of € 300 billion. If Solvency II allows companies to better manage their economic capital positions then only small improvements of capital consumptions are required for the benefits of Solvency II to outweigh the admin costs (provide that the system follows a a risk based economic approach)

28

Impact of Solvency II on the cost of raising and holding capital

In addition CEA’s Impact Assessment Survey indicates that under a risk based economic approach (Scenario 1):

over 75% of the companies expect to raise capital more easily under a risk based economic Solvency II framework ca. 85% of the companies expect that the recognition of more eligible elements (incl. hybrid capital) will decrease the cost of raising capital in the futureapprox. 95% of the companies expect that a overly burdensome regulatory framework will increase the cost of raising capital

In summary, we expect that the initial and ongoing admin costs of Solvency II can potentially be outweighed by the benefits of Solvency II.

However, the benefits associated with Solvency II are extremely sensitive to the final outcome of Solvency IIWe have assumed that Solvency II is designed on a risk based economic approach (Scenario 1)

If Solvency II does not follow an economic approach, then our presented findings will be materially distorted and in such a case, the costs will clearly not outweigh the potential benefits (Scenario 2)

29

Appendix:Background documentation

Solvency II – Introductory GuideA 10-pages brochure (including synthetic executive summary) introducing the main concepts of Solvency II

Solvency II – understanding the processA short brochure that could help ‘newcomers’ to become acquainted with the Solvency II debate. Provides an overview of the key CEA position papers

Frequently Asked QuestionsDynamic document explaining relevant Frequently Asked Questions including references to relevant CEA papers

CEA’s view on the impact of Solvency II on the Average Level of CapitalA guide on the comparison of the current Solvency I and future Solvency II frameworks

Impact Assessment Survey ReportA report of the largest Solvency II related questionnaire executed by the CEA

Topography EU25 ReportDescription and analysis of the EU25 insurance market

CEA Response to CEIOPS’ CP20CEA response to CEIOPS Consultative Paper no. 20 (Pillar I issues)

CEA Preliminary feedback on QIS 2CEA provided preliminary feedback on the second Quantitative Impact Study (QIS 2) results

30

Contacts:

President of CEAGérard de la Martinière (g.delamartiniere@ffsa.fr)

CEA Economics & Finance Committee ChairmanJos Streppel (jos.streppel@aegon.com)

CEA Solvency II Steering Group Chairman: Antoine Lissowski (antoine.lissowski@cnp.com)

CEA Director General: Michaela Koller (koller@cea.assur.org)

CEA Economics & Finance Committee SecretariatPeter Skjødt - acting ECOFIN Director (PSK@ForsikringensHus.dk )Yannis Pitaras (Pitaras@brussels.cea.assur.org)Jérôme Berset (Berset@cea.assur.org)René Doff (Doff@brussels.cea.assur.org)Benoît Malpas (Malpas@cea.assur.org)Secretary: Valerie Rein (Rein@cea.assur.org)

www.cea.assur.org / www.cea.eu+32 2547 5811