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Benefits and challenges of using an internal model for Solvency II 19th March 2009 Presentation

Benefits and challenges of using an internal model for Solvency II

19th March 2009

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Principle

Principle Capital is a scarce resource And It flows to the highest returns Presentation title here

Capital is a scarce resource

And

It flows to the highest returns

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Agenda

Agenda 1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements • Internal Model
1. Context
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

Do the right things and do the things right We do not need a lot of
Do the right things and do the things right We do not need a lot of

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

Benefits of internal models vs. Standards formula Under Solvency II firms can choose using the standard

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 company’s 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

Agenda 1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements • Internal Model
2. Timetable
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

Solvency II timetable Internal Model approval “Dear CEO” letter Plan to seek approval of Internal Model

“Dear CEO” letter

Plan to seek approval of Internal Model

“Dear CEO” letter Plan to seek approval of Internal Model 04/09 UK 06/09 Europe 06/10 to

04/09 UK

06/09 Europe

06/10 to 11/10

10/12 Internal

Implementation

Implementation

Internal Model Dry

plan Approval of the SII Framework Directive

plan

run submission

Model approval

Solvency II Implementation

Internal Model Dry run submission
Internal Model Dry run submission

QB1, Participate to QIS4 exerciseSolvency II Implementation Internal Model Dry run submission Aviva / FSA Dialogue QB2, Made substantial progress

Aviva / FSA Dialogue
Aviva / FSA Dialogue

QB2, Made substantial progress towards documentationQB1, Participate to QIS4 exercise Aviva / FSA Dialogue QB3, Prepared a Solvency II implementation plan

QB3, Prepared a Solvency II implementation plan to get internal model, risk management and associated systems embeddedQB2, Made substantial progress towards documentation 2009 2010 QB4, Be able to calculate the EC on

2009
2009
2010
2010

QB4, Be able to calculate the EC on a regular basis

2011
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

Agenda 1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements • Internal Model
3. Target operating model
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

Aviva target operating model Drivers for integrated risk and capital management Regulatory drivers Business drivers
Drivers for integrated risk and capital management Regulatory drivers Business drivers Management Management
Drivers for integrated risk and capital management
Regulatory drivers
Business drivers
Management
Management
Governance
Governance
Information
Information
Strategy
Strategy
& &
Incidents & Loss
Incidents & Loss
Risk
Risk
Roles & delegated
Roles & delegated
Plans
Plans
Solvency II
events
events
Appetite
Appetite
authorities
authorities
D D
LEARN FROM
LEARN FROM
Efficient use of capital
I I
PAST
PAST
S S
Risk profiles
Risk profiles
Line
Line
C C
& &
quantification
quantification
management
management
Risk
Risk
Policies
Policies
analysis
analysis
& &
Reporting
Reporting
L L
FSA
Management
Management
Risk
Risk
PRESENT
PRESENT
Identification
Identification
O O
& &
Assessment
Assessment
Maximising risk reward
S S
Predictor events
Predictor events
trade off through
FUTURE
FUTURE
Decision
Decision
Committees
Committees
U U
Making
Making
managing upside risk
Monitoring
Monitoring
R R
& &
Standard & Poor's
E E
Controls
Controls
Systems and Tools
Systems and Tools
Other international work
Maximising adverse risk
exposure/ managing
downside risk
Communication, Education Training and Guidance
Communication, Education Training and Guidance
Internal Model
Internal Model
Market drivers
Hardening insurance
market
Extreme events
Market turbulence
Competitor activity

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Agenda

1. Context

2. Timetable

3. Target operating model

Agenda 1. Context 2. Timetable 3. Target operating model 4. Solvency II Requirements • Internal Model
4. Solvency II Requirements
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

Solvency II Requirements Internal Model Approval Criteria The internal model approval process requires firms to

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. 119 Statistical
quality standards
Art. 118 Use test
Art. 122 Validation
standards
Art. 44
O
Art. 120 Calibration
standards
R
Internal Model
Art. 123 Documentation
standards
Approval
S
A
Art. 121 Profit and loss
attribution
Art. 124 External models
and data
and loss attribution Art. 124 External models and data • The purpose of the use test

• 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

of internal model and risk management processes Solvency II relevant texts • Art 123: …”The
Solvency II relevant texts • Art 123: …”The documentation shall indicate any circumstances under which
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

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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
Documentation

Complexity of the model

Agenda

1. Context

2. Timetable

3. Target operating model

4. Solvency II Requirements

• Internal Model Approval Criteria

• Documentation

• Internal Model Approval Criteria • Documentation 5. How to get there: Key features to be
5. How to get there: Key features to be taken into account when designing an
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

Why is Capital so important Problem: How to model the different risks to what extent? Which

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

Some risks are almost inaccessible

Operational

Legislation

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150 100 50 0 -6 -4 -2 0 2 4 6 150 100 50 0
150
100
50
0
-6
-4
-2
0
2
4
6
150
100
50
0
-6
-4
-2
0
2
4
6

Sweden

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Capital model – allocate capital

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Balance sheets and Risk Capital

Statutory balance-sheet Fair value balance-sheet for control of risk capital Assets Liabilities Assets Liabilities
Statutory balance-sheet
Fair value balance-sheet for
control of risk capital
Assets
Liabilities
Assets
Liabilities
statutory
fair /
valued
market-
insurance
near
liabilities
valued
insurance
liabilities
Probability Density Provisions at Fair Value Median Confidence Interval (Best Estimate) Required Additional
Probability Density
Provisions
at
Fair Value
Median
Confidence Interval
(Best
Estimate)
Required
Additional Available Capital
Provisio
Capital
ns
50%
50%
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Value
50% 50% Presentation title here 00.00.00 page 18 Value A/L management focuses on Statutory view and

A/L management focuses on

Statutory view and

Mark to market view

Therefore the balance sheet need to be recalculated

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

Design of an Internal Model that can be used in day- to-day business: Key features to be taken into account

day- to-day business: Key features to be taken into account KEY FEATURES COMMENTS Frequency of calculations

KEY FEATURES

COMMENTS

Frequency of calculations

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

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

Use of internal model in decision making

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

Board /Senior management need to understand:

High level principles, assumptions and limitations

 

Commercial implications

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Practical applications to make better decisions

Practical applications to make better decisions AREAS PRACTICAL APPLICATIONS Reinsurance • Analysis, design

AREAS

PRACTICAL APPLICATIONS

Reinsurance

• Analysis, design and purchase of the reinsurance programme

Underwriting

Pricing of the business through the allocation of capital to lines of business and linking to the plan targets

Investment Management

• Determining the possible effects of investment decisions

Product Development

• Understanding the potential impact of new products

Management Information

• Understanding the risk in the plan and sensitivities to key assumptions

Strategy & Planning

• Assessing the possible impact on the risk and capital of the business of various strategies

Corporate Finance

• Assessing the possible impact on the risks and capital profile of the business of potential M&A

Finance Function

• Risk based performance reporting using measures such us return on risk adjusted capital

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Models in General

Scylla and Chaybdis

Models in General Scylla and Chaybdis Reality Model Observable Parts of the world: Observable Parts in
Reality Model Observable Parts of the world: Observable Parts in the model: 1) Share Prices
Reality
Model
Observable Parts of the world:
Observable Parts in the model:
1) Share Prices
2) Discount Rates
3) Forward rates
1) Share prices
2) Discount rates
3) Forward rates
4) etc.
4) etc.
Real Questions:
Deductions and solved questions in the
model:
1) Value of an entity
2) Cost of a product
3) Required risk capital
4) etc.
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

• Internal Model Approval Criteria • Documentation 5. How to get there: Key features to be

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
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
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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management, 36% for asset strategy and 28% for product design and pricing Presentation title here 00.00.00

Agenda

1. Context

2. Timetable

3. Target operating model

4. Solvency II Requirements

• Internal Model Approval Criteria

• Documentation

• Internal Model Approval Criteria • Documentation 5. How to get there: Key features to be

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
7. Challenges and Opportunities

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Severity

Treats and Opportunities 1/2

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Treats and Opportunities 2/2:

Manage the business – Sensible MIS to enhance returns

and Opportunities 2/2: Manage the business – Sensible MIS to enhance returns Presentation title here 00.00.00
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Consequences

Consequences • Always keep the purpose in mind • No mathematical woo do! • No Eulenspiegel

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?

Risk Management Process – Do you know where YOU stand? Identify all relevant risks and allocate

Identify all relevant risks and allocate them to risk categoriesRisk Management Process – Do you know where YOU stand? Measure the assumed risks Monitor Compliance

Measure the assumed risksall relevant risks and allocate them to risk categories Monitor Compliance with Limits Review the risk/return

Monitor Compliance with Limitsallocate them to risk categories Measure the assumed risks Review the risk/return rations Identification Risk

Review the risk/return rationsMeasure the assumed risks Monitor Compliance with Limits Identification Risk Management Process Management

Identification Risk Management Process Management Monitoring Monitoring Measurement
Identification
Risk Management
Process
Management
Monitoring
Monitoring
Measurement
Process Management Monitoring Monitoring Measurement Define the measurement methodology Measure the

Define the measurement methodology

Define the measurement methodology

Measure the individual risk factors

Measure the individual risk factors

Aggregate the risk exposures

Aggregate the risk exposures

Fix the limits / maximal allowable risk exposuresthe individual risk factors Aggregate the risk exposures Evaluate the existing and required risk capital Presentation

Evaluate the existing and required risk capitalexposures Fix the limits / maximal allowable risk exposures Presentation title here 00.00.00 page 28 Actively

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Actively manage risk exposuresmaximal allowable risk exposures Evaluate the existing and required risk capital Presentation title here 00.00.00 page

The floor is open!

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