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«The Solvency II Actuary Kathryn Morgan Financial Services Authority, 25 The North Colonnade, Canary Wharf, London, E14 5HS kathryn.morgan ...»

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The Solvency II Actuary

Kathryn Morgan

Financial Services Authority,

25 The North Colonnade,

Canary Wharf,

London, E14 5HS

kathryn.morgan@fsa.gov.uk

Annette Olesen

PricewaterhouseCoopers LLP

6 Hay's Lane,

London,

SE1 2HB

annette.olesen@uk.pwc.com

Abstract:

Solvency II is a fundamental change for the insurance industry. As a profession we have

a key part to play to fulfill the requirement for an Actuarial Function as set out in Article

47 of the framework Directive, and the challenge to get involved more widely in the risk management of the organisation to potentially assist and play a key role the assessment of regulatory capital requirements. These parts of the solvency framework have not been assigned solely to the Actuarial Function but are areas where we face the challenge of demonstrating that we can add value and that we should be involved.

We need to drive the development of methodologies and deal with a number of fairly complex technical challenges not all of which we do today. This paper presents some of those challenges. Over and above this, we must be able to clearly communicate complex issues and results to our colleagues and senior management.

We believe that Solvency II will fundamentally change and set standards for our work for years to come.

Introduction ‘Solvency II is not just about capital. It is a change of behaviour’. The Chairman of CEIOPS Thomas Steffen made this comment at the launch of the Solvency II Framework Directive in July 2007.

Keeping in mind that the Actuarial Function is one of four core functions mentioned within the proposed Directive, this paper explores how the upcoming regime may influence the role, remit and responsibilities for actuaries across the European Union, and possibly more widely as Solvency II extends across the world.

The Solvency II regime will in our view bring a number of challenges for the profession but also opportunities to widen our role and to get more proactively involved in strategic business decisions.

Executive summary Solvency II is a fundamental change for the insurance industry. As a profession we have a key part to play to fulfill the requirement for an Actuarial Function as set out in Article 47 of the framework Directive, and the challenge to get involved more widely in the risk management of the organisation to potentially assist and play a key role the assessment of regulatory capital requirements. These parts of the solvency framework have not been assigned solely to the Actuarial Function but are areas where we face the challenge of demonstrating that we can add value and that we should be involved.

We need to drive the development of methodologies and deal with a number of fairly complex technical challenges not all of which we do today. This paper presents some of those challenges. Over and above this, we must be able to clearly communicate complex issues and results to our colleagues and senior management.

We believe that Solvency II will fundamentally change and set standards for our work for years to come.

Solvency II – where do the actuaries fit?

The introduction of a more risk-sensitive approach to supervision will encourage alignment between prudential supervision and enterprise-wide risk management (ERM).

This will encourage, if not require, companies to enhance risk management, upgrade information systems and embed risk awareness more closely into the governance, strategy and operations of their business in order to demonstrate to their supervisor that they are operating on a sound basis.

The Framework Directive will require companies to conduct their own risk and solvency assessment (ORSA). This assessment must include compliance on an ongoing basis with the Solvency Capital Requirement (SCR) and with the requirements for technical provisions, taking into account the company’s specific risk profile. To calculate the SCR, companies can either use the SCR Standard Formula or, if approved for use by their supervisor, the entity’s own internal model.

Based on the experience from banking, under Basel II, the supervisory approval process for a model can be challenging, costly and time-consuming. The challenge under Solvency II will be to demonstrate that the model meets five tests around data quality, calibration, validation, documentation and usage, or embeddedness. The use test will focus on the extent to which the model is trusted by the business as an integral part of its risk management and strategic decision-making process.

The Solvency II framework will hence encourage a wide co-operation across different functions within an organisation. In addition to the core functions listed within the Framework Directive (the risk management, compliance, internal audit and actuarial functions) we would expect finance, capital management, the business and the senior management team/executives to all be involved in some capacity in order to convince the supervisor that the business is Solvency II compliant.

The exact functions to be involved will of course be dependent on the individual company’s organisational structure and allocation of responsibilities together with its ambition level for Solvency II. For example, companies will generally have a choice around whether to go down the internal model route or use the standard formula to assess the SCR. The expectation is that the Solvency II framework will encourage internal models as these may result in lower regulatory capital requirements than the corresponding SCR standard formula; in addition rating agencies are likely to push companies in this direction. The strategic decisions made by top management will obviously influence the remit and work of actuaries.





For each of the 3 pillars under Solvency II the illustration below lists the parts where actuaries are likely to get involved.

–  –  –

Best estimates For Pillar III the Framework Directive proposes that companies will be required to provide annual and publicly available reports on their solvency and financial condition.

The reports should include information on the risk profile, governance systems, nature and performance of the business, along with the approaches to valuation and capital management. This is another area where the actuarial profession may have an important role to play.

The table below summarises the main components of the Solvency II framework focusing on the functions within the organisation that are likely to be involved and to be the drivers of the various components.

–  –  –

In the remaining part of the paper we cover the duties of the Actuarial Function as set out in the Framework Directive proposals followed by for each of the areas above, an overview for each of the areas above of the Solvency II approach, the existing issues and the implications for the profession both in terms of development of technical knowledge and behaviour.

It should be noted that we have not included the Minimum Capital Requirement (MCR) in the above table, as the calculation method is as yet undecided. It is expected that the MCR will be a simple and easy to calculate measure. Whether it ends up as a percentage of SCR or as a linear function, our expectation is the calculation will be straight forward and most likely be performed by the Finance functions (or whoever in the organisation today calculates the Solvency I minimum capital requirement). In addition, a firm will need to monitor its free assets against the MCR and report regularly to its supervisors.

One area that will be important within an internal model and for any solvency assessment is own funds. Although not included explicitly in the above table, the tiers of capital and asset mix, although owned and assessed by the accounts and finance, need to be consistently applied within the internal model framework.

The Actuarial Function Companies will be required to formalise their systems of governance to demonstrate sound and prudent management under Solvency II. The system of governance should include a clear allocation of responsibilities and effective reporting lines, underpinned by thorough documentation and internal review. Companies are required to have risk management, compliance, internal audit and actuarial functions.

The risk based nature of Solvency II is a great opportunity for actuaries and we have a key part to play, thanks to the requirement for an Actuarial Function as set out in Article 47 of the framework Directive:

Article 47 Actuarial Function

1. Insurance and reinsurance undertakings shall provide for an effective actuarial

function to undertake the following :

a) to coordinate the calculation of technical provisions;

b) to ensure the appropriateness of the methodologies and underlying models used as well as the assumptions made in the calculation of technical provisions;

c) to assess the sufficiency and quality of the data used in the calculation of technical provisions;

d) to compare best estimates against experience;

e) to inform the administrative or management body of the reliability and adequacy of the calculation of technical provisions;

f) to oversee the calculation of technical provisions in the cases set out in Article 81;

g) to express an opinion on the overall underwriting policy;

h) to express an opinion on the adequacy of reinsurance arrangements;

i) to contribute to the effective implementation of the risk management system referred to in Article 43, in particular with respect to the risk modeling underlying the calculation of the capital requirements set out in Chapter VI, Sections 4 and 5 and the assessment referred to in Article 44.

2. The actuarial function shall be carried out by persons with sufficient knowledge of actuarial and financial mathematics and able where appropriate, to demonstrate their relevant experience and expertise with applicable professional and other standards.

The majority of the responsibilities set out in the article focuses on our core competences around technical provisions (point a) to f)) whereas the requirements around opinions on overall underwriting policy and adequacy of reinsurance arrangements (points g) and h)) are areas provided by few if any actuaries today. Details are currently not available on what constitute an opinion and further guidance is likely to be developed as part of the implementing measures.

As a profession we have the challenge to get involved more widely in the risk management of the organisation to potentially assist and play a key role with the implementation of ORSA and the assessment of regulatory capital requirements. These parts of the solvency framework have not been assigned solely to the Actuarial Function although it is acknowledged (point i)) that we should contribute in particular around the modelling components. We face the challenge of demonstrating that we can add value and should be involved.

Technical provisions – best estimate

Overview The best estimate technical provisions has been defined within the Framework Directive as the probability-weighted average of future cash-flows relating to the settlement of the current insurance/ reinsurance obligations taking into account the time value of money1.

The best estimate should be calculated gross, without deduction of amounts recoverable from reinsurance contracts and/or special purpose vehicles. The amount expected to be recovered should be calculated separately. In doing so companies should consider any adjustments required due to potential counterparties default and time lags between recoveries and direct payments.

The best estimate (gross and from recoveries) should according to the proposed legislation be based upon current and credible information, realistic assumptions and be performed using adequate actuarial methods and statistical techniques.

Issues Current accounting practices (local GAAPs) across Europe are diverse and do not produce consistent best estimates. This issue has not been addressed by IFRS Phase I.

In addition to the different local accounting rules, differences may exist in the interpretation of what constitutes a discounted best estimate (this can be between companies as well as between countries) e.g. there is not one exact answer to what constitutes the best estimate, as the results are ultimately driven by a number of underlying assumptions based on a combination of market as well as entity specific information (that could reasonably have been selected higher or lower).

Solvency II will therefore challenge and stretch national conventions and practices. This will mostly be a cultural issue and acquires a shift in mindset including the acceptance of potentially multiple versions of balance-sheets (this is clearly dependent on the developments in IFRS, which seem to be heading in the same direction as Solvency II2) i.e local GAAP versus discounted best estimate and recognition of difference in the assumptions and bases underlying these balance sheets.

The probability-weighted average of future cash-flows mentioned within the Directive could simply imply the mean value of the expected cash-flows. However in the context of most commonly used reserving methods being listed under acceptable proxies in QIS4 there appears to be a push for stochastic reserving within the Directive and in CEIOPS 1 Article 76 of the proposed Framework Directive 2 IFRS DP 2007 publications. This is an area where the actuarial profession across Europe is currently engaged, although standard actuarial practice lags behind what is required, and there is in some quarters scepticism as to the advantages of such methods.

Classification of business for reserving purposes may be influenced over time by the line of business definition within the Solvency II framework, which is based on the Accounting Directive3. As a minimum the actuary/ company will require a mapping between reserving classes used and the specified line of business definition (within QIS4 12 lines of business have been defined that are subdivided by geographical areas). The split of reserves by the specified classification will be required for the calculation of the SCR standard formula, and for the comparison with internal model results (where applicable).

Implications for the actuarial profession



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