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«SOlVENCY II Technical Provisions under solvency II Detailed Guidance JULY 2015 update CONTACT DETAILS For technical queries: Henry Johnson, Market ...»

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Technical Provisions under solvency II

Detailed Guidance

JULY 2015 update


For technical queries:

Henry Johnson, Market Reserving & Capital

020 7327 5235 henry.johnson@lloyds.com

Ben Thomas, Market Reserving & Capital

020 7327 5528 ben.thomas@lloyds.com

Catherine Scullion, Market Reserving & Capital

020 7327 5567 catherine.scullion@lloyds.com

Taraash Gautam, Market Reserving & Capital 020 7327 5092 taraash.gautam@lloyds.com

For general queries:

Please contact your Solvency II Account Manager, or email:

Solvency2@lloyds.com 2 Contents

1.0 Introduction

1.1 Solvency II

1.2 General principles

1.3 Technical provisions

1.4 Minimum segmentation

1.5 Best estimate cashflows

1.6 Recognition of contracts

1.6.1 Business incepted at valuation date 9 1.6.2 Business not incepted at valuation date 9

1.7 Reinsurance

1.8 Expenses

1.9 ENIDs

1.10 Uncertainty

1.11 Risk margin (or Market Value Margin (MVM))

1.12 Process and methodology

1.13 Assumptions

1.14 Validation and back-testing

1.15 Data implications

1.16 Documentation

1.17 Actuarial function

2.0 Potential Impact at Lloyd’s

Lloyd’s technical provisions

2.1 2.2 Impact on technical provisions in the balance sheet

3.0 General Requirements

3.1 Basis of calculation

3.2 Use of adequate techniques

3.3 Appropriate valuation techniques

3.3.1 Use of simplified methods 16 3.3.2 Calculation of Technical Provisions on a quarterly basis. 16

3.4 Future management actions

3.4.2 Realism 18 3.4.3 Verifiability 18

3.5 Proportionality

4.0 Segmentation

4.1 Minimum lines of business (Non-Life)

4.2 Minimum lines of business (Health)

4.3 Minimum lines of business (Life)

4.4 Annuities relating to non-life and health policies

Contracts covering multiple lines of business and “unbundling”


4.6 Homogeneous risk groups for calculation of best estimates

4.7 Currency groups

4.8 Potential practical issues

4.8.1 Homogeneous risk groups 26 4.8.2 Unbundling multiple lines of business 27

4.9 Suggested approaches

4.9.1 Possible methodologies 27

5.0 Calculation of best estimate and Cashflows

5.1 Requirements for cashflow projections

5.1.4 Time horizon 29 5.1.5 Options and guarantees 29

–  –  –

The majority of this section’s requirements are based on Articles 48, 76 & 83 of the Level 1 texts, Articles 17 & 272 of the Level 2 texts, Guidelines 12 & 82 of the Level 3 Guidance on the valuation of technical provisions and Guideline 6 of the Level 3 Guidance on contract boundaries.

1.1 Solvency II Solvency II seeks to create a harmonised, risk-based approach to supervision, solvency and capital requirements for insurers within the EU. The detailed content of the Solvency II regime, which is due to be implemented from January 2016, has now been finalised.

This guidance is an update of the detailed version issued in March 2011. Please note that most of the uncertainties have now been resolved following finalisation of the level 2 delegated acts and EIOPA’s level 3 guidelines but there may still be further clarifications which will be considered in future updates to this guidance. Please note that although this document will be maintained, updates will depend on the materiality of changes made to underlying requirements. Minor changes will be noted on the relevant section of Lloyds.com but only made periodically to the guidance so please refer to Lloyds.com before relying on the guidance.

The majority of the original guidance still holds. The areas where there have been changes or clarifications are listed below and detailed further in the guidance.

The main update to the 2011 guidance relates to the contract boundaries to be considered for outwards reinsurance.

It has been clarified that for existing or legally obliged reinsurance contracts any contractually obliged premiums arising from current business should be included in full (to the extent to which it is contractually obliged), with no consideration to the future inwards business. For future reinsurance contracts the expected proportion of the premium that applies to existing inwards contracts should be included, this proportion will need to be clearly justified.

The four other areas that have seen either changes or clarifications since 2011 are:

Confirmation of the treatment of contract boundaries on binders business as a “look through” basis. This is unchanged from Lloyd’s original proposed approach.

Recommendation that a “proportionate” run off simplification for the calculation of the risk margin is not appropriate without justification. This is a change from the original guidance.

- Introduction of matching and volatility adjustments to risk free rates and a description of why these are generally not significant for Lloyd’s entities.

Relabelling “binary events” as “Events not in Data” or ENIDs, although their treatment is essentially unchanged from the original guidance

All of these items are discussed in more detail throughout the document.

Technical provisions are the largest item on an insurance undertaking’s balance sheet, meaning an undertaking’s financial strength is sensitive to movements in their value. Under Solvency II, major changes are proposed to the valuation of technical provisions and the impact on reserving processes will be marked.

This guidance is intended to assist managing agents in valuing technical provisions on a Solvency II basis. The guidance offers practical solutions in places but these should not be taken as Lloyd’s “rules” or as the only solutions and in many cases alternative approaches, with justification, are equally valid. The guidance is intended to cover all applicable requirements; in broad terms this means satisfying the relevant requirements of the level 1, 2 and 3 texts.

Appendix 6 includes a list of these requirements, at a high level, and a broad mapping to the guidance provided to show under which section this is covered. The document also includes references to other documents where applicable, for example to PRA supervisory statements.

Solvency valuations are required alongside the current valuation basis under UK GAAP for accounting purposes until 2016 however UK GAAP Technical Provisions will be required for the accounts beyond 2016.

1.2 General principles There are a number of general principles which underlie Solvency II and several of these will apply in the calculation of technical provisions. The key principles for calculation of technical provisions are listed below and then discussed

further as part of the detailed guidance:

 The selection and use of adequate and appropriate valuation techniques  The use of expert judgement, which must be justified

–  –  –

 Proportionality, for which any simplifications must be justified

1.3 Technical provisions Whilst some of the approaches and techniques applied under Solvency II will be similar to those followed currently, there are other areas where there will be major changes. Some of the more important and challenging requirements are listed below. All of these are discussed in more detail in the main document.

 Movement to a cashflow basis for valuation of both gross business and outwards reinsurance  Removal of any implicit or explicit margins within technical provisions to give a “true best estimate” for solvency purposes, defined as the mean of the full range of all possible future outcomes  Introduction of the valuation of very low probability extreme events including latent claims, referred to as “Events not in Data” (ENIDs)  Removal of the requirements to hold an unearned premium reserve and to allow for other non-monetary items.

These are replaced by “premium provisions”, valued on a best estimate basis. This also includes a requirement to take account of all future premium cash inflows  Movement to recognising contracts on a “legal obligation basis”. This will mean the inclusion of business currently not valued as part of technical provisions - for example 1st January renewals entered into prior to a 31/12 valuation  The basis for recognising existing contracts will also impact reinsurance contracts and their expected cashflows  Introduction of discounting, leading to increased volatility in reserves  Introduction of the principle of a market consistent basis and calculation of a Risk Margin (or Market Value Margin)  Valuation of liabilities segmented by at least Solvency II lines of business  Introduction of governance requirements for an explicit ”actuarial function” with defined responsibilities, of which many relate to technical provisions  Introduction of explicit data requirements  Increases to documentation and validation requirements  Introduction of explicit links to other areas of Solvency II such as internal models  Introduction of the principle of proportionality that underlies the calculations

1.4 Minimum segmentation Solvency II requires technical provisions to be segmented by defined lines of business. There are also requirements to value the best estimate in all (significant) currencies.

Lloyd’s view is that the fundamental underlying principle to ensure suitable and accurate assessment of best estimate technical provisions is to value the liabilities by homogeneous risk groups, at least for calculation of undiscounted best estimates. Results on this basis may then require further allocation to significant currencies or aggregation to lines of business to finalise the calculation.

The Solvency II lines of business represent the minimum level of granularity at which to perform the calculation. The principle of substance over form should underlie any segmentation.

Business written at Lloyd’s is expected to fall into one of the groups summarised below (a subset of all Solvency II minimum lines of business), with further details given in the Segmentation section.

 12 direct classes (non-life and health)  12 proportional classes (non-life and health, corresponding to those above)  4 non-proportional (non-life and health)  4 “Other” life insurance classes covering death, health or miscellaneous  4 “Other” life reinsurance classes covering reinsurance of death, health or miscellaneous  1 class for annuities stemming from non-life contracts relating to health obligations 8  1 class for annuities stemming from non-life contracts relating to obligations other than health Lloyd’s expects agents to use a reasonable basis to allocate business to the Solvency II minimum lines of business.

Appendix 5 contains a risk code mapping that may assist agents in the process of allocating obligations to the Solvency II minimum lines of business. Note that additional data sources or assumptions may be needed to allocate and report to the required levels.

1.5 Best estimate cashflows The technical provisions must be calculated gross using a cashflow basis with a separate explicit calculation for outwards reinsurance, also using a cashflow basis. Further to the minimum segmentation noted above, the best estimate must also be split between claims and premium provisions for non-life business.

The cashflows will include future cash in-flows such as premiums. Provisions are therefore net of future premium receipts which can make them negative. The inclusion of premium provisions and move to a cashflow basis is a major change to the Solvency I basis.

The best estimates must not include margins for optimism or conservatism. Reserves held in excess of the best estimate must be excluded from the technical provision calculation for solvency (but may still be included for financial reporting purposes). Future profits recognised through the calculation of a best estimate premium provision (rather than the current unearned premium reserve approach) will be eligible as tier 1 capital.

 Cashflows must be discounted for the time value of money. The yield curves for major currencies to apply by currency will be supplied by supervisors and will be fixed for each valuation date.

In the event that the overall weighted discount rate is negative throughout the term of the cash flow then the impact of discounting would be expected to increase the Technical Provisions.

1.6 Recognition of contracts Another major change to the current basis is the system for recognising existing contracts. Under the legal obligation basis of Solvency II, all existing contracts must be valued, whether the contracts have incepted or not.

Distinct areas to be considered can be split into:

1.6.1 Business incepted at valuation date  Gross claims cashflows within claims provisions (earned incepted business)  Gross claims cashflows within premiums provisions (unearned incepted business)  Gross future premium receivable (incepted business) 1.6.2 Business not incepted at valuation date  Gross future premium and claims cashflows for policies not yet incepted by the valuation date, but already forming part of contractual obligations (“unincepted” business). These will form part of the premium provision.

For a 31 December valuation this will generally include the 1st January renewals for the coming year.

There is an associated impact on delegated authority or binder business which must be assessed on a “look through” basis with the boundaries of the actual underlying contracts of insurance being tested (rather than the delegated authority or binder that are not contracts of insurance). This may include estimations if data is not immediately available.

1.7 Reinsurance The technical provisions are calculated gross, with reinsurance calculated separately under the same principles.

Reinsurance recoveries will continue to allow for expected non-payment whether caused by default or dispute.

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