Central Bank of Ireland industry briefing on Preparatory Guidelines for Solvency II

At an industry briefing this morning the Central Bank of Ireland outlined their plans to implement EIOPA’s Guidelines for the Preparation of Solvency II. The briefing covered a summary of the CBI Guidelines, and an outline of their supervisory approach for the Preparatory Guidelines.

The CBI Guidelines follow the EIOPA Guidelines quite closely. In the summary below we have noted some key points from the CBI Guidelines and the proposed supervisory approach.

The CBI has indicated that it will conduct surveys on companies’ level of preparedness in Q3 2014 and Q3 2015 and we expect that Solvency II implementation will receive increased regulatory focus from now on.

The Introduction to the CBI Guidelines on Preparing for Solvency II includes information on general issues as well as on the scope of the Guidelines. The Guidelines apply from 1 January 2014 until the implementation of Solvency II. The provisions could still be reviewed should Solvency II implementation be later than 1 January 2016, however following the recent trialogue agreement on Omnibus II this is now highly unlikely.

The principle of proportionality is embedded in the guidelines and they should be applied in a manner which is proportionate to the nature, scale and complexity of the risks inherent in the business of an undertaking. The CBI has reflected this by aligning the requirements with the PRISM framework.

Thresholds based on PRISM impact categories are set out in the Guidelines. The relevant impact category is the one that applies at 31 December 2013. Where a firm’s impact category is reclassified from high/medium-high impact to low/medium-low impact, the Guidelines will continue to apply in the way they do for high/medium-high impact undertakings. Where a low/medium-low impact undertaking is re-categorised as high/medium-high impact, all Guidelines will apply in the way they do for high/medium-high impact undertakings.

The Guidelines apply to all undertakings expected to be within the scope of the Solvency II Directive. There are some limited exclusions for certain companies due to size and other criteria such as being in run-off. Companies must notify the CBI if they expect that the Guidelines do not apply.

The Guidelines relevant to groups are addressed to groups where the Central Bank expects to be the group supervisor under Solvency II.

The Guidelines cover four key areas:

I. System of governance
• High & Medium-High impact companies: subject to all Guidelines from 2014
• Medium-Low & Low impact companies: subject to all of the general requirements from 2014. The four key functions (Risk Management, Internal Audit, Compliance, and Actuarial) should be established & the associated Guidelines apply from 2015.
• The CBI indicated that Medium-Low and Low impact companies will need to work on risk policies in 2014.
• Also, companies will have flexibility in how they organise their control functions and that, with the exception of the Internal Audit function, it will be possible to integrate functions. They also reaffirmed that it would be possible to outsource any/all functions.
• For Medium-High and High impact companies, the CBI has indicated that it will not be necessary to calculate technical provisions in 2014 with the focus being on data and methodologies. The Actuarial function report will not therefore need to include technical provision results but instead report on how the compliance of data and methodologies and the areas where work is needed. However the CBI considers it to be ‘best-practice’ for companies to conduct ‘dry-runs’ of the calculation process in order to road-test their systems in 2014. EIOPA is expected to publish a revised Pillar 1 Technical Specification in Q2 2014.

II. Forward Looking Assessment of the undertaking’s own risk (based on Own Risk and Solvency Assessment (“ORSA”) principles)

• High & Medium-High impact companies: Perform & report on overall solvency needs in 2014. Perform & report on overall solvency needs, compliance on a continuous basis, and deviation from SCR assumptions using own structured report in 2015.
• Medium-Low & Low impact companies: Perform & report on overall solvency needs using CBI ORSA / FLAOR tool in 2014 & 2015.
• The online FLAOR tool for Low and Medium-Low impact companies is expected to be available in early Q3 2014. An electronic upload facility is expected to be available for Medium-High and High companies’ reports (pdf, word, excel) in early Q2 2014.
• The FLAOR in 2014 will need to address quantitative requirements at risk category level.
• EIOPA is expected to publish a document setting out the assumptions underlying the Standard Formula SCR in Q2 2014 to help companies judge the appropriateness of the Standard Formula to their business.

III. Submission of information to National Competent Authorities (“NCAs”)

• High & Medium-High impact companies: Prepare reporting systems during 2014. Submit annual (as at YE 2014 ) & quarterly templates (as at Q3 2015) during 2015.
• Medium-Low & Low impact companies: Prepare reporting systems during 2015.
• Pillar 3 reporting will be via XBRL. EIOPA is developing a tool to facilitate this process. Commercial tools (such as STAR Vega from Milliman) will also provide the functionality to allow uploading via XBRL.

IV. Pre-application for internal models.

• The CBI Guidelines that relate to pre-application for internal models only apply to insurance or reinsurance undertakings engaged in the Central Bank pre-application process.

How Milliman can help

To help companies with this process Milliman has developed a Solvency II Readiness Assessment Tool that is relevant for life / non-life / (re)insurance companies that:

• Provides companies with a clear assessment of the status of the organisation’s Solvency II project across key areas;
• Includes a separate assessment for both the Preparatory Guidelines and full Solvency II implementation;
• Identifies work remaining in key areas and assists with project planning;
• Is an easy-to-use reference tool with automatic links to the Solvency II regulations;
• Enables benchmarking against industry best practice.

This brochure provides more information on this easy-to-use tool. If you would like to arrange a free demonstration of the Solvency II Readiness Assessment Tool please contact your usual Milliman consultant.

This e-Alert is intended solely for educational purposes and presents information of a general nature. It is not intended to guide or determine any specific individual situation and persons should consult qualified professionals before taking specific actions. Neither the authors, nor the authors’ employer, shall have any responsibility or liability to any person or entity with respect to damages alleged to have been caused directly or indirectly by the content of this e-Alert.

Milliman Solvency II briefing – Omnibus II provisional agreement

On 13 November 2013 the European trilogue parties, comprising the European Parliament, the European Commission and the Council of the European Union reached a provisional agreement on the Omnibus II Directive allowing Solvency II to move forwards towards implementation. The Directive will now be subject to a final approval from the European Council and a Plenary vote by the European Parliament, currently expected to be held on 3 February 2014, before it can be approved into European legislation.

A press statement from the Presidency of the Council of the European Union stated that the agreed new rules contain “so-called “long term guarantees” (LTG) measures which adjust current Solvency II framework to cope with “artificial” volatility and low interest rate environment, and allow for the smooth transition from the Solvency I regime to Solvency II.”

In addition, the Omnibus II Directive is understood to include enhanced requirements for risk management, supervisory review process, public disclosure and the possibility to review the LTG measures, in order to ensure prudence and transparency of the framework.

At a press conference held on 14 November 2013 by Burkhard Balz MEP, the European Parliament economic and monetary affairs committee (ECON) rapporteur for Omnibus II, and Sharon Bowles MEP, Chair of the European Parliament’s ECON Committee, Balz noted that the Omnibus II text should present an “efficient and practical solution” under Solvency II for firms offering long-term guarantee products and should ensure that these firms can continue to operate in difficult market conditions and in low interest rate environments. Specifically, Balz noted that the solutions set out in the Omnibus II Directive should allow firms to continue to offer these products and to maintain their role as long-term investors.

The press conference confirmed a number of details of the content of the approved text, including:

• A matching adjustment (MA) to be applied to the discount rate used to value annuity-style liabilities meeting specific requirements in relation to the liability cashflows and the assets held to match these. The value of the MA looks set to be calculated as the spread over risk-free rates on the matching assets less an allowance for defaults (the fundamental spread). The fundamental spread is expected to have a floor of 30% of long-term average spreads for government bonds and 35% of long term spreads for other eligible assets.
• A volatility adjustment to be applied to the discount rate used to value all other business, calibrated as 65% of the risk-adjusted spread of assets in a representative portfolio.
• Transitional arrangements for existing life insurance business to adjust to Solvency II over a period of 16 years.

While the package of measures has deviated from that set out by the European Insurance and Occupational Pensions Authority (EIOPA) following the long-term guarantees assessment (LTGA) run earlier this year, in particular with less onerous calibrations on a number of the measures, Bowles and Balz noted that this has been balanced by the introduction of important qualitative requirements relating to the governance and disclosure of these measures. The press conference highlighted the need for firms to maintain a liquidity plan, for proper supervision of the LTG measures and for these measures to be applied in a transparent way.

While Balz acknowledged that the new rules were ambitious he highlighted the importance of respecting the principle of proportionality when applying them. In particular, he noted that while the reporting obligations will include asset-by-asset reporting and annual reporting, exemptions for certain parts may be available for smaller firms.

Significantly for European groups, the approved text includes an extended provision for transitional equivalence for third countries. This would allow the European Commission to grant provisional equivalence to third countries for a period of 10 years, at which point it would be reviewed with the option to extend for a further 10 years (and potentially indefinitely). The approval of this provision would allow the US to be considered as an equivalent regulatory regime, allowing European firms with US subsidiaries to use local regulatory methods when calculating group solvency requirements. While this provision has been developed as a specific response to the US regulatory situation it has been stressed that this will provide flexibility to develop pragmatic solutions for other regulatory regimes to ensure that European groups are not disadvantaged when operating in third countries.

Balz confirmed that the expected timeline is for Solvency II to be operational for firms from 1 January 2016 with transition into national regulation required by 31 March 2015. These dates are expected to be confirmed at an EP Plenary session in Strasbourg later this month.

Copies of Solvency II summary papers, together with copies of papers on other topics published by Milliman, can be found here.

We look forward to hearing from you if you have any questions or comments on this briefing or any other aspect of Solvency II.

Please contact your usual Milliman consultant, or email us here for more information.

Lack of management action plans may leave European insurers exposed

This Risk.net article (subscription required) highlights Milliman’s “Dynamic policyholder behavior and management actions survey report”. In the article, Ed Morgan discusses how the absence of management action plans by European insurance firms can lead to shortcomings in governance. Here is an excerpt:

The majority of European insurers are not formally documenting how management teams plan to respond to changing economic conditions and are not modelling the impact of such management behaviour in stress scenarios, a survey has found.

Only five out of 20 European firms currently possess an official plan listing the actions management will take in certain economic scenarios, according to the survey by actuarial consultancy Milliman.

This is despite such plans being a requirement for European insurers under the Solvency II directive.

Ed Morgan, managing director of Milliman’s operations in Italy and Central Eastern Europe, says not having well-documented management actions is a governance issue, as well as being an issue for modelling and financial reporting.

“The absence of management action documents and model functionality can sometimes be because firms haven’t fully appreciated their importance,” says Morgan. “But you could also argue that sometimes management themselves might prefer not to be subject to this high spotlight governance in case it makes it harder to justify the actions they take in real life after the event.”

… The reason why some European firms have to do model management actions, despite regulatory pressure, is unclear, says Morgan.

“One thing may be lack of awareness of how modelling management actions can materially improve results. If you model management actions in an overly simplistic way, then they’re very likely to be suboptimal under various stress scenarios, and likely to overstate required risk capital,” he says.

The way companies are organised may also play a part in how management actions are modelled, says Morgan. For example, the actuaries that are building the model may not be close to the personnel setting investment decisions. “So when it comes to modelling management actions in regards to investment decisions, one set of people have one view on what they’re doing, another set of people are doing the modelling, and potentially a lack of communication and of understanding prevents a proper linkage being made between the two,” Morgan adds.

Dynamic policyholder behaviour, management actions, and life insurance

D Clark - J  Kent - E  MorganMilliman has just published a new report summarizing the results of a recent survey of current practice in the modelling of dynamic policyholder behaviour (DPB) and management actions (MA) for life insurance business.

There are 56 companies represented in the survey, across Europe, the United States, and Japan.

The survey revealed some interesting results. For instance:

• For variable annuities/unit-linked with guarantees, only around 50% of respondents model at least one type of DPB. This increases to 85% for other types of products (what we have termed “traditional” products).
• Of respondents offering guaranteed annuity options (GAOs) on traditional products, only around 16% of respondents were modelling them with dynamic take-up rates.
• Around 60% of companies have monitored DPB experience against that predicted by their models; of these, almost half say their models predicted experience well.
• Most companies in the United States and Europe model assets and liabilities, the interactions between them, and some type of future investment strategies (a form of MA) for certain classes of business. However, future investment strategies modelled are often oversimplistic, for instance being invariant to economic conditions.
• Only a minority of companies hold a formal documented plan for management actions. Most companies also don’t monitor actual management actions against those predicted by their models.
• Actuaries were the most prominent group involved in setting modelled MA rules, followed by investment and risk management professionals. Other professionals were more rarely involved.

DPB and MA are becoming increasingly important aspects of modelling as more focus is placed on stochastic calculations and the tails of distributions. In particular, Solvency II in Europe specifies requirements for both DPB and MA, so we expect significant work will be required of companies in these areas, particularly as they should form a key component of a company’s risk management.

Market turmoil in recent years across various regions highlights the importance of working to understand and model how management may react to such scenarios. However, the survey results show that many companies are failing to model DPB for some key options. Modelling of MA is also underdeveloped in many cases, with some key actions not being modelled at all, or in an oversimplistic way that doesn’t appropriately reflect reality.

DPB and MA predicted by models should also be monitored against actual experience as it emerges, with models being refined over time.

To download a copy of the DPB and MA study, click here. For further information email Jeremy Kent.

Consequences for Irish insurers following EIOPA publication of the final guidelines for the preparation of Solvency II

Following our eAlert on the 30th September, we have published a more detailed Briefing Note on the final EIOPA guidelines for the phased introduction of specific aspects of the Solvency II requirements into national supervision from 1 January 2014.

Under the guidelines, all firms will be required to implement a System of Governance in line with Solvency II requirements and submit an assessment of overall solvency needs in 2014. In addition, firms identified by national supervisors as falling within the specified thresholds (i.e. high and medium high impact under PRISM in Ireland) will be required to submit one annual and one quarterly information package (QRTs and narrative reporting) in advance of the implementation of Solvency II. Assuming implementation on 1 January 2016 this means an annual submission and a quarterly submission of information as at 31 December 2014 and 30 September 2015 respectively. In 2015, these firms will also be required to perform an assessment of whether they would comply with Solvency II regulatory capital requirements and technical provisions on a continuous basis as well as an assessment of deviations from the assumptions underlying the capital calculation. These items will be based upon technical specifications that EIOPA intends to issue during 2014.

EIOPA publishes the final guidelines for the preparation of Solvency II

On 27 September 2013, the European Insurance and Occupational Pensions Authority (EIOPA) published the final guidelines on the preparation for Solvency II following a public consultation earlier this year. The guidelines are aimed at National Competent Authorities (“NCAs”) and allow for the phased introduction of specific aspects of the Solvency II requirements into national supervision from 1 January 2014, in advance of the full implementation of the Solvency II regime. The following key areas are each covered by a separate set of guidelines:

• System of governance
• Forward Looking Assessment of the undertaking’s own risk (based on Own Risk and Solvency Assessment (“ORSA”) principles)
• Submission of information to NCAs
• Pre-application for internal models

Responses to specific issues raised are included in each document providing clarification in a number of areas. EIOPA also responded to more general issues raised including timings during the preparatory phase and the extent of supervisory actions expected during this period.

The 57 requirements included in the consultation under the systems of governance have been reduced to 52 with the removal of some actuarial function requirements and the rationalisation of the internal audit guidelines. The final guideline on group internal models has also been removed and several wording changes have been made to the remaining guidelines.

The 25 guidelines for the Forward Looking Assessment of the undertaking’s own risk are largely unchanged from those included in the consultation.
However under the Forward Looking Assessment, the following aspects have been deferred to 2015 for all entities:

• The assessment of the continuous compliance with capital requirements and technical provisions
• The assessment of the significance of any deviation of the risk profile from the SCR assumptions.

The assessment of solvency needs will be required on a best efforts basis during 2014 irrespective of Omnibus II discussions and the Solvency II start date.

In relation to the submission of information, the 38 guidelines included in the consultation have been increased to 39, but this reflects a reformat of one of the guidelines rather than new content. EIOPA has concluded that one quarterly submission prior to Solvency II implementation is sufficient (i.e. Quarter 3 2015 if January 2016 is agreed as the Solvency II implementation date) and EIOPA has granted 2 extra weeks for completing the annual submission in 2015 for year-end 2014 (so 22 weeks after year end). EIOPA has introduced some further materiality thresholds and exemptions in the interests of proportionality. A final list and format of templates has been provided (with new naming conventions) including a log of changes from previous versions.

Under the pre-application for internal models, undertakings are required to submit the standard formula Solvency Capital Requirement during the pre-application process. The 72 guidelines that were consulted on have been reduced to 70 with one guideline on decision making being removed and the guideline on the application of profit and loss attribution and the use test also removed.

If you have any questions or comments on this eAlert or any other aspect of Solvency II, please your Milliman consultant.

New techniques for identifying emergent operational risks

Techniques for assessing operational risk have come a long way in the past ten years. Today, many companies are going beyond the regulatory minimum to implement sophisticated models that contribute to better understanding and management of operational risk across the business.

One question that tends to push the limits of existing models, however, is identifying emerging operational risk before it produces a loss. Given that risk events are typically not entirely new but rather simply new combinations of known risks, an approach that enables us to analyze which risk drivers exhibit evolutionary change can identify which ones are most likely to create emergent risks. By borrowing a technique from biology—phylogenetics, the study of evolutionary relationships—we can understand how certain characteristics of risk drivers evolve over time to generate new risks. The success of such an approach is heavily dependent on the degree to which operational risk loss data is available, coherent, compatible, and comprehensive. A well-structured loss data collection (LDC) framework can be a key asset in attempting to understand and manage emergent risks.

Broadening the definition of operational risk
In the financial industry, where operational risk has been a significant target of regulators for more than a decade, operational risk is typically defined as “the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.” However, this definition doesn’t consider all the productive inputs of an operation, and, more critically, does not account for the interaction between internal and external factors.

A broader, more useful definition is “the risk of loss resulting from inadequate or failed productive inputs used in an operational activity.” Operational risk includes a very broad range of occurrences, from fraud to human error to information technology failures. Different production factors can be more or less important among various industries and companies, and relationships among them—particularly where labor is concerned—are changing rapidly. To be effective as tools for managing operational risk day-to-day, models need to account for the specific risk characteristics of a given company as well as how those characteristics can change over time.

Examples productive inputs relevant for operational risk

Type Productive input Description
Natural resources Land The physical space used to carry out the production process that may be owned, rented, or otherwise utilized.
Natural resources Raw materials Naturally occurring goods such as water, air, minerals, flora, and fauna.
Labor Physical labor Physical work performed by people.
Labor Human capital The value that employees provide through the application of their personal skills that are not owned by an organization.
Labor Intellectual capital The supportive infrastructure, brand, patents, philosophies, processes, and databases that enable human capital to function.
Labor Social capital The stock of trust, mutual understanding, shared values, and socially held knowledge, commonly transmitted throughout an organization as part of its culture.
Capital Working capital The stock of intermediate goods and services used in the production process such as parts, machines, and buildings.
Capital Public capital The stock of public goods and services used but not owned by the organizations such as roads and the Internet.

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What scenarios pose the greatest risks to the Pension Protection Fund?

The U.K.’s Pension Protection Fund (PPF) will be taking over an insolvent pension plan for the first time. This news brings the following question into focus: Are there scenarios that may render the organisation unviable?

A team from the PPF and Milliman recently performed a reverse stress test of the fund to identify risks that could result in organisational failure. This aiCIO article highlights the results from their subsequent paper. Here is an excerpt:

Lucy Currie, an actuarial practice leader at the PPF, was tasked with finding out under which scenarios the institution could-and would-fail.

“We looked at what a successful PPF was, and what could go wrong,” Currie told aiCIO after presenting a paper she co-authored on the study last month. “We looked at the definition of failure and realised there was no single one. There were various routes, including reputational and political issues, but none of them were financial.”

…She, along with a team from consultants and actuaries Milliman, set about interviewing a range of these stakeholders at the PPF. This ranged from the press relations and human resources departments to board members at the institution. Across a series of meetings, the team built up a cognitive map using the responses they gathered that showed the routes to failure.

“We talked about specific scenarios to make it real for stakeholders so they could draw on past experiences,” Currie said. “It was also a good way to validate what we are getting right.”

The map used the same language as had been reported in the stakeholder interviews, as the results had to be meaningful and relatable to all parties.

These responses fed into “critical nodes”, an impact upon which could trigger a tipping point to failure for the PPF.

The six scenarios identified included staffing and administration issues, or outside forces impeding the institution’s proper function.

“We worked back and looked at how they could all happen,” said Currie. “We created something that would feel real for the board and ran a ‘scenario day’.”

The scenarios identified were not just present day potential failures, but also looked to the future.

“We looked at underlying issues that pervade across the entire organisation,” said Currie, “and we did not identify any new risks. We did make new connections to how scenarios could occur, however-the board was reassured.”

The exercise offered new insight if not new risks, the team said, and made connections between the “owners” of the risks and those with power to monitor and manage them.

The article also poses another interesting question. With Solvency II-type governance for pensions delayed, is it time for European funds to conduct comparable exercises to comply with IORP Directive regulations?

To read the entire paper on reverse stress testing at the PPF, click here.

The business value of modelling operational risk

Every organization tries to reduce operational risk as a basic part of day-to-day operations whether that means enforcing safety procedures or installing antivirus software. Yet not as many take the next steps to holistically assess operational risk, quantify the severity, likelihood, and frequency of different risks, and understand the interdependencies among risk drivers. Companies may see operational risk modelling as an unnecessary cost, or they may not have considered it at all. Yet the right approach to modelling operational risk can support a wide range of best practices within an organization, including:

• Risk assessment: Measuring an organization’s exposure to the full range of operational risks to support awareness and action.
• Economic capital calculation: Setting capital reserves that enable organizations to survive adverse operational events without tying up excessive capital.
• Business continuity and resilience planning: Discovering where material risks lie and changing systems, processes, and procedures to minimize the damage to operations caused by an adverse event.
• Risk appetite and risk limit setting: Creating a coherent policy concerning the amount of operational risk an organization is willing to accept, and monitoring it to ensure the threshold is not breached.
• Stress testing: Modelling how an organization performs in an adverse situation to aid in planning and capital reserving.
• Reverse stress testing: Modelling backward from a catastrophic event to understand which risks are most material to an organization’s solvency.
• Dynamic operational risk management: Monitoring, measuring, and responding to changing characteristics of operational risk that is due to shifts in the operating environment, risk management policies, or company structure.

At the more basic level, having a detailed understanding of operational risk simply supports efforts to manage and reduce it—a worthy goal for almost any organization. Modelling enables an organization to consciously set an appropriate balance between operational resilience and profitability.

In order to achieve these goals, it is important to choose a methodology for which the results are accessible and actionable for the decision makers on the front lines of operational risk. Even financial organizations that once chose models primarily to meet regulatory requirements are beginning to move toward models that help the organization actively understand and reduce operational risk. The tangible business benefits are simply too great to ignore.

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Implementing and integrating next-generation analytical techniques in the financial industry

The state of operational risk modeling in the financial industry today
Basel II allows banks to choose from three approaches to operational risk: the Basic Indicator Approach (BIS), the Standardized Approach (SA) and the Advanced Measurement Approach (AMA) While the BIS and SA are attractively simple and inexpensive to implement, they are ultimately very blunt tools.

While adopting an Advanced Measurement Approach is much more labor-intensive and requires regulatory approval, large institutions recognize that these challenges are outweighed by the benefits of a more sophisticated approach to measuring operational risk. These include improved reputation among investors and other stakeholders, significantly reduced operational risk capital requirements, and, most importantly, better risk management processes that can actually help reduce losses.

The Advanced Measurement Approach brings with it many requirements, but does not require banks to use a specific modeling methodology. Nevertheless, most banks today have converged on the loss distribution approach (LDA). In the LDA, the severity and frequency of operational risk losses are analyzed and modeled separately. Once severity and frequency have been calculated, the aggregate loss distribution is typically generated using Monte Carlo simulation techniques.

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