Article on Risk-based solvency requirements for life insurers – International Actuarial

Association Conference – Paris, June 2006

Ernst & Young Actuaires-Conseils

Ludovic Antony
Lotfi Elbarhdadi

"European Solvency regimes and economic capital - assessing the impacts for French Life
Companies"

Introduction

The European commission is currently developing a new framework (Solvency II) for
solvency assessment of insurance undertakings operating in the European Union (EU). The
future solvency II directive will be approved by the European Parliament at the end of a
process, which is anticipated to tentatively end in 2010.

One of the key outcomes of the project will be an assessment of capital requirements on a
realistic basis to better reflect the risks faced by companies and encourage improved risk
management throughout organizations.

With the recently issued Consultation Paper 7, the Committee of European Insurance and
Occupational Pensions Supervisors (CEIOPS), which is the advisor of the European
Commission on technical matters, has set out the broad directions of the future solvency II
framework, regarding the measurement of liabilities and capital. CEIOPS have invited the
industry to comment on the paper by 30, September 2004.

Parallel to the Solvency II initiative, some regulators and rating agencies have anticipated the
movement toward realistic based solvency assessment and are at various levels of
investigation and implementation of new solvency frameworks. Some of the most important
initiatives from regulators include:

• Financial Services Authority (FSA) new regulation providing for Enhanced Capital
Requirement and Individual Capital Assessment (ECR and ICA, respectively) in the
assessment of solvency in the United Kingdom (UK) for general and life insurers 1 – This
came into effect on 31, December 2004.

• Swiss Solvency Test (SST) 2 in Switzerland – Currently the industry is going through a
second field test, involving 45 insurance and reinsurance companies, at the end of which a
new supervision act is to be implemented in January 2006.

• Financial Assessment Framework (FTK) 3 in the Netherlands – Publication in October

2004 of a consultation paper setting out the details of the framework, with an indication
that the FTK should converge toward the Solvency II framework. At this stage, recent

1
Based on Policy Statement 04/16 Integrated Prudential sourcebook for Insurers (2004), and Consultation
Paper 195 “Enhanced capital requirements and individual capital assessments for life insurers (2003)
2
Based on Swiss Federal Office of Private Insurance White Paper of the Swiss Solvency Test (2004)
3
Based on consultation paper Financial Assessment Framework (2004)

1
 developments in the Solvency II project seem to have attracted most of the attention of the
Dutch supervisor and the project has temporarily come to a halt.

In the first section of this paper, we briefly present common features and key differentiators of
the regimes identified above, focusing exclusively on life operations. Our goal in this section
is to show that the standard approaches for the measurement of realistic capital requirements
for the regimes currently being developed and the future Solvency II framework tend to rely
on a particular approach to the measurement of capital requirements for insurance companies
which is heavily influenced by practices developed by banking institutions.

In the second section, we have developed an alternative approach to the measurement of

capital. We develop the key features of this approach, address the practical aspects of
implementing this approach for a typical French insurance company, and finally present a
case study to compare the results of this approach with Solvency I capital requirements.

Common features and key differentiators among realistic based solvency regimes

In order to facilitate the comparison of the different solvency frameworks applicable, we have
established a list of criteria that will facilitate the analysis.

• Overall design of quantitative capital framework – Presenting the overall design of

the solvency framework and defining target and minimum capital requirements.

• Overview of measurement frameworks – Presenting the framework for measuring

assets and liabilities on which the capital requirements will depend.

• General considerations regarding the calculation of target capital requirements –

Defining time horizon, risk measures used, and risk tolerance levels chosen for target
capital or enhanced and individual capital calculation under standard formulas and
internal models.

• Scope of risks measured and risk measurement techniques – Description of risks

faced by life insurers for which measurement is required and comparison of
measurement and aggregation techniques across regimes.

We then provide a conclusion on the comparison analysis performed.

Overall design of quantitative capital framework

The overall design of the capital framework is similar under Solvency II, the SST and the
FTK. Regarding these, there is a target capital requirement and a minimum capital
requirement:

• Target capital (Solvency Capital Requirement under Solvency II) – This represents
the level of capital that a company needs to hold to protect itself against unforeseen
losses over a specified time horizon, at a given risk tolerance level. In this context, risk
may be defined as the probability of the undertaking becoming insolvent. Companies
may temporarily drift away from target capital but must take steps to restore their
capital at the targeted level in case capital is depleted.

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 • Minimum capital – This represents the level of capital below which companies
cannot operate. If available capital became lower than this, regulators would step-in
immediately and take control of the undertaking. Under the SST and FTK, current
Solvency I rules should be applied to define the minimum capital requirements. Under
Solvency II, CEIOPS recommends testing several approaches in addition to the
current Solvency I approach (with potential modification following the modification
of the measurement methodology for assets and liabilities).

For UK companies, the framework is different than the one adopted for the other regimes, as
described below:

• Enhanced capital requirement and twin peaks regime – Under the UK regulation,
for companies having with-profit liabilities greater than 500m£ (realistic basis
companies), companies must calculate two amounts of capital in order to determine
their enhanced capital requirement. The first amount is calculated based on statutory
accounting rules with some slight modifications (regulatory peak) 4 and Solvency I
rules. The second results from a calculation using a realistic measurement framework
and a risk sensitive approach (realistic peak) defined by the regulator to determine
capital requirements. The enhanced capital requirement is set equal to the greater of
the two amounts. For other companies there is just one peak, which is the regulatory
peak.

• Individual Capital Assessment – This is a self-assessment of the amount of capital

that a company deems necessary to hold in a realistic measurement framework and
taking into account al the risks it is faced with.

Overview of measurement framework

The measurement framework is the framework under which assets and liabilities are
measured for the purpose of the solvency assessment. Under all cited frameworks above,
assets and liabilities are valued on a market consistent basis. Market values of assets are often
readily available when quoted, or actively traded on non-organized markets, and when cash
flows are fixed. However, the measurement of insurance contract liabilities is often a
challenge and definitions of market consistent values may be different across regimes.

Under Solvency II the measurement framework for liabilities, is expected to converge with
the IASB Phase II framework for measuring liabilities. In the absence of a defined framework
under IFRS, CEIOPS has already set forth some principles regarding the determination of
liabilities for solvency purposes:

• Insurance risks – liabilities must be set equal to their discounted best estimate
(potentially the discounted expected value of liability cash flows under the realistic
probability measure), plus a risk margin. The risk margin must be set so that the total
liability must correspond to the 75th (or 90th) percentile of the distribution of liabilities
for insurance related risks (longevity, mortality, etc.). For skewed distribution, the risk
margin should not be inferior to a proportion of the liabilities’ standard deviation. The
level of prudence in provisions mentioned above will be ascertained following further
investigations. Regarding discounting, at this stage the best candidate appears to be the
4
Muir, Martin, and Waller, Richard (2005), Twin peaks – The enhanced Capital Requirement for Realistic Basis
Life Firms, November

3
 risk free yield curve, although some members of CEIOPS have introduced the
possibility of using prudent discount rates, such as the ones currently used in existing
regulatory frameworks.

• Non-insurance risks (all other risks related to the behavior of economic variables
such as interest rates and equity and property prices which impact most with-profit
contracts in Europe) – for liabilities which depend on these, CEIOPS is not sure of the
approach to follow to calculate liabilities. Potentially, the same approach as above
could be adopted (a), or an approach using market consistent valuation techniques (b).
Please note that these two approaches could probably require two different set of
economic assumptions: realistic ones under approach (a) and risk neutral ones under
approach (b).

Under the FTK, liabilities are the sum of two components:

• Realistic value of liabilities – This is the value of liabilities projected using best
estimate assumptions (potentially for economic assumptions as well) and discounted
using the current risk free yield curve plus the value of guarantees and options
determined using a market consistent valuation framework for economic assumptions.

• Market value margin for unavoidable risks – In the absence of framework in the
IASB directive to evaluate market value margins, this is temporarily defined as the
difference between the maximum of the 75th percentile of the liability distribution and
a fixed percentage of the liabilities standard deviation for skewed distributions and the
realistic value. Unavoidable risks are arising out of model and parameter uncertainty
(and potentially structural uncertainty).

The FTK definition for liabilities therefore seems to have inspired CEIOPS when they wrote
Consultation Paper 7, although CEIOPS does not fully (yet) follow the FTK approach. Both
liability frameworks would probably require clearer definitions of best estimates.

The definition of liabilities presented in the SST White paper is in essence similar to what is
described for the FTK, although the best estimate value is not split into two components. In
addition, a different approach is adopted for the measurement of liability risk or market value
margins.

Under the SST, liabilities are measured on a market consistent basis. The market consistent
value of liabilities is defined as the sum of:

• Best estimate value – While the SST White Paper does not prescribe any specific
methodology to determine best estimates, they clearly identify market consistent
valuation techniques, such as replication techniques, and valuations using risk neutral
economic scenarios or realistic economic scenarios plus deflators, as the basis for
calculating these. This implies that guarantees and options will implicitly be valued
under such techniques. The evaluation of liabilities on a market consistent basis will
also enable companies to find hedging strategies to diversify risks away.

• Risk margin – However, there will always be residual risks associated with a
portfolio of insurance contract liabilities that cannot be diversified away, such as the
risks implied by model and parameter uncertainty. A consequence of this is that

4
 companies are forced to hold capital to ensure they will be able to meet liabilities at a
given confidence level. As shareholder often require a risk premium over the yield on
assets in which their capital is invested, the value of the risk premium is considered to
be a proxy for the market price of risks associated with insurance liabilities.

Under FSA requirements for realistic basis companies, the realistic value of liabilities is
defined as the market consistent value of liabilities, similar to the best estimate value of
liabilities under the SST. The realistic value of liabilities does not include any risk margins.

From the description of measurement frameworks above, it appears that all solvency regimes,
except maybe for Solvency II at this stage, are opting for market consistent valuation
frameworks for the assessment of solvency requirements.

General considerations regarding the calculation of target and enhanced capital

requirements

Key elements under consideration in this section are general decisions and parameters
regarding the measurement of target capital at the corporate level once all risk distributions
have been combined (aggregation is discussed below), as follows:

• Time horizon – Under Solvency II, the SST and the FTK, the time horizon is one year
(under Solvency II, this is only a tentative CEIOPS recommendation. CEIOPS also
states that longer time horizons could be adopted), which means that target capital at
the end of the reporting period must be sufficient to cover losses paid during the year
plus remaining realistic liabilities at the end of the year (including risk margins when
this is relevant). This assumes that liabilities related to the run-off reserves and one
year of business (new business and renewal premiums) are calculated at the end of the
one-year time horizon. Contractual premiums, for instance on traditional products are
taken into account until the term of premium payment period.

Under FSA requirements for realistic basis companies, there is no new business taken
into account in the measurement of ECR and ICA, and capital requirement are
implicitly based on a simulation of the company’s realistic balance sheet at the end of
a one year time horizon.

We have three comments regarding this approach:

- For life business in general, adding one year of new business would generally not
change dramatically the risk profile of companies, except if dramatic changes to
the portfolio of contracts will take place. For non-life business a significant source
of risk comes from underwriting risks on premiums and adding one year of
premium in the framework is critical. Moreover, some also argue that for non-life
long tail lines, where there can be compensation between underwriting years,
taking into account more than one year of premium could lead to a reduction of
target capital requirements.

- Economic risks can only occur over a one year time horizon, and there is a
disconnection between the term of liabilities and risks that can occur until the
term. We will come back to this aspect of the framework in greater depth below.

5
 - Some groups that have commented on CEIOPS Consultation Paper 7, including
the CRO forum, have already argued that risk margins in liabilities could
potentially lead to double count target capital requirements.

• Risk measures and risk tolerance level – Under the SST, the risk measure chosen is
the Conditional Tail Expectation (CTE, a.k.a. worst expected shortfall, a.k.a. TailVar).
Under Solvency II, CEIOPS also recommends CTE while Value at Risk (VaR) is still
a potential candidate. Under the FTK and FSA requirements, VaR with a risk
tolerance level of 99.5% are the underlying elements required to calculate target ECR
and ICA.

CEIOPS recommends using the same risk tolerance level under Solvency II, although
it is not clear in Consultation Paper 7 what the tolerance level refers to (VaR or CTE).
Under the SST, the risk tolerance level has not been defined in the SST White Paper
and will be defined by the regulator.

In practical terms, the impact of risk measures on capital requirements heavily

depends on the calibration of risk tolerance level chosen. At the aggregate level, one
could obtain the same results using two sets of risk measures and risk tolerance level.
However, if capital requirements are calculated at a more granular level and then
aggregated, the choice of using VaR and CTE could lead to significantly different
results depending on the tail behavior of individual risk distributions. The
shortcomings of VaR when working with heavy tail risk distributions are discussed at
length in numerous papers based on the work performed on coherent risk measures by
Artzner, Delbaen, Eber and Heath 5.

Scope of risks measured and risk measurement process

Scope

Starting with Solvency II, five main broad categories are distinguished in CEIOPS’
Consultation Paper 7:

• Underwriting risk – This is the risk arising from premium exposure and potential
deviation in reserves as compared to their current estimates. For life companies, these
risks arise from mortality risk and morbidity risk, lapse risk, and expense risk.

• Market risk including Asset and Liability Management (ALM) risk – This is the
risk arising from movements in equity, property, and currency market prices,
movements in bond values due to changes in risk free interest rates, and the impact of
these movements on the market consistent value of derivatives and policyholder
options and guarantees.

• Credit risk – This is the risk of loss in value for corporate bonds due to changes
following movements in individual ratings, changes in the term structure of default
spreads, and defaults (including defaults from reinsurers).

5
Artzner, Delbaen, Eber, and Heath (1998), Coherent Measures of Risk

6
 • Liquidity risk – This is the risk arising from the companies cannot realize their assets
when needed due to their lack of liquidity.

• Operational risk – This is the risk arising from losses due to failed internal processes,
people and system disruptions, and external events affected adversely companies.

Concerning market and credit risk, concentration risk should also be taken into account in the
range of risks that need to be modeled. However, CEIOPS recognizes that models will not be
able to capture risks, such as concentration and liquidity, adequately and recommends using a
“prudent person plus approach”. Under this, companies will be subject to quantitative and
qualitative rules regarding the eligibility of assets, the concentration of assets and ALM
policies.

While it is hard to precisely compare frameworks, the SST and FTK frameworks have
roughly adopted the same risk classification as CEIOPS for the Solvency II project, with
differences outlined below.

• SST – Operational risk, as well as concentration and liquidity risks should be excluded
from the scope of risks to be measured quantitatively. For these qualitative treatment
is required.

• FTK – Concentration risk is defined as a separate risk category and precisely includes
concentration risk on liabilities in addition to risks on assets. In addition, the FTK
consultation paper states that companies will have to add an extra-layer of capital if
their portfolios are less diversified than that of average companies.

Risks can also be defined in a more precise manner than under CEIOPS Consultation
Paper 7. For instance, under the underwriting risk category, in addition to premium
risk, economic and policyholder risks are also defined. Also, under the credit risk
category, political and country risks are defined.

• FSA (realistic basis companies) – Some of the risks described above of are not taken
into account in the stress scenarios used to calculate capital requirements under the
realistic peak:

- Adverse currency movements

- Movements in implied volatility of assets and interest rates

- Changes in shape of the yield curve

- Liquidity risk

- Insurance risks, excepts lapse and mortality risks

- Operational risks.

However under the ICA, these risks would normally be covered.

7
In conclusion, the objective of all of the frameworks is ultimately to capture all the risks that a
company is faced with (with more or less refinements). The challenge will be to measure all
these risks in robust fashion. In particular, this will imply building information systems that
will enable them to keep track of more information that they used to, in order to calibrate
stochastic parameters (e.g., for lapses, mortality, etc.). In this context, life companies, which
will implement these frameworks for the first time, will first focus on the material risks they
face, namely ALM risks arising from contracts’ options and guarantees, and dynamic
policyholder behavior, and adopt shortcuts for other risks, such as operational risks, or credit
risk. As they step up the learning curve, they will probably implement more sophisticated
approaches for these risks.

Risk measurement process

Under the Solvency II, the SST, and FTK framework, companies will be able to calculate
target capital requirements using standard model or formulas or internal models. Under the
FSA requirements for realistic basis companies, the ECR will be calculated using standard
models, while companies will have to implement the ICA, probably based on internal models
with various levels of sophistication. Below, we describe measurement techniques for the
standard models and formulas under each solvency framework.

In order to determine target capital requirement under the standard formula in the Solvency II
framework, CEIOPS advised the EU to explore different routes based on a mix of factor-
based approaches (use of factors applied to reserves, assets, or premiums – depending on the
risks – to account for mortality and expense risk, lapse risk, market risks, credit risk, and
operational risk, respectively) combined with scenario approaches (lapse and market risk).
The final approach, including aggregation of target capital amounts calculated for individual
risk factors, will be adopted following quantitative impact study (QIS) analyses. In the current
state, CEIOPS recommendations are too general to anticipate the shape of the future Solvency
II standard model or formula.

Under the FTK, SST, and the FSA ECR, capital requirements under standard models are
determined through the measurement of the impact on realistic net assets (market consistent
value of assets minus market consistent value of liabilities) of the application of instantaneous
shock scenarios for risks modeled under the framework. For a given risk factor, target capital
is defined as the difference between current net assets and net assets required under the stress
scenario for this specific factor. Our understanding of the required steps in order to calculate
target capital amounts for each risk factor, assuming the calculation of target capital takes
place at year end N and neglecting the one-year time horizon for a moment.

• Determine the realistic balance sheet at year end N

• At year end N, assume a shock6 is performed on the particular risk factor for which we
want to calculate required capital, e.g., the current term structure of interest rates is

6
We do not refer in this document to the various shock scenarios performed in each model because these shocks
were calibrated based on the type of contracts written by companies in each of the countries. As contracts written
in France probably have different risks, the interest we have in these scenarios is second order. However, a
description of these scenarios can be found in the 2005 report ‘Solvency Assessment Models Compared’ by
CEA and Mercer Oliver Wyman.

8
 shifted downwards 20 basis points. The shock can typically be due to an event that
happens between the close of business at year end N and the next day.

• Based on this new yield curve, recalibrate economic scenario generators to be

consistent with market prices implied by the “shock”, or non economic assumptions

• Recalculate the market consistent value at year end N of liabilities using the
recalibrated assumptions

• Recalculate the market value of assets following the shock

• Target capital is the difference between the starting net asset position and the net asset
position recalculated after the shock.

The approach we have just described resembles the approach that was adopted in order to
calibrate the shock scenarios for the calculation of target capital under the ECR realistic
peak7, except that under the latter, economic scenario generators have been used to determine
the evolution of economic variables monthly over a one year time horizon. Under each
scenario and for each month, target capital was determined as the amount of capital needed at
year end N to avoid insolvency (negative net realistic assets) at the end of each month during
the following one year period. This therefore integrates the one-year time horizon.

Depending on the frameworks, aggregate target capital can be calculated as the sum of target
capital amounts calculated independently for all the risks, less an allowance for diversification
effects through the use of correlation coefficients or matrices (FTK and SST) – further details
about the practical aspects of aggregation techniques can be found in the documentation cited
above. Under the FSA ECR framework, the total target capital is the sum of target capital
amounts calculated independently for all the risks. However, diversification is implicitly taken
into account in the calibration of stress scenarios so that required capital amounts can be
directly summed across risk factors.

In summary, the process above is similar to what banks would do to calculate a VaR amount
over a one year time horizon taking into account correlations between risks. The process
companies would have to go through to calculate this would prove a great challenge for
companies implementing this methodology for the first time. In particular, this is due to the
multiplication of runs and calibrations required to recalculate the market consistent value of
liabilities following realistic shocks. In addition, this approach assumes assets are liquidated
at the end of the one year time horizon. In reality, assets would be liquidated only in case of
cash shortfalls, or for internal asset strategies. On the liability side, on the contrary, as the
market consistent valuation of liabilities is the average present value of liability cash flows
across projected scenarios, the impact of worst case scenarios are dampened.

Finally, one advantage of the methodology, if life insurers use market consistent frameworks,
such as market consistent embedded values, to manage performance, this will be directly
integrated in the risk and capital management framework, as described by Hancock, Huber,
and Koch8. The question is: how many insurers, especially small and medium size insurers

7
Watson Wyatt, Financial Services Authority (2004), Calibration of the Enhanced Capital Requirement for
with-profit life insurers
8
Hancock, Huber, and Koch (2001), How insurers create value for Shareholders

9
have implemented market consistent valuation frameworks for performance measurement?
On the short run, it is likely that only big size insurers will be able to take up the challenge of
implementing these frameworks.

In the following section, we present an alternative approach to the measurement of capital for
a typical life company. This approach may be more familiar to life insurers and is potentially
easier to implement. Based on further testing, it would be possible to calibrate risk tolerance
levels so that this approach and approaches analyzed above lead to target capital amounts that
are of the same order.

An alternative framework for the measurement of target capital requirements

In the development below, we focus on the measurement of target capital requirement for
typical French with-profit company only selling euro savings contracts. Assets backing
product reserves are invested in the company’s general account. As compared to the scope of
risks described above for Solvency II, we neglect mortality risk (not important for the type of
products modeled), credit risk, concentration and liquidity risks, as well as operational risk.

Our approach is based on a specific definition of target capital:

• Required capital – For a given economic scenario, we define required capital as the
amount, which invested in a portfolio of assets that will earn the same yield as the
assets invested in the company’s general account, will enable the company to meet the
discounted value (at the projected yield) of liability cash-flows in excess of assets
currently backing policyholder reserves, and other specific reserves (see below),
which are projected in the model. The following steps are performed to calculate
required capital amounts:

- For a given economic scenario, projection of assets and liabilities under French
statutory accounting rules.

- Assets backing liabilities, mathematical reserves, other specific reserves and assets
and liability cash flows are projected taking into account the bonus crediting
policy of the company, its investment strategy and interactions between assets and
liabilities

- Liability cash flows are then discounted at the market yield on assets backing
liabilities.

- Required capital is equal to the difference, at start of the projection, between the
market value of assets baking liabilities and the present value of liability cash
flows.

• Target capital – This is equal to the Tail Conditional Expectation (TCE) or the VaR
(depending on the risk measure selected) calculated on the distribution of required
capital amounts determined for a significant number of scenarios (1000 in this study).

In projecting future liability cash flows under the approach described above, the following
aspects need to be specifically addressed:

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 • Portfolio of contracts and policyholder contractual guarantees – This is the
portfolio of contracts that our company has on its books and associated contractual
rights provided to policyholders, including guaranteed rates, profit sharing rates, and
rights to lapse their contracts at a value different from the market value of assets
backing reserves.

• Accounting and regulatory constraints – In developing the model, French

accounting and regulatory constraints need to be modeled, as these will impact profit
sharing and eventually policyholder cash flows.

• Profit sharing mechanism – The French profit sharing mechanism is presented under
this.

• Management actions – These are the strategy levers that companies can use to adjust
their strategy in the future. This includes decisions regarding the strategic asset
allocation (e.g., adjustment of the duration and convexity of assets to manage the
mismatch between assets and liabilities, adjustment of equity backing ratio) and the
bonus crediting strategy. This will depend the following key items:

- Initial “wealth” and buffers of the company plus additional “wealth” and buffers
generated in the future. This is composed of unrealized capital gains on assets
backing reserves, as well as specific reserves or equity items that can either be
used to credit higher rates to policyholders in a distressed environment or offset
losses incurred by companies when forced to realize capital losses on asset sales.

- Accounting, regulatory and market constraints.

• Policyholder behavior – This is supposed to reflect the realistic behavior of

policyholders in response to changes in the economic environment.

In order to project future asset values (book and market) and cash flows, as well as market
variables, an economic scenario generator was used. This generated nominal and real
government yield curves, equity, property capital and dividend indices, as well as inflation in
a real world environment.

Portfolio of contracts and policyholder contractual guarantees

The products on the books of our company are single premium Euro savings products (similar
to US Single Premium Deferred Annuities). These contracts are considered whole life
contracts. Reserves accumulate at a credited rate which depends on the profit sharing
participation, subject to minimum guaranteed rates.

The main guarantees arising out of the contracts modeled are guaranteed rates, and the right
given to the policyholder to lapse their contract at relatively low costs, at the accumulated
value of the reserves (without market value adjusters).

We considered that our company’s in force reserves were composed of two types of contracts:

11
 • (a) Contracts with fixed guaranteed rate until termination, representing 33% of total
reserves. We performed sensitivity tests on the level of guaranteed rates: 2,5% and
3,5%

• (b) Contracts with variable guaranteed rates equal to 60% of a long term government
yield (TME), representing 67% of total reserves.

Newer generations of products are of type (b). However, companies could still have on their
books contracts of type (a).

Accounting and regulatory constraints

Our description of the accounting and regulatory framework starts with the presentation of the
French statutory accounting balance sheet (table 1 below) and of each specific item (reserve
or equity component), other than mathematical reserves, that will impact our cash flow
projections.

Table 1: Statutory balance sheet for French with-profit contracts

Assets
Assets backing guaranteed funds –
general account &
segregated funds (excluding Unit-
Linked contracts)
(At amortized cost for bonds and
historical cost for equity, and
allowing for reserves for impairment
of assets)
Including differed acquisition costs limited
to zillmer spreads
Liabilities
Statutory Capital
Including réserve de capitalisation
• Reserve for asset and liability
inadequacy (PAF)
• Reserve for future maintenance costs
(PGG)
• Reserve for illiquidity of
equity/property assets (PRE)
• Mathematical Reserves Claims
Reserves
• Unallocated bonus reserve (PPE)

We now present each of the specific items in the balance sheet above:

• Bonds and equity/property assets – As indicated in the balance sheet above, bonds
are valued at amortized cost and equity/property assets, as well as mutual funds at
valued at their historical costs. We considered that our company does not have
unrealized gains or losses.

• PPE – This is the accumulation of bonuses that have not yet been distributed to
policyholders. Credits to the PPE must be attributed to policyholders within a
maximum period of eight years following the year in which they have been credited to
the PPE. The PPE belongs to policyholders and cannot be used to offset financial
losses incurred by the companies. It is used to credit higher (in-the-market) rates to
policyholders if earned rates are insufficient for a company to remain competitive. In

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 addition, we consider the following additional features. We considered that our
company had an initial PPE representing 0% or 4% of initial mathematical reserves.

• ‘Réserve de capitalisation’ (RC) – This reserve is considered as part of capital. The

RC increases by the amount of realized capital gains on bonds. In case of realized
capital losses on bonds, losses are compensated by negative movements on the RC
(limited to the reserve level). Movements on the RC are included in the calculation of
financial results, and subsequently in the calculation of profit sharing amounts. At the
term of the projection, the remaining RC, when it belongs to shareholders, should be
considered as available for shareholders. We considered that our company had an
initial RC representing 0% or 3.5% of initial mathematical reserves.

• PRE – This is a reserve that is booked when equity, mutual funds, and property assets
are in an overall unrealized loss position. This reserve does not apply to directly held
bonds. As this reserve enters in the calculation of profit sharing, it will be modeled in
the future.

• PAF and PGG – PAF is a regulatory “ALM” reserve constituted to cover potential
future shortfalls of book yield to cover guaranteed rates. PGG is a maintenance cost
reserve, whose purpose is to cover future costs that are not covered by future charges.
PGG and PAF are not modeled in our approach because these reserves do not
materially impact future policyholder cash flows.

In addition to the items above, the regulator also requires that companies continuously
maintain a book value of assets equal to the book value of reserves. In our model, we
therefore respect this constraint and inject capital in the company when asset fall below
reserves. When assets are greater, dividends are paid to shareholders.

Finally companies are subject to constraints regarding minimum profit sharing rules. This
is described in the next paragraph.

Profit sharing

With our understanding of the French statutory accounting framework based on the
description above, we are ready to present how profit sharing works in France, and
specific constraints associated with profit sharing.

Each year a profit sharing amount is calculated based on statutory financial and technical
results for all contracts in aggregate. When this is positive, a proportion is directly
attributed to policyholder reserves, another to the PPE. The remaining portion is attributed
to shareholders. The proportion attributed to policyholder reserves and allocated to the
PPE is generally defined contractually, subject to a minimum imposed by the regulator.

We now present into further details how the profit sharing amount is calculated, what are
the minimum profit sharing rules, typical profit sharing rates, and how profit are generally
attributed to policyholder reserves on the French market:

• Profit sharing amount – The profit sharing amount is composed of the gains arising
from the difference between experience and pricing assumptions:

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 - (a) Difference between earned rates (book yield) and minimum guaranteed rates
(financial results)

- (b) Difference between pricing mortality and experience mortality (technical

results)

- (c) Difference between fees and experience costs and commissions (technical
results).

In practice, under most contractual terms, a proportion of (a) will be attributed to

policyholder reserves and allocated to the PPE. As, such we detail the calculation of
the book yield. The book yield is calculated as follows:
Financial Income
BY = ,
Average Book Value of Assets
Where Financial Income includes coupons, dividends, rents, capital gains, movements
of PRE, change in other impairment reserves, movements of RC, change in accrued
interests, and amortization of bonds. The following additional comments apply to the
determination of Financial Income:
- Investment income on the RC is not included in the book yield used to calculate
the profit-sharing account, unless the RC belongs to policyholders, but movements
on the RC are included.
- Investment income on the PPE is included in the minimum profit sharing account
calculation as well as in the contractual account.
- For certain companies, movements of PRE may not go through the income
calculation. In this study, movements of PRE are included in the book yield
calculation. However, we have considered that losses due to movements of PRE
could be carried forward the next year. This is to avoid the distribution of capital
injections due to losses induced by movements of PRE to policyholders.
• Minimum profit sharing rules – Allocation of profits to policyholders is subject to a
regulatory minimum, which is calculated as follows:

- Calculation of the contractual profit sharing amounts at each fund level (for
segregated guaranteed funds and the company’s general account).

- Performance of a test to verify that for the products above, the amount of profit
allocated to policyholders during the year is at least equal to the sum of:

(a) 85% of financial results if positive, and zero otherwise

(b) 90% of technical results, if positive, and zero otherwise.

In case (a) plus (b) is negative, losses can be carried forward to the next period.

• Typical profit sharing rates – In practice, insurers allocate profits to policyholders

based only on a percentage of financial income or the financial result (income less
guaranteed rate), but ensure that the aggregate amount of profit allocated to

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 policyholders is higher than the regulatory minimum. The following are typical profit
sharing schemes implemented by insurers in France:

- (a) Profit sharing rate determined by the insurer in respect of the minimum
regulatory rules, as indicated in the contract terms.

- (b) Fixed profit sharing rate, e.g., x% of financial results

- (c) A mix of (a) and (b).

In situation (a) and (c), insurers have significant discretion regarding the amounts of
profit allocated to policyholders, which could enable them to offset negative financial
results generated by groups of products with gains generated by others, subject to the
minimum profit sharing requirement.

In situation (b), they have much less discretion. However, in this situation, they can still
decide on the contracts they allocate profits to and when they realize capital gains on
assets other than bonds, which are then shared with policyholders through the profit
sharing mechanism.

In this study, we have considered that profit sharing rates were fixed at the portfolio
level and equal to 90%.

• Profit attribution – Profits allocated to policyholders can be split into two components:

- Profits directly attributed to policyholder reserves

- Profits allocated to the PPE.

Attribution of PPE amounts will generally be driven by the evolution of market rates as
compared to book yields on the asset portfolio:

- In case book yields are high as compared to market interest rates, companies will
credit policyholder reserves with the amount required to reach a target credited
rate, and allocate the residual amount of profit to the PPE.

- In case book yields are low as compared to market interest rates, companies will
use the PPE to credit rates that are in line with market interest rates.

In the next section we determine the assumptions used in our model regarding the
management of the PPE.

Management actions

There are two sets of management actions modeled, asset sales and purchases, and bonus
crediting strategy:

• Asset sales and purchases – The main assumption is that the company will maintain the
initial strategic asset allocation across the projection. At the end of each period, the asset
portfolio is rebalanced, so as to maintain the breakdown of the market value of assets

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 constant across the projection. For our company, we have modeled the following strategic
asset allocations

A) Asset allocation 1
- Bonds: 80% with duration of approximately 7 years.

- Equity: 10%

- Property: 5%

- Cash: 5%.

B) Asset allocation 2
- Bonds: 70% with duration of approximately 7 years.

- Equity: 20%

- Property: 5%

- Cash: 5%.

In addition, when the company does not have sufficient book yields to cover guaranteed
rates, capital gains on property/equity assets, and mutual funds are realized. Also, assets
are sold when the company does not have sufficient cash flows from coupons, rents,
dividends, and redemptions to pay liability cash flows.

• Bonus crediting strategy – The goal of our company is to credit policyholders with a rate
equal to the 10-year government bond yield. When yields are not sufficient to achieve
this, the PPE is used to meet this target. When yields allocated to policyholders are above
the target rate, the difference between the yield and the target rate is allocated to the PPE.
Under normal circumstances, the PPE is credited to policyholder reserves on a regular
basis (within 8 years starting form the allocation date).

In addition, our company could potentially use discretion regarding the contracts it
allocates profits to in priority. In this context, for instance if the company was selling had
traditional products on their book, profits generated by these could eventually be
attributed to euro savings products.

Policyholder behavior

In addition to best estimate mortality and lapse assumptions, we have introduced a dynamic
lapse formula to model the policyholder’s possible reaction to low credited rates as compared
to market rates. According to this formula, lapse rates increase when the 10-year government
bond yield becomes higher than credited rates. Calibration of such a function is very difficult
given the lack of historical data. Our calibration is based on reasonable choices after doing
some sensitivity testing around the parameters used.

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Results

As a reminder, under statutory rules, the capital requirement is equal to 4% of the reserves.

The table below shows the target capital requirements (columns on the right) in % of
mathematical reserves for the simulations of all the sensitivity scenarios described above for
our company.

• Level of guaranteed rates for products with fixed guaranteed rates

• Level of PPE at start of projection in % of policyholder reserves at the start of the

projection

• Level of Réserve de capitalization in % of policyholder reserves at the start of the

projection.

• Asset scenario 1 and 2, respectively.

Results are presented at various confidence levels (95%, and 99,50%, respectively) under the
VaR measure:

VaR with VaR with

Sensitivity Guaranteed Level of Asset Asset
scenarios rate PPE RC Confidence Allocation 1 Allocation 2
1 0,00% 95% 0,5% 2,7%
2 0,00%
99,50% 3,6% 8,2%
2,00%
3 3,50% 95% 0,0% 0,0%
4 99,50% 0,4% 4,8%
5 0,00% 95% 0,1% 2,2%
6 3,50%
99,50% 3,3% 8,3%
7 3,50% 95% 0,0% 0,0%
8 99,50% 0,2% 4,9%
9 0,00% 95% 1,7% 4,4%
10 0,00%
99,50% 5,6% 11,3%
3,50%
11 3,50% 95% 0,0% 1,2%
12 99,50% 2,0% 7,8%
13 0,00% 95% 1,3% 4,0%
14 3,50%
99,50% 5,3% 11,5%
15 3,50% 95% 0,0% 1,1%
16 99,50% 1,7% 8,0%

The following comments apply to the table above at 99.5% confidence level:

• Risk arising from guaranteed rates – As expected, the higher the guaranteed rate,
the higher the target capital requirement.

• Risk arising from asset allocation – As expected, the riskier the asset allocation, the
higher the target capital requirement: In all of the scenarios above, target capital
requirements are higher under asset allocation 2 than under asset allocation 1.

• Reduction of target capital due to RC – In situations where the RC represents 3.5%

of the reserves, its effect on target capital requirement, as compared to the scenario
with 0%, depends on the scenario:

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 - Asset allocation 1 (lower risk)

If we compare scenario 10 and 12, and 14 and 16, respectively, which are similar,
except for the level of RC, the reduction of target capital due to the introduction of
the RC is of approximately 100% of the total RC amount available at the start of
the projection: for example, the difference in the % of target capital between
scenario 10 and 12, is equal to 3.6%, which is roughly the initial RC amount.

However, the reduction of target capital induced by the RC can be lower and fall
around 90% of the starting RC. This is observable when we compare scenario 2 to
scenario 4, and scenario 6 to scenario 8.

- Asset Allocation 2 (higher risk) – under all scenarios, the reduction of capital due
to the RC is approximately equal to the initial level of RC under all circumstances.

The descriptions above indicate that there are scenarios under which some of the initial
RC is transferred to policyholders via the profit-sharing mechanism: There are cases under
which, when the RC is used to offset realized losses on bonds, this leads to amounts of
profit sharing being allocated to policyholders. When the RC is not modeled, under
similar circumstances, there is no profit sharing allocated to policyholders due to losses
realized on bond sales, and subsequently, liabilities increase less than under the situation
where there is an initial RC. This does not happen with the less risky asset allocation, as in
this case, the scenarios lead to having a cost of guarantee which is significant enough, so
that the effect described above is immaterial.

Differences in the impact of the RC on target capital show that, contrary to what is usually
admitted, not all the entire amount of RC can be considered as available capital to the
shareholders. Subsequently, this means that the initial RC should be projected in the
model in order to estimate its effect in the level of target capital.

• Reduction or increase of target capital due to PPE – In the model, as mentioned above,
we have considered that the PPE belonged to shareholders. In this respect, it should not be
used to offset losses arising from guaranteed rates being higher than book yields, or any
loss arising from asset sales. This means that the only source of target capital reduction for
shareholders in future years is the profit on investments on the initial PPE that they will
share with policyholders.

However, as we consider that management had discretion over the use of PPE to credit
higher rates to policyholder and prevent lapses when assets were in an unrealized loss
position, this may create a source of target capital reduction for the company. The results
of our simulations show that depending on the situations, the PPE can decrease the level
of target capital or increase it:

- Asset allocation 1: The PPE reduces the target capital requirement for the reason
outlined above.

- Asset allocation 2: The PPE increases the target capital requirement. This is due to
the fact that there is an offsetting effect to the one mentioned above. In some
situations, the company uses it amount of PPE to credit higher rates to

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 policyholder reserves. This leads to an increase of the reserves and eventually
liability cash flows, as compared to the case when no PPE is modeled. This effect
offsets the prevention of lapses.

These observations suggest that the PPE cannot always be considered as a buffer for
companies, and that the initial PPE should be projected in the ALM model.

Other effects – Further testing, not presented in the table below, shows that the level of
initial unrealized capital gains contributes to a significant reduction of target capital
requirements.

Conclusion

Our analysis of various solvency initiatives has shown that the measurement of target capital
requirements in solvency frameworks across Europe (although the Solvency II framework is
still under construction) were converging toward a very specific solvency model, based on
market consistent principles, which establishes a strong link between insurance solvency
models and VaR models implemented by banking institutions. These frameworks attempt to
measure all the risks companies are potentially faced with, and take into account in the
assessment of the overall target capital calculation of diversification effects across risks. We
anticipate that implementing these frameworks will imply significant implementation
challenges, both technical and human, for most companies, especially those who have not
already implemented market consistent frameworks for performance measurement.
Maintenance and regular update of calculations may also prove put additional pressure on
these companies.

We also show there are potential alternatives to these frameworks, which are able to capture
risks satisfactorily (as compared to the Solvency I framework), and maybe simpler to
implement due to the need of less calibration and stochastic runs. In addition, the case study
we have developed has enabled us to determine the key risk drivers that life insurers selling
Euro savings contracts are exposed to:

• Strategic asset allocation

• Contractual guarantees

• Level of initial ‘wealth’ and buffers: unrealized capital gains, level of PPE and réserve de
capitalization.

We have also outlined possible counter-intuitive results regarding the impact of buffer
reserves, such as the initial RC and PPE: The initial PPE can lead to situations where it
increases target capital requirements. Also, there are scenarios under which the RC cannot be
entirely used to reduce target capital requirements

Potential directions for future work include:

• Additional of products (traditional, annuities, and unit-linked) to the modeling framework

described in the alternative approach

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• Compare the two types of solvency approaches described in this document (one year VaR
approach and alternative approach).

We hope you have found this study useful.

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