(status: 13 December 2010)
A. FULL IMPLEMENTATION: TIMING AND GENERAL INFORMATION
1. What is the implementation timetable?
Together with the fully revised Swiss Federal Act on the Supervision of Insurance Companies (Swiss Insurance Supervision Act; ISA; SR 961.01) and the associated Swiss Federal Ordinance on the Supervision of Private Insurance Companies (Insurance Supervision Ordinance; ISO; SR 961.011), the Swiss Solvency Test was introduced as the new method for assessing the solvability of insurance companies as of January 1, 2006. The financial situation of the insurance companies is assessed based on the ratio between the eligible equity (risk-bearing capital) and the risk-based required capital (target capital).
The major life and property insurance companies have been using SST since 2006, the others since 2008. According to Article 216 (4) d of the ISO, the insurance companies must accrue the risk-bearing capital required to cover their target capital within five years of the ISO coming into effect, i.e. by 1 January 2011. From this date on, they submit the results of their SST as of 1 January by 30 April each year at the latest. SST is calculated on a semi-annual basis for insurance groups (1 January and 1 July).
2. Are disclosure requirements also linked to the end of the five-year transitional period for insurance companies?
At present there are no disclosure requirements vis-à-vis the general public (financial analysts, investors, shareholders, rating agencies, etc.). However, it is at the insurance company’s discretion to provide information on its SST cover, for example as part of its analysts’ and media conference. However, in so doing, it should be clearly pointed out whether this information relates to indicators that are based on FINMA’s SST principles, or if these are modified indicators used within the company.
3. Will FINMA introduce disclosure requirements at a later date?
FINMA continues to aim to ensure that SST is equivalent to Solvency II for insurance groups and conglomerates (see Chapter F below). This equivalence not only relates to purely quantitative requirements (pillar I) but also to qualitative aspects (pillar 2) and disclosure requirements (pillar 3). As a result, it is possible that FINMA may amend the regulations for disclosure requirements at a later date.
4. Do SST figures have to be audited from 1 January 2011?
Initially, SST figures do not have to be audited from 1 January 2011.
5. What is the financial situation for insurance companies?
As a result of the financial crisis in 2008, many (life) insurance companies experienced a difficult financial situation. In terms of SST, there were, in some cases, major losses in risk-bearing capital, mostly caused by the wider interest rate spreads and reductions in the value of equities and alternative investments. As part of the SST 2009, which was based on the opening balance sheet as of 1 January 2009, according to their own information some life insurance companies have an SST ratio of less than 100%. That means that their available capital is not sufficient to cover the target capital. As a result, many insurance companies "de-risked" by selling risky investments or hedging these using derivative financial instruments.
The continued low interest rates are mostly problematic for life insurance companies. Their portfolios of traditional life insurance products have average technical interest rates of between 2.5% and 3%. Compared with the current return of approx. 1.5% for a ten-year government bond, this is a very high figure. Under the SST, low interest rates generally result in an increase in liabilities that are valued market-consistently. This valuation is often higher than the corresponding increase in fixed-income investments. This results in a reduction in risk-bearing capital, which is reflected in the lack of solvency capital.
B. FULL IMPLEMENTATION: FAILURE TO UPHOLD SST REQUIREMENTS
6. What are the consequences of failing to uphold the SST requirements?
The SST assesses the financial security of an insurance company according to the risks to which the company is exposed. If the risk-bearing capital is less than the target capital required according to the risk exposure, this does not automatically mean bankruptcy. It is much rather the case that this signalises that the insurance company does not have enough risk-bearing capital to be able to bear the average loss for a 100-year loss event. In this case, the insurance company must either reduce its risk exposure or ensure that it has more risk-bearing capital.
The provisions in Annex 4 ("Intervention thresholds") in the FINMA circular 08/44 "SST" also come into effect on 1 January 2011:
- If this figure falls below the 100% threshold (yellow zone), a plan of activities must be presented and implemented, and specific decisions must be presented in advance to FINMA for approval. These include, for example, dividend payments and allocating surpluses.
- If this figure falls below the 80% threshold (orange zone), FINMA can prohibit new business or parts thereof.
- If this figure falls below the 33% threshold (red zone), FINMA can revoke the license.
7. Why not wait until the life insurance companies’ financial situation gets better on its own?
Depending on changes in interest rates, there is the danger that the life insurance companies’ financial situation could continue to deteriorate. If the interest rates continue to fall, the companies’ asset-liability mismatch and the marginal capitalisation will result in a very difficult situation: Many life insurance companies would fall below the various intervention thresholds and it cannot be ruled out that FINMA would have to decide whether or not to revoke the license (red zone) in some cases.
8. Do insurance companies with weak capitalisation have a realistic chance of covering their target capital with risk-bearing capital within the prescribed period?
Insurance companies with weak capitalisation can achieve an SST solvency ratio of at least 100% by:
- Reducing their risks. In the case of life insurance companies, this is most effectively done by improving the asset-liability match.
- Increasing their capital. This can often be done without transactions on the capital markets for group companies. For example via an intra-group loan from a parent or non-life company to the life company.
- Use of guarantees from group companies. However, only part of the risk can be covered using intra-group guarantees, as this would otherwise result in excessive concentration risks. See Chapter E below.
Most insurance companies with weak capitalisation can achieve an SST ratio of at least 100% by using a reasonable combination of the above methods. It must be noted that FINMA can grant an insurance company which is in the yellow zone a one-year deadline to cover its target capital with risk-bearing capital. If the insurance company is in the orange zone, this period may be up to three years. These periods are over and above the five-year introductory period.
9. Is it not an unfavourable time to change investments over to bonds right now given the low interest rates?
Yes, there have been more favourable periods in the transitional period which has been running since 1 January 2006 to increase the bond portfolio. However, the acute interest-rate risks described above mean that just waiting out the problem is not an option.
C. FULL IMPLEMENTATION: MODALITIES
10. What basis is used for SST 2011?
Risks are quantified in SST 2011 based on the standard model, an approved internal model or a provisional transitional model, see the FINMA Newsletter 11 (2010) dated 16 July 2010.
11. How is the transitional model defined?
As a rule, the transitional model is based on the not-yet approved internal model. However, this means that FINMA must be aware of this. For example, this is the case if this was applied as part of SST 2009 or earlier. It is also conditional upon the model not having any major deficiencies.
12. How do insurance companies find out which risk model they have to use as part of SST 2011?
FINMA defines the model used as part of SST 2011 individually, and communicates this to the insurance companies by the end of September 2010 at the latest.
13. What basis will life insurance companies that do not have a suitable internal model use to implement SST 2011?
Based on the "Life" standard model, which FINMA has newly developed.
14. What does the new standard model "Life" comprise?
The market risk module in the new standard model "Life" is based on a so-called delta-gamma approach. This allows the non-linear functional connection between the risk-bearing capital and the risk factors to be better mapped (second order approximation instead of a first order approximation). The delta-gamma method and its implementation is described in detail in the supplement to the FINMA Newsletter 11 (2010) dated 16 July 2010.
Irrespective of the model used to quantify risks, each insurance company has to value its assets and liabilities market-consistently. This applies, in particular, to the options and guarantees embedded in the life insurance products. (Article 48 and Annex 3 of the ISO, see also Chapter E below). With regard to the definition of market-consistency, please also refer to Annex 1 of the FINMA circular 08/44 "SST".
15. Which insurance companies have to use the new standard model "Life"?
Insurance companies for which the former delta-normal approach is not suitable and which do not have their own suitable internal model have to use the new standard model "Life".
16. What happens if a life insurance company is not able to implement the delta-gamma approach?
In this case FINMA charges a surcharge on the life insurance company’s target capital based on the sensitivities that have to be identified as part of the standard model.
17. What happens if the life insurance company is not able to value the options and guarantees that are embedded in the life insurance products?
In this case, FINMA charges a discount on the risk-bearing capital. This is based on a market standard.
18. What happens if the life insurance company doesn’t agree with this discount?
In this case, the life insurance company can, at its own expense, use an external consultant authorised by the supervisory authority to review the discount.
D. CHARACTERISTICS OF ECONOMIC VALUATION AND RISK MODELS
19. Why do the SST indicators fluctuate so strongly from survey to survey?
The basic principle behind the SST of a total market-consistent balance sheet approach brings with it natural volatility in the items to be measured. This volatility is mostly caused by market parameters that fluctuate over time, such as interest rates, exchange rates, share prices, interest rate spreads, etc. The consequence is that the resulting SST indicators have a certain volatility. This volatility can be reduced to a certain extent from a risk management perspective - for example by using derivative financial instruments or via consistent asset liability matching.
20. Does the SST behave pro-cyclically?
Pro-cyclically means the need to sell financial assets at an unfavourable moment as a result of financial markets that have come under pressure.
Economic solvency systems such as SST and Solvency II are pro-cyclical by their very nature (see also the comments under 19 above). This pro-cyclical behaviour could only be fully eliminated by deviating from the economic valuation and risk measurement principle. This in turn would have other undesirable characteristics.
The pro-cyclical effects of an economic solvency system can be reduced by adding a buffer. If an insurance company aims, for example, for an SST solvency ratio of 150%, it can use the overcover by 50 percentage points to compensate for fluctuations in volatile investments. This would mean higher capital adequacy than the BBB requirements which are inherent in SST.
21. Can SST capital requirements compare with Solvency II capital requirements?
The Quantitative Impact Studies (QIS1 - QIS4) conducted by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) have, to date, shown results that differ greatly. As a result, it is scarcely possible to compare the results with each other, not only from study to study, but also in comparison with SST. A comparison with SST is also difficult as the two concepts differ in several respects. For example the issue of discounting or provisions for own funds. In spite of this, however, FINMA has reviewed the specifications of QIS4 and has compared these with the SST requirements in the standard model.
For example, the reviews have shown that the major market risk drivers (interest, spread and equity risk) have a slightly larger weighting in the SST model than under QIS4. Compared with the Solvency II standard model, however, this effect is compensated for by larger diversification effects in the SST standard model.
This is different for life insurance risks. The Solvency II requirements in this regard tend to be higher. This is because, when determining life insurance risks, Solvency II differs from the total balance sheet approach and only uses the prescribed scenarios for part of the life insurance policies. In contrast, the parameters in the SST relate to all insurance policies. This allows the SST standard model to include the natural diversification effects between the life insurance products.
Conclusion: It is difficult to compare capital adequacy under SST and Solvency II. In cases where comparisons are possible, reviews by FINMA have shown that capital adequacy under SST is certainly not excessively higher than under Solvency II.
E. SELECTED VALUATION AND RISK MODELLING ASPECTS
22. What basis is used to determine the risk-free interest curve in SST?
For the SST, counterparty risk-free CHF, USD and GBP yield curves are directly derived from government bonds. In order to exclude the spread risks of individual eurozone countries (which need to be captured separately), the EUR yield curve, however, is based on generic data. In addition, potential illiquidity premiums are filtered out for all counterparty risk-free yield curves (cf. annex 3 ISO).
23. Can technical provisions be discounted using the risk-free interest rate plus interest rate spread (illiquidity premium)?
As part of the credit crisis in 2008, the idea was raised of discounting technical insurance obligations using the risk-free interest rate plus the interest spread, in line with the valuation of corporate bonds (illiquidity premium). UK life insurers in particular backed valuing their obligations from pension portfolios in this manner.
However, the concept of an illiquidity premium goes against the grain of the market-consistent valuation principle. This is based on the principle of replication using tradable, liquid (financial) instruments. The replicating portfolio for a simple European financial option, for example, comprises investments in the underlying and the risk-free bank account. In order to reproduce the payoff upon maturity under all circumstances in the world, it is necessary to constantly regroup the replicating portfolio. As a result, illiquid instruments cannot be used for replication. If we apply this to the valuation of technical insurance obligations from insurance policies, this means that replication may not include any illiquid financial instruments, otherwise the principle of market-consistent valuation would be violated. That is why FINMA is against the use of an illiquidity premium to value technical insurance obligations as part of SST.
24. Are future shareholder profits (PVFP) eligible for risk-bearing capital?
Under the traditional SST valuation approach, risk-bearing capital mostly comprises statutory equity and the valuation reserves on the assets and equity and liabilities sides of the balance sheet. The PVFP approach refines this traditional SST valuation approach by breaking down the valuation reserves between the shareholders and the insured parties. It must be noted that this breakdown affects, in particular, modelling of policyholder behaviour (surrender behaviour): Changes in profit participation impact policyholder behaviour.
Anticipated future shareholder profits from insurance policies that apply on the valuation date are thus eligible as part of SST. However, the risk-bearing nature of the future profit participation must be taken into account when calculating the target capital.
25. What do embedded options and guarantees mean?
Embedded options in a (life) insurance policy means that the insured party has a right to change the contractually agreed performance during the term of the contract, in line with the conditions agreed at the start of the contract. Options are thus exercised via conscious actions on the part of the contracting parties. Examples of embedded options include surrender rights or capital options in endowment life insurance where the benefits can either be drawn as capital or a life-long pension.
In contrast, performance under (financial) guarantees is initiated automatically, without the contracting parties consciously acting. In the case of financial guarantees, losses, which generally result from disadvantageous developments on the market, are borne by the insurance company. A classic example of a financial guarantee is the guaranteed minimum return for an endowment life insurance policy. In terms of financial mathematics, guarantees are generally financial options.
26. How do we identify the value of embedded options and guarantees?
The first stage in determining the value of embedded options and guarantees is to determine all of the risk factors that impact the exercise behaviour for options and which impact the financial guarantees. These also include so-called management rules. The market-consistent value of options and guarantees comprises the intrinsic value and the time value. The intrinsic value is the payout if the option is exercised directly. In contrast, the time value reflects the fact that the option may increase in value if it is exercised later. As a result, on the maturity date, the option value corresponds to the intrinsic value, the time value is zero.
The complexity of options and guarantees mean that stochastic simulation models are most suitable for valuing these. These models simulate a large number of scenarios on the financial markets - while correctly using the corresponding financial mathematical principles - and they identify the corresponding value of the options and guarantees depending on these principles. The value is then given by forming an average across all of the simulation path-dependent values of the options and guarantees.
27. Which embedded options and guarantees are to be measured as part of the SST?
Options and guarantees are to be measured taking the principle of materiality into account. This could also include non-financial guarantees (for example, premium adjustment due to favourable claims experience), to the extent that these are key component of the portfolio.
28. How are operational risks dealt with in SST?
Until further notice, operational risks are only included in terms of quality. These are not quantified as a result of a lack of suitable methods, including statistical data for calibration purposes. If quantification is required as part of the equivalence test SST – Solvency II (see Chapter F below), FINMA would propose a corresponding method as part of a standard approach.
In order to cover the quality-based aspects of risk-oriented supervision, FINMA uses methods that are characterised, to a great extent, by principle-based requirements. Together with SST, the Swiss Quality Assessment (SQA) is a central component of the new insurance supervision that was introduced on 1 January 2006 together with the Swiss federal act on the Supervision of Insurance Companies.
29. Which government bonds have a positive interest-rate spread above risk-free?
In general, all government bonds which are issued in a currency not controlled by the government include a spread risk. These also include euro government bonds from member states of the European Union. This spread risk must be taken into account to a reasonable extent in the SST. Information on how this is to be treated in the standard model will be provided in the instructions on SST 2011.
30. Is there a technically mature real estate risk model that FINMA has approved?
The market risk module in the SST standard model is based on a variance-covariance method. As part of this model, real estate (and also shares) are mapped using specific indices. The index which is used most often in this regard, is the IAZI Investment Real Estate Performance Index (IAZI Index). The nature of this model means that the capital backing for the real estate thus modelled depends on the volatility of the IAZI index and on the correlation with other risk factors, in particular with interest. As part of the SST, these parameters are estimated based on the history of the past ten years. The volatility which thus results for SST 2010 totals 4.7% and is thus significantly lower than the volatility of the real estate as part of Solvency II. In contrast to what is often maintained, the volatility of the real estate is also significantly lower than the volatility of the equities.
It is often argued that real estate behaves like bonds and is thus particularly suitable for duration matching with the technical insurance provisions. If this hypothesis were accurate, as part of the standard model we should expect negative historical correlations between interest rates and the real estate. However, the estimated correlations are mostly slightly positive, which does not confirm this theory. One reason for this could be the fact that changes in interest rates could also result in changes in the property cash flows, as rent depends on mortgage interest rates and inflation.
Despite the fact that the above hypothesis is not confirmed by empirical observations, FINMA is checking real estate-related internal models at insurance companies. An initial model was rejected due to substantial weaknesses in its methods. A second model is currently being checked. As a rule it must be noted that there are limits for the application of the general duration concept and its implementation in a simple standard risk model with possible interest rate-dependency of the cash flows to be valued. In addition, "duration" and "correlation" are technical terms which are perfectly suited to describe the dependency structure of random variables in a linear world. In contrast, in a non-linear world, there may very well be a (strong) dependency between two non-correlated variables: In this case, the (linear) correlation is simply the wrong measure to make a statement about the dependency structure.
FINMA is cautious about approving internal models due to the fact that this creates incentives for the insurance company's investment strategy. On average, life insurance companies make 11% of their investments in real estate. This is in line with reasonable diversification. However, in extreme cases, individual life insurance companies make 20% to 30% of their investments in real estate. A life insurance company with 30% real estate can only survive when a real estate bubble bursts if it has excellent capitalisation.
31. Is there a concentration risk if there are group-internal interdependencies (guarantees, loans, re-insurance, …)?
Instruments that transfer risks and capital such as (intra-group) re-insurance or loans and guarantees are eligible as part of SST. The impact, for example, of guarantees on the level of SST cover is to be determined both by the recipient of the guarantee and also by the provider of the guarantee within an insurance group, and must be adequately included in the model. The level of SST coverage for a subsidiary (with weak capitalisation) can thus be significantly reinforced using a corresponding guarantee from the parent company (with strong capitalisation).
FINMA believes that this approach results in a substantial concentration risk for the recipient of the guarantee, which has to be managed beyond using the purely model-based quantitative inclusion in the level of SST cover. This can be done by evaluating a corresponding scenario. This scenario could simulate adverse market conditions which not only have a negative impact on the financial statements of the guarantee recipient, but also cause the provider of the guarantee to default. In this case, the financial impact on the guarantee recipient which has an SST requirement would have to be determined and discussed with senior management.
As a rule, FINMA demands that this kind of concentration risk must be restricted: The level of SST cover should also be at least in the yellow zone even without the corresponding guarantee.
F. SST, SOLVENCY I AND SOLVENCY II
32. Was bedeutet die Koexistenz von SST und Solvenz I?
At the end of the five-year transition period and the binding introduction of SST from 1 January 2011, the financial soundness for insurance companies will be identified in parallel according to Solvency I and SST principles, see Article 22 (2) of the ISO. As the mechanisms these regimes use differ, this results in challenges in managing an insurance company’s investment portfolio. These challenges should not be underestimated.
FINMA is aware of these problems. However the methods used to calculate the solvency ratios, in particular Solvency I, cannot be easily changed. This demands a change in the supervision ordinance, which cannot be executed over the short term. There will be a consolidation when the time comes. This will give a greater weighting to risk-based supervision (SST) than the capital adequacy requirements under Solvency I.
33. What is the equivalence status of SST/Solvency II?
FINMA is continuing to follow the Solvency II project with a great deal of attention and it keeps itself regularly updated. It attaches great importance to the equivalence of the two supervisory regimes (see Articles 172, 227 and 260 of the Solvency II Directive).
In its opinion dated July 2010, CEIOPS made a proposal to the European Commission that the Swiss supervisory system (together with the system in Bermuda) should be considered in the first wave of the third country equivalence assessment with regard to all three articles on equivalence (Art. 172 Equivalence for re-insurance supervision, Art. 227 Calculating group solvability, Art. 260 Equivalence for third country group supervision).
Reference: Consultation Paper no. 81, Draft CEIOPS Advice to the European Commission, Equivalence assessments to be undertaken in relation to Articles 172, 227 and 260 of the Solvency II Directive.
34. Which Swiss insurance undertakings are affected by the equivalence?
Equivalence of SST with Solvency II relates to insurance groups registered in Switzerland which have subsidiaries (insurance sub-groups) in the European Union (EU). In contrast, this does not affect Swiss insurance companies with EU branches; these branches must, in any event, report to the local supervisory authorities according to Solvency II.
35. What are the consequences if the EU commission does not regard SST as being equivalent?
In the case of positive equivalence, the EU supervisory authorities use the equivalent group supervision performed by FINMA, see Art. 261 of the Solvency II Directive. In addition, the EU supervisory authorities also recognise the internal group model validated by FINMA.
In contrast, in the event that the EU Commission does not recognise the Swiss supervisory system as being equivalent, the EU supervisory authorities aim to bring about reasonable supervision of the insurance (sub-) group. As a rule, this is ensured by applying Articles 218 to 258 of the Solvency II Directive to the corresponding group in the third country. In this event, the group has to report as part of its group supervision under Solvency II or another supervisory regime that has been recognised as being equivalent.
36. Whom can I contact if I have additional questions?
quantitative-risk-management@finma.ch or Tel. 031 327 91 00