Financial Services the way we see it

Risk Management in the

Insurance Industry and
Solvency II
European Survey – 2006
Contents
Preface 3
About The Survey

1 Management Summary 4 This survey and report was produced

by Capgemini’s Compliance and Risk
Management Centre of Excellence.

2 About the Survey 6 Author

Sjaak Bouma

Contributors
3 Solvency II: The New Regulatory Capital Framework 8 Luca D’Onofrio
3.1 Solvency I 8 Augusto Franconi
3.2 Solvency II 9 Giuseppina Aprile
3.3 Improved Risk Management 11 Vincenza Tarallo
3.4 Solvency II’s Impact on Insurance Marketing Policies 11 Marco Folpmers

Sponsor
Harmen Meijnen, Global Lead,
4 Solvency II and IAS/IFRS 13 Compliance & Risk Management
4.1 Solvency II and IAS/IFRS Phase 2: 14 Centre of Excellence
the guidelines and the timing of both projects are crucial
Survey Coordination
4.2 Examples of current differences in the financial statements 14
Jan van Rompay, Council of Europe
of European insurance companies
Compliance & Risk Management

Local Survey Coordination

5 2006-2007: The Time To Approach Solvency II 15 Norway
Jon Qvigstad
Peer Timo Andersen
Germany
6 Survey results 17
Ulrich von Zanthier
6.1 Importance and Development of Risk Management 17
Andreas Duldinger
6.2 Risk Management Organisation and Processes 22
6.3 Internal Reporting 25 Netherlands
6.4 Legal Framework 27 Marien van Riessen
6.5 Methods of Risk Management 28 Garnt van Logtestijn

Belgium
Dermot Redmond
7 Key Findings and Conclusions 33
France
Antoine Pailhes

Portugal
Appendix 1: Sample Insurance Company Participants 34
Ana Cerqueira
Appendix 2: Economic Capital as an Implementation Framework 35
Appendix 3: Literature 38 Spain
Lucia Gonzalez

Italy
Luca D’Onofrio
Claudio Trecate

Preface
Insurance is a form of risk management that parties use to protect themselves
against a loss. Ideally, it involves the equitable transfer of the risk of loss from
one entity to another, over a set period of time, in exchange for a reasonable fee.
For insurance companies, risk is more
integral to business than it is in perhaps
any other industry, so why do European
regulators want to introduce new
requirements for solvency and risk
management in the form of Solvency II?
The answer, in short, is that regulators
want to protect the stability of the
financial system. However, there are
three different underlying drivers of
change to consider.
■ First is the economic development
of the insurance segment itself. The
insurance sector has grown significantly
in recent decades, making it the
second-largest within the European
financial services industry. Due to
this growth, any negative disturbances
within the industry will potentially
affect the entire financial system.
■ Second, companies and markets are
becoming increasingly complex,
creating new types of risk, such as
operational risk. Insurers may not be
able to manage these new risks as
well as they manage those that are
core to their business, such as the
insurance technical risks. To preserve
systemic stability, regulations must
therefore tackle a broader range of
risks. Concomitantly, technological
developments are creating advanced
risk management possibilities, and
insurance companies must learn to
use these technology-enabled tools
in order to manage both existing and
new risks properly.
1
Source: Jean-Claude Trichet, Developing the Work and Tools of CEIOPS: the views of the ECB, Keynote speech at the Committee of European Insurance and
Occupational Pensions Supervisors (CEIOPS) conference, Frankfurt, November 2005
Financial Services
■ Third, the increased use of risk
vehicles could result in risk being
transferred to sectors in which capital
requirements are lowest. This type
of reallocation is possible because
capital regulations are not the same
across the financial services industry.
The inconsistency means financial
services companies can potentially
reduce regulatory capital without
reducing risk—especially at financial
conglomerates, which operate both
banking and insurance businesses.
In November 2005, European Central
Bank president Jean-Claude Trichet
addressed a CEIOPS (Committee of
European Insurance and Occupational
Pensions Supervisors) conference1
and warned of how the growing link
between banking and insurance
could weaken the insurance industry,
and the financial system as a whole.
He specifically noted how financial
conglomerates face larger capital
requirements in banking than they
do in insurance. By transferring risk
from their banking divisions to their
insurance divisions, conglomerates
can therefore benefit from capital
relief without actually reducing the
amount of risk exposure for the
conglomerate as a whole. Such risk
transfer could potentially weaken
conglomerates, he said.
the way we see it
These changing market conditions are
the reason the European Commission
(EC) is trying to develop a
state-of-the-art solvency framework –
Solvency II – to ensure proper
protection for policyholders.
In light of the pending revolution,
Capgemini conducted a survey
entitled Risk Management in the
Insurance Industry and Solvency II
to gauge how European insurance
companies are positioned to tackle
the risk-management challenge
created by Solvency II. This report
presents our findings, and offers
additional context and detail on the
new solvency framework.
Since Solvency II represents significant
challenges for the Insurance industry,
The European Financial Management
and Marketing Association (EFMA)
welcomes the opportunity to bring
these latest findings, market research
and insights to its members as part of
their value-added services. Capgemini
welcomes this collaborative effort to
bring industry leading research to the
EFMA community.
3
1 Management Summary
Times have changed. Insurance
companies and their operating
environment have been radically
altered by growing complexity in
markets and products, evolving
technology standards, globalisation
and conglomeration. As a result,
says the European Commission (EC),
existing solvency requirements fail
to provide the necessary level of
policyholder protection. In developing
Solvency II, the EC hopes to make
solvency requirements more relevant.
Solvency II envisages enterprise-wide
risk management as the basis for capital
requirements. It also seeks to create a
harmonised set of requirements across
Europe, providing a level playing field
in the financial services industry.
Solvency II seeks to incorporate IFRS
(International Financial Reporting
Standards) on valuation, but it will be
complex to develop, as it is seeks to
assure consistent guidelines.
Solvency II is built on a three-pillar
framework like the Basel II approach
developed for the banking industry,
and it similarly aims to align capital
requirements more closely with actual
risks. The framework also provides
incentives for insurance companies
to disclose their entire risk profile to
both supervisors and the market – a
provision the EC hopes will encourage
insurance companies to develop their
risk management function proactively.
4
For insurance companies, then,
Solvency II presents a looming
compliance challenge. Lessons
learned from Basel II reveal two
key imperatives.
■ The first involves implementation,
and the need to influence the entire
insurance organisation. Solvency II
will require well-planned change
programmes, whose impact will
reach from the front office to the
board of directors and from risk
management to IT. These programmes
will span several years, but must start
promptly to ensure compliance in
2010, when Solvency II is currently
expected to take effect. The demands
on personnel in the organisation will
be significant throughout the
implementation years.
■ The second major challenge will be
managing the strategic consequences.
Solvency II should offer competitive
advantage to companies with a
low risk profile and superior risk
management as it will lower their
capital requirements. Risk-savvy
insurers can also use insights from
their sophisticated internal risk
models to develop risk-based
marketing, and employ risk-based
performance management, helping
to optimise their balance sheet.
Insurance companies that move
quickly to execute such risk-based
activities are likely to become
winners in the insurance industry.

As of this point, though, where does
the European insurance industry
stand in terms of risk management?
A survey conducted by Capgemini
across 8 European countries
and 63 insurance companies reveals
the following five insights about the
European insurance industry:
■ The development of the risk
management function typically
reflects the importance of the
underlying risk. As such, policies,
procedures, frameworks and strategies
are most often in place for the more
important risk types and are less
developed for less important risks.
There is also a difference between
the risk profile of life and non-life
companies, and thus their capabilities.
Since Solvency II requires disclosure
on specific risk types, it is likely that
most insurance companies will need
to fortify their risk management
function in certain areas.
■ Most insurance companies use
similar risk management processes,
procedures, frameworks and strategies,
but there are some tangible differences
across peer groups. Overall, for
example, large insurance companies
are more advanced in their risk
management approach than small and
medium-sized insurance companies.
That disparity justifies the existence
of a standard capital formula for
smaller insurance companies in the
Solvency II framework.
Risk Management in the European Insurance Industry and Solvency II
Financial Services the way we see it
■ Risk profiles – and capabilities – differ In summary, Capgemini’s insurance
among business segments. Companies and risk management experts are
with both life and non-life businesses convinced that Solvency II needs to
are less sophisticated in areas where be high on the agenda of European
risks are to be integrated under insurance companies. The risk
Solvency II, and on enterprise-wide management function in insurance
risks, such as operational risk. In is well-developed, but shows some
addition, less then half of participating tangible gaps with respect to current
insurance companies currently employ Solvency II blueprints.
integrated risk management as is
advocated by the new framework. Among insurers, the current state
■ Current risk-management practices of the risk management function, and
suggest many European insurers thus the roadmap towards compliance,
may face a significant capability gap depends on the company’s size, region
when it comes to Solvency II’s and business segment. To develop
risk-based approach: a company-specific roadmap and to
prepare for Solvency II, Capgemini
- Insurers may be familiar with
recommends that insurance companies
risk-management methods such
conduct three key initiatives:
as stress-testing, scenario analysis
(1) compliance scans (2) development of
and actuarial approaches, but not
(quantitive) advanced risk management
with specific risk dimensions, such
skill sets (3) pre-emptive data
as the probability of economic ruin
management and data gathering.
and value at risk, which are likely
to be integral to the Solvency II
In the next couple of years, the strategic
approach.
impact of Solvency II is likely to start
- Almost half of the participating producing industry-wide changes for
insurance companies already have insurance. Now is the time for insurers
access to their own internal risk to ready themselves for Solvency II,
models, which are an option for and prepare to leverage the potential
calculating solvency ratios under benefits of the changes that are to come.
the new framework.
■ Insurance companies already
comprehend the gravity of risk, and
expect risk to become even more
important in the future. Significantly,
though, improvements in risk
management are being driven first
by compliance and only secondarily
by the business case, even though
insurers across Europe see the
potential commercial benefits of
improved risk management.
5
2 About the Survey
The survey “Risk Management in the
Insurance Industry and Solvency II” was
developed and conducted in light of the
new regulatory capital requirements
being prepared by the EC. The results
provide valuable insight into the status
of the risk management function
across European insurance companies
in relation to the new Solvency II
framework, and the data highlight
potential compliance gaps. The survey
results should help to increase awareness
at insurance companies across Europe.
For participants, the findings offer insight
into their position relative to all insurance
companies and to others in their peer
groups and should, therefore, help
these companies to identify potential
development areas on the road to
Solvency II compliance.
6
Questionnaire
The survey questions cover five topics:
1. Key areas of risk. Questions relate
to the current and future importance
of risks, as well as to the processes
and procedures set to manage
these risks.
2. The risk management organisation
and processes, including the presence
of a framework, risk strategies and
responsibilities, and the integration
of risk management.
3. Internal risk reporting, including
processes and the distribution of
risk reports.
4. Legal framework.
5. Available risk management methods.
Some of the questions relate to the
importance, quality or existence of risks,
processes and procedures and require a
self-assessment. The results assume the
respondent was capable of answering
the question and of answering honestly
and objectively. The development of risk
management and the existence of certain
risks may vary anyway, depending on
the insurer’s size or business segment.

Participants
Capgemini used its international network
of offices to conduct the survey in
local markets. In total, the survey
covers 63 insurance companies across
8 European countries – Norway,
Germany, The Netherlands, Belgium,
France, Italy, Spain and Portugal.
Appendix 1 names some of the
participating companies. Note that
five questions reflect answers from
only 7 countries, due to certain
national differences in the survey.
Peer Groups
and Insurance Types
Two peer groups are defined. The first
comprises small and medium-sized
insurance companies with total annual
premium revenue of < €1.5 billion.
The second comprises large companies
with total annual premium revenue
of ≥ €1.5 billion.
Table 2.1 Distribution of participants
Total number of participants
Peer groups
Small and medium-sized insurance companies
Large insurance companies
Insurance type
Life insurance business
Non-life insurance business
Life and non-life business
Risk Management in the European Insurance Industry and Solvency II
Financial Services the way we see it
For the purposes of this survey, Results
participants are characterised as In general, the survey analysis
one of the following: presented in chapter 6 reflects
1. Life insurance business the consolidated results from
all participants, but we also offer
2. Non-life insurance business,
comparisons of peer groups or
including health insurance
insurance business types when
and credit insurance
those data breakdowns are of
3. Life and non-life business particular interest.
The distribution of participants across
peer groups and insurance categories
is outlined in Table 2.1.
Country Comparisons
Solvency II is not just a state-of-the-art
solvency framework; it will further
harmonise the existing European
insurance market. As Europe moves
toward unifying legislation and a single
market, national differences should
play a far reduced role, so the findings
are presented from a single European
market perspective, and there is generally
no comparison of regions or countries.
63
32
31
20
16
27
7
3 Solvency II: The New Regulatory
Capital Framework
The insurance market has been subject
to significant change in recent years. The
industry has had to cope with major
destabilising forces, from technology to
terrorism and financial market instability.
The insurance market has also grown
in size and complexity, making it
second in size only to banking among
European financial services. From
a regulatory standpoint, then, the
importance of solvency has increased
dramatically, since any failure in the
insurance market potentially creates
systemic risk – risk that threatens entire
financial markets and systems, not
just individual market participants.
The threat of systemic risk has also
become more acute with the growth
of financial conglomerates, which
combine banking and insurance
activities. Jean Claude-Trichet, president
of the ECB, said in 20052 that there
are several ways in which insurance
companies can potentially affect banks
and disrupt financial stability. Perhaps
most striking is the danger created by
the fact that insurance and banking are
subject to different capital regulations.
As a result, a bancassurance group could
transfer risk from its banking business
to its insurance companies and capture
capital relief without actually reducing
risk for the group.
All in all, then, the EC believes existing
solvency regulations are not adequate to
protect policyholders and beneficiaries.
The EC started to develop Solvency II as
a way to provide the proper protection.
The new framework also aims to create
a level playing field for all participants,
2
See footnote 1
3
Source: HM Treasury, Solvency II: a new framework for prudential regulation of insurance in the EU, a
discussion paper, London, February 2006
8
harmonise supervision across EC
member states, improve capital
allocation, and increase competition
in the European insurance industry.
3.1 Solvency I
To frame the discussion of Solvency II,
it is important to look first at existing
regulations. Solvency I comprises a
core set of regulations plus various
amendments. The non-life and life
directives of 1973 and 1979, respectively,
form the core of the framework.
Additional regulations adopted for
both businesses in 2002 aimed to
improve the calculation of solvency
margin requirements. For the life
business, the solvency requirement
is based on a percentage of the
mathematical provisions plus a
percentage of the remaining positive
capital at risk. In non-life, the required
solvency margin is based on a
percentage of gross written premiums,
a percentage of average claims over a
time period, or the carried-forward
amount of preceding years. The
solvency requirement can be reduced
by reinsurance. For both businesses
there is a minimum guarantee fund
that provides a safety net.
Current regulations do provide a certain
level of protection to the policyholder,
but there are limitations. A UK Treasury
report provides examples of where the
regulatory capital based on the current
framework diverges from an individual
company’s economic capital3. Another
limitation of Solvency I is that non-life
solvency margins are based on the
volume of contracts rather than the

Figure 3.1 Solvency II Roadmap
2004 2005 2006 2007
Formal
QIS1 QIS2
Adoption of
European Framework
CEIOPS Commission Draft from
Answers To Calls of Directive Commission
For Advice (Oct. 2006) (July 2007)
Source: Capgemini 2006
actual risks embedded in specific
contracts. Other examples of short-
comings relate to the inadequate
determination of technical provisions
and the lack of comprehensive
guidelines on how to benefit from
diversification and pooling effects.
These examples illustrate just a few
of the solvency provisions that are
inadequate for today’s environment.
3.2 Solvency II
The EC’s new regulatory framework
for insurance follows closely on the
heels of Basel II capital regulations
developed for the banking industry.
Presented in July 2004, Basel II adopts
a new approach to the management
of risk and the calculation of capital
requirements. Its three-pillar framework
deals specifically with credit, market
and operational risk and offers banks
the option of using their own internal
risk models to estimate risk and
calculate risk-weighted assets.
4
Source: European Commission, Amended framework for consultation on Solvency II, April 2006
Risk Management in the European Insurance Industry and Solvency II
2008 2009
Definition of
Realisation
Dates
Adoption of
European Commission Effective Date
Suggestions Solvency II
The EC has similar aspirations for
insurance, and is employing a three-
pillar approach for Solvency II, though
the scope of each pillar will obviously
be tailored to insurance. In the proposed
framework being used in consultations
with the industry, the EC has defined
some general conditions4, including
the following:
■ The framework should provide
supervisors the ability to assess the
overall solvency of individual life
insurance, non-life insurance and
reinsurance institutions.
■ This assessment of overall solvency
should be based on a risk-oriented
approach.
■ The framework should contain
incentives for insurance companies to
measure and properly manage risks.
■ Solo supervision should remain a
national supervisor’s task. However,
it should be a goal to harmonise
supervision across member states.
Financial Services the way we see it
■ Solvency II should be compatible
with valuation standards and thus with
the accounting standards of the
International Accounting Standards
Board (IASB).
2010
■ The framework should encourage
a level playing field in the financial
industry by being consistent and
compatible with banking regulations.
■ Small insurance concerns should
be able to comply with Solvency II
without having to incur
disproportionate costs.
In developing the framework, the
EC is using the so-called ‘Lamfalussy’
method, which takes a phased
approach to legislative and regulatory
changes to ensure that EC-wide,
national and industry issues are
addressed separately but consistently.
In the case of Solvency II, Level 1
focused on developing the framework
and should, based on current timelines,
be adopted by July 2007. In the
next levels, technical details will be
worked out (until 2009) followed by
implementation across the countries
involved. According to current timelines,
Solvency II should take full effect in
2010 (see Figure 3.1).
Within the Lamfalussy approach,
the CEIOPS has an important
advisory role on Solvency II. The
EC initiated three waves of calls
for advice from the CEIOPS. The
consultations yielded responses in June
and November 2005 and May 2006,
which together provide the first
indications of what the three-pillar
framework requires.
9
The Solvency II framework (see
Figure 3.2) mirrors the concept of
its Basel II forerunner. Pillar I deals
with the quantitative determination of
capital requirements, and Pillar II with
the supervisory review process. Pillar III
tackles disclosure, sets requirements
with respect to market transparency
and completes the framework.
Pillar I contains four items of note.
First, it stipulates how technical
provisions should be calculated. The
CEIOPS advice—and thus potentially
the framework—advocates a policy-by-
policy valuation (rather than a portfolio
approach) and a calculation of the risk
margin per business line. Second, the
pillar stipulates Minimum Capital
Requirements (MCR), which CEIOPS
explains as follows5: “The MCR reflects
a level of capital below which an
insurance undertaking’s operations
present an unacceptable risk to
policyholders. If an undertaking’s
available capital falls below the MCR,
ultimate supervisory action should be
triggered”. Third, Pillar I contains
Solvency Capital Requirements (SCR),
and states that the SCR level of capital
should be enough to allow an insurer
to absorb unforeseen losses and should
assure the desired level of policyholder
protection. Insurers have the option of
calculating the SCR, which must take
into account all material and quantifiable
risks, using a standard formula or using
(partly or wholly) an internal model.
Smaller insurance companies are likely
to use the standard formula, allowing
them to comply without incurring
disproportionate costs. By using internal
models, though, insurance companies
5
Source: CEIOPS, Answers to the European Commission on the second wave of Calls for Advice in the framework of the Solvency II project, October 2005.
10
Figure 3.2 Solvency II Three Pillar Framework
Pillar I
Quantitative Requirements
MCR
SCR; Standard Formula,
Subjects
Internal Models
Risk Dependencies
Risk Mitigation
Technical Provisions
Material, Quantifiable Risks
■ Underwriting Risks
■ Market Risk
Risks
■ Credit Risk
■ Operational Risk
■ Liquidity Risk
■ ALM Risk
■ Other
Source: Capgemini 2006
can tailor capital requirements to their
specific risk profile. Fourth, Pillar I
deals with investment management
rules. The call for advice focuses on
asset eligibility and high level
requirements for Asset and Liability
Management (ALM), investment and
concentration limits, and the balance
between these items and financial
resources calculated under the
technical provisions, SCR and MCR.
Pillar II pertains to corporate governance,
ALM and investment management rules
and the supervisory review process
(SRP). Corporate governance in the
Solvency II framework focuses on risk
management processes and the internal
Pillar II Pillar III
Supervisory Review Process Market Discipline
Corporate Governance & Supervisory Disclosure
Internal Control
Supervisory Review Process Public Disclosure
Supervisory Powers
Safety Measures
Solvency Control Levels
Risk Management Function
Asset & Liability Management
All Risks
control function. The involvement of
the board of directors and that of senior
management are frequently stated
requirements. Other requirements relate
to ‘fit and proper’ personnel, risk
strategies, risk reporting, responsibilities,
independence of functions, and risk
management policies and procedures.
An important feature of Pillar II is
the power of the supervisor to require
additional capital, resulting in a
so-called adjusted SCR, and to take
measures to reduce risks. Pillar III
completes the framework with a set
of disclosure requirements. Unlike
Basel II, which only demands market
disclosures, Solvency II establishes rules
for supervisory and public disclosure.

Risk
Management
Systems
Capital Allocated
Source: Capgemini 2006
3.3 Improved Risk Management
Solvency II reflects the EC’s desire to link
solvency capital more directly to the
actual risks faced by an individual
insurance company, and it contains
specific incentives to encourage
insurance companies to improve their
risk management function. In short,
insurers will be able to directly influence
their solvency capital requirements in
a number of ways under Solvency II.
■ First, each insurance company has
three options for calculating SCR,
and the more advanced the chosen
approach, the lower the SCR will
be, all else being equal.
■ Second, the formula used to calculate
the SCR is likely to be based on Tail
Value at Risk (TailVaR; see Appendix
2). TailVaR, unlike Value at Risk
(VaR), takes account of losses in the
tail of a distribution. By reducing the
magnitude of losses in the tail, an
insurance company can reduce
solvency capital.
■ The third incentive for insurers is in
Pillar III, which demands that insurers
report risks to market parties, such
as investors and rating agencies.
Insurers that demonstrate superior
risk-management capabilities should
enjoy higher company ratings (and
potentially share prices) than those
companies that prove to be less
sophisticated in risk management.
6
Standard & Poor’s, Industry Report Card: European Insurance, January 2005
Risk Management in the European Insurance Industry and Solvency II
Financial Services
Return
on Invested
Capital
in Line with
Actual Risks
3.4 Solvency II’s Impact on
Insurance Marketing Policies
The Solvency II model will require
insurance groups to allocate capital
based on insurance, financial and
operational risks. It is therefore likely
that levels of solvency capital will vary
between insurance companies with
different risk profiles. This disparity
will create strategic opportunities.
We strongly believe insurance
companies will be presented with
four avenues through which they
can gain a competitive edge as a
result of Solvency II:
I. Competitive Advantage in
Capital Requirements
Specific types of insurance companies
will benefit from lower capital
requirements than their competitors,
due to differing company profiles.
Large insurers are expected to benefit
from risk diversification, both
geographically and across portfolios.
“Niche” players are another group
of potential ‘winners’. Some of those
insurance companies will have
relatively simple and low-risk
portfolios that will have relatively
lower capital requirements.
the way we see it
Indeed, the Standard & Poor’s
credit-rating agency has said “leaders
in adopting Solvency II principles may
benefit from significant competitive
advantages, while laggards risk having
to give up their independence or even
quit the market”.6
II. Risk-Based Marketing
Until now, insurance companies have
defined the price of new products
based almost solely on technical
insurance indicators. When Solvency
II takes effect, the product price must
also take account of financial and
operational risk indicators. Insurance
companies should also be able to
garner superior portfolio insights from
the historical data and risk modelling
required for Solvency II.
By leveraging risk insights in commercial
activities, insurers can develop a risk-
based marketing approach, characterised
by risk-based pricing, targeted portfolios,
more relevant product development,
improved cross-selling, and the buying
and selling of portfolios based on the
underlying risk profile.
In short, we expect the first adopters
of new capital-allocation criteria will
have a competitive edge, making better
strategic choices as they align product
development with the best profitability
on risk ratios.
III. Performance Management
New profitability indicators required to
manage risk will also offer a competitive
advantage to some insurance companies.
The valuation of profitability will no
longer be based on absolute returns
on equity ratios. Rather, profitability
will be based on returns on equity
adjusted for risk capital consumption.
The RORAC (return on risk-adjusted
capital) ratio, which will replace EVA
(economic value added), is considered
to be a better indicator of the risk
capital allocation.
11
 Pioneers of Solvency II’s risk-based
principles will gain a competitive
advantage by proactively and promptly
identifying and pursuing profitable
lines of business and abandoning less
profitable ones.
Capgemini advocates the use of
an economic capital approach in
implementing Solvency II (see
Appendix 2 for details). Economic
capital, a recognised risk-based
performance management tool, provides
an approach for steering business based
on the optimal mix of profit and risk.
As such, it provides a performance
management solution that aligns well
with the new Solvency II requirements.
12
IV.External Rating
Pillar III includes requirements
not only on supervisory disclosure,
but on market disclosure. Insurance
companies will be required to report
on risks and the management of risk
in their annual reports. For investors
and rating agencies, such information is
useful in determining creditworthiness.
In the future, then, the share prices and
credit ratings of insurance companies
will be more dependent on risk profile
than ever before—and it will be in the
best interest of insurance companies to
demonstrate sound risk management.
 Financial Services the way we see it

4 Solvency II and IAS/IFRS

The insurance market faces radical IFRS 4 (International Financial

change due to Solvency II. Indeed, the
French Society of Financial Analysts
(SFAF) has called the new framework
a “Revolution in value measurement
and strategy” for the insurance sector.7
To fulfil the solvency requirements,
insurance companies must review
both the business processes and the
profitability of their business lines.
Certainly, Solvency II is revolutionary
in that it provides:
■ A better and more detailed
measurement of risks
■ The evaluation of company assets at
market value according to IAS/IFRS
accounting principles
■ A global focus on enterprise risk
management (not only technical
risks but also financial, operational
and other risks)
Reporting Standard 4) on accounting
for insurance contracts already took
effect in Europe in January 2005, but
IFRS 4 represented only the first phase
of the IASB’s project to develop a
comprehensive accounting framework
for insurance companies. In Phase 2,
the IASB will issue a Discussion Paper
detailing new and complete IAS/IFRS
principles on insurance contracts. The
paper is due out by December 31st 2006
(see Figure 4.1).
Then the IASB will deliver definitive
IAS/IFRS principles, currently expected
by September 30th, 2008. The last step
will be to implement an insurance
liabilities evaluation and measurement
model based on fair value. It is due to
take full effect by 2010.

Figure 4.1 IAS and Solvency II Roadmaps

IFRS 4 Discussion Paper Exposure Draft Final IFRS IAS Phase 2

Phase 2 (31-Dec) Phase 2 (30-Jun) (30-Sep) Balance Sheet
Local Year 1: IAS
& Int’l. Balance Sheet
Acct.
Principles International Accounting Principles
2004 2005 2006 2007 2008 2009 2010

Definition of
Formal Realisation
QIS1 QIS2 Adoption of Dates
European Framework
CEIOPS Commission Draft from Adoption of
Answers To Calls of Directive Commission European Commission Effective Date
For Advice (Oct. 2006) (July 2007) Suggestions Solvency II

Source: Capgemini 2006

7
Source: “Solvency II, une rèvolution pour la valorisation et la strategie” – Analyse Financiere n° 20 – July,
August, September 2006 – from the Dossier “Avenir radieux pour l’assurance” (Translation: “Solvency II,
a revolution in value measurement and strategy” from the Dossier “Great perspectives for insurers”)

Risk Management in the European Insurance Industry and Solvency II 13

Meanwhile, the EC is expected to finalise
the draft directive of Solvency II’s 3-pillar
framework by October 20068, with
formal EU adoption due by July 2007.
European countries are due to adopt
the Directive in 2008, and insurance
companies are expected to be compliant
by 2010.9 This timeline remains subject
to change, however.
4.1 Solvency II and IAS/IFRS
Phase 2: the guidelines and
the timing of both projects
are crucial
The IAS/IFRS accounting principles
and the Solvency II capital standards
both hinge on the evaluation of
insurance contracts. It is essential to
calculate company liabilities accurately
in order to determine appropriate
solvency ratios and capital requirements.
Insurance contracts are the main
component of an insurance company’s
liabilities, and the adoption of IAS/IFRS
accounting rules will create an important
tool for evaluating those contracts.
Phase 2 of the IAS/IFRS project is
expected to deliver the key reference
guidelines on solvency issues. The IASB
aims to create one set of accounting
principles for both financial and
regulatory reporting – a set that also
matches the demands of Solvency II.
Currently, however, inconsistencies seem
inevitable. For example, Solvency II
8
Source: European Commission, “Solvency II Roadmap – Towards a Framework Directive”, July 2005
9
Source: “CEIOPS Expected Project Time Schedule”
14
demands that insurers estimate all risks,
including catastrophic and equalisation
risks. IAS/IFRS Phase 1 does not include
provisions for catastrophic risks, though
IAS/IFRS Phase 2 seems to consider the
possibility of making provisions for
identifiable catastrophic risks, such as
earthquakes, in calculating risk margins.
IAS/IFRS Phase 2 insurance principles
are still in the draft stage, and any hold-
up in the definitive version might delay
the implementation of Solvency II.
On the other hand, if Solvency II took
effect before IAS/IFRS Phase 2, it would
reduce accounting transparency, since
standards would not be harmonised.
Ideally, then, Solvency II regulators
will take IAS/IFRS Phase 2 drafts as
a benchmark, rather than using the
interim Phase 1 rules, in order to
prevent conflicts in the application
of the related disposals and controls.
Certainly, the alignment of Solvency II
and IAS/IFRS Phase 2 principles could
help insurance companies to avoid
the additional expense of updating
information systems and reengineering
business processes to get the data
required for one initiative and
then another.
4.2 Examples of current
differences in the financial
statements of European
insurance companies
According to IFRS 4, an insurance
company must fulfil the local generally
accepted accounting principles (GAAP)
in calculating liabilities until the
definitive IAS/IFRS accounting
principles on insurance contracts
based on fair value are adopted.
As a result, the following issues can
arise currently:
■ The different evaluation of assets
(at fair value - IAS 39) and liabilities
(local GAAP) means a company’s
results can be highly volatile, and
vary significantly from one reporting
period to the next. It can also create
an “accounting mismatch”. The
mismatch can be mitigated by
short-term investments, but these
may produce an economic loss.
■ It can be difficult to compare insurance
companies in different countries,
because GAAP differs by location.
■ IAS principles demand that insurers
distinguish life-insurance contracts
from financial contracts. However,
they do not provide any quantitative
rules for evaluating those contracts,
so GAAP prevails. In Italy, for example,
insurers distinguish life contracts on
the basis of the size of the risk—and
that risk is significant, ranging in 2005
from 5% to 10% of the total value of
the contract.
 Financial Services
5 2006-2007: The Time
To Approach Solvency II
The new regulatory framework is
revolutionary for the insurance industry.
With Solvency II, regulation will move
away from rules-based supervision
and give companies the lead in
assessing risks and calculating capital
requirements. Based on current work by
the EC, and lessons learned in banking
from Basel II, a few realities are becoming
clear, including the following:
■ Solvency II regulations will
radically change the business
of insurance groups.
■ The business scenario is being made
more complex by the concomitant
development of the Solvency II and
IAS/IFRS Phase 2 projects; the timeline
to implement and fulfil these
requirements is extremely tight.
■ The sooner insurance groups can
adopt an integrated vision and a
structured project approach to
accomplish the changes required
for Solvency II, the better business
opportunities they can get, and the
more likely it is they can beat
the competition and become
market leaders.
Dealing with these realities will create
numerous difficulties for insurance
companies, but the overall challenge
is essentially two-fold. First insurers
must ensure robust implementation
of Solvency II. Second, and more
importantly, they must decide how
to recognise and utilise the strategic
opportunities of the new framework
(as discussed in section 3.4).
Risk Management in the European Insurance Industry and Solvency II
the way we see it
To fulfil Solvency II and IAS/IFRS
Phase II requirements, European
insurance companies must accomplish
an in-depth review of their business
processes, information systems and
organisational structures. In short,
they should spend coming months
defining their Solvency II business
and operating plans.
We advocate an integrated vision,
using a structured project plan that
addresses the following themes:
1. Design of future risk management
model. A first design of the
Integrated Model for financial,
technical and operational risk.
2. Strategy to manage required
organisational and commercial
changes.
3. Future state design of risk data
management and reporting function.
The next step is to ingrain the new
business model into the organisation,
so it can drive business decisions
optimally. The change process will
entail multi-year programmes, involving
people, processes and technology
throughout the organisation, and it
is critical that the process be iterative.
15
 Figure 5.1 Project Scope for Adopting a New Enterprise Business Model

Corporate Governance Model

Processes and Risk Internal Control

Procedures Management System
Structure System

Information System

Source: Capgemini 2006

To develop a company-specific roadmap Accordingly, insurers should make

to prepare for Solvency II, Capgemini
strongly recommends that insurance
companies conduct three key initiatives:
Compliance Scan
Compliance scans are a useful tool
in identifying weak spots in the risk
management domain. Insurance
companies can develop a checklist
of likely needs, based on available
Solvency II guidelines, and use that
list as a framework for assessing
people, processes, procedures and
existing methodologies. The outcome
of the compliance scan provides
valuable context for crafting the
Solvency II change programme.
Development of (Quantitative)
Advanced Risk Management
Skill Sets
One lesson learned from Basel II is
that the implementation of such a
framework demands both knowledge
and resources in various areas.
sure to assess resource availability
in the preparation phase and act
on the outcome. They should,
for example, make sure they
have adequate quantitative risk
management expertise for risk
modelling—a resource that many
banks have found to be in short
supply in preparing for Basel II.
Pre-Emptive Data Management
and Data Gathering
With Solvency II taking effect
around 2010, it is critical for
insurance companies to start
capturing and manage the right
risk data in the right way as soon
as possible—in order to avoid
costly manual risk data gathering
and recovery later. First, capital
calculations require enterprise data,
so data from all business units or
sub-divisions must be unified and
stored. Second, adequate data history
must be developed for model
validation purposes.

16
 Financial Services the way we see it

6 Survey results

6.1 Importance and What Levels of Importance

Development of Do the Following Areas of Risk
Risk Management Have In Your Company at the
The risk management function will Present Moment?
change significantly in coming years The five risks defined by the IAA are
amid the move to a more risk-based insurance technical risk, market risk,
solvency approach. The new supervisory credit risk, operational risk and liquidity
regime will force insurance companies risk. Survey responses show market risk
to be proactive in moving to Solvency II and insurance technical risk are the most
compliance. In preparing for Solvency II, important types of risk for insurance
it is vital for insurance companies to companies (see Figure 6.1). Each risk
understand the importance of the scored a 3.7 on a scale from 1 (low
five types of risk that are central to importance) to 4 (high importance),
the framework and to assess where followed by credit risk and operational
they stand in their ability to manage risk (both scoring 3.0). Liquidity risk
those risks. is the least important (2.3).

Figure 6.1 Present Level of Importance Per Risk Area

4.0
■ All insurance companies
■ Life
■ Non-Life
■ Both Life and Non-Life
3.5
1 (no importance) to 4 (high importance)

3.0
Importance

2.5

2.0

1.5

1.0
Insurance Market Credit Operational Liquidity

Risk Area

Source: Capgemini Analysis, 2006

Risk Management in the European Insurance Industry and Solvency II 17

This assessment differs little between
large insurance companies and small
and medium-sized companies, though
large companies generally assign
slightly more weight to most risk
types. For technical risk, though, large
companies actually assigned slightly
less importance (0.1) to the risk than
did the smaller companies.
Considering different insurance
businesses, technical risk is more
important for non-life insurance (4.0)
then for the other segments (life, 3.5,
combined life and non-life, 3.6). Not
surprisingly, market risk is paramount
in the life business (4.0), where horizons
are long, and there is a big difference
between the maturities of premiums
and claims. The gravity of market risk
is slightly lower for non-life companies
(3.6) and those operating in both
segments (3.7).
18
What Level of Importance Do You
Think the Different Areas of Risk
Will Have in the Future?
The importance of these five risk types
changes little in the future. Again,
insurance technical risk and market
risk are deemed most important (both
3.8), followed by operational risk (3.3)
and credit risk (3.2). Liquidity risk is
still least important, with a score of
2.6. As is the case in the current state,
the importance of a specific risk type
varies most between countries for
credit risk and liquidity risk, though
the divergence is slightly larger in the
future assessment.
Survey respondents expect all types of
risk to become more important in the
future, with the gravity of individual
risk types rising as much as 12.3% (for
operational risk - see Figure 6.2). The
Figure 6.2 Increase of Importance Per Risk Area
14.0%
12.0%
10.0%
8.0%
% Increase
6.0%
4.0%
3.4%
2.1%
2.0%
0.0%
Insurance Market
Risk Area
Source: Capgemini Analysis, 2006
increased focus on operational risk
no doubt reflects a real increase in
such risks, but it is probably also a
manifestation of the increased attention
that operational risk has received in
recent compliance initiatives, from
Basel II to Sarbanes-Oxley.
Again, large insurance companies tend
to assign a greater importance to all risk
types than do small and medium-sized
insurers. Only for market risk is the
same score assigned (3.8). The largest
gap in perceived importance lies in
credit risk, where large insurers assigned
a 3.4 score, compared with 3.0 among
smaller ones. Again, certain risks are
expected to remain more important
to some segments than others in
the future, though the size of those
differences between businesses
tends to decrease in the future.
■ All insurance companies
12.3%
11.7%
6.8%
Credit Operational Liquidity

For the Following Areas of Risk,
Have You Established a Risk
Management Procedure?
Managing risk is not just a matter of
developing tools and models. It is
equally important that the tools and
models be used properly. Pillar II of
the Solvency II directive will contain
requirements related to processes and
procedures for identifying, measuring,
monitoring and managing risks. These
strategies, policies and procedures
should assure adequate day-to-day
execution of risk management activities.
Processes and procedures should be in
place for each risk type, and should be
updated on a regular basis. It is likely
that all insurance companies—regardless
of size or segment—have procedures
for the defined risk types, but the
level of detail and quality will vary
among companies.
Figure 6.3 Presence of Risk Management Procedures Per Risk Area
100%
80%
% of Companies with Procedure
Established or Recently Started
60%
40%
20%
0%
Insurance
Source: Capgemini Analysis, 2006
Risk Management in the European Insurance Industry and Solvency II
Financial Services
The survey shows the existence of
risk management procedures for a
specific risk type largely depends
on the importance of the risk type.
Procedures are established for
insurance technical risk and market
risk at 77.8% of all survey participants.
For operational risk and liquidity risk,
such procedures are in place for only
47.6% and 46.8%, respectively. (We
assume that respondents who say
procedures are not in place mean
those procedures are not properly
established, as opposed
to being non-existent.)
In fact, the presence of risk management
procedures is exactly in line with the
stated importance of those risks when
we consider the number of insurance
companies that have established or
recently started risk management
■ All insurance companies
■ Life
■ Non-Life
■ Both Life and Non-Life
Market Credit Operational Liquidity
Risk Area
the way we see it
procedures. In other words, there are
relatively more companies with risk
management processes for the more
important risk types. In the case of
operational risk, the majority (47.6%)
have procedures in place and many
(30.2%) have recently started to employ
such processes.
Procedures for managing market,
credit and operational risk are equally
prevalent across business segments
(see Figure 6.3). However, 100% of
non-life companies have well- or
recently established procedures for
managing insurance technical risk,
though only 28.6% have processes
for handling liquidity risk. That is far
less than the 84.6% of life insurance
companies and 55.6% of companies
operating in both life and non-life that
have liquidity-risk processes in place.
19
 How Would You Assess Your Risk
Management Processes Within
These Different Areas of Risk?
Insurance companies are more confident
in their ability to manage market and
technical insurance risk than other
types of risk. On average, market risk
management processes scored 3.3 on
a scale from 1 (bad) to 4 (very good).
Technical-risk activities scored a 3.0,
while the marks were lower for credit
risk (2.8), and liquidity risk (2.4).
Participants were least confident in
operational risk management processes,
which received a grade of 2.3.
Among individual countries, assessments
differed most widely on credit and
liquidity risk. Large insurance companies
generally believe their processes to be
of a slightly higher quality than do
smaller companies. (The difference in
scores ranged from 0.1 for liquidity
risk to 0.4 for credit risk.)
Life insurance companies are less
confident in their capabilities than
non-life businesses, except in the
case of managing liquidity risk, which
life insurers scored at 2.7, compared
with the non-life score of 1.5. According
to the assessments by survey
participants, non-life insurance
companies have the best processes
for insurance technical, market and
operational risk management, while
insurance companies operating in
both life and non-life segments are
best at handling credit risk.
10
Methodology: participants are asked for an assessment of their risk profile by dividing total (100%) risk over
the five risk types. Guidance was given by dividing the whole spectrum in five categories. But more specific
answers were also given and used. To assure total risk of 100% per respondent, some of the answers were
calibrated by the survey team.
20
How Important are the
Various Areas of Risk
Relative to Your Company’s
Aggregated Risk Exposure?10
Solvency II aims to create a level playing
field across the financial sector in
Europe. As a result, there are definite
similarities between Basel II and
Solvency II. Nevertheless, fundamental
differences between the industries also
require the two frameworks to diverge.
In particular, Basel II focuses on the
asset side of bank balance sheets, while
Solvency II targets the liabilities side
for insurers. Also, Basel II reflects the
paramount importance of credit risk to
banking, while Solvency II must reflect
the relative importance of different
risk types to insurance companies.
Our survey shows market risk is the
most important risk type for European
insurance companies, accounting for
38% of aggregate risk exposure (see
Figure 6.4). Insurance technical risk
is second, accounting for 31% of total
risk. Credit risk (13%) and operational
risk (14%) are next, and about equally
important, while liquidity risk accounts
for only 6% of total risk. Respondents
were also asked to identify any other
important risks they face. Several cited
business risk, but the results offer no
insight into the degree of exposure to
that type of risk.
Since Solvency II is a pan-European
initiative, we generally did not dissect
the survey results by country or region.
However, we thought it would be
interesting to look for any country
divergence in risk exposure, since such
differences might pose a challenge for
the EC as it seeks to unify solvency
regulations. Significantly, the survey
confirms insurance companies in
northwest European countries have
a different risk profile from those
operating in southern European
countries.
 Financial Services the way we see it

In southern Europe, market risk Figure 6.4 Relative Risk Exposure Among Insurers, by Region
represents a smaller share of total
risk than it does in the northwest or All Insurance Companies Region North-West Region South
in Europe as a whole, while operational
Liquidity Liquidity Liquidity
risk plays a larger role (see Figure 6.4). 6%
Insurance Operational
3%
Insurance 10% Insurance
Liquidity and credit risk are also more Operational 31% 11% 32% Operational 31%
14% 19%
important than in the northwest or the Credit
continent as a whole. For insurance 12%

companies in northwest Europe, market Credit

13%
risk accounts for 44% of aggregate
exposure, significantly more than in
southern Europe, and more than the Market Market Credit Market
38% 44% 15% 25%
continent’s average, while operational and
liquidity risk are relatively less important. Source: Capgemini Analysis, 2006

The survey does not offer a rationale

for these divergences. It is possible
that companies in different regions
Figure 6.5 Relative Risk Exposure Among Insurers, by Business
simply define risk categories differently,
or that the sampling itself has skewed Both Life and Non-Life
Life Insurance Companies Non-Life Insurance Companies
the results. CEIOPS’ quantitative Insurance Companies
impact studies may provide more Liquidity Liquidity Liquidity
8% 2% 7%
insight into the risk definitions and Insurance Operational Insurance Insurance
Operational 22% 11% 47% 29%
insurer risk profiles. 13% Operational
Credit 16%
9%
Risk profiles do not seem to differ
Credit
much with company size. Market, 16%
Credit
13%
operational and credit risk make up
much the same proportion of risk for Market
Market 32% Market
large and small and medium-sized 45% 35%
insurance companies. Insurance Source: Capgemini Analysis, 2006
technical risk accounts for a greater
portion of total risk at smaller companies
(35% vs. 27% at larger companies),
while credit risk accounts for less
(11% vs. 16%).

Risk profiles do differ among insurance

businesses, though (see Figure 6.5).
Market risk accounts for the largest
share of aggregate risk exposure for
life insurance companies (45%), while
insurance technical risk looms largest for
non-life businesses (47%). Interestingly,
companies involved in both life and
non-life are exposed to more operational
risk (16% of total risk) than companies
dedicated to one business or the other,
but their exposure to other types of
risks generally lies somewhere between
the two.

Risk Management in the European Insurance Industry and Solvency II 21

Which Factors Will Influence
Your Future Development
and Improvement of Risk
Management Processes?
The EC hopes Solvency II will encourage
insurance companies to become more
sophisticated risk managers. Indeed, the
framework offers capital incentives to
those that move past mere compliance
and adopt a risk-based approach. But
are insurance companies also looking at
Solvency II as a business opportunity?
And what is really driving any plans to
develop their risk management function?
The survey shows regulatory
compliance is still the main driver
behind improvements in risk
management processes (see Figure 6.6).
Regulatory compliance scored an
average 3.8, on a scale from 1 (no
influence) to 4 (high influence). Other
facets of compliance are also quite
important, including the requirements
of the company owner (3.2) or the
market (3.0).
Business logic, however, is the second
most powerful force (3.3). Losses
incurred by others provide the least
impetus for improving risk management
(2.1), and few companies are driven
by aspirations to be risk-management
pioneers (2.2).
“Losses incurred by own company”
seem to be more influential in cases
where the loss has been considerable.
The distribution of survey responses
on this driver was widespread, and
suggests a company that experienced
major losses over an extended period
is more likely to be driven by that loss
to improve risk management than a
company that has suffered only a mild,
short-term loss. Generally, though,
insurance companies do not seem
to be image-driven when it comes
to improving their risk-management
function, though reputational risk is
always an issue.
In short, the survey results show
insurance companies know they need
to comply with new regulations, and
many believe enhanced risk management
could improve their business and
revenues. Few, however, see enough
benefits to want to pioneer risk
management advances.
6.2 Risk Management
Organisation and Processes
Does Your Company Have a Risk
Strategy Related to Risk Classes
and Overall Risk Exposure?
The economic capital framework
presented in Appendix 2 starts by
defining the risk appetite and scope
for economic capital management—
two aspects of corporate risk strategy.
Solvency II will require insurance
companies to develop risk strategies,
and the board of directors will need to
be involved in the process, and informed
about these strategies at all times.
Day-to-day risk management activities
should reflect the strategies defined.

Most European insurance companies

have such strategies for the most
Figure 6.6 Level of Influence on the Development and Improvement in Risk important risk types—insurance
Management Processes technical risk and market risk (see
Comply with 1 = No Influence Figure 6.7). Credit risk comes third,
regulatory requirements 4 = High Influence with slightly more than half of the
4.0 insurance companies having a strategy
3.5 Comply with fully in place (52.4%). For operational
Image driven the requirements
of the owner
risk, most companies are in the
3.0
decision-making or implementation
2.5 stage. For liquidity risk and overall
2.0
risk, about one-third have neither set
a strategy nor decided on one.
1.5

Be a pioneer in Comply with As is the case with the presence of risk

risk management market requirements
frameworks, strategies are more common
for large insurance companies, where
processes are in place or partly in place
for between 63.0% (liquidity risk) and
93.5% (market risk) of all companies,
Losses made Business depending on the risk type. For small
by others driven logic and medium insurance companies
these percentages range from 37.5%
Losses in (overall risk) to 78.1% (market risk).
own company Less than 40% of the companies in
Source: Capgemini Analysis, 2006
this group have any type of liquidity-
risk strategies in place. There is little
significant difference between strategy
positions among business segments,

22
 Financial Services the way we see it

with results per business type fluctuating Figure 6.7 Presence of Risk Strategy Per Risk Type
around the average of all companies,
with an absolute maximum deviation
100% 3.2% 3.2% 3.2% 9.5% 17.8% 17.7%
of 14.4%. 6.3% 4.8% 11.1%
90% 6.3%
11.1% 9.5%
Does Your Company Have
15.9% 11.1%
a Department With Overall 80% 20.6% 15.6% 14.5%
22.2%
Responsibility for the Company’s
22.2%
Risk Exposure? Do You Account 70% 69.8%
for Dependencies Between Risks? 13.3% 12.9%
If You Have Established / Plan to 60% 22.2%
Establish Such a Unit, Where in the 57.1%
17.7%
52.4% 8.9%
Organisation Does / Will It Reside? 50%
Solvency II contains requirements for 44.4%
overall risk and risk interdependencies. 40%
38.1% 37.1%
The survey shows 55.6% of European
30%
insurance companies already have a
department with overall responsibility
20%
for risk. An additional 17.5% have
such responsibilities partly in place.
10%
The remaining 27.0% have not assigned
overall responsibility for risk to any
0% Insurance Market Credit Operational Liquidity Overall Risk
specific department(s).
■ In Place
■ Partly In Place
Among small and medium-sized ■ Planned
insurance companies, overall ■ Decision Not Taken
■ No
responsibility is in place for 53.1%,
partly in place for 15.6% and not Source: Capgemini Analysis, 2006

in place for 31.3%. Among large

insurance companies, 58.1% have
assigned overall responsibility for risk,
19.4% have partly assigned it, and
Table 6.1 Department with Overall Responsibility for Risk
22.6% have no overall governance.

Companies with both life and non-life Departments % of companies that assigned overall
responsibility to this department
insurance businesses are less likely
than life or non-life companies to have
1. Project team in the IC 2.3%
assigned (wholly or partly) overall
responsibility for risk. Admittedly, the 2. Controlling unit in the IC 23.3%
organisational structure of life/non-life
companies is generally more complex, 3. Risk controlling/risk management 51.2%
perhaps making it more difficult to
4. Other staff division in the IC 4.7%
assign overall responsibility. The survey
shows 63% of companies involved in 5. Board of directors of the IC 25.6%
both businesses have defined overall
responsibility for risk, a much smaller 6. Corporate level 23.3%
proportion than life insurance (80.0%)
or non-life insurance companies (81.3%). 7. Others 9.3%

Total (multiple answers possible) 139.5%

The department (or departments) to
which overall responsibility is assigned
varies by company. Most common is
a risk-controlling or risk-management
unit in the insurance organisation
(see Table 6.1). For companies with
a department responsible for overall risk,

Risk Management in the European Insurance Industry and Solvency II 23

51.2% embed it in a risk controlling/ Figure 6.8 Presence of Integrated Risk Management
management unit. Other popular
overseers are the controlling unit, the
board of directors and the corporate 100%
level (e.g., corporate risk controlling). 8.3% 12.5% 4.2%
4.2%
90% 12.5% 16.7%
Solvency II will contain more 20.8%
complex requirements than Basel II 80%
with respect to risk dependencies. 12.5%
29.2%
Basel II includes a general function 70%
to calculate diversification effects, 22.9% 8.3%
but Solvency II will have a set of 60%
requirements more tailored to specific 16.7%

circumstances. The survey shows 34.9% 50%

of European insurance companies 45.8%
40% 43.8%
already take risk interdependencies 41.7%
into account, and the process is partly
30%
in place for another 27.9%. Those
averages also hold largely true for
20%
small and medium-sized insurance
companies, where 57.1% already have ■ In Place
10% ■ Partly In Place
processes wholly or partly in place ■ Planned
■ Decision Not Taken
to account for interdependencies, ■ No
0%
compared with 68.2% of large All Insurance Small and Medium Large Insurance
companies and 62.8% of all companies. Companies Insurance Companies Companies

Is Your Risk Management Integrated? Source: Capgemini Analysis, 2006

What Importance Do You Consider
Integrated Risk Management to Have?
Integrated risk management takes
account of the active influence of Figure 6.9 Presence of Internal Risk Reporting Processes Per Risk Type
all aspects of all kinds of risks at the
same time, considering the correlation 100%
between the risks in order to control 7.9% 6.3% 6.3% 6.3% 17.4% 16.1%

the potential loss by selectively using 90% 3.2% 4.8% 11.1% 12.7%
control measures. The survey shows 9.5% 4.8%
all European insurance companies— 80% 6.3% 12.7% 17.4% 16.1%
17.5%
regardless of size or segment—believe 17.5%
77.8%
integrated risk management is very 70%
11.1%
important, with a score of 3.7 on 9.7%
8.7%
a scale from 1(low importance) to 60% 61.9% 23.8%
58.7% 21.0%
4 (high importance). 8.7%
50%
47.8%
40%
39.7%
37.1%
30%

20%

10%

0%
Insurance Market Credit Operational Liquidity Overall Risk
■ In Place
■ Partly In Place
■ Planned
■ Decision Not Taken
■ No

Source: Capgemini Analysis, 2006

24
 Financial Services the way we see it

Of all participating insurance companies, manner and appropriate form to risk Again, small and medium-sized
43.8% already have integrated risk management, senior management insurance companies are less
management in place (see Figure 6.8), and the board of directors, depending advanced than large companies.
while 22.9% are in a transition phase. on their information needs. The The number of small and medium
Similarly, 41.7% of small and medium- complexity of Solvency II, and in insurance companies with reporting
sized insurers have integrated risk particular the interaction between processes in place or partly in place
management in place, while 16.7% are risks, will require even more ranges from 42.1% for liquidity risk to
in transition, compared with 45.8% and sophisticated internal reporting. 78.1% for insurance technical risk.
29.2%, respectively, of large insurers. For large insurance companies, the
However, a large number of the smaller Again, capabilities are strongest range is from 64.3% for liquidity risk
companies have not yet decided to in the area of market risk. Of all to 93.5% for market risk.
adopt integrated risk management. participating companies, 77.8% have
processes in place for market risk Across business types the number of
6.3 Internal Reporting reporting (see Figure 6.9), followed by insurance companies that have reporting
Does Your Company Have a Reporting insurance technical risk (61.9%) and processes in place is relatively low
Process That Takes Into Account Both credit risk (58.7%). The implementation among companies with both life and
Individual Categories of Risk and the of risk reporting processes for non-life business (see Figure 6.10). For
Interdependencies Between Them? operational risk is only complete at four of the six risk types, this group
Adequate management and control over 39.7% of companies. However, scores lower than the groups comprising
risks requires high-calibre reporting insurance companies are progressing, companies active in only the life or
processes that form an institutionalised as evidenced by the fact that 23.8% non-life segments. Remarkable are
procedure in which flows, roles and have reporting processes for operational operational risk and overall risk, where
responsibilities are regulated. Risk risk partly in place and 17.5% are the number of companies with reporting
reports provide vital information planning to adopt such processes. processes in place or partly in place is,
and should be available in a timely in absolute figures, between 10% and
37% lower than for the two other groups.

Figure 6.10 Presence of Internal Risk Reporting Processes Per Risk Type, by Business

100% ■ All insurance companies

■ Life
■ Non-Life
■ Both Life and Non-Life

80%
% of Companies with Process
In Place or Partly In Place

60%

40%

20%

0%
Insurance Market Credit Operational Liquidity Overall Risk

Risk Area

Source: Capgemini Analysis, 2006

Risk Management in the European Insurance Industry and Solvency II 25

Does Your Company Issue an Internal
Table 6.2 Availability of Reports Per Risk Type
Report on Each Risk Type and On
Risk Interdependencies? If So, Who
Report Availability in %
Receives Which Reports?
The risk report most commonly Insurance Technical Risk 83.6%
available in the desired form relates
to market risk (see Table 6.2). About Market Risk 90.7%

90% of companies create internal

Credit Risk 83.3%
reports on market risk, and more than
83% of companies create insurance Operational Risk 69.8%
technical risk and credit risk reports.
Least prevalent are liquidity risk Liquidity Risk 60.5%

reports, which are available at about

Dependencies Between Risk 66.0%
60% of participating insurance
companies—although that number is
perhaps higher than expected, given
that insurance companies assign a
relatively low importance to liquidity Figure 6.11 Distribution of Reports
risk. In fact, though, a similar number
of companies also have available
operational-risk and risk- Local Division/Department Heads
interdependency reports.
Head Controlling

It is not surprising that internal reports Head Risk Controlling/

Risk Management
are so readily available for the more
common risk types, since these are Head Finance
typically required by regulation. But
Head Accounting
it is worth noting that the absence of
a report does not necessarily equate Head Other Staff Division
to an omission. Some reports are not
Board of Directors
required (in the case of small companies,
for example), and some information Division at Group Level
may be relayed in a form the survey
respondents do not class as a report. Internal Audit

External Accountant
When a company has a report for a
specific risk type it goes, on average, to Other Division
four divisions or division heads in the
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
organisation. In other words, a single
report is typically sent to four different Source: Capgemini Analysis, 2006
departments in that insurance company.
The board of directors receives 81.3%
of all risk reports (see Figure 6.11). Risk
management or risk controlling receives
56.2%, followed by internal audit
(51.5%). Solvency II requires tangible
involvement in risk by the board and
“senior management” – a term that has
not yet been clearly defined but is likely
to include local division/department
heads, who now receive 42.6% of
available reports.

26
 Financial Services the way we see it

6.4 Legal Framework Figure 6.12 Assessment per Solvency II Relevant Aspect
Solvency II: How Would You Assess
Your Company With Regard to the
70%
Following Aspects? ■ Existent
■ Partly Existent
Lessons learned from Basel II suggest ■ Non Existent

insurance companies will have to work 60%

hard on Solvency II in the coming
years. The road to timely compliance
50%
will be paved with new experiences,
cultural change and potential pitfalls.
Prerequisites include proper information, 40%
free capacity and know-how for % of Total

implementation. The survey shows most

European insurance companies— 30%
regardless of size or segment—believe
they are only partly armed for the
challenge (see Figure 6.12). Since 20%
Solvency II offers different approaches,
it makes sense that the size of the
10%
company does not affect its perceived
readiness for the new framework.
0%
With respect to risks, 55.8% of insurance Level of Free Capacity Know-How Open Attitude Open to Changes
Information of for SII for SII Towards Risk
companies have an open mind toward Employees on SII Implementation Implementation
the dynamics and transparent handling Risk Area
of risk. Also positive is their openness
to change—an attitude that exists among Source: Capgemini Analysis, 2006
59.6% of the participating European
insurance companies. In fact, no
company said it would not reconsider
its risk management approaches.
Table 6.3 Department Responsible for Solvency II

Which Department(s) Within Your

Not Defined 11.1%
Company Is (Are) Responsible For
Solvency II? Department % of Companies That Assigned
Of survey participants, 11.1% Responsibility for Solvency II
to this Department
have not assigned responsibility for
Solvency II to any department (see
Project Team in IC 25.4%
Table 6.3). Of those that have assigned
the responsibility—to one or more Central Controlling Unit in the IC 17.5%
departments—42.9% said responsibility
resides with the central risk controlling Central Risk-Controlling Unit/ 42.9%
Risk-Management Unit in the IC
or central risk management unit, and
25.4% put a project team in charge
to ensure sound implementation. The Other Staff Department in the IC 15.9%

board of directors is widely expected

Direct Responsibility of the 17.5%
to sponsor Solvency II efforts, but is Board of Directors of the IC
held directly responsible at only
17.5% of companies. Group (e.g. Group Risk Controlling) 12.7%

Others 9.5%

Total (Multiple Answers Possible) 152.4%

Risk Management in the European Insurance Industry and Solvency II 27

6.5 Methods of Risk Management Figure 6.13A Usage of Stress Testing Per Risk Type
Which Methods and Dimensions
Do You Use in the Risk Management
Process for the Various Risk Types?
100.0%
Which of Them Do You Plan to Use? ■ As Is
■ As Is/To Be
For each risk type, there are several 90.0% ■ To Be
common methods used in the risk-
management process. None is the 80.0%
obviously preferred method (see 25.5%
12.7%
Figures 6.13A–D), with the exception 70.0%
of actuarial methods to manage 18.2%
18.2%
insurance technical risk, CEIOPS 60.0%
documentation refers often to stress 18.2%
10.9%
tests, scenario analysis and simulation 50.0%
14.5%
techniques—methods that will be 47.3%
required where they can help assure 40.0% 43.6%
9.1%
robustness and validation of models.
34.5%
Actuarial methods are also relevant. 30.0%
30.9%

Taking the average use per risk type, 20.0%

simulation techniques are the least

10.0%
used method with 23.3% (average of
as is percentages for insurance, market,
0.0%
ALM and loss/solvency/credit risk), Insurance Market ALM Loss/Solvency/Credit
followed by actuarial methods (30.5%),
scenario analysis (37.7%) and stress
testing (39.1%). Where most methods Source: Capgemini Analysis, 2006

are more or less used equally across

risk classes, actuarial methods are
typically reserved for insurance risk.
Taking into account that insurance Figure 6.13B Usage of Scenario Analysis Per Risk Type
companies have methods partly in
place (as is / to be) or are planning
to implement a method (to be), stress 100.0%
■ As Is
testing and scenario analysis are likely ■ As Is/To Be
to be used most in the future, while 90.0% ■ To Be
actuarial methods remain favoured
for managing insurance risk. Only a 80.0%
few participants plan to use actuarial 16.4%
12.7%
approaches for other risk types. 70.0%

60.0% 20.0% 23.6%

16.4%
18.2%

50.0%

45.5%
40.0% 9.1%
10.9%
40.0%
34.5%
30.0%
30.9%

20.0%

10.0%

0.0%
Insurance Market ALM Loss/Solvency/Credit

Source: Capgemini Analysis, 2006

28
 Financial Services the way we see it

Figure 6.13C Usage of Simulation Techniques Per Risk Type

100.0%
■ As Is
■ As Is/To Be
■ To Be
90.0%

80.0%

70.0%
27.8% 21.8%
60.0%

25.5%
50.0%

40.0% 16.4% 27.3%

9.3%

30.0%
29.6% 7.3%
27.3%
20.0% 23.6%

3.6%
10.0% 12.7%

0.0%
Insurance Market ALM Loss/Solvency/Credit

Source: Capgemini Analysis, 2006

Figure 6.13D Usage of Actuarial Methods Per Risk Type

100.0%
■ As Is
■ As Is/To Be
■ To Be
90.0%
10.9%

80.0%
25.5%
70.0%

60.0%

50.0% 52.7%
5.5%
40.0% 12.7%

30.0% 10.9%
5.5%
29.1%
3.6%
20.0% 21.8% 3.6%
18.2%
10.0%

0.0%
Insurance Market ALM Loss/Solvency/Credit

Source: Capgemini Analysis, 2006

Risk Management in the European Insurance Industry and Solvency II 29

Various risk management methods are Figure 6.14A Dimensions Used for Insurance Technical Risk Management
used quite commonly in the European
insurance industry, but certain measures 100.0%
■ As Is
or dimensions are not. Of the dimensions ■ As Is/To Be
named, Value at Risk is used most often ■ To Be
90.0%
(see Figures 6.14A–D). Depending on
the risk type, between 18.5% and 36.4% 80.0%
of companies use VaR. Variance is the
second most frequently used measure, 70.0%
followed by probability of economic
ruin. Expected policy holder deficit, 60.0%
RAROC and RORAC are hardly used. 23.6%
Significantly, Solvency II will contain 50.0%
explicit requirements related to the use
of VaR (TailVaR) and probability of 40.0% 18.2%
economic ruin, so the survey results 7.3%
12.7%
30.0%
highlight a significant potential
capabilities gap for many in the 9.1%
20.0% 3.6% 7.3%
European insurance industry. 21.8%
5.5% 7.3%
16.4% 7.3% 9.1%
10.0% 12.7%
20.0% 3.6% 3.6%
5.5% 3.6% 5.5%
0.0% 1.8%
Variance Coefficient Probability of VaR Expected RAROC RORAC
of Variation Economic Policy Holder
Ruin Deficit

Source: Capgemini Analysis, 2006

Figure 6.14B Dimensions Used for ALM Risk Management

100.0%
■ As Is
■ As Is/To Be
■ To Be
90.0%

80.0%

70.0%

60.0%

50.0% 18.5%

40.0%

30.0% 14.8%
11.1%

20.0% 5.5%
5.6% 18.5% 12.7%
5.5% 12.7%
10.0% 12.7% 3.6% 13.0%
5.5% 3.6% 3.6%
3.6% 3.6%
0.0% 3.6% 1.8% 1.8% 3.6%
Variance Coefficient Probability of VaR Expected RAROC RORAC
of Variation Economic Policy Holder
Ruin Deficit

Source: Capgemini Analysis, 2006

30
 Financial Services the way we see it

Figure 6.14C Dimensions Used for Market Risk Management

100.0%
■ As Is
■ As Is/To Be
■ To Be
90.0%

80.0%

70.0% 16.4%

60.0%

20.0%
50.0%

40.0%
7.3%
36.4%
30.0%
5.5% 12.7%
25.5%
20.0% 12.7%
5.5%
3.6% 12.7%
5.5%
14.5%
10.0% 3.6%
10.9%
5.5% 3.6% 7.3%
0.0% 1.8% 1.8%
Variance Coefficient Probability of VaR Expected RAROC RORAC
of Variation Economic Policy Holder
Ruin Deficit

Source: Capgemini Analysis, 2006

Figure 6.14D Dimensions Used for Loss/Solvency/Credit Risk Management

100.0%
■ As Is
■ As Is/To Be
■ To Be
90.0%

80.0%

70.0%

60.0%

50.0%

14.8%
40.0%

30.0% 9.3%
14.5%
5.5%
20.0% 3.6% 22.2% 12.7%
18.2% 14.5%
1.8%
1.8% 14.5%
10.0% 3.6%
9.1% 1.8%
3.6% 1.8% 7.3%
0.0% 1.8% 3.6%
Variance Coefficient Probability of VaR Expected RAROC RORAC
of Variation Economic Policy Holder
Ruin Deficit

Source: Capgemini Analysis, 2006

Risk Management in the European Insurance Industry and Solvency II 31

 Figure 6.15 Presence of Internal Model(s)

100%
5.5%
14.5%
90%

80%
12.7%

70%
18.2%
60%

50%
49.1%

40%

30%

■ Present
20% ■ Under Implementation
■ Planned
■ Decision Open
10% ■ Not Present

0%

Source: Capgemini Analysis, 2006

Does Your Company The survey shows 49.1% of

Use an Internal Model?
The more advanced Solvency II
approaches allow, and even encourage,
insurance companies to use internal
models. The framework will also set
standards for the robustness, validation
and improvement of internal models.
The development of Solvency II-
compliant models will be a challenging
task, but will ultimately yield several
benefits—for both insurers and
supervisors. Recognised benefits cited
in the CEIOPS advice include the
convergence of internal and external
risk measurement, improved adequacy
in modelling non-linear contracts,
and risk parameters providing a
framework for discussion between
insurer and supervisor.
participating insurance companies
already use an internal model (see
Figure 6.15). Another 18.2% are in
the implementation phase, and 12.7%
plan to build an internal model. Another
14.5% have yet to decide on whether
to build an internal model, and 5.5%
are not even considering it.
Companies are using or planning to
use different kinds of models—34.7%
are Risk Based Capital (RBC) models,
31.9% use simulation, 25% are based
on Dynamic Financial Analysis (DFA),
and 8.3% are other kinds of models.

32

7 Key Findings and Conclusions
Solvency II is expected to become a challenging compliance
theme for the insurance industry. It is much like the Basel II
framework for banking, but includes some enhancements
and additional requirements. Solvency II provides incentives
for insurers that potentially offer strategic and organisational
benefits. Insurance companies are also confronted, however,
with meeting evolving IAS/IFRS standards (though there
is some overlap with Solvency II).
The magnitude of the challenge for insurance companies
hinges on the present state of their risk management
function, and our survey results reveal five key findings
about the state of the European insurance industry:
1. Insurance companies have more advanced risk
management for more important risks. For other
risks there are potential gaps with Solvency II.
The survey reveals that insurance companies
acknowledge risks are important—and will become
even more important in the future. In general, the more
important a specific risk type, the better the existing
risk management function—in terms of processes,
procedures, frameworks and strategies. Similarly, risk
profiles differ among companies in different insurance
segments—life, non-life, or both life and non-life
business. As a result, the calibre of the risk management
function for specific risk types also varies. Solvency II
requires disclosures on specific risk types and it is likely
that the risk management function for some of these
risks will require attention at some insurance companies.
2. Results for small insurance companies justify the
standard formula in the framework.
Risk management processes, procedures, frameworks
and strategies are common across most insurance
companies. However, not surprisingly, large insurance
companies are generally better equipped than small
and medium-sized ones. This reality supports the
inclusion in Solvency II of a standard capital formula
that smaller companies can use.
3. Companies with both life and non-life business are
not as advanced in integrated risk management as
those focused solely on life or non-life.
Integrated risk management is in place for less then
half of insurance companies—a marked counterpoint
Financial Services the way we see it
to the aspirations of Solvency II. Insurance organisations
that are active in both life and non-life business are
likely to be more complex, but the survey shows these
companies are less advanced in managing integrated
risks and enterprise-wide risks like operational risk.
Capgemini experts believe that integrated risk
management will be a key challenge for these companies
on the path towards Solvency II compliance.
4. The likely need to use TailVar and probability
of economic ruin in Solvency II calculations
represents a capability gap for many insurance
companies.
Risk management methods, like stress-testing, scenario
analysis and actuarial methods, are quite commonly
used by the insurance industry. However, Solvency II
is likely to require insurance companies to use measures
such as probability of economic ruin and Tail Value
at Risk. These measures are currently used by very
few insurance companies, suggesting a significant
capabilities gap for the industry. In addition to the
various risk measures, however, internal models are
already available at almost half of the participating
insurance companies.
5. Business-driven logic is an important engine
for improvements in risk management.
Improvements in risk management are primarily being
driven by compliance, but business logic is also a
significant engine of change. However, while insurance
companies see the potential benefits of Solvency II,
few aspire to be pioneers in risk management.
In conclusion
The European insurance industry is already moving
towards the latest risk-management standards, even for
relatively new types of risk. However, important gaps
exist between the current state and the expected
Solvency II requirements, and closing those gaps will
put significant demands on the insurance industry.
According to Capgemini’s insurance and risk management
experts, modelling and reporting requirements, risk
calculation at detailed levels, integration of risks and the
requirements related to the supervisory review process are
some of the key topics that will emerge in the Solvency
II programmes of European insurers in coming years.
33
Appendix 1 Sample Insurance
Company Participants

Table 1.1 provides a partial listing of the survey participants11 by peer group and
business type.

Table 1.1 Peer Group (Annual Premium Revenues)

Small & Medium Companies < € 1.5b Large Insurance Companies > € 1.5b

■ Carige Vita Nuova ■ Aviva

■ Loyalis ■ CNP
Life Business

■ LV1871 ■ Eurizon Vita

■ Neue Bayerische Beamten ■ Storebrand
Lebensversicherung ■ Tranquilidade
■ Nordea ■ Vital
■ SB1 – Liv
■ Swiss Life

■ Atradius ■ Giensidige
Non-Life Business

■ Bayerische Beamten Versicherung ■ IF

■ BBV Krankenversicherung ■ KLP – Skade
■ Rural Seguros
■ SB1 – Skade
■ Verenigde Assurantiebedrijven Nederland

■ Açoreana Seguros ■ Allianz Portugal

■ Agrupació Mutua ■ AXA
■ Cardif ■ Caser
■ Império Bonança ■ Delta Lloyd
Both Life and Non-Life Business

■ Mutua General ■ Dexia Insurance Belgium

■ Pelayo ■ Eureko
■ Santalucia ■ Fidelidade Mundial
■ V VAA Groep ■ Fondiaria-SAI
■ Fortis Verzekeringen Nederland
■ ING Insurance Belgium
■ KBC
■ Lloyd Adriatico
■ MAIF
■ Mapfre
■ MMA
■ Nationale-Nederlanden
■ SNS Reaal

11
Some responses pertain to companies that are part of a larger insurance group, and some insurance
groups are represented by responses from more than one business unit.

34
 Financial Services
Appendix 2 Economic Capital
as an Implementation
Framework
Solvency II sets standards for risk
management practices, and uses an
economic capital approach that offers
a powerful performance management
solution for insurance companies. Here
we outline Capgemini’s assessment of
the benefits of a risk-based approach.
In short, Capgemini’s Economic Capital
approach to handling Solvency II offers
three main advantages. First, the
approach is dynamic, as opposed to
the static directive, which offers no
roadmap for implementation. Second,
the risk-based solvency approach can
help to frame operational and strategic
decision-making, turning a compliance
requirement into a business benefit.
Third, economic and regulatory capital
will be harmonised.
Of course, regulatory requirements and
economic capital guidelines have already
started to converge in recent years, and
Solvency II represents the next step.
In practice, the SCR under the internal
model approach will converge with
economic capital. (Both tend to include
all quantifiable risks. The minimum of
the SCR—the MCR—can be calculated
with a prescribed formula.) Aside from
solvency standards, the economic
capital framework includes reporting,
governance, usage and quality
management guidance. So why use
the more complex economic capital
approach? The answer lies in benefits.
Without an economic capital provision,
Solvency II would simply be the latest
in a long line of compliance initiatives.
Economic capital turns Solvency II
into a business enabler. Economic
Risk Management in the European Insurance Industry and Solvency II
the way we see it
capital is not only a tool for solvency
capital management. It is also a tool
for risk-adjusted performance
management, which will help companies
to steer their business units based on
a mix of risk and return. From a
commercial standpoint, economic capital
can be used in product pricing and
can help to prevent adverse selection.
So how does the economic capital
approach work? Capgemini developed
a logical framework consistent with
Solvency II Pillars I and II. It
consists of four sequential steps,
which together form a dynamic
implementation path (see Figure A2.1).
The first step for an insurance company
is to define its risk appetite by setting
its confidence level. This means
determining its desired probability
of ruin—the chance that the
company will not be able to meet
its policyholder liabilities. Based on
current documentation, Solvency II
is likely to require a confidence level
of 99.5%, with a corresponding 0.5%
probability of ruin. In other words,
an insurance company’s capital level
should be enough to absorb 99.5% of
all negative shocks without becoming
insolvent. The risk appetite chosen
by the insurance company determines
the risk for the policyholder.
35
Figure A2.1 Economic Capital Framework

Risk Appetite Economic Capital Scope Data Processing and Use Quality

1. Set Conference 2. Define Risks 3. Define 4. Develop Data 5. Economic Capital 6. Economic Capital
Level and Controls Organisational Scope Systems and Reporting Use Quality Management
Methods and Governance

Ruin Probability IAA Risks Entities Involved Data EC Reporting Quality

■ 95% ■ Underwriting Risk ■ Main Entity ■ Supplier ■ Reporting of EC Management
■ 97.5% ■ Market Risk ■ Daughters/Affiliates ■ Input ■ Risk Contributions/ ■ Data Quality
■ 99% ■ Credit Risk ■ Suppliers ■ Process Component VAR’s ■ Documentation
■ 99.5% ■ Operational Risk ■ Output ■ Diversification ■ Validation
■ Liquidity Risk ■ Customer Benefits ■ Back Testing
■ Stress Testing
Extra Risks ■ MCR and SCR
■ ALM Risk Comparison
■ Other Risks ■ Supervisor
Involvement

VAR Calculation Risk Systems Use

■ Horizon Classification ■ Data Warehouse ■ Solvency Target/
■ Frequency ■ Pillar 1 ■ QRM Capital Management
■ Management ■ Pillar 2 ■ Statistical Systems ■ Economic Profit
Intervention ■ BI Tools ■ Risk-Based Pricing
■ Prospective Control

Solvency Measures Methods Governance The Risk Control

■ Minimum Capital ■ VAR vs TVAR ■ Senior Management Function
Requirement (MCR) ■ Delta-Normal Involvement ■ Board of Directors
■ Solvency Capital ■ Delta-Gamma ■ Responsibilities and Senior
Requirement (SCR) ■ Historical Simulation ■ Changes Management
■ Monte Carlo ■ Policies and
Simulation Procedures
■ Methods for ■ Adequate
Mitigation
■ Reinsurance Correlation & IT Systems
Diversification ■ Qualified Staff
■ Alternative Risk
■ Scaling EC
Transfer
■ IFRS and Valuation

Source: Capgemini, 2006

36

Figure A2.2 Tail Value at Risk
Mean
VaR (99.5th percentile)
Source: CEIOPS, Answers Second Wave, p.82, October, 2005
The second step relates to the scope
of economic capital. The sub-steps
(Nos. 2 and 3 of 6) involve defining
risks and controls and organisational
scope to establish the scope of
implementation. To be compatible
with Solvency II, the risk types
identified by the IAA (International
Actuarial Association) should at least
be included, along with other material
and quantifiable risks. The IAA risk
types are insurance technical risk,
market risk, credit risk, operational
risk and liquidity risk. In addition,
Solvency II Pillar II risks should be
included (e.g., MCR, SCR). In the
calculation of solvency capital, CEIOPS
is advising that mitigation techniques,
such as reinsurance and ART (Alternative
Risk Transfer) also be included.
Solvency II requires a calculation of
both the MCR and SCR. In practice,
the SCR will converge with economic
capital, including similar risks, so the
use of the economic capital framework
enables an insurance company to
calculate the SCR.
Risk Management in the European Insurance Industry and Solvency II
Financial Services
Not to scale
Tail-VaR (99.5th percentile)
average of losses in the shaded area
Loss
The third step pertains to data
processing and use. The first sub-step
in this phase involves the development
of data systems and methods, with
different methods for each risk type.
CEIOPS recommends using Tail Value
at Risk (TailVar)—a concept illustrated
in Figure A.2.2—instead of Value at
Risk (VaR) to create an incentive for
insurance companies to control the
height of expected losses in the tail
of the loss-distribution. The economic
capital framework also uses TailVar.
Since TailVaR measures the probability-
weighted average amount present in the
statistical tail of the loss distribution,
insurers can reduce their capital
requirements by better managing and
reducing the risks in the tail. VaR,
commonly used in banking, does not
take into account losses in the tail.
Another data step (sub-step 5) relates
to data reporting, use and governance.
Solvency II will include similar
governance requirements in Pillar II.
the way we see it
Specific items mentioned in current
CEIOPS documentation include:
■ Active involvement of senior
management and the board of
directors.
■ Embedding risk management
policies by implementing
procedures.
■ Adequate IT systems.
■ ‘Fit and proper’ personnel:
sufficiently educated, qualified
and sound—particularly for key
personnel in critical functions.
The fifth and last phase in the economic
capital framework pertains to quality. The
internal control function is a key part
of measures aimed at ensuring high-
calibre economic capital management.
Advantages of Economic Capital
The economic capital approach offers
more then just a dynamic framework
for implementing Solvency II. It
includes potential benefits from
a commercial, organisational and
financial perspective. As economic
and solvency capital converge, an
insurance company can harmonise its
balance sheet by reducing divergences
in capital requirements. Organisational
benefits are felt when the insurer starts
using economic capital in performance
management. Using risk-adjusted return
on capital (RAROC), business units can
be steered by a mix of profit and risk.
The commercial benefits include the
potential for incorporating capital
requirements in product pricing. In
summary, the dynamic framework
helps insurance companies to cope
with the challenges of Solvency II.
37
Appendix 3 Literature
BIS, International Convergence of
Capital Measurement and Capital
Standards, A revised framework,
Updated November 2005
BIS, The joint forum—Regulatory
and market differences: issues and
observations, May 2006
BIS, The joint forum—Trends in risk
integration and aggregation, 2003
CEIOPS, Annual Report 2004 and
Work Programme 2005, 2005
CEIOPS, Answers to the EU on the
first wave of Calls for advice in the
framework of the Solvency II project,
June 2005
CEIOPS, Answers to the EU on the
second wave of Calls for advice in the
framework of the Solvency II project,
October 2005
CEIOPS, Answers to the EU on the
third wave of Calls for advice in the
framework of the Solvency II project,
May 2006
Drzik, J., At the crossroads for change:
risk and capital management in the
insurance industry, The Geneva
Papers 2005, 30
38
European Commission, Amended
Framework for consultation on
Solvency II, July 2005
European Commission, Amended
Framework for consultation on
Solvency II, April 2006
HM Treasury, Solvency II: a new
framework for prudential regulation
of insurance in the EU, a discussion
paper, London, February 2006
IASB, Insurance contracts—Phase II,
11 July 2006
Nakada, P., H. Shah, H. Ugur Koyluoglu,
O. Collignon, P&C RAROC: a catalyst
for improved capital management in
the property and casualty insurance
industry, The Journal of Risk Finance,
Fall 1999
“Solvency II, une rèvolution pour la
valorisation et la strategie”—Analyse
Financiere n° 20—July, August,
September 2006—from the Dossier
“Avenir radieux pour l’assurance”
Solvency Working Party, Report of
Solvency Working Party. Prepared for
IAA Insurance Regulation Committee,
February 2002
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