JUNE 2016

Enhancing your risk-adjusted operating model to thrive in today’s turbulent market environment

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INSURANCE RISK & OPERATIONS, EUROPE

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Noel Hillmann: Can you talk to us about Pillar 3 reporting and how you have understood the associated challenges faced by insurers in 2016?

Antoine Bourdais: After years of preparation, the Solvency II regime came into force on 1 January 2016, bringing to the European Union (“EU”) insurance market the most complete reporting package the industry has ever known. Based on the experience of the 2015 preparatory phase, we can say that insurers are ready to face the first challenges of Pillar 3 reporting. But the main issue is coming at the end of this year when the full scope of the regulation will effectively come into force with the annual 2016 data submissions.

The first submissions under the Solvency II regime have just been made in May last month for the day one and quarterly reporting requirements. Whilst these reporting requirements were pretty close to what insurers have already experienced during the 2015 preparatory phase reporting exercise, the real challenge they face today is to be fully prepared to jump into the deep end for the first annual Solvency II submissions requested in 2017, based on December 2016 data.

In my opinion, one of the key factors of success consists of not underestimating the real reporting workload that will be required for this first annual report. Part of the challenge will be to efficiently achieve the necessary internal re-organisation of human resources in the company, so as to be able to cope with the multifaceted burden of Pillar 3 reporting. Not only do insurers have to meet the 2016

regulatory requirements whilst getting ready for the 2017 annual reporting, but they also have to anticipate future evolutions of the regulation.

These evolutions encompass regular updates of the main requirements (the next release of the European Insurance and Occupational Pensions Authority (“EIOPA”) XBRL taxonomy is expected this summer and taxonomy amendments are likely to continue further on). They also encompass additional reporting obligations, such as the National Specific Templates (“NST”) that a number of countries have already mandated, like Ireland in 2016 and France in 2017.

All this adds to the challenges faced by report preparers. If large companies may have distinct teams dedicated to each of these issues, it is a real organisational challenge for a host of smaller entities where it is often the same person who is in charge of both “producing for the present” and “preparing for the future”.

In addition to the issues we just talked about, which are mainly due to the recent entry into force of the regulation and its relative lack of stability for now, the next challenge for insurers is to get started (or pursue) a gradual industrialisation of their reporting production processes. Today, insurance companies are still “exploring” the Solvency II framework. None of them are 100% ready to automate the production of the whole set of expected reporting templates.

Noel: You mention the danger of underestimating the real reporting work load for insurers. In what

particular areas do you see insurers underestimating?

Antoine: There are several possible scenarios. For some insurers, simply because they have successfully managed the preparatory phase reporting exercise as well as their day 1 and quarterly submissions, report preparers consider themselves ready to meet the full scope of Solvency II reporting. In this case, they are not fully aware that future requirements include new families of reports that they have never experienced before. In my opinion, they are clearly underestimating their capability of preparing the full package of templates for the annual reporting.

For some other insurers, although the team in charge of the production are well aware of the additional workload that will be required, it is mainly a budget issue. As the regulation officially came into force the boards of some insurers haven’t identified yet the need to maintain the internal taskforce or get help from external resources.

Noel: Have the reporting templates of Pillar 3 been completed, are companies operationally ready? Has business and IT established an end-to-end system and data processes that are sustainable and cost effective to Solvency II reporting framework?

Antoine: If we only keep our eye on the visible part of the iceberg, yes, we can say that they are ready. Regulators received their Solvency II data, which reflects that they were indeed ready to submit some reports. But if we take a closer look at the situation, the hidden part is that they are still producing

1.4 INTERVIEW

Mastering Pillar 3 reporting – understanding the challenges and developing your processesInterviewer Interviewee

Antoine BourdaisDirector of the Banking & Insurance Division, Invoke

Noel Hillmann Noel Hillmann, Managing Director, Clear Path Analysis

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Mastering Pillar 3 reporting – understanding the challenges and developing your processes

these reports using, partly if not entirely, manual processes.

Today, I don’t think we can say that insurers are ready to manage Solvency II. They can survive under the Solvency II newly implemented regime, but again, they definitely need to move to an industrialised, end-to-end reporting process if they want to be in a good position to meet their reporting obligations eventually.

Noel: So you are saying that the end to end system and data processes are not at this point sustainable for insurers?

Antoine: At this point, processes are not sustainable. This is partly due to the relative instability of the EIOPA taxonomy – insurers already had to comply with two different versions of taxonomy for the preparatory phase on the one hand and the day one and quarterly reporting on the other hand. They will have to report quarter four and annual reporting under the new version which is due to be released this summer.

As a consequence, it is obvious that the IT system in charge of the reports production cannot be easily stabilised. The impact of these regulatory evolutions is all the greater for companies that started automating their production processes. Despite the edge effects of these regulatory evolutions, the latter will nevertheless have the opportunity to locate these impacts, to then better anticipate future ones.

Noel: Insurers have to report additional statistical data in 2016 and some of the data requested cannot be retrieved from available Solvency II data. How can they overcome the challenge of gathering data for Solvency II, enriching this data with any additional information and making sure it’s of sufficient quality to form a report?

Antoine: The introduction of the additional Financial Stability reporting templates by the European Central Bank is a typical example of what you may anticipate from a new regulation. The volume and scope of requirements always tend to increase, not decrease. Insurers have to keep in mind that the Solvency II regulation will probably be subject to further enhancements of this kind in the near future.

We are currently observing new emerging projects amongst our insurer clients that show more ambition than merely initiating the industrialisation of the regulatory reporting production. These projects aim at extending the use of the invoke regulatory reporting platform to exploit it further upstream in the regulatory production chain as a regulatory data warehouse.

This data warehouse enables them to collect, store and process not only the data required to meet the initial EIOPA Solvency II requirements, but also the statistical data required to meet the additional reporting requirements of the ECB and the Financial Stability Board (“FSB”). Data is sourced from multiple, heterogeneous systems and centralised in the data warehouse. Based on this, the software then enables them to define cross-system

data consistency checks and to validate data quality.

Data quality is a hot topic at the moment, as regulators communicated during the preparatory phase to the industry that the quality of the data submitted was not sufficient enough. The goal of these emerging projects is to move from a pure reporting system to a comprehensive regulatory platform, in order to manage data quality prior to automated reporting production.

Noel: What is the key to a successful Pillar 3 reporting strategy?

Antoine: It is crucial to have the right target in mind i.e. to have an industrialised process of production of data applicable to Pillar 3 reporting.

To be able to assess this target, insurers have to choose the appropriate way to get there smoothly depending on their current situation. This means that companies need to have a clear assessment of their I.T system maturity because they have to identify which sort of data is already Solvency II ready and what is not mature enough to be used for an automatic production of reports.

Based on these diagnostics they have to define the relevant milestones to make a good decision around the evolution of their current processes. We have seen some insurance companies deciding that their system is not Solvency II mature enough at the moment and so they prefer to keep a tactical solution to produce the Solvency II reporting. This means that they will continue to prepare it manually and just use software to transform the Excel data into the expected XBRL format.

As for our clients who decided to adopt a global reporting approach, they are using their current invoke reporting system to manage and concentrate all of their data through. They can then manage the data quality before

“We are currently observing new emerging projects amongst insurers that show more ambition than merely initiating the industrialisation of the regulatory reporting production.”

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Mastering Pillar 3 reporting – understanding the challenges and developing your processes

producing both regulatory reports and internal reporting.

Depending on the capability of each entity to adapt a tactical, strategic or global approach it will define the rhythm at which each company is able to achieve the right target which is clearly a fully industrialised reporting process.

Noel: Thank you for sharing your view on this subject.

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Elena: A turbulent economic environment and low interest rates put a lot of pressure on life insurance firms. Financial market risks have been further exacerbated due to the new market based Solvency II regime. How has Solvency II adapted to this turbulent economic environment?

Simen: Our main business is within the non-life insurance sector which hasn’t really been affected by the low interest rate levels, however, we also have a small life insurance company that has been substantially affected by the low interest rate environment. We also noticed that the Solvency II ratio has been changing from quarter to quarter due to the fluctuating interest rate levels.

We have developed a standard model for Solvency II calculations for the life insurance business that is similar to our own portfolio. We have a mix in the portfolio of both Defined Contribution (DC) plans and Defined Benefit (DB)plans with a guarantee investment inthe products. This is the portfolio thatcreates the most unstable Solvency IIcalculations.

We see that our portfolio mix does not derive any benefits from the implemented transitional risk from the FSA but in the future, in our opinion, our portfolio will be more robust to these calculations.

Elena: How are companies dealing with these challenges and what kinds of solutions can they include in their operations on the investment side?

Simen: I feel that companies are doing what they are able to do within these

limits. It is not that easy to increase the risk and the expected returns on the assets side because there are a lot of issues such as equity charges on the calculations under the Solvency II ratio which insurance companies need to take into account.

Elena: As internal models are still being improved, are companies ready for this challenge and are there best practices already in development in the market?

Simen: 2016 is the first year where Solvency II has been enforced but the preparations for it had been going on for years.

Parallel to the Solvency II preparations we have also seen that the FSA has placed increased attention on how the insurance companies are organised and been working on processes that should be implemented to reduce operational risks.

Within our risk department we have been working with different measures to get into a position where we can handle risk effectively. Another action the FSA has taken since 2014 is to ask all insurance companies to deliver an ORSA report. Also during the spring of 2015 a lot of direction was provided by the FSA to the companies regarding this report.

This was very helpful and most insurance firms have become quite well prepared for Solvency II as a result. Internal models are still under development. However we see that several insurance firms have already applied for an approval of their internal models. Note that for most insurance

companies its only a partial model since operational risk is probably not an area where it is common to have an internal model.

In the near future when the financial position is reported to the market we will see the Solvency II position from a perspective where the standard formula is compared to internal model results. We also have a rating from Standard & Poor’s which is important to take into consideration while looking at the internal model in conjunction with the level required by Solvency II.

It is a little early to say that best practices for internal models already exist but I think it is heading in the right direction. More companies are going to make their calculations public and to share their assessments of the results of their internal models. Based on this, insurance firms will be able to develop best practice over time.

Elena: Have the reporting templates of Pillar III been completed? Do insurance firms still require extra resources?

Simen: Looking back at last year’s pre-reporting phase I think It was a very important exercise for large insurance companies. This exercise prepared them well for this year’s compulsive reporting. These days we are finalising the reports and the opening balances of 2016, as well as the first quarter results.

Elena: What needs to be done for next year’s required reporting?

Simen: We will have to deliver the complete Pillar III package by the end

1.1 INTERVIEW

Living with Solvency II in the current market turmoil: Setting your risk tolerance levels and capital frameworkInterviewer Interviewee

Elena StevensonReport Publisher, Clear Path Analysis

Simen GaarderChief Risk Officer, Gjensidige Forsikring ASA

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Living with Solvency II in the current market turmoil: Setting your risk tolerance levels and capital framework

of 2016 in the spring of 2017. To make this possible, regulators are reviewing approximately 63 templates which will provide very comprehensive reporting, This will include very detailed descriptions of each company, the way it’s organised and the different roles of the first, second and third line, as well as the governance of the company.

Do insurance companies still require extra resources? I would say, at least for many it’s probably too late to increase the resources because we already have to start planning for next year’s reporting.

Elena: How are companies working with Solvency II now that it is here and what is next?

Simen: For the first few years, you will be able to carry out Solvency II reporting, there will also be room for improvements and it will probably take some time for most of the companies before reporting can be streamlined and done in a more efficient way.

Elena: How do you design products that are appropriate within Solvency II? How do you set your risk tolerance levels?

Simen: Since the development of the internal model we have seen that by using it companies gained some advantages particularly in the pricing of products. The reason is that insurance firms now have consistent methods of dealing with all elements, including the capital needs for each product. We will use the internal model to secure the profitability for each product so Solvency II will actually affect the design of the product.

Elena: Do you have any final thoughts on this topic?

Simen: Regarding templates relating to Pillar II we have seen that reporting also helps to build up data warehouses, meaning that we have all of the required data available prior to

reporting. Developing all the needed data has been quite a challenge.

Elena: Do you have any tips on addressing this challenge?

Simen: The most important thing to remember is that it just takes a lot of time as it is very time consuming to build a data warehouse. Also, one shouldn’t underestimate the level of support needed from top management,

Elena: How difficult is it to involve top level management in this?

Simen: It takes time to organise meetings etc but we started setting up meetings and training sessions with all members of the top management group and the CEOs. As we have an internal model we spent a lot of time also training the board to actually understand the model and how it works.

Elena: After that is it down to communication and educating your board?

Simen: That is right, however there is also a need for some technical communication which is quite a difficult area to communicate to the boards.

Elena: Thank you for sharing your views on this topic.

“The reason is that insurance firms now have consistent methods of dealing with all elements, including the capital needs for each product. We will use the internal model to secure the profitability for each product so Solvency II will actually affect the design of the product.”

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Noel Hillmann: How has the role of risk management changed in response to the new regulations?

Eberhard Muller: The integration of quantitative and qualitative risk management during my last 10 years before retiring as CRO has been the biggest challenge for me given my quantitative background as an actuary. The role of a Chief Risk Officer deals with qualitative issues fifty percent of the time and quantitative issues the other half of the time.

One of the the biggest challenges has always been to keep the balance between risk management and capital allocation. Additionally, determining the correct margins that should be allocated to a business to cover risk and to fulfil the regulatory requirements which were not always aligned with the businesses objectives is difficult. Keeping the regulator happy whilst trying to maintain some balance between the underwriter and the regulator is very challenging.

Noel: Given that Solvency II is now in place there has been great talk about the move on with regards to risk managers focussing on new areas. Do you think that risk management team dynamics are changing and moving towards a new “urgency”? If so, what do these urgencies look like?

Eberhard: A necessary consideration for any risk taking business is the separation of key functions. Usually we consider the first, second and third lines of defence principles. The first line is taking risk, the second is independently monitoring risk and the third is the internal audit unit

examining the first and second lines. But there will still be an ongoing debate about whether it is really justified to have those functions mandatorily further separated within the second line of defence. In my opinion, the risk management function and the actuarial function are inseparable and should be kept aligned.

If an expensive CRO, an expensive Chief Actuary and an expensive Chief Compliance Officer are all fighting competitively against each other rather than aligning their forces to effectively challenge the first line of defence it does not make too much sense. This also should be obvious to regulators.

Noel: What would you do differently next time around?

Eberhard: Nowadays, Hannover Re has the advantage of an internal model that was already approved by middle of 2015 so they work quite safely. Since they have been doing risk based capital allocations since the late 90’s there hasn’t been too much change.

Having said that the main change was the integration of quantitative and qualitative risk management functions as well as the integration of life and non-life risk management in order to achieve a full holistic approach. When looking to the future, in my opinion, the one challenge that might remain is how to get resources in line with the real requirements and not waste too many resources on pure regulatory exercises, particularly, on the quantitative reporting side (quantitative reporting templates).

In this area I predict there will be even tougher resource management reviews conducted on the risk management side compared to what we’ve had in the past.

Noel: What process have insurance companies changed or adapted in order to comply with the ever-changing regulatory environment?

Eberhard: The regulatory impact for Hannover Re and other major reinsurers came after the rating agency impact. The largest impact on the risk management function came from Standard & Poor’s in 2005. That took place when they published their updated requirements for excellence in risk management.

This was the reason for establishing the role of a CRO and a risk committee that meets quarterly to review the risk reports and dynamic financial analysis reports. All of this was already in place when the regulatory requirements came up under Solvency II so we actually benefitted from meeting the first rating agency’s requirements.

In the future we have to look at the different key functions and we have to be very careful that the regulatory requirements do not ask us to implement processes which, at the end, are ineffective and will waste resources.

Noel: Do you think the regulators take into account how changes will affect the industry’s ability to perform and grow or do they merely act as “policemen”?

Eberhard: It depends whom you are talking about, if you are talking about

1.2 INTERVIEW

Adapting your business operations to an ever changing regulatory landscape

Interviewer Interviewee

Noel Hillmann Noel Hillmann, Managing Director, Clear Path Analysis

Eberhard MullerFormer Chief Risk Officer and Managing Director, Hannover Re

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Adapting your business operations to an ever changing regulatory landscape

the management of regulators then they are definitely able to contemplate what they are doing. It starts with EIOPA and Gabriel Bernardino who is a knowledgeable and fair person. This is also true when you look at the national supervisors like Felix Hufeld from BaFin (Germany), he knows about the impact of various regulations because he also came from the industry.

When going down the ladder to the operational level more and more “policemen” come onto the scene. Unfortunately, my observation is that inexperienced young regulators behave more like “policemen” than they should. Solvency II is originally constructed as a principle orientated system which gives some room to manoeuvre, however, inexperienced regulators on the operative level are trying to “play it safe” by taking a conservative approach. This principle orientated system will gradually move into a rule based system.

Noel: How do you feel that regulators can appropriately adapt to ensure that they are more in line with what the industry needs? Do you feel there needs to be more working groups that involve industry participants? What actions do you see them taking that would be productive?

Eberhard: Absolutely, it starts with the education of regulators and their presence at conferences. I was quite glad to see representatives from the German regulator BaFin in the Re-Insurance Association of America’s (RAA) natural catastrophe modelling conference which is held

every February in Orlando. It’s a great opportunity to give regulators a platform to communicate with business.

Those events bring knowledge from one side to the other and I don’t understand why some regulators didn’t allow their representative to attend those conferences.

Noel: Do you anticipate any impending changes? How will this affect the way you do business?

Eberhard: The next beast on the horizon is ComFrame which is the initiative currently being done under the roof of G20 and IAIS. Its aim is to establish a worldwide solvency capital requirement for internationally active insurance groups and a common framework for insurance supervision.

Here the danger is what has been established as a regulatory framework in Europe under Solvency II might not be in line with the U.S. and other interests.

We may face additional or deviating requirements in the future and I can only ask government bodies in Europe especially EIOPA to be very clear that we will not deviate from the Solvency II standards.

Noel: Thank you for sharing your views on this topic.

“Solvency II is originally constructed as a principle orientated system which gives some room to manoeuvre, however, inexperienced regulators on the operative level are trying to "play it safe" by taking a conservative approach.”