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Impact of Solvency II on Investment Management SystemsThe report and valuation obligation related to Solvency II directive of the European Insurance and Occupational Pensions Authority (EIOPA) comes into force on 1st January 2013, according to the current EU commission timetable, for all insurance companies in the Euro-pean Union (EU). The regulatory guide-lines are to be applied, after an initial testing period and subsequent one-year transitional period, for the first time in the 2014 financial year. The implemen-tation of these guidelines will directly affect the system for the controlling of assets and present a considerable chal-lenge for the IT departments of insur-ance companies.

The Swiss Financial Market Supervisory Authority (FINMA) already introduced the Swiss Solvency Test (SST) as a counterpart to the European Directive, within the Swiss insurance sector on 1 January 2006; it has been binding since 1 January 2011, with a transitional period of 2 years. The goal of both directives is the protection of insurance policy-holders from the consequences of insolvency on the part of insurance companies by means of a compre-hensive, risk-based system for the supervision of such companies. In the case of Solvency II, insur-ance companies quantify the risks to which they are exposed by their insurance policies on the liabilities side and their capital investments on the asset side. This objective is achieved by means of a three-pillar model: the first pillar determines the amount of capital adequacy (the minimum and the solvency capital requirement) in relation to the deductible amount of equity capital (available solvency capi-tal), the second pillar relates to risk management and compliance processes, and the third pillar com-

prises reporting structures in conformity with other statutory reporting obligations such as accounting in accordance with the IFRS. Insurance companies can choose either to apply a standard formula − a less complex approach, though one which tends to overstate the level of capital required − or to create an internal model tailored to the transaction struc-ture in question, which is a more elaborate but less capital-intensive undertaking.

Experience with the SSTIn Switzerland it has emerged that the require-ments imposed by FINMA, according to whom the amount of additional expense incurred by insur-ers in carrying out the solvency test should remain proportionate, cannot be implemented in practice. The main point of contention here is the standard-ised SST model, which does not address the risk-related provisions in respect of either small, large or medium-sized providers and, in particular, disre-gards the life insurance business in which consid-erably more capital is tied up than in other areas. This results in greater expenditure in terms of both time and money for the introduction of internal risk models that must be individually approved by the authorities.

Furthermore, the risk-free yield curve for the eval-uation of the insurance assets and the evaluation model for share and real estate investments are subject to debate. On the one hand, the discount rate is based on government bonds, which do not reflect the time frame of insurance companies with regards to the risks to be hedged. On the other hand, real estate and shares are both declared to be risky investments. In addition to capital increases and shifts to less risky classes of investments, which obviously generate less revenue, group compa-nies are permitted, to a limited extent, to provide

guarantees for the purposes of minimising risk. As a result, however, the Swiss subsidiaries of foreign insurance companies have a competitive advantage over domestic insurance companies, given that they receive favourable guarantees from their foreign parent companies and thus have to provide less equity capital. Swiss insurers emphasise that both directives diverge significantly from each other and that Solvency II is less strict than the SST.

Status of the Current Debate regarding Solvency IIAlthough Switzerland has taken the lead in Europe thanks to the SST, the lessons learned from the experience appear to have only had a minor influ-ence on the implementation of Solvency II within the EU. The criticisms levelled to date at Solvency II are similar to those levelled at the SST: the require-ments are generally too detailed and the evaluation rules too complex. Smaller life insurance and health insurance companies are at a disadvantage, par-ticularly where their legal form is that of a mutual insurance association, which are limited in their ability to obtain new funds via the capital markets.

As per Solvency II, liquid swap rates rather than bonds form the basis of the yield curve. The dis-counted value of the insurance liabilities is, how-ever, highly sensitive to even small changes. The incidental curve progression at year end is con-sequently the decisive factor as to whether the equity ratio to be attained will decrease, or, in the case of low interest rates, increase. The projected stress factor of 25 % for real estate investments, which is based on assumptions of the British real estate market, is also the subject of debate, given that fluctuations in value in Great Britain are not representative of those in all of the other markets within the EU. Even where the extent of the deter-

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Publication

Implementing the Solvency II directives in the Asset Management of Insurance Companies2

Profidata AG, In der Luberzen 40, 8902 Urdorf, Switzerland, phone +41 44 736 47 47, www.profidatagroup.com

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mined stress factor is explained on the basis of the internationally diversified real estate portfolios of the insurers, the fact that the majority of the mar-ket participants, Germany in particular, invest in domestic real estate contradicts this argument. A stress factor of 15 % is thus considered to be rea-sonable. Nevertheless, the allocation of real estate funds to equity risk is not considered to be partic-ularly meaningful.

Contrary to shares or real estate, insurers are not currently obliged, according to current Solvency II guidelines, to set aside additional equity capital for government bonds of heavily indebted countries. The question of whether to distribute government bonds according to senior and subordinated classes (as is currently the case for corporate bonds) is cur-rently under debate, as is the possibility of imple-menting the so called Counter Cyclical Premium (CCP). The CCP presupposes increased yields dur-ing times of economic crisis with the consequence that the required technical provisions for these bonds are commensurately reduced. Thus insurance companies would be freed from having to accumu-late increased technical provisions due to their cli-ent obligations if the value in the portfolio contain-ing the government bond fell.

Representation of the Capital Invest-mentsThere is a danger that further quantitative impact studies (QIS), the sixth one of which is currently underway, and the lingering debate over Solvency II will have a direct effect on the legislation, which will then have to be implemented at short notice. In order to be able to handle the complex require-ments imposed by Solvency II, insurance companies will need to have an efficient and flexible IT infra-structure in place, which must provide the necessary functions for the controlling of capital investments and, by facilitating the required asset classification, assist in establishing an integrated risk assessment approach across pillars 1 and 3.The primary focus in this respect lies on the recording of all investments. Traditional and exotic financial instruments are to be recorded according to a uniform concept and with input from multiple data providers. The subsequent transactions need to be recorded as freely configura-ble transaction types. The entire transactional proc-ess can then be tailored to the customer’s needs in conjunction with automated and workflow-control-led front-to-back processing.

The modelling of financial instruments also com-prises the setup of derivative and structured prod-

ucts, which frequently form part of the portfolios of insurers. Externally administered positions, such as alternative investments, real estate property or loans, i.e. those that are recorded for information purposes but must be evaluated for the purposes of moni-toring capital investments, can be imported at the level of individual positions or grouped together as aggregate positions in maturity bands. Freely defin-able data fields are highly advantageous when clas-sifying financial products. For example, in the quan-titative reporting template (QRT) D4 for invest-ment funds, the underlying assets are to be grouped according to a multitude of data fields, not to men-tion the complementary identification code (CIC) or the geographical zone of issue. By means of business rules, a consistent rule language, the relevant cate-gories can be derived from the master data fields and the positions thus correctly allocated. Various ratings can also be maintained on a parallel basis within the master data for the purposes of assessing default risk. At the same time these ratings can be harmo-nised, or internally ranked, again by the application of business rules. The results are kept in historical records. Business rules and flexible data fields can be employed throughout the system and are used, along with the above examples, to define workflows and key ratios, as well as attributes enabling the sep-

Fig. 1: Risk module in accordance with the Solvency II QIS 5 standard formula

Implementing the Solvency II directives in the Asset Management of Insurance Companies 3

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aration of positions. Given that the evaluation of all assets is essential for the calculation of the equity capital required by Solvency II, access to all data is assured at all points within the system. As a result, the master data can also be used for the pricing of individual assets such as, for example, in the theoreti-cal evaluation of interest-bearing securities by means of yield and spread curves.

Risk CalculationThe ‘prudent person’ principle requires an appropri-ate reconciliation of capital investments against lia-bilities, as well as asset diversification for the bene-fit of the insurance policyholder. The allocation of the individual positions takes place in accordance with the market and default risk module for the sol-vency capital requirement laid out in the standard formula of QIS 5 (Fig. 1) or an internal model.

With a view to optimising capital investments and hedging market risk, key factors such as ‘economic exposure’ and ‘systematic risk’ arising from selected positions are weighted and the number of deriva-tives contracts required for the attainment of the stipulated targets is calculated. Parameters can in turn be defined for these optimisation models by applying business rules. The same applies to com-

pliance rules, by means of which compliance with statutory, contractual and internal limits is verified both pre- and post-trade, and in order to avoid the concentration of risk proscribed by Solvency II. Default risk, which results from OTC transactions but which can be kept at a low level by means of effective collateral management, must also be con-sidered in this context. Both in the compliance & risk and reporting contexts, indirect investments must be reviewed, i.e. fund certificates, etc. must be decomposed into fundamental individual positions, which are then allocated to the pertinent market risk category. Furthermore, market data scenarios and stress tests (shifting of the yield curve, loss of market value, foreign currency shocks, etc.) must also be simulated, including adjustments for corre-lations, with a view to reducing market risk. More advanced techniques, such as the application of parametric and non-parametric Value-at-Risk mod-els, are also available within an integrated system and their ability to represent internal risk models in addition to the standard formula can be assessed by means of back testing.

Accounting and ReportingReporting to the Federal Financial Services Supervisory Authority as requiredby Solvency II presupposes the

existence of corresponding quarterly financial state-ments. Parallel accounting in compliance with national and international accounting standards is an integral element of an investment management system. Trans-action components can be generated on the basis of rules and transaction types and can be booked in accordance with the maintained charts of account. A complete evaluation of the categorised balance sheet items also includes a simulation of period-end financial statements - which can be carried out at any time - and establishes the existence of possible write-offs, whilst generating cash-flow projections for liquidity planning purposes. In addition to the entering of quantitative information relevant to the solvency balance sheet and capital management in the QRTs, specific information regarding risk management must be provided and per-formance results disclosed in the qualitative Report to Supervisors (RTS) and the Solvency and Financial Con-dition Report (SFCR).

Given that an asset management solution will not typ-ically display insurance liabilities, the entire reporting obligation of Solvency II cannot be met in the capital investment system. Notwithstanding this, an integrated reporting engine should be flexible enough to generate reports both for a part of the investment universe – e.g. the special funds – of an insurer (without correlated

Fig. 2: Solvency II Reporting

Implementing the Solvency II directives in the Asset Management of Insurance Companies4

Profidata AG, In der Luberzen 40, 8902 Urdorf, Switzerland, phone +41 44 736 47 47, www.profidatagroup.com

risks), and reports (with correlated risks) for the entire capital investment (direct mandates incl. special funds). Moreover, necessary data from the liabilities side must be imported along with the administration of the assets side and further processed in the system. This enables the relevant QRTs to be filled directly or created. In addition, an integrated data warehouse or an exter-nal system should be supplied at all times with data packages which, for instance, comply with the current QIS requirements (Fig. 2) by means of export functions. The data supply process also comprises direct access to

transactions and evaluated positions. Time-consuming calculations on a period basis can be avoided through the use of caching technology, which is characterised by the fact that the entire data inventory upon which an evaluation, for example, is based is uploaded from the database on the first run-through and thereafter only changes to the data are taken into account.

ConclusionThe upcoming adjustments to be made by insur-ance companies in accordance with Solvency II may

be facilitated by software providers, provided that close contact is maintained with the supervisory authorities, industry associations and the affected insurance companies or pension funds, and stat-utory directives are constantly subjected to anal-ysis. However, prompt reactions to the regulatory changes introduced by the EIOPA will only be pos-sible if the structural modules of the software sys-tems allow for quick and easy configuration and additional software development can largely be dispensed with.

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Peter KleinMember of the Management Boardphone +41 44 736 47 90 peter.klein@profidatagroup.com

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