Chief Risk Officer Forum July 2008 Market Value of Liabilities for Insurance Firms Implementing elements for Solvency II 1 The Chief Risk Officer Forum (CRO Forum) comprises risk officers of the major European insurance companies and financial conglomerates. It is a professional group that was formed to develop and promote industry best practices by working jointly to address key risk-related issues facing the industry. The membership is shown below. MEMBER COMPANY REPRESENTATIVE EMAIL ADDRESS Aegon NV Tom Grondin [email protected] AIG, Inc Robert Lewis [email protected] Allianz AG Tom Wilson [email protected] Aviva PLC Jim Webber [email protected] AXA Group Jean-Christophe Menioux [email protected] Chubb* Joel Aronchick [email protected] Eureko Margreet Haandrikman [email protected] Fortis Olav Jones [email protected] Generali Paul Caprez [email protected] Groupama Rene Cado [email protected] Hannover Re Eberhard Mueller [email protected] HBOS* Roger Dix [email protected] ING Group Jeroen Potjes [email protected] Insurance Australia Tony Coleman [email protected] Group* MetLife* Henry Essert [email protected] Munich Re Jo Oechslin [email protected] Old Mutual plc* Daniel Bruce [email protected] Prudential plc Philip Long [email protected] Royal & SunAlliance* Neil Macmillan [email protected] Swiss Re Raj Singh [email protected] Zurich Financial Services Axel Lehman [email protected] * Associate members that participated in the preparation of this paper Chief Risk Officer Forum Contact Details: Via E-mail: [email protected] [email protected] The CRO Forum has already made significant contributions to the debate on valuation of insurance liabilities. Building on its previous position papers, the CRO Forum is now pleased to present this discussion paper, “Market Value of Liabilities for Insurance Firms - Implementing elements for Solvency II”. The paper addresses some core principles and the practical issues regarding the calculation of the market value of liabilities. In addition, given the inter-linkages between the issues, the CRO Forum has also incorporated the perspectives of the CFO Forum in formulating this paper. The CRO Forum member companies have discussed and agreed on the principles and practical approaches described herein. The CRO Forum would also like to thank Dr. Philipp Keller of Ernst & Young and Professors Shaun Wang and Richard Phillips of Georgia State University for providing research regarding the calibration of the cost of capital rate; and Oliver Wyman for assisting in the preparation of this paper. 2 Contents 1. Executive Summary and General Principles............................................................... 4 1.1. Objectives and key considerations..................................................................... 4 1.2. Definition of the Market Value of Liabilities ........................................................ 5 1.3. General principles for calculation of the MVL..................................................... 5 1.4. Specific implementation proposals..................................................................... 6 2. Objectives and Key Considerations ............................................................................ 9 2.1. Objectives .......................................................................................................... 9 2.2. Distinction between solvency and accounting standards................................... 9 2.3. Distinction between market-consistent valuation and pricing practices ........... 11 3. Specific Implementation Proposals ........................................................................... 12 3.1. Use of entity-specific and non-entity specific assumptions .............................. 12 3.2. Swap rates as the definition of risk-free ........................................................... 13 3.3. Projection of SCR required capital ................................................................... 14 3.4. Context to determination of the Cost of Capital Rate....................................... 15 3.5. Calibration of the Cost of Capital Rate............................................................. 16 3.6. Realistic best estimate basis............................................................................ 18 3.7. Pillar 3 as Mechanism for Harmonisation......................................................... 18 Appendix A. Examples of hedgeable and non-hedgeable risk .................................. 21 Appendix B. Summary of Research Findings............................................................ 22 Appendix C. Frictional Cost of Capital ....................................................................... 24 Appendix D. Weighted Average Cost of Capital ........................................................ 37 Appendix E. Market Price of Risk Method ................................................................. 43 Appendix F. CAPM and FF2F Method ...................................................................... 49 Appendix G. Companies included in FIIB analysis .................................................... 63 Appendix H. References............................................................................................ 71 3 1. Executive Summary and General Principles Over the past 3-4 years a tremendous amount of positive energy and resource has been expended in the name of improving the efficiency and effectiveness of the oversight of insurance entities, globally, by regulatory and supervisory bodies, industry associations and commentators alike. The CRO Forum is pleased at the pace and direction of the changes under consideration. However it has also become clear that in the course of the wider dialogue, confusion has sometimes arisen about the intended meaning about certain principles and elements of suggested implementation frameworks. Moreover, parallel discussions in the field of financial accounting have meant some terminology has dual meanings. The aim of this paper is to explain in more detail the CRO Forum's position on the topic of the Market Value of Liabilities (MVL) of insurance firms, particularly on how it should be defined and parameterised. For those who have followed our past position papers on this and related topics, you will find that while the positions described herein are entirely consistent with those described in each of our earlier publications, we have adapted some of the terminology used previously with the aim of establishing a clear and unambiguous position. 1.1. Objectives and key considerations The CRO Forum is primarily concerned with ensuring that the Market Value Balance Sheet provides the appropriate basis for assessment of the economic solvency of insurance companies. The MVL is a key component of this balance sheet The CRO Forum would like to ensure that the construction of the MVL is consistent with regulators’ views and is also consistent with sound risk management principles followed by leading insurers. From a risk management perspective, it is important to note that the basis for solvency assessment using MVL will be complemented by the requirements of supervisory review and external disclosures under Pillar 2 and Pillar 3 of the Solvency II framework, respectively One aspect of this is to ensure that the MVL provides a genuinely economic valuation of the technical liabilities, in the sense that it does not contain margins for prudence; these are contained exclusively in the required capital The CRO Forum believes that the requirements of a solvency framework, while complementary to, may not necessarily be the same as, the needs of financial accounting frameworks. In particular, the solvency framework should present a fair reflection of the economic value of liabilities through the MVL and should not be influenced by considerations relating to the timing and certainty of profit recognition - This position is consistent with the view adopted by the European CFO Forum that states that any allowance for accounting considerations should be explicitly introduced as an additional balance sheet item The CRO Forum emphasises that market-consistency refers to values that are consistent with those observed in deep and liquid financial markets and therefore draws a distinction between market-consistent valuation and observed pricing practices in the insurance markets. Insurance premium rates and prices are not considered an adequate basis for the valuation of insurance liabilities because primary insurance markets are illiquid and inefficient and because pricing practices in the primary insurance markets are driven by a range of considerations beyond the economic value of the liabilities generated 4 1.2. Definition of the Market Value of Liabilities The CRO Forum defines the MVL as the market-consistent fulfilment cost to the insurer to meet its obligations to policyholders over time in the ordinary course of business. The MVL, therefore, represents the present value of the financial costs to an insurer that is obliged to meet those liability cash flows. The costs are comprised, inter alia, of policyholder benefits, expenses, tax payments and capital costs, net of expected future premiums and fees from the existing contracts. Whenever such obligations, or some component thereof, can be hedged through the financial markets, a valuation approach that is consistent with those markets