On 8 July 2015, the Swiss Financial Market Supervisory Authority FINMA put a revised package of circulars out for consultation. Although the main text of the FINMA circular on the SST (2008/44) has not been amended, many proposed changes have a direct and indirect impact on the Swiss Solvency Test (SST) and its use by Swiss Insurers.
The most significant impacts arise from the newly released circulars on public disclosure and ORSA.
Seen in the wider context these proposed changes move the Swiss insurance regime closer to the EU in terms of the qualitative Pillar 2 (ORSA) and Pillar 3 (disclosure) requirement but retain the specific quantitative differences (Pillar 1). In particular under Pillar 1 the end of the temporary capital relief for insurers under the SST means they will no longer be able to value their business using swap rates (as per Solvency II) and must return to the SST-specific rates implied by Government bonds. Many insurers lobbied FINMA for the right to discount insurance liabilities using swap rates, on the basis of competition with European firms, comparability with Solvency II as well as theoretical economic valuation arguments. The approach taken in this area will thus not be welcomed by the industry in general.
Further FINMA intend to mandate the use of the standard model as opposed to internal models to a greater degree than currently, and require that Operational Risk is quantified.
Public disclosure of Solvency & Risk Management information
The FINMA circular on public disclosure requires the publication of a report on the financial position of an insurer (“Bericht über die Finanzlage“), both from a quantitative and qualitative perspective. One key requirement for the report is it has to contain information about the solvency, risk management, risk profile and also the methods used to calculate insurance liabilities.
In particular, the following supplementary information has to be disclosed:
- Market value balance sheet i.e. market value of assets and liabilities
- Components of the risk bearing capital under SST
- Components of the target capital under SST i.e. insurance risk capital, market risk capital, credit risk capital and the market value margin.
Some large Swiss insurers already disclose such information and those medium sized insurers reporting under IFRS disclose the market value of assets. However the full market value balance sheet along with the composition of target capital is currently considered highly sensitive information by most insurers.
The public disclosure of SST figures is likely to have an impact on the overall business strategy and risk management as well as on the SST models and their production processes too.
Investors as well as current and potential policyholders will be able to compare the financial condition of insurers more easily. Insurers will react by adjusting to the demands of these stakeholders. In general investors prefer a low capitalisation with a low volatility, which should lead to a higher capital utilisation and thus higher expected returns for a given level of risk.
The largest risk life insurers currently face is not underwriting or insurance risk, but rather credit and market risk, which could be seen as non-core risks for insurers. Ultimately investors do not need to invest in an insurer and suffer associated frictional costs to take market or credit risk. There are more efficient ways of doing so. They will thus question the risk capital allocation to market and credit risk for those insurers with a particularly large allocation here.
On the other side, policyholders and thus regulators obviously prefer a high SST ratio i.e. a high level of security and capitalisation. This trade-off between the shareholder and policyholder demands will perhaps become more an issue given the enhanced level of disclosure. In the long run, insurers may try to adapt also their SST models to attain an enhanced external view of their risks.
Furthermore, the risk of misinformation increases with this additional disclosure requirement. It is thus likely Boards and the regulator will demand higher standards of governance and enhanced controls within the production of the SST, possibly including full audit.
The Own Risk and Solvency Assessment (ORSA) requires an insurer to consider his risks over the whole business planning cycle (at least two years). Stress scenarios used to test solvency are multiyear and extend the one-year SST view. Stress and scenario testing will become more a focus area therefore and it is likely insurers will need to give more thought to the impacts including second and subsequent order impacts of given scenarios. This detailed consideration is likely to enhance the usefulness of the scenarios for risk management purposes.
The (required) availability of multiyear SST projections will increase the applicability and relevance of the SST in wider risk management considerably. It will allow more holistic and sustainable risk management decisions. We believe that insurers will benefit considerably from implementing the ORSA and it will enable the use of the SST as a risk management instrument in a more complete manner by all insurers, large or small.
Although FINMA allows simplifications and approximations in the production of multiyear SST figures, the new requirement is likely to have a considerable impact on the production of the SST as well, with increasing demands for automation and finance transformation.
End of the capital relief and adjustment of the SST circular
FINMA announced that it will not extend the SST capital relief that was introduced in 2012. The Federal Council affirmed its belief that the valuation of insurance liabilities should in principle be carried out using a risk-free yield curve, derived from Government bonds.
Although FINMA states that the impact of the relief on the SST ratio across the market as a whole was only a few percentage points as of 1 January 2015 and thus the impact of this decision will not be significant.
However, the temporary adjustment of the deadlines for restoring compliance with the thresholds (i.e. the level of the SST ratio at which FINMA will intervene in the management of a company) will be incorporated permanently into the SST regulatory framework. In general the increased flexibility of the threshold will allow distressed insurers to develop a more sustainable recovery plan.
Additionally, FINMA has signified their intention to redevelop the standard SST model and make it branch specific (i.e. life, non-life, captives, reinsurance, etc). Further, FINMA intends to mandate the use of the standard model in significantly more cases and thus some insurers may be required to move to the standard model, which will generally result in an increased capital requirement for them. It is possible some insurers may challenge this and that the capital adequacy of the industry as a whole would be reduced. It is unclear how flexible the new standard models will be. For example will the addition of new risk factors, within the standard model framework, be considered an internal model, a partial internal model or just a standard model variant? Further it remains to be seen whether firms will use their internal models for ORSA purposes, even if required to move to a standard model for the SST (Pillar 1).
Operational risk quantification
Despite the new requirement in the AVO that operational risk needs to be quantified with the SST, the proposed circulars contain no indication of the specifics of this. It remains to be seen how the new standard models will include quantification of op risk.
Reinsurance captives are now also subject to the SST, rather than the old factor based Risk Based Capital (RBC) regime. These captives will now need to undertake additional calculations and the cost of implementing even the standard model will not be insignificant. In the medium term this may result in a reduced number of captives in Switzerland and less new captive establishing themselves here.
In summary, the proposed requirements on the disclosure and audit of SST figures and the introduction of the Swiss ORSA will have a significant impact on the internal and external relevance of the SST. Many insurers will have to transform their SST production process and enhance its governance.
The introduction of ORSA will turn the SST into a full-fledged risk management tool, whereas the impact of the end of the capital relief is rather immaterial.
- Article: New Swiss ORSA for insurers – first impressions
- Article: Impact of revised FINMA Circular on insurer investment guidelines
- FINMA press release: Changes to insurance regulation
- Insurance Services at KPMG