The document discusses the implications of Solvency II on asset management for insurance companies. It covers the following key points: 1) Under Solvency II, asset values will be marked-to-market, which increases the perceived riskiness of equity and other assets compared to a book value approach. This will impact return on capital calculations for different asset classes. 2) There is debate around what interest rate should serve as the risk-free rate for discounting insurance liabilities, with options including swap rates, government bonds, or AAA-rated corporate bonds. The choice will affect capital requirements and surplus. 3) Sovereign debt from different countries may receive different capital charges under Solvency

1. SII effects on asset management
CFA UK
31 October 2012
Servaas Houben
Maarten Koppenens
1

2. Agenda
• The VaR framework
▫ Return on capital in Solvency II
• The current landscape
▫ Risk free rate in insurance
▫ Spread components
▫ Solvency II framework
▫ Sovereign credit risk
• Opportunities for asset managers
▫ Return on capital optimisation
▫ Hedging and de-risking
2

3. Mark to market value matters
• Value at Risk
▫ Solvency II suggests 99.5% percentile
▫ Over the last 5 years about 1,800 daily returns, 99.5% VaR is the 9th worst
daily return
▫ Equity looks very risky indeed on this measure
3

4. A comparison of VaR across asset types
Source: Bloomberg,
4

5. Assets of European insurance companies
Source: Bloomberg
5

6. The Big 5 dominate - regional asset size
Source: Bloomberg,
6

7. Return on capital - Summary
7
 The return on capital for an individual asset class is calculated as the return above the minimum guarantee rate of 2.5% divided by the required
capital charge for that asset class.
 Viewed in isolation, the RoC of an individual asset class is a straightforward indicator of its attractiveness. However, in the context of the
portfolio, the RoC of the entire portfolio does not necessarily consist of the asset classes with the highest RoC, due to the effects of aggregating
the return and the charge.
2 years
duration
bucket
4 years
duration
bucket
6 years
duration
bucket
8 years
duration
bucket
3% 12% 12% 17% 26% 28% 31%
47% 50% 50% 59%
87%
CLOS(Cash SMEs) Equity Property Mortgages Cov AA Corp AA Brazil (BBB) Collateralised
Funding (USRMBS
AAA)
Collateralised
Funding (High Yield)
Collateralised
Funding (FI
Securities including
CLOs)
Corp BBB Corp A
0% 1% 4% 5% 12% 12% 15% 16% 17% 27% 30% 36% 39% 42%
59% 65%
83%
RMBSUK
(Prime)
RMBSDutch
(Prime)
India (BBB) CLOS(Cash
SMEs)
Equity Property Corp AAA Korea (A) Mortgages Corp AA Cov AA Corp A Corp BBB Brazil (BBB) Collateralised
Funding (US
RMBSAAA)
Collateralised
Funding (FI
Securities
including
CLOs)
Collateralised
Funding (High
Yield)
1% 1%
9%
12% 12% 13%
17%
21% 21%
25% 28% 29%
39%
Russia (BBB) Cov AAA India (BBB) Equity Property Korea (A) Mortgages Corp AAA Brazil (BBB) Corp AA Corp BBB Cov AA Corp A
8%
12% 12% 12% 14% 17%
21% 22%
28% 29%
37% 39%
Russia (BBB) Equity Property Cov AAA India (BBB) Mortgages Corp AAA Korea (A) Corp BBB Corp AA Corp A Cov AA

8. Risk free rate - 1
•Several options for risk free curve:
▫Swap curve with credit adjustment
▫Government curve
▫Corporate bond curves
▫Collateralised AAA curves
8

9. Risk Free rate - 2
Snapshot of market and Solvency II curves
Risk Management  Hedging uses assets quoted on OIS
Pricing (Guarantees)  Funding for hedging based on OIS
Provisioning  Solvency II based on LIBOR & UFR
– One-off surplus (based on current market environment)
– Hedging efficiency and provisioning risk due to LIBOR-OIS basis
EUR
24 August 2012
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
1 11 21 31
Term (Years)
EUR / 24 August 2012 / Spot / Annual
Market LIBOR
Market OIS
Solvency II Risk Free
Source: Bloomberg
9

10. Spread components
•Spread = yield corporate bonds – risk free yield
▫Credit risk factors:
Expected default
Spread widening
Downgrade/transition
▫Non credit risk factors:
Tax
Regulatory
Liquidity
10

11. Solvency II & Basel III spread assessment
• Solvency II favours EEA government debt over other forms of sovereign debt
• Basel III does not make this EEA/non EEA distinction
• Issues regarding the standard formula:
– No capital requirement EEA government/CDS exposure
– No inclusion in default risk module
– Preferential treatment of government bonds
11
Solvency II sovereign
categorisation
Issued in domestic
currency
Issued in non-domestic
currency
EEA government bonds None Level 2 text: Article 156.3 –
high charge
Non-EEA government
bonds
Level 2 text: Article 163
SR7.4 – low charge
Level 2 text: Article 156.3 –
high charge

12. Differentiation EEA governments 1
Yield as per 1 Jan 2006
2
2.5
3
3.5
4
4.5
- 5 10 15 20 25 30
Term in years
Yield:Ger,Fra,Gre,Bri
Germany France Greece Britain
12
Source: Bloomberg

13. Differentiation EEA governments 2
Yield as per 14 Feb 2012
0
0.5
1
1.5
2
2.5
3
3.5
4
- 5 10 15 20 25 30
Term in years
Yield:Ger,Fra,Bri
0
50
100
150
200
250
300
350
400
450
YieldGreece
Germany France Britain Greece
13
Source: Bloomberg

14. Differentiation EEA governments 3
CDS development
-
50
100
150
200
250
31/01/2006 15/06/2007 27/10/2008 11/03/2010 24/07/2011
date
CDSpremiumGer,Fra,Bri
-
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
CDSpremiumGre
Germany France Britain Greece
14
Source: Bloomberg

15. Conflicts of interest government yield curve
• Government can avoid default
• In case of default local regulator is under pressure to write down liabilities
in line with the loss in value of local government bonds
Policyholder
security
Pressures
government to
reduce liabilities
National interest,
stability, political
motives
Insurance
company
Regulator
Government
15

16. Default definition – what’s in a name?
• Dominic Republic 2005:
▫ Recovery rate on defaulted bonds 95%
▫ Rating agencies’ verdict: default
• Zimbabwe 2006:
▫ Annual inflation rate: 1,216% p/a
▫ Rating agencies’ verdict: no default
• Angola 1996:
▫ Annual inflation rate: 4,416% p/a
▫ Rating agencies’ verdict: no default
Default and re-scheduling
1800-24 1825-49 1850-74 1875-99 1900-24 1925-49 1950-74 1975-2006
Africa NA NA 1 1 1 0 1 21
Asia NA NA NA NA 1 2 4 7
Europe 13 9 7 5 2 12 0 7
Latin America NA 15 10 22 13 18 11 36
Default and re-scheduling
1800-24 1825-49 1850-74 1875-99 1900-24 1925-49 1950-74 1975-2006
Africa NA NA 1 1 1 0 1 21
Asia NA NA NA NA 1 2 4 7
Europe 13 9 7 5 2 12 0 7
Latin America NA 15 10 22 13 18 11 36
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Reinhardt & Rogoff

17. Limitations rating agency data
• Lack of historical data: are the
Probability of Default and Recovery
Rate robust?
• Changing data set over time:
historical average not reflecting
future risks
• Lack of transparency: how to
compare different 1-year PDs?
• Difference local and foreign defaults
• No historical 1 year PD for
investment grade (BBB and higher)
• Lowest rating is “mixed” bag
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1983 1990 1995 2000 2005 2010
Moody's distribution sovereign issuer ratings
Aaa Aa A Baa Ba B Caa-C
17
Moody’s

18. Matching Premium – Draft Level 2 Text
18
Methodology
Matching PremiumSpread
= IRR on Asset portfolio - Fundamental Spread - IRR on liability cashflows
(discounted using Solvency II risk free rate.)
Fundamental Spread
= MAX (Minimum Fundamental Spread, Expected Default)
Expected Default
= Probability of Default x LGD + Marked to Market due to a rating downgrade
Minimum fundamental spread
= 75% of Long Term Average Spread
Qualifying Liability
• No future premiumallowed.
• Underwritingrisk covers only longevity, expense and revision risks
• No option for surrender or only a surrender option where the surrender
value does not exceed the value of the assets.
Assumptions
Our analysis assumes:
• Long Term Average Spread by rating and term can be derived from the
iBoxx GBP Corporate Bond Index spread history.
• Fundamental Spread is equal to 75% of Long Term Average Spread.
• Assets are invested in the same index constituents by rating and term as the
relevant iBoxx indices.
Qualifying Assets
• Ring fenced from other insurance portfolio
• Same currency as liability.
• Cashflow matched to liability cashflows.
• Cashflows of the assets are fixed cannot be changed by the issuer or any
third parties. (Except for Inflation linked instruments matching inflation
linked liability)
• Investment grade bonds only
• Limited to a maximum investment of 30% in BBB bonds
• Limited to a maximum investment of 15% in BBB for bonds which are
purchased after 31-Dec-2012

19. Matching Adjustment – Draft Long Term
Guarantee Assessment
19
Matching Adjustment (previously known as Matching Premium) is split into “Classical Matching Adjustment” and “Extended Matching Adjustment”.
Classical Matching Adjustment (Article 77c)
Same as the draft level 2 text “Matching Premium” approach.
• No future premium
• Underwriting risk covers only longevity, expense and revision risks
• No option for surrender or only a surrender option where the surrender value does not exceed the value of the assets.
Extended Matching Adjustment (Article 77e)
The insurance company can apply a portion of the matching adjustment to the portfolio which remains matched under stressed situations.
• Allows future premium
• Underwriting risk covers only longevity, expense, revision, lapse and disability recovery risks.
Key Impact – this widens the scope for applying matching premium to insurance liabilities other than UK and Spanish annuities. Insurance liabilities which
previously were discounted using the risk free curve may be eligible for discounting at a higher yield than risk free yield.
Assessment for Cashflow Mismatch
There will be a breach if one of these 2 conditions is not met for liability cashflows < last liquid point:
a) sum of cashflows < sum of liability cashflows per bucket (monthly, quarterly, semi annually or annually)
b) company unable to provide evidence that any mismatch shall not jeopardize the timely payment of benefits
Admissible assets
• The limit on BBB rated bonds is 33.33%, excluding member state government bonds.
• Make-whole clauses on callable bonds are eligible.
• Cashflows of a single asset cannot be split into admissible & inadmissible parts.
Fundamental Spread
• Some preliminary fundamental spread was presented for GBP and EUR corporates grouped by ratings, sectors and duration bands.
SCR Treatment
• Under the SCR module, the increase in spread assumed in the spread SCR module can be passed on the discounting of liability as well.
• This means that the liability value may be reduced under the matching adjustment treatment leading to a lower spread SCR when holding credit.
Transitional Measure
• It appears that if the matching adjustment treatment is elected then the transitional measure would no longer apply.

20. Proposed Scenarios for the
Quantitative Assessment
20
I - Adapted relevant risk-free interest rate term structure
No adaptation
Standard adaptation
50% of standard adaptation
200% of standard adaptation
Standard adaptation only for liabilities w/ duration > 7 yrs
II - Extrapolation
QIS5 with LLP of 20 yrs for EUR
LLP 20yrs for EUR, 40 yr convergence
LLP 20yrs for EUR, 10 yr convergence
III - Article 77c Matching adjustment
No Matching Adjustment
Matching Adjustment
IV - Article 77e Matching adjustment
No Matching Adjustment
Matching Adjustment using standard adaptation for lapse risk
Matching Adjustment using alternative adaptation for lapse
risk
V - Transitional Measures
No transitional measure
Transitional measure applied to all existing business
Transitional measure applied to paid in premiums only
VI - Scenarios
Reference date 31 December 2011
Reference date 30 June 2012
Reference date 31 December 2010
Reference date 31 December 2004
Prolonged low interest rate environment for 7 years

21. Matching Premium vs Liquidity Premium (1)
21
Historic Comparison of iBoxx EUR Corporate A 10Y Matching Premium vs QIS 5 Liquidity Premium
1. Low spread
environment
generates a
negative matching
premium when the
spread falls below
the fundamental
spread.
3. Post 2007
Matching Premium
exceeds QIS 5
Liquidity Premium
due to spread
widening.
2. Pre 2007 -
Matching Premium
is below the QIS 5
Liquidity Premium.
QIS 5 Liquidity Premium
QIS5 Liquidity Premium (currency)
= 50% x MAX (iBoxx Corporate Spread (currency)- 40bps, 0)
• Varies by currency
• Independent of assets held
• Is fixed for the first 30 years of maturity and then set to 0.
• Floored at 0
Matching Premium
Matching Premium (rating, term, currency)
= 100% x [iBoxx Corporate Spread (rating, term, currency)- Fundamental
Spread (rating, term, currency)]
• Varies by currency and rating
• Dependent of assets held
• Varies by maturity term.
• Can be negative.
• Matching Premium for BBB corporate is capped at the AA or A level.

22. Matching Premium vs Liquidity Premium (2)
22
iBoxx EUR AAA 10Y Corporate iBoxx EUR AA 10Y Corporate
iBoxx EUR A 10Y Corporate iBoxx EUR BBB 10Y Corporate
Temporary spike in
spread due to GE
downgrade from
AAA to AA
Matching Premium
for BBB bonds is
effectively floored at
the AA level
regardless of the
spread on the BBB
bonds.
QIS 5 Liquidity
Premium is fixed
and independent of
the rating of the
bonds invested.
Historic Comparison of iBoxx EUR Corporate 10Y Matching Premium vs QIS 5 Liquidity Premium by rating

23. Sample Matching Premium Calculation
– iBoxx Corporate Index
23
Based on our understanding of the likely proposal for Matching Premium, we have provided an estimate of the matching premium by
rating and maturity term.
Long Term Average Spread = Average Z
Spread on iBoxx Indices.
Note that there is no history prior to the
inception of iBoxx indices back in 1999.
Fundamental Spread =
75% x Long Term Average Spread
iBoxx Corporate Spread =
Z Spread to Swap Curve
Matching Premium Estimate=
iBoxx Corporate Spread – Fundamental
Spread Matching Premium for
BBB bonds is
effectively floored at
the AA level . Hence
the overlapping line
for BBB and AA
corporates.

24. About us
Servaas Houben heads the risk scenario generation team at Prudential, London.
He studied econometrics in the Netherlands and worked in life insurance for the
first four years of his career. Following this, he worked in Dublin and London.
Besides actuarial, Servaas completed the CFA and FRM qualifications, and
regularly writes on his blog, for CFA digest and Dutch actuarial magazines.
• Email: servaashouben@gmail.com
• Blog: http://actuaryabroad.wordpress.com
• Tel: +44 (0) 207 548 2774
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Maarten Koppenens joined UBS in April 2010 and is responsible for Dutch
insurance solutions focusing on accounting and regulatory frameworks, liability
management and optimalisation of asset allocation. Prior to joining UBS, Maarten
worked at Swiss Re as a marketing actuary focusing on de-risking of insurance
liabilities. Besides being a qualified actuary, Maarten holds a degree in
econometrics and an MBA.
• Email: maarten.koppenens@ubs.com
• +44 (0) 207 567 4357

25. References & contact details
• Churm & Panigirtzoglou, Decomposing credit spreads, Bank of England working paper no 253
• Kahneman, Thinking fast and slow, 3 November 2011
• Moody’s, Corporate Default and Recovery Rates, 1983-2010, February 28, 2011
• Moody’s, Narrowing the gap – a clarification of Moody's approach to local versus foreign
currency government bond ratings, February 2010
• Moody’s, Sovereign Default and Recovery Rates, 1983-2010, May 10, 2011
• Reinhart & Rogoff, This time is different: A Panoramic View of Eight Centuries of Financial
Crises, April 16, 2008
• Remolona, Scatigna, Wu, A ratings-based approach to measuring sovereign credit risk,
International Journal of Finance and Economics volume 13 (2008)
• S&P, Sovereign Defaults And Rating Transition Data, 2010 Update, 23 Feb 2011
• Webber – bank of England, Decomposing corporate bond spreads, 2007Q4
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