Presentation on theme: "A Review of the Capital Requirements for Life Insurers in India"— Presentation transcript:
1 A Review of the Capital Requirements for Life Insurers in India By Jim Thompson , Raju S,Richard HollowayThis paper provides an overview of how life companies determine the amount of capital required to run their businesses, focusing in particular on the current and future situation in India.As we will see in the paper solvency is only the minimum amount of capital required to run the business. A more appropriate question management needs to know is what level of capital is appropriate for my business.Here in India we live in interesting times for the Life Insurance industry as new players with the backing of large international companies enter the market. For these new entrants the capital that is likely to be required in the Indian market is of prime importance to them. The initial experience indicates that the level of capital may be more that was envisaged in the initial business plans. The competition is quite intense as companies scramble for market share with very competitive products.The amount of capital required has been set as the minimum of50 CroresAn amount of capital dependent on the insurers mathematical reserves and sums assuredInitially the amount of capital will be dominated by the 50 Crore – however this will soon change to capital dependent on the size of business.This paper will be making the following pointsInternational markets are changing their approach to capital requirements from a formula driven approach to one size fits all to a Risk Based Capital (RBC) where the amount of capital is dependent on the risks undertaken by the insurer. The level of capital is dependent on dynamic solvency computer simulations.The greater the risk taken by the insurer, the greater is the level of capital required.There are some anomalies in the current system which can make the pricing of term products and rider benefits expensive to the consumer as large capital is required.Our recommendation is that the regulator considers moving to an RBC approach within the next 3-5 years and that the industry prepares itself for such a shift.Presented at the 5th Global Conference of Actuaries - Delhi, February 2003
2 Content Background The current situation in India Developments in other marketsConclusions and recommendations for India
3 Why Capital/Solvency Margin? To give the regulator and the policyholder the peace of mind that he will be paid what he has been promisedLife Insurance companies are in the business of taking long term risks. Risk is about the probabilities of something happening. Access to capital is required when the something does happen.The regulator and the policyholder want to be assured that the company has enough capital to remain in business. The shareholders of the company on the other hand want to make sure capital is used efficiently and the business is profitable. The company needs to have adequate capital and also be solvent.RBC is a methodology that identifies the amount of capital required to remain solvent. It also identifies when a company has adequate capital.
4 Major risk areas of a life insurance company Life insurance company risk universeInvestment riskMarket riskLiquidity riskCredit riskCurrency riskMismatch riskOperational riskExpense riskNew business riskInsurance riskIn the extreme, all of us – insurance companies included – are exposed to a near infinite number of distinct risks. To help an insurance company identify and manage the risks that it is exposed to it is first helpful to classify risks into groups. A potential set of risk classifications could be:Investment risk – covers the better understood risks involved in holding assets for a purpose. This area is sufficiently developed that it suits us to further break this down into sub-classesMarket risk – adverse movements in asset values and incomes due to market forces.Credit risk – complete loss of capital on investments due to the default of counter-parties.Mismatch risk – divergence in the value of asset proceeds and the purpose for which they are held.Liquidity risk – inability to convert the investment held to a form (usually cash) suitable for it’s ultimate purpose without destroying value (anything can be sold, but at what price).Currency risk – a special case of mismatch risk in which divergence of value is due to currency exchange ratesBeyond the class of investment risks come classifications that are in some cases less well understood or defined:Operational risk – examples would include IT risk, (eg back up procedures, risks of viruses etc) and fraud.Expense risk – the risk that expenses get out of control eg the impact of devaluationsNew business risk – this can operate in two directions. The risk of too little new business is more obvious, with implications for expense levels and expense overruns, however excessive new business acts as a strain on solvency if valuation bases are more prudent than pricing bases (often the case).Insurance risk – the core experience risks taken on by insurers. The risk of too heavy mortality or too light mortality falls into this group alongside morbidity and lapse experience. Lapse experience can also cut both ways and business supported by punitive surrender values are exposed to the risk of greater than anticipated persistency.Group risk – despite the careful management of your own company’s risks, the activities of other related companies may introduce the chance of strains on solvency coming from the cashflow struggles of a parent (particularly when the capital of multiple financial institutions is managed collectively at a group level as is the case for many banking organisations).Credit risk – beyond the risk of borrowers defaulting on issued debt, or the complete loss of value of an equity holding, any organisation which may have a liability to the insurer should be assessed for credit risk. The most likely example here is that of reinsurer default.Regulatory risk – while non-compliance with regulations often carries financial penalties, the second order impact of negative press also warrants considering. With these things in mind the role of compliance officers and proper staff trainingOther risks – this should cover every exposure that doesn’t fit snugly in one of the above categories. Meteor strikes may be far a field but an earthquake is not. Are electronic records backed up sufficiently far away that in the event of a nuclear strike surviving policyholders can find out their fund balances. Legal risks could also be included here.Having identified and quantified all our areas of sensitivity, it is then appropriate to consider if there is correlation between risk groups. In this information age, a failure in one area, even if already anticipated, may affect confidence in other areas. An easy example is the relationship between falling asset markets and surrender rates. It is very difficult to identify the correlation between risks and even harder to quantify the effect of correlations.Group riskCredit riskRegulatory riskOther risksCorrelation between risks
5 Internal and external risks – Examples Bonus structure and policyholders’ expectation of a smoothed return has meant that the fall in investment markets cannot be fully passed onRegulatory issuesIncrease compliance costsCompensation costs from mis-selling (USD20 billion)Government imposed product pricing (UK)Increasing solvency requirements (Phase 2)High level of guaranteed investment returns and mismatching as a result of falling investment returnsDistributor pressureRising costsCompetition from cheaper channelsOther guaranteesAnnuity optionsSurrender valuesBenefits on investment-linked contactsSome more specific examples of insurance risks are as follows.Internal risks are those that an insurer controls itself.External risks are risks that are less easy to control and are often forced upon companies by external forces.To protect the public, regulations are imposed, which of course, carry the risk of sanctions if they are not adhered to. In fact retrospective assessments of improper action (which may have been legal at the time) may carry penalties. While profits are desirable, there is the risk that they may be pursued at too great an expense to others. Identifying exposure to rules that are not yet in place may seem a bit hopeful, but if actions are assessed with a sufficient degree of independence and objectivity, their implications beyond today’s bottom line is more easily assessed. Needs assessment tools to determine whether a product is right for the policyholder and not just the company or the distributor are a subtle example of risk management.Besides governments and their agents, there are competitors and partners. In each case their actions will affect us. This much we know but can we develop models to quantify the effect of actions by others and can we attach probabilities to these actions.Asset market movements while unpredictable are at least familiar. In many ways this is due to the significance of the risk and the length of time we have been conscious of it.Falling investment marketsMerger and acquisition activity(Declining value in acquisitions)
6 Common risks that the Indian insurer faces…. Asset defaultMortality and Morbidity understatedInterest Margin PricingInterest MovementsGuarantees givenBusiness RisksThe following risks are perhaps most relevant in the Indian market today.The asset default represents the risk of loss of principal and interest due to defaults under fixed interest investments and loss of market value for equities and fixed interests.A common insurance risk relates to the choice of assumptions for mortality and morbidity, which given the lack of historical data leads companies to take on risk. In the case of health and morbidity this could be significant, without the support of a reinsurer. For annuities the risk is of mortality improvement which needs to be factored into the pricing; failure by companies to adequately allow for this in other markets has proved to be very costly.The downward movement in interest rates has been significant over a short period of time. This will be impacting significantly on the profitability of many products, especially non-participating products. Changes in interest rates can have major implications for pricing of new products and the sustainability of existing business.The provision of guarantees need to be considered carefully. Very few companies now offer guaranteed annuity rates and defer the terms of the annuity until vesting. Other guarantees need to be considered as they invariably require companies to hold a greater level of capital.Business Risks coverRisks associated with failure of systemsImprudent management decisionsFraudLitigationChanges to Government policies eg taxationChanges to the competitive environment – particularly relevant in India today as new companies fight for market share.Changes in capital markets
7 Traditional approaches to determining capital requirements AbsoluteamountRs. 50 croresFixedfactors6% reserve +0.45% sum at riskAbsolute amountwith fixed factorsMAX[6% reserve %sum at risk. Rs. 50 crore]Traditionally regulators have defined capital requirements in fairly simplistic terms. In general, the terms and formulae are the same for most companies, irrespective of their size and the nature of the business.The most simplistic approach is a requirement to hold a cash sum. The problems with this approach include how to set the sum, the fact that it is the same for each company, and the need to update the amount over time as a result of inflation etc. An absolute number is the extreme form of one-size-fits-all capital adequacy assessment.A proportional approach using fixed factors is more appealing as the capital does vary depending on the size of the company. The link to reserves does however need to be controlled. For example, under-reserving reduces the requirement for additional capital rather than increasing it. For this reason this approach tends to be combined with the regulators specifying a minimum valuation basis. The percentage of sum at risk ensures that there is still a capital requirement for policies with low reserves, yet high sum at risk (eg term assurance).The combination of the fixed factors and an absolute sum has the ability of ensuring a minimum level of capital, but with the formulae approach being adopted as companies reach a certain size.Another approach is dynamic solvency testing, where capital requirements are not set by a formula. Rather the company carries out financial projections under various scenarios to determine the required level of capital . Where this falls down is that the regulators often choose the scenarios, that may or may not be reasonable scenarios for a specific company to adopt. If the company has the discipline to choose scenarios that are appropriate for its own situation, this may be more appropriate.None of the approaches above relate the capital requirements to the specific risks that a company may have.Dynamicsolvency testingSolvency testing underprescribed scenarios
8 What is Risk Based Capital A realistic assessment of the capital requirements for the risks being runRisk BasedCapitalVaries from company to companyTends to focus on the key measurable and quantifiable risksIntroduced in many of the more developed marketsRisk Based Capital is a ‘new’ approach for determining capital where the capital requirements are related to the risks within a specific company.The move to RBC has followed developments in the banking sector. With regulators wanting to develop a level playing field in terms of capital requirements across different financial instruments RBC is slowly being introduced into the insurance sector. One implication of this is that regulators can supervise the industry based on their perception of the relative risks of different companies. Ie the more riskier companies attract a greater amount of supervision.
9 Content Background The current situation in India Developments in other marketsConclusions and recommendations for India
10 India – Overview of solvency requirements Typical formula approachSimplistic and easy to administerWorking solvency margin is 150% of the formulaMinimum solvency requirement of Rs 50 CrSolvency margin can be met by Surplus from Policyholder fund and Shareholder fundIndian regulations prescribe the Gross Premium method for policy reserves and a standard formula approach for the capital requirement that is very similar to EU requirement. It basically prescribes x% reserves and y% of sum at risk as capital requirement, where Sum at Risk is Sum Assured less Statutory Reserves. This is obviously simple and easy to administer, though not equitable.In practice companies are required to hold 150% of the formula result as their minimum capital. On top of this, there is an absolute minimum capital requirement of Rs 500 million (50 crore). The capital requirement can be met through share capital and retained surplus created through undistributed bonus in the policyholder account
11 Valuation of assets and liabilities Assets are largely valued as a mixture of book value and market valueNo explicit charge for Asset RiskCertain assets are inadmissible for solvency purposesGross premium method for policy reserves with allowance for future bonusesThe policy reserves include some “solvency margins” via the Margins for Adverse DeviationsAssets are largely valued as a mixture of book value and market value. Unrealised gains/ losses arising due to changes in the fair value of equities shall be taken to equity under the heading “Fair Value Change Account”. Fair value changes in the case of equities and Revaluation reserves in the case of properties as directed by the regulators can be used to top-up surplus for bonus declaration. It is also clarified that no other amount shall be distributed to shareholders out of Fair value change/Revaluation reserves.When it comes to demonstration of solvency, fair value changes in equities are deducted in Form AA (as reflected in Form K- Table III- Note 1). It is not clear whether similar treatment is intended for properties. It is also not clear whether a different treatment is intended for shareholders fund (as reflected in Form K- Table III- Note 4).Certain assets like Furniture, fixtures etc are inadmissible for solvency purposes. There is a provision to charge for Non-mandated investments of the policyholder fund. Currently this charge is set to zero.Policies are to be valued by the Gross Premium method with assumptions set by the actuary. Explicit provision is required for future bonus, profits and taxation for participating policies.Much of the capital requirement is built into the policy reserves through margins for adverse deviation (‘MAD’). Currently, there is no specific requirements/guidelines with regard to the level of MAD, but this is likely to be developed by The Actuarial Society of India.
12 Solvency requirement Non-linked business: Linked Business: 4% Reserves + 0.3% Sum at riskLinked Business:with guarantees: 2% Reserves + 0.2% Sum at riskwithout guarantees: 1% Reserves + 0.3% Sum at riskGroup Business:premiums guaranteed for not more than one year:1% Reserves + 0.2% Sum at riskpremiums guaranteed for more than one year:3% Reserves + 0.3% Sum at riskThe regulator requires companies to hold 150% of the amount calculated above.Some of the issues that arise from the application of this approach are:Non-linked business: there no differentiation between par and non-par policies.Linked Business- with guarantees: there is no reference or link to the level of guarantees involved.Linked Business- without guarantees: it is debatable if there is actually a need for capital.Group Business: the current capital requirement is quiet onerous for pure risk products.Credit for reinsurance is available up to a certain level - up to 15% of Reserves and 50% of Sum as Risk.
13 Solvency requirement for rider policies Similar treatment for base policies and ridersSimplistic examplePremium = 1.5 ‰Reserves = 0.75 ‰Required solvency margin (RSM) = 3.03 ‰150% of RSM = 4.55 ‰The capital requirement is quiet onerous for pure risk policies eg Riders and Group Term policies.In this example RSM = 4% Reserves + 0.3% Sum at risk = 3.03‰. As given above the capital requirement can easily be three times the premium or six times the reserves.In addition to this, other restrictions on rider policies such as the classification of all riders attaching to participating policies as participating business, the restriction that rider premium cannot exceed 30% of the base premium, and the restriction that a rider sum assured cannot exceed the base sum assured all contribute to make rider policies unattractive.
14 Limitations of current framework Formula approach for solvency does not vary between companiesDoes not differentiate between different mix of business e.g. par and non-par businessLittle differentiation between insurers with good and bad investmentsNo reflection of the specific risks that each company is exposed to.No allowance for the mismatchingIt is just one formula for all companies.
15 AnomaliesPenalizes companies holding stronger reserves by imposing higher solvency requirementsOnerous requirement for pure risk policies e.g. Riders and Group Term policiesLighter requirement for health insurance (e.g. 4% reserves), which is known to be a riskier businessUnder the current system Companies holding stronger reserves need to hold higher capital. The RSM formula of 4% Reserves + 0.3% Sum at risk can be rearranged as 3.7% Reserves + 0.3% Sum Assured. With Sum Assured being fixed, the Capital requirement becomes an increasing function of Reserves.As we saw earlier the capital requirement for Riders and Group policies are onerous.The Capital requirement for health business is driven only by the reserves held and is independent of Sum at Risk.
16 Content Background The current situation in India Developments in other marketsConclusions and recommendations for IndiaThe overseas developed markets we will be looking at areUKUSACanadaAustraliaSouth AfricaSingapore
17 UK – Valuation of liabilities Net Premium method with appropriate marginsPRE to provide for appropriate level of RB to emerge, but provision of TB not requiredMortality/Morbidity rates determined by Appointed ActuaryValuation interest rate reflects yield on existing assets less 2.5%Resilience Reserves determined on various scenariosSufficient to cover prescribed scenariosDifferent scenarios for par (3 scenarios) and non-par business (1 scenario)In the United Kingdom, the valuation of liabilities is an amalgamation of multiple approaches coming from gradually changed thinking on what needs to be achieved by a valuation.Traditional participating business has retained a net premium approach however market value awareness is introduced by using valuation interest rates based on the yields on the assets held by the insurer. Non-participating business and unitised with profits business have migrated to a gross premium approach with margins incorporated into the assumptions.All assumptions are at the discretion of the Appointed Actuary however legislation and professional guidance instruct the Actuary on the degree of prudence that is expected in selecting assumptions. In some cases limiting conditions are applied to certain key assumptions such as the valuation interest rate (restricted to 97.5% of the yield on backing assets).While most insurance risks are left to be covered by the margins in the valuation assumption, the regulators concern for the exposure to investment market risks is reflected in the design of dynamic solvency tests to determine a resilience reserve. UK resilience reserves act as a stress test on the capital resources of the insurer and prescribe combinations of equity and property market falls alongside changes in fixed interest yields. Assets must be sufficient to meet the prudent valuation of liabilities under each scenario.Recent rule changes, brought on by current market conditions, have revised the equity component of the scenarios to reflect falls from the 90-day average market level prior to the valuation date rather than the market level on the valuation date. This is an example of the context sensitivity of rules that is desired by UK regulators.
18 Capital requirement Single tier capital requirement – Solvency margin Solvency margin defined as % of SAR and policy reservesMinimum solvency margin is 800,000 ECUAssets held at market value/net realisable valueCertain assets are inadmissible for solvency purposesBeyond the prudent policy reserves and the global resilience reserve (which is treated no differently than the individual policy reserves), there is a single element of additional capital required.This solvency margin is calculated as the maximum of an absolute amount and the result of a fixed factors formula. The factors to be applied are a percentage of reserves to cover investment exposure and a percentage of sum at risk to cover claim exposure however even here an element of context sensitivity is introduced. For certain classes of business the factors will vary by the extent of guarantees offered by the product. Unit linked contracts may require solvency margin of up to 4% of reserves, but this percentage may be reduced to 1% if there are no investment guarantees or fall further to 0% if there are no guarantees on the level of expense charges.The variability of factors is the result of efforts to consider the risk exposure of the insurer in setting it’s capital requirements. You may write business with guaranteed annuity rates but you are expected to hold greater capital to support this than someone who offers only to invest a policyholders money and return it.While assets are held at market values there are restrictions on admissibility. Again, risk exposure drives the rules. A list of familiar asset classes are allowable and anything outside of this list is not considered. It doesn’t mean that rare art in the lobby is not a viable investment, but it does mean that the risks associated with such an investment are outside the range the regulator is willing to consider. Even within the permitted asset categories the maximum exposure to a single counterparty is restricted to 2.5% of aggregate assets.Counterparty restriction extends to reinsurers as well as the maximum credit that can be taken on the value of a reinsurance treaty is driven by exposure limits.The EU has announced plans to review the solvency calculations and changes can be anticipated more in line with risk based approaches.
19 USA – Valuation of liabilities Net Premium method with a prescribed minimum basisMortality – 1980 CSOPrescribed dynamic maximum valuation interest rateAdditional cash-flow testing requirementAsset adequacy using cash-flow testingProject asset and liability cash flows (excluding new business) under various scenariosThe rules for prudent valuation of liabilities in the US varies as each state has its own insurance commission with state specific regulations and jurisdiction. Given the 5,000+ insurance companies in the US, this degree of regulatory subdivison may in fact be best, however, it does introduce room for variance in requirements. The National Association of Insurance Commissioners offers some assistance in homogeneity as regulation templates are the basis of most state rules.The net premium method is employed with state prescribed valuation bases. Asset adequacy is assessed using cashflow projection techniques, however the differences in valuation bases are smoothed out by the application of a nationwide risk based capital assessment that calculates higher capital requirements for companies with less prudent valuation bases and vice versa. As a result, the national RBC standards become the common factor in US capital requirements.
20 Capital requirement Risk based capital requirement Minimum capital specified based on company’s size and risk profileRBC identifies major risk factors with an adjustment for correlation between the various risks: Risk Category RBC Regulatory TriggerAffiliates Risk (C0) >199% No action requiredAsset Risk (C1) 150% – 199% Company actionInsurance Risk (C2) 100% – 149% Regulatory actionInterest Rate Risk (C3) 70% – 99% Authorised actionBusiness Risk (C4) <70% Mandatory controlRBC = f (C0,C1,C2,C3,C4)The NAIC specifies a risk based capital model applicable to US insurers. The system has two main components:RBC formulae establish hypothetical minimum capital levels that are compared with actual levelsRBC model law grants authority to state insurance regulators to take action based on the level of impairmentAffiliates risk is really a sub-group of assets risk as it assesses the risk of default on affiliated investments. This is taken as the RBC requirement of insurance subsidiaries while different factors are applied to other subsidiaries.Asset risk represents the risk of default for debt securities and the risk of capital losses on equity type holdings.Insurance risk factors calculate the capital required for claim variance and pricing inadequacy.Interest rate risk addresses the sensitivity of the insurer to changes in interest rates. Close matching of cashflows will reduce this component while aggressive mismatching will increase the requirement.Business risk covers a wide range of general risks faced by life insurers. Formulae consider elements such as the variability of operating expenses, collectibility of payments and even exposure to excessive growth.A covariance formula is applied to allow for correlations between the events and is designed to reflect the fact that the cumulative risk of the independent events is less than the sum of the individual risks.Following the assessment of the minimum capital level, the relative solvency of the insurer dictates what action is taken.At 200% of the minimum or above, no action is required.Between 150% and 200% an insurer must submit a report outlining the corrective actions that will be taken and the conditions contributing to the current financial state of the company.Between 100% and 150% the action plan is required however the state insurance commissioner now performs examination and analysis itself and issues corrective orders based on it’s judgement.Between 70% and 100% a regulator may take control of an insurer.Below 70% a regulator is required to take control of the insurer.It is worth noting that control may be ceded to the regulator while the company is still solvent (ie assets exceed liabilities).
21 Canada – Valuation of liabilities Gross premium valuation with margins for adverse deviationMargins represent limited and reasonable level of mis-estimation and deterioration from expected experience scenario assumptionsDue regard to PRE (provision for all future bonuses)Discount rate dependent on existing asset yieldsNo resilience reserve requirementAll assets are admissibleCanadian valuations (overseen by the Office of the Superintendent of Financial Institutions) employ a gross premium method with explicitly prescribed margins for adverse deviation applied to best estimate assumptions selected by the appointed actuary. Margins are chosen to add a level of prudence without being overly cautious so as to allow manipulation of reserves.All future distributions of surplus to policyholders are considered and the valuation interest rate to be used is dependent on actual backing asset holdings and yields.
22 Capital requirementRisk based capital requirement-Minimum Continuing Capital and Surplus Requirement (MCCSR)MCCSR determined by applying factors to each of four risk components and adding the resultsRisk components of MCCSR and composition of total capital requirement (at year end 1998) wereAsset default risk %Mortality/morbidity/ lapse risk 31%Interest margin pricing risk 4%Changes in Interest Rate Environment Risk 15%Target MCCSR ratio is 150% (however may vary according to individual company risk profile)The Minimum Continuing Capital and Surplus Requirement (MCCSR) parallels the US risk based capital assessment as risk classes are specified and factors are used to quantify the capital required to protect against the risk identified.The classes identified are familiar:Asset default risk – including the risk of reinsurer defaultMortality/morbidity/lapse riskInterest margin pricing risk – representing risk on investment decisions and pricing assumptions other than asset default and interest rate movementChange in interest rate environment riskWhile several main risk categories are not explicitly identified such as business risk and expense risk, the target solvency level of 150% of the MCCSR is set to exceed 100% to cover further unmodelled variances. The OSFI recognises two tiers of capital. Tier 1 core capital is expected to make up 105% of the MCCSR while tier 2 supplementary capital may account for the balance if neccesary. The MCCSR stands as guidance rather than legislation to allow for greater flexibility and easier amendment as views on risks and the appropriate margins to cover them evolve.
23 Australian – Capital Adequacy Standards Margin on Services Valuation – Gross Premium BasisStatutory Valuation = BEL + Profit MarginAll assumptions are based on the latest best estimates at the time of valuation – pro active basisAustralia introduced a new valuation methodology in the 90’s coupled with a two tier level of capital management regime based on the RBC approach. The two tier approach to capital was influenced by the Canadian model.A gross premium valuation is adopted with one extra feature in that the valuation liability does not change markedly as a result of assumption changes. Reserves can only be released according to a profit carrier e.g. premiums or claims. The only profit you can release is that for the current year i.e. you can not capitalize the expected profits for future years. This gives a much more stable pattern of profit. The overall framework is ofter referred to as the ‘Margin on services’ approach for valuing liabilities.Both the asset and liabilities are valued on the latest market bases - i.e.they can change every valuation.Although this valuation framework was considered leading edge, the future of the Margin on Services approach does not fit with the introduction of fair value accounting. A move to a more traditional gross premium valuation approach is likely.
24 Two Tiered level of Capital Adequacy Solvency StandardIntended to ensure Solvency of the companyDisclosed in the Financial StatementsCapital Adequate StandardIntended to ensure financial soundness of the company as and ongoing concern.Not disclosed in the financial statementsUnlike India where there is only one level of solvency Australia has two levelsThe first stage is you meet the Solvency Standard which basically means you meet the bare minimum to remain in business but the regulator is heavily involved in the affairs of the company. The solvency levels are published in the accounts of the company.Companies are required to cover the solvency level and many companies use it as a marketing tool to say how much their reserves exceed the solvency standard. 1.5 times or 2.0 times.The second stage is you meet the capital adequacy standard by which the regulator regards you as not on the endangered list and you are free to operate freely. In the assumption setting for capital adequacy the Appointed Actuary is required to set assumptions he believes are appropriate for his company – i.e. they are unique for each company.
25 Requirements Solvency Solvency Requirement Other Liabilities Resilience ReserveInadmissable Assets ReserveExpense ReservesCapital AdequacyCapital Adequacy RequirementOther LiabilitiesResilience ReservesInadmissable Asset ReserveNew BusinessReserveThe solvency standard requires you not only to use more stringent assumptions than those used in the valuation but it also requires you to hold other reserves for the risks identified in the earlier part of the presentation. These other reserves are listed in the slide above.Resilience reserves are the reserves necessitated by the mismatching of assets and liabilities.The expense reserve for solvency is the provision for expenses which can occur should the company close to new business and which are not anticipated in the Solvency liability.Inadmissible assets are assets dependent on the ongoing business, associated financial entities, and concentrated assetsNew business reserves for capital adequacy are provisions for planned business initiatives over a prescribed period of three years.
26 Margins Capital Adequacy Solvency Min. Max. 110% Best Est 110% 140% 0.25% 0.5% 2.5%MortalityDisabilityCriticalIllnessIn Australia the assumptions do not give the Appointed Actuary leeway as most of the assumptions are prescribed whereas for capital adequacy the Actuary is free to choose within a range a level that he feels appropriate for his company.The same approach is taken with the setting of investment assumptions.InvestmentLinked
27 Investment Assumptions Solvency Capital AdequacyMinimum MaximumGross Redemption BE – 0.4% BE – 3.0%Yield of a 10 yearGovt SecurityThis slide shows the Solvency is regimented but the Capital Adequacy standard is more attuned to the risks the Actuary believes the company is running.
28 Resilience ReservesThe amount that needs to be held before the happening of a prescribed set of changes in the economic environment such that after the changes the company is able to meet the liabilities of the fundA resilience reserve is part of the standards. The assumptions are specified for both solvency and capital adequacy. The appointed actuary sets the assumptions for his own company for capital adequacy but is restricted by prescribed maximum and minimum assumptions.
29 Resilience assumptions Solvency Capital Adequacy1.25% 0.5%+(0.4xYield)1.25% %1.75% %+(0.2xYield)0.6% 1.0%10% 15%EquityPropertyInterestBearingIndexedBondsThe resilience reserves can not be less than zero.The figures above refer to an adverse change in the levels described above. In calculating the resilience reserves these assumptions are also fed into the liability.Currency
30 Singapore – Valuation of liabilities Looking to move to a gross premium basis - basis selected by actuary, having regard to professional guidance (a change from net premium valuation)A PAD is added to the best estimate liabilities.Propose risk free rates are used for non-participating business (based on government bonds).Can significantly increase liabilityFor many years Singapore has used a net premium approach for valuing liabilities.Late in 1999 the regulators (Monetary Authority of Singapore) wanted to look at an RBC approach for determining capital adequacy. This also necessitated a review of the regulations for valuing liabilities. After much work and debate within the industry the MAS is now thinking of introducing a gross premium approach for valuing liabilities along side an RBC approach for determining capital.The gross premium approach has margins or PADs. Although the framework has yet to be completed it is likely to necessitate much professional guidance to help the actuaries select assumptions.Risk free rates are proposed for the valuation of non-participating business, which can lead to significantly higher liabilities than the current net premium approach for some classes of business.The choice of the gross premium methodology was also selected having regard to the likely requirement for fair value accounting. Initially the MAS was looking to use the Australian Margin on Services approach but this is considered to be inappropriate for a fair value framework.
31 Singapore – Capital requirements Regulators are proposing a change to the current traditional framework (3% reserves per mille of sum at risk) that is more in line with banking sector, is risk based, flexible and transparent.New framework will have a fund solvency requirement (for each fund) (‘FSR’), and an overall capital adequacy requirement (‘CAR’).A RBC approach is being proposed for determining capital requirements.There will be a fund solvency requirement for each fund (eg participating, non-participating) and a capital adequacy requirement at the company level.The final parameters are yet to be finalised. The MAS has required the industry to go through an intensive testing period so that it can understand fully the implications of the new framework and so that it can gather information to help it set the parameters for the framework. With an industry that comprises of few companies that differ in size significantly, this is not a straightforward task. The volatile nature of the Singapore stock market also makes the selection of assumptions difficult.
32 Singapore – Capital requirements FSR takes in to account liabilities and risks in the form of three components:LC1 - Liability component (as per valuation with margins)LC2 - Market, Credit and Mismatching RiskLC3 - Inadmissible asset risk componentFSR = LC1+LC2+LC3 - Value of liabilitiesCapital adequacy such that:Available capital/Required Capital > Specified minimumThe derivation of the fund solvency requirements is described above.Three calculations are carried out to assess the three components LC1, LC2 and LC3 from which the value of liabilities is deducted. Hence the FSR is essentially a margin over and above the value of the liabilities.
33 Singapore – Fund Solvency Requirement LC3Inadmissible AssetSurplusFund Solvency RequirementLC2Market, Credit & Mismatching Risk ComponentPolicy LiabilityFair Value of AssetsLC1The approach can be represented graphically.If the project goes to plan, the new framework will be introduced as at the end of There is however still much work to be done. One key issue is the impact the new regime has on taxation. There is also a requirement to draft new legislation and professional guidance. If the framework does get introduced there could also be a phasing in period where the new approach is blended with the current approach for a number of years.It is worth noting that the entire process is likely to have been planned and implemented over a period of 3 to 4 years.Liability Component
34 South Africa Capital Adequacy Requirements Gross Premium Valuation BasisOne level of Capital AdequacyRBC ApproachThe South African market is one of the most developed in the world with very little in the way of government support to the populace. People need to make their own provisions for their retirement and any calamities they might meet on the way. The insurance companies provide the products for this.This gross premium valuation and RBC approach to solvency was introduced in the late 1980’s(1986) so we have seen in the 80’s and 90’s a shift around the world to this approach to solvency and capital adequacy as computer power grew. This gave the actuaries the tools to compute the capital required by each individual company. The risks vary between the companies and so should the capital.South Africa has only one level of capital adequacy but considers the capital required for a much larger number of parameters in isolation.
35 OCAROCAR = IOCAR grossed up for the effect of the assumed fall in fair value of the assets backing itOCAR = IOCAR/0.7 if assets in equities assumed to fall 30%OCAR = IOCAR if assets in cashOCAR stands for Ordinary Capital Adequacy requirements. The OCAR is the IOCAR which stands for the Intermediary Ordinary CapitalAdequacy requirements grossed up for the effect of an assumed fall in the value of the assets backing it.
36 IOCARIOCAR = Intermediary Ordinary Capital Requirements before taking into account the effect of the assumed falls in fair value of the assets covering it – Resilience scenarioLike other countries South Africa they divide the capital requirements into two partsThe capital associated with the liabilities sideThe capital associated with the asset side of the balance sheet
37 Elements of Capital Adequacy IOCAR = a2 + b2 + ci2 + cii2 + ciii2 + d2 + e2 + f2 + g2 + h2 + i2 + ja = Lapse riskb = Surrender riskci = Mortality Fluctuationcii = Morbidity Fluctuationciii = Medical Fluctuationd = Annuitant Mortalitye = Mortality, Morbidity Medical Assumptions - Capital AdequacyRequirements; (Mortality 5%, Morbidity 10%, Medical 15%)f = Expense Fluctuation (10% last year’s renewal expenses)g = Expense Assumption (policies not valued on a discounted cash flow basis)h = Investment Capital Adequacy Requirementi = Foreign Exchange Risk – 20% Movementsj = Any understatement of LiabilitiesIn Australia all assumptions on the capital adequacy basis are set at once and included in the computer runs. In South Africa each of the assumption changes are changed one at a time and the effect of that one assumption is assessed. The whole is the sum of the parts.The lapse requirement is equal to 40% of the amount required to ensure that no policy has a negative liabilityThe Surrender risk is the capital required to ensure that no policy liability is less than the current surrender value.The risk fluctuations are there as a buffer against year to year fluctuations not that the underlying assumption is wrong.Expense assumption for policies not valued on a discounted cash flow. The liability is set assuming the renewal expenses grow at 2% higher than the inflation rate for a period t until management is expected to take action.As you can see this is not a trivial exercise given the sheer number of parameters to be looked at individually.
38 Investment Capital Adequacy Requirements Greater of:Resilience Capital Adequacy Requirement – volatile market conditionsWorse Investment Return – Investments returns 2% lower than assumed in valuationThe Resilience capital adequacy requirement is to test the robustness of the financial position of the insurer in the face of volatile market conditionsThe worse investment returns assumes that in the long term the investment returns stay depressed.Thus South Africa looks at both the short term volatility and the lower returns into the future.
39 Resilience Capital Adequacy AssetFall in fair valueProperty15%Fixed interestFall equivalent to a 3% increase in yieldsCash0%EquitiesDividend Yield <= 4%30%Dividend Yield >= 5%20%OtherInterpolateThe interesting thing about the South African market is that it does take into account the level of the stock markets. If the markets are high a greater amount of capital is required.
40 Country Comparison Country Valuation Solvency India Gross Premium FormulaUKNet PremiumFormula but under reviewUSARBCAustraliaSouth AfricaCanadaSingapore (Proposed)What we can deduce from this slide is that there has been a notable shift in the last twenty years or so away from traditional approaches (ie net premium + prescribed formulae for solvency margins) to a gross premium valuation and RBC approach to capital. This is driven a lot by developments in the banking sectors of most countries (which use RBC approaches) and the development of technology that will support more complex approaches.India has started with a gross premium basis but has surprisingly opted for the formula approach for determining solvency/capital. We would suggest such an approach does not ‘fit’ together and needs reviewing.A more modern RBC approach will help to protect the industry against companies that have low gross premium reserves, and hence low solvency requirements. A risk based approach will also lead to companies setting capital having regard to their own specific position.
41 Capital Requirements Internationally Move to a Gross Premium valuation and Risk Based Capital Approach.Margins are generally specified and part of the solvency calculation.Methodology is based on projections.Resilience Reserves focus on both assets and liabilities.Resilience Reserves are related to the level of markets.JT/RH
42 Content Background The current situation in India Developments in other marketsConclusions and recommendations for India
43 ConclusionsSolvency is not a big issue for new companies at the moment, but this will change as companies get bigger.Globally move to Gross Premium Valuation and RBC SolvencyEnsures greater consistency to other financial sectorsValuation of assets and liabilities consistentFocuses attention on risk managementCan vary by company.India has Gross Premium Valuation move to RBC logicalSolvency and capital adequacy are not a big issue for new companies in India at this point in time. The cap of Rs 50 crore is the significant factor at this time, but this will change as companies get bigger and the formula approach becomes significant.The global trend to RBC should be considered in India as it helps to set capital having regard to the particular issues within each company. India already uses a gross premium approach for the valuing of liabilities and so the move to an RBC approach for capital will be easier that if it were using a net premium approach.
44 Implementation Issues to consider TechnologyHow do we get the know howPhasing in to existing levels of capitalSetting of the risk charges/parametersImpact on BusinessBig workload on the Regulator and IndustryThe process for considering the impact of RBC should not however be taken lightly.In addition to the many technical aspects the industry needs to understand the likely impact on business in India. For example, countries that have introduced RBC have seen a shift in product design towards unit linked business.A project involving the regulators and the industry is perhaps the best way to look at the implications.
45 RecommendationIRDA start giving consideration to adopting a RBC approach to solvency in 3 – 5 yearsThe Regulator should involve the Industry and work together to discuss the implications of moving to an appropriate RBC regime for IndiaThe Singapore experience would suggest that the introduction of RBC could take up to 5 years to implement successfully. In India, where gross premium valuations are already adopted the timeframe could be shorter. It is important however not to rush the transition so that the new framework is understood by all interested parties.
46 AcknowledgementsWe take this opportunity to thank all those actuaries and Appointed Actuaries in India who provided us with valuable inputs for this paper.All the views expressed in this paper are the views of the authors and are not necessarily the views of our employers