Calculation of the Best Estimate for insurance obligations Hugo Borginho TAIEX seminar Istanbul, 5 th November 2010

Agenda Introduction to the EU Solvency II regime Principles for the calculation of the best estimate Tasks and responsibilities on the calculation of technical provisions 2

Introduction to the EU Solvency II regime

The EU Solvency II regime SII aims for a global and deep review of the regulatory and supervisory framework for the insurance sector of the European Economic Area Framework Directive (level 1): 2009/138/CE, which is expected to come into force from 1 st January 2013 onwards Solvency regime more adapted and sensitive to the risks to which each undertaking is effectively exposed 4

Key objectives of Solvency II Enhance the protection of insurance policyholders and beneficiaries Promote a risk management culture within the undertakings Convergence of supervisory practices amongst different supervisors, encouraging a level playing field Increase the competitiveness and innovation ability of the market Promote transparency and market discipline 5

Principle of proportionality The regime should not be overly onerous for “low risk” undertakings Criteria: nature, scale and complexity of risks 2-way principle: regime will be more demanding for “high risk” undertakings Applies to all areas of the regime, in particular to the degree of sophistication of the methods and assumptions for calculating technical provisions 6

7 Technical provisions vs. capital Technical provisions aim to ensure the full settlement of insurance obligations – include the amount of expected losses (best estimate) and the cost of transferring these liabilities to a third party (risk margin) Capital aim to protect the technical provisions against unexpected losses

Principles for the calculation of the best estimate

The best estimate The best estimate is the major component of technical provisions, and is calculated as: “the probability–weighted average of future cash flows, taking account of the time value of money (expected present value of future cash flows), using the relevant risk-free interest rate term structure” (article 77(2) of Directive 2009/138/EC (Solvency II)) 9

Key principles for calculation The calculation of the best estimate should be: – Based on up-to-date and credible information – Based on realistic assumptions – Derived from adequate, applicable and relevant actuarial and statistical methods The availability and quality of historical data is crucial! 10

Key principles for calculation The calculation of the best estimate should: – Be based on the projection of all future cash flows necessary to settle the insurance obligation till run-off (e.g. claims, expenses, premiums, …) – Take into account the uncertainty of the cash flows (timing, amount, probability) – Deliver the mean of the probability distribution (i.e. no prudence attached) 11

Data quality Data used in the calculation should be: – Accurate: free from material errors; consistent within periods – Complete: sufficiently granular and with enough information to assess the underlying risks – Appropriate: fit for purpose; reflective of the underlying risks Data may be internal, external or both 12

Data quality Where data is insufficient or is not of appropriate quality to apply a reliable actuarial method, undertakings may use approximations, including case-by-case approaches 13

Cash flows to be projected – Notations: CF(i) denotes the non-discounted cash flow to be paid/received at time i r(i) denotes the risk-free interest rate for maturity i The valuation is reported to time i=0 14

Cash flows to be projected 15

Cash flows to be projected The valuation should be prospective, i.e. it should reflect the future expectations and trends. Examples: – Increase in the average life expectancy – Medical and technological developments – Future inflation (appropriate indices) – Changes in the legal environment – Etc. 16

Cash flows to be projected Cash flows should be discounted with the risk-free interest rate term structure for the currency in which the obligations should be settled – On-going discussion about the inclusion of an illiquidity premium 17 Euro curve

Cash flows to be projected Future profit sharing (Life insurance) should be included in technical provisions – i.e. amounts which are not guaranteed at the valuation date, including benefits of a discretionary nature Explicit valuation of options and guarantees embedded in insurance policies 18

Cash flows to be projected Expenses should include: – Administrative expenses – Investment management expenses – Claims management expenses – Acquisition expenses, including commissions – Overheads (general management expenses) 19

Methodologies The valuation should be based on appropriate actuarial and statistical methodologies, e.g.: – Simulation – Deterministic methods – Analytical techniques Liabilities whose underlying risks evidence non- linear behaviour (e.g. embedded options and guarantees, profit sharing) would, in general, require more advanced techniques (simulation) 20

Embedded options and guarantees Both the intrinsic value and the time value should be captured in the valuation Methodologies: – Stochastic model, including a model for projecting the market value of the financial assets – Series of deterministic scenarios, with attributed probabilities – Deterministic valuation, to the extent it captures appropriately the non-linear characteristics 21

Other issues to be considered Realistic assumptions on: – Future management actions – Policyholder behaviour Use of expert judgement is subject to additional requirements 22

Life specific features Rule: policy-by-policy valuation – Model points may be used where appropriate, provided it does not lead to material errors Surrender value does not constitute a floor to the valuation 23

Life specific features Where applicable, at least the following risk factors should be explicit in the valuation: – Probabilities of death/survival (use of prospective mortality tables) – Disability rates – Option take-up rates, including lapse assumptions – Expense assumptions 24

Life specific features Methodology: – Common life actuarial techniques (deterministic) may be sufficiently appropriate for traditional products – Complex products, exposed to non-linear risks or whose cash flows depend of asset returns are likely to require the use of more sophisticated techniques (simulation) 25

Non-life specific features Separate valuation for: – Claims provision (claims incurred, including IBNR) – Premium provision (future claims covered by the insurance policies in force at the valuation date) Calculation further divided by homogeneous risk groups 26

Non-life specific features Methodology: – Common non-life actuarial techniques, e.g. methods based on the projection of run-off triangles (Chain Ladder), may be sufficiently appropriate for the main lines of business – The use of stochastic models is advisable, as it allows for the assessment of the uncertainty underlying the estimates 27

Tasks and responsibilities on the calculation of technical provisions

System of governance 29 I NTERNAL C ONTROL S YSTEM R ISK M ANAGEMENT S YSTEM Compliance function Risk management function Actuarial function Internal audit function

Actuarial function Key responsibilities on the area of technical provisions: – Coordinate the calculation – Ensure the appropriateness of the methodologies used as well as the assumptions made – Assess the sufficiency and quality of the data used – Compare best estimates against experience (back testing) – Inform the management body of the reliability and adequacy of the calculation – Oversee the calculation when a case-by-case valuation approach is followed 30

Actuarial function Must be carried out by persons with appropriate knowledge of actuarial and financial mathematics and demonstrable level of experience Should have full access to the IT systems providing the necessary data for the fulfilment of its tasks When issuing opinions, it must be objective and have a reasonable degree of independence towards other functions of the undertaking (including the management body) 31

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