1 INSURANCE ADVISORY – ACTUARIAL SEVICES Technical provisions Methods and statistical techniques to calculate the best estimate Imrich Lozsi 4. December 2009

2 Agenda The valuation process Cash flow projections Options and guarantees Policyholder behavior Discretionary benefits Assumptions Validation methods

3 The valuation process (1) It should not rely solely on models but also requires Expert judgment with sound reasoning and business logic Analysis of the underlying liabilities Collection of qualitative and quantitative information Components of the valuation process Collection and analysis of the data Determination of assumptions Modeling, parameterization and running the models Assessment and appropriateness of estimations Documentation and controls

4 The valuation process (2) Requirements for an individual performing the process Knowledge of actuarial and financial mathematics Ability to demonstrate this with applicable professional standards Revision by person with adequate knowledge and skills and independent of the valuation process Upon request from the supervisory authority to demonstrate The robustness of the valuation process Appropriateness of the level of technical provisions Applicability and relevance of the methods used Adequacy of the underlying statistical and financial data

5 Cash flow projections All cash in- and out-flows required to settle the obligations Best estimate is calculated gross, without deduction of amounts recoverable from reinsurers and SPVs Expected realistic future demographic, legal, medical, technological, social or economical developments Appropriate assumptions about future inflation Identification of the type of inflation to which particular cash flows are exposed Projection horizon to cover the full lifetime of all obligations To be determined on up-to date and credible information and realistic assumptions

6 Cash in-flows Future premiums Receivables for salvage and subrogation Should not take into account investment returns!

7 Cash out-flows Benefits Claims payments Maturity benefits Death and disability benefits Surrender benefits Annuity payments … Expenses Other cash flow items

8 Cash flows from all expenses that will be incurred in servicing all obligations related to existing contracts over their lifetime This shall specifically include Administrative expenses Claims handling expenses Investment management expenses Acquisition expenses including future commissions Expense items

9 Expenses include Allocated, i.e. directly assignable to individual claims, policies or transactions; and Unallocated (overhead) expenses Principles of allocation to LOBs, homogeneous risk groups … According to professional judgment and realistic assumptions Based on realistic and objective principles Principles and their application shall be documented and the undertaking should be able to explain their changes over time Changes in the pre-defined split permitted only if the new split will better fit the current situation Expense allocation (1)

10 For non-life insurance obligations and where appropriate, expenses shall be allocated between Premium provisions; and Claim provisions Premium provisions Administrative expenses including maintenance commissions Claims administration expenses related to future claims from in force contracts Claim provisions Claims administration expenses related to unsettled claims incurred before the valuation date Expense allocation (2)

11 Own experience and any relevant market data Inclusion of expenses directly related to administration of obligations related to existing contracts, together with share of relevant overhead expenses Liability: how much to pay to transfer, how much to receive to accept => Share of overheads on a going concern basis. Run off basis only if it is very likely in the near future Allowance for expected future cost increase but no allowance for cost reductions where these have not yet been realized May anticipate an expected cost reduction to the five years after licensing of the undertaking Expenses – other considerations

12 Cash flow projection should be based on policy-by-policy approach (cash flows depend on biometrical risk of each policyholder) but suitable model points are permitted The grouping shall not Misrepresent the underlying risk and significantly misstate the costs Result in the loss of significant attributes of the valued portfolio … No surrender value floor (… no need to increase the value of insurance liabilities to the surrender value) Negative reserves permitted (… undertakings are not required to set zero the value of best estimate) Life insurance obligations

13 Non life insurance obligations The valuation of the claim and premium provisions shall be carried out separately Claim provisions Premium provisions Future premium payments Future claim events Allocated and unallocated claims management expenses Expenses associated with ongoing administration of in-force policies Policyholder behavior, time value of the money All future claim payments whether reported or not Claims management and claims administration expenses associated with these claims

14 Options and guarantees (1) Identify all contractual options and financial guarantees (“right to change the benefits to be taken at the choice of its holder, on terms that are determined in advance”) For each type of contractual options identify all risk drivers, which have the potential to materially affect Option take up rates Level of moneyness Capture the uncertainty of cash flows Consider a sufficiently large set of scenarios, including adverse ones

15 Options and guarantees (2) Best estimate should reflect both the intrinsic and the time value Assumptions on policyholder behavior should be appropriately founded by statistical and empirical evidence to the extent that this is deemed representative of the expected future behavior Consideration should also be given to an increasing future awareness of policy options as well as policyholders’ possible reactions to reduced solvency

16 Policyholder behavior Policyholder behavior which change the expected future cash flows of the contract, if exercised in line with options contained in the policy should be taken into account When assessing past policyholders behavior, appropriate attention should be given to whether the option is out or barely into the money … Policyholders’ behavior should not be assumed to be independent of financial markets, an undertaking’s treatment of customers or publicly available information, unless proper evidence assumption can be observed.

17 Discretionary benefits (1) When calculating technical provisions participants should take account of all payments to policyholders and beneficiaries, including future discretionary bonuses, which they expect to make, whether or not these payments are contractually guaranteed, unless those payments fall under surplus funds

18 Discretionary benefits (2) Guaranteed benefit The value of the liability, which does not take into account any future declaration of future discretionary bonuses Conditional discretionary benefit This is a liability base on declaration of future discretionary benefits influenced by legal or contractual declarations and performance of the undertaking/fund (performance-related) Pure discretionary benefit This is a liability based on the declaration of future benefits which are at discretion of the management (decision-related)

19 Discretionary benefits (3) Detailed documentation of the mechanism for distributing discretionary benefits When valuation of discretionary benefits depends on the assets held by the firm Assets assumed in valuation to be consistent with the assets held at the valuation date Changes in asset allocation should be taken into account if requirements on management actions are met The valuation of the discretionary benefits should be consistent with the choice of the risk-free rate for discounting

20 Assumptions (1) Assumptions shall be set consistently with Information provided by the financial markets Generally available data on insurance and reinsurance technical risks

21 Assumptions (2) General principles for assumption setting In a realistic manner and consistently from year to year without arbitrary changes Changes of assumptions from one period to another shall be traced, explained and documented … Assumptions shall be appropriately documented including the suitability of data sources, derivation of assumptions and the limitations in the results The underlying data shall be credible and meet the relevant standards When based on external data Available to the extent that they may be validated Produced sufficiently frequently to permit analysis

22 Where an assumption is produced by a market consistent asset model, that model shall satisfy the following criteria Shall deliver prices for the assets and liabilities that can be directly verified by the market Shall be arbitrage free A market consistent asset model shall be calibrated to Reflect the nature and term of the liabilities particularly those giving rise to significant guarantee cost The current risk free term structure An appropriate volatility measure Deep liquid and transparent market If not, insurer shall be capable to demonstrate that the calibration is appropriate Assumptions – Information provided by the financial markets

23 Assumptions – Data on insurance and reinsurance risks Assumption shall be derived consistently Across homogeneous risk groups or lines of business With the undertaking’s knowledge of the business and practices for managing the business Credible information which is relevant to the cash flows Undertakings shall consider whether assumptions adequately reflect the underlying uncertainty Appropriate allowance for future trends or changes both in the portfolio and external socio-economic factors

24 Assumptions – Use of expert judgment (1) Scope Data, assumptions and in respect of the applied method General conditions Compatibility with CEIOPS advices, in particular it shall not replace appropriate collection processing and analysis of data according to advice on data quality standards Shall not be applied in isolation Should be prudent if applied in isolation or to an assumption with significant impact Expert with relevant knowledge, understanding and comprehension of the subject

25 Assumptions – Use of expert judgment (2) Documentation in a manner which makes possible the accountability and verification of the expert judgment Inputs Objectives and decisional criteria Any material limitations and the steps to be taken to eliminate them The envisaged validation and back testing Back testing Against additional experience or emergent information Compared to external information Sensitivity analysis

26 Validation methods Validate the amounts of technical provisions Ensure applicability and relevance of the methods and assumptions applied and appropriateness of the level of technical provisions Ensure that the actuarial methods and statistical techniques are appropriate to the nature, scale and the complexity of the risks Compare the best estimate against experience, understand and explain sources of differences At least once per year but significant changes may necessitate ad-hoc checks more often Appropriate documentations

27 Imrich Lozsi Senior Manager, Actuarial Services KPMG in the Central and Eastern Europe c/o KPMG Česká republika, s.r.o The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Informace zde obsažené jsou obecného charakteru a nejsou určeny k řešení situace konkrétní osoby či subjektu. Ačkoliv se snažíme zajistit, aby poskytované informace byly přesné a aktuální, nelze zaručit, že budou odpovídat skutečnosti k datu, ke kterému jsou doručeny, či že budou platné i v budoucnosti. Bez důkladného prošetření konkrétní situace a řádné odborné konzultace by neměla na základě těchto informací být činěna žádná opatření. © 2007 KPMG Česká republika, s.r.o., a Czech limited liability company and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in the Czech Republic.