Best Estimate of the Technical Provisions Seminar on Risk-Based Supervisory Practices and Regulatory Capital Stuart Wason, FSA, FCIA, CERA Senior Director, OSFI September 7, 2011

Agenda Objectives and main building blocks of quantitative solvency assessment Valuation of technical provisions Moving forward: from regulation to supervision

Objectives and Main Building Blocks Overall goals of solvency assessment under IAIS ICP 14 –Valuation of assets and liabilities on consistent bases, –Shall recognise specific risk-profile of each undertaking –Principles-based calculations allowing flexible approaches –Based on sound economic valuation principles –reveal the true financial position of insurers increase transparency increase confidence in the whole sector

Total Assets Base Estimate Technical Provisions Available Capital Resources Main Building Blocks Risk margin Current/best Estimate

IAIS ICP 14 The supervisory regime establishes requirements for the valuation of assets and liabilities for solvency assessment purposes. –Valuation addresses recognition, derecognition and measurement of assets and liabilities. –Valuation of assets and of liabilities is undertaken on consistent bases. –Valuation of assets and liabilities is undertaken in a reliable, relevant and transparent manner. –Valuation of assets and liabilities is an economic valuation. –An economic valuation of assets and liabilities reflects the risk-adjusted present values of their cash flows. –Value of technical provisions and other liabilities does not reflect the insurer’s own credit standing –Valuation of technical provisions exceed the Current Estimate by a margin (Margin over the Current Estimate or MOCE).

IAIS ICP 14 continued The supervisory regime establishes requirements for the valuation of assets and liabilities for solvency assessment purposes. –Current Estimate reflects the expected present value of all relevant future cash flows that arise in fulfilling insurance obligations, using unbiased, current assumptions. –MOCE reflects the inherent uncertainty related to all relevant future cash flows that arise in fulfilling insurance obligations over the full time horizon thereof. –Valuation of technical provisions allows for the time value of money. The solvency regime establishes criteria for the determination of appropriate interest rates to be used in the discounting of technical provisions. –Solvency regime requires the valuation of technical provisions to make appropriate allowance for embedded options and guarantees

Total Assets At Market Value Base Estimate Technical Provisions Available Capital Resources Inconsistent bases? Risk margin Current/best Estimate Using Fixed Assumptions Solvency value?

Total Assets Base Estimate Technical Provisions Available Capital Resources Economic valuation – Solvency II – an example Risk margin Current/best Estimate Market consistent valuation of assets and liabilities

Total Assets Base Estimate Technical Provisions Available Capital Resources Economic valuation – Solvency II - an example Risk margin Current/best Estimate Market consistent valuation of assets and liabilities MCR SCR Free assets

Current estimate ICP 14 – “Current Estimate reflects the expected present value of all relevant future cash flows that arise in fulfilling insurance obligations, using unbiased, current assumptions.” Key words: –Expected present value –All relevant future cash flows –Fulfilling insurance obligations –Unbiased, current assumptions Reference: Measurement of Liabilities for Insurance Contracts: Current Estimates and Risk Margins, IAA 2009

Expected present value An economic principle for the measurement of insurance contracts is the recognition of the time value of money Future cash flows can be valued to the present using observed discount rates Discount rate based on portfolio of assets with cash flows suitable to provide for insurance obligations

All relevant future cash flows Expected financial effect of all contractual rights, obligations, guarantees and options included Probability weighted best estimate of all scenarios Not always possible to develop distributions – expert judgement required

Fulfilling insurance obligations Measurement approach should be consistent with the application (eg sale of portfolio, financial reporting, run-off, pricing) Convergence (at least among IASB and IAIS) appears to be towards fulfillment measurement approach Projected cash flows are to be appropriate to an on-going operation

Unbiased current assumptions Unbiased –Neither conservatism nor lack of it Current –Appropriate over the term of the cash flows being projected –Appropriate to the obligations being valued –Based on market inputs to the extent possible (eg industry wide data or prices where relevant and useful) –Using non-market inputs (eg credible insurer experience) where appropriate –Historical data to be updated based on trends

Unbiased current assumptions Data issues (eg mortality rates) –Does the insurer merge data from a variety of systems (how clean and consistent is the data) –Does the data from certain years contain unusual one-off events (eg flu spike) –Does the data contain the impact of changes in claims handling or underwriting practices (latter more important for health and general insurance in the short term) –How will changes in the economy or health care affect the rate mortality improvements –Actuarial function plays a key role

Unbiased current assumptions Inter-related (eg lapse and mortality rates) –Typically a valuation of technical provisions involves the specification of many assumptions some of which inter-relate to each other (eg renewable term insurance where the mortality experience depends on the lapse experience at renewal) –Careful attention must be paid to these linkages in the valuation

Valuation of Technical Provisions General principles –Economic and market-consistent valuation –Calculation to be based on current and credible information and realistic assumptions –Flexible and principle-based framework –“Best Estimate + Risk Margin” approach –achieve better comparability and transparency –consistency with with valuation of assets and other liabilities –alignment with IFRS

Total Assets Base Estimate Technical Provisions Available Capital Resources Include a risk margin for each assumption Risk margin Current/best Estimate

IASB Stage II Insurance Contracts recap Risk + residual margin, or composite margin? Risk adjustment plus residual margin – Strong support in Europe as this is consistent with Market Consistent Embedded Value and Solvency II – Supported by Australia and Canada as they already have a risk adjustment included in the measurement of insurance liabilities Composite margin – Supporters concentrated in the United States, Japan and China – Supported for the perceived subjectivity involved in determining this risk adjustment In June, IASB tentatively decided to allow for some re-measurement of residual margin ED called for an explicit risk margin, plus a locked-in residual margin to eliminate day one profits. Comment letters: Risk adjustment plus residual margin, or composite margin?

Valuation of Technical Provisions Valuation of technical provisions is not just about a number, it is a process requiring expert judgement Data Assumptions Methodologies Assessment & Validation

Valuation of Technical Provisions The valuation process has to be consistent with regulatory and other requirements Data Assumptions Methodologies Assessment & Validation Valuation Process Valuation Requirements regulatory professional financial reporting regime

Valuation of Technical Provisions And has to be embedded into the undertakings system of governance… Data Assumptions Methodologies Assessment & Validation Valuation Process Governance general requirements: Risk management system, including Data policy Claims management procedures Validation of technical provisions Documentation Internal reporting and communication Internal control

Valuation of Technical Provisions Challenges –Consistency and coherence of conceptual framework –Appropriate calibration (interest rate curve and CoC factor) –Compatibility of framework with IFRS –Insurers’ ressources: Data, IT, actuarial expertise –Application of valuation methodology: setting assumptions and selecting methods –Ensure that valuation is embedded in insurer’s risk management: proper validation and assessment is key! –Appropriate use of judgement –Supervisory review and assessment

Valuation of Technical Provisions Conceptual framework – issues at debate –Risk margin Recognition of unavoidable market risk Extent of allowance for diversification effects Simplifications –Discounting Illiquidity premium Extrapolation of the risk-free curve Credit risk in swaps

IASB Stage II Insurance Contracts recap - Discount rate More controversy than consensus: Those with long duration liabilities advocate for asset-based rates, locked-in rates or some combination Many alternatives presented to IASB Comment letters: Should a liability based discount rate be used? Comment letters: What method for the rate? Current direction is that discount rate will not be based on assets held: Major change for Canadian (and US) lifecos Potential for substantial mis-matches and earnings volatility

IASB Stage II Insurance Contracts recap Discount rate Tentative decisions: –Reflect the characteristics of the liability; no linkage to assets –No “locking in” of the rate –Allow a “top down” approach (IASB ‘clarification’) Applying the “top down” alternative –Deduct risks not present in the liability, e.g. investment risks that can’t be passed to the policyholder (expected and unexpected defaults) –IASB: bottom up and top down should essentially get to the same place - ? –Might reduce but not eliminate problems of volatility and losses at inception Risk- free rate Liquidity premium ED: “Bottom up” approach Credit default “Top down” alternative ? Asset rate >

Valuation of Technical Provisions Carrying out the calculation – main practical difficulties –In setting of assumptions with regard to Policyholder behaviour (e.g. lapses) –Expenses –Management actions and future discretionary benefits –Use of economic scenario generators –In applying valuation methods:Options & guarantees –Stochastic modelling in life insurance –Use of economic scenario generators –Reinsurance recoverables –Premium provisions in non-life insurance

Valuation of Technical Provisions Carrying out the calculation – main practical difficulties –In setting of assumptions with regard to Policyholder behaviour (e.g. lapses) –Expenses –Management actions and future discretionary benefits –Use of economic scenario generators –In applying valuation methods:Options & guarantees –Stochastic modelling in life insurance –Use of economic scenario generators –Reinsurance recoverables –Premium provisions in non-life insurance

Valuation of Technical Provisions Method selection – general considerations –Underlying assumptions of method must be clear and explicit –Data must be verifiable and sufficiently granular –Assessment and communication of uncertainty and sensitivities in estimate is key –Stress & scenario testing have important role to play –Weight to be given to losses with low probability and high cost –Stochastic methods are not a panacea – if deterministic methods fail then stochastic methods will normally also fail –Limitations of the valuation must be understood

Valuation of Technical Provisions Data used in the calculation of technical provisions –Insurers need to implement internal processes and procedures to ensure appropriateness, completeness and accuracy of data used This includes:Implementation of well- organised IT data system Data policy Compilation of a directory of data used –Supervisory reporting requirements set minimum standard on granularity of data –Data can be internal or external –However insurer needs to be able to demonstrate adequacy of external data against own risk profile

Valuation of Technical Provisions Use of external data for benchmarking –Insurance market data can provide “benchmark” information –Useful for validation and assessment of valuation In non-life can e.g. be represented as:development parameters/factors per line of business aggregate summary statistics per line of business –In life insurance comprises e.g. tables on mortality risks –Insurance market data could be provided through supervisory authorities, industry or actuarial associations

Valuation of Technical Provisions Supervisory considerations –Pillar I verification “use” vs “rely” External actuarial review External auditor actuarial staff –Pillar II Benchmarking Stress testing ERM ORSA –Pillar III

Selected references Measurement of Liabilities for Insurance Contracts: Current Estimates and Risk Margins, International Actuarial Association, 2009 IASP 5 – Current Estimates, International Actuarial Association ICP 14 – Valuation of Assets and Liabilities for Solvency Purposes, International Association of Insurance Supervisors

Questions