1. Capital modeling from a South African Regulatory Perspective Sam Isaacson 1 February 2007 SA International Insurance Symposium 31 January – 2 February 2007

2. © Capital Analytics 2006 - 2007 2FCR Modeling – February 2007 Capital Analytics  A leading Actuarial & Business Consulting firm  Focus on the application of robust modeling principles to business problems… In particular, we specialize in short-term insurance  Founded by Sam Isaacson, an Actuary with extensive consulting experience in Financial Services… Assisted the FSB in setting the new regulatory capital and reserving requirements (2005/2006)  We have a Complete Actuarial Service Offering for Short-Term Insurers: Regulatory & Economic Capital modeling (reserving, capital & strategy) Data Mining & Analysis (premium rating) Experience & understanding of the short-term insurance industry

3. © Capital Analytics 2006 - 2007 3FCR Modeling – February 2007 Outline of this presentation 1. Synopsis of the current regulatory framework 2. Practicalities of implementing a capital model 3. Ingredients of a capital model Requirements Timelines Options FCR report Extracting value from FCR Steps in an internal modeling exercise What is DFA Components of a DFA model Analysis of the results

4. © Capital Analytics 2006 - 2007 4FCR Modeling – February 2007 Regulatory background  FSB Issues Paper: Financial Condition Reporting – Proposed Solvency Assessment for Short-term Insurers, 15 December 2006 (source)  FCR is a risk-based regulatory approach to statutory financial reporting proposed by the FSB  Primary focus is on Insurance Liabilities and Capital Adequacy  FSB acknowledge that FCR will cost insurers money but are comfortable that the benefits outweigh these costs  Allowance made for the appointment of a Statutory Actuary in certain circumstances

5. © Capital Analytics 2006 - 2007 5FCR Modeling – February 2007 FCR Timelines & Consequences FSB COMPANIES Industry Consultation 2006200720082009 Release of FSB issues paper Full Implementation Operational Capital Model Model Development FSB Closure for comment Insurance Amendment Bill tabled in parliament Implementation of FCR Transition Arrangements The FSB has stated that it will consider approval of models that have been in operation for at least a year before implementation First time implementation for Financial year-ends after 1 January 2009 The creation & calibration of a company-specific Capital model is not a trivial task

6. © Capital Analytics 2006 - 2007 6FCR Modeling – February 2007 Current options  Allowable approaches to modeling: Internal (ultimate aim for the FSB) Certified (includes company specific elements, stepping- stone) Prescribed (applies historic industry averages)  Certified models are unique to SA A simple way of allowing flexibility within the prescribed framework Prescribed Model Alternate Parameters Non-proportional re-insurance Alternate model structure Actuarial Sign-off Model Review Increasing Cost, Complexity & Appropriateness

7. © Capital Analytics 2006 - 2007 7FCR Modeling – February 2007 A continuum of possibilities… Prescribed Model Certified Model Internal Model Certified Model Certified Model OR Internal Model Internal Model Scope for certified models Scope for internal models A grey area!  Sensible regulation could turn this grey area into a healthy breathing space for companies

8. © Capital Analytics 2006 - 2007 8FCR Modeling – February 2007 Financial Condition Report  Irrespective of model type applied, to be submitted annually by all registered Short-Term Insurers  Outline of “the key risks and matters impacting on the financial condition of the insurer”  Adverse issues require recommendations to remedy the situation  A large component will deal with the capital and/or reserving calculations performed by the insurer  Principles-based report, therefore smaller insurers may be able to report less than larger insurers  Should not be viewed as an annexure to the Statutory Returns  Sign-off by Chairman & CEO (approval of the board)  State where assistance was obtained by a suitably qualified approved person – in all likelihood, Actuarial assistance will have been obtained for the calculations etc…

9. © Capital Analytics 2006 - 2007 9FCR Modeling – February 2007 Issues for discussion in an FCR report  Insurer background  Recent experience  Risk management strategy  Liability valuation  Asset and Liability Management  Business projections  Capital Management & Capital Adequacy  Premium Adequacy  Reinsurance Management Strategy  Credit risk  Operational risk

10. © Capital Analytics 2006 - 2007 10FCR Modeling – February 2007 Extracting value from FCR FCR Risk Management Strategic Pricing Reinsurance Purchasing Asset Allocation Capital Management Capital Allocation Expansion Plans Accounting Disclosures: Risk  Can be viewed as a regulatory burden OR…  Integrate FCR within existing business processes and gain quantitative insights into your business

11. © Capital Analytics 2006 - 2007 11FCR Modeling – February 2007 Steps Company-specific capital model Components of an internal capital modeling project Structure It is vital that the structure of the model reflects the structure of the business. This assists later in understanding and communication of the model results. Further, data is most likely to be available in line with the natural structure of the business. Key Risks The list of risks to be discussed in the FCR document can be used as a guide. In the majority of cases an insurer would focus on modeling underwriting risk & reserving risk. Software Mapping Software can assist you in putting together a capital model but does not replace the crucial modeling elements discussed above! At the end of the day, people perform modeling not software. Calibration The structure set-up in the preceding steps needs to be populated with parameters relevant to the key risks identified. This will be accomplished with reference to company-specific data and industry-data on a case by case basis Analysis While the modeling tasks are complete, the analysis of results can now begin. This stage will depend on the particular investigation (capital modeling, reinsurance strategy, etc…)

12. © Capital Analytics 2006 - 2007 12FCR Modeling – February 2007 Company Structure ACCACC ENGENG GTEGTE LIABLIAB MISCMISC MOTMOT PROPPROP TRATRA REINSURANCE Aggregate Products treaty1 treaty2 treaty3 Channel1 Channel2 Product1 Product2 RI Layer1 RI Layer2 Aggregate (a) Statutory/FSB(b) Cell (c) Reinsurance treaty centric (d) Product/Channel centric

13. © Capital Analytics 2006 - 2007 13FCR Modeling – February 2007 Where does DFA fit into FCR?  DFA (Dynamic Financial Analysis) is the term for the computational engine that computes the results for FCR  It is a projection of the Income Statement and Balance Sheet of a Short-Term Insurer applying a dynamic simulation based approach  In ordinary projections, a single estimate of a variable of interest would be made – think of producing a budget with excel…  DFA computes a range of values for the variable of interest together with their relative frequency – statistical variability  FCR dictates that the primary variable of interest is the statistical distribution of year one profit/loss  In particular FCR focuses on the 99.5% sufficiency level – the worst case loss 200 years

14. © Capital Analytics 2006 - 2007 14FCR Modeling – February 2007 Even Actuaries want to be fashionable  Formulas are out…simulations are in!  An insurance company is too complex to be governed by a single formula – however long & complicated  It is difficult to allow for uncertainty through the use of a deterministic formula  A simulation naturally gives a range of answers as its output, thereby encapsulating the uncertainty in a natural manner  Simulations were known about in the past but are only now becoming a reality for computation due to increases in computing power

15. © Capital Analytics 2006 - 2007 15FCR Modeling – February 2007 DFA building blocks Premiums Claims Commission & Expenses Investment Return Line of Business One Line of Business Two Line of Business Three RI Layer One RI Layer Two Σ Aggregation (Correlation & Diversification) Σ

16. © Capital Analytics 2006 - 2007 16FCR Modeling – February 2007 How can DFA assist you (I)  It can associate probabilities with the financial outputs – a decision makers dream!  On the side we show the statistical distribution of profit one, two and three years into the future  Note the increase in uncertainty as the projection period increases

17. © Capital Analytics 2006 - 2007 17FCR Modeling – February 2007 How can DFA assist you (II)  It can assist in accurate capital allocation between lines/classes of business  This assists in setting an adequate capital charge for each class in product pricing Expected Claims Expense Allowance Commission Margin Excess / Shortfall Components of Premium Return on Capital

18. © Capital Analytics 2006 - 2007 18FCR Modeling – February 2007 How can DFA assist you (III)  Different strategies can be compared with respect to risk and reward (re-insurance, investment, pricing,…)  Above, option one dominates at the lower risk levels and option two dominates at the higher risk levels

19. © Capital Analytics 2006 - 2007 19FCR Modeling – February 2007 Questions?

20. Sam Isaacson Cell: 073 190 1978 Fax: 086 637 7494 Email: sam@capitalanalytics.co.za Web: www.capitalanalytics.co.za 305B Killarney Mall Office Towers 66 Riviera Rd Killarney 2193 Johannesburg