1. Financial Condition Reporting for South African Short Term Insurers Emile Stipp Sam Isaacson 24 November 2005

2. 2 Financial Condition Reporting for South African Short Term Insurers Background and scope Overall framework Insurance capital charge Investment capital charge Putting it all together Reserves Results Recommendations The way forward Contents

3. Financial Condition Reporting for South African Short Term Insurers 3 Background and scope

4. 4 Financial Condition Reporting for South African Short Term Insurers Where it all started Started at the end of 2001 Current “one size fits all” approach does not make sense – move to a risk-based approach Paper presented at ASSA convention in 2002 Working group discussed initial draft guidelines and made various changes Tender for recalibration sent out in November 2004, awarded to Deloitte AIS & Insight ABC in March 2005

5. 5 Financial Condition Reporting for South African Short Term Insurers Terms of reference, reliances and limitations Deloitte and Insight ABC appointed by FSB to calibrate formulae for Financial Condition Reporting for Short Term Insurance industry in SA Hence: –Construct formula –In accordance with industry data in STAR returns –And principles of Dynamic Financial Analysis –And recommend new capital requirement for Short Term Industry: the “Industry Calibration” The main limitations: –Data not contained in STAR returns, particularly in respect of non- proportional reinsurance –Inaccurate data Held an industry workshop introducing concepts on 11 August Sent two sets of individual results to each company in South Africa Had meetings with individual companies, reinsurers, cell captives and Actuarial Society STIC for feedback

6. 6 Financial Condition Reporting for South African Short Term Insurers Terms of reference, reliances and limitations This is an industry calibration – there will always be “overs and unders” The question is whether it is more accurate than 25% of net written premium currently required The model does not guarantee solvency under all circumstances And individual results for individual companies may be more or less appropriate depending on unique factors Some companies with specific needs: –Reinsurers –Cell captives –Those operating on behalf of Government, with effective Government guarantees –Selected companies in niche markets Models could not be calibrated for each of these separately due to: –Lack of homogeneity –Lack of data

7. Financial Condition Reporting for South African Short Term Insurers 7 Overall framework

8. 8 Financial Condition Reporting for South African Short Term Insurers The three models

9. 9 Financial Condition Reporting for South African Short Term Insurers The three models

10. 10 Financial Condition Reporting for South African Short Term Insurers Compared against current model The above framework is preferable, as the current model does not take into account: –Risks faced by company: classes of business written, size of insurer, combination of classes, details of reinsurance programme, expenses etc And requires level of capital which is prudent for some and not prudent for others Advantage of current model: it is simple We hope that industry calibration will be simple to apply in practice as it can be built into STAR returns And hence not require companies to apply detailed formulae And they can test different levels of capital required under different circumstances Industry calibration is balancing act between: –Greater complexity due to desire to allow for individual circumstances of companies VS –Desire for simplicity

11. 11 Financial Condition Reporting for South African Short Term Insurers Schematic representation of framework

12. 12 Financial Condition Reporting for South African Short Term Insurers Comparisons The above approach is consistent with international trend towards risk-based capital. Adopted, among others, by: –Australia, USA, UK, Germany, Switzerland, Canada, Holland Also in line with principles established by International Actuarial Association And in line with investment capital charge adopted for long term insurers

13. 13 Financial Condition Reporting for South African Short Term Insurers Components of the framework Capital charge –Insurance capital charge –Investment capital charge Reserving –Best estimates –Prescribed margins

14. 14 Financial Condition Reporting for South African Short Term Insurers Data Intensive data cleansing process Used data from 1075 STAR returns

15. Financial Condition Reporting for South African Short Term Insurers 15 Insurance capital charge

16. 16 Financial Condition Reporting for South African Short Term Insurers Insurance Capital Charge Two primary investigations of Star return data: –Underwriting risk (ULR) –Reserving risk Using net ULR and net reserving risk measures But calibrated to gross written premium (GWP) and gross unearned premium (GUPR) GWP is estimated for year following date of solvency calculation And GUPR can be regarded as looking back building blocks approach Determined initially for each of the 8 classes of business on a stand- alone basis

17. 17 Financial Condition Reporting for South African Short Term Insurers Insurance Capital Charge

18. 18 Financial Condition Reporting for South African Short Term Insurers Insurance Capital Charge DFA Engine Underwriting RiskReserving Risk Gross Written Premium Gross Unearned Premium Simulation Results

19. 19 Financial Condition Reporting for South African Short Term Insurers Insurance Capital Charge We ran model for notional companies and used interpolation to determine results for particular company

20. 20 Financial Condition Reporting for South African Short Term Insurers ULRs - means For all classes of business, relationship between mean ULR and GEP

21. 21 Financial Condition Reporting for South African Short Term Insurers ULRs – standard deviation For all classes of business, relationship between std dev ULR and GEP

22. 22 Financial Condition Reporting for South African Short Term Insurers Underwriting cycle Allowed for implicitly. Evidence of cycle:

23. 23 Financial Condition Reporting for South African Short Term Insurers Reserving risk Expresses development of claims relative to reserves

24. 24 Financial Condition Reporting for South African Short Term Insurers Reserving risk Expresses development of claims relative to reserves

25. 25 Financial Condition Reporting for South African Short Term Insurers Required number of simulations in DFA model Determined for each level of sufficiency – in the end ran 79.2m simulations

26. 26 Financial Condition Reporting for South African Short Term Insurers Stand-alone capital Gross stand-alone capital – surface at 99.5% sufficiency

27. 27 Financial Condition Reporting for South African Short Term Insurers Diversification and correlation Allowed for explicitly And on the basis of data Writing more than one line of business – reduces capital requirements (diversification effect) Correlations between lines of business – generally increases capital requirements (correlation effect) This should discourage companies from “dumping” everything into the Miscellaneous class Finally, there is allowance for investment return on assets backing liabilities to reduce insurance capital charge

28. Financial Condition Reporting for South African Short Term Insurers 28 Investment capital charge

29. 29 Financial Condition Reporting for South African Short Term Insurers Overview To allow for fact that assets backing liabilities and capital may decrease in value to such an extent that solvency is threatened Hence, to the extent that market asset values are subject to variation, additional assets need to be held We performed this analysis using internationally the recognised Smith Model (TSM) – stochastic asset model calibrated for South African market For different types of asset, determined additional assets to be held, at different levels of sufficiency First step is allocation exercise – least risky assets allocated first (cash) If particular asset “runs out”, allocate from more risky assets Order of riskiness: Cash, bonds, property, equity, other assets

30. 30 Financial Condition Reporting for South African Short Term Insurers Equity example Equity factors at different levels of sufficiency:

31. 31 Financial Condition Reporting for South African Short Term Insurers Other risks to allow for? Operational risk: –Allowed for implicitly –If operational risk can be measured, company should do something about it rather than setting aside additional capital –Unfair to penalise whole industry for operational inefficiencies in some companies by requiring everyone to set aside additional capital for operational risk –Also, did not have sufficient data to make explicit allowance for operational risk

32. Financial Condition Reporting for South African Short Term Insurers 32 Putting it all together

33. 33 Financial Condition Reporting for South African Short Term Insurers Framework Insurance and Investment Capital Charges are combined recognising that there is some correlation between insurance and investment risks, but not 100% And capital should be grossed up to allow for type of investments Allowed for in formula: But only 50% of g 2 allowed for This is similar to the intended approach in Germany, as it deals with fact that insurance catastrophe may well affect investment market, but investment market crash may have no relation to insurance risks

34. Financial Condition Reporting for South African Short Term Insurers 34 Reserving

35. 35 Financial Condition Reporting for South African Short Term Insurers Liability estimation: IBNR and OCR IBNR: –Use best estimate –Table determined for companies who do not do own IBNR calcs: –Percentage of claims run off after each year: OCR: –Companies’ case estimates

36. 36 Financial Condition Reporting for South African Short Term Insurers Liability estimation: Prescribed Margin Added to IBNR and OCR best estimates To take up to 75 th percentile Based on formula: Where:

37. 37 Financial Condition Reporting for South African Short Term Insurers Liability estimation: UPR Aim is also to have best estimate But if UPR calculated using 365ths method, already includes margin of prudence given that premium includes profit margin We have assumed this margin takes us up to 75 th percentile But still need to estimate the implicit margin for giving credit towards total capital requirements…

38. 38 Financial Condition Reporting for South African Short Term Insurers Recap: we have all elements of framework:

39. Financial Condition Reporting for South African Short Term Insurers 39 Results of calibration

40. 40 Financial Condition Reporting for South African Short Term Insurers Overall results: reserves

41. 41 Financial Condition Reporting for South African Short Term Insurers Overall results: reserves Reserves may be understated for niche insurers and reinsurers – due to longer run-off patterns – inadequate data to calibrate separately for them…

42. 42 Financial Condition Reporting for South African Short Term Insurers Overall results: MCR

43. 43 Financial Condition Reporting for South African Short Term Insurers Overall results: Total Capital Required (MCR + PM)

44. 44 Financial Condition Reporting for South African Short Term Insurers Comparison: different levels of sufficiency

45. 45 Financial Condition Reporting for South African Short Term Insurers Comparison with adjusted shareholders’ assets Adjustment takes into account prescribed reserving method and a release of the 10% contingency reserve Only show companies with shortfall – several have adequate capital…

46. 46 Financial Condition Reporting for South African Short Term Insurers Applicability of industry calibration We believe it should generally be applicable to typical insurers But with cell captives, does not adequately reflect: –Non-proportional reinsurance (and expenses sometimes included in reinsurance) –Lower risks due to structuring of business: e.g. recapitalisation built into contracts Very limited data for cell captives Industry calibration more appropriate to third party rather than first party cells Recommendation that cell captives submit capital requirements on the basis of a certified model Extensive consultation with cell captive market still required

47. 47 Financial Condition Reporting for South African Short Term Insurers Applicability of industry calibration Industry calibration should be applied with care for reinsurers: –Reinsurance business may be more risky / volatile than traditional –Longer tail business due to reporting delays –Format of data in STAR returns not appropriate Recommendation for reinsurers: –At least reserving calculation on certified model basis, given longer run-off –Modify STAR returns –Impractical to calibrate specifically for them, given small number in SA Niche insurers: may also not be appropriate depending on nature of business: –E.g. some have different run-off patterns (up to 15 years) –Some have specific arrangements e.g. Government guarantee For companies in run-off, model may give artificially low result for capital – certified model should apply to capital calculation

48. 48 Financial Condition Reporting for South African Short Term Insurers What level of sufficiency to adopt? We believe 99.5% level too prudent at the outset – rather build up to it over time… Allows companies to build up capital, also using investment returns on increasing assets, and gives time to collect more data and test 99.5% level before implementing it finally Following tables show years of net profit vs capital required at industry level Imperfect measure, but perhaps gives some indication of when industry should move from 98% to 99% to 99.5% Also, bear in mind with certified models that companies with most significant shortfall will probably apply to reduce capital requirement

49. 49 Financial Condition Reporting for South African Short Term Insurers What level of sufficiency to adopt? At 98% level, number of years’ net profit required to build up to capital (e.g. for 55% of market by number of companies and 66% of market by net premium = 0 years):

50. 50 Financial Condition Reporting for South African Short Term Insurers What level of sufficiency to adopt? After 4 years, 87% of market (by net premium) is at 99% level (if using only net profit)

51. 51 Financial Condition Reporting for South African Short Term Insurers What level of sufficiency to adopt? After 6 years, 90% of market (by net premium) is at 99.5% level (if using only net profit)

52. Financial Condition Reporting for South African Short Term Insurers 52 Recommendations

53. 53 Financial Condition Reporting for South African Short Term Insurers Recommendations We recommend that: –Industry calibration should be done in accordance with the methodology and assumptions outlined above –STAR returns to be expanded to include more data on non-proportional reinsurance, reinsurers, cell captives and co-insurance –Reinsurance data may be used to refine calibration of model in future –No explicit allowance should be made for the underwriting cycle –No explicit allowance should be set aside for operational risk –Specific attention to be given to developing framework for certified model for cell captives (esp first party cells), reinsurers, some niche insurers, companies in run-off –Further consultation required with these sectors –Despite this, industry calibration should be used as benchmark for all sectors –FSB should also establish framework for internal models –Grossing-up factor on insurance capital charge to be limited to 50%, to avoid requirement being too onerous

54. 54 Financial Condition Reporting for South African Short Term Insurers Recommendations We recommend that: –Capital requirement implemented at 98% for 4 years, then 99% for two years thereafter, then 99.5% –Collected additional data to ensure that refinements can be made by the time 99.5% level reached –Determine intervention points: we recommend a fairly low intervention / action point, say 1.1. times MCR, with more extensive interventions when falling below MCR –Every company falling short of MCR should agree with the FSB: –Whether they will use certified model or internal model –Whether they will apply for special dispensation even if using certified model or internal model –How the company will reach capital required as agreed with FSB –To make application of model easier for companies, use spreadsheet contained in STAR returns –Our recommendations are first step: FSB now has to decide how to take it forward…

55. Financial Condition Reporting for South African Short Term Insurers 55 The way forward

56. 56 Financial Condition Reporting for South African Short Term Insurers The way forward Recalibration report will be published FSB working group will discuss its findings and other outstanding issues (e.g. internal models, reporting etc) Working group will discuss draft wording for changes to legislation to implement FCR The usual process to change legislation will be followed Implementation - not before 2007