Chapter 13- On-going Solvency

Question 1

Describe the purpose for analysing on-going solvency? (6)

Answer 1

• One of the primary roles of the HAF is to ensure that the life insurance office remains solvent

• Additionally policyholder reasonable expectations (PRE) needs to be satisfied for with-profit policies

• Exposures to risks that have not been explained to some policyholders will create probabilities of not meeting PRE
o E.g. investment policies that differs significantly from similar companies

• The capital requirements cannot simply be assessed by considering current assets and liabilities

• The need for capital is driven by the tails of the loss distribution from all the risks borne by the company as well as the requirement to fund the on-going business strategy

• This requires the projection of on-going solvency for the company that allows appropriately for the size and probability of downside risk and capital need to support new business strategy

Question 2

List the various needs for capital? (8)

Answer 2

• Providing protection against adverse experience
• Funding new business
• Support a riskier investment strategy
• Funding overheads and development costs
• Acquiring companies and blocks of business
• Satisfying solvency valuation requirements
• Supporting with-profit bonuses and smoothing
• Provide day-to-day working capital

Question 3

List the reasons for projecting solvency? (4)

Answer 3

• Assess impact of Planning & business strategy decisions
o E.g. NBS (and hence volume of new business) supportable by available capital
o Funding plans are put in place where available capital is insufficient

• Preparing run-off plans for funds
o especially with-profits funds that are closed or in decline

• Estimate the pattern of capital releases to shareholders
o  to assess cost of capital in calculating EV

• (Risk management) SAM  solvency projections required under ORSA

Question 4

Describe the characteristics of assets to be regarded as a source of capital? (4)

Answer 4

• For the purposes of demonstrating solvency capital is only allowed for to the extent that it is available to be transferred to the policyholder fund should a shortfall arise in adverse circumstances and in extreme event to meet policyholder liabilities

• Funds that are available but rank equally to the claims of the policyholder would not constitute capital

• Retained earnings or subordinated debt to the interests of the policyholders could be regarded as capital

• Funds that could be called up in the future if needed could also be regarded as capital (ancillary own funds)

Question 5

List methods of raising capital? (4)

Answer 5

• Further issue of ordinary shares

• Preference shares and loan stocks are discouraged in practice

• The registrar has however recently allowed hybrid debt that is subordinated to the interests of the policyholder

• Under SAM preference shares and hybrid debt will be subject to tiering depending on the quality of the instrument

Question 6

Define economic capital, required economic capital, available economic capital and methods of calculating economic capital? (4)

Answer 6

• Internal assessment of the value of assets required in excess of liabilities so that
o claims can be met with a high degree of certainty when they fall due
o (allowing for [all risks] and the [company’s ongoing business strategy])

• Required economic capital:
o capital required to support a business with a certain probability of default
 ‘required’ from eco point of view, not regulatory
o ‘amount of eco cap business believes it needs’

• Available economic capital:
o excess of the value of the company’s assets over the value of its liabilities on a realistic or market-consistent basis
 closely related to EV
o ‘amount of eco cap the business actually has’

• Methods of calculating EC:
o Stochastic modelling
 Usually used to asses market and interest rate risks
• By projecting A&L’s across large # of real world inv scenarios
 Can also be used for other risks – if distribution of possible outcomes is available
• Eg use stochastic mortality to model longevity risk for annuities
o Stress tests:
 where the distribution of a particular risk is less clearly understood
 impact of inter-dependencies between risks needed
• to develop overall eco cap requirement

Question 7

Describe Capital Rating Agencies? (3)

Answer 7

• Rating agencies have own measure of capital adequacy (together with other measures)

• Insurer wants to meet these requirements in order to achieve a certain credit rating

• Rating agencies’ capital adequacy standards may be considered a proxy for policyholders’ requirements

Question 8

Describe regulatory capital? (5)?

Answer 8

• The purpose is to satisfy the regulator that a company has sufficient recourses to fulfil obligations to policyholders
• The calculation is designed to quantify the minimum level of excess assets than liabilities that will provide a cushion against extreme fluctuations in the experience in any variables used in statutory valuation
• The quantum of the cushion is set in such a manner that majority of the experience will result in a reduced cushion rather than a deficit under statutory valuation
• The regulatory capital is usually set with reference to a confidence interval that is the same for all companies
• The second function is to act as a regulatory warning system to possibly indicate the need for regulatory intervention and remedial action

Question 9

Describe the 7 principles of financial soundness according of FS1?

Answer 9

• Insurers must hold own funds of sufficient quality and quantity to absorb unforeseen losses arising from the insurers activities
• The risk tolerance of the PA that informs minimum financial soundness requirements should be defined as the insurer maintaining regulatory solvency in face of a range of adverse scenarios
• The regulatory approach to calculating solvency capital is risk-based and forward looking
• In determining the value of eligible own funds, assets and liabilities should be valued on a market consistent basis unless specified otherwise
• The regulatory capital should address areas where the insurer is exposed and be proportionate to the nature scale and complexity of these risks
• The capital required should take into account diversification as well as correlations between risks
• The financial soundness requirements include trigger level of eligible own funds in which regulatory intervention will occur

Question 10

Describe the valuation of the assets for the prudential supervision balance sheet? (4)

Answer 10

The value of assets mainly follows International financial reporting standards (IFRS) i.e. market consistent and economic approach. There are some minor deviations from IFRS to bring assets and liabilities closer to an economic approach

• Goodwill should be valued at zero

• Other intangible assets should only be included given that fair value can be paced on them

• Financial assets (derivatives, loans, debt and equity) must value at fair value

• Participations (i.e. subsidiaries) must be valued at
o Market value if listed
o Adjusted net asset value (NAV less goodwill and intagibles) if unlisted possible
o IFRS value otherwise

Question 11

Describe the valuation of the liabilities for the prudential supervision balance sheet? (3)

Answer 11

• Liabilities consist of technical provisions and other liabilities

• Technical provisions are obligations to policyholders and beneficiaries and are calculated on a market consistent basis

• Other liabilities are non-insurance liabilities such a tax (current and deferred) which can also include creditors and subordinated debt (generally valued using IFRS fair value principles)

Question 12

Describe basic own funds in the prudential supervision balance sheet? (2,7)

Answer 12

• Basic own funds are defined in market consistent balance sheet as excess assets over liabilities plus subordinated debt less any regulatory adjustments

• Regulatory adjustments are made for:
o Certain intangible assets
o Holdings in own shares
o Holding in own holding company shares
o Cash deposits in a bank in the same financial conglomerate
o Restrictive reserves
o Participation in financial and credit institutions
o Ring-fenced funds

Question 13

Describe eligible own funds in the prudential supervision balance sheet? (6)

Answer 13

• Capital resources for financial soundness purposes are denoted own funds which consist of basic own funds and ancillary own funds

• Ancillary own funds are off-balance-sheet capital recourses that can be called upon to meet loses

• Available own funds are split into tiers based on strict criteria that take into account whether assets will be available immediately at full value

• Limits apply to various tiers in which they can be used to cover SCR and MCR requirements

• There are also limits on the own funds that can be used in demonstrating financial soundness

• The remaining own funds are denoted as eligible capital

Question 14

Describe Solvency Capital Requirements? (4)

Answer 14

• SCR corresponds to the value-at-risk of basic own funds subject to a confidence level of 99.5% over a one year time horizon

• SCR can be calculated using a full or partial internal model or a standardised formula

• The standard formula is designed to be relatively simple to apply and is suitable for a company with typical risk exposures

• Simplifications in standardised formula make it less suitable for specialised insurers with complex risk

Question 15

Describe the SCR calculation using a standardised formula (5)?

Answer 15

• The standardised formula follows a modular structure calibrated to south African market
• The main features of a standardised formula is that
o it is forward-looking and risk based that addresses key risks faced
o measures risk primarily through stress scenarios on assets and liabilities of the insurer
o Is proportional in that simplifications may be allowed
o Makes allowance for diversification between risks, risk mitigation instruments, future management actions and policyholder behaviour

Question 16

List the modular composition of the standarised formula approach to calculate SCR? (4,7,7)

Answer 16

• The composition of SCR using the modular approach is as follows:
o BSCR
 Market
• Interest rate
• Equity
• Property
• Spread and Credit default
• Currency
• Concentration
• Illiquidity
• Adjses (look into this further?)
 Life underwriting
• Mortality
• Longevity
• Morbidity
• Lapse
• Expense
• Retrenchment
• catastrophe
o Operational risk
o Participation
o Adjustments

Question 17

List the general structure of FSI 4? (6)

Answer 17

General Approach
o Treatment of new business
o Allowance for management actions
o Allowance for policyholder behaviour and risk mitigation
o Ring-fenced funds
o Simplifications
o Treatment of participations within the same sector

Question 18

Describe the various risk caegories included in FSI 4.1, 4.2, 4.4? (3)

Answer 18

• FSI 4.1 Market risk capital requirement covers the risk of loss arising for movements in market variables that affect the assets and liabilities of the insurer including credit default risk

• FSI 4.2 Life underwriting capital requirements. This covers the risk from insurance obligations such as poor claims experience, expense over-runs and policy lapses

• FSI 4.4 Operational risk capital requirements. This covers the risk of loss for the failure of systems, internal control, people and external events

Question 19

List examples of changes for interest rates shocks in standardised formula approach to calculate SCR? (5)

Answer 19

• The greater of proportional shifts in the nominal yield curve upwards or downwards by varying magnitudes by term

• The greater of proportional shifts in the real yield curve upwards or downwards by varying magnitudes by term (nominal yield remains the same)

• The shifts also need to result in absolute change of 1% and are subject to a minimum of 0% (ZLB)

• An increase in the swaptions implied volatility which varies by term

• Allowance for diversification of above risks

Question 20

List examples of changes for Equity shocks in standardised formula approach to calculate SCR? (5)

Answer 20

• Instantaneous fall in the price of equities, with separate reduction in various categories:
o Global equities
o SA equities
o Infrastructure assets
o Other

(A systematic adjustment is also made to the above categories)

• Equity volatility risk i.e. an increase in equity volatility assumptions with increases dependent on terms to maturity as well as depending in whether the estimates are implied or observed

Question 21

List examples of changes for Property shocks in standardised formula approach to calculate SCR? (1)

Answer 21

• Property risk an instantaneous decrease in the value of property (25%)

Question 22

List examples of changes for currency shocks in standardised formula approach to calculate SCR? (1)

Answer 22

• Currency risk either a proportional instantaneous 50% rise or 30% fall of other currencies against the rand

Question 23

List examples of changes for spread and deafult shocks in standardised formula approach to calculate SCR? (3)

Answer 23

o the sum of spread risk on interest bearing instruments i.e. change in value of instrument due to changes in credit spread

o Default risk complex calculation based on credit rating and exposure (done separately for rated exposures, non-rated exposures and cash held at banking institutions allowing for diversification)

o No diversification for above allowed

Question 24

List examples of changes for concentration shocks in standardised formula approach to calculate SCR? (1)

Answer 24

• Concentrations risk i.e. based on exposure concentration and credit rating of counter parties

Question 25

List examples of changes for Mortality shocks in standardised formula approach to calculate SCR? (1)

Answer 25

• Mortality risk a 15% permanent increase in mortality rate for all ages relative to best estimate for policies with a mortality benefit

Question 26

List examples of changes for longevity shocks in standardised formula approach to calculate SCR? (1)

Answer 26

• A permanent 10% relative decrease in mortality rates relative to best estimate assumptions (i.e. mortality rates should be multiplied by 0.9) and a permanent absolute 1% increase in future mortality improvements relative to best estimate assumptions for each age and each policy, where the payment of benefits is contingent on longevity risk.

Question 27

List examples of changes for Morbidity/Medical shocks in standardised formula approach to calculate SCR? (5)

Answer 27

Disability or morbidity risk is the risk of loss or adverse change in the value of insurance obligations resulting from changes in the level, trend or volatility of disability-morbidity rates.7 The capital requirement for disability-morbidity risk must also cover for the risk of changes to medical inflation relating to medical expense insurance obligations.

o Medical expense obligations
 A permanent absolute increase of 1% in claims inflations assumptions with a 5% permanent relative increase in claims rates
 If premiums are reviewable then a 5% decrease in the claims assumptions (resulting in lower premiums)

o Income protection and lumpsum disability benefits
 Increase of 25% in disability/morbidity assumptions relative to best estimate
 Decrease of 20% in disability/morbidity assumptions recovery rates where applicable

o No allowance for diversification

Question 28

List examples of changes for Lapse shocks in standardised formula approach to calculate SCR? (3)

Answer 28

o Mass lapse scenario: immediate lapse of a percentage of homogenous groups (40% individual life and 70% for group). Total expenses are to remain constant for one year.

o Level stress scenario: the greater of a permanent reduction (per homogenous group) or permanent increase in assumed option exercise rates in all future years

o Combined stress scenario i.e. Mass lapse and an adjusted level stress scenario

Question 29

List examples of changes for Expense shocks in standardised formula approach to calculate SCR? (2)

Answer 29

o An increase in 10% of all future expenses relative to best estimates
o The greater if an absolute addition of 2% or a proportional increase of expenses inflation by 20%

Question 30

List examples of changes for Life catastrophe shocks in standardised formula approach to calculate SCR? (2)

Answer 30

o Additions to the mortality and morbidity rates for the next three months and then assumptions returning to best estimate values

o An allowance for diversification is permitted

Question 31

List examples of changes for retrenchment shocks in standardised formula approach to calculate SCR?

Answer 31

o A permanent increase in retrenchment inception rates relative to best estimate for each age

Question 32

Explain the calculation of operational risk category in standardised formula approach to calculate SCR? (5)

Answer 32

o For non-investment life operations the greater of
 4% of the sum of earned premiums over the past 12 months
 0.45% of technical provisions excluding risk margins (subject to minimum of zero)
 With an absolute maximum of 30% of BSCR

o Investment insurance obligations equal to the greater of:
 25% of annual expenses incurred over past 12 months excluding commission
 Sliding scale percentage of assets under management’

Question 33

Describe the general approach/methodology of the calculation of SCR using standardised formula? (5)

Answer 33

• Separate correlation matrices are used to aggregate the capital requirements at different stage/levels of granularities
o Combining risk with the specific risk modules e.g. different types of equity in equity risk
o Combining risk across risk modules e.g. interest, property and credit risk within market risk category
o Combining risk categories e.g. market and underwriting categories to obtain BSCR

• The overall capital requirements are calculated by then adding the capital requirements for
o participation within same sector
o Operational risk
o Adjustment for loss absorbing capacity of deferred tax

• The loss absorbing capacity arises because the deferred tax liability can be reduced due to a loss from an SCR

• Allowance is also made for the loss absorbance of technical provisions (within market risk) which takes into account the ability to
o Vary bonuses on participating business
o Vary premium and charges in response to shock

• Changes to policyholder behaviours should also be include in determining the capital requirements
o Take up rate on guarantees and options
o Reduce lapses when guarantees and options are likely to bite

Question 34

Describe considerations when allowing for the loss absorbing capacity of technical provisions? (3)

Answer 34

• This need to take into account policyholder reasonable expectations and needs to be approved by the board

• The capital requirement calculation needs to consider whether the impact is insurer specific or industry wide when taking into account loss absorbing capacity of technical provisions

• An explicit adjustment for double counting loss absorbing ability of the technical provisions needs to be made

Question 35

Describe the shortcomings of the standardised formula approach? (7)

Answer 35

• The use of multiple correlation matrices is theoretically invalid which would result in inaccuracies in the correlations between risks

• May not be appropriate for fast growing or closed book business

• Operation risk is model at a very high level without reference to an insurers risk management framework

• It does not allow for non-linearity i.e. the quantum of individual capital requirements of risks are higher if they occur together example longevity and interest rate risk

• Complex risk management techniques cannot be allowed for in the standardised formula

• There is only an adjustment for double counting loss absorbing capacity of technical provisions in market risk module what if may result in another module

• The allowance of risk sharing in cell captives is allowed on a approximate basis which may overstate SCR

Question 36

Describe the use of an internal model as alternative to calculate SCR as well as requirements? (8)

Answer 36

• A full or partial internal module will allow for a broader understanding of the range of risks a company faces

• The key difference is that the model does not provide a point estimate based on pre-specified scenarios but considers a wide range of scenarios (probability density forecast)

• The use of an internal module is subject to regulatory approval by the PA and needs to satisfy the following requirements:
o There needs to be effective governance regarding the internal module including the model change policy that will applicable
o There needs to be a demonstration via use test of the model being widely in decision making and risk management and plays an important role in governance
o The internal model should meet appropriate statistical quality, data quality, calibrations and validation requirements
o The internal models design and operations should be appropriately documented
o Partial internal models require additional justifications and demonstration of integration with standardised formula

The use test includes the use of the internal model in:
• Decision making processes
• Business planning
• Risk management
• Capital assessment and allocation
• ORSA

Question 37

Describe minimum capital requirements? (5)

Answer 37

• The MCR specifies a lower bound for SCR were if capital were to fall below this level would result in unacceptable risk for the policyholder in operations continue

• The MCR is calibrated at the VaR of basic own funds with a 85% confidence level over a one year period

• MCR is a simple application of a formula equal to technical provisions and capital at risk factors multiplied by specific factors

• There also are upper and lower bounds proportional to SCR

• Furthermore the MCR is subject to an absolute minimum of R15 million or 25% of gross annualised operation expenses