Chapter 14: Reserving bases

Question 1

9 Reasons for assessing a general insurer’s liabilities

Answer 1

To determine liabilities:

• – for demonstrating supervisory solvency
• – for internal management accounts
• – for published accounts
• to provide information to management on business performance by area
• to estimate claims costs for premium rating
• to value an insurer for sale or purchase
• to negotiate a commutation for the buyer or seller
• to transfer a book of business
• to ascertain tax liabilities
• to check reasonableness/adequacy of reserves
• to test the adequacy of case estimates

Question 2

Define ‘reserving basis’

Answer 2

the methodology and assumptions chosen in a reserving exercise.

Question 3

Considerations when setting reserving bases for:
Published accounts (6)

Answer 3

The legislation and accounting principles governing the preparation of those accounts in the territory concerned:

• Whether the accounts are to be prepared on a going concern basis?
• Whether the accounts are required to show a true and fair view.
• Whether reserves are required to be assessed as best estimates or on some other basis.
• Whether reserves are required to be discounted, and if explicit risk margins need to be held.

basis used in prior years

Question 4

Considerations when setting reserving bases for:
Tax purposes

Answer 4

Depends on the tax regulations in the relevant country.

Tax authorities may penalise an insurer when it is found to have over-reserved and therefore paid less tax.

Question 5

Considerations when setting reserving bases for:
Management accounts

Answer 5

Mgmt Information/accounts:
*generally on a realistic basis
* because it is used in decision making
*a range of results helps in decision making, hence stochastic reserving basis may be helpful
*depends on the purpose for which management is seeking information
*disucssion with management on the requried strenght of the reserves will help choose the right method/basis”

Question 6

Considerations when setting reserving bases for:
Sale or purchase

Answer 6

A starting point for negotiations is the liabilities shown on the balance sheet.

A purchases will want a more prudent view compared to the vendor.

Question 7

Considerations when setting reserving bases for:
Commutation

Answer 7

Similar to sale and purchase, but also consider:

• the effect on reinsurance recoverability
• the relative strategic / commercial importance of the commutation between the two parties
• the actual / perceived financial strength of parties

Question 8

Commutation

Answer 8

The finalisation of an outstanding liability by payment of an agreed amount.

Question 9

Reserving methodologies are likely to vary according to (7)

Answer 9

• the PURPOSE of the reserving exercise.
• CLASS OF BUSINESS, in particular the timing of the run-off of the liabilities and the exposure period of the insurance / reinsurance contracts
• the TYPES OF CLAIM that have been incurred or may be expected to occur
• the key factors that determine the development of claims
• HISTORICAL trends and patterns
• the extend and quality of the available DATA
• the AGE of the business

Question 10

What extra information can be gained from modelling IBNER and pure IBNR separately?

Answer 10

We can determine whether a change in our required outstanding claims reserve is due to an increase in the number of claims reported, or due to prudence / optimism in our original case estimate assumptions.

Question 11

State how an actuarial report could communicate uncertainty (4)

Answer 11

• giving a range, measure of the value at risk or other statistical calculation
• showing the numerical consequences of changes in assumptions
• presenting the outcomes of scenarios, possibly including extreme scenarios
• describing the uncertainty and explaining why it has not been quantified.

Question 12

Considerations regarding DISCOUNTING when reserving

Answer 12

Discounting makes allowance for investment income because delays in claim payment results in an opportunity to invest for an insurer.

By deciding whether to discount reserves, we should consider whether discounting is allowed by regulation.

If allowed, regulation might specify a discount rate.

Question 13

If not specified, then the discount rate needs to be determined based on (3)

Answer 13

• currency of liabilities
• nature of liabilities and assets
• risk-free yield curve at the valuation date.

and also term of the liabilities

Question 14

14 main items or topics to be included in the scope of an aggregate report on the technical provisions of an insurance entity

Answer 14

• PURPOSE of the report and to whom it is addressed
• a statement of whether the results are the outcome of a planning exercise, a valuation exercise, or some other exercise
• a statement of which TAS the report complies with
• an indication of any material EVENTS that HAPPENED since the effective date of the data
• a description of the DATA used and the source of the data
• a description of any material uncertainty over the ACCURACY of the data and how this has been allowed for
• a summary of the ASSUMPTIONS used and the rationales behind these
• a description of any other material MATTERS relating to the work
• the nature and extent of any material UNCERTAINTY in the work / results
• the METHODS and measures used in any calculations
• the nature and timing of any CASHFLOWS being calculated
• a description of any PROBABILITIES
• a comparison with PREVIOUS WORK
• a PROJECTION OF RESULTS at future points in time

Question 15

When communicating the uncertainty of the results, an actuary should: (7)

Answer 15

• explain WHAT HAS BEEN ALLOWED FOR the best estimate, and WHAT HAS NOT
• ensure stakeholders understand the LEVEL OF UNCERTAINTY
• comment on the UNCERTAINTY IN THE CONTEXT AND SCOPE and purpose
• focussing on the most SIGNIFICANT ISSUES, given the purpose of the exercise
• emphasise the unusual issues
• avoid MISUNDERSTANDINGS
• be consistent with VOCABULARY used by other professionals, and explain terms

Question 16

Reasons for assessing liabilities

Answer 16

“TAT IS CRAP
Tax Liabilities
Adequacy of Case estimates
Transfer of Book of business
Information to Management
Supervisory Solvency
Commutation
Reasonableness of reserves
Accounts published
Purchase/Sale/merger & Premium rating”

Question 17

What is the appropriate basis for each purpose ie. assessing liabilities

Answer 17

“Published accounts – prudent basis, to ensure stability and consistency year on year. Alternatively, best estimate. It depends on whether the insurer is using IFRS 4, IFRS 17, Solvency II, UK GAAP, etc.

Solvency supervision accounts – best estimate under Solvency II. In some territories outside the EEA (European Economic Area), a prudent basis may be used, to protect policyholders.
 
Internal management accounts – best estimate basis, to give a realistic view of the financial condition of the company.
Rating process – best estimate basis. A prudent basis could lead to the premiums being set too high while an optimistic basis could lead to the premiums being set too low. We don’t want implicit margins in the premium rates.
The
Purchase or sale – best estimate basis is likely to be the starting point for negotiations. However, the seller might want to use an optimistic basis and the buyer might want a prudent basis. The final basis will depend on the relative bargaining power of the two parties.

Accuracy of previous reserve estimates  often no estimation is needed since we are comparing actual paid claims with those expected by previous estimates. If we are analysing incurred claims, then it makes sense to use the same basis as that used in the previous reserve estimation exercise in order that a meaningful comparison can be made.

Information for management – best estimate basis, to give a realistic view. We will also be interested in the sensitivity of the results, so we will use several different bases, for example worst case scenarios”

Question 18

Factors that will influence the choice of valuation method and assumptions

Answer 18

”* Line of Business - long tailed or liability may need stronger reserving basis
* Size of free reserves or solvency margin - ie companies with very large margins may be relaxed about using strong bases
* Purpose of the valuation and strength of reserves appropriate for the purpose - eg. tax purpose vs. solvency
*Data availability, data quality and if experience is stable
* Age of the book of business”

Question 19

Choosing a discounting rate for reserves

Answer 19

Considerable delays can arise between receipt of the premium by the insurer and ultimate payment of claims. Hence there is an opportunity to earn investment income. This can be allowed for in the calculation of reserves by discounting the expected future claim payments to the calculation date

”*Based on the underlying assets supporting that class of business
*the expected rate of return from those assets given the term of such liabilities, risk free yield curve, currency, etc.
*We should determine whether the discount rate is gross or net of tax and disclose this as part of the reserving basis.
*should be consistent with inflation assumptions
*should be allowed for the purpose of the reserving exercise under the prevailing regulations”
Discounting may be more appropriate where we wish to have a realistic picture of the economic results or financial condition of the insurer.
Discounting gives a more realistic view of the profits and makes comparison between classes more valid. Not discounting makes long-tail classes look relatively less profitable.

Regulation may specify the assumption for the rate of discount to be used for the purpose in question. It could also be specified in a contract, for example the commutation clause in a reinsurance treaty.

Question 20

what is best estimate

Answer 20

Best estimate basis reflects the mean or expected value of an outcome as judged by an actuary.

For reserving - The definition of a ‘best estimate’ differs between practitioners, however it is generally understood to represent the mathematical expected value (mean) of the distribution of possible outcomes of the unpaid liabilities.

Question 21

Why two actuaries come up with different results on a best estimate basis

Answer 21

”*Different data, methods and assumptions
*Different time period
*Errors in the work or data which is not resolved
*Difference in judgement, subjective nature of work
*Availability of data and alternate methods used to compensate for it
*Different number of simulations or outcomes considered leading to different mean values”

Question 22

A2021 - Q.8:
Company XYZ is a general insurance company that will be required to do its financial
reporting based on a new accounting standard in a couple of years. As part of this new
standard, it is prescribed that claims liabilities must be discounted using a suitable
yield curve, with the discounted reserves being reported in the company’s balance
sheet. The company’s current approach is to report the reserve amounts in its balance
sheet on an undiscounted basis.
(i) Discuss the factors that Company XYZ should consider when discounting its
claims liabilities.

Answer 22

Q8
(i)
The Company will require a paid claims pattern, in order to project out the future claims cashflows to be discounted [½]
Need to consider how to derive the paid pattern [½]
The pattern should not be too volatile from one reporting period to the other [½]
Choosing a suitable yield curve [½]
Regulations/accounting standards ay specify the yield curve to be used [½]
Or it could likely be set with reference to the risk-free yield curve as at the valuation date [½]
The illiquidity premium should allow for the difference between the liquidity characteristics of the insurance contracts and the liquidity characteristics of assets used to arrive at the Company’s selected yield curve [½]
As well as adjusting due to differences between asset and liability cashflows in terms of amount/timing/mean term/uncertainty [½]
should also take into account the currencies of its claims liabilities [½]
Will need to take into consideration any implicit discounting [½]
What the competitors/peers/Group company is doing [½]
Communicating the change in reserves due to discounting, its impact on profits and taxes [½]
Its impact on the market risk calculations [½]
It is important to consider consistency between the economic inflation assumptions and the discount rate [½]
as well as any assumptions used for yields and asset returns in a corresponding solvency assessment [½]
Need to consider whether the rate of discount is gross or net of tax and disclose this as a part of the reserving basis
Potential implications on any reinsurance terms and conditions [½]

Question 23

A2021 Q.8:

The new accounting standard requires quantification of the impact that movements in
the chosen yield curves have on claims liabilities from one year-end to the next when
producing the company’s income statement. The impact on assets must also be
considered, with the combined impact on both assets and liabilities then disclosed in
the company’s income statement. Movements in claims liabilities due to movements
in yield curves introduces additional volatility into the company’s income statement.
(ii) Discuss how this volatility may be reduced when the impact of movements in
yield curves is considered for both assets and liabilities in aggregate.

Answer 23

(ii)
Combining/Aggregating the impact of the change in liabilities and assets caused by movements in yield curves, will remove at least some of the volatility compared to if we considered the Company’s liabilities in isolation [2]
[2] marks to be awarded only if all aspects from the above point have been conveyed.
for instance if the candidate says it will remove all volatility then only ½ mark to be awarded
Assuming that the Company is to some extent matched from an asset-liability matching perspective, then the additional source of movement in the Company’s claims reserves (caused by discounting), would be offset by movements in asset values in the opposite direction [1]
For example, if downward shifts in the Company’s chosen yield curves caused liability values to increase, this may be offset (at least to some extent) by an increase in the value of the corresponding assets [1]
However, it might not be possible to fully eliminate the volatility, due to an imperfect matching of assets and liabilities in real-life scenarios [1]
Any other suitable point [1]

Question 24

A2021 Q.8:
The company expects that on average its assets will be of shorter duration than its
corresponding claims liability exposures.
(iii) Describe the impact of a downward movement in yield curves on the
company’s income statement. [3]
(iv) Suggest two possible actions Company XYZ could take in relation to the
duration of its assets and liabilities as a result of a greater than expected
increase in yield curves.

Answer 24

(iii)
Assuming the level of the Company’s reserves is stable from one year-end to the next, and yield curves are positive [½]
A downward movement in yield curves will reduce the discounting impact within the Company’s claims reserves, and as such its claims liabilities will increase [½]
On the assets side, the movement downwards in yield curves is likely to increase the value of the Company’s assets [½]
This increase in the value of the Company’s assets will offset to some extent the increase in the value of the Company’s claims liabilities [½]
If the Company’s assets are on average of shorter duration than its corresponding liabilities, then the downward movement in yield curves will cause the value of the Company’s liabilities to increase by more than the corresponding increase in the Company’s assets [1]
Therefore, this will have an adverse impact on the Company’s Income Statement [½]
1 mark to be awarded only if the full meaning is conveyed, award half a mark if the relative movement between duration and change in the interest rates is not clearly articulated
Any other reasonable argument [1]
[Marks available 4½, maximum 3]
(iv)
Assuming the question is in relation to the preventing a negative impact on the income statement due to a greater than expected increase in the yield curves [½]
If yield curves rise more than expected, the value of both the Company’s claims liabilities and corresponding assets will decrease [½]
It could invest in assets of average duration shorter than that of its corresponding claims liabilities [½]
This will allow the Company to make a relative gain if yield curves rise by more than expected going forward [½]
Alternatively, Management may pursue a strategy where the Company is perfectly matched from an asset-liability perspective, such that regardless of the direction of movement in yield curves, this does not have an impact on the Income Statement, i.e. volatility removed [1]
1 mark to be awarded only if the full meaning is conveyed, award half a mark otherwise
Any other suitable action [1]

Question 25

Allowance for future inflation

Answer 25

In many situations, the allowance for future inflation will be implicit within the methodology, for example where a method implicitly assumes that future inflation will be similar to the average inflation experienced in the past.
However, we may consider the allowance for future inflation an important assumption in a particular context, or we may need to investigate the impact of alternative future inflation assumptions.
For example, in periods of economic instability, when future inflation may be uncertain, an insurer may wish to investigate the likely impact of different economic scenarios on future claims costs. This is particularly the case when an economic downturn may increase the incidence of fraudulent claims, and therefore exacerbate the extra cost to the insurer.
This may influence the method selected because explicit allowance for inflation within the estimates can be more easily incorporated in some methods than in others. For example, explicit allowance for inflation can usually be more easily incorporated in average cost per claim methods.
When making an assumption about inflation, we should carefully consider the allowance, if any, for inflation in excess of general economic inflation, such as consumer price and wage inflation. Such superimposed inflation could be a result of future step changes in average claim size arising from a change in the law or be reflective of the historical level of inflation seen in the claims.
For example, court award inflation in recent years has been well in excess of price inflation.
Relevant indices might be available from government or industry sources. Alternatively, the insurer may be able to prepare indices from its own claims experience. These may be more up to date and relevant than the other figures, but could be more uncertain if based on scanty or poor quality data.