Chapter 9- Supervisory and Published Reporting Valuations

Question 1

Describe the 3 main purposes for the valuation of liabilities as well as the associated bodies and regulation in which they are governed (3)?

Answer 1

(1) Published Reporting in financial statements which is governed by the registrar of companies and the companies Act. Usually valued using an IFRS methodology.

(2) Prudential reporting which is governed by the prudential authority and the Insurance Act 2017 and associated prudential standards

(3)Tax liability calculations are governed by SARS as well as the Income Tax Act

Question 2

Describe the IFRS standards applicable to the financial soundness methodology (FSV) ? (5)

Answer 2

• The financial soundness valuation method (described in SAP 104) play an important role in the valuation of liabilities for IFRS purposes for insurance contracts

• This methodology is current recognised practice and should be used unless a more reliable and relevant standard such is IFRS 17 is adopted

• Investment contracts with discretionary participation features can be valued using the financial soundness valuation until the implementation of IFRS 17 (look into this further when reading SAP 104)

• Other investment contracts are required to be treated in accordance with IFRS 9 (financial instruments) with disclosures governed by IFRS 7

• IFRS 15 revenue from contracts with customers deals with revenue recognition with investment contracts

Question 3

Describe the valuation of liabilities in the financial soundness methodology (FSV) ? (10)

Answer 3

FSV is intended to be prudently realistic and explicitly allow for
o future actual premiums received over the term of the contract
o as well as future experience including interest rates, expense, mortality and morbidity and other factors

• Minimum resilience is added to best estimate values of parameters through a compulsory margin

• Further resilience and prudent release of profits may be achieved through additional discretionary margins

• Negative reserves can be removed in order to remove the risk of surrender strain from earnings

• Both decision regarding the use of discretionary margins as well as treatment of negative liabilities lies with the board of directors

• Future options such a voluntary premium increases should only be included if they lead to higher liabilities

• The premium and benefits that should be included in the valuation must be those payable I terms of the contract and incorporate policyholder reasonable expectations

• The liabilities must be calculated excluding reinsurance with values of reinsurance separately quantified and reported

• Additional guidance for allowing for AIDS in mortality assumptions are included in APN 105

• Additional guidance for valuing guarantees and options are included in APN 110

Question 4

List the 4 components that influence the valuation assumptions in FSV (4)?

Answer 4

• Best-estimate assumptions
• Compulsory margins
• Discretionary margins
• Policyholder’s Reasonable Expectations

Question 5

Describe how best estimate liabilities are calculated in FSV (5)?

Answer 5

• Should be realistic,
o generally guided by past experience,
o and modified by any expectations regarding the future
o depend on nature & term of business

• Consider separately for homogeneous policy groups – eg split by:
o product type,
o demographic characteristics (cohort),
o distribution channel and
o location

• Allow for
o Realistic expenses
 Split between initial and renewal
 Expense inflation – consistent with i-rate used
o Lapses & surrender
 Consistent with past experience – modify for future trends
o Mortality & morbidity
 Consistent with past – modify for trends
 Include BE effect of AIDS

• Interest rate(s) to discount L’s
o Mutually consistent & consistent with yields of fixed-I securities
o Consider future inv returns of appropriate portfolio of A’s
 Term, nature & duration
o Allow for tax
 Effect of tax on inv returns
 Future changes in tax position
 Consider separately for each tax fund

• Sensitivity testing
o Assess sensitivity of valuation results to changes in parameters
o  may need to undertake valuations on more than one basis (but only report on ONE)

Question 6

Describe purpose and application requirements (not values) of complusory margins for liabilities calculated in FSV (5)?

Answer 6

• To introduce a degree of prudence
o and to defer profits
 (reduce risk that profits are recognised prematurely)

• If business not expected to be profitable on [BE assumptions] + [compulsory margins]
o a [new business loss] will have to be reported

• Retrospectively calculated reserves should be at least equal to the
o corresponding prospective reserve, which must make allowance for the compulsory margins

• Must be added throughout the lifetime of policies,
o except for regular renewable policies
 until at a min: max(12m; next renewal date)

• Future management actions may not be assumed to reduce compulsory margins

Question 7

Describe the calculations of the compulsory margin for various assumptions? (9)

Answer 7

Mortality 7.5% (increase for assurance, decrease for annuities)
Morbidity 10%
Health/medical 15%
Lapse 25% (eg if BE is 10%  margin is 2.5%)
Terminations for disability benefits in pmt 10%
Surrenders 10% (increase or decrease, depending on which alternative increases liabilities)
Expenses 10% level
Expense inflation 10% (of estimated escalation rate)

Charge against investment return
• Linked business (rand reserve):
o assume an investment fee (mngmt fee) that is 25 bps lower
o Eg inv fee is 1.5%  assume 1.25%

• Non-profit business:
o value liabilities at 0.25% less than the rate for valuing assets,
o adjusted for ax, asset mngmt charge and credit risk

• Reversionary bonus business:
o value liabilities at 0.25% less than the valuation rate for assets,
o adjust for tax, asset mngmt charge and credit risk
o WITHOUT adjusting the expected future bonus rate accordingly

Question 8

Describe how the direction of the complusory margin needs to be taken into account in the application (3)?

Answer 8

• Apply margins at a [policy grouping level]
o consistent with the level at which best-estimate assumptions have been set
o e.g. mortality assumption  increase for assurance vs decrease for annuity

• Direction may depend on duration of policy
o e.g. lapses  increase in early duration vs decrease at later durations
 whichever is more prudent (otherwise reserve is understated)
  if possible, increase lapse assumption in early durations and decrease it at later durations

• Charge against the investment return:
o negative liabilities at certain durations for some policies  rather ADD investment return margin to the BE rate

Question 9

Describe the puprose of discretionary margins including various examples of discretionary margins (5)?

Answer 9

• Include where the actuary believes that:
o Compulsory margins are insufficient for prudent reserving in a particular case
o To defer release of profits consistent with policy design or company practice

• Examples:
o Additional margin over & above compulsory margin
 Compulsory margin not prudent enough or
 Allow profits to be released in line with key profit drivers (eg mort)

o Add margin to assumption without compulsory margin
 Eg 20% margin to retrenchment claim rates
 Introduce appropriate prudence or
 Allow profits to be released in line with retrenchment risk

o Reserving on retrospective basis
 Discretionary margin = [retrospective L] - [prospective L including compulsory margins]
 Align release of profits with occurrence of policy CF’s

o Zeroising negative L’s
 Policy-per-policy basis / product level
 Increase prudence around withdrawal risk
 Reduce excessive profits at point of sale
• Zeroised Ls  profits recognised as and when you earn them
• Negative Ls  profits recognised at inception

Question 10

Descrbe how policyholder reasonable expectations need to be taken into account in the valuation of liabilities under FSV? (4)

Answer 10

• Depends on: type of product, past practice, market practice, marketing material, announcements / actions (e.g. PPFM published by 2007 year-end), market returns

• In calc of L’s  take account of PRE that will influence decisions on future distributions of surplus

• The bonus declarations will be set such that it is consistent with future economic conditions however PRE may result in declarations being different due to smoothing or reputational considerations

• The insurer may have made clear actions to change expectations of policyholders
o The actuary would need to considered what expectations have been created and how does the action change these expectations
o Expectation are usually created through the following:
 History of maintenance of bonus rates or strong smoothing of bonus over sustained period
 Illustration of future values assuming maintenance of bonus rates

Question 11

Describe the prudential valuation methodology (SAM) arcording to the Insurance Act 2017? (8)

Answer 11

• Actuarial liabilities calculated for prudential supervisory reporting are based on market consistent principles

• They consist of a best estimate liability as well as a risk margin for non-hedgeable risk

• The best estimate liability is a probability weighted average of projected cashflow discounted using a risk-free term structure

• The risk margin is an additional value to compensates the “receiver insurer” for the cost of capital to maintain financial soundness regarding the liabilities transferred

• When the cashflows of liabilities can be replicated in all scenarios by a portfolio of assets which are traded in an active market with reliable market values then the technical provisions can be set to the market value of portfolio of assets

• In this case it is not necessary to calculate the best estimate value and the risk margin as the technical provisions can be calculated as a whole

• Furthermore best estimates should be calculated gross of reinsurance with reinsurance recoverables (net of credit default risk) explicitly reflected as an asset on the balance sheet

• Simplifications can be done in the calculation of technical provisions and reinsurance recoverables that are proportionate to the nature, scale and complexity of the risk

Question 12

Describe the calculation of the best estimate liabilities in SAM valuation? (9)

Answer 12

• This is the discounted value of projected cashflows under each policy up until the “contract boundary” on a policy per policy basis

• It is possible for the best estimate liability to be negative

• The assumptions underlying the calculations of best estimate liabilities should be best estimate without a margin for prudence

• Projection should allow for expected decrements and policyholder actions including lapses

• The assumptions must be set by considering both internal and external data such that they reflect the risk profile/characteristics of the underling book

• The best estimate assumptions can allow for future management actions (such as reviewing premiums that the insurer could reasonably expect to implement)

• The management actions should take into account implementation time and be realistic and consistent with current business practice and strategy (unless evidence that this may change)

• Management actions should also be consistent with PPFM (principles and practice of financial management)

• Financial guarantees and options would need to be valued using stochastic analysis

Question 13

Describe the risk-discount rates used in the valuation of liabilities under SAM? (3)

Answer 13

• The risk-free term structure to discount cashflows shall be a government bond curve

• Where an insurer matches the liability with swap based assets the insurer can apply a swap curve (adjusted from credit and liquidity) as a basis for risk-free curve

• For annuities an illiquidity premium may be added subject to certain requirements to allow for the fact that a higher rate can be earned if assets are held to maturity

Question 14

Describe the calculation of the risk margin in the valuation of liabilities under SAM? (6)

Answer 14

• The risk premium is the additional amount that the receiver insurer would require to take over liabilities above the best estimate value

• It representations theoretical compensation of experience being worse than assumed in best estimates as well as for the cost of regulatory capital held against the risk

• The risk margin is calculated as the cost of holding an amount of eligible capital equal to SCR to support insurance obligations over lifetime (only for non-hedgeable risks)

• The prescribed cost of capital to be used in the calculation is 6% i.e. frictional cost of locking in SCR rather than using it freely

• When projection future non-hedgeable SCR simplifications can be used subject to the principle of proportionality

• The calculation of SCR allows for diversification across different lines of business therefore it is calculated for the business as a whole and then proportioned

Question 15

Contrast the valuation of participating and smooth bonus contracts under FSV and SAM? (11)

Answer 15

• Valuation of participating business under FSV should include expected allocation of profit to shareholders (if there is a relationship between profit attributable to shareholders and bonus declared for policyholders)

• However if expected allocations to shareholders acts as a buffer to adverse experience, the higher of expected allocations or compulsory margins should be used

• Where there is smoothing of distribution (i.e. conventional or accumulating with-profit) polices should also include the bonus stabilisation reserve that exists (i.e. undistributed surplus for future distribution)

• If the bonus fluctuation reserves is negative because of downward fluctuations in the market and the amount will likely be recovered through under distribution in ensuing three years which that this has been agreed with the board it can be used to reduce liabilities

• Under prudential supervisory reserves future discretionary bonuses needs to be included in technical provisions

• This is based on what the insurer expects to declare given the with profit asset pool

• The future bonuses increase/decrease in line with how bonuses are expected to be declared in the future

• The calculation needs to reflect realistic management actions e.g. dynamic reversionary bonus rates, equity backing ratios, charges that vary with economic conditions

• Furthermore policyholder behaviour would need to be taken into account example withdrawals relative to attractiveness of guarantees

• Unlike FSV it does not include the value of shareholder transfers in respect of future bonus declarations (recognition of surplus upfront for shareholder allocations)

• The best estimate valuation for business with discretionary elements should be calculated based on two separate components
o i.e. the guaranteed component i.e. basic benefit and vested bonuses attaching
o Unvested bonuses declared and future bonus declarations possibly using stochastic methods

Question 16

Contrast the valuation of annuity contracts under FSV and SAM? (4)

Answer 16

• Valuation under FSV requires the expected projected cashflows to be discounted according to the duration in the yield curve of appropriate backing assets which would have been reduced to allow for
o Management fees
o Credit risk
o Investment return compulsory margin

• Alternatively the cashflows can be discounted using a single rate that
results in the same valuation as above

• Inflation linked annuities should be valued in real terms according to the adjusted real yield in the same way as above

• Prudential supervisory reporting the risk-free yield curve is used to discount projected cashflows determined under the general standards (adjusted for an illiquidity premium)

Question 17

Describe the valuation of unit reserves under FSV and SAM? (3)

Answer 17

• The unit reserve will equal the number of units allocated to the policy multiplied by the unit price at the valuation date (with an allowance for tax)

• The FSV valuation allows for the reduction in the unit reserve due to actuarial funding

• The prudential supervisory method allows for a reduction in the unit reserve but this is offset by the increase in non-unit reserve due to less management charges in the future

Question 18

Describe the valuation of non-unit reserves under FSV and SAM? (6)

Answer 18

• The non-unit reserve is the amount required to ensure that the company is able to cover the costs of claims and meet expenses from product charges and fees

• The non-unit reserve which can be positive or negative must be derived from the discounted cashflows that allows
o Expected future mortality and morbidity experience including margins plus
o Expected future commission, expense and inflation plus
o Cost of guarantees (in excess of the unit fund) provided in terms of the contract less
o Expected future risk benefit premiums, contractual expense charges, contractual management fees and contractual charges for guarantees

• Liability is dependent on factors such as
o Unit allocation percentage
o Management charge fluctuations due to movements in value of units
o Expected future management charges due to changes in expected unit fund growth

• Cashflows are projected for each year taking into account all aspects of the policy including decrements from:
o Lapse
o Surrender
o Mortality

• There should also be an allowance for guaranteed surrender values as well as surrender penalties

• Partial surrenders as well as cash payments from the unit fund should be considered as they affect future management charges

Question 19

Describe the allowance for negative non-unit reserves under FSV and SAM? (6)

Answer 19

• Negative non-unit reserves are permissible under both FSV and prudential supervisory valuation

• Negative non-unit reserves under FSV allows credit to be taken for positive future cashflows in advance

• If the projection will requires compulsory and discretionary margins it will result in less negative non-unit reserves (This is not the case for prudential valuation)

• The use of a negative non-unit reserve is an effective tool to reduce new business strain (i.e. at commencement additional funds will be released to cover commission and upfront acquisition costs)

• The use of non-negative unit reserves will however result in increased market risk (via future management charges needing to be sufficient to cover credit taken) as well as increased surrender risk (as asset will be lost if surrender occurs unless appropriate surrender penalty is in place)

• Under FSV the non-negative unit reserve can be set to zero via discretionary margins however this is not permitted for prudential valuation

Question 20

Describe how assumptions will be set for the valuation of unit-linked business under FSV? (9)

Answer 20

• Unit growth rate-This will reflect the average likely return on assets in which units are invested as well as consistency of the assumptions with yields on the valuation date. The management charges are dependent on the fund value therefore a lower rate will be more prudent. There is no regulation regarding the maximum rate. The rate should be calculated net of tax for the appropriate fund

• Non-unit fund interest rate-This will reflect the return on assets to which non-unit fund is invested

• Expense inflation-This will be set consistently with the rate of unit growth i.e. investment returns

• Expenses-These will be based on pasted experiences and future budgeted expenses. It may be appropriate to exclude certain once of expense business. Usually set on going concern basis (i.e. reducing fixed cost per policy) however allowances can be made for shrinkage

• Terminations –prudent allowance on recent experience would be made

Other factors that may need to be considered include:’

• The ability to vary management as well as expense/risk charges would need to be considered

• The ability of the policyholder to cease payment of premium for a period without making the policy paid up

• The paid up term and whether valuation strain would arise

• Allowance must be made for minimum surrender values according to regulation 5 of the long-term insurance Act

Question 21

Describe the valuation of group life contracts under FSV vs. SAM? (4)

Answer 21

The Financial soundness valuation (FSV) splits the reserve into four components:

• Unexpired (or unearned) premium reserve (UPR)-This is usually taken as a fraction of the annual premium corresponding to the portion of the year up to the next renewal date

• Incurred but not reported claims reserve (IBNR)-This covers claims that have occurred but have not been reported to the company as at the valuation date

• Deficiency reserve-This is to cover any inadequacy in premiums that the company. This can determined by considering the difference between the premium that is being charged vs. the premium that should be charged

• Experience Refund (or profit share reserve) – This is applicable if the policy contains an experience refund. The amount needs to be accumulated over the period until the next refund is made. The reserve will ideally reflect the individual scheme experience.

The prudential supervisory reserve will follow a discounted methodology valuing cashflows until the boundary date. Although simplifications may result in a similar approach a FSV.

Question 22

Describe the valuation of group life Permanent health insurance contracts under FSV vs. SAM? (4)

Answer 22

The FSV can be split into the following parts:

• UPR and deficiency reserve which will be calculated as for a group life contract

• IBNR which needs to be looked at in two parts due to the deferred period in these contracts
o A part relating to potential claims within the deferred period
 Assume that the premium has not been earned until the deferred period is complete (i.e. calculate expected claims as the premium associated with the deferred period)
 Calculate the reserve as a percentage of premiums based on past experience
o A part relating to true IBNR which is calculated as group contracts

• Reserve for claims in payment
o These could be valued as disability annuities taking into account both recovery as well as death from incapacity

• The experience refund reserve will be calculated as for group contracts

Question 23

List the purpose of IFRS 17 as well as the various elements in IFRS 17 reporting? (5)

Answer 23

• IFRS 17 will come into effect in January 2023

• The aim is to standardise insurance accounting globally in order to make sensible comparison easier

• Elements of IFRS 17 are contract classification, level of aggregation, measurements of liabilities

Question 24

Describe the contract classification of IFRS 17? (3)

Answer 24

• The definition of an insurance contract to fall within the scope of IFRS 17 requires one party to accept significant insurance risk from another party

• Insurance risk is significant if and only if an insurance event can cause the entity to pay amounts that are significant in any single scenario

• Investment contracts with discretionary participation features are also included in the scope of IFRS 17 if the entity also issues insurance contracts

Question 25

Describe the aggregation of polices in IFRS 17? (4)

Answer 25

• Entities are required to identify portfolios of insurance contracts i.e. contracts with similar risks that are managed together e.g. product lines

• An entity shall divide each portfolio of the insurance contracts in the following groups:
o A group of contracts that are onerous at recognition (i.e. results in a loss being recognised at inception)
o A group of contracts that do not have a significant possibility of becoming onerous subsequently
o A group of remaining portfolios

• A entity shall not include contracts issued more than one year apart in the same group of contracts (Cohort period)

• This results in a portfolio being made up of many groups

Question 26

List the components of liabilities under IFRS 17?

Answer 26

Under IFRS 17 an entity shall measure the liabilities of a group of insurance contracts as the total of:
• The fulfilment cashflows which comprise of
o Best estimate of future cashflows and an adjustment to reflect the time value of money
o Risk adjustment for non-financial risk (underwriting risks?)

• Contractual service margin

Question 27

Describe the calculation of BEL, risk adjustment (RA) and the contractual service margin (CSM) under IFRS 17? (6)

Answer 27

Discounted Best Estimate Cashflows
• Cashflows are projected up until the contract boundary of the contract to get a best estimate assessment future premium, claims, commission and expenses
• The discount rate applied to give the best estimate liability shall reflect the time value of money
o The characteristics of the cashflows and the liquidity characteristics of insurance contracts

Risk adjustment
• This adjustment reflects the compensation for the entity for the uncertainty associated with amount and timing of cashflows arising from non-financial risk
• There are disclosure requirements regarding the confidence intervals used in the calculations of the risk adjustment

Contractual Service Margin

The CSM is set up at inception for a group of contracts. It represents the unearned profits on the group of contracts such that it emerges in line with general accounting principles:

• If a group of contracts are profitable at inception i.e. (BEL+RA<0) the CSM is set equal to –(BEL+RA) such that profit recognised is zero and profit is then recognised over the lifetime of the policy
o The CMS of a group of contracts is a retrospective build up allowing for
 growth from interest
 Reassessment of fulfilment cashflows
 Amount released from the CSM into profit in recognition of services provided
• If a group of contracts are onerous at inception then CSM is set to zero and the loss is recognised immediately

Question 28

Describe when a simplified premium allocation approach (PAA) may be used to value contracts under IFRS 17? (2)

Answer 28

• An entity may simplify the measurement of a group of contracts using a premium allocation approach (PAA) if
o The contract boundary is 12 months or less
o The simplification would not produce a materially different result

Question 29

Describe the transition considerations from IFRS 4 to IFRS 17? (3)

Answer 29

• IFRS 17 is effective from January 2022 however both IFRS 4 & 17 methodologies need to be included as of January 2021
• The contractual service margin (CSM) needs to be calculated and the transition date which is a retrospective calculations
• The default approach is a full retrospective calculation however alternative are
o Modified/simplified retrospective calculation
o Difference between Fair value of liabilities (IFRS 13) and fulfilment cashflows