FSI 2.2- (Guidance Note) Valuation of Technical Provisions

Question 1

Outline the general guidance for determining a contract boundary? (3)

Answer 1

• Ensures that all known material risk inherent in the policy is included in the technical provisions and capital requirements

• When the insurer has a unilateral right to review policy conditions to reflect future known material risk the contract boundary is set at this point

• Internal and external limitations to review policy conditions to reflect risk such as regulation and implementation time

Question 2

Describe the specific guidance for contract boundaries for linked investments, investment with no guarantees, guaranteed annuity options, investment with guarantees, individual life risk, grouped individual life risk and group life policies? (7)

Answer 2

• Linked investment polices
o Zero contract boundary with the valuation being the number of unit multiplied by the unit price at valuation date

• Investment policies with no financial guarantees
o Contract boundary where insurer has unilateral right to change conditions of a contract (not longer than contractual end of policy)
o Account balance needs to be projected to contract boundary
o Open ended contracts where insurer does not have unilateral right, a long contract boundary should be assumed with persistency assumptions dictating run-off

• Guaranteed annuity options on RAs should not extend the contract boundary as the embedded investment derivative will be valued according to technical provisions

• Investment policies with financial guarantees
o Maximum of (1) Contract boundary where insurer has unilateral right to change conditions of a contract (not longer than contractual end of policy) and (2) the point where the financial guarantee ends
o Account balance needs to be projected to contract boundary
o Open ended contracts where insurer does not have unilateral right, a long contract boundary should be assumed with persistency assumptions dictating run-off

• Individual risk polices
o The contract boundary would usually be set equal to term that was considered in the pricing of the premiums
o Allowance should be made for management actions to review premiums after guaranteed period allowing for expected policyholder behaviour
o if insurers can only re-price on a portfolio level the unilateral risk is limited and a longer boundary should apply . A shorter period would require re-underwriting of existing business to provide rates consistent with new business.
o May not be longer than the end of the contractual policy

• Group individual risk policies
o These policies should be assessed as group life assurance where contract boundary is the next review date

• Group life assurance
o The boundary should be where insurer has unilateral right to change policy conditions on a scheme level to fully reflect risk i.e. review date (unless guarantee period is applicable)

Question 3

Outline the splification in calculating risk margins that are applicable to life insurers? (3)

Answer 3

1. Level 1-approximate the individual risk categories of components within some or all of the modules used for the calculation of future SCR
2. Level 2-approximate the whole SCR for each future year by using a proportional approach
3. Level 3-estimate all future SCR at once by using an approximation based on a duration approach

Question 4

outline the level 1 simplification for life underwriting risk in the calculation of SCR? (1)

Answer 4

The simplification for calculating the following risks in the life underwriting risk module of SCR can be applied to future SCR see FSI 4.2 for details:
• Mortality
• Longevity
• Disability-morbidity
• Lapse
• Expense
• Catastrophe
• Retrenchment

Question 5

outline the level 1 simplification for counter party default risk in the calculation of SCR? (3)

Answer 5

• The standardised formula the counter party default risk is assessed for the whole portfolio rather than separate segments

• If the risk of default in a segment is then estimated as proportion of total capital charge for reinsurers default risk based on reinsurer share of best estimates in year zero

• This may be applied to developmental years if exposure to default does not vary considerably

Question 6

outline the level 1 simplification for unavoidable market risk in the calculation of SCR? (4)

Answer 6

• This usually arises when there is an unavoidable mismatch between the cashflows of the insurance liabilities and financial instruments e.g. duration mismatch

• This usually leads to capital requirement for interest rate risk under the downward stress scenario (as liabilities increase more than assets as well as bond prices increasing for reinvestment purposes)

• The approximation of the additional SCR due to unavoidable market risk is the ‘
o best estimate liability net of reinsurance at time zero
o Multiplied by the absolute decrease in the risk-free rate
o Multiplied by (difference in duration (modified) between liability and longest duration of financial instrument)/ (difference in duration (modified) between liability and longest duration of financial instrument +1)
o Multiplied by 0.5

• If there is a significant difference between the durations then the approximation may be replace by more accurate simplification

Question 7

Outline the level 2 simplification using a proportional approach? (5)

Answer 7

• Simplification is based on the assumption that future SCR are proportional to best estimate technical provisions for the relevant year (net of eligible reinsurance)

• Where the proportion is the ratio of present SCR to present best estimate technical provisions

• The future projections of SCR combine basic SCR and SCR related to operational risk

• This approach assumes that certain risks associated with insurance obligations remain the same:
o The composition of the risk components of underwriting
o Average credit standing of reinsurers remains the same
o Reinsurer’s share of obligations remain the same
o Unavoidable market risk in relation to best estimate

• An insurer may decide to apply the simplification in a more granular fashion e.g. individual risk modules

Question 8

Outline the level 3 simplification using a duration based approach? (5)

Answer 8

• This simplification uses the modified duration of the liabilities to calculate single and future SCRs in a single step

• The approximation is the
o cost of capital
o multiplied by the modified duration
o Multiplied by the current SCR
o Discounted a risk-free rate at year 1

• The approach combines basic SCR and SCR relating to operational risk

• The following simplified assumptions hold remain constant:
o The composition of the risk components of underwriting
o Average credit standing of reinsurers remains the same
o Modified duration is the same net and gross of reinsurance
o Unavoidable market risk in relation to best estimate

• Qualitative assessment on the materiality of assumptions not holding should be conducted

Question 9

Outline guidance regarding where technical provisions can be calculated as a whole? (4)

Answer 9

• Main instance where obligations can be replicated reliably using financial instruments where a reliable market value is available is where benefits of the insurance obligation:
o Consist of delivery of a portfolio of financial instruments for which a reliable market value is observable
o Are based on the market value of the portfolio when benefits are paid

• In particular, the following cash flows should not be regarded as capable of replication:
o Cashflow that depends on policyholder will exercise a contractual option including lapse and surrender
o Cashflows that depend on the level, trend or volatility of mortality, sickness, disability or morbidity
o An expense incurred in servicing the insurance obligations

Question 10

Outline the general principles of proportionality when evaluating am appropriate valuation method? (5)

Answer 10

• The principle of proportionality requires that an insurer should apply a valuation method that is:
o Suitable to achieve the standards of market consistent valuation but
o No more sophisticated in order to reach this objective

• In the valuation of technical provisions tassessment of the way the principle of proportionality is applied should involve
o Assessing the nature, scale and complexities of underlying risks
o Assessing the valuation methodology is proportionate to underlying risks having a regard to model error
o Back testing and validating assessments’

Question 11

Describe the guidance regarding the assessment of the nature, scale and complexity of risks? (5)

Answer 11

• This is done to assess if simplified models are appropriate

• The scope of risks that should be assessed are those that which may materially affect the timing and amounts of cashflows required to settle the insurance obligation

• The following may need to be analysed when assessing the nature and complexity of risks:
o Type of business
o Correlation
o Impact of mitigation instruments

• Furthermore the following factors may indicate the presence of more complex less predictable risks:
o Path dependency of cashflows
o Non-liner interdependence between several drivers of uncertainty
o Cashflow materially affected by future management actions
o Risks that have asymmetric impact on the value of cashflows such as options and guarantees
o Values of options and guarantees affected by policyholder behaviour
o Complex risk mitigation instruments
o A variety of covers bundled into a policy
o Terms of the contract are complex

• Assessing scale involves differentiating between small and large risks

Question 12

Describe the guidance regarding the assessment of the proportionality and model error? (6)

Answer 12

• An assessment of model error is required i.e. whether a given valuation technique would result in an estimate that materially diverges from the current transfer value

• Assessment may be carried out by expert judgement or by other approaches such as:
o Sensitivity analysis
o Comparison of results with other methods
o Analysis of descriptive statistics
o Back testing

• Where the model error is material alternative techniques should be considered

• A degree of material model error should be documented and the implications of overall uncertainty on financial soundness

• Where the valuation technique results in material uncertainty associated with the best estimate liability the degree of conservatism should be increased in assumptions and parameters

• In the event that several methods are proportionate the most appropriate method underlying the risk should be selected

Question 13

Ouline guidance regarding back testing of assumptions? (5)

Answer 13

• Insurers should periodically check whether best estimate created in past years remain appropriate to subsequent years

• Where there is a material difference between best estimates and experience the first two steps of proportionality must be re-performed

• Such re-assessment should be performed where the insurers risk profile has significantly changed

• In current methods are no longer appropriate alternative methods should be undertaken

• The scope and frequency of the back testing needs to be proportional to risk of assumption

Question 14

outline possible simplifications when determining underwriting risk? (5)

Answer 14

• Biometric risk are underwriting risks that refer to human life conditions such as mortality, longevity, disability and morbidity

• Possible simplifications in deriving biometric factors include:
o Disregard future changes in biometric risk for short-term polices
o Assuming independence of biometric risk from other factors
o Using cohort or period data to analyse biometric risk
o Adjusting standard tables by multiplicative factors

Question 15

outline possible simplifications when determining surrenders? (6)

Answer 15

• Assume that surrenders occur independently of financial/economic factors
• Independence with regards to biometric risk factors
• Independence to future management actions
• Surrenders occur independently of insurer-specific information
• Using a table of surrender rates that are differentiated by factors such as age, duration, product types and other factors
• Modelling surrenders as a hazard process either with constant or non-constant intensity

Question 16

outline possible simplifications when determining options and guarantees? (6)

Answer 16

• Simplifications such as the black-Scholes model can be used for financial options and guarantees provided that assumptions used in the model is reasonably suitable to apply to the experience

• For investment guarantee:
o No path dependency in relation to management actions, regular premiums and cost deductions
o Representative deterministic assumptions of possible outcomes when determining the intrinsic value
o Assume deterministic scenarios for future premiums, mortality, expenses and other scenarios
o Simplified formula approach for the times values if they are not seen to be material

• Possible simplifications for other types of options and guarantees include:
o Grouping guaranteed expense charges and/or guaranteed mortality charges with investment guarantees and valuing them as a single investment guarantee
o Using above simplifications I there is an absence of other valuation approaches

Question 17

outline possible simplifications when determining discretionary bonuses? (3)

Answer 17

• Possible simplifications for determining future bonuses associated with policies with discretionary participation features:
o Assume economic conditions will follow a certain pattern (not stochastic)
o Business mix will follow a certain pattern

• The amount of extra benefits available for distribution can be approximated by the value of the current asset share less technical provisions for the policy (without taking into account future bonuses) (constant distribution rate of extra benefits required)

Question 18

List other simplifications in valuation of technical provisions? (5)

Answer 18

• Assume that premiums are paid independently of financial markets and specific info (for lapses and paid ups)
• Assuming that cashflows occur at the end of the year if middle of the year
• Grouping assets with similar features or using representative assets or indices to undertake value projections
• Independence of returns between asset classes
• Applying different projection periods for cashflow projections

Question 19

Outline direct vs. indirect expenses? (3)

Answer 19

• Expenses can be divided into:
o Direct expenses- Expenses which are directly assignable to individual claims, policies and transactions
o Indirect expenses- Balance of expenses that are not directly assignable to the functions above. This includes once-off costs and costs associated with group wide functions

• The assigning of indirect expenses to lines of business, homogenous risk groups and other segments should be performed using an economic basis using realistic and objective principles

• The costs can be reconciled against those reflect in IFRS financial statements

Question 20

outline how expenses should be grouped and taken into account in cashflow projections when determining technical provisions? (8)

Answer 20

• The direct and indirect expenses incurred by the insurer should be categorised into the three expense category:
o Initial expenses-these are expenses occurred at the outset of the policy and would include commission, administration as well as underwriting
o On-going maintenance expense to service the obligation of the policyholder e.g. administration
o Once-off expense- these are expenses for once off in nature example for once-off project costs

• The on-going expense should be included in the cashflow projections and should include:
o Administrative expenses
o Investment management expenses
o Claims management expenses
o On-gong commission expenses

• Once-off expenses should be appropriately analysed to ensure that they are reflected in the cashflow projections:
o Once of costs that relate to future initiatives that have no benefit for the existing in-force book does not have to be included
o Large project costs may be capitalised as intangible assets for IFRS purposes. In these cases it would be appropriate to include future depreciation charges associated with these projects
o Cost not capitalised for IFRS purposes needs to be taken into account in cashflow projections and may run more than one year

• Motivation for the classification is required