FSI 2.2-Valuation of Technical Provisions

Question 1

Outline The principles and requirements of the standard ? (7)

Answer 1

• Insurers must establish technical provisions that correspond to the current value of their insurance obligations

• Insurers must segment their obligations into homogeneous risk groups when calculating technical provisions

• The value of technical provisions should consist of a best estimate assumption and a risk margin

• Insurers must use actuarial and statistical techniques that are proportionate of the nature, scale and complexities of risk to value technical provisions

• Amounts relating to recoverable must be calculated separately as part of the valuations for technical provisions

• The valuation of the technical provision must take into account the time value of money by using a relevant risk-free interest rate term structure specified by the PA

• Insurers are permitted to apply simplified methods in the valuations of technical provisions

Question 2

Outline additional general principles for calculating technical provisions (not included in requirements and principle summary)? (2)

Answer 2

• The risk margin must be calculated as cost of providing an amount of eligible own fund to support insurance obligations over their life time

• For certain products best estimate and risk margin can be calculated as a whole (i.e.where replication using market quated instruments are possible)

Question 3

Describe the segmentation requirements and purpose? (4)

Answer 3

• In valuing technical provisions, insurers must segment their insurance obligations into minimum sub-line of business prescribed attachment 1

• The purpose is to prevent distortion in the valuation due to dissimilar lines of business

• For financial soundness purposes must be based on the nature of the underlying risks rather than legal classification (“substance over form”)

• Segmentation must be applied both the best estimate and risk margin

Question 4

State how best estimate cashflows in foriegn currency should be treated? (2)

Answer 4

The best-estimate must be valued SEPARATELY for obligations in different currencies.

The time value of money of future cash-flows in different currencies must be valued using the risk-free interest rate term structure of the relevant currency.

Question 5

Describe the issues specific to lif insurance companies in the valuation of technical provisions including model points, negative liabilities and lower bounds on technical provisions? (5)

Answer 5

• The valuation of life insurance obligations would usually be based on a policy-per-policy approach

• However approximations can be made to group polices when projecting cashflows i.e. projection is based on model points (representative policy)
o The grouping should not underestimate the underlying risks or distort the valuation of technical provisions
o Sufficient validation needs to be conducted to verify the grouping does not lead to a significant loss of attributes of the policy being valued

• In certain circumstances the value of the liability may be negative however this value should not be set to zero

• The liability may have a negative value due to reinsurance agreements in which case an adjustment can be made of credit risk i.e. default

• No implicit or explicit surrender value floor is applicable to the valuation of the liability

Question 6

List the assumption set using financial market information when calculating best estimate liabilitiues? (3)

Answer 6

o Relevant risk-free rate term structure
o currency exchange rates
o Market inflation rates

Question 7

ouline 4 “Market-consistent asset model” criteria (when used to produce projections of market parameters)? (4)

Answer 7

o Assume no arbitrage opportunities

o Generate asset prices that are consistent with deep and liquid financial markets

o Allow for properly calibrated volatility measure

o Be calibrated to reflect the nature and term of the liabilities, and the current risk-free term structure

Question 8

Describe how assumptions are set using generally available for insurance risk? (4)

Answer 8

• Generally available data refers to both internal and external (industry data) on insurance risk

• All relevant data whether internal or external should be taken into account in deriving assumptions that best reflect the characteristics of the underlying portfolio

• The extent to which internal data is taken into account is dependent on
o Availability, quality and relevance of external data
o Quantity and quality of internal data

• The insurer must derive the underwriting risk based on external data if used:
o Demonstration that the sole use of internal data is not more suitable than the external data
o The origin, assumptions and methodology used to process that data which is known and that they reflect the characteristics of the underlying portfolio

Question 9

Describe how assumptions regarding the future behaviour of policyholders should be incorporated in the calculation of best estimates? (2,5)

Answer 9

• The assumptions regarding the exercise of contractual options including surrenders and lapses need to be based on credible information (the assumption should take into account future conditions)

• The exercise of contractual options should be based on analysis of past policyholder behaviour (which should consider)
o How beneficial the exercise was given past circumstances
o The influence of past circumstances
o The impact of past management actions
o How past projection compared to the actual outcome
o Any other circumstances that will influence the exercise of the option

Question 10

Describe how future managment actions should be taken into account when calculating best estimate liabilities? (5)

Answer 10

• Future management actions refers to all mechanisms or actions approved by the governance structure within the insurer to respond to a specified event to reduce impact on NAV

• The assumptions need to be realistic and consistent with the insurers current business practice and business strategy

• The costs associated with the future
management action or risk mitigation needs to be considered as well as the market capacity to transfer the risk under the scenario

• The time required to implement the future management actions should be considered

• The assumptions needs to be verified by comparing previous actions assumed with the actual experience

Question 11

List possible future managment actions incorporated in the valuation of best estimate liabilities? (7)

Answer 11

o Changes in assets allocation to manage fund returns, liquidity risk, asset/liability mismatch, target asset mixes and changes in market conditions

o Changes in bonus rates or product changes (such as changes to profit participation to mitigate risk)

o Changes in fees charged to policyholders

o Changes in future market value adjustment factors

o Renewal of outwards reinsurance arrangements

o Renewal of hedging strategies

o Revision of premium rates

Question 12

State the use of expert judgement in the valuation of liabilities? (2)

Answer 12

• Expert judgement may be required in determination of best estimate liabilities in relation to data, assumptions and techniques

• The use of judgement should be well-founded, documented (including process), transparency and subject to validation

Question 13

Describe the recognition criteria of polices to be included in technical provisions? (4)

Answer 13

• The insurance policy must be recognised from the earlier of the following dates:
o Beginning of coverage period
o Date on which the first payment of policyholder becomes due (or is received)
o Date on which the portfolio to which the policy belongs becomes onerous

• Insurers must not recognise cashflows before the applicable inception date described above

• Insurer must not recognise an assets or liability relating to expected premiums outside the contract boundary

• An insurance policy should be derecognised as an existing contract only when the obligation specified in the policy expires, has been discharged or cancelled

Question 14

Describe how to detrmine a contract boundary in the valuation of technical provisions? (4)

Answer 14

• The best estimate liability is calculated as the discounted projected cashflows up to contract boundary

• The contract boundary is defined as the insurer has an unilateral right to:
o Terminate the contract
o Reject premiums payable under the contract
o Amend premiums and benefits payable such that premiums reflect the risks i.e. expected benefits and expenses do not exceed premiums

• The unilateral right to review conditions reflect a legal right but should also consider policyholder reasonable expectations, policyholder behaviours and market pressures

• If the contract has a boundary determined by this standard of less than 91 days it can be excluded from valuations of best estimate

Question 15

Describe a contractual option and provide examples of contractual options? (5)

Answer 15

• A contractual option is defined as the right to change the benefit of a policy taken at the choice of the holder on terms established in advance
o Surrender value option with pre-defined lumpsum
o Paid-up policy options
o Annuity conversion option, convert lumpsum based on minimum rate of conversion
o Policy conversion options, i.e. the right to convert one policy to another
o Extended coverage option

Question 16

Describe financial gurantee that need to be taken into account when calculating best estimate values? (3)

Answer 16

o A financial guarantee is where loss can be passed to insurer or an increase in benefits as a result of changes in financial variables e.g.
 Guaranteed investment capital
 Guaranteed minimum investment return
 Profit sharing

Question 17

State various methods for the valuation of contractual options and financial guarantees? (3)

Answer 17

• Best estimate guarantees and options may be valued using a
o Stochastic approach (closed form or simulation)
o Series of deterministic projections
o Deterministic valuation based on expected cashflows
(The principle of proportionality should be consider when deciding on an approach)

Question 18

Describe the treatment of discretionary benefits in the calculation of best estimate liabilities? (7)

Answer 18

• Linked polices should not be considered as having discretionary features
• Value of financial and other guarantees should be included in guaranteed benefits rather than discretionary benefits
• Discretionary benefits should include historic vesting claim bonus at the valuation date, other non-vesting bonuses and future benefits payable in terms of policyholder reasonable expectations
• The value of discretionary benefits in technical provisions should take into account level of accumulated surplus or deficit at the valuation date
• The distribution of surplus would be classified as a management action and would need to meet requirements of that assumption
• The discretionary benefits would depend on the assets held by the insurer at the valuation date
• Where a risk neutral approach is used the investment underlying the discretionary bonus should not exceed the forward rates derived from the risk-free term structure

Question 19

Describe recoverable in the valuation of technical provisions? (3)

Answer 19

• These may arise from reinsurance or other risk mitigation instruments (the best estimate value should be gross of recoverable)

• Amounts recoverable (premiums, claims and other cashflows) from eligible reinsurance agreements must be calculated separately

• Recoverable need to be adjusted for expected loss due to default of the counter party based on a market consistent probability of default (the adjustment should be calculated separately)

Question 20

Outline the discount rate required for valuation of technical provisions? (3)

Answer 20

• Unless otherwise approved the government bond risk-free term structure published by the prudential authority should be used to discount technical provisions
• An application can be made to use term-structure stripped from the swap market (however the rates must not include a margin for credit risk or illiquidity risk)
• Foreign cashflows need to use a term structure appropriate to the currency

Question 21

Outline the requirements for the use of an illiquidity premium in the valuation of an annuity portfolio? (10)

Answer 21

o A portfolio of bonds and other assets with similar cashflow characteristics to cover the best estimate portfolio of life annuities over the life time of the obligations
o In terms of matching either the cashflows of the annuity portfolio is replicated or the interest rate sensitivity are matched between assets and liabilities (Immunisation?)
o The annuity policy does not give rise to future premium payments
o The only underwriting risk involved is longevity and expense risk i.e. and includes no options or surrender values (in excess of the assets)
o In the case of nominal portfolio of annuities the asset cashflows are fixed
o In the case of inflation-linked portfolio the assets cashflows are inflation linked
o Cashflows of the assets cannot be changed by the issuer (unless the holder of asset is suitably compensated)
o The liquidity premium used must be that implied by the price of the assets relative risk-free term structure multiplied by 50%
o Where an liquidity premium is used it must be calculated is subject to a maximum of 50 bps
o No liquidity premium is allowed for discounting liabilities denominated in foreign currency

Question 22

State the definition and calculation of a risk margin? (3)

Answer 22

• The risk margin represents the cost of providing an amount of eligible own funds equal to SCR necessary to support insurance obligations until contract boundaries

The risk margin is calculated as the sum of the cost of capital multiplied by projected future SCR discounted risk-free rate over each year within contract boundary

The cost of capital that must be used in the period of determination of the risk margin is 6%

Question 23

Describe the scenario under which the risk margin is calculated? (8)

Answer 23

o The whole portfolio of the insurance obligations that calculates the risk margin is taken over by another insurer (reference insurer)
o The transfer must include reinsurance and other risk mitigation instruments relating to obligations
o The reference insurer does not have any insurance obligations and eligible own funds before the transfer
o After the transfer the reference insurer raises eligible own fund equal to amount to support SCR over the lifetime of obligations
o The assets that cover SCR is selected to minimise market risk for the reference insurer
o The SCR is calculated to incorporate
 insurance risk
 unavoidable market risk’
 credit risk associated with recoverables
 operational risk
o The loss absorbing capacity in technical provisions remains the same
o The reference insurer adopts the same future management actions

Question 24

Describe the level of granularity in the risk margin calculation? (5)

Answer 24

• The risk margin must be calculated per sub-line of business however the calculation should take into account diversification between lines of business

• Therefore the calculation should be done for the business as a whole and then allocated to each sub-line

• The allocation to sub-lines must be consistent with the lines contribution to the SCR for the whole business

• The contribution of the each sub line is derived by calculating it SCR assuming no other lines of business exist and then considering it relative to the sum of total SCR of all sub-lines calculated in isolation

• No risk margin is required where technical provisions are calculated as a whole

Question 25

State when technical provisions can eb calculated as a whole? (3)

Answer 25

• Where cashflows associated with obligations can be calculated be replicated using financial instruments in the market for which a reliable market value is available then the separate calculation of a best estimate and risk margin is not required

• The technical provisions will be set to the market value of the replicating portfolio

• Unbundling of cashflow in a policy that stratify this criteria is permitted if feasible

Question 26

State guidance criteria regarding the detrmination if insurance obligations can be replicated? (3)

Answer 26

• The cashflows of the financial instruments should replicate the timing and amount of cashflows associated with the insurance obligation (taking into account the uncertainty associated with the cashflows in all scenarios)

• Financial instruments to be used in replication needs to be traded in an active market with sufficient frequency and volume of transactions to provide information on an on-going basis

• The financial instruments used in replication must satisfy the following criteria
o A deep market where large number of instrument can be transacted without affecting the market price
o A liquid market where instruments can be bought or sold without significantly affecting the price
o Transparent market i.e. trade and price information are normally readily available to the public

Question 27

Describe the allowance for tax in the calculation of technical provisions? (3)

Answer 27

• I-E cashflows in technical provisions should allow for tax (to policyholders fund) on assets backing the best estimate

• If the adjusted tax basis places a higher value on liabilities than technical provisions and non-hedgeable SCR then the impact of frictional tax costs associated with the difference needs to be evaluated if it is material

• Deferred tax liabilities created by different values calculated in calculated accordance with the tax basis vs. financial soundness basis should be assumed to be available for loss absorbing capacity