Prudential Standard FSI 2.2 (Valuation of Technical Provisions)

Question 1

Key principles of the standard

Answer 1

• technical provisions correspond to the current value of insurance obligations
• insurance obligations should be segmented into homogeneous risk groups
• valuation should incorporate a best estimate and a risk margin (with exceptions)
• actuarial and statistical techniques used should be proportionate to the nature, scale and complexity of the risks
• recoverables must be calculated separately
• technical provisions should take into account the time value of money using the relevant risk-free interest rate term structure
• Insurers are permitted to apply simplified methods subject to proportionality

Question 2

Broad calculation of best estimates

Answer 2

Best estimates should be calculated on a GROSS BASIS

without deducting reinsurance / risk mitigation recoverables.

Question 3

Broach calculation of the risk margin

Answer 3

The risk margin should be calculated by reference to
… the COST of providing
… an amount of Eligible Own Funds
… necessary to support insurance obligations over their lifetime.

Question 4

The purpose of segmentation

Answer 4

To prevent potential distortions in the valuation process that may arise from combining dissimilar lines of business.

Question 5

Segmentation should be based on…

Answer 5

the nature of the risks underlying the insurance obligation,

rather than the legal form of the insurance contract.

(i.e. the principle of “substance over form”)

Question 6

The best estimate

Answer 6

The probability weighted-average of an insurer’s future cash-flows stemming from its insurance business,

taking into account the time value of money,
and all possible scenarios of future potential outcomes.

Question 7

8 Cash-flow characteristics that should be taken into account in the projection (for purposes of best-estimate valuation)

Answer 7

Uncertainty in the:
- timing, frequency and severity of claim events.

Uncertainty in:

• claim amounts and the period needed to settle claims;
• the value of an index used to determine claim amounts.

Uncertainty in entity and portfolio-specific factors, such as:

• legal,
• social, or
• economic environmental factors.

Uncertainty in policyholder behaviour

Path Dependency

Inter-dependency between 2 or more causes of uncertainty.

Question 8

Path-Dependency of cash-flows

Answer 8

Where the cash-flows depend not only on circumstances such as economic conditions on the cash-flow date, but also on those circumstances at previous dates.

Question 9

Best-estimate valuation of obligations in different currencies

Answer 9

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 10

Best-estimate valuation methodology:

Treatment of reinsurance and risk-mitigation

Answer 10

The best estimate must be valued on a GROSS BASIS, without deducting amount recoverable from reinsurance contracts and other risk mitigation instruments.

Recoverables from reinsurance and other risk-mitigation instruments must be calculated separately.

Question 11

Best-estimate valuation methodology:

Cash-flow projections

Answer 11

Cash-flow projections must reflect realistic future
- demographic,
- legal,
- medical,
- technological,
- social, or
- economic
developments.

They should incorporate appropriate assumptions for future INFLATION.

Question 12

Best-estimate valuation methodology:

Cash-flow projection horizon

Answer 12

Must cover the full lifetime of the cash in-flows and out-flows required to settle insurance obligations of existing policies.

Question 13

For non-life insurers, a separate valuation of the best estimate must be carried out for provisions for

Answer 13

• claims outstanding
• premium provisions, and
• “other technical provisions”

Question 14

Premium provisions relate to…

Answer 14

claim events occurring after the valuation date and during the remaining coverage period of existing policies.

Question 15

The cash-flow projection w.r.t. the best estimate for premium provisions should comprise:

Answer 15

all future

• claim payments
• claims administration expenses
• ongoing administration expenses of existing policies
• expected premiums stemming from existing policies

Question 16

Provisions for claims outstanding relate to…

Answer 16

claim events that have occurred before the valuation date - regardless of whether the claims arising from these events have been reported or not.

Question 17

3 Components that should be valued separately in relation to the best estimate for “other technical provisions”

Answer 17

• Cash-back and other loyalty provisions
• Contingent commission provisions
• Other contingent payment provisions

Question 18

Assumptions consistent with information about / provided by financial markets include: (3)

Answer 18

• Relevant risk-free interest rate term structure;
• Currency exchange rates; and
• Market inflation rates (CPI or sector inflation)

Question 19

4 “Market-consistent asset model” criteria

when used to produce projections of market parameters

Answer 19

The model must:

• Generate asset prices consistent with deep, liquid and transparent financial markets
• Assume no arbitrage opportunities
• Allow for a properly calibrated volatility measure
• Be calibrated to reflect the nature and term of the liabilities, and the current risk-free interest rate term structure used to discount cash-flows.

Question 20

The extent to which internal data is taken into account should be based on (2)

Answer 20

• the Availability, quality and relevance of external data

- the Amount and quality of internal data.

Question 21

Where insurers use data from an external source, they must derive assumptions on underwriting risks that are based on that data according to 2 requirements:

Answer 21

• The insurer can demonstrate that the sole use of data which is available from an internal source is not more suitable than external data.
• The origin of the data, and assumptions or methodologies used to process them, is known to the insurer and the insurer is able to demonstrate that these assumptions and methodologies appropriately reflect the characteristics of the portfolio.

Question 22

“Future management action”

Answer 22

Refers to all mechanisms or actions approved by a governance structure within the insurer that will be implemented in response to the occurrence of a specified adverse event, whereby the actions aim to reduce the impact of the specified adverse event on the insurer’s net asset value.

Question 23

7 actions that may be considered as future management actions

Answer 23

• Changes in asset allocation to manage fund returns, liquidity rates, asset/liability mismatch risk, target asset mixes and changes in market conditions;
• Changes in bonus rates or product changes, such as changes to policies with profit participation to mitigate market risks.
• Changes in fees charged to policyholders, e.g. administration or investment management charges on linked business;
• Changes in assumed future market value adjustment factors;
• Renewal of outwards reinsurance arrangements;
• Renewal of hedging strategies; and
• Revision of premium rates.

Question 24

Inclusion of management action in the valuation of technical provisions

Answer 24

The valuation of technical provisions should take account of potential future actions by the management of an insurer, and other risk mitigation instruments employed to manage an insurer’s risk.

Question 25

Risk mitigation instrument

Answer 25

All instruments and arrangements in which an insurer is able to transfer part or all of their risks to another party.

Question 26

Use of expert judgement in the valuation of the best estimate

Answer 26

Expert judgement may be used in relation to the data, assumptions and techniques used to value the best estimate.

The use of expert judgement must be well-founded, documented, transparent and subject to validation.

Question 27

When may an insurance policy be derecognised as an existing contract? (3)

Answer 27

Only when the obligation specified in the policy:

• expires,
• has been discharged,
• or cancelled.

Question 28

Define the contract boundary

Answer 28

The date in which the insurer has a unilateral right to:

• Terminate the contract;
• Reject the premiums payable under the contract; or
• Amend the premiums or benefits payable under the contract at a future date in such a way that the premiums fully reflect the risks.

Question 29

Contractual option

Answer 29

A right to
change the benefits of a policy,
to be taken at the choice of the holder,
on terms that are established in advance.

Question 30

5 Examples of contractual options

Answer 30

• Surrender value option
• Paid-up policy option
• Annuity conversion option
• Policy conversion option
• Extended coverage option

Question 31

Surrender value option

Answer 31

The policyholder has a right to fully or partially surrender the policy and receive a pre-defined lump sum amount.

Question 32

Paid-up policy option

Answer 32

The policyholder has the right to stop paying premiums and change the policy to a paid-up status.

Question 33

Annuity conversion option

Answer 33

The policyholder has the right to convert a lump survival benefit into an annuity at a pre-defined minimum rate of conversion.

Question 34

Policy conversion option

Answer 34

The policyholder has the right to convert from one policy to another at pre-specified terms and conditions.

Question 35

Extended coverage option

Answer 35

The policyholder has the right to extend the coverage period at the expiry of the original policy without producing further evidence of health.

Question 36

Financial guarantee

Answer 36

Arises when there is a possibility to pass losses to the insurer or to receive additional benefits as a result of changes in some financial variables.

Some examples:

• Guaranteed invested capital
• Guaranteed minimum investment return
• Profit sharing

Question 37

Non-financial guarantees

Answer 37

Provide benefits that are driven by changes in non-financial variables, such as reinstatement premiums in reinsurance and experience adjustments to future premiums.

Question 38

The best estimate of contractual options and guarantees must capture…

Answer 38

• the intrinsic value,
• timing, and
• uncertainty
  of cash-flows

taking into account the likelihood and severity of outcomes from multiple scenarios combining the relevant risk drivers.

Question 39

The best estimate of contractual options and guarantees may be valued using (3)

Answer 39

• a Stochastic approach (closed-form or simulation)
• a Series of deterministic projections, or
• deterministic valuation based on expected cash-flows

The approach used should be proportionate to the nature, scale and complexity of the insurer’s business.

Question 40

Calculations of amounts recoverable (for non-life insurers)

Answer 40

Amounts recoverable from reinsurance contracts and other risk mitigation instruments should be calculated SEPARATELY for provisions for claims outstanding and for premium provisions.

Question 41

Valuing the best estimate of amounts recoverable

Answer 41

• take account of the time difference between payments and recoveries
• take account of potential differences in the contract boundary (between reinsurance contract and the underlying policies)
• allow for possible changes to reinsurance contract terms

Distinguish between:

• events that relate to market risk
• event that relate to underwriting risk

Only payments in relation to compensation of insurance events should be included when valuing amounts recoverable.

Expenses incurred in relation to the management and administration of reinsurance contracts & risk mitigation must be included in the best estimate.

Question 42

Adjustment of recoverables for expected losses due to counterparty default

Answer 42

The adjustment for expected counterparty default should be based on a market-consistent assessment of the probability of default of the counterparty, and the average loss resulting from this default.

Question 43

Discount rates to be used for the purposes of valuing technical provisions

Answer 43

Unless otherwise approved by the Prudential Authority, insurers must use the GOVERNMENT BOND CURVE published by the Prudential Authority as the risk-free interest rate term structure to discount cash-flows.

Question 44

Risk margin

Answer 44

The part of the technical provisions that ensures that the value of the technical provisions is equal to the amount that another insurer would be expected to pay to take over and meet the insurance obligations of the insurer.

Question 45

Broad calculation of the risk margin

Answer 45

The risk margin must be calculated by determining the cost of providing an amount of Eligible Own Funds equal to the SCR necessary to support the insurance obligations over their lifetime.

The rate used in determination of the cost of providing that amount of Eligible Own Funds is referred to as the “cost-of-capital” rate.

Question 46

Cost-of-capital rate

Answer 46

The annual rate applied to the capital requirement in each period when determining the risk margin.

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

Question 47

Calculating the adjustment for expected loss due to counterparty default risk

Answer 47

• Should approximate the losses given default of the counterparty, weighted by the probability of default of the counterparty.
• Determination of the adjustment for counterparty default risk must take into account possible default events during the whole run-off period of the recoverables.
• Calculation should be carried out separately by counterparty and each line of business, and separately for premium provisions and provisions for claims outstanding.
• Methods used must provide reasonable assurance of market consistency.
• Assessment of the probability of default and loss-given-default must be based on current, reliable and credible information.

Question 48

Loss-given-default

Answer 48

The expected present value of the change in cash-flows underlying the recoverables resulting from a default of the counterparty at a certain point in time.