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Dynamic Solvency Testing Models

Tom Karp
10 Oct 2002

Slide 1
 
Opening slide.
 
Slide 2
 
Today I will discuss in brief the insurance regulatory capital standards in Australia. For both general and life insurance Australia has risk-based capital standards which operate in a market value accounting regime.
 
I will spend more time on the life insurance arrangements because they embody scenario testing requirements and therefore come closest to some form of dynamic solvency testing.
 
As well as describing the regulatory requirements I will work through some simplified examples to bring out the principles used.
 
Slide 3
 
Both the life insurance and general insurance legislation and regulatory requirements have undergone significant reforms in Australia in recent years.
Life insurance was reformed in 1995 which was 50 years after the first national legislation and it was the first major overhaul during that period.
 
General insurance was reformed only recently and the new arrangements came into effect on 1 July this year.
 
Both regimes have capital requirements which are risk-based and therefore require more capital for more risky business lines or if more risky assets are held.
 
Much of the detail for the capital requirements in contained within prudential standards issued by the regulator APRA (this is predominantly the case for general insurance) or in actuarial standards issues by a Government appointed Actuarial Standards Board (this is the case for life insurance).
 
In both general and life insurance there is a strong reliance on actuaries to determine or provide expert advice on the valuation of policy liabilities or technical provisions. This is necessary to provide consistency across companies in each industry, but also for general insurance provides a more solid base to which the capital charges are applied.
 
For general insurance APRA sets high level principles for the valuation of policy liabilities and the Institute of Actuaries of Australia will provide a professional standard for detailing the calculation methodologies.
 
For life insurance the Life Insurance Actuarial Standards Board has produced an actuarial standard which details the valuation methodology and a best estimate assumption approach. This Board has also produced a Solvency Standard and a Capital Adequacy Standard for determining required reserve levels above the best estimate policy liabilities amount.
 
Slide 4
 
There is no prescribed Dynamic Solvency Testing Model which general insurers must use to determine their regulatory capital needs.
 
APRA has issued a Standard for the valuation of policy liabilities which covers both outstanding claims and premiums liabilities. Both are required to be calculated on a forward looking basis using realistic assumptions but discounted back to present values. If there is under-pricing this will require the premium liability to be higher than a pro-rated unearned premium. In almost all cases the approved actuary of the general insurer is required to provide the insurer’s board with expert advice on the determination of outstanding claims and premiums liabilities which are expected to be sufficient 75% of the time. So there is a required prudential or risk margin incorporated into the technical provisions.
 
In addition to the technical provisions there are various capital charges to cover insurance risk, investment risk and concentration risk in both the liabilities and assets. The insurance risk charges apply to the liability valuation and vary by line of business with higher charges for longer tail business and higher charges for premiums liabilities than outstanding claims. The charges vary from around 9% for short tail business through to 27% for longer tail inwards reinsurance excess of loss business. The investment risk charges vary by type of investment ranging from 0.5% of the asset value for cash and Government securities through to 10% for real estate and unlisted equities. Certain assets such as intangibles and loans to directors and related entities are excluded for capital adequacy purposes. For asset concentrations to counterparties less than a Standard & Poors A- there is a limit as a percentage of the insurer’s capital base on how much of the asset can count for capital purposes. For concentrations in the liabilities insurers need to calculate their largest Probable Maximum Loss from a catastrophic event net of reinsurance recoveries but including their reinsurance reinstatement premium assuming a return period of 250 years (ie a 1 in 250 year catastrophe). This is called the insurer’s Maximum Event Retention and and it is added to the insurer’s other regulatory capital requirements.
 
What I have described is the standard capital requirements for general insurers. Our new regime in Australia does allow insurers to use an Internal Model Based method for determining their regulatory capital.
 
Slide 5
 
The model used is subject to APRA approval which requires that the model meets a number of descriptive, qualitative, and quantitative criteria.
 
For approval the model must be comprehensive and rigorous, and as yet we have not approved any internal models for use by general insurers, but a few insurers are currently developing such models.
 
There are a series of stated qualitative criteria, including:
  • operate in a risk management environment that is conceptually sound and supported by adequate resources
  • covers all material risks the insurer is reasonably expected to be exposed to
  • independent risk management unit - APRA doesn’t intend to mandate a particular structure on the entity
  • board and senior management should be actively involved in the risk management processes which is closely integrated into the day to day risk management process of the insurer
  • there should be appropriate audit and compliance procedures such that the capital measurement model and overall risk management process should be reviewed ideally not less than once a year.
  • The standard prescribes a list of items that should be reviewed as part of the process, including integrity of the systems, scope and accuracy of the risks being assessed, and the appropriateness of the distributional assumptions.
  • The quantitative requirements of the model state that the model should calculate the capital requirement so as to "reduce the insurer’s probability of default over a one year time horizon to 0.5% or below." The standard does however allow different time horizons and default probabilities subject to APRA approval.
  • APRA approval would be granted where the insurer could demonstrate that the alternative parameters are appropriate for its business mix and produce a result which is consistent with the benchmarks set above.
  • Prior to approval the insurer must also identify the risk factors "that impact on the value of the insurer’s assets and liabilities" and the internal model must be sufficient to capture these inherent risks. The standards do not set an exhaustive risk but outlines investment, insurance, operational risks and correlation between the risk classes should all be considered.
  • APRA also expects that entities employing the internal model method will have developed a comprehensive stress testing program to supplement their capital measurement requirements. APRA will not set the stress testing requirements. The stress testing should encompass changes to the assumptions as well as the impact of larger events such as catastrophe risk, or extreme market conditions.
Slide 6
 
For life insurance there are actuarial standards which set the regulatory capital requirements. These standards are determined by the Life Insurance Actuarial Standards Board established under provisions within the life insurance legislation. The Government appoints the individual members of this board and the actuarial standards have the force of law; they are not simply professional standards of the Institute of Actuaries of Australia.
 
There are 3 main standards which are integrated and together these lay down the requirements for valuing policy liabilities for profit reporting purposes and the determination of separate Solvency and Capital Adequacy requirements.
 
The Valuation of Policy Liabilities Standard requires that insurance companies value liabilities on a "best estimate" or "market value" set of assumptions. This provides consistency with the valuation of assets which are on a net realisable market value basis. The actuarial methodology laid down in this standard is commonly referred to as Margin on Services or MoS because the expected future profits thrown up by using best estimate assumptions are then expressed as a profit margin on the services delivered under each type of contract and these future profits are respread back over the future life of the contracts and included as part of the policy liabilities. In this way these expected future profits are only released as they are actually earned year by year as the policy valuation process unwinds over the life of contracts.
 
The Solvency Standard lays down how policy liabilities are revalued for solvency purposes and other reserves are required to be held so that the existing liabilities of a life insurer can be run off with a sufficient financial buffer to withstand a range of adverse scenarios. It is based on a scenario of a company not writing new business and running off its liabilities so it contains elements of a wind-up situation.
 
The Capital Adequacy Standard is based on a scenario of a company being an ongoing viable operation open to accepting new business, but remaining strong enough to withstand a range of scenarios somewhat more adverse than those in the Solvency Standard.
 
Slide 7
 
If we look at the Solvency Standard in a little more detail we see that it contains the following main elements to essentially re-evaluate the companies balance sheet and then show the company still has positive net assets after the re-evaluation.
  • Solvency Liability requires that the liabilities be valued conservatively - discounting the future liabilities at the government bond rates instead of at the expected rate of return on the investments, using mortality, morbidity, lapse and expense assumptions which have adverse deviation margins in them.
  • The liabilities to creditors other than policyholders (e.g. tax and suppliers) are also included, but approved subordinated debt arrangements are excluded as these funds can be used like equity to pay obligations to policyholders.
  • Expense reserve requires an entity to assess its solvency requirement and must provide for a reserve against the risk of an overrun in acquisition expenses as the company moves into run-off.
  • The Inadmissible Assets Reserve is a reserve against the risks associated with assets where their value may well reduce in a run-off situation, may not be fully available or involve undue concentration of exposure to individual counterparties. This includes assets such as loans to directors and agents; holdings in associated financial entities; and individual asset exposures above certain percentages total assets.
  • The Resilience Reserve is a reserve against adverse economic shocks. Its determination considers the mismatch of changes to the assets and/or liabilities in the case of specified adverse market movements. It is the component of the Australian regime which is closest to dynamic solvency testing.
Slide 8
 
To assess resilience requirements, life insurers calculate assets and liabilities using an adjusted yield on each major asset class, and hold resilience reserves to cover any asset shortfall if the insurer’s assets were to suffer from the adverse yield change. The adjusted yield comprises of the current yield, plus a prescribed yield change multiplied by a discount factor to allow for diversification across asset classes.
 
RR is the Resilience Reserve
L = current liability value
A = current asset value
L’ = value of liabilities after the prescribed yield change
A’ = value of assets after the prescribed yield change
Adjusted Yield = Current Yield + DF * Prescribed Yield Change
DF = Discount Factor
 
Discount Factor determined as
 
DF= Ö (E2+P2+F2+I2)/(E+P+F+I)
 
E, P are the proportionate holding of assets in equities and property, each multiplied by the factor for that sector: Increase in Yield/Current Yield
F, I are the proportionate holding of assets in the asset sectors Interest Bearing and Indexed Bonds respectively each multiplied by the factor for that sector:
 
(Asset value at Current Yield/Asset value after Prescribed Change) – 1.
 
The easiest way to consider the resilience reserve is to consider the formula on the right, namely
 
[L + RR] * A’/A = L’
 
Essentially what this says is the insurer must be hold assets equal to its current liabilities and the resilience reserve, such that if the economic shock hits and those assets are devalued by the ratio A’ over A then the insurer will still have assets to meet the new value of its liabilities after the economic shock.
 
Slide 9
 
The prescribed yield changes vary for each sector, and is different again when calculating the resilience reserves for capital adequacy and solvency purposes.
The minimum adverse yield change for the capital adequacy requirement is that of the solvency requirement.
 
These yield adjustments were decided on after considerable stochastic modelling of the asset-liability position of a capital guarantee investment account style product.
 
In the case of capital adequacy the regulator is primarily interested in the ability of an insurer to continue to meet the solvency requirements at future balance dates. So the capital adequacy risk criterion was set at a 2% probability of assets falling below the required solvency level at the next annual balance date.
 
In the case of solvency the regulator is primarily interested in the ability of the insurer which is put into run-off because it has breached the solvency requirement to be able to run-off its policy liabilities in an orderly fashion. The solvency risk criterion was set at a 5% probability of assets falling below liabilities within any of the next 3 annual balance dates.
 
It was decided to use yield changes as the driver rather than percentage drops in asset values because using yield changes produces dynamic reserves as the market moves above or below its historically average levels. So if the stock market is historically high, current yields will be low and the prescribed yield changes will lead to large drops in asset values, may be as much as 40%.
 
Whereas if the market is low yields would be high and the prescribed yield changes will lead to smaller drops in asset values, may be around 15-20%.
 
Lets look at a few simplified examples to see how this actually works.
 
Slide 10
 
In this example I have used a fixed death benefit payable in the very short term, so I have assumed that the liability is fixed and does not alter with yield changes.
 
The assets are cash of $1,000 and other investments of $1,000, which are all in equities. The current equity dividend yield is assumed to be 3% and the current interest yield 7%.
 
In this case only equities will drop in value from $1,000 to $706 as the dividend yield increases from 3% to 4.25%, and hence an increase in the dividend yield will lead to a total asset value of $1706, while the value of the liabilities will not change. In this example the resilience reserve required would be $300.
 
This demonstrates the reserve requirements when the assets are exposed to adverse yield changes, but the liabilities side of the balance sheet is fixed.
 
Slide 11
 
In this case the liabilities comprise a short term fixed death benefit of $500 and a 30 year annuity of $100 pa with no mortality risk.
 
The investments are entirely in cash.
 
In this case the annuities would be impacted by drop in interest rates pushing up the value of the liabilities to $1994. In this case the resilience reserve would need to be $253.
 
This demonstrates the reserve requirements when the liabilities are exposed to adverse yield changes, but the assets side of the balance sheet is fixed.
 
Slide 12
 
In this example we have the same liabilities as those in example 2 (ie short term fixed death benefit and an annuity) and the same assets as in example 1 (ie cash and equities).
 
This demonstrates the reserve requirements when both the asset and liabilities are exposed to adverse yield changes.
 
The resilience reserve in this example is $597 and is much larger than the previous cases reflecting the increased vulnerability of the portfolio with exposure to adverse movements on both sides of the balance sheet.
 
Slide 13
 
This example has the same liabilities as examples 2 & 3 but the assets are cash and fixed interest investments, but no equities.
 
Similarly to the previous example this one includes exposures on both sides of the balance sheet. In this example however, as the fixed interest investments are affected by interest rate movements in the same way as the annuity liability is there is a degree of matching between assets & liabilities. This has the impact of partially offsetting adverse movements in the value of the liabilities and hence the resilience reserve of $327 is smaller than the previous example.
 
Slide 14
 
Appointed Actuaries of insurer should be examining the impact of a combination of adverse movements, and set the resilience reserves based on the combination with the largest impact.
 
As an example one insurer initially tested 2 adverse yield scenarios and took the greater of the two as the resilience reserve:
  • Run 1. Rising yields for all asset classes
  • Run 2. Rising yields for equity and property classes, rising real yields for investment linked bonds and falling fixed income yields
They went the step further to test other combinations of rising and falling yields for different classes. However it was indicated that one of the above scenarios will always yield a higher result that a combination of scenarios. A combination of rising and falling yield scenarios was achieved through a matrix formation illustrating individual effects of yield changes between various asset classes.
 
Another approach set a matrix illustrating various other adverse market scenarios the company is especially sensitive to and highlight for instance, large market falls in particular equity industries. The resilience amount is then found by taking the maximum asset and liability mismatching value obtained under all adverse scenarios considered.
 
Slide 15
 
Now for a few final comments on the Capital Adequacy requirements for life insurers in Australia to explain the difference between them and the Solvency requirements, why have adopted this 2-tier approach and how it is meant to work in practice.
 
Firstly, the capital Adequacy reserves are structured in the same way as the Solvency reserves, but they are generally more conservative with higher margins for adverse, mortality, morbidity lapse and expense assumptions and larger economic shocks for the resilience reserves. Because Capital Adequacy is based on a going concern philosophy some of the inadmissible asset requirements are less than those for Solvency. As Solvency requirements are based on a run-off or wind-up philosophy assets which will reduce in value in such a situation are not counted or counted for reduced value for Solvency purposes.
 
The Capital Adequacy requirements do contain an extra reserve for new business which is not contained in the Solvency requirements. The approach to calculating this reserve is that the Appointed Actuary must project the insurer’s balance sheet for the next 3 years assuming the insurer meets its new business plans and be able to demonstrate that at the end of that period the insurer will be able to meet the Solvency requirement. So a company which is growing rapidly selling life products which require significant amounts of new capital will have a high new business reserve, while a mature company may have no new business reserve even though it is still selling new business because the next 3 years profits coming from existing business will be adequate to fund the new business capital requirements.
 
This 2-tiered capital approach leads to the following supervisory responses to differing situations.
 
If an insurer meets capital adequacy requirements we regard them as adequately capitalised and they have relative flexibility to go about their business, but of course we still monitor their financial position and they would be advising us of any major deals or restructuring.
 
If an insurer is below capital adequacy, but above the solvency requirements we do not regard them as financially healthy enough and so we require them to develop a detailed business plan to get themselves above capital adequacy again within a reasonable time frame. We also do not allow any distributions out to shareholders to occur until capital adequacy is again reached.
 
If an insurer is below the solvency requirement we regard them as strong enough to continue writing new business and we would move to appoint a Judicial Manager who would report to the Court about the affairs of the company and its future prospects. When this happens it is very unlikely a company would recommence writing new business and more likely it would move into run-off, sell its business or move to be wound up.