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INSURANCE

ADVISORY – ACTUARIAL SEVICES

Technical provisionsMethods and statistical techniquesto calculate the best estimate

Imrich Lozsi4. December 2009

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Agenda

The valuation process

Cash flow projections

Options and guarantees

Policyholder behavior

Discretionary benefits

Assumptions

Validation methods

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The valuation process (1)

It should not rely solely on models but also requiresExpert judgment with sound reasoning and business logicAnalysis of the underlying liabilitiesCollection of qualitative and quantitative information

Components of the valuation processCollection and analysis of the dataDetermination of assumptionsModeling, parameterization and running the models Assessment and appropriateness of estimationsDocumentation and controls

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The valuation process (2)

Requirements for an individual performing the process Knowledge of actuarial and financial mathematics Ability to demonstrate this with applicable professional standards

Revision by person with adequate knowledge and skills and independent of the valuation process

Upon request from the supervisory authority to demonstrate The robustness of the valuation processAppropriateness of the level of technical provisionsApplicability and relevance of the methods usedAdequacy of the underlying statistical and financial data

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Cash flow projections

All cash in- and out-flows required to settle the obligations

Best estimate is calculated gross, without deduction of amounts recoverable from reinsurers and SPVs

Expected realistic future demographic, legal, medical, technological, social or economical developments

Appropriate assumptions about future inflationIdentification of the type of inflation to which particular cash flows are exposed

Projection horizon to cover the full lifetime of all obligationsTo be determined on up-to date and credible information and realistic assumptions

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Cash in-flows

Future premiums

Receivables for salvage and subrogation

Should not take into accountinvestment returns!

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Cash out-flows

BenefitsClaims paymentsMaturity benefitsDeath and disability benefitsSurrender benefitsAnnuity payments…

Expenses

Other cash flow items

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Cash flows from all expenses that will be incurred in servicing all obligations related to existing contracts over their lifetime

This shall specifically includeAdministrative expensesClaims handling expensesInvestment management expensesAcquisition expenses including future commissions

Expense items

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Expenses include Allocated, i.e. directly assignable to individual claims, policies or transactions; and Unallocated (overhead) expenses

Principles of allocation to LOBs, homogeneous risk groups …According to professional judgment and realistic assumptions Based on realistic and objective principles

Principles and their application shall be documented and the undertaking should be able to explain their changes over time

Changes in the pre-defined split permitted only if the new split will better fit the current situation

Expense allocation (1)

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For non-life insurance obligations and where appropriate, expenses shall be allocated between

Premium provisions; and Claim provisions

Premium provisionsAdministrative expenses including maintenance commissions Claims administration expenses related to future claims from in force contracts

Claim provisionsClaims administration expenses related to unsettled claims incurred before the valuation date

Expense allocation (2)

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Own experience and any relevant market data

Inclusion of expenses directly related to administration of obligations related to existing contracts, together with share of relevant overhead expenses

Liability: how much to pay to transfer, how much to receive to accept => Share of overheads on a going concern basis. Run off basis only if it is very likely in the near future

Allowance for expected future cost increase but no allowance for cost reductions where these have not yet been realized

May anticipate an expected cost reduction to the five years after licensing of the undertaking

Expenses – other considerations

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Cash flow projection should be based on policy-by-policy approach (cash flows depend on biometrical risk of each policyholder) but suitable model points are permitted

The grouping shall not Misrepresent the underlying risk and significantly misstate the costsResult in the loss of significant attributes of the valued portfolio…

No surrender value floor (… no need to increase the value of insurance liabilities to the surrender value)

Negative reserves permitted (… undertakings are not required to set zero the value of best estimate)

Life insurance obligations

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Non life insurance obligations

The valuation of the claim and premium provisions shall be carried out separately

Claim provisions Premium provisions

Future premium paymentsFuture claim eventsAllocated and unallocated claims management expensesExpenses associated with ongoing administration of in-force policies

Policyholder behavior, time value of the money

All future claim payments whether reported or notClaims management and claims administration expenses associated with these claims

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Options and guarantees (1)

Identify all contractual options and financial guarantees (“right to change the benefits to be taken at the choice of its holder, on terms that are determined in advance”)

For each type of contractual options identify all risk drivers, which have the potential to materially affect

Option take up ratesLevel of moneyness

Capture the uncertainty of cash flowsConsider a sufficiently large set of scenarios, including adverse ones

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Options and guarantees (2)

Best estimate should reflect both the intrinsic and the time value

Assumptions on policyholder behavior should be appropriately founded by statistical and empirical evidence to the extent that this is deemed representative of the expected future behavior

Consideration should also be given to an increasing future awareness of policy options as well as policyholders’ possible reactions to reduced solvency

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Policyholder behavior

Policyholder behavior which change the expected future cash flows of the contract, if exercised in line with options contained in the policy should be taken into account

When assessing past policyholders behavior, appropriate attention should be given to whether the option is out or barely into the money …

Policyholders’ behavior should not be assumed to be independent of financial markets, an undertaking’s treatment of customers or publicly available information, unless proper evidence assumption can be observed.

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Discretionary benefits (1)

When calculating technical provisions participants should take account of all payments to policyholders and beneficiaries, including future discretionary bonuses, which they expect to make, whether or not these payments are contractually guaranteed, unless those payments fall under surplus funds

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Discretionary benefits (2)

Guaranteed benefitThe value of the liability, which does not take into account any future declaration of future discretionary bonuses

Conditional discretionary benefitThis is a liability base on declaration of future discretionary benefits influenced by legal or contractual declarations and performance of the undertaking/fund (performance-related)

Pure discretionary benefitThis is a liability based on the declaration of future benefits which are at discretion of the management (decision-related)

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Discretionary benefits (3)

Detailed documentation of the mechanism for distributing discretionary benefits

When valuation of discretionary benefits depends on the assets held by the firm

Assets assumed in valuation to be consistent with the assets held at the valuation date Changes in asset allocation should be taken into account if requirements on management actions are met

The valuation of the discretionary benefits should be consistent with the choice of the risk-free rate for discounting

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Assumptions (1)

Assumptions shall be set consistently with Information provided by the financial marketsGenerally available data on insurance and reinsurance technical risks

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Assumptions (2)

General principles for assumption settingIn a realistic manner and consistently from year to year without arbitrary changesChanges of assumptions from one period to another shall be traced, explained and documented …Assumptions shall be appropriately documented including the suitability of data sources, derivation of assumptions and the limitations in the resultsThe underlying data shall be credible and meet the relevant standards

When based on external dataAvailable to the extent that they may be validatedProduced sufficiently frequently to permit analysis

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Where an assumption is produced by a market consistent asset model, that model shall satisfy the following criteria

Shall deliver prices for the assets and liabilities that can be directly verified by the marketShall be arbitrage free

A market consistent asset model shall be calibrated toReflect the nature and term of the liabilities particularly those giving rise to significant guarantee costThe current risk free term structureAn appropriate volatility measure

Deep liquid and transparent marketIf not, insurer shall be capable to demonstrate that the calibration is appropriate

Assumptions – Information provided by the financial markets

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Assumptions – Data on insurance and reinsurance risks

Assumption shall be derived consistently

Across homogeneous risk groups or lines of business

With the undertaking’s knowledge of the business and practices for managing the business

Credible information which is relevant to the cash flows

Undertakings shall consider whether assumptions adequately reflect the underlying uncertainty

Appropriate allowance for future trends or changes both in the portfolio and external socio-economic factors

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Assumptions – Use of expert judgment (1)

ScopeData, assumptions and in respect of the applied method

General conditionsCompatibility with CEIOPS advices, in particular it shall not replace appropriate collection processing and analysis of data according to advice on data quality standardsShall not be applied in isolationShould be prudent if applied in isolationor to an assumption with significant impactExpert with relevant knowledge, understanding and comprehension of the subject

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Assumptions – Use of expert judgment (2)

Documentation in a manner which makes possible the accountability and verification of the expert judgment

Inputs Objectives and decisional criteriaAny material limitations and thesteps to be taken to eliminate themThe envisaged validationand back testing

Back testing Against additional experienceor emergent informationCompared to external informationSensitivity analysis

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Validation methods

Validate the amounts of technical provisionsEnsure applicability and relevance of the methods and assumptions applied and appropriateness of the level of technical provisionsEnsure that the actuarial methods and statistical techniques are appropriate to the nature, scale and the complexity of the risksCompare the best estimate against experience, understand and explain sources of differencesAt least once per year but significant changes may necessitate ad-hoc checks more oftenAppropriate documentations

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Imrich Lozsi

Senior Manager, Actuarial Services KPMG in the Central and Eastern Europe

c/o KPMG Česká republika, s.r.o.

+420 222 123 627

ilozsi@kpmg.cz

www.kpmg.cz

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