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International Regulatory Changes Actuarial Applications

International Regulatory Changes Actuarial Applications. By Eric Lecoeur, FIA SCOR, Group Chief Actuary. Disclaimer.

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International Regulatory Changes Actuarial Applications

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  1. International Regulatory ChangesActuarial Applications By Eric Lecoeur, FIA SCOR, Group Chief Actuary CAS 2005 Seminar on Reinsurance

  2. Disclaimer • The following presentation focuses on international regulatory changes in progress in the framework of IFRS phase II and Solvency II. It reflects opinions and interpretations of available material at May 2005. Positions and interpretations on any issue raised may subsequently change, according to the publication of official directives concerning certain accounting standards. • This presentation creates no contractual relationship with SCOR. • The participant has to be aware that, in making this presentation available, SCOR is not providing professional advice and accepts no liability arising from reliance upon this presentation. • Any decision by a participant in this session or other readers of this presentation to rely on the opinions expressed here shall be at the participant’s own risk. CAS 2005 Seminar on Reinsurance

  3. Schedule 2002 2003 2004 2005 2006 IAS / IFRS Exposure Draft for Phase I (31/07/03) Final Phase I Standards IFRS 4 (31/03/04) Phase I Balance Sheet (published at 31/12/05) Final Phase II standard : 2007, 2008 ? Phase II Financial Statements Published : 2009 ? Solvency I Müller Report in 1997 Solvency I project initiated Solvency I Completed (inforce by 2004) Directive of the European Parliament on reinsurance Proposal for the directive (21/04/2004) Proposal backed by the European Economic ans Social Committee Enforcement ? Solvency II Sharma Report (2001) : project initiated End of Phase I (design of the system) Exposure Draft finalised for Phase II : 2005-2006 ? … ICAS by FSA (UK) CP 190 (non life) + CP 195 (life)  Integrated Prudential Sourcebook FSA’s ICA review CAS 2005 Seminar on Reinsurance

  4. Content • IAS / IFRS – Their impact on liability assessment • Solvency II – Their impact on liability assessment • Conceivable actuarial approaches CAS 2005 Seminar on Reinsurance

  5. IAS / IFRS Their impact on liability assessment CAS 2005 Seminar on Reinsurance

  6. Phase I : IAS 39 / IFRS 4 IAS / IFRS – Their impact on liability assessment • IFRS 4 focuses on 3 points : • Definition of an “insurance contract” • Unbundling of deposit elements • Separate embedded derivatives • Enhanced disclosure • sensitivity analyses • risk management procedures • Principle of “Fair Value” IAS 39 CAS 2005 Seminar on Reinsurance

  7. Phase I : Accounting policies IAS / IFRS – Their impact on liability assessment • PROHIBITED • Catastrophe and equalization provisions • Offsetting reinsurance assets against insurance liabilities • MANDATED • Liability adequacy testing CAS 2005 Seminar on Reinsurance

  8. Phase I : Accounting policies IAS / IFRS – Their impact on liability assessment • ALLOWED TO CONTINUE (but not implement) • Undiscounted liability basis • Deferred Acquisition Costs / Unearned Premium Reserve approach • CAN BE IMPLEMENTED • Use of market discount rates (if undiscounted liability is used) • Use of shadow accounting (life insurance) CAS 2005 Seminar on Reinsurance

  9. Phase II – Actuarial consequences on reserving 1/3 IAS / IFRS – Their impact on liability assessment • Catastrophe and equalization provisions are banned because they do not meet the criteria for liabilities • Premiums and costs will no longer be smoothed over time (through deferred acquisition costs and unearned premium reserve) • Liabilities measured at their “fair value”  Interpretation : discounted anticipated value, at the closing date, of future cash flows CAS 2005 Seminar on Reinsurance

  10. Phase II – Actuarial consequences on reserving 2/3 IAS / IFRS – Their impact on liability assessment • Use of discounting : • The discount rate is likely to be the return on a risk-free asset • Still some discussions about whether the credit quality should impact the liability recorded • Comments on the Credit Standing of the issuer: • From a strictly theoretical point of view, the fair value of a liability should recognize that there is some possibility of default  reduction of the expected value of future cash flows and therefore the level of the liability • Weaker insurers would reserve less than stronger players for the same liability … CAS 2005 Seminar on Reinsurance

  11. Phase II – Actuarial consequences on reserving 3/3 IAS / IFRS – Their impact on liability assessment • A risk premium (Market Value Margin or MVM) must be taken into account because of the uncertainty of the liabilities • Format of the Market Value Margin • Adjusting the discount rate applied to expected cash flows … • Incorporating a variability in loss reserve payment timing and then using a risk-free discount rate for the cash flows (it seems to have the preference of IASB) • Comments on the Market Value Margin • Making accounts more opaque (e.g. some capital may be hidden in the form of MVM) / An ability to be misused as a profit smoothing device • Phase II is little developed. Some points are not yet solved, for instance the lack of diversification credit (the MVMs are likely to be additive between the pools or segments that they are calculated in) CAS 2005 Seminar on Reinsurance

  12. IFRS / Solvency II Solvency II Assets (market value) Economic net assets Liabilities (economic Value) IFRS versus Solvency II IFRS Phase II IAS Fair Value Present Value of Future Cash flows  Market Value Margin CAS 2005 Seminar on Reinsurance

  13. Solvency II Their impact on liability assessment CAS 2005 Seminar on Reinsurance

  14. Objectives of Solvency II SOLVENCY II – Its impact on liability assessment • Global solvency approach • Protect policyholders • Provide comparability, transparency and coherency • Enhanced risk sensitiveness • Reflect market developments (derivatives, ALM …) • Encourage internal risk management CAS 2005 Seminar on Reinsurance

  15. Organisation of Solvency II Actuaries  IAA  Groupe Consultatif « A global framework for insurer solvency assessment » (Jan. 2004) IAIS Solvency II EC CEIOPS / EIOPC Basel II IASB EU States’ project Australian project Canadian project US project Switzerland APRA OSFI CIA NAIC SOA Netherlands CAS «Australian capital requirements for non-life insurers: Internal model Based Method» (2002) FSA UK CAS 2005 Seminar on Reinsurance

  16. SOLVENCY II – Its impact on liability assessment SOLVENCY II Pillar I Pillar II Pillar III Capital requirements Supervisory Review process Market transparency Disclosure A « three pillars » approach CAS 2005 Seminar on Reinsurance

  17. SOLVENCY II – Its impact on liability assessment Final output CAS 2005 Seminar on Reinsurance

  18. SOLVENCY II – Its impact on liability assessment Spreads (Bonds) Loans / Debtors Reinsurers Concentration Model Credit Risk Operational Risk Interest Rates Economic Factors Share Price Catastrophes Market Risk Insurance Risk FX New Business Volatility Old Business Liquidity Concentration Concentration Model Model CAS 2005 Seminar on Reinsurance

  19. SOLVENCY II – Its impact on liability assessment Spreads (Bonds) Loans / Debtors Reinsurers Concentration Model Credit Risk Operational Risk Interest Rates Economic Factors Share Price Catastrophes Market Risk Insurance Risk FX New Business Volatility Old Business Liquidity Concentration Concentration Estimation of the reserving risk Model Model CAS 2005 Seminar on Reinsurance

  20. Consequences on reserving SOLVENCY II – Its impact on liability assessment • Preservation of the equalization reserves (contrary to IFRS) • Discount of the reserves with a risk-free rate corresponding to the average duration of the liabilities (coherent with IFRS approach) • Necessary to replace deterministic approaches with stochastic one, in order to quantify the level of prudency. Different measures are proposed: • the IFRS approach : best estimate + « market value margins » • VaR / Tail-VaR • Best-estimate loaded with a coefficient linked to the volatility of the LoB CAS 2005 Seminar on Reinsurance

  21. Consequences on reserving SOLVENCY II – Its impact on liability assessment VaR / Tail-VaR The Value at Risk (VaR) is the alpha-% quantile of the ultimate losses’ distribution. The Expected Shortfall (ES), or tail conditional expectation: expectation of the ultimate losses amount given that it exceeds the VaR. ES(alpha) = E[ X | X > VaR(alpha) ] CAS 2005 Seminar on Reinsurance

  22. Conceivable actuarial approaches Review of regulations in Asia-Pacific CAS 2005 Seminar on Reinsurance

  23. Conceivable actuarial approaches The Singaporean point of view • According to the Insurance Act (Chapter 142), the valuation of insurance policy liabilities of each line of business must comprise: • Best estimate of the premiums liabilities • Best estimate of the claims liabilities • Provision for adverse deviation that relates to the inherent uncertainty in the best estimate value of both the premium and claims liabilities at a minimum 75% confidence level. CAS 2005 Seminar on Reinsurance

  24. Conceivable actuarial approaches The Australian point of view • Extract of the Australian Prudential Standard GPS 210 : • “Insurance liabilities include both the insurer’s Outstanding Claims Liabilities, and its Premiums Liabilities.” • “The Approved Actuary must provide advice on the valuation of insurance liabilities at a given level of sufficiency – that level is 75% (or, in some circumstances, the central estimate plus one half of the coefficient of variation).” • “Insurance liabilities are to be valued on a discounted basis. The rate to be used in discounting is the risk-free rate; i.e. the gross redemption yield of a portfolio of sovereign risk securities with a similar expected payment profile to the insurance liabilities” CAS 2005 Seminar on Reinsurance

  25. Conceivable actuarial approaches The Australian point of view • Claims liability • “Stand alone” risk margins for the Net Outstanding Claims Liabilities for Primary Insurers • “Stand alone” risk margins for the Net Outstanding Claims Liabilities for Inwards Reinsurance: • - For proportional inwards reinsurance : same coefficients • - for non-proportional inwards reinsurance : coefficient to be applied to direct risk margin (about 2) Coefficients for the risk margin computation from the report of Bateup&Reed CAS 2005 Seminar on Reinsurance

  26. Conceivable actuarial approaches The Australian point of view • Premium liability • “Stand alone” risk margins for the Net Premium Liability : • The recommended multiples of the net outstanding claims liability risk margin to be applied for determining premium liability risk margins, are as follows : • - 1.75 for short tail lines of business • - 1.25 for long tail lines of business CAS 2005 Seminar on Reinsurance

  27. Conceivable actuarial approaches The Australian point of view • Diversification: • “Rule of thumb”: • Diversification discount = f (C, N, S) • Where: • C = coefficient of concentration = (Net insurance liability for largest LoB) / (Total net insurance liability) • N = number of lines of business • S = size of the insurer’s total insurance liabilities in $ million CAS 2005 Seminar on Reinsurance

  28. Conceivable actuarial approaches Risk Margin Estimation Risk margin estimation under some classical underlying distribution assumptions : Let X be the random variable “Ultimate Aggregate Loss” with average m (which is the best estimate) and standard deviation σ. What is the loading Lα to be applied to the best estimate to achieve a level of confidence of α percent? Notation: we will name AlphaEst the new estimate. CAS 2005 Seminar on Reinsurance

  29. Conceivable actuarial approaches Risk Margin Estimation Assumption of log-normality : Let X follow a lognormal distribution with parameters μ and σ The random variable Y defined as ln X follows a N(M,S), with : Introducing the variation coefficient of X, , we have : which leads to the loading Note: under an assumption of normality, the loading is CAS 2005 Seminar on Reinsurance

  30. Conceivable actuarial approaches Bootstrapping the Chain Ladder (simplified) Definitions Assume that the data consist of a triangle of incremental claims: The cumulative claims are defined by: and the loss development factors (LDF) of the chain-ladder technique are denoted by : CAS 2005 Seminar on Reinsurance

  31. Conceivable actuarial approaches Bootstrapping the Chain Ladder (simplified) • Obtain the standard chain-ladder development factors • Obtain incremental fitted values by backwards recursion • Calculate the unscaled Pearson residuals and the scale parameter Ф • Resample with replacement the adjusted residuals • Obtain pseudo data • Use chain ladder and estimate future incremental payments CAS 2005 Seminar on Reinsurance

  32. Conceivable actuarial approaches Bootstrapping the Chain Ladder (simplified) • Simulate future payments from process distribution assuming the mean is the incremental value obtained • Repeat many times, storing the reserve estimates, giving a predictive distribution • Prediction error (variability in the data and variability due to the estimation) is then standard deviation of results Where SEbs(Ri) is the bootstrap standard error of the reserve estimate and p is the number of parameters estimated CAS 2005 Seminar on Reinsurance

  33. Conceivable actuarial approaches Improving bootstrapping • Variability often changes across in triangle. The idea is to divide the triangle into “zones” for simulation. • Use of correlations between LoBs •  use of rank correlations between the simulations of the triangles for each Line Of Business (see Kirschner, “Two approaches to calculating correlated reserve indications across multiple lines of business”) ZONE 1 ZONE 2 CAS 2005 Seminar on Reinsurance

  34. Conceivable actuarial approaches Mack’s model The Mack’s model reproduces chain-ladder estimates. The model is distribution-free and only specifies the first two moments of the distribution. The hypothesis are similar to those of the Chain Ladder method, with in addition that the variance of Dij is equal to And consequently : CAS 2005 Seminar on Reinsurance

  35. Conceivable actuarial approaches Mack’s model Under the assumption of independence between the accident years, the model provides estimators for λj (Loss Development Factors of the chain ladder method) and For 1 ≤ j ≤ n – 2 : The mean squared error of the estimated reserve Ri can be estimated by : CAS 2005 Seminar on Reinsurance

  36. i Conceivable actuarial approaches Example • In this example, we use the same data as Verrall (1990, 1991) and Mack (1993) : • Run-off triangle (accumulated figures) CAS 2005 Seminar on Reinsurance

  37. Conceivable actuarial approaches Example • Bootstrapping the reserves allows to obtain the distribution (outputs from RESQ® of EMB) : Cumulative distribution Density function CAS 2005 Seminar on Reinsurance

  38. Conceivable actuarial approaches Example CAS 2005 Seminar on Reinsurance

  39. Conceivable actuarial approaches Example Errors of estimates: CAS 2005 Seminar on Reinsurance

  40. Selected references • England P.D., Verrall R.J. (1999) : « Analytic Bootstrap estimates of prediction error in claims reserving » Insurance : Math. And Econ. Vol. 25, 281-293 • Mack T. (1993) : « Distribution free calculation of the standard error of Chain Ladder reserve estimates » Astin Bull. Vol. 23, 213-225 • Prudential Standard GPS 210 : « Liability Valuation for General Insurers » www.apra.gov.au • FitchRatings (May 2004) : « Mind the GAAP: Fitch’s view on Insurance IFRS » www.fitchratings.com • www.iasplus.com - Deloitte • R. Bateup and I. Reed, (November 2001) : « Research and data analysis relevant to the development of standards and guidelines on Liability valuation for General Insurance » CAS 2005 Seminar on Reinsurance

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