Best Estimate Technical Provisions

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1 Solvency II - QIS5 Non-Life Technical Provisions 15 September 2010 Dimitris Dimitriou 1 Best Estimate Technical Provisions 1

2 Agenda 1. Segmentation 2. Future Premiums 3. Valuation Techniques 4. Simplifications 5. Gross-to-net Techniques 6. Discounting 7. Risk Margin Non-life direct business (incl. proportional re) segmented into 12 lines of business: 1. Medical expenses 2. Income protection 3. Worker s compensation 4. Motor vehicle liability 5. Motor, other classes 6. Marine, aviation and transport 7. Fire and other damage 8. General liability 9. Credit and suretyship 10. Legal expenses 11. Assistance 12. Miscellaneous Non-life non-proportional inwards re into 4 lines 2

3 Unbundling - Considerations Need to separate obligations under contracts covering multiple lines of business into the individual lines, but the allocation may not be obvious in practice (e.g. how to split indirect expenses by LOB?). Proportionality argument can be used to allocate the contract to the main risk driver where only one is deemed to be material, but how this would apply in practice is currently unclear. Data implications what to do if required past data does not exist? May need to change data collection processes in future! Requirements relating to choice of valuation techniques more clearly defined than in QIS4 Claims outstanding & IBNR reserve Needs to include policy admin and claims handling expenses Annuities: separation and treatment according to life valuation principles where material Premium Provision Needs to include policy admin and claims handling expenses, and allow for lapses (this was previously not explicitly specified in QIS4) 3

Non-Life Cash flows Solvency II requirement for BEL to represent probability weighted average of future cash flows Which cash flows should be modelled?

4 Non-Life Cash flows Solvency II requirement for BEL to represent probability weighted average of future cash flows Which cash flows should be modelled? All future claims, expenses and premiums (split between claims provision and premium provision) Separate claim types with different payment patterns splitting between attrition, large and cat claims will become more common Renewal Date Remaining term New Contract? Future benefits and premiums can be taken into account until undertaking has right to reject the premium or unlimited ability to amend premium and/or benefits in the future QIS5 requests details on the impact of the treatment of renewal options on the value of technical provisions Annex D of the QIS5 technical specifications gives examples of the treatment for certain product types: suggests any ability to amend premiums (or benefits) would mean that only 1 year s cash flows could be included in calculation of technical provisions. 4

5 Premium Provisions First Simplification (Provision for unearned premiums + Provision for unexpired risks) / (1+i/3) Second Simplification Expected Claims Ratio Basis (Similar to QIS4) BE = CR UPR + (CR 1) PVFP + AC PVFP First method is just a special case of the second method Motor policy written on 30/6/2009 for Gross Written Premium of 1000 euros Expected Claims Ratio: 65% Acquisition Cost Ratio: 20% Expense Ratio: 10% Under the Current Valuation Principles on 31/12/2009 Unearned Premium Reserve: 500 Unexpired Risks Reserve: - Deferred Acquisition Cost: 100 5

6 Motor policy written on 30/6/2009 for Gross Written Premium of 1000 euros Expected Claims Ratio: 65% Acquisition Cost Ratio: 20% Expense Ratio: 10% Under Solvency II QIS5 Expected Cash flows: Expected Claims: 325 (65% x 500) Expected Expenses: 50 (10% x 500) Total Premium Provision: 375 Deferred Acquisition Cost: - Motor policy written on 30/6/2009 for Gross Written Premium of 1000 euros Expected Claims Ratio: 65% Acquisition Cost Ratio: 20% Expense Ratio: 10% Differences Assets Reduced by 100 (DAC disallowed). Technical Provision Reduced by 125 6

large and cat claims will become more common Claims Provisions IBNR First Simplification: IBNR reserve

7 Claims Provisions Simplifications 1. I (N i A i ) P i 2. Case-by-case approach Separate claim types with different payment patterns splitting between attrition, large and cat claims will become more common Claims Provisions IBNR First Simplification: IBNR reserve year t = C t x N t Second Simplification: Provision IBNR LOB = factor LOB_U x PCO_reported LOB Methods are uncommon and unlikely to be widely applicable 7

8 Medical expense Income protection Workers' compensation Motor vehicle liability 16/09/2010 Total Health non SLT and Non- Technical provisions- Health non SLT and Non-life Life Gross - Current bases Provision for unearned premium 0 Life assurance provision 0 Claims outstanding 0 Provision for bonuses and rebates 0 Equalisation provision 0 Other technical provisions 0 thereof: provisions for unexpired risk 0 Net - Current bases Provision for unearned premium 0 Life assurance provision 0 Claims outstanding 0 Provision for bonuses and rebates 0 Equalisation provision 0 Other technical provisions 0 thereof: provisions for unexpired risk 0 Technical provisions with illiquidity premium minus recoverables from re and SVP- QIS5 basis 0 Life principles need to be used 0 Premiums provisions 0 Claims Oustanding 0 How to allow for outwards Re? Best estimate calculated gross, without deduction of amounts recoverable from re contracts Will generally be acceptable to use a Gross to Net technique, similar to current practice Allow for lag in timing of re cash flows where material Apply gross-to-net technique at sufficiently granular level Adjustment for counterparty default 8

63% QIS4 and CEIOPS final advice QIS4: Swap rates No illiquidity premium Constant forward rate extrapolation.

9 Adjust for Counterparty Default RR = (PP gross -PP net )+(PCO gross -PCO net ) Recovery Rate Probability of default (1 year) Approximate adjustment (duration of recoverables ~ 5 years) AAA 50% 0.05% 0.13% AA 45% 0.1% 0.28% A 40% 0.2% 0.60% BBB 35% 0.5% 1.63% QIS4 and CEIOPS final advice QIS4: Swap rates No illiquidity premium Constant forward rate extrapolation. CEIOPS Final Advice: Government AAA Bonds No illiquidity premium allowance although additional comments added that an illiquidity premium may be allowed Four extrapolation techniques proposed as no single approach considered appropriate for all currencies 9

QIS5 Swap rates with adjustment for credit risk (-10bps) Illiquidity premium (+53bps for Euro, +82bps for Sterling) added to spot rates and classified in three buckets (100%, 75% and 50%).

10 QIS5 Swap rates with adjustment for credit risk (-10bps) Illiquidity premium (+53bps for Euro, +82bps for Sterling) added to spot rates and classified in three buckets (100%, 75% and 50%). Max duration for illiquidity premium varies by currency (15 yrs for Euro, 30 yrs for GBP) and then linearly reduces to 0 over the next 5 yrs Macroeconomic technique adopted for extrapolation: Unconditional long-term forward rate ( UFR ) equal 4.2% for Euro QIS5 package includes reference spot rate curves for main currencies Data collected to assess impact of illiquidity premium Risk Margin: Projection Project SCR Need to project future SCRs t=0 included Apply CoC factor (6%) and discount CoCM = CoC t 0 SCR RU (t)/(1+r (t+1) ) t+1 10

Risk Margin: Diversification QIS5 allow for diversification between lines of business when calculating the risk margin, but: allocation of risk margin required separately for each line of business;

11 Risk Margin: Diversification QIS5 allow for diversification between lines of business when calculating the risk margin, but: allocation of risk margin required separately for each line of business; SCR COCM RU, lob(0) lob COCM SCR (0) lob RU, lob Risk margin calculated net of re SCR RU (Total for risk margin calculation) SCR RU Underwriting risk SCR RU Counterparty default risk SCR RU Unavoidable market risk SCR RU Operational risk Adjustment for loss absorbing capacity of technical provisions BSCR RU Risk Margin: Simplifications Hierarchy of simplifications: Full projection of future SCRs Approximate some risks or modules Approximate whole SCR for each future period Approximate all future SCRs using duration based approach Approximate the risk margin as a percentage of the best estimate 11

12 Medical expense Income protection Workers' compensation Motor vehicle liability 16/09/2010 Future cash flows that can be replicated using financial instruments for which a market value is observable are deemed to be hedgeable Perfect hedges are not required but any basis risk must be immaterial Technical provisions are then set equal to market value of replicating hedges If in doubt, assume cashflows are non-hedgeable In practice few (if any) cashflows are likely to be hedgeable Risk margin Information required QIS5 spreadsheet Insurance with profit participation Index-linked and unit-linked Other life and Other Disability/Mor bidity Annuities stemming from non-life contracts Accepted Re Risk margins Total (Life) Calculation method used Risk margin of which Death 0 of which Survivorship 0 of which Savings 0 of which Health 0 Risk margins Calculation method used Risk margin Total Health non SLT and Non- Life 12

Complexity/Predictability 16/09/2010 Proportionality: Best estimate Proportionality assessment: Nature, scale, complexity of risks; and Model error.

13 Complexity/Predictability 16/09/2010 Proportionality: Best estimate Proportionality assessment: Nature, scale, complexity of risks; and Model error. Example assessment: Low-High Medium-High High Low-Medium Low-Medium Medium-High Low Low-Medium Low-High Scale of risks choice of method Deterministic methods should be appropriate for most non-life classes, at least in the short term Key consideration is to use the most reliable reserving method Deterministic methods are better understood, more flexible and transparent Easier to integrate expert judgment Can be considered to implicitly allow for all future scenarios (QIS5 tech spec supports this argument) Stochastic methods may become more important in the medium term Area of ongoing research, may become more prevalent Useful where complex re covers are in place May still involve calibration from deterministic methods 13

14 THANK YOU!

QIS5 Workshop. Warsaw, 5 October 2010

QIS5 Workshop. Warsaw, 5 October 2010 QIS5 Workshop Warsaw, 5 October 2010 Agenda 10:00 10:15 Introduction and opening remarks 10:15 11:00 Speaker from the EC 11:00 12:30 Technical Specifications QIS5 (part 1) Valuation Own Funds 12:30 13:30