1. INTRODUCTION AND PURPOSE

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1 Solvency Assessment and Management: Pillar 1 - Sub Committee Technical Provisions Task Group Discussion Document 87 (v 6) Future Management Actions in Technical Provisions EXECUTIVE SUMMARY 1. INTRODUCTION AND PURPOSE The purpose of this document is to define the terms future management action and risk mitigation in order for the various SAM Task Groups to apply a consistent interpretation. This discussion note covers two topics:,, and The Internal Models Task Group considered the definition of a management action and a risk mitigating action in Discussion Document 55 (version 1). We have independently looked at this topic but include their recommendation (together with our views) within this document for completeness. This discussion document has only been viewed by a few individuals within the Technical Provision Task Group. In addition, the other Task Groups affected by this definition have not had an opportunity to provide comments as yet. 2. INTERNATIONAL STANDARDS: IAIS ICPs Neither of the terms are defined in the ICPs. There are, however, a number of requirements imposed on insurers who wish to use management actions within their regulatory and internal solvency assessments. These include: When undertaking a forward-looking continuity analysis and modelling of its future financial position, an insurer should ensure that the management actions included in the forecasts are approved at a sufficiently senior level (ICP ) Insurance Groups are required to outline the management actions they would take to manage the implications of a stress scenario (ICP ). Disclosure of the impact on earnings due to management actions (ICP20) ICP , defines guaranteed benefits as the minimum amount payable on death and/or maturity or any insured event. Non-guaranteed, optional or discretionary benefits are those where the policyholder has a right to participate in the performance of the relevant class of contracts, related assets or both. The insurer has some discretion over the amount or timing of the resulting distributions to policyholders, but there are often constraints over that discretion.

2 Both guaranteed and non-guaranteed benefits (according to ICP ) are established as stemming from the contractual relationship between the insurer and the policyholder. 3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1) 3.1 EU Directive: The term management action is not defined in the EU Directive. A risk mitigation technique is defined as all techniques which enable insurance and reinsurance undertakings to transfer part or all of their risks to another party. Article 78, refers to all payments, including future discretionary bonuses, that need to be included in the calculation of the technical provision whether or not those payments are contractually guaranteed. 3.2 SAM primary legislation: The first draft of primary legislation for SAM includes the following definition: risk-mitigation techniques means the measures that enable an insurer to transfer part or all of its risks to another party; No reference is made to management actions c.iii contains the same wording as Article MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE There are no differences. 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) 5.1 IAIS standards and guidance papers ICP references have already been covered above. 5.2 EIOPA CPs (consultation papers) Management actions and risk mitigation techniques are discussed in Former CP32 (Assumptions about future management actions), CP39 (Actuarial and statistical methodologies to calculated the best estimate), CP54 (Loss-absorbing capacity of technical provisions and deferred taxes) and CP56 (Tests and standards for Internal Model approval). Page 2 of 9

3 Wherever the term risk mitigation is used, its use and meaning is consistent with the definition used in the Directive. Allowable future management actions and when to classify a risk mitigation technique as a future management action are explored in the CPs. Former CP32: Assumptions about Future Management Actions CP32 recommends that the methods and techniques for the estimation of future cash-flows, and hence the assessment of the provision for insurance liabilities, could take account of potential future actions (3.23). Primary responsibility is given to the insurer to verify whether its future management actions are objective, realistic and verifiable (These criteria are fully defined). If these criteria cannot be demonstrated, the management action should not be taken into account (3.24). Insurers are required to maintain a comprehensive plan which outlines the future management actions which may be used and the extent/circumstances to which they can be expected to be used (3,28). The types of future management actions discussed include: Changes in asset allocation (which would include actions for the dynamic rebalancing of the assets portfolio) Changes in bonus rates or product changes (such as profit sharing policies to mitigate market risks) Changes in expense charges (which would include those relating to guarantee charges) Former CP56:Tests and Standards for Internal Model Approval Future management actions can be linked to any decision which the undertaking has the right to make. They are the currently anticipated exercise or implementation behaviour of any such right of decision (such as applying a market value adjustment) and only become effective after certain events have occurred clarifies that all risk mitigation techniques which the undertaking only plans to have in force at a future point in time (eg future reinsurance after renewal of existing policies) are future management actions. Only those management actions where the intention has been signed off by the board may be reflected in an internal model. In addition, requirements for inclusion of management actions within an internal model are the same as for technical provisions (as discussed in CP32). Former CP31: Allowance of Financial Risk Mitigation Techniques If the right to renew a hedge is fully committed at the date of the solvency assessment and all costs for the renewal are taken into account in the SCR calculation, undertakings may allow for the additional hedging instruments (for example, as part of a rolling hedging programme) beyond the balance sheet date within the standard formula SCR.(3.79) i.e. this would not be classified as a future management action Former CP39: (Actuarial and statistical methodologies to calculate the best estimate) Paragraph states that 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. The need to distinguish the value of technical provisions between the guaranteed and discretionary bonus parts is primarily needed for taking into account the loss absorbing capacity of technical provisions in the SCR calculation defines a guaranteed benefit as representing the value of future cash-flows which does not take into account any future declaration of future discretionary bonuses. The cash-flows take into account only those liabilities to policy holders or beneficiaries to which they are entitled at the Page 3 of 9

4 valuation date. Guaranteed benefits at the valuation date are those benefits that cannot be reduced. The CP divides discretionary benefits into conditional discretionary benefits and pure discretionary benefits although the reason for needing to do so is not given. A conditional discretionary benefit is a liability based on the declaration of future benefits influenced by legal or contractual declarations and performance of the undertaking/fund. Discretionary participation features are defined as additional benefits that are contractually based on: a) the performance of a specified pool of contracts or a specified type of contract or a single contract b) realised and/or unrealised investment return on a specified pool of assets held by the issuer; or c) the profit or loss of the company, fund or other entity that issues the contract. A pure discretionary benefit represents the liability based on the declaration of future benefits which are at the discretion of the management. Discretionary participation features are defined as additional benefits whose amount or timing is contractually at the discretion of the issuer. If a risk neutral approach is used, paragraph requires the valuation of discretionary benefits, including any projections or assumptions on future returns of the firm s asset portfolio, to be consistent with the choice of the risk-free interest rate curve used for discounting. 5.3 Other relevant jurisdictions (e.g. OSFI, APRA) Requirements from other relevant jurisdictions were only reviewed in respect of areas where recommendations differ from the EIOPA level 2 advice. Canada (OSFI) Guidance for the Development of a Models-Based Solvency Framework for Canadian Life Insurance Companies The proposed Canadian guidance states the following: In this context: A company may recognize contracts that it has entered into as of the valuation date, but may not recognize contracts that have not yet been entered into; and the only management action that may be recognized in the calculation of the supervisory target capital requirement is: o the exercise of options that the company holds as of the valuation date and; o the implementation of a standard investment strategy at the end of the initial time period. contracts includes reinsurance contracts and other contracts entered into for the purpose of risk mitigation and exercise of options includes: o the filing of claims under reinsurance contracts that are in force as of the valuation date and o the exercise of privileges under contracts entered into for the purpose of risk mitigation that are in force as of the valuation date. Therefore, in the proposed Canadian guidance, the definition of risk mitigation and management actions are very clear, as are the conditions under which allowance may be included in the calculation of the regulatory required capital. Australia (APRA) Prudential Standard GPS 113 Page 4 of 9

5 There are no references to management actions and risk mitigation in the document reviewed. We have not extended our review beyond GPS 113. No other jurisdictions were considered 5.4 Mapping of differences between above approaches (Level 2 and 3) OSFI has a very limited allowance for management actions that may be taken into account. The majority of the items they list as management actions would be included as risk-mitigation techniques under Solvency II. 6. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT 6.1 Discussion of inherent advantages and disadvantages of each approach Future management actions included within the technical provisions calculation will usually only be considered when stochastic (or equivalent) calculations are employed, but would also include allowance for future contractual premium rate or charge increases based on the best estimate assumptions. Summarising the CPs, a future management action that may be taken into account for solvency purposes may be defined as: the currently anticipated exercise or implementation of any right of decision that the insurer has, where the intention has been signed off by the board, that will be become effective after certain adverse events have occurred, and is objective, realistic and verifiable A planned risk mitigation technique that is not yet in place, is considered a future management action. Risk mitigation techniques that are already in place are not. (For example, the future renewal of an investment hedge, where the terms are not already agreed, is a future management action) The advantage of using this definition above compared to the one used by OSFI (which is more limited in its allowance of management actions) is that is allows for the solvency capital requirement to more closely reflect economic reality making it a useful measure for decision making purposes (assuming all other elements are also economic). The CPs, explicitly mention the following as future management actions: Changes in asset allocation, Changes in bonus rates, Product changes (such as profit sharing policies), Changes in expense charges, Applying a market value adjustment, Page 5 of 9

6 Renewal of reinsurance, Renewing hedging strategies, and Changes in policy charges Depending on what contract boundary definition is used for SAM, future management actions may also need to include the re-pricing of premiums. We would add that consideration must be given to the potential impact of market and other future conditions on the ability of and cost to the company to implement these assumed management actions under the various future scenarios contemplated in the calculation. In addition, future management actions must be determined in the context of meeting Policyholder Reasonable Benefit Expectations (RBE) and in terms of the principles of Treating Customers Fairly (TCF). Internal Model s Task Group s definition As mentioned in the introduction, the Internal Models Task Group, considered the definition of a risk mitigation action and a management action in Discussion Document 55 (v1). They considered that CP56 was vague when differentiating between the two terms. We disagree with them but for completeness sake wish to include their recommendation and give our specific comments on this. The definition proposed is: A risk mitigating action or management action is a mechanism that would reduce an undertaking s liability in response to future circumstances arising. If a mechanism needs Board or Statutory Actuary sign-off to be put into practice or exercised, then it should be classified as a management action. If no such sign-off is required, and the mechanism is already in place then it is classified as a risk mitigating action. If a mechanism doesn t require Board or Statutory Actuary sign-off but it is not in place, then undertakings may not use that mechanism to reduce liabilities in response to a change in circumstances In our working group s views: Any risk mitigation technique would form part of the overall risk management policy of the insurer and would as such also need to be approved by the board. Some management actions and risk mitigation techniques impact on the asset side of the balance sheet and not necessarily the liability side, so it is more correct to refer to a change in net asset value. The role of the Statutory Actuary under SAM is still being decided. If a definition is though necessary in secondary legislation, we thought of using the words governance structure approval instead. Given our assessment of CP56, any risk mitigation in place already (or where the future terms are already agreed) is not a future management action. All other planned risk mitigation techniques are future management actions. The task group agreed with the definitions provided in CP39. Page 6 of 9

7 In brief, the value of guaranteed benefits includes all liabilities to policyholders for benefits to which they are entitled at the valuation date excluding future discretionary bonuses. These Guaranteed benefits cannot be reduced at any time. Discretionary benefits broadly cover benefits that may vary in future at the discretion of the insurer. These benefits may be influenced by a contractually defined driver such as investment performance or profits. In order to clarify the distinction further, we have included the following guidance: The value of financial and other guarantees should be included in the value of guaranteed benefits (including embedded investment guarantees) Non-guaranteed benefits will include historic non-vesting claim bonuses as at the valuation date, other non-vesting bonuses and future vesting and non-vesting bonuses assumed to be declared in terms of the calculation of the technical provisions. This will include future benefits payable in terms of PRE or TCF considerations. The value of discretionary benefits in the technical provisions needs to take into account of the level of accumulated surplus or deficit at the valuation date. In terms of the CP39 guidance the future bonuses to be assumed in the calculation of the technical provisions should reflect the expected payments to be made to policyholders in future. By implication the assumed future bonus rates should be set at a level at which any accumulated surplus or deficit at the valuation date (BSR under the FSV approach) is absorbed into the technical provision calculation. When setting this bonus rate the company will implicitly be applying assumed management actions in terms of future bonus declarations in the calculation of the technical provisions. 6.2 Impact of the approaches on EU 3 rd country equivalence This discussion document essentially only provides clarification and as such will not threaten 3 rd country equivalence 6.3 Comparison of the approaches with the prevailing legislative framework In PGN 104, both the embedded investment derivatives liability valuation and the capital adequacy requirements take account of the expected future management actions resulting from adverse experience. The management actions allowed are similar to those contemplated in the CP s although the documentation and disclosure requirements under CP32 are greater. Management action with regards to the reduction in future discretionary bonuses is limited to the amount that can reasonably be expected to be recovered through underdistribution of bonuses during the ensuring three years, provided that the Statutory Actuary is satisfied that if the market values of assets do not recover, future bonuses will be reduced to the extent necessary. This limiting condition was incorporated into SA QIS1. This is again a matter for the Capital Requirements Task Group to consider further and is beyond the scope of this discussion document. 6.4 Conclusions on preferred approach Page 7 of 9

8 A risk mitigation technique should continue to be defined as all techniques which enable insurance and reinsurance undertakings to transfer part or all of their risks to another party. We further conclude that a future management action that may be taken into account for solvency purposes is: the currently anticipated exercise or implementation of any right of decision that the insurer has (referred to as a mechanism), where the intention has been signed off by a governance structure, that will be become effective after certain adverse events have occurred, and is objective, realistic and verifiable A planned risk mitigation technique that is not yet in place, is considered a future management action. Risk mitigation techniques that are already in place are not. The CP s don t allow for management actions regarding the re-pricing of policies given than the Solvency II contract boundary does not extend beyond the first reviewable premium date. If the SAM contract boundary is extended beyond this point, this issue will need to be discussed by the Capital Requirements Task Group who are considering the loss absorbing capacity of technical provisions. Our conclusions are fully discussed in 6.1 above. 7. RECOMMENDATION We recommend that the definition contained in the Directive and the draft primary legislation continue to be used. If a definition is to be included in secondary legislation for management actions, we recommend that the following definition be used: A risk-mitigation technique" includes: all techniques which enable insurance and reinsurance undertakings to transfer part or all of their risks to another party. A future management action includes all governance structure approved mechanisms that will be implemented in response to a specified adverse event to reduce the impact on an undertaking s net asset value and are objective, realistic and verifiable. Planned risk mitigation techniques that are not yet in place, are considered to be future management actions. Risk mitigation techniques that are already in place are not considered future management actions. Governance approved replacements of a risk mitigating technique are considered to be in place provided the risk mitigating technique is already in place and that the replacement is not conditional on any future event which is outside of the control of the insurer or reinsurer Page 8 of 9

9 Together with the definitions provided in CP39, we recommend the following clarifications be given: The value of financial and other guarantees should be included in the value of guaranteed benefits (including embedded investment guarantees) Non-guaranteed benefits will include historic non-vesting claim bonuses as at the valuation date, other non-vesting bonuses and future vesting and non-vesting bonuses assumed to be declared in terms of the calculation of the technical provisions. This will include future benefits payable in terms of PRE or TCF considerations. The value of discretionary benefits in the technical provisions needs to take into account of the level of accumulated surplus or deficit at the valuation date i.e. the assumed future bonus rates should be set at a level at which any accumulated surplus or deficit at the valuation date is absorbed into the technical provision calculation. Page 9 of 9