SOLVENCY ASSESSMENT AND MANAGEMENT (SAM) THEMATIC REVIEW ON THE METHODOLOGY USED TO SET EXPENSE ASSUMPTIONS

Transcription

1 SOLVENCY ASSESSMENT AND MANAGEMENT (SAM) THEMATIC REVIEW ON THE METHODOLOGY USED TO SET EXPENSE ASSUMPTIONS DECEMBER 2015

2 CONTACT DETAILS Physical Address: Riverwalk Office Park, Block B 41 Matroosberg Road Ashlea Gardens, Extension 6 Menlo Park Pretoria South Africa 0081 Postal Address: P.O. Box Menlo Park 0102 Switchboard: SAM.ComprehensivePR@fsb.co.za Website:

3 CONTENTS 1. Executive Summary Background Information Requested Findings Recommendations Appendix... 15

4 1. EXECUTIVE SUMMARY 1.1. The purpose of this report is to report back on the findings from the thematic review that the FSB carried out with a selected number of insurers on the methodology used to set expense assumptions for determining policyholder liabilities on the statutory valuation basis The report has been published and provided to the insurers that participated in the thematic review, as well as to the relevant SAM structures. A copy of this report will also be provided to the Actuarial Society of South Africa ( ASSA ) The report provides background to the purpose of the expense review as well as summarising the findings of the review Overall the FSB found that there was a large degree of consistency amongst insurers in the setting of expense assumptions However, with the imminent implementation of SAM in mind, the FSB may need to make minor adjustments to the planned Insurance Prudential Standards 1 based on these findings. The adjustments will provide an explanation of the principles that insurers will need to use when allocating expenses using the 3-buckets approach (explained in detail in section 5 of this report). This will assist in clarifying a few areas where insurers have indicated that additional guidance will be useful and also assist in achieving consistency in the treatment and reporting of certain items The proposed recommendations are discussed at the end of the report. 1 Insurance Prudential Standards is the term used in the Insurance Bill, 2015, to refer to subordinate legislation that can be made by the prudential regulator. The Insurance Prudential Standards will provide the technical details on the prudential requirements under SAM. Insurance Prudential Standards will replace existing Board Notices and Directives under the current Long-term and Short-term Insurance Acts. Thematic Review Expense Assumption Methodology 4

5 Introduction 2. BACKGROUND 2.1. At the start of 2015, the FSB initiated a thematic review for selected life insurers ( insurers ) of the methodology used to set expense assumptions for determining policyholder liabilities on the statutory valuation basis The need for the thematic review arose from a trend analysis conducted between insurers and their peers. The FSB noted significant deviations between the actual and expected expenses in the analysis of surplus for individual, group and shareholder expenses shown in the statutory returns for some insurers One of the risks that the FSB was concerned about was whether or not insurers were making adequate provision for on-going maintenance expenses in their policyholder liabilities (or technical provisions in SAM terminology) A particular focus area was the notable portion of expenses shown as shareholder expenses in the statutory returns for some insurers The FSB was interested in the type and nature of items insurers classified as shareholder expenses and if these expenses were recurring in nature, which may need to be reserved for and included as part of the on-going maintenance expense assumption for determining the policyholder liabilities / technical provisions in the statutory returns The chosen sample was aimed at covering a large portion of the market being the larger insurers as well as medium-sized / niche insurers Following an initial analysis, the FSB was concerned that insurers may have different interpretations or practical applications of Board Notice 14 of 2010, Standard of Actuarial Practice 104 ( SAP104 ) and of the guidance to the completion of the statutory returns Another area the FSB wanted to pursue was whether there is a need to clarify certain aspects of actuarial assumption setting methodology as outlined in the draft SAM technical specifications prior to the implementation of SAM. In particular, the FSB wished to understand the methodologies used for setting best-estimate ongoing maintenance expense assumptions and whether these methodologies are aligned with international best practice Information requests were sent to insurers in March Following the submission of the information by the insurers, representatives from the FSB met with the statutory actuaries and other parties (as chosen by the insurer) to discuss the information submitted. Thematic Review Expense Assumption Methodology 5

6 3. INFORMATION REQUESTED 3.1. The FSB requested a wide range of information, including details of management information and documentation related to the items listed below: A high level summary of the methodology used to arrive at the best estimate maintenance expense assumption for statutory valuation purposes, and the working papers evidencing that methodology; Copies of the information submitted to the insurer s Board or relevant Board subcommittee to obtain approval for these assumptions; The minutes of the meeting(s) referred to above; Copies of correspondence received from external auditors and / or external consultants on the methodology and process of arriving at the best estimate expense assumption; A description of how total non-acquisition expenses are split between expenses relating to policyholders and those relating to shareholders; A description of how management incentive bonuses are provided for, with specific reference to the allowance for that part of the incentives that is expected to be payable if actual experience follows the best estimate assumptions; An explanation of non-acquisition expenses that are excluded from setting a best estimate expense assumption; A summary of any differences between the expense assumptions used for the Statutory Valuation Method ( SVM ) and Embedded Value ( EV ), should there be any; and A description of how the expense assumption setting methodology will vary between the current SVM basis and SAM A generic copy of the information request is included in the Appendix to this report The information submitted was extensive and of sound quality. Whilst the information submitted addressed most of our queries, the FSB deemed it appropriate to engage with the insurers to hold follow-up discussions in person. These meetings were most informative and have assisted the FSB in drafting this report. Thematic Review Expense Assumption Methodology 6

7 Introduction 4. FINDINGS OVERVIEW OF FINDINGS: 4.1. Overall the FSB found that there is a large degree of consistency amongst the insurers when setting the expense assumptions. However, with the imminent implementation of SAM in mind, the FSB may need to make minor adjustments to the Insurance Prudential Standards based on these findings to clarify the principles to use when apportioning expenses The FSB believes that this will assist in clarifying a few areas where insurers have indicated that additional guidance will be useful and also assist in achieving consistency in the treatment and reporting of certain items This is particularly the case where the SAM technical specifications allow for subjective interpretation. Subjective areas include the definition and apportionment of once-off expenses, as well as how to apportion indirect expenses The FSB team concentrated their efforts on understanding how the insurers distinguish between once-off, on-going maintenance and initial expenses, as well as direct and indirect costs and how these are reserved for in the statutory returns Prior to meeting with the insurers, the FSB was concerned that there were some costs that were recurring in nature, but that insurers were not making adequate provisions, if they deemed them to be once-off in nature. The FSB focused on specific selected expenses discussed further below The current statutory returns allow for shareholder expenses in the format of the statutory analysis of surplus and the FSB wanted to establish on what bases insurers distinguished between shareholder and policyholder expenses. The FSB had noted significant deviations between the actual and expected shareholder expenses in the statutory analysis of surplus for some insurers Following the meetings held with the insurers and the FSB team, it would seem as though shareholder expenses (as reflected in the statutory returns) often relate to indirect expenses that cannot be allocated to a particular line of business or to costs that are considered to be once-off or costs relating to large and non-recurring projects The FSB does not intend deviating from a principles-based approach when making the necessary clarifications to guidance to deal with areas requiring significant interpretation by insurers. Any changes would be aimed at ensuring that insurers calculations comply with the objective of a principle-based system. The proposed changes are discussed further in section 5 of the report (Recommendations). Thematic Review Expense Assumption Methodology 7

8 4.9. The areas the FSB team focussed on are covered below. FOCUS AREA: APPORTIONMENT OF EXPENSES SHAREHOLDER VERSUS POLICYHOLDER The FSB wanted further clarity on the basis used by insurers to distinguish between shareholder and policyholder expenses This was driven by the large expense variances noted in the statutory returns of some insurers in respect of individual, group and shareholder expenses. These results suggested that some insurers were potentially underproviding for on-going maintenance expenses in their statutory technical provisions, particularly with respect to recurring shareholder expenses The initial analysis and interaction with insurers suggested that not all insurers may be making adequate provision for items such as on-going regulatory interventions, system upgrades and management incentive bonuses The information submitted and subsequent discussions held with the selected insurers have shown that most insurers do not distinguish between shareholder and policyholder expenses Instead the FSB found that most insurers distinguish between initial, on-going maintenance and once-off expenses, with the insurers making provisions in respect of the on-going maintenance expenses and reporting such in the statutory returns. These expenses would include those directly attributable to a line of business as well as those that are not. Indirect expenses are more prevalent for the larger insurance groups The SAM technical specifications (TP QIS 3 Technical Specifications) incorporated into the draft Insurance Prudential Standards state the following: TP.16.3 In determining the best estimate, the insurer should take into account all cash-flows arising from expenses that will be incurred in servicing all obligations related to existing insurance and reinsurance contracts over the lifetime thereof. This should include (non-exhaustive list): (a) Administrative expenses (b) Investment management expenses (c) Claims management expenses / handling expenses (d) Acquisition expenses including commissions which are expected to be incurred in the future. TP.16.4 Expenses should include both overhead expenses and expenses which are directly assignable to individual claims, policies or transactions. Thematic Review Expense Assumption Methodology 8

9 TP.16.5 Overhead expenses include, for example, expenses which are related to general management and service departments which are not directly involved in new business or policy maintenance activities and which are insensitive to either the volume of new business or the level of in-force business. Overhead expenses may also include costs incurred in starting up a new insurer. The allocation of overhead expenses to lines of business, homogeneous risk groups or any other segments of the best estimate should be done on an economic basis following realistic and objective principles The FSB s conclusion on the sample of selected insurers is that the current approach to distinguishing between initial, on-going maintenance and once-off expenses is essentially in line with the proposed treatment of expenses set out in the SAM technical specifications for most of the sampled insurers. Certain of the selected insurers indicated that they have already enhanced their current expense assumption methodology for the SAM comprehensive parallel run submissions so as to ensure that the expense assumptions for the determination of technical provisions are in line with the SAM requirements Insurers interviewed were of the opinion that the current SAM guidance distinguishing between initial, maintenance and once-off expenses is in line with market and international best practice The FSB found that there is an element of discretion when insurers distinguish between once-off, on-going maintenance and initial expenses. FOCUS AREA: APPORTIONMENT OF EXPENSES DIRECT VERSUS INDIRECT COSTS Another objective was to see if the selected insurers clearly distinguish between direct and indirect costs and how these are apportioned and reserved for All the insurers in the sample confirmed that they distinguish between direct and indirect costs. Direct costs are allocated to a particular function / business unit or relevant product line. Indirect costs are allocated according to a function or business unit if possible. Judgement is required when apportioning indirect costs if these are not clearly linked to a business unit / product line Common areas that require more judgement include group-wide functions. The FSB team found that a greater degree of judgment was involved for the larger insurance groups due to the complexity of the group On the whole it was found that most insurers have a very small proportion of maintenance expenses that are not allocated to a particular function or business unit The FSB found that if a group predominantly writes life insurance business, then the insurer would allocate the majority of the expenses to the relevant life company business units and this would be reserved for in the technical provisions. Any Thematic Review Expense Assumption Methodology 9

10 variances would be shown as an expense variance for individual or group ( policyholder ) business in the statutory returns The remaining indirect expenses tend to be included as shareholder expenses and any variances in these would be shown as a line item as a shareholder expense variance in the statutory analysis of surplus The FSB team found that there is discretion when insurers make the allocation of indirect expenses. FOCUS AREA: SETTING THE BASIC BEST ESTIMATE ASSUMPTION Based on the feedback submitted, the basic methodology used by the selected insurers in setting the best estimate assumption for maintenance expenses is in line with generally accepted actuarial practice The basic methodology includes using the budgeting process as a base for setting the assumptions, adjusting for any expected deviations and making suitable allowance for expense inflation. Insurers also monitor these assumptions on a regular basis Most of the insurers interviewed are planning to use a similar methodology to set the best estimate assumption under the SAM regime. FOCUS AREA: TREATMENT OF SPECIFIC EXPENSES This section deals with the treatment of specific expenses that the FSB focused on in its discussions with the selected insurers. Once-off project costs The objective of the FSB team was to compare how insurers allow for expenses associated with both once-off and on-going projects The initial analysis by the FSB suggested that there may be project costs that were deemed to be once-off, but on closer scrutiny are instead recurring in nature. There was a concern that not all insurers may be making suitable provision for these project costs in the expense assumption for policyholder liabilities / technical provisions. It was however established that, if the insurer reasonably expects to make on-going system adjustments or allow for on-going regulatory implementation costs, most insurers include these costs in the maintenance expense assumption Most insurers confirmed that they interrogate whether projects are once-off and will not reserve for these if they can reasonably justify that they are once-off. Thematic Review Expense Assumption Methodology 10

11 4.33. A point to note is that for those expenses that are considered to be initial or once-off, all insurers included in the sample make a suitable capitalised deduction in their embedded value calculation if an embedded value calculation is performed. The size of the capitalised deduction differs by company and the nature of the project. Share-based payment charges The objective of the FSB team was to assess how insurers allow for costs related to share-based payment charges, particularly whether these costs are included as part of the maintenance expense assumption Most insurers advised us that they treat these expenses in line with the provisions of IFRS This means that most insurers allocate the costs of share-based payment charges as part of the usual budgeting process and make suitable allowance in the maintenance expense assumption. Balance sheet management function The objective of the FSB team was to compare how insurers who have a balance sheet management function allow for the costs of running this function Some of the larger insurers have this function in their business and in most instances this department performs functions similar to what one would normally expect from a treasury function, an asset liability function, as well as to maximise returns on shareholder assets The FSB found that most insurers in the sample consider activities in this area to be very closely aligned with policyholder activities and therefore most insurers allocate a very large part of these expenses to on-going maintenance expenses. The FSB concurs with this treatment. Management incentive bonuses The objective of the FSB team was to compare and understand how the selected insurers allow for management incentive bonuses; in particular, whether insurers are making adequate allowance for these expenses in their on-going maintenance cost assumption or if they are instead relying on positive experience variances (compared to assumptions) to fund the management incentive bonuses Most insurers confirmed that where there is a history of paying management incentive bonuses, allowance for these expenses is included as part of the on-going maintenance expense assumption. The degree of allowance varies amongst insurers, but on the whole the FSB felt that sufficient allowance is made by most insurers in the sample. Thematic Review Expense Assumption Methodology 11

12 FOCUS AREA: TREATMENT OF EMBEDDED VALUE VERSUS THE CURRENT STATUTORY VALUATION METHOD ( SVM ) BASIS The FSB wanted to assess if the expense assumption methodology differs between the embedded value and SVM basis for the sampled insurers Most insurers stated that there is no difference in the methodology for setting the best estimate assumption for on-going maintenance expenses relative to the SVM basis, although there would be additional reserving margins in respect of the SVM basis. There are however areas where the methodology could differ for example when valuing the policyholder liabilities for group business or investment business As mentioned, all insurers included in the sample make a suitable capitalised deduction to the embedded value for those expenses that are classified as initial or once-off in nature The FSB also compared the reconciliation between the published and statutory reports to see whether the analysis of embedded value and analysis of statutory surplus clearly shows the expense variances. This was found to be an area that may require further work under the new SAM regime. FOCUS AREA: FORMAT OF THE ANALYSIS OF SURPLUS (STATUTORY AND PUBLISHED BASIS) Based on the comparison of the treatment of embedded value / published basis versus the current SVM basis, the FSB is of the view that the analysis of surplus in the SAM returns (QRT s) needs to better allow the FSB to clearly identify the sources of profit and also of any variances All the insurers indicated that they would be interested in assisting with developing the new format of the analysis of surplus for the QRT s so as to better classify the items of profit and strain to not only obtain clarity but also for consistency within the industry The FSB will engage further with insurers by establishing a task group in this regard. FOCUS AREA: TREATMENT OF SAM VERSUS THE CURRENT SVM BASIS The FSB also wanted to assess if the expense assumption methodology differs between the SAM and SVM basis Most insurers stated that the process and methodology remains the same. When analysing the SAM QRT s, the FSB will specifically focus on further understanding the process and methodology used when setting the expense assumptions. Thematic Review Expense Assumption Methodology 12

13 Introduction 5. RECOMMENDATIONS 5.1. Based on the information submitted by the insurers and our follow-up meetings, the FSB is of the opinion that there is a large degree of consistency amongst the insurers with respect to setting the assumptions for on-going maintenance expenses During the meetings between the FSB and selected insurers, the FSB specifically tested whether insurers believe that the SAM technical specifications are adequate. Whilst most companies commented that the technical specifications are adequate for their needs, it was also suggested that it may be necessary to add a little more guidance on specific aspects, particularly where the standards are to open subjective interpretation With this in mind, the FSB reassessed the current technical specifications under SAM and compared this with international best practice Recommendations have been made in respect of the areas where there may be possible inconsistencies of interpretation and room for improvement. The FSB is of the opinion that the recommendations being made are in line with international best practice. APPORTIONMENT OF EXPENSES SHAREHOLDER VERSUS POLICYHOLDER: 5.5. The FSB determined that international best practice is for insurers to distinguish between once-off, initial and on-going maintenance expenses versus distinguishing between policyholder and shareholder expenses. All on-going maintenance expenses would be included as part of the expense assumption used in calculating the policyholder liabilities / technical provisions Therefore, one particular area that the FSB would like to clarify is that all expenses incurred by the insurer and those of the group should be categorised into one of the three expense categories (referred to as the 3-buckets approach ) mentioned above. The insurer should be able to clearly motivate why they have classified expenses into these three buckets Based on discussions with the insurers, the FSB believes that the definition of onceoff project costs may pose a challenge as this is quite subjective in a principlesbased regime The proposal by the FSB is that insurers approach the cost allocation process guided by the principle that the overarching objective of an insurer is to provide benefits to policyholders. Thematic Review Expense Assumption Methodology 13

14 Therefore any decision to exclude on-going maintenance costs should be able to be justified by the insurer with this overarching objective in mind The SAM technical specifications (draft Insurance Prudential Standards) will be amended accordingly to explain the principles to be used in allocating expenses using the 3-buckets approach, and will be supplemented, where appropriate, by guidance on interpretation of this principle. APPORTIONMENT OF EXPENSES INDIRECT COSTS: Another area that may require further clarification is how indirect costs that are not clearly linked to a business unit / function or product should be allocated The proposal in this regard is similar to that mentioned above. Insurers would need to clearly explain why they are of the opinion that the indirect costs are excluded from the on-going maintenance costs with the overarching objective that the primary function of the insurer is to provide benefits to policyholders The expenses that are to be included would also be allocated using the 3-buckets approach. OTHER AREAS REQUIRING FURTHER WORK: A further area where the technical specifications may require further work is the analysis of surplus format in the QRT s. The format must better allow for the classification of variances so that insurers and the regulator are better able to demonstrate and understand the items of profit and strain. PROCESS GOING FORWARD: This report has been made available to the insurers who participated in the thematic review, as well as the relevant SAM structures and ASSA. The results were also formally conveyed during the SAM Workshops held with industry in early November The process going forward will be to amend the draft Insurance Prudential Standards as proposed above, which will require insurers to distinguish between once-off, initial and on-going maintenance expenses The FSB may also issue further Level 3 guidance to elaborate on how the Prudential Standards are to be applied The draft Prudential Standards will be published by the end of 2015 for comment by the relevant SAM structures and industry forums For more information please contact Mr Grant Bushney (SAM Unit). Thematic Review Expense Assumption Methodology 14

15 6. APPENDIX For information purposes, we include the standardised letter that was sent to industry participants: INFORMATION REQUEST REGARDING SELECTED ACTUARIAL ASSUMPTION PRINCIPLES AND METHODOLOGIES BACKGROUND AND CONTEXT 6.1. Recent reviews of the statutory returns of the larger insurers and insurer groups have highlighted a number of areas we would like greater clarity on. The questions arise from trend analyses between insurers and their peer groups From follow-up questions, it would appear that insurers may have different interpretations or practical applications of Board Notice 14 of 2010, of Standard of Actuarial Practice 104 (SAP104) and of the guidance to the completion of the statutory return We also would like to use this information to determine to what extent there is a need to clarify certain aspects of actuarial assumption setting prior to SAM going live in particular, methodologies for setting best-estimate maintenance expense assumptions and whether these methodologies are aligned with best practice internationally We expect that the information requested below should be readily available and we would like to encourage insurers to submit what they currently have and not to embark on a large piece of work to satisfy the request. It is envisaged that selected follow-up interviews or visits may be arranged once we have received and reviewed the information. INFORMATION REQUEST 6.5. Please submit the following information and respond to the specific questions below: A high level summary of the methodology used to arrive at the best estimate maintenance expense assumption for statutory valuation purposes for the most recent financial year end; Copies of the working papers evidencing that methodology for the most recent financial year-end; Electronic copies of the packs that were submitted to the Board and / or Audit or Risk or Actuarial sub-committee of the Board to discuss and approve those assumptions for the most recent financial year-end; Thematic Review Expense Assumption Methodology 15

16 The minutes of the meeting(s) referred to above; Copies of correspondence received from external auditors and / or external consultants on the methodology and process of arriving at the best estimate expense assumption for the most recent financial year-end; If not already covered in above, please provide a brief description of how total non-acquisition expenses are split between those expenses relating to policyholders and those relating to shareholders. Please also comment whether allowance is made in policyholder liabilities for on-going shareholder expenses; If not covered in 6.5.1, please provide a brief description of how management incentive bonuses are provided for, with specific reference to the allowance for that part of the incentives that is expected to be payable if actual experience follow the best estimate assumptions; If not covered in 6.5.1, please provide a brief explanation of non-acquisition expenses that are excluded from setting a best estimate expense assumption. For example, items such as once-off project costs or if share based payments are not included in the expense assumption; If an Embedded Value calculation is performed, please provide a brief summary of any differences between the expense assumptions used for SVM and EV should there be any; Please provide a brief description of how the expense assumption setting methodology for your company will vary between the current SVM basis and SAM The information requested above should be submitted to Tienie Hamman by no later than 17 April 2015 on marthinus.hamman@fsb.co.za Please do not hesitate to contact Tienie Hamman should you have any questions or would like to discuss any of the items further Please share this letter with your auditors. Yours faithfully DEPUTY EXECUTIVE OFFICER: INSURANCE JI DIXON Thematic Review Expense Assumption Methodology 16