Solvency Assessment and Management: Steering Committee Position Paper 73 1 (v 3) Treatment of new business in SCR EXECUTIVE SUMMARY As for the Solvency II Framework Directive and IAIS guidance, the risk arising from new business should be allowed for in the calculation of the SCR under SAM. For Solvency II the requirement is to include the risk arising from new business expected to be written over the following 12 months in the calculation of the SCR. The rationale of allowing for new business in the SCR stems from its basic definition under Solvency II The SCR should correspond to the Value-at-Risk of the basic own funds of an insurer or reinsurer subject to a confidence level of 99.5% over a one-year period. The standard formula methodology of assessing capital is to assess the impact of instantaneous stresses on the economic balance sheet at the valuation date rather than more accurately to assess the impact of gradual stresses over the year on the economic balance sheet a year after the valuation date (which would require an explicit allowance for new business). The standard formula methodology is thus a simplification of the SCR requirement. New business would need to be projected under the latter methodology and thus should in some way be allowed for under the former methodology (i.e. new business should be allowed for in the standard formula whether implicitly or explicitly). The QIS 5 approach to allow for new business is simple to apply and the simplifying assumptions used in the SCR are satisfactory for most insurers. However, the simplifying assumption may not be appropriate for rapidly expanding insurers or for certain lines of business. New business will be taken into account in the ORSA for all insurers. Since the ORSA should identify any major new business issues, changing the standard formula to allow for assumptions that are not fully appropriate for certain insurers or certain lines of business may be unwarranted. Currently the Solvency II approach for the SCR is recommended for SAM. This recommendation will need to be reviewed once boundary conditions and the standard stress methodologies have been finalised. A proposal for the secondary legislation is contained at the end of this report. The proposal is largely similar to the wording in QIS5 (shown in section 5.2), but has been elaborated on for further clarification. For insurers adopting an internal model approach, the internal model should cover the risk of business expected to be written over the following 12 months in a manner that is appropriate to its business model. 1. INTRODUCTION AND PURPOSE 1 Discussion Document 73 (v 3) was approved as a FINAL Position Paper by the Steering Committee on 19 April 2013.
This document sets out the recommendations of the SCR Structure working group with respect to the treatment of risk arising from new business in the calculation of the SCR. 2. INTERNATIONAL STANDARDS: IAIS ICPs IAIS is the international standards setting body for insurance supervisors. The FSB as a member of the IAIS aims to adhere to these standards. The standards are principles based, and as such are difficult to ascribe to individual risk modules. However, the following ICP s are relevant within the broad framework concerning the treatment of new business in the calculation capital requirements: ( Insurance Core Principles, Standards, Guidance and Assessment Methodology Consultation Draft February 2011 ) ICP 14 Valuation The supervisor establishes requirements for the valuation of assets and liabilities for solvency assessment purposes. A large component of Section 14 deals with boundary conditions. Within this context the following guidance is given: only cash flows arising in respect of the currently in-force contract are included for valuation purposes, whereas the impact of new business might be considered in capital requirements or capital resources by the solvency regime. ICP 16 Enterprise Risk Management for solvency purposes The supervisor establishes enterprise risk management requirements for solvency purposes that require insurers to address all relevant and material risks. New business is mentioned several times within ICP16, however particularly in the context of an own risk and solvency assessment (ORSA), not in the context of calculating regulatory capital requirements. ICP 17 Capital Adequacy The supervisory regime establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforeseen losses and to provide for degrees of supervisory intervention. The following paragraphs are guidance on ICP17 specifically mentioning new business: Establishing regulatory capital requirements 17.2.3 In the context of its own risk and solvency assessment (ORSA), the insurer would generally be expected to consider its financial position from a going concern perspective (that is, assuming that it will carry on its business as a going concern and continue to take on new business) but may also need to consider a run-off and/or winding-up perspective (e.g. where the insurer is in financial difficulty). The determination of regulatory capital requirements may also have aspects of both a going concern and a run-off or winding-up perspective. In establishing regulatory capital requirements, therefore, supervisors should consider the financial position of insurers under different scenarios of operation. Approaches to determining regulatory capital requirements 17.6.4 Capital should also be capable of protecting policyholders if the insurer were to close to new business. Generally, the determination of capital on a going concern basis would not be expected to be less than would be required if it is assumed that the insurer Page 2 of 12
were to close to new business. However, this may not be true in all cases, since some assets may lose some or all of their value in the event of a winding-up or run-off, for example, because of a forced sale. Similarly, some liabilities may actually have an increased value if the business does not continue (e.g. claims handling expenses). The IAIS paper Common Structure for the Assessment of Insurer Solvency issued in November 2007 states the following: A robust solvency regime should aim to ensure that there is a high degree of certainty that insurance obligations can be met even if the insurer is unable to continue in business. The regime, and insurer, should thus consider the need to meet obligations in relation to the existing book of business, including a possible run-off or transfer of the insurance obligations, as well as addressing going concern situations, including the potential impact of new business. 3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1) In Article 101 of the Solvency II Level I text (the Framework Directive - DIRECTIVE 2009/138/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance) it is stated that The Solvency Capital Requirement shall be calculated in accordance with paragraph 2 to 5 where paragraph 3 is as follows: The Solvency Capital Requirement shall be calibrated so as to ensure that all quantifiable risks to which an insurance or reinsurance undertaking is exposed are taken into account. It shall cover existing business, as well as the new business expected to be written over the following 12 months. With respect to existing business, it shall cover only unexpected losses. It shall correspond to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level of 99,5 % over a one-year period. 4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE Both the IAIS ICPs and EU Directive recognise the potential need to allow for the impact of new business on capital requirements. Both recognise that new business must be allowed for within an own risk and solvency assessment, which is beyond the scope of this discussion document. 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) 5.1 IAIS standards and guidance papers This is covered in section 2 above 5.2 CEIOPS CPs (consultation papers) The QIS5 Technical specification includes the following: Treatment of new business in the standard formula Page 3 of 12
SCR.1.12. The SCR should cover the risk of existing business as well as the new business expected to be written over the following 12 months. SCR.1.13. In the standard formula, new non-life insurance and Non-SLT health insurance business is taken into account in the premium risk part of the premium and reserve risk sub-modules. The volume measure for this risk component is based on the expected premiums earned and written during the following twelve months. The sub-modules thereby allow for unexpected losses stemming from this business. However, the standard formula does not take into account the expected profit or loss of this business. SCR.1.14. For life insurance and SLT health insurance the calculation of underwriting risk in the standard formula is based on scenarios. The scenarios consist of an instantaneous stress that occurs at the valuation date and the capital requirements are the immediate loss of basic own funds resulting from the stresses. The scenarios do not take into account the changes in assets and liabilities over the 12 months following the scenario stresses. Therefore these capital requirements do not take into account the expected profit or loss of the business written during the following 12 months. The draft Level II Commission Regulation makes no reference to new business in the context of the Solvency Capital Requirement. The current draft SAM Insurance Bill does not make reference to new business in the context of the Solvency Capital Requirement. If this is omitted from the Bill, and the intention is to include the risk exposure of new business expected to be written in the following 12 months to be consistent with the Solvency II Level I text, then this requirement will need to be included somewhere else. 5.3 Other relevant jurisdictions (e.g. OSFI, APRA) APRA As per the document titled Life Insurance (prudential standard) determination No. 8 of 2010 - Prudential Standard LPS 3.04 Capital Adequacy Standard Life Insurance Act 1995 dated 28 June 2010: PART A PRINCIPLES SECTION 1 The Capital Adequacy Standard Overview The Solvency Standard requires that the statutory fund of a life company has available a minimum level of net assets in excess of its liabilities - the Solvency Requirement - to provide for the security of the policy owners guaranteed entitlements under a range of adverse conditions. However, the prudent regulation of the life insurance industry requires that the level of security offered to policy owners exceed that of a standard which secures solvency. The Capital Adequacy Standard requires that each statutory fund has available sufficient additional assets to provide confidence Page 4 of 12
in the longer term financial strength of the fund. A fund that is capital adequate would have the ability to write new business, in an unfettered manner, with the expectation of remaining solvent into the future. The Capital Adequacy Requirement is determined by considering the various risks undertaken within the statutory fund which could impact the longer term security of the policy owners entitlements, and requiring the provision of a prudent level of reserve against such risks. These risks, and an assessment of the prudent provision, are considered in the context of an ongoing operation; a fund open to new business and meeting policy owner expectations in a competitive market. A statutory fund that meets the Capital Adequacy Requirement would be considered by the Australian Prudential Regulation Authority to be financially strong fund - however this does not imply an absolute guarantee of security to policy owners... 1.3 The Actuary, in determining the Capital Adequacy Requirement, must make an assessment of the effect of the company s realistic new business plans on the future solvency of the statutory fund. Where SECTION 2 Scenarios of Adverse Conditions Overview The Capital Adequacy Requirement broadly comprises the following components: the Capital Adequacy Liability; the Other Liabilities; the Inadmissible Assets Reserve; the Resilience Reserve; and the New Business Reserve The New Business Reserve Provision for planned business operations over a prescribed future period of three years, with the intention of securing the continued solvency of the fund over that period. SECTION 6 The New Business Reserve 6.1 The Capital Adequacy Requirement must provide for a reserve in respect of any additional capital required to ensure that the statutory fund will be able to meet the Solvency Requirement over the next three years, given: a) levels of projected business over that period in accordance with the realistic business plans of the company; and Page 5 of 12
b) experience during that period in accordance with Best Estimate Assumptions. SECTION 12 The New Business Reserve 12.1 In the case of a friendly society, the New Business Reserve is Nil: the risks associated with financing the business plans of the company are borne, and hence provided for, in the management fund. (Refer to the Management Capital Standard). 12.2 The New Business Reserve is determined as: a) the additional amount required to ensure that the Solvency Requirement of the statutory fund will continue to be met over the next three years, allowing for capital and profits emerging over that period from the existing business of the fund; less b) the New Business Capital; less c) the Offset Statutory Capital. 12.3 Subject to paragraph 12.5, new business capital is the aggregate of: a) existing, binding arrangements for the external raising of capital specific to the financing of new business within the statutory fund; and b) capital (existing or emerging) in any other statutory fund, to the extent it is (or would be) available to be transferred to the shareholders fund at that time. 12.4 Offset Statutory Capital applies in the case of a life company which is neither a friendly society nor an eligible foreign life insurance company. It is the amount of Statutory Capital which is appropriately utilised in meeting the new business reserve requirements of the statutory fund. 12.5 The New Business Reserve must not be less than zero. No APRA guidance on the treatment of new business in the calculation of capital requirements in respect of the non-life insurance business was found. OSFI As per the document titled Key Principles for the Future Direction of the Canadian Regulatory Capital Framework for Property & Casualty Insurance prepared by the Property & Casualty (P&C) MCT Advisory Committee dated January 2010: Key principles The new capital framework should: On risk measurement 6. Reflect existing risks on going concern basis and consider windingup and restructuring Risks should be measured on a going concern basis and should consider winding-up and restructuring costs. Page 6 of 12
Regulatory capital available has two key functions: it allows institutions to absorb losses during ongoing operations and it protects policyholders and creditors from loss in the event of liquidation. In defining available capital and required capital, risks should not be double counted. Existing risks include all current commitments, whether on- or off-balance sheet. Future new business and renewals have to be considered. No OSFI guidance on the treatment of new business in the calculation of capital requirements in respect of the life insurance business was found. 5.4 Mapping of differences between above approaches (Level 2 and 3) There are no apparent contradictions between Solvency II and the IAIS standards and guidance papers. In the APRA and OSFI guidance found, allowance should be made for new business in the calculation of capital requirements. Since no detail on the approaches to allowing for new business were found, these jurisdictions have not been considered further below. 6. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT 6.1 Discussion of inherent advantages and disadvantages of each approach Since the IAIS guidance in principle does not disagree with Solvency II, the following section deals with the inherent advantages and disadvantages of the Solvency II approach adopted in QIS5. The Solvency II Framework Directive specifies that the risk arising from new business should be allowed for in the calculation of the SCR. In QIS5, this is allowed for using assumptions in the standard formula in both the life and non-life underwriting risk modules; albeit different assumptions respectively. Across all modules of QIS 5, the standard formula does not take into account the expected profit or loss of new business. (I.e. It is assumed that the economic profit of new business written over the coming year is zero.) Although it is expected that insurers would write business at a profit, assuming that insurers would achieve a return in excess of the cost of capital assumed in the model, may be imprudent prior to the actual sale taking place. On the other hand, assuming an insurer would continue to write business at an economic loss in assessing current solvency may also not be appropriate. Thus, making no allowance for the expected profit or loss of new business is considered to be a reasonable assumption for the SCR calculation. Page 7 of 12
Within the non-life underwriting risk sub-module of QIS5, the unexpected losses on new business are only allowed for in the premium section of the premium and reserve risk sub-module, where stresses are applied to total premiums expected to be written over the coming year. Since the expected written premium over the year includes premiums expected to be received on new business in line with management forecasts, new business premium risk should be adequately reflected. For the other elements of the non-life underwriting risk sub-module, no explicit allowance is made for the risk arising from expected new business. The impact of new business on these other elements of the non-life underwriting risk sub-module are implicitly captured by applying instantaneous stresses at the valuation date. The implicit assumption made in these elements is that the exposure to risk in respect of these other elements is stable over time. This assumption should be appropriate for most insurers, unless for example they are rapidly expanding or contracting. Since the standard formula is meant to be reflective of the general case, this approach is considered appropriate for the SCR calculation. Within the life and health underwriting risk sub-modules of QIS5, the unexpected losses on new business are not allowed for explicitly in the standard formula, as the stresses are only applied to contracts in-force at the balance sheet date. Although the stresses are instantaneous, many stresses are only applied to the remaining term of the contract (e.g. The mortality stress is applied as an instantaneous increase in the future monthly mortality rates). Thus if the contract boundary on a policy is within 8 months from the balance sheet date, the mortality rate will only be increased for effectively 8 months of the contract. The underlying assumption made in the SCR, if it is intended that it includes the impact of the unexpected losses of new business, is that the release of capital over time is the same as the additional capital required to support new business if an insurer has reached a stable state (i.e. where the mix of business by size, type, duration etc. is remaining the same over time and where the business is not growing or shrinking, amongst others) then this assumption may be valid. If this assumption is not true (e.g. as in the case of a rapidly expanding insurer then this may constitute a significant deviation from the assumptions underlying the standard formula and may require an insurer to make appropriate adjustments to the standard formula and/or result in a capital add-on. The advantage of the QIS 5 lifemodule approach, however, is that it requires no additional work and this treatment should be reasonable for most insurers. Since the standard formula is meant to be reflective of the general case, this approach is considered appropriate for the SCR calculation. One potential disadvantage of the Solvency II approach for the life underwriting module in QIS5 is that it understates the risk of existing business in respect of the mortality catastrophe shock. The mortality catastrophe shock is applied as an increase to the monthly mortality rate for one year. If the remaining term (determined by the boundary conditions) is less than one year than the standard formula would understate the capital requirement if the event were to happen at some instantaneous point during the year even if the insurer were not rapidly expanding. This issue is particularly relevant for group life business if the boundary conditions decided upon under SAM would typically make the outstanding duration on group life Page 8 of 12
less than one year and the treatment of mortality catastrophe risk under SAM were based on life techniques (i.e. not basing the stress on the expected premiums to be written during the year). Boundary conditions recognising the longer term exposure to group life business (even if premiums are reviewable) or treating group life business on non-life techniques would address this concern. Further clarification on boundary conditions under SAM and the treatment of group life business in the SCR under SAM is required to ascertain whether the impact of new business in respect of such business has been adequately allowed for in the SCR. The understatement of the mortality catastrophe risk can also be addressed by changing the mortality catastrophe stress to an instantaneous mortality event at the valuation date rather than an addition to mortality rate for one year after the valuation date. If this methodology is adopted, then the mortality catastrophe stress should be appropriate even if boundary conditions are less than one year on certain lines of business. Boundary conditions less than one year may not be appropriate for certain stresses if in practice the insurer is unable to quickly re-price within an event (e.g. mortality level). In such cases, it may be appropriate to consider a longer term than one year for capital requirement purposes. However, since such losses are as a result of limitations in operational capabilities in re-pricing risk timeously (as allowed under the contract terms), such losses may considered to be operational losses (i.e. not mortality risk losses in the example above). Hence, such losses may already be deemed to be captured in the operational risk requirement. The impact of new business will however be allowed for within an insurer s ORSA. If the issues identified above are material, they should be reflected in the ORSA anyways and thus the need to include these complications in the standard formula may not be warranted. Listed below are further issues raised at the working group meetings and our understanding of their treatment under QIS5: (1) Should one allow for the impact of new life business if the value is negative? This may particularly be the case for start-up insurers, which may have planned for reduction in unit costs based on projected new business volumes. The QIS5 technical specification recognizes that the standard formula does not allow for the expected loss/profit of new business. The Solvency II Framework Directive explicitly states that in respect of existing business only unexpected losses shall be covered it does not stipulate that the expected profit/loss on new business can t be included. If the approach to new business in the Solvency II standard formula is adopted as is, then no allowance is made for the expected losses from new business. However, if the business is a start-up then the underlying assumption described above may not be appropriate and adjustments may need to be made. The assumptions used should be consistent with the assumptions used in the calculation of technical provisions. Page 9 of 12
(2) It was however noted that new business projections would be dealt with in the ORSA and further that there was an expense inflation component within the SCR calculations. Any further allowance for new business would need to take these into consideration so as to avoid double counting of potential impacts of new business. As per the Solvency II Framework Directive, new business should be included in the ORSA and the expense in the technical provisions should be allowed for on the basis that the insurer continues to write new business. Any further allowance for new business would need to ensure that the overhead costs have been dealt with appropriately and not double counted. 6.2 Impact of the approaches on EU 3 rd country equivalence The approach discussed above is the Solvency approach. Hence, if such an approach were to be adopted, equivalence should be easy to demonstrate. 6.3 Comparison of the approaches with the prevailing legislative framework Under the prevailing legislative framework, new business is not taken into account in calculating the Capital Adequacy Requirement. In PGN 104, the following paragraph is included in the Additional considerations and guidance subsection of the Statutory reporting: Capital Adequacy Requirement section: 6.15.2 It has been decided to ignore the effect of future new business when calculating the Capital Adequacy Requirement, as is the case with the statutory valuation method in general. In considering the future financial position of the office, the Statutory Actuary will of course take expected new business into account. 6.4 Conclusions on preferred approach The rationale of allowing for new business in the SCR stems from its basic definition under SAM The SCR should correspond to the Value-at-Risk of the basic own funds of an insurer or reinsurer subject to a confidence level of 99.5% over a oneyear period. The standard formula methodology of assessing capital is to assess the impact of instantaneous stresses on the economic balance sheet at the valuation date rather than more accurately to assess the impact of gradual stresses over the year on the economic balance sheet a year after the valuation date (which would require an explicit allowance for new business). The standard formula methodology is thus a simplification of the SCR requirement. New business would need to be projected under the latter methodology and thus should in some way be allowed for under the former methodology. Allowance for new business should be made in the SCR in accordance with the IAIS guidance. The QIS 5 approach does make either explicit or implicit allowance for new business in the SCR in both the life and non-life modules. The QIS 5 approach is simple to apply and the simplifying assumptions used in the SCR are satisfactory for most insurers. Page 10 of 12
Changing the mortality catastrophe stress to an instantaneous stress would help address some of the disadvantages of these simplifying assumptions. However, these simplifying assumptions may still not be appropriate for rapidly expanding insurers. Since new business will be considered in the ORSA, it may not be warranted to make any further adjustments for new business as this may over-complicate the standard formula. 7. RECOMMENDATION As for the Solvency II Framework Directive and IAIS guidance, the risk of new business should be allowed for in the calculation of the SCR under SAM. The simplifying assumptions used in the standard formula of QIS5 are satisfactory for most insurers. As noted in 6.1 above, the simplifying assumption may not be appropriate for all insurers or certain lines of business. Changing the mortality catastrophe stress to an instantaneous stress would help address some of the disadvantages of these simplifying assumptions. It is recommended that such a change in the mortality catastrophe stress be investigated. New business will be taken into account in the ORSA for all insurers. Changing the standard formula to allow for assumptions that are not fully appropriate for certain insurers or certain lines of business may be unwarranted since new business issues should be identified within the ORSA. Currently the Solvency II approach for the SCR is recommended for SAM. This recommendation will need to be reviewed once boundary conditions and the standard stress methodologies have been finalised. For insurers adopting an internal model approach, the internal model should cover the risks of new business written over the following 12 months in a manner that is appropriate to its business model Proposal for secondary legislation: Treatment of new business in the standard formula 1. The SCR should cover the risk of existing business as well as the risk of new business expected to be written over the following 12 months. 2. In the standard formula, the risk of new non-life insurance (and Non-SLT health insurance business if still applicable) is taken into account in the premium risk part of the premium and reserve risk sub-modules. The volume measure for this risk component is based on the expected premiums (as required by the appropriate SCR risk modules) during the following twelve months. The submodules thereby allow for unexpected losses stemming from this business. No allowance is to be made for the expected profit or loss of the expected new business written during the following 12 months. 3. For life insurance (and SLT health insurance if still applicable) the calculation of underwriting risk in the standard formula is based on scenarios. The scenarios Page 11 of 12
consist of an instantaneous stress that occurs at the valuation date and the capital requirements are the immediate loss of basic own funds resulting from the stresses. The scenarios do not take into account the changes in assets and liabilities over the 12 months following the scenario stresses. Thus, the standard formula does implicitly allow for the risk of new business by assuming that the capital released from existing business over the year is sufficient to cover the capital required by new business over the year. Therefore no explicit allowance for the risk of new business needs to be made in the calculation of the life underwriting risk SCR and the health underwriting risk SCR. No allowance is to be made for the expected profit or loss of the expected new business written during the following 12 months. 4. For all other elements of the standard formula SCR calculation no explicit allowance is to be made for the risk of expected new business written during the following 12 months. 5. The expected profit or loss of new business is not captured in the standard formula. (A more general comment in the secondary legislation is required to deal with the implications of the assumptions underlying the SCR calculation not being materially appropriate for any particular (re)insurer) Page 12 of 12