FINANCIAL SERVICES BOARD. Issues Paper:

FINANCIAL SERVICES BOARD Issues Paper: Financial Condition Reporting Proposed Solvency Assessment for Short-term Insurers INTRODUCTION...2 RISK-BASED SUPERVISION...6 LEGISLATION CHANGES...6 THE FINANCIAL CONDITION REPORT...7 PRESCRIBED MODEL...17 TRANSITION ARRANGEMENTS FOR THE PRESCRIBED METHOD...29 NEW APPLICATIONS...30 APPLICATION AND APPROVAL PROCESS FOR ALTERNATIVE MODELS...31 CERTIFIED MODELS...34 INTERNAL MODELS...44 TECHNICAL GUIDANCE...58 DEFINITIONS AND ABBREVIATIONS...59 APPENDIX 1...63 APPENDIX 2...71 REFERENCES...75 Issued for industry comments 1

Introduction Purpose of the paper 1 The purpose of this paper is to inform the short-term insurance industry of the method of statutory financial reporting that will be required in South Africa in the future. This method is called Financial Condition Reporting (FCR). 2 This paper describes FCR and the methods of calculating a short-term insurer s insurance liabilities and Capital Adequacy Requirement (CAR) that will be required by the Financial Services Board (FSB). 3 The paper also describes changes that will need to be made to legislation governing short-term insurance in order to accommodate FCR. It also outlines the arrangements for transition between the current method of financial reporting to FCR. It sets out deadlines by which all short-term insurers in South Africa should have made the transition. 4 The paper contains a fair amount of technical information. Insurers are advised to consider obtaining professional advice to determine the effect that these proposals will have on their specific circumstances. Issued for industry comments 2

Comments 5 This paper is open for public comment until 31 May 2007. Comments will not be treated as confidential, unless specifically stated as such. 6 Comments must be sent, using the accompanying document template for comments, to: Mrs Hantie van Heerden Actuarial Department Financial Services Board PO Box 35655 MENLO PARK 0102 Fax number (012) 347 1288 E-mail address: hantiev@fsb.co.za Why Financial Condition Reporting? 7 By introducing FCR, the FSB is following a risk-based regulatory approach that is becoming more acceptable internationally. Some of the countries that have already adopted a risk-based regulatory approach are Australia, the UK, the USA, Germany, Canada, Holland and Switzerland. 8 The advantage of the current approach is that it is easy to administer. Effectively, it requires each short-term insurer to hold risk capital at least equal to 25% of its annual net written premium. Its disadvantage is that it is not sufficiently prudent for all insurers as the risk capital is independent of the size of the insurer and the underlying risk. Thus it cannot be fully relied on to alert the FSB when a certain insurer is in trouble. The current approach is also not useful for an insurer s risk management. 9 FCR is favoured because it requires each insurer to calculate risk capital that depends on the underlying risk of its business. This will allow insurers to make more efficient use of capital when they manage the underlying risk. Issued for industry comments 3

10 FCR will aid insurers in their risk management. This is because the method requires insurers to implement sound risk management strategies and to use the report and models that accompany the method in the day-to-day running of their business. This will result in a better understanding of an insurer s risks by its management, its board and the FSB. Costs 11 The benefits of FCR will cost money. A significant portion of the cost will be incurred in complying with the regulation. This cost will ultimately be borne by the same policyholders that FCR will aim to protect. However, the FSB is of the opinion that the benefits will outweigh the cost. Envisaged use of models to determine Capital Adequacy Requirement and liabilities 12 The FSB s preferred approach to calculating risk capital and liabilities is through using an Internal Model. This is because, of all the options that insurers have, it is the most accurate in calculating risk capital. It is envisaged that ultimately, all insurers will be required to use Internal Models to calculate their risk capital. Since the Internal Model requires specialised expertise and judgement to develop, the person responsible to develop it should have an appropriate professional certification. 13 The Internal Model has the drawback of the cost and expertise that is required in developing it. To aid companies that will not be in the position to build their own Internal Model by the time that FCR becomes a requirement, the Prescribed Model has been developed. It is based on the whole shortterm industry and will be most accurate for companies that are average in most respects. Although the formulae are complex, the model is easy to use and is already incorporated into the ST2006. 14 Another option that companies have to calculate their risk capital and liabilities is the Certified Model. Many of the features of this model are the same as those of the Prescribed Model. However, individual insurers are able to change some elements of the Prescribed Model to meet their specific circumstances. The person responsible to develop the Certified Model should also have an appropriate professional certification. In its certified model application, the insurer should outline its strategy and time frame in progressing to an internal model. In addition, the insurer should outline Issued for industry comments 4

the enterprise wide risk management procedures it has in place as part of its risk management strategy. 15 The diagram below compares the different types of model that insurers can choose from. Prescribed Model Certified Model Internal Model Industry Structure Industry Parameters Industry Structure Company Parameters Annual certification by actuary Company Structure Company Parameters Peer review at application Annual certification by actuary 16 The diagram below summarises FCR, its requirements and the methods that can be used to calculate liabilities and risk capital. Free Assets Fair value of assets Fair value of admissible assets Excess assets CAR Min R10mil PM, CM or IM Liabilities Best estimate + Prescribed margins PM, CM or IM Risk Management Use in day-to-day running of business Financial Condition Report Issued for industry comments 5

17 If the insurer received approval to issue debentures or preference shares (other than compulsory convertible preference shares) these instruments will be viewed as suitable capital to back the CAR. The same terms and conditions, as prescribed by the Registrar in the approval of these instruments, will apply. Risk-based supervision 18 The FSB is in the process of implementing risk-based supervision. Under this approach, the riskier an insurer is, the more stringently it will be regulated. 19 Insurers will be classified into categories of risk and control levels will be established to determine the level of regulation that each insurer will be subject to. 20 FCR fits in naturally with risk-based supervision as it will provide the FSB with more accurate information regarding each insurer s level of risk. Legislation Changes 21 Legislative changes will be necessary to implement FCR. The changes that we have proposed in the Insurance Amendment Bill 2007 are discussed below. 22 The main change will be to remove the sections on the valuation of liabilities from Schedule 2 and replace it in a Board Notice / Regulation format. The reason for this is to simplify the process in future if changes to the formulae or other technical aspects are required. 23 If it happens that the Insurance Amendment Bill is enacted before FCR can be implemented, we propose that the current legislation s principles should be included in the Board Notice / Regulation until the time that FCR is implemented. A proposal, if this should occur, is attached in Appendix 1 in a Board Notice format 1. 1 The same information can be put into the format of Regulations Issued for industry comments 6

24 Once FCR is implemented the Board Notice / Regulation should contain the principles as set out in this issues paper, in other words the details regarding the Prescribed Model, Certified and Internal Models as well as the disclosure thereof. 25 Other act changes include the following: All references to the contingency reserve must be removed. All references to the additional amount must be removed and replaced with capital adequacy requirement. (Referring to a capital adequacy requirement also makes the short-term legislation more comparable with the long-term legislation.) References to liabilities in the Act must be changed to liabilities and capital adequacy requirement. Allowance must be made for the appointment of a statutory actuary in certain circumstances, including the right to the FSB to approve (and remove) such an appointee. An additional requirement must be added in section 28 (2) to state that an insurer shall be deemed to be financially unsound if it has not made provision for the capital adequacy requirement. Part 2 of the Regulations to the Act must be removed. 26 It is not certain when the Insurance Amendment Bill will be tabled in Parliament, but we hope that it will happen during the latter half of 2007. The Financial Condition Report 27 A Financial Condition Report provides an outline of the key risks and matters impacting on the financial condition of the insurer. This includes providing the insurer with implications of issues identified and, where these implications are adverse, proposing recommendations designed to address the issues. It augments, but does not replace, statutory returns. 28 The Board of directors of the short-term insurer should assure themselves and demonstrate within this report that adequate capital support is in place to minimise the risk of possible financial failure of the insurer. Issued for industry comments 7

29 The report should focus on principles. For example, smaller insurers may need to report less than larger insurers. 30 The principles of disclosure that should be adhered to are described in this section. Therefore no standard template is given at this stage. Financial Condition Report submission 31 The report must be submitted by all registered short-term insurers. This includes registered shortterm insurers in run-off. 32 This report must be completed on an individual short-term insurer level and not at a group level 2. 33 This report must be submitted to the Registrar of Short-term Insurance on an annual basis accompanying the annual statutory return (within four months after the financial year end of the insurer). It should not be viewed as an annexure to the statutory return or the published annual financial statements. Neither should any cross-reference be made between the report and the statutory return or the published annual financial statements. 34 The Registrar may at any time require, with valid reasons, a short-term insurer to compile and submit, within a reasonable period of time, a Financial Condition Report. This request by the Registrar may be made on an ad hoc basis (over and above the annual submission requirement) depending on the nature of the short-term insurer s financial position. 35 This report must be signed off by the chairperson of the Board of Directors and the chief executive officer of the short-term insurer. 36 In the event the short-term insurer was assisted by an approved person in compiling any part of the report, the report must state the name and level of assistance provided by the approved person. 2 However, if an insurer is prone to systemic risk, this should be mentioned and addressed. Issued for industry comments 8

Insurer's background 37 The report must outline and describe the intrinsic nature of the business and the external environment within which the short-term insurer operates. Such information includes: the corporate structure; the ultimate beneficial shareholder of the insurer as well as the financial condition of the holding company; and the business classes registered and registration conditions imposed. Recent experience 38 The report must identify and comment upon significant features or trends in the insurer s recent experience, including any impacts due to external factors. Deviations in actual experience from expected experience must also be discussed, including reasons for these deviations. 39 The report must comment on any steps taken, or proposed to be taken, by the Board and senior management of the insurer to address areas of deviation and adverse experience. Risk management strategy 40 The report must outline the short-term insurer s risk management strategy. It should be a demonstration of the systems and procedures in place to identify, assess, mitigate and monitor the risk with which the insurer is faced. 41 The report must disclose the following matters in respect of the risk management strategy: the risk governance relationship between the Board, Board committees and senior management; the processes for identifying and assessing risks; the process for establishing mitigation and control mechanisms for individual risks; the process for monitoring and reporting risk issues (including communication and escalation mechanisms); those persons in the insurer with managerial responsibility for the risk management framework, their positions, roles and responsibilities; the process by which the risk management framework is reviewed; the mechanisms in place for monitoring and ensuring continual compliance with the Capital Adequacy Requirement (CAR); and Issued for industry comments 9

the processes and controls in place for ensuring compliance with all other prudential requirements. 42 Additional requirements will be necessary if the insurer uses an internal or certified model to calculate its liabilities and / or CAR. These are described in the sections on certified models and internal models below. Liability valuation 43 In determining the value of its insurance liabilities, an insurer must determine a value for both its outstanding claims liabilities and its premium liabilities for each short-term regulatory return class of business. Where, outstanding claims liabilities relate to all claims incurred prior to the valuation date, whether or not they have been reported to the insurer; and premiums liabilities relate to all future claim payments arising from future events post the valuation date that are insured under the insurer s existing policies that have not yet expired. 44 The report must include the method used to calculate the liabilities, whether this is the Prescribed Model (PM) or a company-specific calculation performed by an Approved Actuary. 45 When the calculation is performed by an Approved Actuary the calculation needs to be done in accordance with the guidance notes prescribed by the Actuarial Society of South Africa. 46 Irrespective of the methodology used the following information is required by class of business: a best-estimate value of the outstanding claims liabilities, split between case reserves for outstanding claims and incurred but not reported (IBNR) reserves; a best-estimate value of the premiums liabilities; risk margins for each insurance liability specified above, determined on a basis that is intended to value the insurance liabilities of the insurer at a 75% level of sufficiency; an analysis of the historical adequacy of each liability estimate over the past five years; and if the historical provisions have been inadequate, an explanation for these inadequacies and steps taken by the insurer to prevent the situation from persisting needs to be included. Issued for industry comments 10

Asset and liability management 47 The report must comment on the current approach of the insurer to asset and liability management in relation to the liability profile and liquidity needs of the short term insurer. 48 The report must outline the process followed to implement an investment strategy, including the following: the investment objective of the insurer; how the capital position, the term and currency profile of its expected liabilities, liquidity requirements and the expected returns, volatilities and asset class correlations are incorporated in this objective; the formulation of the investment strategy, discussing strategic asset allocation, assets allocation ranges, risk limits target, currency exposures and ranges; the management of individual asset classes, whether performed internally or outsourced to investment managers; the responsibilities of individuals and committees deciding and implementing the investment strategy; the selection process of the investment managers as well as the monitoring of these investment managers in respect of adherence to their mandates; the process of ensuring the continuing appropriateness of the investment strategy; and the monitoring of compliance with the investment strategy. 49 The report must outline the liquidity plan for different classes of business at different points in time. 50 In respect of derivatives transactions the report must outline the objective in using derivatives; risk tolerance or allowed exposure of the insurer and a management framework consistent with the risk tolerance; lines of authority and responsibility for transacting derivatives; and the consideration of worst-case scenarios and sensitivity analyses. Issued for industry comments 11

Business projections 51 The report must include the projected premium income used in the calculation of the CAR, by line of business. 52 The report must include a comparison of actual premium income achieved against projected premium income used for previous CAR calculations. The comparison should contain figures for the previous five financial periods split by line of business with an explanation for any major discrepancies between actual and expected premium income. Capital management and capital adequacy 53 The report must outline the insurer s strategy for setting and monitoring capital resources over time and the processes and controls in place to monitor and ensure compliance with the CAR as determined in accordance with professional guidance as prescribed by the Actuarial Society of South Africa. Comment must be made on the strategy, including targets and trigger ratios included in the strategy, and any issues arising from the use of the strategy, having regard to the insurer s CAR and future capital needs to support the business plan. 54 The report must include the method used to determine the CAR, whether this is the Prescribed Model Method (PM), Certified Model Method (CM) or Internal Model Method (IM). 55 Where an IM or CM is used, the report must include the date at which the model was last approved by the Registrar and any subsequent changes to the model since that date. 56 Where a CM is used, the report must indicate which business has been calculated under the CM and report this business separately. 57 Where a CM is used, the insurer must report on the progress made towards implementing an Internal Model. Issued for industry comments 12

58 The following items of information must be disclosed: the capital base of the insurer; the CAR of the insurer, stipulating the model used; and the capital adequacy multiple of the insurer. 59 The report must comment on whether or not the insurer is complying with the CAR, and has complied with the CAR continuously over the past year. 60 The report must identify trends in the insurer s compliance with its capital targets over the last three years. 61 The report must comment on the extent of, and reasons for, any breaches by the insurer of its targets during the past year and the subsequent actions that were taken by the insurer to rectify any breaches. Where such breaches have occurred it is necessary for an Approved Actuary to comment on the extent of and reasons for any breaches by the insurer of its CAR during the past year and the subsequent actions that were taken by the insurer to prevent such breaches from reoccurring. 62 The Approved Actuary must consider and comment on the insurer s capacity to continue to meet the CAR and its capital targets over the next three years. This assessment should include quantitative and qualitative stress and scenario testing. Premium adequacy 63 The report must outline the insurer s approach to the premium determination process. This must include commentary on underwriting practices, expense assumptions and profit margins. Reinsurance management strategy 64 The report must outline the insurer s reinsurance management strategy and must comment on any issues arising from the use of the specified reinsurance strategy and arrangements. This must include: the primary objectives when placing reinsurance; Issued for industry comments 13

the process for selecting reinsurance partners; the process of establishing the type and level of reinsurance required; and the methodology used to calculate the maximum loss per risk and per event. 65 The report must outline the process for ensuring continuing appropriateness of the reinsurance strategy and implementation of this strategy and highlight the monitoring and oversight of this strategy. 66 The report must describe the impact of the reinsurance strategy on the overall capital model. 67 The report must comment on the use of facultative reinsurance by the insurer with reference to how and why the decision to purchase facultative reinsurance is made. 68 The report must comment on the level of catastrophe cover purchased with commentary on the decision process for selecting this amount of cover. 69 The report must highlight changes to the reinsurance strategy over the prior reporting period, with specific reference to: the type of reinsurance cover purchased; the net retention levels; the amount of catastrophe cover purchased; and the lead reinsurer on major contracts. 70 The report must indicate in a form of a table the exposure to the insurer s five largest reinsurance partners. This table must include: the name of the reinsurer and country of incorporation; the total proportional treaty premium; the total catastrophe non-proportional treaty premium; the total non catastrophe non-proportional treaty premium; the facultative premium; and the percentage of the premium paid to this reinsurer in relation to all reinsurance premiums paid. Issued for industry comments 14

71 In respect of the Motor, Property and Engineering business classes the report must include the following information per cresta zone: the number of risks; the total sum insured; the total estimated maximum loss; and the gross and net premium income. 72 The report must outline the maximum protected and unprotected net retention per risk. 73 The report must outline the automatic capacity available per business class, including: the maximum amount of non-proportional risk capacity purchased; the maximum amount of proportional treaty capacity automatically available; the nature of this proportional capacity (surplus, quota share or autofac); and for property and engineering classes, the minimum estimated maximum loss percentage without reference to the lead reinsurer. Credit risk 74 The report must outline the processes in place to manage and monitor the credit risk exposure of the short-term insurer. 75 The report must describe how the insurer defines acceptable ranges, quality and diversification of credit exposures. It is recommended that this be related to different categories such as reinsurers, brokers, policyholders, investments and other. 76 The report must include the limits set for credit exposures and the maximum exposure at the reporting date to single counterparties and groups of related counterparties. 77 The report must include a description of the process for approving changes in the credit mandate and changes in limit structures. 78 The report must include a description of the process for reviewing and, if necessary, reducing or cancelling exposures to a particular counterparty where it is known to be experiencing problems. Issued for industry comments 15

79 The report must include a list of any material third-party defaults over the prior reporting period and the processes and procedures in place to mitigate such defaults from reoccurring in the future. Operational risk 80 The report should include a definition of what the insurer perceives as operational risks within its business context. Such risks may include: the risks associated with outsourcing work; business continuity risk; the risk of inadequate human resources; internal and external fraud; the risks associated with project management; the risks associated with underwriting and claims; and the risks around the introduction of new products. 81 The report needs to provide detail on the processes incorporated by the insurers to manage and monitor the operational risk exposure. 82 The report must include a description of the process that the insurer applied to identify key areas of risks which has been included under their definition of operational risk. This should also include commentary regarding the reassessment of the insurer s activities and internal functions to update the definition. 83 The report must include detail on the financial losses suffered due to operational losses over the prior reporting period. This must include: a description of the events that caused the loss; the control procedures that were not functioning to prevent the loss; and mitigating actions taken to prevent these losses in the future. Issued for industry comments 16

Prescribed Model 84 The Prescribed Model can be used to calculate the insurance liabilities of an insurer as well as its Capital Adequacy Requirement (CAR). 85 The Prescribed Model was calibrated using industry data from historical STAR returns. As such it provides an approximate measure of an insurer s insurance liabilities and its CAR. Also, whenever the model refers to business classes, it refers to the eight business classes as used in the statutory return. 86 Since the Prescribed Model is an industry average model, it has certain limitations and can not be accurate for all insurers. This is firstly because the STAR returns did not contain all the necessary data required and secondly because the data that were available were not always reliable. 87 In particular the data did not allow a split and analysis between proportional and non-proportional reinsurance, since only certain non-proportional reinsurance is seen as approved reinsurance in the Act. In the STAR return only the earned premium of the non-proportional approved reinsurance is taken into account, and not the full effect that the reinsurance can have on the liability profile. This has important implications for an insurer with a significant amount of non-proportional reinsurance. 88 Also, in the STAR return data it is not possible to separate extreme events from attritional losses. Thus the calibration implicitly modelled these different types of losses together. 89 By its nature the Prescribed Model is approximate and will therefore not fit individual companies with specific circumstances. The lack of fit can be expected to be particularly pronounced for niche insurers, cell captive insurers and reinsurers. 90 The Prescribed Model estimates insurance liabilities that are 75% 3 sufficient. It also calculates the CAR for different sufficiency levels (98%, 99% and 99.5%). However, the requirement is for insurers to hold a CAR that is 99.5% 4 sufficient. 3 This means that the liabilities will be expected to be insufficient once in every four years. 4 This means that the insurer will be expected to have insufficient capital once in every 200 years. Issued for industry comments 17

Insurance liabilities 91 The diagram below slices the liabilities side of an insurer s balance sheet in different ways to summarise the Prescribed Model and the elements of liabilities and risk capital it calculates. CAR Min R10mil 99.5% sufficient CAR TCR Liabilities Best estimate + Prescribed margins 75% sufficient Prescribed Margin on Premium Prescribed Margin on Claim Liabilities Best Estimate of Premium Liabilities Best estimate of Liabilities Best Estimate of Claim Liabilities (IBNR and OCR) 92 In the Prescribed Model, insurance liabilities are made up of the claims liabilities, the prescribed margin on the claims liabilities, premium liabilities and the prescribed margin within the premium liabilities. 93 The claim liabilities is a reserve with respect to claims that have occurred in the past. The unearned premium liabilities is a reserve with respect to future claims on business already written. The Prescribed Model provides a best estimate of both these reserves. The purpose of the prescribed margins on these reserves is to make the total insurance liabilities 75% sufficient. 94 The calculation of the claim and premium liabilities is described separately below. Issued for industry comments 18

Claims Liabilities 95 The claim liabilities is a sum of OCR Incurred But Not Reported reserve (IBNR) and Outstanding Claims Reported reserve (OCR). 96 Insurers provide their own best estimate of the OCR. 5 IBNR 97 The Prescribed Model uses a table, based on the chain ladder method, to calculate the best estimate IBNR reserve. It uses a different six-year run-off pattern for each business class to calculate the percentage of claims not yet reported at the end of every year. Business Class Percentage of claims not yet reported for the current financial year less x years where x = 0 1 2 3 4 5 Accident 9.00% 2.90% 0.94% 0.30% 0.10% 0.03% Engineering 8.67% 2.57% 2.04% 1.99% 1.98% 1.98% Guarantee 24.92% 5.46% 1.39% 0.54% 0.36% 0.33% Liability 17.01% 3.73% 1.32% 0.89% 0.81% 0.80% Motor 4.33% 0.63% 0.31% 0.28% 0.28% 0.28% Property 6.14% 0.43% 0.12% 0.10% 0.10% 0.10% Transport 9.71% 3.40% 1.69% 1.22% 1.10% 1.06% Miscellaneous 7.30% 1.01% 0.29% 0.20% 0.19% 0.19% 5 Depending on the insurers current methodology, this reserve should not change from the current method to the Prescribed Method. Issued for industry comments 19

98 The IBNR reserve is obtained by summing the products of earned premium and the appropriate percentage of claims not yet reported for each combination of business class and relevant year. 99 Example: Consider an insurer that writes Motor and Property business only. The following information applies: Each class of business is completely run off after two years The earned premiums for the two classes are as follows: Business Class Earned premium for current financial year less x years where x = 0 1 Motor 3 000 000 2 000 000 Property 5 000 000 3 500 000 Using the Prescribed Model, the IBNR calculation for this company would be performed as follows: Business Class Calculation for current financial year less x years where x = 0 1 Motor 3 000 000*4.33% 2 000 000*0.63% Property 5 000 000*6.14% 3 500 000*0.43% This would give the following results for IBNR: Issued for industry comments 20

Business Class Result for current financial year less x years where x = 0 1 Total Motor 129 900 12 600 142 500 Property 307 000 15 050 322 050 Total 436 900 27 650 464 550 The total IBNR for the insurer is therefore R464 550. 100 The methodology described above will be the minimum level of IBNR required. If an insurer wants to use a lower IBNR percentage, it needs to get approval from the FSB. The Registrar may direct in a particular case, another percentage to be used. Prescribed margin on the claim liabilities 101 The prescribed margin on the claim liabilities increases the sufficiency of the total claim liabilities (IBNR + OCR) to 75%. It is found by using the following formula: Pr escribed _ M argin = a + b ( Gross _ IBNR + Gross _ OCR) c 102 The scale used should be in R 000s. Issued for industry comments 21

103 The parameters a, b and c are given below for each business class: Business Class a b c Accident -2.22492 2.79709-0.01411 Engineering -1.31733 1.60758-0.00220 Guarantee -7.46957 8.22086-0.00624 Liability -1.29049 1.59921-0.00358 Motor -1.86457 2.55882-0.02002 Property -3.64609 4.48216-0.01284 Transport -15.67146 16.30213-0.00241 Miscellaneous -4.75294 5.57018-0.01016 Premium Liabilities Unearned Premium Provision 104 The Unearned Premium Provision (UPP) must be calculated using the current estimation technique, namely the 365 ths method. If an insurer wants to use a different method, the FSB must approve the alternative method, whether the alternative method is more conservative or not. Unexpired Risk Provision 105 Where an insurer has specific knowledge that its premiums are inadequate, appropriate prudence would need to be borne in mind when setting an Unexpired Risk Provision (URP). This URP would also form part of the insurance liabilities and would have to be set at a 75% level of sufficiency. Since the calculation of the URP would depend on the context and the specific circumstances of the insurer, a formula is not prescribed for it. Issued for industry comments 22

Prescribed margin within UPP 106 The prescribed margin within UPP needs to be calculated in order to quantify its contribution to Total Capital Required. It is calculated by using the following formula: c Pr escribed _ M argin = max[0,1 a b ( Gross _ Earned _ Pr emium) ] UPP 107 The parameters a, b and c are given below for every business class: Business Class a b c Accident 0.909828 0.000000 0.000000 Engineering 0.884053 0.000000 0.000000 Guarantee 0.950792 0.000000 0.000000 Liability 0.861766 0.000000 0.000000 Motor 0.866146 4.325236-0.312100 Property -90.139828 91.659539-0.000482 Transport -7.738425 9.022793-0.004004 Miscellaneous -25.797955 27.875147-0.002596 Risk capital required The Total Capital Required (TCR) as calculated by the Prescribed Model is the result of the formula explained below. Total Capital Required 108 The formula that calculates TCR uses the following charges for risk as inputs: Charge for investment risk, called the Asset Capital Charge (ACC) Issued for industry comments 23

Charge for insurance risk, called the Insurance Capital Charge (ICC) Asset Capital Charge 109 The Prescribed Model specifies a capital adjustment factor for each investment class. The capital factors were estimated using the Smith Model, calibrated to the South African market. The aim of the capital adjustment factor is to provide the specified level of protection against loss in market value of the assets backing the liabilities and other capital elements. 110 The ACC is calculated by first allocating assets to liabilities (both current liabilities and insurance liabilities) and Capital Adequacy Requirement elements to decide which assets the capital adjustment factors need to be applied to. The ACC is the sum of the products of the capital adjustment factor and the amount of assets held in each investment class for all investment classes. 111 The capital adjustment factors for different investment classes are given in the following table for a 99.5% level of sufficiency: Investment Class Capital Adjustment Factor Cash 0.0% Equity 38.0% Property 32.5% Fixed Interest (Outstanding Term = 1 year) 6.7% Fixed Interest (Outstanding Term = 2 years) 11.27% Fixed Interest (Outstanding Term = 5 years) 19.8% Fixed Interest (Outstanding Term = 7 years) 24.6% Fixed Interest (Outstanding Term = 10 years) 27.0% Issued for industry comments 24

Insurance Capital Charge 112 The diagram below shows how the insurance capital of a short-term insurer is built-up from various components. This diagram is best understood from the bottom-up, since each component of risk feeds upwards into the component above it. 113 Gross Stand-alone Risk Capital is capital that covers the risk within each of the business classes. It is stand-alone because it does not yet take into account the correlation and diversification that Issued for industry comments 25

exists between the business classes. It is gross of reinsurance. Gross Stand-alone Risk Capital is estimated by using tables. The tables are results of a dynamic financial analysis model calibrated to STAR returns data. Their inputs are class of business, Gross Written Premium and Gross Unearned Premium Provision. The tables can be found in Appendix 2. 114 Net Stand-alone Risk Capital is calculated by firstly multiplying the Gross Stand-Alone Risk Capital by the retention factor for the appropriate business class. The retention factor is based on proportional reinsurance. It is at this point where the Prescribed Model can be significantly inaccurate for companies with a significant amount of non-proportional reinsurance. This is because detailed data available was not available in STAR returns for a more in-depth calibration taking into account the type of reinsurance taken out by an insurer. 115 In the event of a worst-case insurance loss (as envisaged by the net stand-alone risk capital calculated at this point) the company will also incur expenses in the normal course of business. These expenses thus need to be allowed for in the Capital Adequacy Requirements of each class of business by adding them to the net stand-alone risk capital. Insurers can use their current level of expenses as an indication of the likely level of expenses in the coming year. Further, should insurers feel that their expenses would rise significantly in times of high insurance losses, they should estimate their expenses on this basis. 116 To calculate the ICC, Net Stand-alone Capital is calculated for each of the eight STAR return business classes. From the Net Stand-alone Capital for each business class the overall insurance charge for all business classes can be calculated. This is achieved by summing of the Net Standalone Capital for each business class and multiplying the sum by a diversification and correlation factor. The factor is determined as follows: factor ( p) = DCC( p) TSC( p) Where DCC(p) = Diversified and Correlated Capital at the p th percentile TSC(p) = Total Stand-Alone Capital at the p th percentile Issued for industry comments 26

DCC is the appropriate percentile of a log-normal distribution with the following mean, E[DCC], and variance, V[DCC], appropriately parameterised for underwriting risk: N E [ DCC] = E[ EPi E( ULR i )] i= Where: N = The number of classes of business i = The specific class of business under consideration EPi = The earned premium in class of business i E[ULRi] = The expected ultimate loss ratio for class of business i V[ DCC] = N i= 1 ( EP ) i 2 V[ ULR ] + 2 i i< j ( EP )( EP ) Cov[ ULR, ULR ] i j i j Where: V[ULR i ] = The variance of the ultimate loss ratio for class of business i Cov[ULR i ; ULR j ] = The covariance of the ultimate loss ratios of class i & j TSC is the sum of the appropriate percentiles of a series of lognormal distributions where only underwriting risk is allowed for. The following mean and variance are used in estimating the parameters of each lognormal distribution: E SC ] = EP E( ULR ) [ i i i 2 V [ SC ] = ( EP ) V ( ULR ) i i i The ratio of DCC to TSC is an approximate measure of the appropriate factor to be applied to the net total capital required to allow for diversification and correlation effects. 117 Finally, the ICC is calculated by subtracting the investment return on assets backing insurance liabilities from the overall insurance charge. It is yet to be decided whether the rate of investment Issued for industry comments 27

return on assets backing insurance liabilities will be prescribed of if guidance will be provided. A rate of return of 8% has been used in the model embedded in the 2006 statutory return for illustrative purposes. Calculating Total Capital Required 118 The TCR is calculated by using the ACC and the ICC as inputs. TCR = ACC g 2 + ICC acc g icc 2 119 The g acc is the grossing up factor on the ACC and the g icc is the grossing up factor on the ICC. The grossing-up factors are calculated via an intermediate calculation described below. This step involves the performance of an asset allocation (after the allocation of assets to current liabilities and reserves) to adjusted values for the asset capital charge and the insurance capital charge. These adjustments are given below and are performed so as not to penalise companies for the composition of elements of their shareholders funds not being used to back their Capital Adequacy Requirements: TCR adj = Intermediate total capital required (before grossing-up) ACC adj = Adjusted Asset Capital Charge ICC adj = Adjusted Insurance Capital Charge 2 TCR adj = ACC + ACC ICC adj adj = TCR = TCR adj adj ICC 2 ACC ACC + ICC ICC ACC + ICC 120 An asset charge (calculated on the same basis as ACC) is calculated for the allocation of assets to ACC adj and ICC adj. These two charges are the weighted average fall in assets that could result for an appropriate level of sufficiency. Issued for industry comments 28

c = asset charge on ACC adj where 0 c < 1 acc icc < acc c = asset charge on ICC adj where 0 c < 1 < icc 121 The resulting grossing-up factors are calculated as follows: g =1 where 0 g < 1 acc c acc icc c icc < acc g = 1 0. 5 where 0 g < 1 < icc 122 The rationale for the above is that for the ACC, full grossing-up should be allowed for as a grossedup asset charge is needed in precisely the situation that you need the asset charge itself. The grossing-up of the ICC only takes half of the appropriate asset charge into account since a worst case insurance event will not always happen at the same time as a worst case asset event. The use of a factor of a half can be seen to be allowing for a 50% correlation between insurance catastrophes and investment market crashes. This is in line with the intended practice in European markets. Minimum Capital Required 123 The TCR implicitly contains prescribed margins referred to in previous sections. Thus the CAR can be found by applying the formula below to the TCR: CAR = TCR Prescribed Margin on Claim liabilities Prescribed Margin within Unearned Premium Provision 124 The Capital Adequacy Requirement is subject to a minimum of R10 million. Transition arrangements for the prescribed method 125 Should the FSB manage to make the necessary amendments to the Short-term Insurance Act during 2007, then the implementation date for compliance with FCR is for all short-term insurers with a financial year-end after 1 January 2009. Issued for industry comments 29

126 From the date of implementation, insurers will have five financial years to accumulate capital to the 99.5% sufficiency level. To ensure steady progress towards the 99.5% sufficiency level within five years, insurers will be considered financially unsound if they do not comply with the transition capital levels. 127 Transition capital levels are calculated by defining x as the capital at the 99.5% sufficiency level y as 25% of Net Written Premium (the current solvency requirement) and deriving transition capital levels using variable proportions of x and y over the following five year-ends as described in the table below: First Second Third Fourth Fifth year-end year-end year-end year-end year-end Proportion of x 20% 40% 60% 80% 100% Proportion of y 80% 60% 40% 20% 0% 128 The FSB will be open to requests where insurers cannot comply with the transition capital levels. These insurers should make the necessary application for dispensation with a clear motivation why a special dispensation should apply to them. After consideration of the application, the FSB could propose alternative transitional arrangements for such insurers. 129 The transition arrangements described above are applicable to the prescribed method only. If an insurer chooses an internal or certified model, a 99.5% level of sufficiency must be maintained from the date of approval of that method. New applications 130 Entities that apply for a new short-term insurance license before FCR is implemented, will be informed about the new proposals to ensure that no unrealistic capital expectations are set. 131 Applications for a new short-term insurance license after FCR has been implemented, will be required to base their business plans on the same transitional arrangements as described above. Issued for industry comments 30

Application and approval process for alternative models 132 Insurers that choose to use an Internal Model or a Certified Model to demonstrate solvency must lodge an application to the FSB for their models to be approved. 133 For the rest of this section, the word model refers to both an Internal Model and a Certified Model, unless where the context makes it clear otherwise. Model Approval Process 134 An insurer must obtain the FSB's prior approval before it will be able to use its model to determine its CAR. Short-term insurers should make a written application to the FSB. The model approval process can be lengthy therefore insurers should apply well in advance (i.e. at least six months in advance) of the proposed effective date for using their models. 135 The insurer s Board of Directors should sign the model application. 136 Any approval will be conditional on continued compliance with the requirements of these guidelines, as modified from time to time. 137 The FSB process will not be an audit / check on the calculations of the model. The FSB will also consider wider supervisory knowledge on the insurer and knowledge of wider market developments and practices. Assessment of models will also form part of future on-site visits. 138 An external provider s model(s) will not be approved explicitly. Although a provider s model may be acceptable in principle, an insurer will still have to apply individually. 139 Approval will be subject to the outcome of a comprehensive model review process including: completion of a detailed application form about the model and accompanying risk control environment; one or more on-site visits to discuss the detail of the model, risk management systems, and surrounding organisational structure and controls; Issued for industry comments 31

for an internal model, certification (by way of an independent review of the model) by an independent actuary that the model s methodology and assumptions are appropriate; and the model must have been in use for at least one year (in other words, producing results for at least one year-end) as part of the risk management system used by the insurer. 140 If an insurer is applying for the use of a Certified Model, it should complete a single Certified Model application containing all the elements that needs to be certified. Such an application could certify alternative reserving methods, liabilities with prescribed margins and/or CAR. Despite submitting a single application, results for each business class must be available and reported separately. 141 The application should incorporate a level of detail that provides sufficient justification for material assumptions. The onus rests on the insurer to satisfy the FSB that its particular approach is appropriate to its individual circumstances. 142 Once the FSB is satisfied with the extent to which the insurer has met the criteria outlined in these guidelines, the FSB will approve the model. Any conditions on which the approval is granted will also be specified. 143 The FSB will require, as a minimum condition of its model approval, that the insurer undertake to advise the FSB in advance of any material changes to its model or surrounding controls, and that the FSB be provided with any information necessary to satisfy itself that the insurer continues to meet the criteria outlined in this proposal. 144 Examples of material changes include, but are not limited to: A change in model or significant modification to an existing model; changes in assumptions that, when used in the model, result in significant differences in Capital Adequacy Requirements versus prior assumptions; a change in organizational structure that affects the model usage and capital calculation; and new products with features or options that significantly differ from the currently modeled portfolio. 145 Any material modifications to the model will require FSB review and concurrence. Depending on the nature of the changes, a new approval may be required. Issued for industry comments 32

146 If an insurer is applying for the use of a Certified Model, it should outline its strategy and time frame in progressing to an Internal Model. The application should demonstrate to the satisfaction of the Regulator that the insurer is not engaging in a cherry picking exercise that can potentially leave the insurer under-capitalised. 147 Once an insurer has commenced using the model for the measurement of its CAR, the insurer will be required to continue using this method of capital measurement unless: The FSB revokes model approval and directs the insurer to use the Prescribed Model for calculating its CAR; or The insurer seeks and receives approval from the FSB to regress from an Internal Model to the Prescribed Model or a Certified Model or to regress from a Certified Model to the Prescribed Model. 148 The application for approval of a model will be subject to a fee as published in the Government Gazette. Approved Actuary 149 Where an Internal Model or a Certified Model has been used, it is necessary that an actuary be approved as an approved person to assist the short-term insurer in quantifying the insurer s technical liabilities and Capital Adequacy Requirements. However, the final responsibility remains with the Board of the insurer. 150 The Actuarial Society of South Africa (ASSA) must approve the actuary to perform valuations for short-term insurers and the Registrar of Short-term Insurance must approve the ASSA certified actuary to perform valuations for the specific short-term insurer. 151 In the case of a short-term insurer using the Prescribed Model to calculate its Capital Adequacy Requirement, automatic exemption is granted from appointing an approved actuary. 152 The FSB reserves the right to reject and/or to remove an ASSA certified actuary to perform valuations for a specific short-term insurer. Such removal and/or rejection would be substantiated by valid reasons. Issued for industry comments 33

153 A change in the approved actuary for a specific insurer must be approved by the FSB. Certified Models 154 A Certified Model is a medium term temporary solution to assist South African insurers in making the transition from prescribed-formulae-based solvency demonstrations to Internal Model based solvency demonstrations. 155 However, a Certified Model is not: any model used simply to minimise solvency requirements; nor a proxy for an internal model; nor a cherry-picking exercise where insurers select prescribed Capital Adequacy Requirements and Certified Model elements to minimise overall Capital Adequacy Requirements. Relationship with Prescribed Model 156 A Certified Model is an adjustment to the Prescribed Model. It is a tolerable solvency demonstration that is appropriate where the prescribed formulae do not fairly quantify an insurer s risk. 157 It allows consideration of an insurer s individual risk characteristics by applying the insurer s specific risk parameters to the Prescribed Model s structure. 158 The diagram below summarises the certified model framework in the context of the proposed prescribed model s framework: Issued for industry comments 34

Prioritising and selecting business to certify 159 Insurers should prioritise their Certified Model designs according to the sizes (by gross written premium and / or unearned premium provision) of their business classes. Larger classes of business should be certified first. An insurer can model smaller classes first only if the data required for the modeling of larger classes is not available and no reasonable modelling can be done without it. In such cases, the insurer must satisfy the FSB in its application: that the data constraint exists and that it prevents modelling of the larger business class first and that reasonable steps have been taken to possibly model excluded business in the future. 160 To ensure overall sufficiency, developers should make the assumption that, while certifying sections of the business, prescribed requirements for the other sections remain sufficient. Issued for industry comments 35