Solvency Assessment and Management. Summary of Roadmap Responses

Transcription

1 Solvency Assessment and Management Summary of Roadmap Responses AUGUST

2 C O N T A C T D E T A I L S Physical Address: Riverwalk Office Park, Block B 41 Matroosberg Road (Corner Garsfontein and Matroosberg Roads) Ashlea Gardens Extension 6 Menlo Park Pretoria South Africa 0081 Postal Address: P.O. Box Menlo Park 0102 Switchboard: Facsimile: [email protected] (for general queries) [email protected] (for SAM Roadmap related queries) Website: 2

3 Introduction During November 2010 the Financial Services Board (FSB) published a SAM Roadmap. The purpose of the Roadmap was to serve as a concise guide to the new risk-based solvency regime and to assist in preparing for SAM. The Roadmap included 27 questions which were interspersed throughout the document at key junctures to elicit essential information from. The purpose of this document is to provide a summary of the responses to the questions included in the SAM Roadmap. Completion of the questionnaire was voluntary. 81 responses were received from the 191 registered long- and short-term insurance companies 1. Summary of responses Category Number of Responses Total in Industry 1 Percentage Responded Long-Term % Short-Term % Reinsurer % Total % 1 As at 30 November Including Lloyd s Methodology In reporting the responses, where a consolidated response was received for that form part of the same group of companies the same response was allocated to each of the relevant in the group. Respondents were divided into the following categories for reporting the results: Long-term Short-term Re (short-term and long-term re combined) The questions were divided into quantitative and qualitative categories. The quantitative questions are those that required a Yes or No answer (Questions 1-6). The questionnaire allowed for more details to be added, which were generally disregarded if an explicit Yes or No was given. If no explicit Yes or No was given, a judgment call was made whether the response was closer to a Yes or closer to a No, and allocated accordingly. 1 Throughout this document both and re are referred to collectively as or insurance companies unless a specific distinction is drawn in reporting the responses. 3

4 The qualitative questions are the open-ended questions. (Question 2b, 7-27). For these a summary of responses based on the categories mentioned above are provided. Specific thoughts from the FSB have also been included in the document for each of the qualitative questions. For the quantitative responses, the FSB has provided a consolidated commentary at the end of the feedback from participants. Quantitative Responses Question 1: Have you begun planning for SAM implementation? Category Percentage responded Yes Long-Term 87% Short-Term 95% Reinsurer 100% Question 2a: Have you set an internal deadline to perform a gap analysis to determine the transition requirements to SAM? Category Percentage responded Yes Long-Term 74% Short-Term 72% Reinsurer 100% Question 2b: If so, by when? Category Average Response of those responding Yes Long-Term June 2011 Short-Term July 2011 Reinsurer May 2011 Note: a period of 12 months was awarded if an insurer appeared noncompliant or unprepared. 4

5 Question 3: Have you allowed in your planning of SAM implementation the necessary resources and time to complete the South African Quantitative Impact Studies? It appears that the majority of respondents planned to have completed their SAM gap analysis by mid Category Percentage responded Yes Long-Term 58% Short-Term 70% Reinsurer 57% Question 4: Do you intend applying to use an internal model? Category Percentage responded Yes Long-Term 39% Short-Term 74% Reinsurer 57% Question 5: Have you nominated a champion to drive SAM implementation? Category Percentage responded Yes Long-Term 97% Short-Term 88% Reinsurer 86% Note: It was observed that particularly the smaller companies, and those that were less prepared, tended to nominate their CEO as the SAM driver. 5

6 Question 6: Which of the issues: governance arrangements, capital adequacy, use and approval of internal models do you expect to generate significant additional costs and how do you intend to quantify these costs? Category Long- Term Short- Term Governance Arrangements Percentage responded Yes Capital Adequacy Internal Models 45% 26% 45% 33% 26% 53% Reinsurer 29% 0% 14% Note: One small company mentioned tax as an anticipated additional expense. Other responses regarding additional costs related to Human Resources. In terms of quantifying the costs, many respondents indicated that it was too early to obtain a true estimate of the costs. Some respondents have already incurred costs in early development work, but many have indicated that they are awaiting the outcomes of their gap analyses to assist in quantifying costs. Most respondents who have done some level of quantification have utilised third party providers to do so, while the rest have attempted to estimate required resources and time needed. We are pleased to see the progress that the industry is making towards implementation of SAM, specifically to see the high percentage of respondents who have nominated a SAM champion and have begun the planning journey for SAM. Those that have not completed a SAM gap analysis to date are in danger of falling behind the curve in terms of SAM implementation. A relatively high proportion of respondents have indicated that they may be applying for an internal model. Given the onerous nature of the application process and stringent requirements around the model, the FSB expects that some of those intending to apply may not be in a position to do so immediately, but may end up applying at a later stage. 6

7 Qualitative Responses Long-term Question 7: Where these issues are likely to add to your current regulatory commitments, what do you think the benefits are to and their customers? All were positive about the benefits of SAM to themselves and to their customers. There were no significant differences between the responses of long-term, short-term and re. According to the respondents, SAM will lead to better governance and enhanced risk and capital management by, including optimising the return on capital through better capital allocation. As businesses will be managed within a defined risk appetite, with the insurer holding an adequate level and quality of capital for its particular risk profile, the expectation is that this will lead to enhanced policyholder protection. This will lead to increased levels of confidence amongst investors, policyholders and shareholders leading in turn to improved confidence in the industry. There is a view that SAM could lead to increased overall profitability through better pricing of products. There is also a view that premiums could potentially decrease due to a lower cost of capital. A uniform approach to statutory requirements is valued, as well as the fact that the proposed regime will have international recognition. Third country equivalence will be beneficial for forming part of an internationally active insurance group. The SAM regime should also contribute to increased stability in the financial sector. Transparency through new reporting requirements was also valued. However, some respondents raised some potential disadvantages. These related mainly to concerns about the increased cost of regulation and potential increased levels of capital. In contrast to the majority view, some are of the opinion that the new regime will lead to increased premiums and a reduction in earnings. The proposed framework will add to regulatory commitments and reporting and will lead to significant additional work. One respondent was of the view that the new requirements can result in reporting delays and that the SAM framework will have very little, if any, benefit to consumers. A comment emanating from some long-term specifically was that the proposed regime may not be suitable for underwriting pure linked business. 7

8 SAM will bring definite benefits to both the as well as policyholders, as has been acknowledged by the majority of participants. One implication of SAM is that less risky and/or lines of business will require less capital, and hence will generate greater returns on capital and/or result in lower premiums. The converse is true where business is more risky than in the past - it is certainly anticipated that SAM will result in higher regulatory capital requirements for riskier types of insurance business. Regarding concerns raised with respect to the suitability of the regime to pure linked long-term business, the question of whether or not a specific SAM dispensation is required is being actively considered within the SAM project structures. Long-term Short-term Re Question 8: What steps are you taking to develop the appropriate valuation systems to calculate technical provisions under SAM? How is this work linked to the implementation of IFRS Phase 2 standards? Most long-term indicated that they do not anticipate the need to develop a new valuation system and that no big changes are expected. Some are of the opinion that the debates and flux regarding boundary conditions, transitional arrangements and insurance vs. investment allocation has meant that the SAM and IFRS4 Phase 2 projects are being run separately and that there is no link between the two streams. Insurers are concerned that, in certain aspects, Solvency II and IFRS Phase 2 are not currently aligned and are more than likely to remain as such. Most commented that the implications of IFRS4 Phase 2 have not yet been considered. It is too early to judge how the work can be linked since IFRS4 Phase 2 is still in progress and the detail still needs to be finalised. Most short-term indicated that they are spending time on development work as well as efforts to improve the quality and availability of data used to calculate technical provisions. Some short-term indicated that they do not foresee IFRS4 Phase 2 having a material impact on the valuation of their liabilities due to the shortterm nature of the insurance contracts. Re have been developing robust and flexible cash flow models as both valuation bases (SAM technical provisions and IFRS) use best estimate cash flow projections as a starting point. For some re the calculation of technical provisions is centralised at the group level. 8

9 The ability to calculate technical provisions in accordance with the SAM criteria is one of the foundations of Pillar I, and as such those which have not as yet started updating or developing their valuation systems to produce the required provisions will need to do so as soon as possible in order to ensure readiness for the regime as well as to facilitate their participation in future Quantitative Impact Studies (QIS). Long-term Short-term Re Question 9: What steps have you taken to consider whether you have the right quality of capital to meet the capital requirements? Long-term indicated that the majority of solvency capital is in the form of shareholder equity which is classified as Tier 1 capital (i.e. the highest rated form of capital under Solvency II). Some intend to develop capabilities to accurately identify and rank their sources of capital. Another potential step is to perform a gap analysis to identify shortcomings. The majority of short-term have a conservative investment strategy where most of the investment assets are allocated to cash or near cash instruments. As a result they have predominantly Tier 1 capital and no major changes are envisaged. Similar to short-term, the re portfolios are invested conservatively, predominantly in money market instruments and government bonds. Some are closely following the issue of grandfathering of hybrid debt in the European Union. The introduction of capital resource standards is part of the move towards a more risk-based approach to capital. Based on the responses, it seems that most are holding Tier I capital, and these participants will have to ensure that this investment strategy is maintained in order to ensure adequate capital quality. Those with assets falling into Tier II and/or Tier III will have to ensure that their capital strategy provides appropriate coverage of their capital requirements. It is important for to keep up-to-date with developments regarding the classification of different types of capital instruments in the calculation of overall capital resources. 9

10 All Question 10: How do you think could best demonstrate compliance with the Pillar 1 requirements on a continuous basis? There were no significant differences between the responses of long-term, short-term and re to this question. Comments were received that the expression "continuous" needs to be interpreted in a sensible and pragmatic manner. In reality it is not practical to expect that any insurer calculate continuous "real-time" updates to the solvency position - the technological capability (and in particular the data) required is not available. A practical "continuous" monitoring of solvency can be achieved by requiring regular updates on the solvency position at a practical and realistic frequency (e.g. quarterly) and employing approximate techniques (e.g. curve fitting, replicating portfolios) to perform the updates. In general it was felt that compliance would be achieved through processes in all pillars: Compliance can be demonstrated through calculating the MCR plus a suitable margin on a quarterly basis, and the SCR on an annual basis. It was felt that this should be sufficient, unless there is a significant change to the risk profile of the business. There should be detailed commentary on the movements between quarters as well as details of modeling improvements over the period. The insurer then needs to show that the output of the models used to calculate the MCR and SCR are also used for the management and running of the business (i.e. through the use test). The Pillar 1 requirements must be used as the basis for the ORSA process that should take place frequently. In line with the principle of proportionality, an insurer s reporting requirements, aimed at demonstrating compliance with the Pillar 1 (and other) requirements, should be commensurate to the nature, scale and complexity of its risks. The auditors and statutory actuaries should certify compliance with Pillar 1 requirements at regular intervals. The ability to calculate risk-based capital requirements is not only useful for demonstrating compliance, but also in terms of ensuring that management decisions utilise up-to-date risk information. Proportionality is an important concept within the SAM framework, and will aid smaller, lower risk in complying. The role of the statutory actuary is under discussion at the FSB. Question 11: Do you already have a process similar to the ORSA in place? If not, what progress are you making in preparing to develop an ORSA? Insurers submitted a variety of answers. In most cases there has been some progress on various levels towards an ORSA. Most indicated some 10

11 Long-term Short-term Re type of risk management process was taking place, with the intention of formalising the risk management process in order to meet the ORSA requirements. Some long-term, who are part of a banking group, indicated that they had been involved in a process similar to ORSA through their banking group which was helping their preparation for ORSA. The larger long-term insurance groups were generally better prepared for the ORSA than the smaller long-term. For long-term that do not currently have a process similar to ORSA in place, their comments regarding their progress in developing one included performing a gap analysis; formalising, refining and expanding current processes; waiting for further guidance on how the principle of proportionality will be applied to the ORSA and developing an explicit risk strategy and risk appetite limits. Most short-term indicated that they do have an extensive risk matrix in place that is similar to the ORSA, but that this needed to be either developed further or documented better to bring it in line with ORSA. For short-term that do not currently have a process similar to ORSA in place, their comments regarding their progress in developing one included that it will be done as part of the development of their internal model. One shortterm insurer believes the ORSA is much more applicable to third party than to first party. Most re have a number of different processes employed at present which taken together resemble the requirements of the Pillar 2 ORSA. They intend building on what has already been developed and envisage refinements and deepening of their current processes. For re that do not currently have a process similar to ORSA in place, their comments regarding their progress in developing one included that it is still under consideration and that the ORSA requirements are being assessed and will be implemented at the Group level as part of the group Solvency II project. The ORSA, if performed as a collaborative process within an insurer involving senior management and relevant middle management and/or experts, can provide key insights to executives as to the current risks materialising within the business. As such, the ORSA is not only a regulatory requirement, but also provides a useful tool in managing the business in a risk-sensitive manner. All, including those who do not intend to apply for an internal model, should already be taking active steps to develop an ORSA process. 11

12 All Question 12: How do you consider supervisors should respond to a breach of targeted economic capital requirements? There were no significant differences between the responses of long-term, short-term and re on this question. However, this question was interpreted inconsistently as some referred to a breach of the SCR whilst others refer to a breach of the targeted economic capital requirements. Generally, respondents felt that supervisors should engage with the management of an insurer in order to gain a better understanding of the problem and to gain an insight as to how the insurer plans to remedy the situation. The extent, nature and reason for the breach (whether the cause is a once-off event or whether a significant risk of continued deterioration exists) should be considered. The insurer must be able to submit a plan of action on how they intend to rectify the position. Additional reporting requirements should be required until such time that the supervisor is satisfied that the insurer can meet its capital requirement. Most agreed with the Ladder of intervention that was put forward in the SAM roadmap. However, the ladder of intervention should only start at the SCR and the breach of internal economic capital targets should not trigger supervisory intervention, but should simply be observed and monitored. One insurer felt that the FSB should not intervene too frequently or unnecessarily in the affairs of the insurer and that the actions of the FSB should not be of such a nature that they begin to drive company policy and behavior. Definitions of Economic Capital (EC) vary in different organisations, however most definitions relate the capital in some way to the insurer s own assessment of the risks, at the insurer s own defined confidence level. One widely-used definition is that EC is the capital required by a insurer to maintain a targeted credit rating. The FSB would as such take an interest in breaching their EC levels as part of our overall risk-based supervisory process. Question 13: In the event you answered yes to question 4, please indicate both your current level of progress in developing the model and whether you are prepared to make your development work available to the FSB. All respondents indicated that they are generally happy and willing to engage with the FSB to ensure that the ongoing model development reaches the 12

13 Long-term Short-term Re required stage of maturity required before an application is made for approval, provided that the work is not publicly disclosed. For long-term, the various elements of development work underway with respect to components of an internal model are at different stages of maturity. It ranges from that have not yet started with the process to that anticipate shortly carrying out the first dry run of "using" their internal model. Some have done ground work in terms of understanding the risks and have identified the major risks to be modeled. Most of the work done relates to calculations required for PGN104 and PGN110. Although some models are at the starting phase, in general good progress is being made in the short-term industry and some plan to take part in the early pre-application processes. Work needs to be conducted in achieving the desired minimum requirements around data governance, documentation and related business processes. Some models have been in use for some time and have been reviewed by external consultants. Re responses were varied. Whilst some aim to be ready for the preapplication phase and implementation in 2014 others have not progressed very far and intend to draw on work done by their parent companies. The local work is anticipated to largely entail modifying these models to fit their specific market and balance sheet. The development and embedment of an internal model is a significant undertaking, which will take significant time and resources to complete. This is especially true for an internal model to reach the standard required for approval by the FSB for the calculation of regulatory capital. It is important to note the requirement of an independent review as part of the application process 2. Sharing the development work with the FSB, and indeed the information provided along with the early stages of the IMAP (PAQC), will not impact the FSB s level of review of the model, nor should it have an impact on the independent review process. 2 Please refer to the Contents of Application on the SAM site (click here to open) 13

14 All Question 14: To what extent does this description reflect current and planned future internal models? 3 Most indicated that this is an accurate and appropriate description of what they understand an internal model to be and how they would envisage employing it in their business. The future state of internal models is likely to be similar in structure but with further refinements/enhancements to ensure greater compliance with the relevant guidance and directives. The description reflects the fact that an internal model is not just a technical exercise, but a tool to manage risk. Internal models would be preferable for those risks where the standard formula is unlikely to reflect the insurer s specific risk profile. Internal models give flexibility to accurately model their unique risks in situations where the standard formula may give only a high-level view. It is comforting that respondents recognise that an internal model is far from purely a model, but is, as per the definition, a risk management system. All Question 15: SAM is likely to require clear and demonstrable integration between capital measurement systems and capital management. How should demonstrate the link between or integration of their internal model and their risk management framework, in particular to the ORSA? There were no significant differences between the responses of long-term, short-term and re to this question. To demonstrate the link between the capital model and the risk management framework, need to show how the model is embedded in the day-today running of the business (i.e. through the use test). Insurers could demonstrate this link by providing the following to the FSB: documentation, proof that the link has been communicated and practical examples of how the model and the risk management framework have been integrated. The integration of these components allows the supervisor to assess the 3 This question was included in the SAM Roadmap section dealing with Internal Model Development. The description of internal model referred to in the question is the definition used by the International Association of Insurance Supervisors (IAIS), namely: internal model refers to a risk management system developed by an insurer to analyze the overall risk position, to quantify risks and to determine the economic capital required in meeting those risks. An internal model may also be used to determine the insurer s regulatory capital requirements on the basis of the insurer s specific risk profile and the defined level of safety of the solvency regime. 14

15 appropriateness of the model for the risks within the business. ORSA reporting will be the output of this integration process. Insurers must demonstrate how and which decisions were taken using the output of the model. The outputs of the model should contribute towards: the assessment, measurement and management of risks; risk appetite; asset-liability management; capital allocation and optimisation decisions; risk-adjusted pricing and performance measurement; reinsurance strategy; new business strategy; decisions relating to the payment of dividends; target underwriting margins based on allocated capital; and investment strategy. Capital measurement systems should inform the day-to-day management of the entity, to ensure that decision-making takes into account the dynamic risk profile of the organisation. Documentation, communications, and practical examples are all good mechanisms for demonstrating to the FSB how this link has been put into practice. All Long-term Short-term Question 16: Does the use test reflect capital management practice within the industry? If not, how do the use test prescriptions differ from current practice? The general response was that although have capital management processes in place to actively manage their capital, these are not currently formalised and documented as envisaged under the SAM framework. Most long-term felt that although the industry makes efforts to manage its capital, this is not done as rigorously as would be required under the use test. Current practice is less formal, less regular and of a short-term view. Only three indicated that the use test reflects current capital management practice within the industry. The general view was that capital management practices in the short-term insurance industry are not very developed and that there are shortcomings in terms of the inter-linkages between risk management systems and their business decision making. Currently capital is not key to business decision making. The current focus is on profitability rather than capital allocation or return on capital. 15

16 Re Only a few respondents indicated that their internal model is being used extensively with regards to capital management. It was also felt that, as things currently stand, short-term would find it very challenging to demonstrate how capital management practices are integrated into their dayto-day operations. In respect of those re that responded to this question, it was indicated that this issue will be dealt with at group level. The 'Use Test' is a test of whether the model has been incorporated into the day-to-day risk management of the insurer. The principles governing the 'Use Test' are fundamental to the approval of an internal model. Without demonstrating that the model has been used in decision-making, it cannot be approved for quantifying capital needs. The use test furthermore will ensure that risk and capital management practices are more robust, by formalising these processes where they exist. All Long-term Short-term Question 17: What are doing to evaluate and improve data? The insurance industry undertakes continuous reviews on data and it seems that in some cases significant resources have been allocated to improve the quality of data. Many undertook gap analyses to identify information that will be needed in future. Focus areas include data warehousing, data to identify risks and data governance frameworks. Long-term have, in addition to the continuous reviews that are taking place, allocated significant resources to improve the quality of data, with specific focus on automation of processes and improvement of documentation. In some cases the focus is only on data flows as identified within the scope of the internal model. Some of the smaller long-term indicated that additional work on data is not applicable as they do not intend to implement an internal model. For most long-term, regular data quality checks are performed and some have started with gap analyses. Some rely on the statutory actuary to sign-off that the data used is reasonable. One insurer indicated that although they already have good quality data, they are looking to improve data capturing relating to operational risk. Others also indicated that they are redefining reports (and making sure that the necessary data is available to support these reports) and trying to improve data to support effective risk management, albeit not necessarily for the purposes of an internal model. The large short-term are actively addressing data requirements where gaps exist, although it seems that these gaps are not highly prevalent. They are also focusing on data warehousing and data governance frameworks. 16

17 Re Most short-term mentioned that they are constantly refining their data and/or doing regular (e.g. monthly) data reconciliations. There is a drive to perform gap analyses to identify additional information that will be needed in the future. Some mentioned that they are enhancing their systems to store more relevant risk related information. A few small rely on systems implemented in the larger group of companies. In respect of captive and cell captive, respondents reported that analysis is undertaken to ensure that the information received from third parties is valid, accurate and complete. Some are busy implementing either centralised systems or specific requirements regarding the format in which data should be submitted. It is clear that the SAM requirements will raise the expected level of data governance and oversight over third parties responsible for providing data. Although considerable efforts are being made by re, the quantum, quality and availability of data are heavily dependent on other industry players such as brokers, underwriting managers (UMAs) and primary insurance companies. Some are putting processes in place to improve the data they receive, others expect to obtain better data in future (due to the SAM project) whilst others believe that the FSB has a role to play in ensuring the respective practitioners in the industry meet their obligations regarding the provision of quality, accurate data on a timely basis, i.e. requiring specific regulatory provisions to compel the provision of the required data. It is hoped that many of these issues will be addressed through the planned introduction of explicit regulations governing binder agreements. Data quality should be a priority to all, not just those chosing to implement an internal model. Even those that plan to utilise the standard formula will be required to demonstrate that they have adequately identified, measured and managed the risks they are exposed to and understand how this informs an adequate level of capital. They will also need to demonstrate that they have adequately evaluated the extent to which the standard formula is appropriate given their insurer-specific risk profile. In order to do this additional work on data will be necessary. It should be noted that under SAM, sign-off on data quality will become a Board responsibility, informed by the risk management and actuarial control functions. Interestingly, many short-term touched on the issue of ownership of data. The FSB s expectations are that even though certain functions are outsourced, the insurer should always own the data relating to the business that has been underwritten. Many small short-term are dependent on external providers (such as brokers, underwriting managers and administrators) to supply them with data, which adds an additional layer of 17

18 complexity in meeting the proposed SAM regulatory requirements. Many of the issues regarding adequate access to data on the business that has been underwritten have been dealt with in terms of binder regulations, which are expected to be finalised shortly. All Long-term Question 18: What further work (including industry-wide initiatives) might be helpful to improve the completeness of insurer data? Given that one of the aims of SAM is to improve the consistency of treatment of certain risks and enable comparability in the reporting and solvency levels of, many respondents were of the view that industry wide collection and sharing of information, particularly scarce information on rare or tail events, would benefit the industry as a whole. However, some respondents raised a contrary view that industry-wide initiatives (other than marketing initiatives) could prove problematic due to the pending Protection of Private Information Act and restrictions imposed by competition legislation. Particular areas in which respondents felt that (anonymous) industry-wide data may be beneficial included information regarding operational risk (all ) as well as catastrophe risk (short-term ) and correlations between risks (all, but mainly short-term ). The new binder regulations were mentioned as being useful in ensuring that own the data and take responsibility for their portfolios. Historically, much of the available insurer data has been aimed at allowing to determine best-estimate assumptions for the risks captured in their statutory valuation models. Under SAM it will also be very important to have sufficient data to allow to calibrate the stresses and the correlations between stresses used in the internal models for the calculation of the solvency capital requirement. This is complicated by the fact that a lot of the required data is currently either not available or does not exist. To improve on the status quo, many long-term felt that the industry may benefit from an industry-wide collection of (anonymous) historic experience data. Operational risk data is expected to be particularly problematic and there is a view that would benefit from industry-wide sharing of (anonymous) data. Although data relating to market risk is more readily available, some respondents felt that a central collection point for market data (equity returns, yield curves, equity and fixed interest volatilities) would help industry in developing a common understanding of market risks as well as reducing the cost of obtaining such data. Examples of good practice that were mentioned included the European "ORX" or Association of British Insurers ORIX operational risk consortiums, and the UK Actuarial Profession's "Continuous Mortality Investigation Bureau" (CMIB). Other information items considered useful included the cost of implementing the new solvency regime, accurate group risk member data and an industrystandard economic scenario generator. 18

19 Short-term Re Some long-term that operate in a niche market felt that industry-wide data would not directly be useful to them in most circumstances, given the nature of their particular business model. For short-term, important issues included the definition of minimum standards for storage and submission of data on third party systems, the storage of external loss data (including operational risk loss data) and the development of catastrophe modeling in South Africa. There is interest in data sharing initiatives relating to operational risk, catastrophe risk and correlations between risks, but taking into account the differences in underlying policy features of each insurer. It was also mentioned that outsourced administrators should make data available on a frequent basis. There is general support for information sharing platforms (Astute and Stride being mentioned specifically) and developing industry data benchmarks. It was also mentioned by way of a concern that relevant underwriting data is contained in the predominantly intermediary driven data systems currently in use. Re felt that the FSB could work with industry associations like SAIA to develop standardised minimum data requirements to be met by each industry player. Industry-wide data can prove very useful in supplementing own data resources. The FSB acknowledges the potential benefits of the initiatives outlined above, and will engage with industry bodies and professional associations to discuss the feasibility of developing such resources. All Question 19: What further guidance would be useful on good practice in respect of data? As for Question 18, there is broad consensus on the importance of industry data sharing initiatives. This includes industry standards on minimum data requirements, benchmarks and specifications on fields that need to be captured. It was felt that more stringent regulatory requirements were needed with respect of data provision by brokers, administrators and underwriting managers. It was also felt that guidance is needed to specifically address good practice by smaller and medium-size, including how the principle of proportionality can be applied. A minority view was that very little prescriptive guidance should be necessary as this is a competency that is key to the insurance industry; having good data and systems reduces operating costs and can provide a significant competitive advantage and therefore it is hoped that the industry is sufficiently incentivised and self-regulating in this regard. 19

20 Long-term Short-term Most long-term felt that guidance from the FSB regarding best practice, both locally and internationally, will help understand what is required. Guidance is needed on the application of expert judgment in the absence of suitable data to calibrate shocks especially at the tail of the distribution where data is sparse (e.g. in the case of operational risk). The following items regarding further guidance on data were mentioned: developing industry data sharing initiatives (including establishing an industry forum for to share experiences and challenges regarding data); guidance on reconciliation and checks that can be performed; industry standards with respect to the minimum data to be held and reported on; data confidentiality and relevant legislation; fields which should be captured on application forms (to enable consistent data to be compiled for industry data collection schemes and advice regarding anti-discrimination laws) and that must be added to data records; minimum standards for administration systems both in terms of data integrity as well as data protection, administration rights, protection of information and prevention of fraud; and data backup (on- and off-site) and disaster recovery standards. Guidance would be useful in respect of non-policy related data since have not traditionally been involved in that area; for example procedures and techniques for collating data in respect of operational risk. Short-term mentioned that industry data sharing initiatives will be needed. In particular it was mentioned that a sound data governance framework needs to be developed (for example the Data Management Association (DAMA) framework), which should be complied with by all and extended to cover data residing on third party systems. The following items regarding further guidance on data were mentioned: Guidance on minimum data requirements (a code of good practice was also mentioned); standard data quality and data formats; guidance on the volume of data needed for credibility (especially regarding internal models), and when it would be appropriate to give more credibility to expert judgment than to the data; development of industry data benchmarks; more stringent requirements on brokers, administrators and underwriting managers to deliver (re) with the required / requested data; clear and concise guidelines on data criteria expected from companies, depending on whether a standard formula, partial internal model, or full internal model approach is adopted; guidance specifically addressed to smaller and medium on how the principle of proportionality can be applied; guidance on the evaluation of the quality and correctness of data received from third parties; modeling of catastrophes, specific to South Africa; and 20

21 data backup (on- and off-site) and disaster recovery standards. Re Re felt that there should be a statutory prescription of minimum information to be provided and obligations to disclose fundamental changes in an insurer s processing system and to disclose when an insurer changes the service provider(s) it uses. Re mentioned that should be in a position to track whether pricing changes in their portfolio are solely premium related or also due to the impact of coverage and excess changes. It was mentioned that there is an ASISA initiative with the aim of developing standardised templates for reinsurance data, which should assist in determining what data is essential for sound management of business. This will also provide a template for to use when designing data management systems. Finally, it was felt that, subject to relevant privacy requirements, a centralised database that compares basic details such as date of birth, gender, occupation etc. would assist in verifying data and detecting outdated information. The FSB acknowledges the issues pertaining to the management of data. The need for specific guidance from the FSB on this topic will be informed by the relevant SAM structures as well as developments in other regulatory authorities. Long-term Long-term Question 20: Which approaches do use within their capital model? How and why are these approaches used? ( Approaches can be defined or applied at a high level, e.g., stochastic/deterministic) Many use both stochastic and deterministic approaches the stochastic approach being used to reflect the volatile nature of insurance business and the deterministic approach being used in areas where probability distributions are complex or cannot be obtained. Currently most long-term use deterministic approaches although stochastic approaches are also present (as are combinations of stochastic and deterministic approaches). Most indicated that in future a stochastic approach will be used, followed by a deterministic approach and a combination of stochastic and deterministic approaches. The modeling approach is often supplemented by stress and scenario testing. This is done in order to provide additional comfort regarding the distributional assumptions used for capital, given the low probabilities and lack of data when calibrating the model. 21

22 Short-term Re Most short-term are using (often modular) stochastic modeling, with operational risk being based on scenario analysis. Deterministic stress testing is also used. An overwhelming majority of short-term use stochastic methods for capital modeling. A few indicated that they are using deterministic approaches or a combination of stochastic and deterministic approaches. Stochastic modeling is largely based on off-the-shelf capital modeling software. More simplified deterministic approaches are used for certain risks such as operational risk. Some long-term re currently use a scenario-based approach, where stochastically generated stress factors are applied to assumptions and a deterministic projection is run from the stressed assumptions. Choices between stochastic and deterministic models should be made on a case-by-case basis. The FSB would expect that whatever approach is applied to a particular aspect of the overall model, the insurer should have a strong justification for the choice of approach. With off-the-shelf modeling software, it is important that users and decisionmakers considering the output of the model have an understanding of the model mechanics, including weaknesses and limitations. Insurers should avoid a black box scenario when using purchased models, and should remain cognisant of the fact that the insurer and not the third party provider remains responsible for ensuring that the model meets the testing standards required. Stress-testing can be a useful technique to enhance whichever modeling approach is used. Long-term Question 21: Do you consider that there are areas where industry or the profession should be focusing their research capabilities to improve internal models? Please provide examples. Quite a number of technical issues were identified as areas for future research. The most common factors that were highlighted include operational risk, catastrophe risk and correlations especially correlations in extreme events. Long-term identified a number of areas where internal models could benefit from further research: calibration of risk factors and correlations between risks in the extreme scenarios (especially for fat-tailed distributions such as mortality and disability catastrophe risks); 22

23 Short-term non-linearity and dynamic interaction of risks; modeling of management action (i.e. dynamic decision rules); different methodologies that can be used to calculate the solvency capital requirement (e.g. variance-covariance approach vs. copulas vs. curvefitting); quantification of operational risk; counter-cyclical effects; the projection of VaR capital requirements over the lifetime of a book (especially for long-term business); research that seeks to establish the level of realism that can be achieved in modeling a 1 in 200 year (and higher) confidence interval, to assist in placing capital modeling in the industry into context; a review of the Basel II experience of life that were part of banking groups; research regarding replicating portfolios, an appropriate risk free yield curve, stochastic mortality modeling, dependencies between risks, liquidity premium allowances and risk adjusted performance measurements; catastrophe modeling (specifically country specific shocks); credit risk modeling; operational risk modeling; and policyholder behaviour e.g. dynamic modeling of lapses and surrenders. Small long-term suggested that industry players should share their experiences of implementing SAM. The Actuarial Profession could focus on internal models for smaller companies, and what a more cost effective solution or approximate approach might look like. Short-term identified a number of areas where internal models could benefit from further research: catastrophe modeling; asset risk and systemic risk; correlation and diversification risk; modeling reserve risk, in particular the problem of re-reserving at the end of the one year time horizon. This problem may become more complicated when reserve margins are calculated using a cost of capital approach; research on the challenge of calibrating a model up the 1 in 200 year return period having only a few years data; new or emerging risks brought on by climate change and environmental degradation; correlation (and correlation under extreme, stressed conditions) within risk categories and between risk categories; allowing for parameter uncertainty; the loss parameterisation of classes of business with accurate records of extremely low claims incidence over a significant number of years; guidance on operational risk; guidance on pandemic risk; and guidance on how to model credit risk given the lack of historic/experience data in South Africa. 23

24 Re The following factors were mentioned by re: operational risk; catastrophe modeling; credit risk; accumulation risk; tail correlation of demographic and economic assumptions; and policy persistency. There are many areas of internal modeling which may benefit from further research. The FSB supports research initiatives from industry and professional bodies and academic institutions, and would encourage such research. Long-term Question 22: How do you think the FSB should test the adequacy of internal models for example, should we require evidence of peer review, benchmark by industry sector, require external audit review, run benchmark portfolios, or develop our own capital model? What other possibilities do you consider appropriate? The general view of long-term on peer review is that it will be useful and probably add to the credibility of the model, but that it will not necessarily be cost effective or practical. On the other hand, there is almost unanimous support for external peer review from short-term. Participants also agreed that external peer review doesn t need to form part of the external audit process, but could rather be done by any suitably experienced person. Most shared the view that the use of benchmark portfolios is unlikely to provide much insight as it will not reflect the different company specific risk profiles or management practices. Benchmarking may encourage herding behaviour amongst market participants which may detract from the spirit of an internal model which encourages an honest assessment of risks faced. However, benchmarking on non-company specific items could be useful to achieve consistency of assumptions and methods. The general view among long-term is that focus should be placed on requiring to demonstrate how they themselves have taken responsibility for the adequacy of the model and tested it themselves. It was felt that the following should be required by the FSB: thorough review of the use of model results in key business decision making processes; evidence of peer review (internal and/or external this shouldn t be prescribed); evidence of an effective control environment with respect to the models; 24

25 Short-term Re a comparison with the standard formula, with an explanation of any differences; regularly reviewing the results of back-testing the internal model; regularly reviewing the results of profit and loss attribution using the internal model; analysing the impact of running stress scenarios through the internal model; and explaining year-to-year results. There were mixed views regarding a requirement for external review by the external auditors. Some were in favour whilst others felt that it should not be compulsory as it could increase the cost involved. It was felt that it will be difficult for the FSB to develop its own internal model which would remain relevant for all the different risk profiles and management practices of the various. In addition, the use of benchmark portfolios is unlikely to provide much insight as it will not reflect the different company specific risk profiles or management practices. There is also concern about resource constraints at the FSB. Small long-term have mixed views on compulsory peer review. Some suggested that the internal model should be signed-off by an approved statutory actuary. There were also mixed views on benchmarking although most felt that it would only be suitable for items where individual circumstances do not play a major role. Large short-term had a unanimous view that an external review of the model should take place but had mixed views on whether benchmarking would be suitable. There was a view that the FSB should focus on governance, the use test and the ORSA rather than on the finer technical aspects of the internal model. The latter should undergo independent peer review and audit. Small short-term shared the view of the larger ones that an external peer review should be required. There is general support for benchmarking by industry sector but with a concern that benchmarking would fall short for niche (especially if there are no other industry players to compare against). Other points raised include the following: the FSB may want to have a good understanding of software platforms that are used to develop models; differences between the output of the internal model and those of the standard formula should be explained; and the FSB should have appropriate internal expertise to review and evaluate the development and calibration of internal models on an ongoing basis. Re unanimously supported an external peer review although it was mentioned that confidentiality might become an issue. It was also suggested that the FSB should maintain a list of competent entities that can be used for external peer review. 25

26 One respondent suggested that differences in the result from the standard formula compared with the internal model should be explained in relation to a specific benchmark portfolio (where use the same benchmark portfolio). It was recognised however that it would be difficult to create this benchmark portfolio. The FSB is currently developing their review process as well as resources required to conduct the reviews 4. We acknowledge the points raised by participants, and these points will inform our review process. Long-term Short-term Question 23: How do presently carry out profit and loss attribution and how will it be developed toward SAM implementation? Long-term have for some time been performing an analysis of surplus and an analysis of embedded value. Therefore the necessary development work to adopt the SAM framework will be a process of evolution rather than revolution. Extension of existing processes includes the following: performing these analyses on a market value balance sheet (i.e. economic basis); a change in emphasis to focus on return on risk based capital; increasing the frequency with which the attribution is performed; and increasing the granularity of the attribution. Previously there has been no direct requirement to relate the analysis to the drivers of the risk capital. Respondents felt that it would be useful to receive further guidance on the approach required for performing and reporting on profit and loss attribution, with specific emphasis on how the requirements will differ from the current regime. On the other hand, there is much more development work necessary for shortterm. Some are not performing profit and loss attributions at all whilst others will need to expand their current reporting to be more granular, including work to evaluate economic return on capital. In general, profit and loss attribution is currently limited to what is required by international financial reporting standards. It is attributed by major division, business units, source of business or line of business. This will need to be expanded to be more appropriate and more granular. It must be possible to evaluate return on economic capital. 4 Further information on the current developments on the review process can be found on the SAM website under Independent Review Guidelines (click here to open). 26

27 Re Small short-term currently look at underwriting results (focusing on loss ratios and frequency/severity analysis) by line of business and compare budgets (and forecasts) against actual experience. As for their direct counterparts, re writing long-term business perform an analysis of surplus. For short-term reinsurance business, profit and loss distribution is largely attributable to the underwriting result. As improve their data (to comply with SAM) the allocation of underwriting profit and loss to more granular elements of the portfolio will become easier. It is expected that other elements, like expenses, investment return and return on capital will develop as more sophistication is achieved. The ongoing improvement of data in terms of quality and amount will facilitate a more granular calculation. The FSB will consider workings of the Internal Models Task Group when determining the need for specific guidance on the attribution of profits and losses. Long-term Question 24: How do validate internal models currently and to what extent do their processes meet the above indicated criteria? Validation is primarily done by either internal or external peer review and stress testing. Back-testing is already performed by some whilst others indicated that it would be a validation option in future. Most respondents didn t explicitly indicate whether their processes meet the given validation criteria. Those who did, indicated that their current validation methods will need to be expanded; they need to be more formalised and better documented going forward. Long-term currently validate their models using (some of) the following methods: regular experience investigations; back-testing; independent reviews (internal or external); approval by statutory actuary; internal reasonability tests; stress-testing; testing the sensitivity of the model to assumption changes; reconciliation to other published results; analysing the change in capital requirements from one period to another; and using the capital model to perform profit and loss attribution. 27

28 Short-term Re However, the unanimous view is that going forward, the current validation methods will need to be expanded, more formalised and better documented. Short-term currently validate their models using (some of) the following methods: peer review or external validation; stress-testing; back-testing; discussions between the actuarial function, the CRO and the financial director; validation by board committees; review of the on-going appropriateness of the model s specification; analysis of the stability of the internal model; and sensitivity analysis relating to changes in key assumptions. Current peer reviews are performed either internally or by external parties. In some cases the peer review is undertaken by board committees. A rigorous and comprehensive validation process needs to be in place to ensure that the internal model outputs provide accurate capital requirements at a level that should ensure adequate policyholder protection. Given that the internal model will be used to support business decision-making, the insurer will have a vested interest in the validation of the internal model. Insurers intending to use an internal model will need to demonstrate a rigorous validation process as part of their Self Assessment. The rigour of the validation will also give some guidance to the FSB as to the level of review required over the internal model. All Question 25: A simple documentation standard might require that it is extensive enough for the insurer to replicate its model in a different platform and in the absence of original developers. To what extent do already have this in place? There were no significant differences between the responses of long-term, short-term and re to this question. In general the responses indicated that the insurance industry is not prepared in terms of model documentation and that they would not meet the dead man test. The majority of intending to use internal models indicated that their model documentation was a challenge but that it was receiving attention. There was general agreement on the need to have documentation standards and that a documentation policy was important. There was no consensus on the required level of detail of the documentation standards. 28

29 A number of question the need for the excessive documentation standards and the associated cost. The documentation standards were noted as a major reason for using the standardised formula rather than an internal model. A small number of short-term indicated that their internal model has been fully documented and of a sufficient standard to allow replication of the model on a different platform. Some re have put in place internal model documentation for the purpose of satisfying criteria set by offshore regulators. Insurers without this level of documentation run the risk of the dead man scenario referred to in the responses, as well as the risk of the black box effect, whereby a model purchased from an external provider is poorly understood, and as such the outputs thereof cannot be adequately challenged. Thorough documentation mitigates both of these risks. Long-term Question 26: How might ensure that senior executives and the Board of Directors acquire the relevant knowledge to fulfill their duties in respect of model governance? How can this best be demonstrated? Virtually all who responded agreed with the need for the senior executives and the Board of Directors to acquire the relevant knowledge to fulfill their duties in respect of model governance. A large number of noted the importance of having fit and proper boards and some emphasised the importance of the role of Risk and Audit Committee chairpersons. There was a broad consensus amongst that the education process should be continuous, regular and relevant, and that it should be less detailed than the training given to subject matter experts in order to specifically fulfill their duties. Some noted the need for board sub-committees to assume oversight over the education process and that the education should be a mix of internal and external training. A few noted the need for simulated training on internal models and the ORSA, which should practically assist senior executives and the Board of Directors in critically evaluating the assumptions, methodologies and results of models. The alignment of the training to risk, capital, business decisions, sensitivity analysis and how to use models and the limitations of models was also mentioned. Long-term indicated the following means by which senior executives and Boards of Directors could acquire the relevant knowledge to fulfill their duties in respect of model governance: 29

30 Short-term Re regular and appropriate training and discussions on the structure, shortcomings and results of the models and their impact for risk and capital management; ensure that senior executives and the Board of Directors attend workshops conducted by relevant industry bodies, regulators, accounting firms or consultancies; good communication with the Board; technical issues will have to be presented in a clear and easy to understand way in order to engage Board members; clear and concise documentation will help the Board in signing off the models on a regular basis; and regularly expose the Board and senior management to the results obtained from internal models. Demonstration could best be achieved through documentary evidence of the training sessions in the form of minutes, board meetings, agendas, communication and training attendance registers. This could be coupled with Board members personally confirming that they have indeed received such training. Face-to-face interviews with the Board could also be useful in this regard. Short-term indicated the following means by which senior executives and Boards of Directors could acquire the relevant knowledge to fulfill their duties in respect of model governance: regular educational forums and simulated scenarios; the model process, results and updates will be presented to the Board and the Audit Committee as standard agenda items; training and coaching will be provided on an ongoing basis to educate Board members on the internal model and its impact on the business and to ensure that senior management, executives and Board members are empowered to critically evaluate the results, methodology and input assumptions of the internal model; regular exposure to the output and use of the model will familiarise management and directors with its use; and senior management, executives and Board members will need to have a direct working relationship with the internal actuarial function. This enables areas of uncertainty regarding technical modeling and actuarial reports to be debated and discussed as and when the need arises. Annual declarations to the FSB as well as periodic on-site visits by the FSB should demonstrate such knowledge. It may also be demonstrated through the ORSA report, Board minutes and employee records. Re felt that a necessary condition was that fit and proper executives and Board members should be appointed, who have the appropriate qualifications and expertise to fulfil their duties. Sufficient training, both internal and external, will need to be provided to senior executives and the Board. External training should be easily verifiable, and the effectiveness of both internal and external training should be assessed and reported by these executives and Board members on a regular basis. 30

31 Given the requirements for the outputs of the internal model to be used in the decision-making process of the insurer, it is critical that the decision-makers understand the model sufficiently in order to utilise its output for this purpose. The above responses allude to the need for training for the Board regarding model governance. The submission of training material/evidence as well as declarations, on-site visits, the ORSA report etc are all useful suggestions in terms of demonstrating the training and competence. Long-term Question 27: Are there any particular issues or concerns you would like to raise with the FSB? Please provide details. In general not all of the that provided feedback on the other questions responded to this question. A number of long-term raised concerns around the following: the SAM timelines; a view was expressed that they are too ambitious the depth of knowledge, skills and experience available to support SAM not only from the FSB perspective but also from the industry s perspective cost implications relating to the implementation of SAM and the knock-on effect this could have on policyholders the slow progress that is being made by some of the SAM Working Groups data constraints, especially around the number of years of historical data that is available and reliable clarification and more information was requested, and concerns raised, on a number of technical issues around SAM which included the following: in respect of insurance groups supervision under SAM, the possible impact on group solvency requirements of non South African operations that do not follow a risk-based capital regime; how the SAM requirements will be aligned with International Financial Reporting Standards (IFRS); the extensive disclosure requirements; the definition of contract boundaries; the allowance and treatment of negative rand reserves; the impact of the SAM regime on taxation; the need to elaborate on the principle of proportionality; the over-reliance on normal distributions; the role of the Chief Risk Officer versus the role of the Statutory Actuary; the extent to which the SAM framework will differ from Solvency II; and Pillar I capital add-ons. The following recommendations were made with respect to SAM: transitional arrangements should be considered for hybrid instruments; 31

32 Short-term Re internal modeling should not to be required for each risk factor; rather it should only be necessary to model the significant risks, while in respect of less significant risks an approximation should be permitted; the development of a separate regulatory framework for conducting pure linked business only; guidance and experience should also be obtained from non-uk regulators who are implementing Solvency II; and the focus should be on getting the basics right rather than placing too much focus on internal models. Short-term raised the following concerns: the cost and resources implications on the industry in respect of the implementation of SAM the SAM timelines; a view was expressed that they are too ambitious Solvency II is too complex for smaller and transitional arrangements should be considered for smaller the number of regulatory reforms underway, and the speed with which they are being implemented the relevance of the SAM framework for captives and first party cell captives; it was recommended that they be differentiated from the other the implementation of SAM might lead to consolidation in the market and reduced competition. the resources and capacity at the FSB, in particular with respect to internal model review and validation clarification and more information was requested, and concerns raised, on a number of technical issues around SAM which included the following: elaboration on the principle of proportionality; the treatment and recognition of non-proportional reinsurance arrangements; possible reforms to the approved and non-approved principles currently being applied to foreign reinsurance; and the treatment of cash back bonuses going forward. Re raised the following issues: the supervision of insurance groups should be closely aligned with other jurisdictions. the FSB needs to relook at the approved and non-approved reinsurance arrangements currently in place, as well as the possibility of allowing foreign re to operate on a branch basis. The concerns raised by participants have been acknowledged by the FSB, and are under consideration in the relevant SAM project structures (e.g. the SAM Task Groups) and other forums. 32

33 Concluding Remarks The successful implementation of SAM will require much work from both and the FSB. The industry consultative process has thus far proved useful in ensuring that every requirement is carefully thought out and debated, and is applicable to the South African insurance environment. The FSB would like to once again thank all participants for sharing their views, and assisting in shaping regulatory requirements that are relevant and applicable to our insurance market. 33