A Core Curriculum for Insurance Supervisors. ICP 20: Liabilities. Basic-level Module

Transcription

1 A Core Curriculum for Insurance Supervisors ICP 20: Liabilities Basic-level Module

2 Copyright 2006 International Association of Insurance Supervisors (IAIS). All rights reserved. The material in this module is copyrighted. It may be used for training by competent organizations with permission. Please contact the IAIS to seek permission. The module was prepared by Alan Shar, who has filled a variety of roles in the regulatory environment since joining Canada s Office of the Superintendent of Financial Institutions in Prior to this regulatory role, he acquired broad experience in the insurance industry both in Canada and South Africa, working with insurance companies as well as in the consulting environment. Alan is a fellow of the Canadian Institute of Actuaries (CIA) and the Faculty of Actuaries in Scotland. He has been a member of several CIA committees and has written an Educational Note on C-1 risk. The module was reviewed by Tan Hak Leh and Henry Siegel. Tan Hak Leh is a former insurance regulator from the Monetary Authority of Singapore. Hak Leh was actively involved in developing the new risk-based capital model in Singapore, which was implemented in He is currently a managing director of Great Easter Life the largest life insurance company in Singapore and Malaysia where he is responsible for actuarial and marketing functions. Hak Leh is an actuary with over 15 years experience in the insurance industry. He was a member of the IAIS Solvency Sub-committee from 2000 to Henry Siegel is vice president of the Office of the Chief Actuary of New York Life. He is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries. He has 36 years of experience in actuarial work in the United States, including a two-year residency in Japan, specializing in financial aspects of insurance, including financial reporting and mergers and acquisitions. He is vice chair of the Financial Reporting Committee of the American Academy of Actuaries, a member of the Financial Reporting Section Council of the Society of Actuaries, and presidentelect of the Actuarial Society of Greater New York.

3 Contents About the Core Curriculum v Note to learner vii Pretest xi A. Introduction B. General concepts in determining liabilities C. Specific concepts in determining liabilities for life insurance D. Summary E. References Appendix I. ICP Appendix II. Answer key iii

4 Figures Figure 1. Valuation data files Figure 2. Reconciling valuation results

5 About the Core Curriculum A financially sound insurance sector contributes to economic growth and well-being by supporting the management of risk, allocation of resources, and mobilization of longterm savings. The insurance core principles (ICPs), developed by the International Association of Insurance Supervisors (IAIS), are key international standards relevant for sound financial systems. Effective implementation of the ICPs requires skilled and knowledgeable insurance supervisors. Recognizing this need, the World Bank and the IAIS partnered in 2002 to develop a core curriculum for insurance supervisors. The Core Curriculum Project, funded and supported by various sources, accelerates the learning process of both new and experienced supervisors. The ICPs provide the structure for the core curriculum, which consists of a set of modules that summarize the most relevant aspects of each topic, focus on the practical application of supervisory concepts, and cross-reference existing literature. The core curriculum is designed to help those studying it to: Recognize the risks that arise from insurance operations Know the techniques and tools used by private and public sector professionals Identify, measure, and manage these risks Operate effectively within a supervisory organization Understand the ICPs and other IAIS principles, standards, and guidance Recommend techniques and tools to help a particular jurisdiction observe the ICPs and other IAIS principles, standards, and guidance Identify the constraints and identify and prioritize supervisory techniques and tools to best manage the existing risks in light of these constraints. v

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7 Note to learner Welcome to the ICP 20: Liabilities module. This is a basic-level module on insurance liabilities that does not require specific prior knowledge of this topic. The module should be useful to new insurance supervisors and experienced supervisors who have not dealt extensively with the topic or are simply seeking to refresh and update knowledge. Start by reviewing the objectives below, which will give you an idea of what you will learn as a result of studying the module. Then answer the questions in the pretest to help gauge your prior knowledge of the topic. Proceed to study the module either independently or in a seminar or workshop. The amount of time required for self-study will vary but it is best to address it over a short time, broken into sessions on sections if desired. To help you engage and involve yourself in the topic, we have interspersed the module with a number of questions for you to complete. These exercises are intended to provide a checkpoint from time to time so that you can absorb and understand the material more readily and can apply the material to your local circumstances. You are encouraged to complete each of these exercises before proceeding with the next section of the module. If you are working with others on this module, develop the answers through discussion and cooperative work methods. An answer key is provided in appendix II. As a result of studying the material in this module, you will be able to do the following: 1. Describe the factors that determine the ultimate cost of an insurance risk and explain why the liabilities of an insurer at any given time can only be estimated. vii

8 Insurance Supervision Core Curriculum 2. Describe the cyclic process used in establishing technical provisions, sometimes known as the actuarial control cycle, and explain the importance of analyzing experience and comparing it with the assumptions made. 3. Explain the importance of reliable claims estimates. 4. Explain the concept of discounting. 5. Describe the information processing resources required to analyze data for establishing technical provisions. 6. List the reasons why some jurisdictions require a different basis for establishing technical provisions for supervisory purposes from that used for generating general-purpose financial statements. 7. Explain why reinsurance should be considered in establishing technical provisions and the difficulties that may arise in doing so. 8. Elaborate the steps that can be taken to adjust reinsurance credit. 9. Summarize the requirements of Insurance Core Principle 20. Life insurance 10. Describe the following types of liabilities: a. Claims provision (whether reported or not) b. Provision for unearned premiums c. Equalization provision d. Other liabilities related to life insurance contracts (for example, premium deposits and savings accumulated over the term of with-profit policies) 11. Describe different categories of life insurance products and the risks they generate for insurers and policyholders. 12. Provide examples of embedded options sometimes contained in life insurance products. 13. Define and explain the purpose of the life assurance technical provision. 14. Describe the most commonly used actuarial methods and the types of products for which they are appropriate, including: a. Net premium valuations b. Gross premium valuations c. Accumulation method d. Stochastic methods Non life insurance liabilities will be addressed in a separate module. viii

9 ICP 20: Liabilities 15. List the various actuarial assumptions that are commonly required to establish technical provisions for different products. 16. Explain which actuarial assumptions are generally most significant for each type of product. 17. Describe, in general terms, the process of constructing mortality tables and differentiate types of mortality tables. 18. Assess the informational requirements that support the development of life insurance actuarial assumptions, noting which products require more or less information ix

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11 Pretest Before studying this module on liabilities, answer the following questions. The questions are designed to help you gauge your existing knowledge of this topic. An answer key is presented in appendix II at the end of the module. For each of the following questions, circle the response that is correct or most relevant. 1. An insurer s total technical provisions are adequate if: a. They are equal to all claims that are currently outstanding b. They are sufficient to cover all obligations under all current and future contracts c. Together with future expected premiums on contracts issued and investment income they are sufficient to cover all current claims and future obligations on contracts issued d. They equal the assets of the insurer 2. When technical provisions are determined, the assumptions used: a. Are independent of the insurer s experience b. Are the same from year to year c. Depend on the size of the insurer d. May be prescribed by the regulator, implicitly determined, based on the insurer s experience, or a combination of these approaches xi

12 Insurance Supervision Core Curriculum 3. The intent of Insurance Core Principle 20 is that: a. The supervisory authority must prescribe standards for establishing technical provisions and other liabilities b. The supervisory authority has both the authority and the ability to assess the adequacy of technical provisions and to require that that they be increased if necessary c. An insurer must identify and quantify its existing and anticipated obligations without allowing for reinsurance recoverables d. When establishing sufficient technical provisions, which is the amount set aside on the balance sheet to meet obligations arising out of insurance contracts; administration expenses and taxes are not included in the calculation 4. A suitable valuation method will ensure that: a. An insurer will always be solvent b. A profit will be made each year c. Technical provisions must increase each year d. Underwriting practices do not affect results e. None of the above xii

13 ICP 20: Liabilities Basic-level Module A. Introduction Insurance Core Principle (ICP) 20 relates to both technical provisions and other liabilities. This module focuses on technical provisions, the amount held to cover the obligations that an insurer has as a result of the contracts it has issued. Technical provisions are also known as reserves in some jurisdictions. Because the technical provisions relate to insurance products, the module provides background relevant to the characteristics of an insurance contract. An insurance contract is an economic device that manages risk by combining enough homogeneous exposures into a group to make the losses predictable for the group as a whole. In general, an insurance contract is purchased to protect against economic deprivation from personal or property loss or damage. An insurer plans to sell many contracts 1 covering the same type of risk and having the same overall characteristics. Based on the law of large numbers, the insurer expects to spread the risk by having a pool of participants large enough that the number of actual claims is close to the probable or expected number of claims. With sufficient sales, the insurer can be confident that the premium charged will cover expected claims and expenses and generate a profit because the more exposures to a particular risk, the more closely the actual claims equal the expected claims. If the insurer finds that participation is not widespread enough, reinsurance is normally purchased to spread the risk more widely. Once a group of contracts is sold, its profitability cannot be determined until the last contract has expired and all claims have been reported and settled. The insurer must pay the benefits provided by the policies it has sold and cover the future costs of 1. In the case of group insurance, even one contract could provide coverage to many individuals.

14 Insurance Supervision Core Curriculum running a business. Income will come from future premiums and investment earnings. Technical provisions are the present value of the difference between these future inflows and outflows. Discounting is often applied when calculating the present value. When a balance sheet is prepared for the insurance enterprise (at least once a year), technical provisions are calculated for the contracts in force and for other contracts that were previously in force but for which claims have not yet been fully settled. For shortterm policies (those with contract periods of up to a year), where claims settlements are generally completed promptly, technical provisions tend to be relatively small and consist mainly of unearned premiums and the amount of incurred but not reported claims and claims still waiting settlement less any payments due from reinsurers. 2 Commonly used terms Claims provision is the amount set aside on the balance sheet to meet the total estimated ultimate cost to an insurer of settling all claims arising from events that have occurred up to the end of the reporting period, whether reported or not, less amounts already paid in respect of such claims. Equivalent terms: claims reserve, provision for outstanding claims, total claim liability. Equalization provision is the amount set aside on the balance sheet in compliance with legal or administrative requirements to equalize fluctuations in claims ratios in future years or to provide for special risks. Amounts set aside for specific types of business (such as hail, pollution liability, or credit insurance) are referred to as provisions, and amounts set aside to cover fluctuations of the entire portfolio are referred to as reserves. This item may include catastrophe provisions. Equivalent terms: fluctuation provision, (claims) fluctuation reserve, stabilization reserve. Liability is a debt, responsibility, or an obligation that arises from a contract or from a tort committed. Related terms: technical liabilities, technical provision. Life assurance provisions are the actuarially estimated value of an insurer s liabilities for future benefits payments, including bonuses already declared and excluding the actuarial value of the component of future premiums attributable to meeting those liabilities. Equivalent terms: mathematical provisions, policy liabilities, policy reserves. Policy liabilities are the amount that a life insurance company allocates to fulfill its policy obligations. Policy liabilities are calculated so that, together with future premiums and interest earnings, they will enable the company to pay all future claims. Equivalent terms: life assurance provisions, mathematical provisions, policy reserves In some jurisdictions amounts due from reinsurers may be counted as assets in the balance sheet rather than as reductions in technical provisions.

15 ICP 20: Liabilities Policyholder surplus is the surplus of assets over liabilities, both evaluated in accordance with domestic regulation (either in accordance with rules of public accounting or with special supervisory rules) and taking into account domestic requirements as regards eligible capital element in other words, the amount of capital appropriate to cover the required solvency margin in accordance with domestic law or supervisory regulations. Equivalent terms: actual solvency margin, available solvency, available solvency margin, available surplus capital, eligible capital, free capital, regulatory capital, statutory solvency margin, statutory surplus, total adjusted capital. Provision for unearned premiums is the amount of premiums written that will be allocated to the following financial year or to subsequent financial years. Equivalent term: unearned premium reserve. Related term: provision for unexpired risk. Provision for unexpired risks is the amount, in addition to unearned premiums, set aside to cover risks that will be borne by the insurer after the end of the reporting period. The provision provides for all claims and expenses in connection with insurance contracts in force in excess of the related unearned premiums and any premiums receivable on those contracts. Equivalent term: premium deficiency reserve. Related term: provision for unearned premiums. Provisions are the terms or conditions of an insurance policy. Pure premium is the part of the premium that covers claims and claims adjustment expenses but not other expenses. It is calculated as claims divided by exposure, disregarding any loading for commission, taxes, and expenses. Reinsurance is insurance placed by an underwriter in another company to reduce the amount of the risk assumed under the original insurance. Reinsurance credit risk is the risk that a reinsurer will be unable or unwilling to pay its part of the liabilities or the claims incurred, which can put the insurer s liquidity at risk and even cause its bankruptcy. Reserves are the amount set aside to meet unforeseeable liabilities (that is, an obligation that has not yet materialized) or statutory requirements. Reserves come from shareholders capital or, in the case of mutuals, members contributions and accumulated surplus, and are part of the own funds (in contrast to provisions that support liabilities to parties other than shareholders or other owners). Equivalent terms: appropriated surplus, contingency reserve, segregated surplus. Technical risks are risks that are directly or indirectly associated with the technical or actuarial bases of calculation for premiums and technical provisions in both life insur-

16 Insurance Supervision Core Curriculum ance and non life insurance, as well as risks associated with operating expenses and excessive or uncoordinated growth. Technical risks are a direct result of the type of insurance business transacted, meaning they differ by class of insurance. Technical risks exist due partly to factors that are outside a company s area of business activities and that a company has little influence over. If technical risks materialize, a company may no longer be able to fully meet its guaranteed obligations using the funds established for this purpose because the claims frequency, the claims amounts, or the expenses for administration and settlement are higher than expected. There are two types of technical risks: current risks and special risks. Current risks include: Risk of insufficient tariffs Deviation risk Risk of error Evaluation risk Reinsurance risk Operating expenses risk Risks associated with major or catastrophic losses or accumulation of losses caused by a single event. Special risks include: Risk of excessive or uncoordinated growth, leading to a rapidly increasing claims ratio or an aggravated expense ratio Liquidation risk. Equivalent terms: insurance risk, liability risk. Technical provision is the amount set aside to meet liabilities from insurance contracts, including claims provision (whether reported or not), provision for unearned premiums, provision for unexpired risks, life assurance provision, and other liabilities related to life insurance contracts (such as premium deposits and savings accumulated over the term of with-profit policies). Equivalent terms: technical liabilities, (technical) reserves. Related terms: reserves, liability. Unearned premium is the portion of the original premium for which protection has not yet been provided because the policy has not yet expired. A property and liability insurer (non life insurer) must carry unearned premiums as a liability on its financial statement.

17 ICP 20: Liabilities B. General concepts in determining liabilities Technical provisions What is the purpose of a technical provision? An insurer holds a technical provision to demonstrate that it has sufficient funds to meet its expected obligations. The assets behind the technical provision cover the expected shortfall between outgo (future benefits and expenses) and income (future premiums and investment earnings). Assets in excess of technical provisions and other liabilities (generally referred to as capital) are used to cover obligations resulting from catastrophic events. For a group of policies, the overall technical provision required at the valuation date has three primary components: a. The cost of expected future benefits and expenses when the triggering event for the benefit payment has not occurred, offset by expected future income b. The cost of expected future benefits and expenses when the triggering event has occurred c. Premiums already paid covering exposure to a claim arising after the valuation date. For policies where the triggering event for a claim has not occurred, the insurer holds a technical provision to cover the value of expected future benefits and expenses arising from such policies. The provision is reduced by any future income that may be recognized, such as expected premiums and investment earnings. When the triggering event for the claim occurs, there are two possibilities at the valuation date. First, the insurer may have received notice of a claim, but the claim has not yet been paid. A technical provision would be held to cover the expected cost of these known claims. Second, claims have been incurred on some policies but have not yet been reported to the insurer. These are known as incurred but not reported (IBNR) claims. Based on previous experience and recognizing any aspects of the current environment that could affect IBNR claims, the insurer would hold a technical provision to cover IBNR claims. Some liabilities not linked directly to the contractual sum assured may arise from insurance contracts. They are usually related to funds being held or accumulated on behalf of the policyholder. The insurer holds provisions to cover these liabilities as well. Examples of such liabilities include advance premiums held on deposit and dividends accumulated over the term of with-profit policies. As the duration of contracts and the period over which benefits may be paid increase, calculating technical provisions becomes more complex. When values are not prescribed, the actuary bases the assumptions used to calculate technical provisions on expected future experience and often uses past experience as an indicator of the future.

18 Insurance Supervision Core Curriculum The further into the future, the more challenging it is to make predictions related to the required assumptions and the less reliable past experience is as a predictor of future events. Actuaries are usually expected to err on the conservative side in choosing assumptions, especially for regulatory reporting. For the longest liabilities, regulatory authorities often specify conservative assumptions for all companies. The level of conservatism in calculating technical provisions tends to increase with the duration of the product. The Society of Actuaries (2000, chapter 6) discusses technical provisions further. In addition, it covers other topics addressed in this module, including mortality, reinsurance, and life insurance, and presents concepts and material in a manner that can be readily absorbed. Valuation purpose and assumption choices When determining policy liabilities, the approach used to determine the values assigned to the assumptions varies by jurisdiction. The values may involve: a. Values prescribed by the regulator b. Implicit values, where a single assumption provides for more than a single aspect of experience c. Explicit values for each experience element, typically based on the result of experience studies. Statutory valuations, performed for regulatory reporting purposes, often use implicit values. Readers may wish to focus on the methodology followed in their jurisdiction. Section C s discussion of gross premium valuation, stochastic valuation methods, and cash flow method covers the use of explicit values. General-purpose accounting may not be followed in all statements produced by an insurer. For example, regulatory accounting tends to be more conservative, with the valuation assumptions often prescribed. When a choice can be made, usually no one right way exists for choosing the value of variables used to calculate technical provisions. In addition to past experience, the views of different stakeholders affect the value of variables chosen. Three primary stakeholders with differing views on the technical provisions are policyholders, shareholders of the insurer, and government authorities that collect taxes from the insurer. If choice is permitted, the actuary should be prudent in assigning values to the variables, so that the insurer holds enough funds to meet future obligations to policyholders. This approach would satisfy the needs of policyholders, as well as the supervisory authority, which is interested in the insurer s continuing solvency. By contrast, shareholders prefer releasing the bulk of earnings as they arise rather than holding back a significant portion to cover various future unforeseen contingen-

19 ICP 20: Liabilities cies. And because taxes are generally paid on earnings, tax authorities are interested in maximizing earnings. Higher technical provisions usually reduce earnings, so tax authorities may seek earnings based on the expected values of variables without provisions for adverse deviations. Purpose clearly affects the calculated amount of technical provisions. Valuation assumptions Several variables affect risk and the level of technical provisions required. The rate of claim (or frequency) is a key variable in calculating technical provisions for all insurance policies. Some rates of claim are more predictable than others. For example, mortality experience has been collected and studied over a long time in most developed countries, and for a specific insured population results tend to be reliable, provided that enough policies are sold to each age group (the impact of risks such as war are excluded). Morbidity rates have also been tracked for a long time, and while generally reliable, they vary as economic conditions change, increasing in poor economic times. Morbidity is also affected by other factors, such as advances in medical and diagnosis technology and changes in lifestyle. But some new policy types are subject to claim rates that may be less understood for example, critical illness contracts that make payments for specific illnesses, such as cancer. Also, insurers may institute new underwriting procedures whose effects on mortality experience are untested. Some risks are two-tiered. A claim is triggered when the insured event occurs, but the amount of the claim payment (and duration of payment, if applicable) depends on the level of damage or incapacitation and on the chance of recovery. Some payments may continue over an extended period for example, disability payments or the actual level of damage may not be recognized or finalized for some time for example, non life insurance claims resulting from asbestos exposure, where court decisions may significantly alter the cost of the claim. This second tier is referred to as severity. Other variables that can factor into the calculation of technical provisions depend on the policies being valued. Such variables include the future yield on assets supporting liabilities (recognizing the expected default rate of such assets), lapse rates, expenses, level of premium paid (in variable premium products such as universal life), rate of exercising embedded options, and the future rate of inflation. The variable s significance depends on the nature and expected duration of the contract. For example, inflation normally has a negligible influence on expenses over one year but a larger influence over an extended period of time. An increase in the values assigned to the variables often but not always raises the technical provisions required. A higher discount rate lowers the technical provisions, as does higher mortality for an annuity product. Some products are lapse-supported, meaning that the profits expected on policies that lapse before cash values are required

20 Insurance Supervision Core Curriculum to be paid under the contract terms are recognized when setting the premiums, which makes them lower. As a result, for lapse-supported business a drop in the lapse rate assumptions increases the technical provisions. For some lapse-supported products that lack cash values at any duration, actual lapse rates have been much lower than assumed lapse rates, resulting in unexpected losses on the policy group over time. Experience studies Experience studies should be conducted regularly to determine the values assigned to specific variables, such as rates of mortality particularly when using explicit methods of valuation. The cyclic process (or actuarial control cycle) followed when calculating technical provisions begins with analyzing actual experience over the most recent period, comparing it with the experience expected over the period, and reviewing trends in experience. The claims rate is a key variable affecting the level of technical provisions. Technical provisions should be appropriate and neither far more than needed nor inadequate to satisfy future needs. Insurers gather statistics on policies sold, such as rates of claim. Small insurers use the results of large experience studies (for example, intercompany mortality experience studies conducted by various actuarial organizations) because their own experience may not be reliable. But when an insurer s block of policies is large enough, an analysis of its claims may reveal reliable and valid claim rates for those policies. Trends in claim rates would also be reviewed. Such an analysis is known as an experience study. If the factors affecting claims are expected to continue in the future, experience study results could be used in calculating technical provisions, assuming that past experience is a reliable indicator of future experience. But future events could have a dramatic impact on claim rates. The reliability of experience studies depends somewhat on the nature of the variable. For example, with non life insurance, large property claims in the previous year as a result of an earthquake may not be a good indicator of the level of property claims in the coming year. Mortality Mortality is discussed in detail here to illustrate the complexity of the variables that affect technical provisions. The mortality rate for insured people tends to be lower than for the population at large, since underwriting excludes some people with known serious illnesses. Because insured people have sufficient discretionary income to purchase insurance, they are also more likely to better provide for their physical and mental wellbeing. Insurance mortality statistics in developed markets usually cover a large popula-

21 ICP 20: Liabilities tion and have been studied for many years. Much attention has been paid to the subtle nuances that can affect mortality rates, such as policyholder behavior, occupation, and geographic location. For example, nonsmokers have lower mortality rates than smokers, working conditions in a mine are more dangerous than those in an office, and some diseases are limited to specific climatic zones. Also, annuitants tend to have lower mortality rates than people who purchase life insurance. Since annuity payments usually cease on death, people are unlikely to buy an annuity unless they believe that they will live long enough to receive enough payments to earn a reasonable return on the money invested with the insurer. Insurers often use mortality rates that have been calculated on a select and ultimate basis. When a new life insurance policy is underwritten, information is gathered on the insured s health so that an informed assessment of expected mortality can be made at the issue date. A new policyholder in good health would have less risk of dying in the next year than the general insured population of the same age would, since the current state of health for most of the general insured population of the same age would not be known. Select mortality is the policyholder s expected mortality when the policy is issued. As time passes, less is known about that policyholder s current health. Once the policy has been in force for a few years (from 5 to 25 years depending on the type of policy, the effectiveness of the underwriting, and other variables), the policyholder s expected mortality becomes more similar to that of other policyholders of the same age whose policies have also been in force for several years. This is known as ultimate mortality. Ultimate mortality rates are higher than select mortality rates for people of the same age. Actuaries develop mortality tables that recognize the complex interaction of these factors. When select and ultimate mortality assumptions are used in a valuation, the date of birth of the policyholder as well as the date the policy was last underwritten will be required. While mortality has been improving in many parts of the world, actuaries are expected to use prudent mortality assumptions that ignore this trend when calculating technical provisions for life insurance. However, when valuing annuities, it is prudent to recognize improving mortality, since annuity payments would then be expected to be made for a longer period of time, which requires a higher technical provision. Fluctuations in experience The results of experience studies serve as a basis for the values assigned to variables used to calculate technical provisions. Experience studies produce average or expected values that fluctuate, with the frequency and extent of fluctuation depending on the type of variable. The mortality rate of a large group of policyholders will generally not deviate far from expected values. But the intensity and location of future storms are much harder to predict, so future claim rates for storm damage may vary widely. Therefore, it is prudent to allow for fluctuations when determining the values assigned to variables. Such allowance may be made on an explicit basis, starting with the

22 Insurance Supervision Core Curriculum expected values and adjusting them to provide for adverse deviations, or on an implicit basis, assigning values based on conservative assumptions without considering every factor that could cause fluctuations. An implicit basis may not establish separate values for some variables, which may instead be accounted for by using conservative values for other variables. For example, the discount rate used may be well below the insurer s expected interest rates, and that difference may be assumed to address the impact of expenses and future inflation. The regulator may prescribe implicit valuation assumptions for technical provisions. Experience studies are also conducted on other variables, such as lapse rates and expenses. When the results of an experience study are factored into expense assumptions in the valuation, the impact of anticipated future inflation on expenses is also allowed for. Experience studies usually use a calendar year as a reference period. However, the manner in which the results are applied to the valuation assumptions varies. For some variables, such as mortality rates, the results may be averaged over several years to account for short-term volatility or to moderate an apparent trend. Expenses are an exception: the results of the most recent study should be used. To be prudent, anticipated future improvements that lower technical provisions are not normally incorporated in the assumptions until they actually occur. Past experience is also used as a predictor of future incurred but not reported claims and the technical provision required for them. Essential criterion b. of ICP 20 states: The supervisory authority prescribes or agrees to standards for establishing technical provisions and other liabilities. Essential criterion d. of ICP 20 states: The supervisory authority reviews the sufficiency of the technical provisions through off-site monitoring and on-site inspection. Essential criterion e. of ICP 20 states: The supervisory authority requires the technical provisions to be increased if they are not sufficient. In jurisdictions that use an explicit valuation basis, experience studies are an important component in the development and sufficiency of technical provisions. Items of interest to the supervisory authority include: How often experience studies are conducted What experience studies are undertaken Any changes in how the results of experience studies are recognized in the valuation How closely the results of experience studies are followed in the valuation assumptions used How expected future improvements or deteriorations in experience are treated. 10

23 ICP 20: Liabilities Premiums and the term of the contract There are four main types of premiums: yearly renewable, adjustable, fixed level, and single. Two aspects of a contract s duration affect technical provisions. One is how long the contract remains in force if premiums are paid when due. The other is how long it takes to settle all claims due on the contract. Non life insurance is usually sold with yearly renewable premiums (as is some life insurance, such as group insurance) that are reassessed each year according to the risk experience and expenses of the product grouping. For these policies, technical provisions address unresolved claims mostly. Life insurance contracts typically have guaranteed premiums and are in force for a long time. Technical provisions for life insurance generally relate to claims that have not yet happened. With adjustable premium products a policy is sold with a defined premium in force for a period of time, with an option to adjust the premium periodically if the experience changes. In this type of contract there tends to be a short-term buildup of technical provisions over the period the premium is guaranteed. Fixed-level premiums have a fixed premium for the life of the contract. They often cover long-term mortality and morbidity risks, such as whole life insurance and longterm disability, which increase over the term of the policy. Initially the level premium is more than sufficient to cover risk during the year, but over time it becomes inadequate. As a result, technical provisions are built up in the early period and released to cover the shortfalls in the later period. Single premiums are commonly used for annuity products and are sometimes used for life insurance and certain non life insurance products, such as creditor default coverage. For annuities in the accumulation phase technical provisions increase with time, while for annuities in the payout phase technical provisions decrease with time. The technical provisions on single premium whole life insurance increase over the term of the policy, while those on non life insurance products decrease over the term of the policy. Claims made on a contract may be settled quickly or can take years to settle. An example of a quick settlement is a claim payable on death, when the death is reported immediately, appropriate proof of death of the insured is provided, and all terms of the contract are satisfied. By contrast, workers compensation claims for asbestos-related disabilities have taken many years to settle because of extended legal proceedings held to determine the extent of liability. And certain types of benefits, such as disability income and annuity benefits, are designed to be paid out over an extended period of time, sometimes the insured s remaining lifetime. 11

24 Insurance Supervision Core Curriculum Blocks of business From time to time insurers develop new products not surprising, as insurers generally operate in a competitive marketplace. Products have to keep pace with changing economic, market, and environmental conditions. As long as the terms and conditions of a product remain unchanged, all policies sold with those terms and conditions to the same population group are valued together. This grouping is known as a block of business. When terms and conditions are altered in a manner that requires a change to the valuation methodology or assumptions, policies sold after the alteration are treated as a new block of business. An example of such an alteration is to allow policies a cash surrender value after 5 years instead of 10 years. If policies with the same terms and conditions are sold in two geographic areas where the experience is different, the policies sold in each area would be treated as two separate blocks of business. For example, since property insurance sold in a hurricane belt would be valued differently from the same class of insurance provided in an area where there was no exposure to hurricanes, the two groups of policies would be treated as separate blocks of business. The number of blocks of business can be large particularly for insurers that have sold long-term policies for a number of years and managing them adds to the complexity of the information processing requirements, the experience analysis, and the overall calculation of technical provisions. In this situation more focus is given to material blocks of business. If technical provisions for small blocks of business are calculated using approximate methods, a conservative approach is warranted given the limited pool of policies and lack of reliable experience. How would the existence of a large number of blocks of business affect a review of technical provisions? Discounting A technical provision is commonly calculated by taking into account the sum of money that would have to be invested now at an assumed rate of interest to meet an obligation at a specified future date. (In reality the calculation is more complicated, as future premiums and expenses have to be taken into account.) This process of taking into account future investment returns is known as discounting. Discounting recognizes the time value of money: that the amount of securely invested money will grow over time. In other words, the technical provision is based on the present value of the future obli- 12

25 ICP 20: Liabilities gation. As a result, less money is required to be held now than the face value of future obligations. The longer the duration of the contract, the greater the impact of discounting. As interest rates change, the present value changes: the higher the interest rate, the lower the present value. The discount rate used to calculate a technical provision may be prescribed by law or regulation or be based on the projected interest rate (net of investment expenses and defaults) to be earned in the future. If actual interest rates and the timing of the benefit obligation differ from the assumptions, the technical provision may be larger or smaller than ultimately required. Ideally, the cash flows from the assets and future premiums should match the requirements for expenses and expected claims payments. The traditional method for determining the assets needed to cover a technical provision is to discount the future cash flows required to meet claims payments and expenses less the cash flows from premiums and investment income; the value of the assets required would equal the total discounted value of the series of net annual cash flows. If explicit discount rates are used, the following considerations apply: a. Interest rates vary with the risk inherent in the investment. b. Investment in government bonds tends to be more secure than investment in bonds issued by a company; however, the yield on government bonds is lower. c. If the discount rate is based on assets held, a downward adjustment may be made to the return on higher risk investments to account for the risk of some investments failing. Alternatively, the valuation assumptions may include specific variables that allow for the risk of asset default. d. There will also be a deduction from the interest rate to allow for investment expenses. The discount rate may vary from year to year. The rate may blend the return expected each year on current assets and future reinvestments, in which case the rate is affected by the assumptions about reinvestment of existing assets as they mature and about investment of new money from premiums and investment income. For example, if reinvestments were made in 10-year government bonds, the return would normally be higher than if reinvestments were made in 1-year government bonds. Margins for adverse deviations The assumptions used to calculate technical provisions come from analyzing experience studies and assessing the impact of future environmental changes on them. Assumptions are based on expected average (or mean) values. Using an explicit approach to valuation, the results of an experience study would be used to set the expected values of variables in the calculations. Average values imply that some values will be larger 13

26 Insurance Supervision Core Curriculum and others will be smaller. Since the reliability of experience studies varies, this must be recognized when calculating technical provisions. Given the complex nature of insured risks and the difficulty inherent in predicting the future, it is prudent to allow for both misestimates of the mean values and variations about the mean values. Thus a margin for adverse deviations (MfAD) may be established, usually by changing the assumptions. The size of the margin is linked to the reliability of the experience study results; less reliability requires a larger margin for adverse deviations. MfADs increase the technical provisions held by the insurer: the increase in the technical provision is referred to as a provision for adverse deviation (PfAD). A common range for the PfAD is 5 20 percent of the technical provision generated using the expected values. Valuation methodology is such that in a year in which actual experience is better than expected, the difference between the technical provision actually used for that year and the technical provision held for experience expected for that year will be released into profit. But poor experience during the year will be a drain on profit. Reinsurance may be used to control volatility in results when a pool of business is not large enough to adequately spread the risk. Unearned premiums The due date for payments on an insurance policy premium is based on the date the policy came into effect, which could be any day of the year for a given policy. The calculation of technical provisions occurs at the same point in time for all the policies being valued (for example, as of December 31). Premiums for life insurance policies, such as yearly renewable term and group, and non life insurance policies, such as car and home insurance, are assumed to be paid in advance of the risk being covered and may be paid annually or more frequently. Since premiums are paid in advance, part of the premium already paid may provide coverage after the valuation date. A technical provision is needed to cover the cost of providing such future coverage (benefits plus expenses). For example, if an annual premium of 100 was paid six months before the valuation date and commission of 10 was paid once the premium was received, a net premium of 90 would be available to cover benefits and expenses for the year. At the valuation date, halfway through the policy year, half of the net premium, or 45, would be the unearned premium and held as an unearned premium provision. Sometimes other acquisition expenses are also subtracted from the gross premium when calculating the unearned premium. Unearned premium provisions are generally set up for short-term coverage, such as non life insurance. For long-term products, such as life insurance or long-term health care insurance, the equivalent amount is implicitly captured in the technical provisions. 14

27 ICP 20: Liabilities Equalization provision As indicated in the IAIS glossary, an equalization provision (or claim fluctuation reserve) is the amount set aside on the balance sheet to equalize fluctuations in loss ratios in future years or to provide for special risks. However, in many jurisdictions, accounting standards do not permit such provisions. The International Accounting Standards Board (IASB) believes that equalization provisions are inappropriate, so equalization provisions would not be accepted in countries that comply with IASB standards. Catastrophe and equalization provisions are no longer allowed under IFRS 4 (March 2004) because they go beyond the terms and duration of the current contracts (paragraphs BC87 93). Information processing When technical provisions are calculated, the outcome is subject to operational risk. Inaccurate results could arise through system (software) problems or through human errors. Controls are necessary to validate the results. At the start of the valuation process three data valuation files are usually created (see figure 1). A data file should contain all the data required by the valuation program for every policy (or model point representing a homogeneous group of policies) being valued at the valuation date. A movements file, used for reconciliation purposes, should contain policy data covering all movements (new business, deaths, lapses, surrenders, reinstatements, conversions, and the like) since the previous valuation date. An assumptions file Figure 1. Valuation data files Data file Figure 1. Valuation data files Movements file Assumptions file 15