Feedback on the 2012 thematic review of technical provisions Introduction Background In late 2012 the FSA published a question bank 1 on Solvency II (SII) technical provisions for completion by general and life insurance firms intending to submit an internal model. During 2013 the PRA used the information submitted by life and general insurers to carry out a thematic review of firms approaches to technical provisions. The review was not intended to accept or reject the methods and outputs of firms technical provision calculations, but rather to understand how firms have attempted to meet the SII requirements. This document This document sets out observations from the PRA s thematic review, as well as from the PRA s wider SII review work. Its intention is to provide a summary of how firms are preparing to meet the SII requirements for technical provisions and is not intended to set out the PRA s expectations. The recent general insurance supervisory statement, SS5/14 clarifies the PRA s expectations in some areas of the Solvency II Directive that anticipate the application of supervisory discretion and covers both technical provisions and internal models. The PRA s observations The PRA is providing observations on 11 categories of work that were considered in the thematic review, aspects of which are relevant to all firms subject to Solvency II. 1. Best estimate Reserving and governance processes Some firms were already integrating the process to calculate Solvency II technical provisions into the regular reserving process, and reporting movements in technical provisions to the board. However, the degree of preparedness varied widely and some firms had yet to update their reserving processes and documentation. Probability-weighted average Almost all firms had made an allowance for events that did not feature in the historical data used as the basis for the calculation, but could occur in future (events not in data, or ENID). The approach to this allowance varied, from a simple percentage uplift to a quantification of a range of potential future events. 1 http://webarchive.nationalarchives.gov.uk/20130129031720/http://www.fsa.gov.uk/static/pubs/internation al/technical-provisions-question-bank.pdf
Payments falling due In order to separate premium payments between technical provisions and insurance and intermediaries receivable, it is useful to know the due date of each cashflow. Many firms did not have systems in place to capture this information for the reserving teams. Premium cash-flows for expired risks In some situations for example, where premium is swing- or exposure-rated future premium cash-flows may relate to contracts where the risk has expired, and therefore fall into the claims provision. Some firms had dealt with this issue by allocating future premium cash-flows to individual policies or cohorts of policies. Others had simply allocated all future premiums to the premium provision without explanation of the materiality of this approximation. 2. Assumptions Techniques and Approaches Used Most firms had attempted to justify, when using standard and established actuarial techniques, that such techniques were adequate, appropriate and realistic in the specific context of their risk profile. Some firms have attempted to justify the methods they had selected on the grounds that they are industry standard. Validation of Assumptions Most firms re-evaluated their technical provision assumptions for each reserving or valuation exercise. The frequency varied from quarterly to annually, with some firms commenting that it would be more frequent if there was a material change in the risk profile of the business or of the business environment. Examples of approaches used by firms for the validation of assumptions included: Peer review Dialogue with claims/pricing/reinsurance functions Challenge through risk/reserving committee Third party reviews (both internal and external) Sensitivity, stress and scenario analysis Back testing Actual versus Expected analysis Board sign off of technical provisions Some firms were relying on the long service of employees who have detailed knowledge of the firm and of historical movements to interpret the data, using this knowledge to support the setting of reserves. Others firms were ensuring that a clear record is kept of methods, assumptions and the reasoning supporting expert judgements made. Use of Simplifications All firms used simplifications in the calculation of their technical provisions. Some firms did not justify the simplifications used. Others attempted to demonstrate that simplifications would lead to an accurate assessment of technical provisions, or would not understate the
technical provisions or introduce a material error, and provided plans to identify and collect relevant data to support the use of more appropriate methods in future. 3. Risk mitigation Allocation of outwards reinsurance cash flows The PRA has observed a variety of approaches to allocating outwards reinsurance to lines of business and to allocating reinsurance reinstatement premiums between claim provisions and premium provisions. It was often unclear how adjustments were made to allow for future cash flows relating to settled inwards claims, which fall outside of technical provisions on the Solvency II balance sheet. Consistency of boundaries It was often unclear how firms had adjusted technical provisions, and the wider balance sheet, to recognise future management actions to buy reinsurances to cover unexpired risks. Some firms recognised a cash outflow for the whole outwards premium and made adjustments to the balance sheet to match the costs with the risks covered by the inwards contract boundaries. Others recognised a cash outflow for the whole outwards premium and did not make any further adjustment. Some firms included only a pro-rated outwards premium within their technical provisions. 4. Events not in data (ENID, formerly known as extreme events) Terminology The PRA sets out the terminology it uses for events not in data in supervisory statement SS5/14 Solvency: technical provisions and the use of internal models for general insurance firms. This document should be read in conjunction with SS5/14 and the following excerpt (paragraphs 2.4 and 2.5) is included here for ease of reference. Many firms use reserving methods that project forwards from historical data. On its own, this is unlikely to satisfy the Directive requirement for a probability-weighted average of future cash-flows, since not all possible future cash-flows or the events that cause them may be represented in the data. Although these events are sometimes referred to as binary events or extreme events, such terms suggest that events not found in the data are necessarily extreme or rare. This is not the case, so the PRA prefers to use the term events not in data, or ENID. Methods Some firms were allowing for events not in their historical data by adding a fixed percentage onto their initial result, with little or no justification of the percentage chosen. Other firms assumed that their historical data represented events up to a certain percentile of the distribution, with the quality of the justification varying between firms. Many firms were using a scenario approach, seeing it as an opportunity to better understand the range of events that could impact their technical provisions in future. A number of firms
were using a frequency-severity model, and sought input from a variety of internal experts such as claims handlers, underwriters and pricing teams. Events Examples of events that firms had made an allowance for included: An update to the Ogden tables A significant increase in claims inflation A legislative change A new latent claim type emerging Significant claim events, such as severe natural catastrophes (for premium provisions) 5. Risk margin Most firms were using one of the simplifications 2 set out by Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) 3 in the quantitative impact studies 4 to calculate the risk margin. A few firms used methods 4 or 5, typically providing no explanation of the appropriateness of the underlying assumptions, even for material lines of business. Many firms used method 3, approximating future Solvency Capital Requirements (SCR) by assuming that the SCR runs off in proportion to the best estimate. Some firms using this method made an adjustment to the calculation to better fit it to their risk profile, such as taking the square root of the proportion of best estimate remaining in each year. 6. The role of the Actuarial Function in technical provisions The majority of firms were yet to establish a formal Actuarial Function with the responsibilities it will have under Solvency II. Most firms seemed unclear on the requirements of the Actuarial Function and who should be included in it. Most firms described their Actuarial Function as being composed entirely of actuaries, whilst others included non-actuaries with appropriate skill sets. Some firms had outsourced their Actuarial Function to third parties. 7. Data requirements Most firms had started to consider the Solvency II requirements for technical provisions, with IMAP firms often linking this into work on data for internal models. Whilst some firms had yet to compile a formal data directory, most firms were identifying and documenting limitations in the data and the adjustments made to correct for them. Some firms had also set out plans to address the limitations identified. 2 See TP.5.32 of the QIS5 Technical Specifications: https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/qis/qis5/qis5- technical_specifications_20100706.pdf 3 CEIOPS was replaced by the European Insurance and Occupational Pensions Authority (EIOPA) in January 2011 4 https://eiopa.europa.eu/en/consultations/qis/insurance/quantitative-impact-study-5/index.html
Feedback on firms preparations towards the data requirements for internal models was published by the FSA in September 2012 in a paper titled Solvency II: internal model approval process data review findings 5. 8. Documentation Information Provided Some firms were able to demonstrate the appropriateness of the methodology used to calculate their technical provisions, as well as the applicability and relevance of the methods applied. Many firms clearly explained the assumptions that they had made, but the degree of justification of assumptions varied widely between firms. Recording of expert judgements and decisions taken When justifying expert judgements, examples of details provided included: The person making the expert judgement Relevant expertise or qualifications The basis for the expert judgement, e.g. any presumptions relied upon by the expert What alternative judgements had been considered, and why these were rejected Other firms did not go into this detail, with some firms providing nothing more than a statement that expert judgement had been relied upon. 9. Discounting Risk free discount rates to be used in the calculation of technical provisions will be provided by the European Insurance and Occupational Pensions Authority, EIOPA, for each separate currency. The PRA saw a variety of discount rates being used in the calculation of technical provisions. Most firms used the EIOPA rates directly, or used their Economic Scenario Generator to calculate rates equivalent to EIOPA s. A small number of firms were discounting their technical provisions using discount rates that had no relation to the EIOPA risk free rates. 10. Expenses Going concern Almost all firms were aware that SII technical provisions must be calculated on a going concern basis. However, few firms considered the need to split future expenses between business already written or bound which must be included in the technical provisions and future business. Accordingly, few firms had fully considered the impact of assumed future business volumes on this allocation, or the resulting impact on the level of technical provisions. Inclusion of all expenses It was unclear how firms treated some expenses, in particular how firms treated expenses that do not result in cash-flows. Some firms assumed certain types of expenses had zero value on the grounds of materiality without any explanation of the materiality, whilst others 5 http://www.fsa.gov.uk/static/pubs/international/sii-imap-data-review-09-12.pdf
assumed certain expenses had zero value with no justification at all. Examples of expenses that were often assumed to have zero value without justification included: Staff costs Building maintenance and utilities Investment management costs Justification of simplifications The PRA observed a number of firms making strong simplifying assumptions such as basing future expense inflation on historical claims inflation with little or no justification. 11. Segmentation Currency Split A range of approaches were being used to report technical provisions separately for different currencies. Many firms took the approach of splitting out immaterial currencies after the calculation process, rather than calculating provisions for them separately. Bundled Cover A number of firms had difficulty properly allocating their lines of business to SII lines of business in particular where one policy covers risks belonging to more than one SII line. The main lines of business affected were household, commercial packages, healthcare and motor. Homogeneous Risk Groups Many firms acknowledged the SII requirement to calculate technical provisions using homogeneous risk groups, but few justified their choice of grouping for this purpose, or explained the allocation of these groups to the SII lines of business.