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APRA’s GI Capital Requirements: Prescribed Method v Internal Model

APRA’s GI Capital Requirements: Prescribed Method v Internal Model. Christian Sutherland-Wong Actuarial Studies Faculty of Commerce and Economics University of NSW Email: c.s-wong@student.unsw.edu.au Actuarial Studies Symposium, UNSW 14 th November, 2003. Purpose of Study.

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APRA’s GI Capital Requirements: Prescribed Method v Internal Model

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  1. APRA’s GI Capital Requirements:Prescribed Method v Internal Model Christian Sutherland-Wong Actuarial Studies Faculty of Commerce and Economics University of NSW Email: c.s-wong@student.unsw.edu.au Actuarial Studies Symposium, UNSW 14th November, 2003

  2. Purpose of Study • APRA recently introduced two methods to calculate MCR • Prescribed Method • Internal Model Based (IMB) Method • Aim is to analyse the implications for two key stakeholders • Insurers • APRA

  3. Contents • Background • Data & Methodology • Internal Model • Results • Implications • Further Work

  4. Background • APRA recently updated their GI Prudential Standards • External Developments • Basel II • IAA Insurer Solvency Working Party • NAIC, FSA, Canada • Calculating the MCR • Prescribed Method • IMB Method

  5. Data & Methodology • Data Sources • APRA’s June 2002 GI statistics • Tillinghast and Trowbridge Risk Margins • Allianz, Promina, IAG • Methodology • Model Insurer • 5 Business Lines – Domestic Motor, Household, Fire & ISR, Public Liability and CTP • Large, mature portfolio – 10% market share • Industry Investment Mix • 6000 simulations • Compare capital requirements

  6. Data & Methodology (cont’d) • Methodology • Scenario Analysis • Different Volatility Assumptions • Riskier Investment Portfolio • Short Tail only and Long Tail only • Smaller business size

  7. Economic Model DFA Simulation DFA Output Inflation Insurance Model Internal Model • Prophet DFA model used • Economic Model – The Smith Model (TSM) • Insurance Model • 3 Claims Processes • Attritional Claims, Large Claims, Catastrophe Claims • Superimposed Inflation – Two state Model • Reinsurance – Individual XoL and Catastrophe XoL

  8. Internal Model (cont’d) • Assumptions • Expected Claims (incl. expenses and reins. costs) • Set to provide a 15% after-tax return on capital (capital = 1.5x Prescribed MCR) • Claims Volatility – Tillinghast report • Reinsurance – Maximum Event Retention (MER) set to $15M

  9. Results MCR calculated under IMB Method > MCR calculated under Prescribed Method H0: IMB Method MCR = Prescribed Method MCR HA: IMB Method MCR ≠ Prescribed Method MCR

  10. Results (cont’d)

  11. IMB v Prescribed Capital Allocations 80% IMB 70% Prescribed 60% 50% % Allocated 40% 30% 20% 10% 0% Short Tail Long Tail Results (cont’d) • IMB v Prescribed: Short & Long Tail split • Small difference between IMB and Prescribed Method

  12. Short Tail Allocations Long Tail Allocations 100% 100% 90% Home 80% 80% 70% Home 60% 60% CTP % Of Short Tail Allocated % Long Tail Allocated CTP 50% 40% 40% Motor 30% 20% Public Public 20% Motor Liability 10% Liability 0% 0% IMB Method Prescribed Method IMB Method Prescribed Method Results (cont’d) • IMB v Prescribed: Business line split • Significant differences by business line • Household > Motor under IMB Method • CTP > Public Liability under IMB Method

  13. Results (cont’d) • Scenario Results H0: IMB Method MCR = Prescribed Method MCR HA: IMB Method MCR ≠ Prescribed Method MCR

  14. MCR as % of Original IMB 100% Prescribed 90% 71% 80% 65% 70% 60% 60% % of Original 43% 50% 32% 32% 40% 30% 20% 10% 0% Small Insurer Long Tail Only Short Tail Only Original Scenario Scenario Results (cont’d) • Scenario Results • Trowbridge scenario: IMB << Prescribed • Riskier Asset Mix: Greater increase under IMB ($61.0M v $49.0M) • Other scenarios:

  15. Implications • Dependence on outcome on volatility assumptions • Insurers will choose different methods depending on volatility assumed • Need for greater agreement in the industry • Prescribed Method not necessarily conservative • Even if we believe Trowbridge report, the Tillinghast CVs will be representative of some insurers • APRA may need to address business line capital charges • Increase CVs for household or CTP • Include diversification discounts, concentration charges or charges by business size

  16. Implications (cont’d) • Inadequacy of investment risk charge • Increase charges for risky asset classes (equities) • Include diversification discounts or concentration charges • Lack of an incentive to use the internal model • Lower MCR under Prescribed Method • “Black-box” stigma • Trust in method from financial analysts

  17. Further Work • Results in this study are preliminary and highly dependent on assumption that the MCR calculated by the internal model reflects the actual MCR • Further research: • Consensus on CVs • Different dependence models eg Copulas • Different internal model calibrations

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