Session 8: Panel on Liabilities

1. Session 8: Panel on Liabilities Jeffery Yong IAIS Secretariat Regional Training Seminar IAIS-ASSAL San Salvador, 24 November 2010

2. Agenda • Introduction - terminology • International standards • IFRS developments • Examples of valuation methodologies • Summary Session 8: Panel on Liabilities

3. Total balance sheet approach to recognise interdependencies Supervisory assessment of the financial position Public financial reporting Available capital Capital Capital requirement Technical provisions Value of assets for supervisory purposes Risk margin Liabilities Liabilities Best estimate policy obligations Assets Liabilities and capital requirement Financial position Assets Liabilities Session 8: Panel on Liabilities

4. Definitions of key terms BEST ESTIMATE • An estimate that neither overstates or understates the expected outcome. • As a result, it can be considered the estimate that is, in a statistical sense, the mean of the distribution. • Accounting sense - the amount required to compensate a transferee for the risk inherent in a transfer of the liabilities. • Solvency sense - the margin that reflects prudence or a confidence level which, together with the capital requirement in addition to the technical provision, contributes to the overall sufficiency of the solvency assessment regime. • Reflect the level of uncertainty in the calculation of the current estimate. RISK MARGIN Session 8: Panel on Liabilities

5. Technical risk Technical risk = risk associated with the technical/actuarial bases of calculation for premiums and technical provisions as well as risks associated with operating expenses and excessive or uncoordinated growth Session 8: Panel on Liabilities

6. Agenda • Introduction - terminology • International standards • IFRS developments • Examples of valuation methodologies • Summary Session 8: Panel on Liabilities

7. Proposed structure of the new ICPs EXISTING ICPS ICP 18 Risk Assessment and Management ICP 19 Insurance activity ICP 20 Liabilities ICP 21 Investments ICP 22 Derivatives and similar commitments ICP 23 Capital adequacy and solvency NEW ICP STRUCTURE ICP 14 Valuation ICP 15 Investment ICP 16 Enterprise risk management for solvency purposes ICP 17 Capital Adequacy Standard on valuation Standard on investments Standard on ERM for solvency purposes Standard on capital requirements Standard on internal models Guidance on valuation Guidance on investments Guidance on ERM for solvency purposes Guidance on capital requirements Guidance on internal models Session 8: Panel on Liabilities

8. The supervisory authority requires insurers to comply with standards for establishing adequate technical provisions and other liabilities, and making allowance for reinsurance recoverables. Need to be sufficient to meet policy obligations including expenses, options, policyholder bonus, tax etc.. Cover all expected and some unexpected claims and expenses. Based on sound accounting and actuarial principles – methods and assumptions are reliable, objective, transparent and prudent. ICP 20 Liabilities (I) Session 8: Panel on Liabilities

9. The supervisory authority has both the authority and the ability to assess the adequacy of the technical provisions and to require that these provisions be increased, if necessary. Prescribe the procedure and internal control system – data reliability. Review sufficiency through off-site monitoring and on-site inspection. Limit reinsurance recognition based on ultimate collectability and transfer of risk. ICP 20 Liabilities (II) Session 8: Panel on Liabilities

10. Inter-relationship between technical provision and capital requirement Probability Technical provision Capital requirement 1 in 100 years event Losses Current estimate 75% percentile 99% percentile Session 8: Panel on Liabilities

11. Agenda • Introduction - terminology • International standards • IFRS developments • Examples of valuation methodologies • Summary Session 8: Panel on Liabilities

12. IASB exposure draft insurance contracts 97 99 02 Mar 04 May 04 July 2010 Q2 2011 • Present value of fulfilment cashflows • unbiased probability-weighted future cashflows less inflows • discount rate adjusted for time value of money • risk adjustment for uncertainty on amount and timing of future cashflows • Residual margin that eliminates gain at inception • Some of the issues under discussion: • Discount rate – risk-free OR risk-free + liquidity adjustment OR High quality corporate bond yield etc. • Unbundling • Risk adjustment versus composite margin Committee formed Issues Paper Split project Issued IFRS 4 – completed Phase I Discussion Paper Preliminary Views on Insurance Contracts Issued Exposure Draft Insurance Contracts Target date IFRS Session 8: Panel on Liabilities

13. Agenda • Introduction - terminology • International standards • IFRS developments • Examples of valuation methodologies • Summary Session 8: Panel on Liabilities

14. Example – life insurance - gross premium valuation Consider a 2-year regular premium without-profits endowment assurance with sum assured USD10,000 sold to a man aged 25 years old for annual premium of USD500. If he survives to the end of the term, he will receive USD20,000. Acquisition expense is USD100, renewal expense is USD10 and death benefit is payable at the end of the year. Discount @ 5%, Probability of survival 99% Cash inflow Premium USD500 Premium USD500 T=0 T=1 T=2 Acquisition expense USD100 Death benefit USD10,000 Maturity benefit USD20,000 Cash outflow Renewal expense USD10 Death benefit USD10,000 Discount @ 5%, Probability of survival 98%, Probability of death 2% Discount @ 5%, Probability of survival 99%, Probability of death 1% Session 8: Panel on Liabilities

15. Detailed calculation GPV = PV (expected future benefit) + PV (expected future expenses) – PV (expected future premium) PV (expected future benefit) = 10,000 X 0.01 X 1.05^-1 + 10,000 X 0.99 X 0.02 X 1.05 ^-2 + 20,000 X 0.99 X 0.98 X 1.05 ^-2 = 17,874 PV (expected future expenses) = 100 + 10 X 0.99 X 1.05^-1 = 109 PV (expected future premium) = 500 + 500 X 0.99 X 1.05^-1 = 971 Gross premium valuation = 17,874 + 109 – 971 = 17,012 Risk Margin? • If interest rate fell by 1bps, new reserve increase to 17,352 • If mortality decreased by 20%, new reserve increase to 17,064 Session 8: Panel on Liabilities

16. Example – general insurance - basic chain ladder method to value outstanding claims Assumptions: past claims indicative of future trends; first cohort year is fully run-off; weighted average of past claims inflation repeated in future Session 8: Panel on Liabilities

17. Agenda • Introduction - terminology • International standards • IFRS developments • Examples of valuation methodologies • Summary Session 8: Panel on Liabilities

18. Summary of key points • Policy liabilities should be valued appropriately to accord adequate protection to policyholders. • Since the valuations are based on assumptions on future experience, the uncertainties involved should be reflected in the risk margins. • There are different possible approaches to value insurance liabilities. • Technical provisions should be set consistently with regulatory capital requirements. Session 8: Panel on Liabilities

19. Thank you for your attention. Any questions/ comments? jeffery.yong@bis.org www.iaisweb.org Session 8: Panel on Liabilities