A Review of the Capital Requirements for Life Insurers in India

1. A Review of the Capital Requirements for Life Insurers in India By Jim Thompson , Raju S, Richard Holloway Presented at the 5th Global Conference of Actuaries - Delhi, February 2003

2. Content • Background • The current situation in India • Developments in other markets • Conclusions and recommendations for India

3. Why Capital/Solvency Margin? • To give the regulator and the policyholder the peace of mind that he will be paid what he has been promised

4. Major risk areas of a life insurance company Life insurance company risk universe Market risk Investment risk Liquidity risk Credit risk Currency risk Mismatch risk Operational risk Expense risk New business risk Insurance risk Group risk Credit risk Regulatory risk Other risks Correlation between risks

5. Internal and external risks – Examples External Internal Bonus structure and policyholders’ expectation of a smoothed return has meant that the fall in investment markets cannot be fully passed on Regulatory issues • Increase compliance costs • Compensation costs from mis-selling (USD20 billion) • Government imposed product pricing (UK) • Increasing solvency requirements (Phase 2) High level of guaranteed investment returns and mismatching as a result of falling investment returns Distributor pressure • Rising costs • Competition from cheaper channels Other guarantees • Annuity options • Surrender values • Benefits on investment-linked contacts Falling investment markets Merger and acquisition activity (Declining value in acquisitions)

6. Common risks that the Indian insurer faces…. • Asset default • Mortality and Morbidity understated • Interest Margin Pricing • Interest Movements • Guarantees given • Business Risks

7. Traditional approaches to determining capital requirements Absolute amount Rs. 50 crores Fixed factors 6% reserve + 0.45% sum at risk Absolute amount with fixed factors MAX[6% reserve + 0.45% sum at risk. Rs. 50 crore] Dynamic solvency testing Solvency testing under prescribed scenarios

8. What is Risk Based Capital A realistic assessment of the capital requirements for the risks being run Risk Based Capital • Varies from company to company • Tends to focus on the key measurable and quantifiable risks • Introduced in many of the more developed markets

9. Content • Background • The current situation in India • Developments in other markets • Conclusions and recommendations for India

10. India – Overview ofsolvency requirements • Typical formula approach • Simplistic and easy to administer • Working solvency margin is 150% of the formula • Minimum solvency requirement of Rs 50 Cr • Solvency margin can be met by Surplus from Policyholder fund and Shareholder fund

11. Valuation of assetsand liabilities • Assets are largely valued as a mixture of book value and market value • No explicit charge for Asset Risk • Certain assets are inadmissible for solvency purposes • Gross premium method for policy reserves with allowance for future bonuses • The policy reserves include some “solvency margins” via the Margins for Adverse Deviations

12. Solvency requirement • Non-linked business: • 4% Reserves + 0.3% Sum at risk • Linked Business: • with guarantees: 2% Reserves + 0.2% Sum at risk • without guarantees: 1% Reserves + 0.3% Sum at risk • Group Business: • premiums guaranteed for not more than one year: 1% Reserves + 0.2% Sum at risk • premiums guaranteed for more than one year: 3% Reserves + 0.3% Sum at risk

13. Solvency requirementfor rider policies Similar treatment for base policies and riders Simplistic example Premium = 1.5 ‰ Reserves = 0.75 ‰ Required solvency margin (RSM) = 3.03 ‰ 150% of RSM = 4.55 ‰

14. Limitations of currentframework • Formula approach for solvency does not vary between companies • Does not differentiate between different mix of business e.g. par and non-par business • Little differentiation between insurers with good and bad investments • No reflection of the specific risks that each company is exposed to. • No allowance for the mismatching

15. Anomalies • Penalizes companies holding stronger reserves by imposing higher solvency requirements • Onerous requirement for pure risk policies e.g. Riders and Group Term policies • Lighter requirement for health insurance (e.g. 4% reserves), which is known to be a riskier business

16. Content • Background • The current situation in India • Developments in other markets • Conclusions and recommendations for India

17. UK – Valuation ofliabilities • Net Premium method with appropriate margins • PRE to provide for appropriate level of RB to emerge, but provision of TB not required • Mortality/Morbidity rates determined by Appointed Actuary • Valuation interest rate reflects yield on existing assets less 2.5% • Resilience Reserves determined on various scenarios • Sufficient to cover prescribed scenarios • Different scenarios for par (3 scenarios) and non-par business (1 scenario)

18. Capital requirement • Single tier capital requirement – Solvency margin • Solvency margin defined as % of SAR and policy reserves • Minimum solvency margin is 800,000 ECU • Assets held at market value/net realisable value • Certain assets are inadmissible for solvency purposes

19. USA – Valuation ofliabilities • Net Premium method with a prescribed minimum basis • Mortality – 1980 CSO • Prescribed dynamic maximum valuation interest rate • Additional cash-flow testing requirement • Asset adequacy using cash-flow testing • Project asset and liability cash flows (excluding new business) under various scenarios

20. Capital requirement • Risk based capital requirement • Minimum capital specified based on company’s size and risk profile • RBC identifies major risk factors with an adjustment for correlation between the various risks:Risk CategoryRBC Regulatory Trigger • Affiliates Risk (C0) >199% No action required • Asset Risk (C1) 150% – 199% Company action • Insurance Risk (C2) 100% – 149% Regulatory action • Interest Rate Risk (C3) 70% – 99% Authorised action • Business Risk (C4) <70% Mandatory control • RBC = f (C0,C1,C2,C3,C4)

21. Canada – Valuation ofliabilities • Gross premium valuation with margins for adverse deviation • Margins represent limited and reasonable level of mis-estimation and deterioration fromexpected experience scenario assumptions • Due regard to PRE (provision for all future bonuses) • Discount rate dependent on existing asset yields • No resilience reserve requirement • All assets are admissible

22. Capital requirement • Risk based capital requirement-Minimum Continuing Capital and Surplus Requirement (MCCSR) • MCCSR determined by applying factors to each of four risk components and adding the results • Risk components of MCCSR and composition of total capital requirement (at year end 1998) were • Asset default risk 50% • Mortality/morbidity/ lapse risk 31% • Interest margin pricing risk 4% • Changes in Interest Rate Environment Risk 15% • Target MCCSR ratio is 150% (however may vary according to individual company risk profile)

23. Australian – Capital AdequacyStandards • Margin on Services Valuation – Gross Premium Basis • Statutory Valuation = BEL + Profit Margin • All assumptions are based on the latest best estimates at the time of valuation – pro active basis

24. Two Tiered level of Capital Adequacy • Solvency Standard • Intended to ensure Solvency of the company • Disclosed in the Financial Statements • Capital Adequate Standard • Intended to ensure financial soundness of the company as and ongoing concern. • Not disclosed in the financial statements

25. Solvency Solvency Requirement Other Liabilities Resilience Reserve Inadmissable Assets Reserve Expense Reserves Capital Adequacy Capital Adequacy Requirement Other Liabilities Resilience Reserves Inadmissable Asset Reserve New Business Reserve Requirements

26. Margins Solvency Capital Adequacy Min. Max. 110% Best Est 110% 140% 120% Best Est 120% 150% 130% Best Est 130% 160% 0.25% 0.5% 2.5% Mortality Disability Critical Illness Investment Linked

27. Investment Assumptions Solvency Capital Adequacy Minimum Maximum Gross Redemption BE – 0.4% BE – 3.0% Yield of a 10 year Govt Security

28. Resilience Reserves The amount that needs to be held before the happening of a prescribed set of changes in the economic environment such that after the changes the company is able to meet the liabilities of the fund

29. Resilience assumptions SolvencyCapital Adequacy 1.25% 0.5%+(0.4xYield) 1.25% 2.5% 1.75% 1.0%+(0.2xYield) 0.6% 1.0% 10% 15% Equity Property Interest Bearing Indexed Bonds Currency

30. Singapore – Valuation ofliabilities • Looking to move to a gross premium basis - basis selected by actuary, having regard to professional guidance (a change from net premium valuation) • A PAD is added to the best estimate liabilities. • Propose risk free rates are used for non-participating business (based on government bonds). • Can significantly increase liability

31. Singapore –Capital requirements • Regulators are proposing a change to the current traditional framework (3% reserves + 0.2 per mille of sum at risk) that is more in line with banking sector, is risk based, flexible and transparent. • New framework will have a fund solvency requirement (for each fund) (‘FSR’), and an overall capital adequacy requirement (‘CAR’).

32. Singapore – Capital requirements • FSR takes in to account liabilities and risks in the form of three components: • LC1 - Liability component (as per valuation with margins) • LC2 - Market, Credit and Mismatching Risk • LC3 - Inadmissible asset risk component • FSR = LC1+LC2+LC3 - Value of liabilities • Capital adequacy such that: • Available capital/Required Capital > Specified minimum

33. Singapore – Fund SolvencyRequirement LC3 Inadmissible Asset Surplus Fund Solvency Requirement LC2 Market, Credit & Mismatching Risk Component PolicyLiability Fair Value of Assets LC1 Liability Component

34. South Africa Capital Adequacy Requirements • Gross Premium Valuation Basis • One level of Capital Adequacy • RBC Approach

35. OCAR OCAR = IOCAR grossed up for the effect of the assumed fall in fair value of the assets backing it OCAR = IOCAR/0.7 if assets in equities assumed to fall 30% OCAR = IOCAR if assets in cash

36. IOCAR IOCAR = Intermediary Ordinary Capital Requirements before taking into account the effect of the assumed falls in fair value of the assets covering it – Resilience scenario

37. Elements of Capital Adequacy IOCAR = a2 + b2 + ci2 + cii2 + ciii2 + d2 + e2 + f2 + g2 + h2 + i2 + j a = Lapse risk b = Surrender risk ci = Mortality Fluctuation cii = Morbidity Fluctuation ciii = Medical Fluctuation d = Annuitant Mortality e = Mortality, Morbidity Medical Assumptions - Capital Adequacy Requirements; (Mortality 5%, Morbidity 10%, Medical 15%) f = Expense Fluctuation (10% last year’s renewal expenses) g = Expense Assumption (policies not valued on a discounted cash flow basis) h = Investment Capital Adequacy Requirement i = Foreign Exchange Risk – 20% Movements j = Any understatement of Liabilities

38. Investment Capital Adequacy Requirements Greater of: • Resilience Capital Adequacy Requirement – volatile market conditions • Worse Investment Return – Investments returns 2% lower than assumed in valuation

39. Resilience Capital Adequacy

40. Country Comparison

41. Capital Requirements Internationally • Move to a Gross Premium valuation and Risk Based Capital Approach. • Margins are generally specified and part of the solvency calculation. • Methodology is based on projections. • Resilience Reserves focus on both assets and liabilities. • Resilience Reserves are related to the level of markets.

42. Content • Background • The current situation in India • Developments in other markets • Conclusions and recommendations for India

43. Conclusions • Solvency is not a big issue for new companies at the moment, but this will change as companies get bigger. • Globally move to Gross Premium Valuation and RBC Solvency • Ensures greater consistency to other financial sectors • Valuation of assets and liabilities consistent • Focuses attention on risk management • Can vary by company. • India has Gross Premium Valuation move to RBC logical

44. Implementation Issues to consider • Technology • How do we get the know how • Phasing in to existing levels of capital • Setting of the risk charges/parameters • Impact on Business • Big workload on the Regulator and Industry

45. Recommendation • IRDA start giving consideration to adopting a RBC approach to solvency in 3 – 5 years • The Regulator should involve the Industry and work together to discuss the implications of moving to an appropriate RBC regime for India

46. Acknowledgements • We take this opportunity to thank all those actuaries and Appointed Actuaries in India who provided us with valuable inputs for this paper. • All the views expressed in this paper are the views of the authors and are not necessarily the views of our employers