Financial Condition Reporting for South African Short Term Insurers

1. Financial Condition Reporting for South African Short Term Insurers Emile Stipp Sam Isaacson 24 November 2005

2. Contents • Background and scope • Overall framework • Insurance capital charge • Investment capital charge • Putting it all together • Reserves • Results • Recommendations • The way forward Financial Condition Reporting for South African Short Term Insurers

3. Background and scope Financial Condition Reporting for South African Short Term Insurers

4. Where it all started • Started at the end of 2001 • Current “one size fits all” approach does not make sense – move to a risk-based approach • Paper presented at ASSA convention in 2002 • Working group discussed initial draft guidelines and made various changes • Tender for recalibration sent out in November 2004, awarded to Deloitte AIS & Insight ABC in March 2005 Financial Condition Reporting for South African Short Term Insurers

5. Terms of reference, reliances and limitations • Deloitte and Insight ABC appointed by FSB to calibrate formulae for Financial Condition Reporting for Short Term Insurance industry in SA • Hence: • Construct formula • In accordance with industry data in STAR returns • And principles of Dynamic Financial Analysis • And recommend new capital requirement for Short Term Industry: the “Industry Calibration” • The main limitations: • Data not contained in STAR returns, particularly in respect of non-proportional reinsurance • Inaccurate data • Held an industry workshop introducing concepts on 11 August • Sent two sets of individual results to each company in South Africa • Had meetings with individual companies, reinsurers, cell captives and Actuarial Society STIC for feedback Financial Condition Reporting for South African Short Term Insurers

6. Terms of reference, reliances and limitations • This is an industry calibration – there will always be “overs and unders” • The question is whether it is more accurate than 25% of net written premium currently required • The model does not guarantee solvency under all circumstances • And individual results for individual companies may be more or less appropriate depending on unique factors • Some companies with specific needs: • Reinsurers • Cell captives • Those operating on behalf of Government, with effective Government guarantees • Selected companies in niche markets • Models could not be calibrated for each of these separately due to: • Lack of homogeneity • Lack of data Financial Condition Reporting for South African Short Term Insurers

7. Overall framework Financial Condition Reporting for South African Short Term Insurers

8. The three models Financial Condition Reporting for South African Short Term Insurers

9. The three models Financial Condition Reporting for South African Short Term Insurers

10. Compared against current model • The above framework is preferable, as the current model does not take into account: • Risks faced by company: classes of business written, size of insurer, combination of classes, details of reinsurance programme, expenses etc • And requires level of capital which is prudent for some and not prudent for others • Advantage of current model: it is simple • We hope that industry calibration will be simple to apply in practice as it can be built into STAR returns • And hence not require companies to apply detailed formulae • And they can test different levels of capital required under different circumstances • Industry calibration is balancing act between: • Greater complexity due to desire to allow for individual circumstances of companies VS • Desire for simplicity Financial Condition Reporting for South African Short Term Insurers

11. Schematic representation of framework Financial Condition Reporting for South African Short Term Insurers

12. Comparisons • The above approach is consistent with international trend towards risk-based capital. Adopted, among others, by: • Australia, USA, UK, Germany, Switzerland, Canada, Holland • Also in line with principles established by International Actuarial Association • And in line with investment capital charge adopted for long term insurers Financial Condition Reporting for South African Short Term Insurers

13. Components of the framework • Capital charge • Insurance capital charge • Investment capital charge • Reserving • Best estimates • Prescribed margins Financial Condition Reporting for South African Short Term Insurers

14. Data • Intensive data cleansing process • Used data from 1075 STAR returns Financial Condition Reporting for South African Short Term Insurers

15. Insurance capital charge Financial Condition Reporting for South African Short Term Insurers

16. Insurance Capital Charge • Two primary investigations of Star return data: • Underwriting risk (ULR) • Reserving risk • Using net ULR and net reserving risk measures • But calibrated to gross written premium (GWP) and gross unearned premium (GUPR) • GWP is estimated for year following date of solvency calculation • And GUPR can be regarded as looking back • building blocks approach • Determined initially for each of the 8 classes of business on a stand-alone basis Financial Condition Reporting for South African Short Term Insurers

17. Insurance Capital Charge Financial Condition Reporting for South African Short Term Insurers

18. Underwriting Risk Reserving Risk DFA Engine Simulation Results Gross Written Premium Gross Unearned Premium Insurance Capital Charge Financial Condition Reporting for South African Short Term Insurers

19. Insurance Capital Charge • We ran model for notional companies and used interpolation to determine results for particular company Financial Condition Reporting for South African Short Term Insurers

20. ULRs - means • For all classes of business, relationship between mean ULR and GEP Financial Condition Reporting for South African Short Term Insurers

21. ULRs – standard deviation • For all classes of business, relationship between std dev ULR and GEP Financial Condition Reporting for South African Short Term Insurers

22. Underwriting cycle • Allowed for implicitly. Evidence of cycle: Financial Condition Reporting for South African Short Term Insurers

23. Reserving risk • Expresses development of claims relative to reserves Financial Condition Reporting for South African Short Term Insurers

24. Reserving risk • Expresses development of claims relative to reserves Financial Condition Reporting for South African Short Term Insurers

25. Required number of simulations in DFA model • Determined for each level of sufficiency – in the end ran 79.2m simulations Financial Condition Reporting for South African Short Term Insurers

26. Stand-alone capital • Gross stand-alone capital – surface at 99.5% sufficiency Financial Condition Reporting for South African Short Term Insurers

27. Diversification and correlation • Allowed for explicitly • And on the basis of data • Writing more than one line of business – reduces capital requirements (diversification effect) • Correlations between lines of business – generally increases capital requirements (correlation effect) • This should discourage companies from “dumping” everything into the Miscellaneous class • Finally, there is allowance for investment return on assets backing liabilities to reduce insurance capital charge Financial Condition Reporting for South African Short Term Insurers

28. Investment capital charge Financial Condition Reporting for South African Short Term Insurers

29. Overview • To allow for fact that assets backing liabilities and capital may decrease in value to such an extent that solvency is threatened • Hence, to the extent that market asset values are subject to variation, additional assets need to be held • We performed this analysis using internationally the recognised Smith Model (TSM) – stochastic asset model calibrated for South African market • For different types of asset, determined additional assets to be held, at different levels of sufficiency • First step is allocation exercise – least risky assets allocated first (cash) • If particular asset “runs out”, allocate from more risky assets • Order of riskiness: Cash, bonds, property, equity, other assets Financial Condition Reporting for South African Short Term Insurers

30. Equity example • Equity factors at different levels of sufficiency: Financial Condition Reporting for South African Short Term Insurers

31. Other risks to allow for? • Operational risk: • Allowed for implicitly • If operational risk can be measured, company should do something about it rather than setting aside additional capital • Unfair to penalise whole industry for operational inefficiencies in some companies by requiring everyone to set aside additional capital for operational risk • Also, did not have sufficient data to make explicit allowance for operational risk Financial Condition Reporting for South African Short Term Insurers

32. Putting it all together Financial Condition Reporting for South African Short Term Insurers

33. Framework • Insurance and Investment Capital Charges are combined recognising that there is some correlation between insurance and investment risks, but not 100% • And capital should be grossed up to allow for type of investments • Allowed for in formula: • But only 50% of g2 allowed for • This is similar to the intended approach in Germany, as it deals with fact that insurance catastrophe may well affect investment market, but investment market crash may have no relation to insurance risks Financial Condition Reporting for South African Short Term Insurers

34. Reserving Financial Condition Reporting for South African Short Term Insurers

35. Liability estimation: IBNR and OCR • IBNR: • Use best estimate • Table determined for companies who do not do own IBNR calcs: • Percentage of claims run off after each year: • OCR: • Companies’ case estimates Financial Condition Reporting for South African Short Term Insurers

36. Liability estimation: Prescribed Margin • Added to IBNR and OCR best estimates • To take up to 75th percentile • Based on formula: • Where: Financial Condition Reporting for South African Short Term Insurers

37. Liability estimation: UPR • Aim is also to have best estimate • But if UPR calculated using 365ths method, already includes margin of prudence given that premium includes profit margin • We have assumed this margin takes us up to 75th percentile • But still need to estimate the implicit margin for giving credit towards total capital requirements… Financial Condition Reporting for South African Short Term Insurers

38. Recap: we have all elements of framework: Financial Condition Reporting for South African Short Term Insurers

39. Results of calibration Financial Condition Reporting for South African Short Term Insurers

40. Overall results: reserves Financial Condition Reporting for South African Short Term Insurers

41. Overall results: reserves • Reserves may be understated for niche insurers and reinsurers – due to longer run-off patterns – inadequate data to calibrate separately for them… Financial Condition Reporting for South African Short Term Insurers

42. Overall results: MCR Financial Condition Reporting for South African Short Term Insurers

43. Overall results: Total Capital Required (MCR + PM) Financial Condition Reporting for South African Short Term Insurers

44. Comparison: different levels of sufficiency Financial Condition Reporting for South African Short Term Insurers

45. Comparison with adjusted shareholders’ assets • Adjustment takes into account prescribed reserving method and a release of the 10% contingency reserve • Only show companies with shortfall – several have adequate capital… Financial Condition Reporting for South African Short Term Insurers

46. Applicability of industry calibration • We believe it should generally be applicable to typical insurers • But with cell captives, does not adequately reflect: • Non-proportional reinsurance (and expenses sometimes included in reinsurance) • Lower risks due to structuring of business: e.g. recapitalisation built into contracts • Very limited data for cell captives • Industry calibration more appropriate to third party rather than first party cells • Recommendation that cell captives submit capital requirements on the basis of a certified model • Extensive consultation with cell captive market still required Financial Condition Reporting for South African Short Term Insurers

47. Applicability of industry calibration • Industry calibration should be applied with care for reinsurers: • Reinsurance business may be more risky / volatile than traditional • Longer tail business due to reporting delays • Format of data in STAR returns not appropriate • Recommendation for reinsurers: • At least reserving calculation on certified model basis, given longer run-off • Modify STAR returns • Impractical to calibrate specifically for them, given small number in SA • Niche insurers: may also not be appropriate depending on nature of business: • E.g. some have different run-off patterns (up to 15 years) • Some have specific arrangements e.g. Government guarantee • For companies in run-off, model may give artificially low result for capital – certified model should apply to capital calculation Financial Condition Reporting for South African Short Term Insurers

48. What level of sufficiency to adopt? • We believe 99.5% level too prudent at the outset – rather build up to it over time… • Allows companies to build up capital, also using investment returns on increasing assets, and gives time to collect more data and test 99.5% level before implementing it finally • Following tables show years of net profit vs capital required at industry level • Imperfect measure, but perhaps gives some indication of when industry should move from 98% to 99% to 99.5% • Also, bear in mind with certified models that companies with most significant shortfall will probably apply to reduce capital requirement Financial Condition Reporting for South African Short Term Insurers

49. What level of sufficiency to adopt? • At 98% level, number of years’ net profit required to build up to capital (e.g. for 55% of market by number of companies and 66% of market by net premium = 0 years): Financial Condition Reporting for South African Short Term Insurers

50. What level of sufficiency to adopt? • After 4 years, 87% of market (by net premium) is at 99% level (if using only net profit) Financial Condition Reporting for South African Short Term Insurers