Technical Note – Annuity Risk India

Solvency II

gsinghal@annuityrisk.com — Tue, 08 Aug 2023 07:23:38 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

Solvency II is the latest set of regulatory requirements and risk management standards developed by European Union (EU) that aims to enhance the level of policyholder protection, ensure the long-term stability of the insurance industry, and create a more consistent and risk-sensitive framework for insurance supervision and regulation across the EU.

In 1999, the European Commission introduced a pivotal document titled “The Review of the Overall Financial Position of an Insurance Undertaking”, This marked the initial step towards modernizing the prudential oversight framework in the insurance sector. The subsequent global financial crisis in 2008 underscored the urgency of this endeavour, shedding light on the susceptibility of insurers, alongside banks, to inadequate governance practices. As a response to these evolving challenges, the European Union (EU) meticulously formulated Solvency II. This comprehensive framework is tailored to guide and regulate insurance companies and reinsurers within EU member states, ushering in a new era of stability, resilience, and effective risk governance in the insurance industry.

Solvency II is structured around three main pillars, each serving a specific purpose in the regulatory framework for insurance companies within the European Union. These three pillars

Pillars of Solvency Framework

Solvency II is structured around three main pillars, each serving a specific purpose in the regulatory framework for insurance companies within the European Union. These three pillars are designed to work together to ensure solvency, risk management, and regulatory oversight. Here are the three pillars of Solvency II:

Pillar I: Quantitative Requirements and Capital Adequacy

At its core, Pillar I is the foundation of Solvency II, focusing on the quantitative aspects of insurance regulation. It revolves around determining how much capital an insurance company should hold to safeguard against risks. This is done through two key metrics:

The Minimum Capital Requirement (MCR)
The Solvency Capital Requirement (SCR)

The MCR acts as a safety net, ensuring insurers have a minimum level of capital to remain operational even under adverse scenarios. On the other hand, the SCR is a more dynamic and risk-sensitive measure. It requires insurers to assess and quantify various risks they face, including market, credit, underwriting and operational risks. By calculating their SCR, insurers tailor their capital reserves to their unique risk profiles, ensuring they have an adequate buffer to weather unforeseen challenges.

Pillar II: Supervisory Review Process and Governance

Pillar II shifts the focus from numbers to oversight and governance. It underscores the importance of effective risk management and robust internal governance within insurance companies. The Own Risk and Solvency Assessment (ORSA) is the key concept here, where insurers conduct an in-depth self-assessment of their risk exposure and evaluate their ability to manage those risks.

Moreover, Pillar II emphasizes the need for insurers to establish a strong governance framework. This encompasses clear roles and responsibilities, robust internal controls, and transparent communication channels. Supervisors play a critical role by conducting a comprehensive review of an insurer’s risk management practises and overall governance to ensure they align with regulatory expectations.

Pillar III: Reporting and Disclosure

Pillar III puts transparency and accountability in the spotlight. It requires insurers to disclose detailed information about their financial health, risk management practises, and corportate governance. This information is intended for regulatory authorities, policyholders, and the broader public, fostering market discipline and informed decision-making.

Insurers must provide regular reports to regulatory bodies, shedding light on their financial position and risk exposures. Additionally, they are obliged to make specific information accessible to the public, enhancing market confidence and holding insurers accountable for their actions.

In essence, the three pillars of Solvency II collectively form a robust framework that harmonizes quantitative requirements, effective risk management, and transparent reporting. This synergy enhances the stability and resilience of the insurance industry, safeguarding policyholders and promoting a well-regulated financial landscape.

Annuity Risk India - Life Insurance and Annuity Risk Management
Solvency II

Market Consistent Embedded Value

gsinghal@annuityrisk.com — Sun, 09 Jul 2023 07:23:50 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

MCEV

Market Consistent Embedded Value (MCEV) is a popular method used in the insurance industry that is designed to provide a market-consistent valuation of an insurance company, considering the present value of future cash flows and associated risks.

The definition states MCEV as a way to evaluate the total worth of shareholder’s stake in the covered business. The “covered business” is the core business or segment of the company and it has to be clearly identified and disclosed. It should also include, at the very least, any contracts that are considered long-term insurance business by the local insurance supervisors.

MCEV assesses all insurance products including annuities. Several key factors considered for valuing an annuity portfolio under MCEV include:

Expected cash flows of the annuity contract over its lifetime which includes both premiums and future benefits and expected pay-outs from the insurance company.
Discount rate to reflect the time value of money. It is calculated using both risk-free rates and risk premium to account for specific risks associated with annuities.

Investment returns earned on the assets backing the annuity portfolio.

Expenses and costs associated with administering and managing the annuity portfolio.
Risk and uncertainties associated with annuities such as mortality risk, interest rate risk, and lapsation risk. They are modelled using stochastic techniques to capture the range of possible outcomes and their associated probabilities.

MCEV – methodology

MCEV represents the current value of shareholder’s interest or ownership in the profits that can be distributed from the assets allocated to the covered business, considering an appropriate provision for the risks associated. MCEV is the sum of Free surplus allocated to the covered business, required capital and Value in-force. The value of future new business is excluded in the calculation

MCEV = Free surplus+ Required Capital + Value in-force (VIF)

Free Surplus

It refers to the market value of all excess capital or financial resources available to a company after accounting for its liabilities and obligations related to the covered business. Free surplus is calculated by subtracting the required capital to support the covered business from the market value of assets associated with the covered business that are not allocated to cover liabilities.

Required capital

It refers to the market value of assets associated with the covered business and is required by the regulatory bodies over the liabilities already accounted for covered business. The capital allocated must be greater than or equal to the shareholder’s portion of the required solvency capital determined by the supervisory body and its distribution is restricted.

Value of In-Force covered business (VIF)

The value of in-force covered business (VIF) consists of the following components:

VIF = PVFP-TVFOG-FC-CNHR

Present value of future profits (PVFP) – PVFP is the present value of distributable future profits arising from the in force covered business and is calculated as the cash flows from the in-force business, post-taxation, projected based on the insurance company’s best estimate of persistency, mortality/morbidity rates and expenses. It also includes the value of renewals of in-force business.

Time value of financial options and guarantees (TVFOG) – In MCEV, it is necessary to make allowance for the potential impact of financial options and guarantees within the in-force covered business on future shareholder cash flows. This includes making an allowance for the time value of these options and guarantees. Stochastic techniques backed by methods and assumptions consistent with the capital market valuation of assets are employed to estimate this allowance.

Frictional costs of required capital (FC) – It is the additional cost of taxation and investment management incurred by shareholders for holding assets within the company to back the required capital, as opposed to holding them directly in the market. Frictional costs are independent of non-hedgeable risks.

Cost of residual non-hedgeable risks (CNHR) –cost of non-hedgeable risk represents an allowance or an approximate provision for the uncertainty associated with the best estimate of shareholder cash flows due to non-hedgeable risks. This includes an allowance for risks that may not have been explicitly accounted for in the assessment of PVFP, such as operational risks.

Irrespective of the method employed, it is necessary to present it as a single average charge encompassing all residual non-hedgeable risks. Its determination should involve an internal economic capital model with methods that project profit and loss distributions or employ suitable approximations. The resulting capital should align with a 99.5% confidence level over a one-year period, with consideration for management actions if necessary.

As insurance companies strive for more accurate and comprehensive assessments of their financial position and shareholder value, MCEV provides a valuable framework that aligns with market conditions and incorporates various risk factors. It is this realistic view of presenting the underlying profitability of the company that has made MCEV distinct and popular among other valuation frameworks.

Comparison - MCEV, US GAAP, Statutory Accounting and IFRS 17

Framework	Objective	Approach	Focus
MCEV	To assess the economic value of insurance contracts and analyse profitability of insurance company’s business	Market-consistent valuation methodology – includes market variables and stochastic modelling.	Focus on value drivers of insurance contracts – cash flows, discount rates, expenses, investment returns and risks.
US GAAP	To provide a standardized framework for financial reporting to ensure transparency, comparability and consistency in presenting the financial statements.	Historical cost or amortized cost principles, with fair value measurement applied in specific situations.	Emphasizes adherence to specific accounting rules, including revenue recognition, measurement, and disclosure of insurance contract
Statutory Accounting	Accounting framework prescribed by insurance regulators to report financial statements for regulatory compliance purposes.	Prioritizes solvency and prudential concerns over economic or fair value considerations. Rules may vary by jurisdiction	To ensure financial stability and solvency by establishing specific requirements for capital adequacy, reserve calculations and other regulatory ratios.
IFRS 17	To provide a consistent and comprehensive framework for valuing insurance contracts under international accounting standards.	Principles-based approach emphasizing the use of current and unbiased market variables, future cash flows, and measuring insurance liabilities at a present value.	Focus on providing transparent and comparable financial information about insurance contracts.

Annuity Risk India - Life Insurance and Annuity Risk Management
Market Consistent Embedded Value

Risk Based Capital

gsinghal@annuityrisk.com — Sun, 09 Jul 2023 07:23:19 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

Risk Based Capital : As it applies to life insurers in the US

Is RBC applicable to Indian Life Insurance Companies?

Although, as of this writing (August 2023), Risk Based Capital (RBC) is not yet applicable to Indian life insurers, IRDAI is collecting data from Indian insurers (via QIS1), and making a concerted effort towards implementing RBC in India.

What is RBC and how does it work?

Risk Based Capital simply represents an expected dollar amount of loss that the insurer may suffer due to asset risk (defaults), insurance risk (underwriting losses), interest rate risk (asset-liability mismatch) and other operational risks. The credit risk within the asset portfolio, i.e., risk of default of corporate bonds and loans, is the primary driver of RBC for a life insurer, provided that the insurer is solvent and is operating normally.

Risk Based Capital = Book value x RBC Factor

Let us assume that an insurer holds 100 different high-quality investment-grade bonds (from 100 issuers) each worth Rs. 1 crore book value, and the RBC factor is 1.5%. In that case, the expected loss from defaults can be approximated to be around Rs. 1.5 crores (total). RBC = Rs. 100 crores X 1.5% = Rs. 1.5 crores. So, the RBC for this portfolio is Rs. 1.5 crores.

As is evident, RBC is a formula-based approach where RBC factors play a key role. RBC factors increase with increasing asset concentration (opposite of diversification). The RBC factors are calculated using cash flow analysis and historical default rates. The exact methodology and parameters of calculation (percentile risk, time horizon, size of portfolio, covariance adjustments, etc.) are determined by experts.

RBC factors

How many different RBC factors are available?

Using cash flow testing devised by experts, RBC factors have been determined for most asset classes – such as for different grades of bonds and most types of asset-backed loans, including mortgages, preferred and common stocks, etc. RBC factors are regularly updated. The higher the default risk, the higher will be the RBC factor. For instance, a home loan in good standing may have an RBC factor of just 0.14%, while a defaulted farm loan (non-performing asset) may have an RBC factor of 20%. RBC factors have also been determined for other sources of risk besides asset risk, such as insurance (underwriting) risk (~0.2%), interest rate and market risks (~ 1%-3%), and other business risks (~3%). The RBC factors for the assets are much higher in comparison to these other risks, hence asset portfolio drives much of the RBC calculation.

By applying the prescribed RBC formula to the asset book value and business details, and using the updated RBC factors, RBC calculation becomes (somewhat) straightforward.

Consequences : Regulatory Action

What could happen if the life insurance company’s surplus falls below the prescribed level of RBC?

A life insurer in the US is expected to hold an amount of capital greater than 3 x RBC. If the capital falls below 1.5 x RBC, the regulator will take action. Once RBC is implemented in India, we expect such a situation (of surplus falling below a threshold level of RBC) to automatically trigger a set of interventional events to be overseen by IRDAI.

How can an insurer decrease its RBC requirement?

An insurer can either raise capital or reduce its RBC requirement. It can a) reduce asset risk by replacing low-grade bonds with high-grade (less risky) bonds; b) raise capital by issuing stocks; c) free-up reserves by reinsuring policies; d) redesign policies in order to have lower RBC requirement.

Here at Annuity Risk, we are ready to assist you with assessing the impact of RBC implementation and making all preparations for its future implementation.

Annuity Risk India - Life Insurance and Annuity Risk Management
Risk Based Capital

IFRS 17 for Life Insurers

gsinghal@annuityrisk.com — Thu, 09 Jul 2020 07:23:22 +0000

Annuity Risk India - Life Insurance and Annuity Risk Management

IFRS 17 for Life Insurance Companies in India

IFRS 17 is the new principle-based reporting standard implemented by the International Accounting Standards Board (IASB) for insurance (and reinsurance) contracts. This new standard will warrant dramatic changes in the data management and operational workflows of life and annuity insurance companies.

IFRS17 will change how profit emerges from a book of business, and will accelerate recognition of losses on contracts that are expected to be onerous. In addition, a tremendous amount of new data inputs and experience assumptions will be required. New models, new valuation processes and new visualization setup will be required. Audits will require greater granularity of record-keeping, model validation, and experience monitoring. A holistic revaluation of internal and external risk reports, audit trails, and controls will be required.

Implementation

The most important choices regarding IFRS 17 implementation for life insurance and annuity contracts in India are the level of aggregation, and the accounting policy choices (configurations) related to risk adjustment and contractual service margin. Another key choice will be the model used to calibrate discount curves as per the requirement of market consistency.

At Annuity Risk, we are ready to assist with an end-to-end implementation of IFRS 17 accounting standard, or in any customized capacity. We will work closely with your enterprise risk team and your external auditor to choose the right valuation and accounting approaches that will lead to the best outcomes and timely implementation. Our proprietary analytics allow us to forecast significant financial reporting KPIs, and then track them as we progress through the implementation towards actual metrics. Expected impacts on equity and income patterns, including the effect of derivatives, on regulatory capital and key solvency metrics are tracked at multiple stages, and communicated with all stakeholders and auditors.

At Annuity Risk, we deliver the full IT infrastructure that goes well beyond the requirements of IFRS 17, and allows key decision-makers to extract powerful insights from their financial data. We ensure every calculation is auditable and every batch of analysis is properly stored and archived, preserving the greatest level of granularity possible. Our financial and regulatory reporting templates are designed specifically for the new IFRS 17 data schema while preserving the management’s viewpoints and style of risk management.

Annuity Risk India - Life Insurance and Annuity Risk Management
IFRS 17 for Life Insurers