Risk based capital

Risk Based Capital

Peter Tan President & CEO Manulife Insurance (Thailand) Public Limited Date: 26 May 2006

Solvency Capital

A level of capital provides, amongst other things, a “rainy day fund, so when bad things happen, there is money to cover it�

International Actuarial Association Insurer Solvency Assessment Working Party

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Risks • •

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An insurance company is a risk taker.

A policy holder transfers their risk to the insurance company in exchange for a premium An insurance company manages the risk to bearable levels by; • • • • • • •

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Pooling of independent risks Spreading dependent risks Re-insuring large risks Selecting risks Control process to reduce fraudulent risks Matching assets to liabilities Etc etc

Risks Risk to a life insurance company is therefore the possibility that the company result will NOT equal to the assumptions made by the actuary because of random (stochastic) fluctuations or systematic error in assumption made.

Actuarially speaking, risk is • the possibility E(x) is incorrectly estimated (systematic) •The variance and kurtosis of the risk (spread and skewness)

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Risks Assumption made by Actuary

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Bad things that might happen such that the actuary’s assumption is not met

Mortality Tables

• more deaths than assumed • underlying mortality assumption is no longer correct • epidemics, pandemics • Underwriting control not that good • Fraudulent claims • catastrophe – aggregrated risks • etc

Investment Return

• investment return not met • Asset default • asset cannot be sold due to lack of liquidity • assumed long investment return rate is incorrect • Economic downturn • etc

Risks Assumption made by Actuary

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Bad things that might happen such that the actuary’s assumption is not met

Surrenders/ Lapses

• more or less lapses than assumed • assumed lapses no longer correct • etc

Expenses

• Sales volume/ in-force targets not achieved and therefore assumed expense ratios not achieved • Cost inflation different from assumed • Fraud • Bad cost control • etc

Risks Assumption made by Actuary

Reinsurance

And etc ……

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Bad things that might happen such that the actuary’s assumption is not met

• Re-insurer goes bankrupt and cannot pay re-insured claims • etc

Risks Every company therefore has a different risk profile; • • • • • • •

Products it sells Assets it hold Re-insurers it use Volume/ size Expansion plan, state of growth Cost control Etc

Every company therefore has a different Minimum Capital Requirement

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Minimu m Capital Requirem e nt 99% chance that the company will not require any more than the Minimum Capital Requirement at the end of one year to meet its liabilities and financial obligations

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Evolution ofthe Actuary

Stochastic Modelling Deterministic Modelling Scenario Testing

Commutation Functions Combinatorial Probability Theories 10

Minimu m Capital Requirem e nt

Internal Model Based

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Minimum Risk Based Capital Requirement

Prescribed Method

Internal M o del Based • • • •

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aka Dynamic Financial Analysis aka Monte Carlo Method aka Stochastic Modelling Method Instead of trying to use advanced statistical theories to work out the distribution of possible results of the company, use the sheer power of the computer to simulate hundreds of thousands of possible result scenarios. Use random number generator.

Determine the MCR as the level in which capital will be sufficient 99% (or whatever regulator specify) of the time.

Internal M o del Based •

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Step 1 : Make best estimate assumptions* on all the bases (eg.

Mortality shall be 80% of TMO97) Step 2 : Make assumptions of the distribution curve of the bases (eg. The number of claims is a binomial distribution tending towards a lognormal/ normal distribution)

* Best estimate assumptions and not pricing assumptions 13

Internal M o del Based •

Step 3 : Make assumptions about how each of the bases inter-relate to each other (i.e. A table of cross Covariances between each basis). For example; • • • • • •

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Inflation affects both investment return and expense. It is co-related to bond yield Economic conditions affect both some claim rates as well as investment returns Morbidity claims are co-related to death claims Lapse rates are co-related to investment returns Co-relationship of returns of different asset classes and within each asset class Affects of pandemics on asset values and claims

Internal M o del Based •

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Step 4 : Build a complex stochastic model of your company. Fortunately, there are commercially available softwares (eg.

Prophet, MoSes etc) Step 5 : Run hundreds and thousands of simulations using the random number generator Step 6 : Determine the MCR as the level of capital that would be sufficient at the prescribed comfort level (eg. 99% of the time) Step 7 : The Actuary certifies MCR to the DOI.

Minimu m Capital Requirem e nt

Internal Model Based

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Minimum Risk Based Capital Requirement

Prescribed Method

Prescribed Method • •

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aka the Canadian Method Instead of asking each company to build their own Internal Based Model, the regulator prescribes Capital Charges or Risk Charges.

These Capital Charges are based on studies done made to find an approximate fit to different companies in the local conditions had an Internal Based Model been used

Prescribed Method For example, the Minimum Capital Requirement might be prescribed as the liabilities reserves based on a best estimate basis plus the following Capital/ Risk Charges • • • • • • •

5% of reserve, plus 0.5% of total sums at risk up to THB 200 million, plus 0.25% of total sums at risk above THB 200 million, plus 0.2% of reinsured sums with reinsurers rated BBB to C+, plus 5% of asset value invested in shares listed on the SET, plus 20% of asset value invested in non-owner occupied property, plus Etc etc

Disclaimer : The percentages above are only to illustrate as examples and is not by any means a recommendation for Thailand!!!

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Prescribed Method Current Thai Solvency Margin of THB 50 million plus 2% of reserves is a simplistic Prescribed Method with only one Capital/ Risk charge.

However, it has implicit margins in the liability calculations (ie. Net Premium method at pricing mortality and interest rates, no allowance for expenses and lapses).

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Com p arisons Internal Model Based • “Accurate” • Rely on appointed actuary concept • Regulator takes a back seat role • Needs an ample supply of qualified actuaries

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Prescribed Method • One formula fits all – simpler to use • One formula may not fit all – false sense of security • Easier for regulator to “check” for compliance • Small companies can cope

Risk Based Capital •

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Some countries (eg. Australia) use a Prescribed Method and allows company to opt out if they can show that they are capable of building their own Internal Based Model Risks charges are explicitly calculated and allowed for. Should therefore not double count by also using reserving methods which hides implicit margins (eg. Net Premium valuation at pricing assumptions) Risk Based Capital concept goes hand in hand with realistic reporting/ accounting

Questions for Thailand • • • • •

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How many qualified actuaries and actuaries at all level are there in Thailand? Can it cope with an Internal Based Model?

What is the plan to increase the supply and improve training of actuaries?

Does the regulator want to retain control or is willing to accept Appointed Actuary’s concept?

Are the regulations strong enough to ensure independence of Appointed Actuary and ethical behaviour of Appointed Actuary?

Does the regulator have the resources and qualifications to address the RBC issue and build a Prescribed Model?

Q uestions and A nsw er Session

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