By Christopher Critchlow, Consultant Actuary, OAC Actuaries and Consultants
Valuation of assets
There are a number of differences to the way in which the regulatory valuation of assets is determined in a Solvency II world compared with the current Solvency I approach:
• Instead of asset values being restricted by admissibility rules as applies currently on a Solvency I basis, ALL assets of an insurer (except deferred acquisition costs – see below) may be treated as an asset. The risks attached to specific asset types and to concentrations of risk are dealt within the market and default risk capital requirement components of the SCR calculation.
• The value of the benefits provided by a reinsurer are treated as an asset in a Solvency II world and not as a negative adjustment to the liabilities as is currently the case in Solvency I.
• Deferred acquisition costs, to the extent they relate to acquisition cashflows already paid even though they may not yet be earned, are not allowable as an asset under the Solvency II regime.
• The asset valuation includes a reconciliation reserve and this includes the amount of expected profit included in future premiums.
All assets are classified as one of three tiers with limits applying on the extent to which the asset values in each tier may contribute towards “Own Funds” – essentially the capital an insurer has to meet its SCR. The objective of tiering and of restricting the amount that each tier may contribute towards meeting capital requirements is to ensure that these items will have sufficient loss-absorbing capacity should any losses arise.
The life and health risk SCR computation
The life and health risk (at least for business that is modelled on a similar basis to life business) SCR computations broadly capture exposures to similar risk types:
• Mortality – This captures the impact of mortality being higher than expected. It applies only to those contracts which are subject to losses in the event of adverse mortality experience (ie where the sum at risk > 0). The stress is assumed to be a permanent increase of 15% to the rate of mortality.
• Longevity – This captures the impact of mortality being lighter than expected. It applies to those contracts which are subject to losses in the event that mortality is lighter than expected. The stress is assumed to be a permanent reduction of 20% to the rate of mortality.
• Sickness – This captures the impact of sickness claims being higher than expected. The stress is assumed to be a permanent increase to the rate at which sickness claims occur (35% increase in the first 12 months, then from month 13, a permanent 25% increase on base inception rates), combined with a permanent reduction in the rate of recovery of 20%. Medical expense business is subject to separate stresses on both the level of payment and future expense inflation.
• Lapse – This captures the impact of lapses and surrenders on the business and applies in the valuation of any options that attach to a contract. This should be calculated for each contract and reflect the most onerous of fewer, more or a mass lapse event on the portfolio:
- The lapse down stress is a permanent 50% reduction in the assumed rate of lapse.
- The lapse up stress is a permanent 50% increase in the assumed rate of lapse.
- The mass lapse event is one where 40% of the insurer’s business is immediately no longer in-force.
• Expense – This captures the impact of expenses being higher and inflating at a higher rate each year than expected. The stress is a 10% immediate increase in expenses combined with expense inflation being 1% a year higher than expected.
• Revision – This applies only to annuities where the benefits payable under the contract could increase as a result of changes in the legal environment or in the state of health of the person insured – generally non-life contracts where a person’s condition drives the benefits on the contract. The stress is equal to a permanent 3% (life) 4% (health) increase in the annual benefit payable.
• Catastrophe – This applies to contracts where an increase in mortality rates leads to an increase in liabilities. It is calculated as the impact, over the next 12 months only, of a 0.15% addition to mortality rates.
The catastrophe risk for health business is different to that of life business in that allowance is made for the impact of mass accidents, concentrations of risk and pandemics.
The health risk computation for health risk of business that is not modelled in a similar fashion to life business is based on premium and reserve risk factors as well as lapse risk.
The principle of unbundling applies – so that those components of an insurance contract that are exposed to mortality for example are subject to the mortality stress, and those that apply to sickness are subject to the sickness stresses.
Changes to the level of future discretionary benefits may be taken into account to offset capital requirements in all the stresses.
Under the standard formula correlation assumptions, the life and health risk capital requirements are positively correlated by a factor of +0.25.
Next time
Next time, in the last of three articles, we look at market risk allowance on the valuation of assets and their interactions with liabilities. Click here to view the third part in this article series.
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