CPI Workshops FCR Modeling

Capital modeling from a South African Regulatory Perspective Sam Isaacson February 2007 SA International Insurance Symposium 31 January – February 2007 Capital Analytics     A leading Actuarial & Business Consulting firm Focus on the application of robust modeling principles to business problems… • In particular, we specialize in short-term insurance Founded by Sam Isaacson, an Actuary with extensive consulting experience in Financial Services… • Assisted the FSB in setting the new regulatory capital and reserving requirements (2005/2006) We have a Complete Actuarial Service Offering for Short-Term Insurers: • Regulatory & Economic Capital modeling (reserving, capital & strategy) • Data Mining & Analysis (premium rating) • Experience & understanding of the short-term insurance industry FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Outline of this presentation Synopsis of the current regulatory framework Requirements Timelines Options FCR report Practicalities of implementing a capital model Extracting value from FCR Steps in an internal modeling exercise Ingredients of a capital model What is DFA Components of a DFA model Analysis of the results FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Regulatory background      FSB Issues Paper: Financial Condition Reporting – Proposed Solvency Assessment for Short-term Insurers, 15 December 2006 (source) FCR is a risk-based regulatory approach to statutory financial reporting proposed by the FSB Primary focus is on Insurance Liabilities and Capital Adequacy FSB acknowledge that FCR will cost insurers money but are comfortable that the benefits outweigh these costs Allowance made for the appointment of a Statutory Actuary in certain circumstances FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 FCR Timelines & Consequences 2006 FSB Closure for comment 2008 Insurance Amendment Bill tabled in parliament FSB Release of FSB issues paper 2007 2009 Implementation of FCR Transition Arrangements Industry Consultation COMPANIES Full Implementation Operational Capital Model Model Development The creation & calibration of a company-specific Capital model is not a trivial task The FSB has stated that it will consider approval of models that have been in operation for at least a year before implementation FCR Modeling – February 2007 First time implementation for Financial year-ends after January 2009 © Capital Analytics 2006 - 2007 Current options   Allowable approaches to modeling: • Internal (ultimate aim for the FSB) • Certified (includes company specific elements, steppingstone) • Prescribed (applies historic industry averages) Certified models are unique to SA • A simple way of allowing flexibility within the prescribed framework Model Review Actuarial Sign-off Alternate model structure Non-proportional re-insurance Alternate Parameters Increasing Cost, Complexity & Appropriateness Prescribed Model FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 A continuum of possibilities…  Sensible regulation could turn this grey area into a healthy breathing space for companies A grey area! Certified Model Prescribed Model Certified Model Certified Model OR Internal Model Internal Model Internal Model Scope for certified models Scope for internal models FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Financial Condition Report         Irrespective of model type applied, to be submitted annually by all registered Short-Term Insurers Outline of “the key risks and matters impacting on the financial condition of the insurer” Adverse issues require recommendations to remedy the situation A large component will deal with the capital and/or reserving calculations performed by the insurer Principles-based report, therefore smaller insurers may be able to report less than larger insurers Should not be viewed as an annexure to the Statutory Returns Sign-off by Chairman & CEO (approval of the board) State where assistance was obtained by a suitably qualified approved person – in all likelihood, Actuarial assistance will have been obtained for the calculations etc… FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Issues for discussion in an FCR report            Insurer background Recent experience Risk management strategy Liability valuation Asset and Liability Management Business projections Capital Management & Capital Adequacy Premium Adequacy Reinsurance Management Strategy Credit risk Operational risk FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Extracting value from FCR   10 Risk Management Reinsurance Purchasing Accounting Disclosures: Risk FCR Capital Management Expansion Plans Capital Allocation Strategic Pricing Asset Allocation Can be viewed as a regulatory burden OR… Integrate FCR within existing business processes and gain quantitative insights into your business FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Components of an internal capital modeling project Company-specific capital model Steps 11 Structure It is vital that the structure of the model reflects the structure of the business This assists later in understanding and communication of the model results Further, data is most likely to be available in line with the natural structure of the business Key Risks The list of risks to be discussed in the FCR document can be used as a guide In the majority of cases an insurer would focus on modeling underwriting risk & reserving risk Software Mapping Software can assist you in putting together a capital model but does not replace the crucial modeling elements discussed above! At the end of the day, people perform modeling not software Calibration The structure set-up in the preceding steps needs to be populated with parameters relevant to the key risks identified This will be accomplished with reference to company-specific data and industry-data on a case by case basis Analysis While the modeling tasks are complete, the analysis of results can now begin This stage will depend on the particular investigation (capital modeling, reinsurance strategy, etc…) FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Company Structure (a) Statutory/FSB (b) Cell REINSURANCE A C C E N G G T E L I A B M I S C M O T P R O P T R A (d) Product/Channel centric (c) Reinsurance treaty centric Aggregate Product2 Product1 Channel2 RI Layer1 Channel1 treaty2 RI Layer2 Products Aggregate treaty1 treaty3 12 FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Where does DFA fit into FCR?       13 DFA (Dynamic Financial Analysis) is the term for the computational engine that computes the results for FCR It is a projection of the Income Statement and Balance Sheet of a ShortTerm Insurer applying a dynamic simulation based approach In ordinary projections, a single estimate of a variable of interest would be made – think of producing a budget with excel… DFA computes a range of values for the variable of interest together with their relative frequency – statistical variability FCR dictates that the primary variable of interest is the statistical distribution of year one profit/loss In particular FCR focuses on the 99.5% sufficiency level – the worst case loss 200 years FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Even Actuaries want to be fashionable    Formulas are out…simulations are in! An insurance company is too complex to be governed by a single formula – however long & complicated It is difficult to allow for uncertainty through the use of a deterministic formula SCi = β + β1 × GWP + β × (GWP) + β × GUPR + β × (GUPR) + β × (GWP) × (GUPR)   14 A simulation naturally gives a range of answers as its output, thereby encapsulating the uncertainty in a natural manner Simulations were known about in the past but are only now becoming a reality for computation due to increases in computing power FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 DFA building blocks Line of Business One Line of Business Two Line of Business Three Premiums Claims Commission & Expenses Investment Return RI Layer One RI Layer Two Σ 15 Aggregation (Correlation & Diversification) FCR Modeling – February 2007 Σ © Capital Analytics 2006 - 2007 How can DFA assist you (I)   Profit 2007 Statistical Distribution Frequency It can associate probabilities with the financial outputs – a decision makers dream! On the side we show the statistical distribution of profit one, two and three years into the future Note the increase in uncertainty as the projection period increases Profit Profit 2008 Statistical Distribution Frequency  Profit Frequency Profit 2009 Statistical Distribution Profit 16 FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 How can DFA assist you (II)   It can assist in accurate capital allocation between lines/classes of business This assists in setting an adequate capital charge for each class in product pricing Excess / Shortfall property Capital motor engineering liability guarantee Class of business Components of Premium Allocation of Capital to Classes of Business Margin Return on Capital Commission Expense Allowance Expected Claims 17 FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 How can DFA assist you (III)  Different strategies can be compared with respect to risk and reward (reinsurance, investment, pricing,…) Efficient Frontier Option Two Return Option One Downside risk  18 Above, option one dominates at the lower risk levels and option two dominates at the higher risk levels FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Questions? 19 FCR Modeling – February 2007 © Capital Analytics 2006 - 2007 Sam Isaacson Cell: 073 190 1978 Fax: 086 637 7494 Email: sam@capitalanalytics.co.za Web: www.capitalanalytics.co.za 305B Killarney Mall Office Towers 66 Riviera Rd Killarney 2193 Johannesburg