Analysis of LAGIC & Solvency II’s impact on Life Insurers

Analysis of LAGIC & Solvency II’s impact on Life Insurers Kangjing Tan A thesis submitted in partial fulfilment of the requirements for the degree of Bachelor of Actuarial Studies with Honours at the Australian National University 30th October 2015 i Declaration This thesis contains no material which has been accepted for the award of any other degree or diploma in any University, and, to the best of my knowledge and belief, contains no material published or written by another person, except where due reference is made in the thesis Kangjing Tan 30th October 2015 ii Acknowledgements This thesis would not be possible without the assistance of many wonderful people I would like to thank my supervisor, Dr Aaron Bruhn for his continuous assistance, guidance and support throughout the year I would also like to thank Brendan Counsell and Bridget Browne for their kind assistance I would also like to thank the Australian National University for awarding me the ANU-Singapore Alumni undergraduate scholarship and providing me the financial support throughout my degree In addition, I would like to thank the Centre for International Finance and Regulation for awarding me the CIFR/CMCRC Honours Scholarship and providing me the financial support for this thesis Finally, I would also like to thank my family, friends and all honours colleagues for their tremendous support iii Abstract Solvency II is a European Union (EU) legislative program to be implemented across all 28 member states It introduces a new and harmonised insurance regulatory regime across the EU The EU is the single largest economic market in the world and forms 24% of the world’s GDP (IMF, 2014) The implementation of Solvency II garnered vast amounts of attention because it is the first insurance regulatory regime to be applied across all EU member states It is also one of the first insurance regulations in the world to follow the Basel Accord approach with a 3-pillar structure The pillars cover namely capital requirements, risk management and disclosure requirements respectively Previous regimes did not incorporate risk management and disclosure requirements This paradigm shift is not limited to the EU Many countries across the world are shifting towards such insurance regulatory approaches In Australia, the Life and General Insurance Capital (LAGIC), which is the regulation governing life and general insurers, follows a similar approach This research thesis will focus on Pillar 1, Capital Requirements, of the insurance regulations The new Solvency II Pillar Capital Requirements adopts a risk-based capital approach, which measures capital requirements for an insurer based on its risk profile It requires higher amount of capital for a higher amount of risk taken by the insurer Australia’s LAGIC also adopts a riskbased capital approach By having a risk-based approach, regulators around the world hope to achieve a set of capital requirements which tailors to the insurers’ actual risk exposure This is paramount as the insurance industry is widely considered to be of systemic importance to the financial sector of the economy Regulators legislating insurers to set aside an amount of capital as a capital requirement hope to instil confidence and assurance in the insurers’ ability to meet its liabilities should unexpected events occur iv This research thesis aims to achieve the following:  To demonstrate the impact of LAGIC and Solvency II Capital Requirements on different insurance product portfolios, thus allowing a better understanding of both LAGIC and Solvency II  To illustrate the significance of Solvency II’s Matching Adjustment (MA)  To illustrate the differences in capital requirements of LAGIC, Solvency II (without MA) and Solvency II (with MA)  To analyse the sufficiency of LAGIC and Solvency II Capital Requirements by conducting stress tests with the following scenarios: 1) Global Financial Crisis (GFC) conditions 2) Pandemic conditions 3) Pandemic + Financial Crisis conditions separate insurance portfolios were created They are a risk portfolio, annuity portfolio and a combined portfolio The combined portfolio is the risk portfolio combined with the annuity portfolio All portfolios are created with realistic assumptions which reflects current Australian life insurance industry data This research showed that the annuity portfolio required a substantially larger capital requirement than the risk portfolio Furthermore, the bulk of the capital requirements in the risk portfolio and annuity portfolio derives from insurance risks and market risks respectively An interesting result is that the total capital requirements for the combined portfolio is less than the sum of total capital requirements of the risk portfolio and the annuity portfolio This is because of the diversification benefits obtained when the risk portfolio is combined with the annuity portfolio Our stress testing results showed that the capital requirements for the annuity and combined portfolio are insufficient for the GFC conditions stress test for both Solvency II and LAGIC, but sufficient under a milder financial crisis Also, the capital requirements for the risk portfolio are insufficient for the pandemic stress for both Solvency II and LAGIC Does this insufficiency necessarily imply that the capital requirements are inadequate and that insurers are vulnerable to insolvency? No This will be further discussed in the thesis v Table of Contents Declaration ii Acknowledgements iii Abstract iv Table of Contents vi List of Figures & Tables viii List of Acronyms x Introduction 1.1 Background 1.2 Thesis Outline 1.3 Risks Life Insurers face Solvency II Development 2.1 Development of Regulation & Solvency Concepts 2.2 Solvency I & its limitations 2.3 Moving to Solvency II 2.4 Industry Involvement 11 2.5 Quantitative Impact Studies (QIS) 12 2.6 Impact of GFC on Solvency II 15 2.7 From CEIOPS to EIOPA 15 2.8 OMNIBUS II 15 2.9 Delay of Solvency II Implementation 16 2.10 Costs of Solvency II & Other Implementation issues 17 2.11 Industry Preparedness 17 2.12 Summary 19 Solvency II Regulation 20 3.1 Pillar – Quantitative Measures 20 3.1.1 Valuation of Assets & Liabilities 21 3.1.2 Capital Requirements 25 3.2 Pillar – Governance & Risk Management Requirements 29 3.3 Pillar – Disclosure and transparency Requirements 30 Life and General Insurance Capital (LAGIC) Regulation 31 4.1 Background Information 31 4.2 Objectives of the LAGIC 32 4.3 Life and General Insurance Capital (LAGIC) 32 4.4 LAGIC Pillar – Quantitative measures 33 4.5 LAGIC Pillar & Pillar 38 vi Modelling Methodology 39 5.1 Modelling objectives 39 5.2 Models 39 5.3 Assets and Liabilities Assumptions 40 5.4 Other Modelling Assumptions 46 5.5 Policyholders 50 5.6 Solvency II Risk Margin Calculations 55 5.7 Solvency II Capital Requirements Stresses 55 5.8 LAGIC Capital Requirements Stresses 57 5.9 Stress Scenarios 58 Results & Analysis 63 6.1 Liabilities 63 6.2 Capital Requirements 64 6.3 Capital Base 69 6.4 Stress Scenarios 71 Further Discussion 78 7.1 Matching Adjustments (MA) 78 7.2 Stress Scenarios 79 7.3 Sufficiency of Capital Requirements 80 Conclusion 82 References 83 Appendix – Excel Workings 87 vii List of Figures & Tables Figure 1.1 Risks Life Insurers face Table 2.1 Lamfalussy Process 10 Table 2.2 Industry bodies involved in Solvency II development 12 Figure 2.3 Solvency II expected compliance date 18 Figure 2.4 Solvency II expected compliance date by country 18 Figure 2.5 Solvency II development summary 19 Figure 3.1 Pillars of Solvency II 20 Figure 3.2 Calculation of Technical Provisions 21 Figure 3.3 Solvency II Matching Adjustment Illustration 24 Figure 3.4 Solvency II Balance Sheet 25 Figure 3.5 Calculation of the Solvency Capital Requirement (SCR) 27 Figure 4.1 LAGIC Pillars 32 Figure 4.2 Prudential Capital Requirement (PCR) Calculation 34 Figure 4.3 Combined Stress Scenario Adjustment (CSSA) Calculation 36 Table 5.1 Annuity Assets Portfolio 41 Figure 5.2 Mortality Rate of a non-smoker male from age 20 to 70 44 Figure 5.3 Case 1, 30 year old female, non-smoker, Sum Insured = $1m 44 Figure 5.4 Case 2, 60 year old male, smoker, Sum Insured = $200,000 45 Table 5.5 Risk Portfolio Assets 45 Figure 5.6 Annuitant Mortality as a percentage of Population Mortality 48 Table 5.7 Lapse Rates for Level Term and YRT insurance policies 48 Table 5.8 Expenses for Level Term & YRT insurance policies 49 Table 5.9 Commission rates for Level Term & YRT insurance policies 49 Table 5.10 Male Level Term Life Insurance Age & Sum Insured (SI) Distribution 50 Table 5.11 Female Level Term Life Insurance Age & Sum Insured (SI) Distribution 50 Table 5.12 Level Term Life Insurance Policy Year Distribution 51 Table 5.13 Male YRT Life Insurance Age & Sum Insured (SI) Distribution 51 Table 5.14 Female YRT Life Insurance Age & Sum Insured (SI) Distribution 52 Table 5.15 Male Life Annuities Age & Annual Payments Distribution 53 Table 5.16 Female Life Annuities Age & Annual Payments Distribution 53 Figure 5.17 Distribution of Age which policyholder leaves Guaranteed Annuity Policy 54 Table 5.18 Male Guaranteed Annuities Age & Annual Payments Distribution 54 Table 5.19 Female Guaranteed Annuities Age & Annual Payments Distribution 54 Table 5.20 Summary of Solvency II Market Risk stresses 56 viii Table 5.21 Summary of Solvency II Life Underwriting Risk stresses 56 Table 5.22 Summary of LAGIC stresses (Asset Risk Charge) 57 Table 5.23 Summary of LAGIC stresses (Insurance Risk Charge) 58 Figure 5.24 ASX 200 Index 59 Figure 5.25 A-rated Corporate Bond Spread to the Australian Government Bonds 60 Table 5.26 GFC Conditions stress 60 Table 5.27 Pandemic + Financial Crisis stresses 62 Table 6.1 Value of Liabilities for each portfolio 63 Table 6.2 Overall Capital Requirements 64 Table 6.3 Risk Portfolio Capital Requirements 64 Table 6.4 Annuity Portfolio Capital Requirements 65 Table 6.5 Combined Portfolio Capital Requirements 67 Figure 6.6 Capital Requirements as a percentage of liabilities’ book value 68 Table 6.7 Required Capital under Solvency II, Solvency II (MA) and LAGIC 69 Table 6.8 GFC Conditions Stress (Risk Portfolio) 71 Table 6.9 GFC Conditions Stress (Annuity Portfolio) 72 Table 6.10 GFC Conditions Stress (Combined Portfolio) 72 Table 6.11 Pandemic Conditions Stress (Risk Portfolio) 74 Table 6.12 Pandemic Conditions Stress (Combined Portfolio) 75 Table 6.13 Pandemic & Financial Crisis Conditions Stress (Annuity Portfolio) 76 Table 6.14 Pandemic & Financial Crisis Conditions Stress (Combined Portfolio) 76 ix List of Acronyms ABS Australia Bureau of Statistics APRA Australia Prudential Regulation Authority BEL Best Estimate Liability CEIOPS Committee of European Insurance and Occupational Pensions Supervisors EIOPA European Insurance and Occupational Pensions Authority EU European Union EY Ernst & Young FSC Financial Services Council (Australia) IAIS International Association of Insurance Supervisors ICAAP Internal Capital Adequacy Assessment Process LAGIC Life and General Insurance Capital MA Matching Adjustment MCR Minimum Capital Requirements ORSA Own Risk and Solvency Assessment PCA Prescribed Capital Amount PwC PricewaterhouseCoopers PCR Prudential Capital Requirements QIS Quantitative Impact Study RBA Reserve Bank of Australia REIT Real Estate Investment Trust SARS Severe Acute Respiratory Syndrome SI Sum Insured SCR Solvency Capital Requirements YRT Yearly Renewable Term insurance x Next, we will look at the impact on the combined portfolio, as shown in Table 6.12 below Table 6.12 – Pandemic Conditions Stress (Combined Portfolio) Pandemic Mortality Additive Amount 1.0% Total Sum Insured $6,179,876,681 $6,179,876,681 $6,179,876,681 $6,179,876,681 $212,787,567 $212,787,567 Current Year Life Annuity Payments Net Exposure Amount18 0.50% $212,787,567 0.25% $212,787,567 0.15% $5,967,089,114 $5,967,089,114 $5,967,089,114 $5,967,089,114 Net Pandemic Stress Impact $36,728,051 $14,600,071 $5,332,309 $2,419,319 Solvency II Capital Requirements $615,767,419 $615,767,419 $615,767,419 $615,767,419 LAGIC Capital Requirements $562,596,220 $562,596,220 $562,596,220 $562,596,220 Are Capital Requirements Sufficient? Yes Yes Yes Yes The capital requirements are more than sufficient in covering the pandemic stress impact The pandemic stress impact is lower in the combined portfolio case compared with the risk portfolio case This is because the life annuity payments are contingent on policyholder survival The annuitants are also exposed to the pandemic Hence, there is some diversification benefits, with the net exposure amount subjected to the pandemic additional mortality rate being the total sum insured for the risk portfolio minus the current year total annuity payment Does the lack of sufficiency of the Solvency II and LAGIC for the risk portfolio necessarily imply that the capital requirements impose is insufficient? This will be further discussed in chapter 7.3 Pandemic & Financial Crisis Conditions Stress The previous pandemic stress showed the insufficiency of the capital requirements should an extremely severe pandemic for the risk portfolio However, in the absence of a financial crisis which may occur as a result of a pandemic, the annuity and combined portfolio capital 18 The Net Exposure Amount is the Insurance Sum Insured minus the total current year life annuity payments It reflects the total exposure to the additional pandemic mortality rate 75 requirements was assessed to be sufficient This Pandemic and Financial Crisis conditions stress will assess the sufficiency of the annuity and combined portfolios’ capital requirements under Solvency II and LAGIC The following results are obtained for the annuity and combined portfolios as shown in Tables 6.13 and 6.14 Table 6.13 - Pandemic & Financial Crisis Conditions Stress (Annuity Portfolio) Type of Stress Stress Amount Solvency II Solvency II (MA) LAGIC Credit Spread Stress 0.5% $93,523,281 $131,213,851 $91,434,880 Equities Stress 25% $80,855,863 $0 $79,050,329 Properties Stress 25% $192,032,673 $0 $187,744,531 Mortality Stress 1% -$2,127,876 -$2,127,876 -$2,127,876 Expenses Stress 10% $80,000 $80,000 $80,000 Total Stress Impact $364,363,941 $129,165,975 $356,181,864 Capital Requirements $615,782,721 $229,606,284 $559,529,833 Capital Requirements Sufficient? Yes Yes Yes 1.78 1.57 Capital Requirements Sufficiency Ratio19 1.69 Table 6.14 - Pandemic & Financial Crisis Conditions Stress (Combined Portfolio) Type of Stress Stress Amount Solvency II Solvency II (MA) LAGIC Credit Spread Stress 0.5% $93,556,329 $131,213,851 $91,434,880 Equities Stress 25% $80,855,863 $0 $79,050,329 Properties Stress 25% $192,032,673 $0 $187,744,531 Mortality Stress 1% $36,728,051 $36,728,051 $36,728,051 Expenses Stress20 10% $143,580 $143,580 $143,580 Total Stress Impact $403,316,495 $168,085,482 $395,101,370 Capital Requirements $615,767,419 $229,607,561 $562,596,220 Capital Requirements Sufficient ? Yes Yes Yes Capital Sufficiency Ratio 1.53 1.37 1.42 The stress testing results for this scenario indicate that capital requirements for the annuity and combined portfolio are sufficient for a pandemic & financial crisis stress scenario under all 19 Capital Requirements Sufficiency Ratio assesses the extent of sufficiency of the capital requirements It is calculated by dividing the Capital Requirements by the Total Stress Impact A ratio of larger than indicates sufficient capital requirements 20 For the risk portfolio component, the expenses stress is calculated as the additional loss incurred by the entire book of policyholders after the increase in expenses are incorporated 76 regimes The financial crisis embedded in this scenario is less severe than the GFC scenario stress tested earlier Our results indicated that the stress scenario has a larger impact for the combined portfolio than the annuity portfolio This is because the combined portfolio includes the risk portfolio which is severely impacted by a pandemic stress This has been discussed earlier in the pandemic stress section The annuity portfolio mortality stress under this stress scenario has a negative stress impact as shown in Table 6.12 This is because the higher mortality rates will decrease expected life annuity payments as these payments are contingent on survival However, the benefits of higher mortality rates are trivial compared to the impact of higher credit spreads, lower property and lower equity market prices Earlier in the pandemic stress scenario, it was mentioned that the annuity portfolio is expected to benefit the insurer due to the lower annuity payments expected But when we started considering the other secondary impacts which a pandemic might induce, the overall scenario is negative for an insurer holding an annuity portfolio This is because the financial impact of lower market values for its asset portfolio significantly outweighs the benefits of a lower life annuity payments This Pandemic + Financial Crisis stress scenario also showed the sufficiency of capital requirements for the annuity and combined portfolios should a less severe market crash occur for reasons not due to a pandemic Events which led to a 0.5% additive increase to credit spreads and a fall in equity and property prices by 25% have occasionally occurred in recent years (APRA, 2012) Such stress scenarios are less severe than the 99.5% worse-case scenario benchmark which Solvency II and LAGIC capital requirements base itself on Our results showed that the capital requirements are sufficient for such a scenario 77 Further Discussion 7.1 Matching Adjustments (MA) Our results in Section 6.2 showed that the total capital requirements for the annuity portfolio with the MA are substantially lower We will now evaluate the merits of having a MA The benefits from a regulatory capital perspective would be a lower amount of capital required to be set aside, allowing capital to be used for other business purposes However, in order for the MA to be used, insurers have to meet strict rules and conditions Conditions for the MA include:  Assets in the Annuity Portfolio are to be Ring-fenced Ring-fencing segregates this pool of assets from other assets of the insurer These assets can only be used to meet the liabilities in the Annuity Portfolio  Assets in the Annuity Portfolio are to consist of bonds or other assets which similar cashflow characteristics  Cash flows of the asset portfolio are fixed and cannot be changed by the issuers of the assets or any 3rd parties (Official Journal of the European Union, 2009) Our Solvency II (MA) annuity portfolio qualifies for the MA as it is 97% A-rated corporate bonds which are cash flow matched to liabilities In the case of our annuity portfolio, there are substantial opportunity costs in this asset strategy The absence of properties and equities in the assets portfolio is a significant opportunity cost The insurer will not be able to reap the potential benefits of excess returns under these asset classes This may negatively affect profits of the insurer As the assets used in the matching adjustments are ring-fenced, they are not allowed to be used for any other purposes apart from meeting the assigned liabilities’ cash flows This could be a constraint for some life insurers’ overall business strategy In conclusion, the decision on having a MA will depend on the overall business strategy and capital position of the insurer 78 7.2 Stress Scenarios Earlier in chapter 5.9, we discussed the stress scenarios to be applied to our portfolios In our stress testing process, we aim to model the most significant and certain effects which could be easily quantifiable They are also other effects, which would be discussed below GFC conditions stress Our GFC condition stresses only the assets backing the liabilities In the aftermath of such severe financial crises, policyholders’ ability to pay the insurance premiums may be affected and this would possibly increase the lapse rates of our risk portfolio, and may decrease profits Some annuitants in need of cash may decide to surrender their annuities for a lump sum of money However, the extent of such lapses and surrenders due to the GFC are not easily quantifiable and not substantially change the results of our stress analysis The GFC stress scenario aims to assess the sufficiency of the capital requirements arising from an event which results in a huge decline in assets’ market values This aim has been achieved as the most substantial impact of the GFC, which is the market values of the assets, is captured Pandemic conditions stress Our pandemic conditions stress assumed an additional additive mortality rate to the entire population regardless of age, gender and smoking status It is possible that a pandemic may have more adverse effects on a certain age group or gender The 1918 Spanish Flu killed the young population more than the older population This is seen from the higher additional morality rates due to the Spanish Flu for those below the age of 65 compared to those above the age of 65 (Johnson, 2002) The 2003 Severe Acute Respiratory Syndrome (SARS) virus is less lethal in young children based on a Hong Kong study which showed that children suffering from SARS appear to have milder symptoms and be less infectious than adults and teenagers (New Scientist, 2003) The manner which a pandemic virus is transmitted also has to be considered as it affects the probability of infection for various age groups Different virus transmission methods include 79 airborne transmission, contact transmission and arthropod21 transmission For instance, contact transmission is more likely to affect working adults more due to the greater need to travel Because it is impossible to predict whether the method of transmission and the severity of impact on different age groups, we have modelled a pandemic scenario which assumes equal impact on all age groups It is possible that an actual pandemic may be more lethal towards a certain age group which form a significant proportion of our insured policyholders In this case, the additional additive mortality rate will be greater for that age group compared to the general population 7.3 Sufficiency of Capital Requirements Our results in section 6.4 showed that the capital requirements for the risk portfolio is insufficient for a pandemic as severe as the 1918 Spanish Flu In addition, the capital requirements for the annuities and combined portfolio are insufficient for a crisis as severe as the GFC Note that all insurers hold capital in excess of the capital requirements and the insufficiency of the capital requirements not imply insolvency of the insurer The purpose of regulations such as Solvency II and LAGIC is not to guarantee solvency of an insurer under all circumstances Its objectives include ensuring that “under all reasonable circumstances, financial promises made by institutions are met within a stable, efficient and competitive financial system” (APRA, 2012) Solvency II and LAGIC capital requirements are designed to be sufficient at a level of 99.5% Value-at-Risk (VaR) over a year period, equivalent to withstanding a in 200 year event This means that the capital requirements have a 99.5% probability of sufficiency over the next 12 months It is not designed to be 100% sufficient and having too high a capital requirement also has its downsides As advised by industry experts, if a pandemic or financial crisis was believed to be a in 400 year event, then it’s perfectly reasonable that the regulatory capital, designed to withstand a in 200 year event, would fail There has been also substantial debate in industry forums on whether it is 21 Arthropod transmission takes place by an insect such as a mosquitoes, flies and sand-flies Example of virus transmitted in this manner include Dengue and Malaria 80 acceptable for capital requirements to be breached in a particular stress scenario which exceeds the in 200 year benchmark set by capital regulations While having an excessively high capital requirements may slightly reduce the probability of insolvency, the cost of holding excessively high capital requirements will ultimately be borne by consumers The extra capital requirements comes at a cost to the insurers and the insurers will likely pass these costs to the consumers In addition, there are also additional tools which can reduce the overall risk exposure to such events Put options can be purchased which can allow the insurer to hedge its equity exposure as it provides the right but not the obligation for the insurer to sell its equity holdings Also, catastrophe reinsurance could be purchased as a form of risk transfer for a severe pandemic scenario In the event of a stress scenario where the capital requirements may prove to be insufficient, there are corrective actions which an insurer must take to restore its capital positions These include selling off assets and raising capital However such strategies may not work well under GFC conditions where there is a credit crunch Assets would be sold at a huge discount to its fair value and other means of raising capital may be extremely difficult In our calculations, we assumed that the Regulatory Adjustments for Solvency II and LAGIC are zero Regulatory Adjustment is an adjustment which a regulator, in Australia’s case, APRA, can make to the value of the capital requirements Under GFC conditions, the knowledge of the possibility of an insurer becoming insolvent would spread panic and fear into the financial system, further exacerbating financial crisis In such scenario, the regulatory may make an adjustment to the capital requirements so that the insurer will not be forced sell off assets in order to raise capital As the fall in market value of the asset portfolio could happen very quickly, it is absolutely vital that both the insurer and the regulator pay close attention to the solvency of the insurer under such stressed circumstances 81 Conclusion Our results have shown that the annuity portfolio has the most significant capital requirements This is because of the significantly higher asset-related risks and insurance-related risks which the annuity portfolio faces compared to the risk portfolio This is expected under both Solvency II and LAGIC capital requirements regimes as they are both risk-based capital regime Under such regimes, the higher the risk profile of an insurer, the higher the capital requirements This is clearly illustrated by the significantly lower requirements under Solvency II when the Matching Adjustment is applied to the annuity portfolio In this case, the asset backing the liabilities consist of 97% cash flow matched bonds and 3% cash There are no equities and properties in the assets, thus substantially reducing the overall risk and the capital requirements Solvency II and LAGIC are better than non-risk-based capital regimes like Solvency I Under Solvency I, a fixed proportion of the liabilities are set aside as capital requirements This proportion varies under different jurisdictions This capital requirement does not depend on the risk-profile and is not ideal Capital Requirements under such risk-based capital regimes would be sensitive to the individual risk profile of the insurer Such sensitivity may incentivise an insurer to change its product design or adjust its pricing to incorporate the additional cost of the capital requirements As far as the presence of capital requirements increases the solvency for insurers, it does not provide a guarantee of solvency In fact, they are designed to be at least 99.5% sufficient over a period of a year Our stress testing showed that capital requirements may not be sufficient under extreme stress scenarios Although capital requirements play a key role in enhancing the solvency of insurers, it is by no means the only approach It has to be complemented by good risk 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(Accessed: 22 April 2015) Polish Insurance Association, 2015, History Available at: < https://www.piu.org.pl/history > (Accessed: 20 April 2015) RIMES, 2014, RIMES White Paper – Solvency II The Data Challenge Available at : < http://www.rimes.com/sites/default/files/wpsolvency_2ppus_07.pdf > (Accessed: 23 April 2015) Sandstrom, 2007, Solvency – A historic review and some pragmatic solutions Swiss Association of Actuaries, Switzerland Sandstrom, 2011, Handbook of Solvency for Actuaries and Risk Managers Taylor & Francis Group, United States Sigma, 2012, Facing the interest rate challenge, 4th Edition Swiss Re, Zurich, Switzerland Society of Actuaries Ireland, 2013, Solvency II for Beginners Available at: < https://web.actuaries.ie/events/2013/05/solvency-ii-beginners > (Accessed: 24 April 2015) Swiss Re, 2013, A History of Insurance Swiss Re, Zurich Taylor Fry, 2012, How to Extrapolate the yield curve Available at: (Last Accessed: 29 Sept 2015) 86 Appendix – Excel Workings In order to illustrate the calculations and workings used when calculating the value of BEL and capital requirements, we select some individual policies (model points) from our portfolios Projection techniques are then applied in order to determine critical components of Solvency II Calculations for a 10 year level term life insurance and a life annuity will be showed here 10 year level term insurance We have a policyholder with the following attributes: Policyholder Age Gender Smoking Status 59 Male Non-smoker Sum Insured Annual Premium Policy Year $232,877 $2,176 The expenses and lapse rates assumptions which apply to this policy are found in Tables 5.7 and 5.8 respectively The following Tables A1 & A2 shows the BEL calculation and Decrement table respectively for the above policy Table A1 – BEL Calculation22 for a 10 year level term policy Table A2 – Decrement Table 22 boy means beginning of year, eoy means end of year, BEL means Best Estimate Liability 87 Decrement Table:  qx are taken from the FSC-KPMG Lump Sum Experience Investigation  dx = qx × lx , dx is the dependent rate of death  wx = lapse rate (From Lapse Rates Assumptions Table) × lx , wx is the dependent lapse rate BEL Calculation:  Premiums (boy), the 3rd column in the Table A1, are calculated by multiplying the annual premium of $1975.54 by the relevant lx  Claims (eoy), the 4th column in the Table A1, includes Claim amount and Claim expenses Both are assumed to occur at the end of year Expected Claim amount = Sum Insured × dx , Expected Claim expenses = $100 × dx  Expenses (boy) includes Commissions, initial or renewal expenses (whichever applies) and other expenses  Interest is calculated by: Interest Rate (2%) × (Premiums (boy) – Expenses (boy) + BEL), if BEL > Note that both Premiums and Expenses are assumed to occur at beginning of year, while claims at end of year  Net Cash Flow = Premium – Expenses – Claims + Interest  BEL (year end) = [BEL (year end) – Net Cash Flow] ÷ (1 + year Discount Rate)  Policy BEL (year 0) = [BEL (year end) – Net Cash Flow] ÷ (1 + year Discount Rate) Capital Requirements calculations  Solvency II capital requirements are calculated according to the approach discussed in Section 3.1.2 and Section 5.7  LAGIC capital requirements are calculated according to the approach discussed in Section 4.4 and Section 5.8  In calculating the capital requirements for the various modules in Solvency II and LAGIC, the values of the Tables A1 and A2 are changed where appropriate to reflect the relevant stresses of the Solvency II or LAGIC modules Life Annuity We have a female policyholder aged 104 with an annual life annuity payment of $19,859 We will look at the LAGIC case where an illiquidity premium of 0.47% for durations less than or equal to 10 years and 0.2% for durations more than 10 years is added to the risk-free discount rate when discounting future cash flows The expenses assumptions which apply to this policy are found in Table 5.4 Table A3 below shows the BEL calculation for this policy 88 Table A3 – BEL Calculation for a Life Annuity policy LAGIC Age (boy) Year 104 105 106 107 108 109 110 111 112 113 10 114 11 115 12 116 13 117 14 118 15 119 16 120 17 Solvency II - Without Matching Adjustment Discount Rate q age xp age 2.45% 2.55% 2.59% 2.90% 3.36% 3.79% 4.14% 4.38% 4.52% 4.58% 4.35% 4.39% 4.43% 4.46% 4.50% 4.54% 4.58% 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.3448 0.6552 0.4293 0.2813 0.1843 0.1207 0.0791 0.0518 0.0340 0.0222 0.0146 0.0096 0.0063 0.0041 0.0027 0.0018 0.0012 0.0008 Expected Payments (eoy)Expenses (eoy) $13,011 $8,525 $5,585 $3,659 $2,398 $1,571 $1,029 $674 $442 $289 $190 $124 $81 $53 $35 $23 $15 $39 $26 $18 $12 $8 $5 $4 $2 $2 $1 $1 $0 $0 $0 $0 $0 $0 Interest $1,257 $819 $532 $345 $224 $146 $95 $62 $40 $26 $17 $11 $7 $4 $2 $1 $0 BEL (eoy) $31,739 $20,944 $13,647 $8,865 $5,755 $3,740 $2,434 $1,586 $1,033 $672 $436 $280 $178 $110 $65 $35 $14 $0 BEL Calculation:  Expected payments are assumed to be at the end of the year and are calculated by multiplying Annual Payment by xpAge  Expenses are assumed to occur at the end of the year and are calculated by multiplying annual expense (taking into account expense inflation) by xpAge  Interest is calculated by multiplying the interest rate by BEL  Cash Outflow = Expected Payments + Expenses - Interest  BEL (year end) = [BEL (year end) + Cash Outflow] ÷ (1 + year Discount Rate)  Policy BEL (year 0) = [BEL (year end) + Cash Outflow] ÷ (1 + year Discount Rate) Capital Requirements calculations  Solvency II capital requirements are calculated according to the approach discussed in Section 3.1.2 and Section 5.7  LAGIC capital requirements are calculated according to the approach discussed in Section 4.4 and Section 5.8  In calculating the capital requirements for the various modules in Solvency II and LAGIC, the values of the Tables A3 are changed where appropriate to reflect the relevant stresses of the Solvency II or LAGIC modules 89