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A Review of the Capital

Requirements for Life Insurers in


India
By Jim Thompson , Raju S,
Richard Holloway
Presented at the 5th Global Conference of
Actuaries - Delhi, February 2003
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Content
Background
The current situation in India
Developments in other markets
Conclusions and recommendations for India

Why Capital/Solvency Margin?

To give the regulator and the policyholder


the peace of mind that he will be paid what
he has been promised

Major risk areas of a life


insurance company

Life insurance company risk universe


Market risk
Liquidity risk

Investment
risk

Credit risk
Currency risk
Mismatch risk

Operational risk

Expense risk

New business risk

Insurance risk

Group risk

Credit risk

Regulatory risk

Other risks

Correlation between risks

Internal and external risks Examples


External

Internal
Bonus structure and policyholders
expectation of a smoothed return has
meant that the fall in investment markets
cannot be fully passed on
High level of guaranteed investment
returns and mismatching as a result of
falling investment returns

Regulatory issues
Increase compliance costs
Compensation costs from mis-selling
(USD20 billion)
Government imposed product pricing (UK)
Increasing solvency requirements (Phase 2)

Distributor pressure
Other guarantees

Annuity options
Surrender values
Benefits on investment-linked contacts

Rising costs
Competition from cheaper channels

Falling investment markets

Merger and acquisition activity


(Declining value in acquisitions)

Common risks that the Indian


insurer faces.
Asset default
Mortality and Morbidity understated
Interest Margin Pricing
Interest Movements
Guarantees given
Business Risks

Traditional approaches to
determining capital requirements
Absolute
amount

Rs. 50 crores

Fixed
factors

6% reserve +
0.45% sum at risk

Absolute amount
with fixed factors

MAX[6% reserve + 0.45%


sum at risk. Rs. 50 crore]

Dynamic
solvency testing

Solvency testing under


prescribed scenarios

What is Risk Based Capital


Risk Based
Capital

A realistic assessment
of the capital
requirements for the
risks being run

Varies from company to company

Tends to focus on the key measurable and


quantifiable risks

Introduced in many of the more developed markets


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Content
Background
The current situation in India
Developments in other markets
Conclusions and recommendations for
India

India Overview of
solvency requirements
Typical formula approach
Simplistic and easy to administer
Working solvency margin is 150% of the
formula
Minimum solvency requirement of Rs 50 Cr
Solvency margin can be met by Surplus
from Policyholder fund and Shareholder
fund

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Valuation of assets
and liabilities

Assets are largely valued as a mixture of


book value and market value
No explicit charge for Asset Risk
Certain assets are inadmissible for solvency
purposes
Gross premium method for policy reserves
with allowance for future bonuses
The policy reserves include some solvency
margins via the Margins for Adverse
Deviations
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Solvency requirement

Non-linked business:

Linked Business:

4% Reserves + 0.3% Sum at risk


with guarantees: 2% Reserves + 0.2% Sum at risk
without guarantees: 1% Reserves + 0.3% Sum at
risk

Group Business:

premiums guaranteed for not more than one year:


1% Reserves + 0.2% Sum at risk
premiums guaranteed for more than one year:
3% Reserves + 0.3% Sum at risk
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Solvency requirement
for rider policies
Similar treatment for base policies and riders
Simplistic example
Premium = 1.5
Reserves = 0.75
Required solvency margin (RSM) = 3.03
150% of RSM = 4.55
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Limitations of current
framework

Formula approach for solvency does not vary


between companies
Does not differentiate between different mix of
business e.g. par and non-par business
Little differentiation between insurers with good
and bad investments
No reflection of the specific risks that each
company is exposed to.
No allowance for the mismatching

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Anomalies

Penalizes companies holding stronger reserves by


imposing higher solvency requirements
Onerous requirement for pure risk policies e.g.
Riders and Group Term policies
Lighter requirement for health insurance (e.g. 4%
reserves), which is known to be a riskier business

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Content
Background
The current situation in India
Developments in other markets
Conclusions and recommendations for India

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UK Valuation of
liabilities

Net Premium method with appropriate margins

PRE to provide for appropriate level of RB to emerge, but


provision of TB not required

Mortality/Morbidity rates determined by Appointed Actuary

Valuation interest rate reflects yield on existing assets less


2.5%

Resilience Reserves determined on various scenarios

Sufficient to cover prescribed scenarios

Different scenarios for par (3 scenarios) and non-par business (1 scenario)

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Capital requirement
Single tier capital requirement Solvency
margin
Solvency margin defined as % of SAR and
policy reserves
Minimum solvency margin is 800,000 ECU
Assets held at market value/net realisable value
Certain assets are inadmissible for solvency
purposes

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USA Valuation of
liabilities
Net Premium method with a prescribed
minimum basis
Mortality 1980 CSO
Prescribed dynamic maximum valuation
interest rate
Additional cash-flow testing requirement

Asset adequacy using cash-flow testing


Project asset and liability cash flows (excluding
new business) under various scenarios
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Capital requirement

Risk based capital requirement


Minimum capital specified based on companys size and
risk profile
RBC identifies major risk factors with an adjustment for
correlation between the various risks:
Risk Category

RBC Regulatory Trigger

Affiliates Risk (C0) >199% No action required


Asset Risk (C1)
150% 199% Company action
Insurance Risk (C2) 100% 149% Regulatory action
Interest Rate Risk (C3)
70% 99% Authorised action
Business Risk (C4) <70% Mandatory control

RBC = f (C0,C1,C2,C3,C4)
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Canada Valuation of
liabilities

Gross premium valuation with margins for adverse deviation

Margins represent limited and reasonable level of misestimation and deterioration from expected experience
scenario assumptions

Due regard to PRE (provision for all future bonuses)

Discount rate dependent on existing asset yields

No resilience reserve requirement

All assets are admissible

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Capital requirement

Risk based capital requirement-Minimum Continuing Capital and


Surplus Requirement (MCCSR)

MCCSR determined by applying factors to each of four risk


components and adding the results

Risk components of MCCSR and composition of total capital


requirement (at year end 1998) were

Asset default risk


50%
Mortality/morbidity/ lapse risk 31%
Interest margin pricing risk
4%
Changes in Interest Rate Environment Risk

15%

Target MCCSR ratio is 150% (however may vary according to


individual company risk profile)

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Australian Capital Adequacy


Standards
1.
2.
3.

Margin on Services Valuation Gross


Premium Basis
Statutory Valuation = BEL + Profit
Margin
All assumptions are based on the latest
best estimates at the time of valuation
pro active basis
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Two Tiered level of


Capital Adequacy
1.

Solvency Standard
1.
2.

2.

Intended to ensure Solvency of the company


Disclosed in the Financial Statements

Capital Adequate Standard


2.

3.

Intended to ensure financial soundness of


the company as and ongoing concern.
Not disclosed in the financial statements
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Requirements
Solvency
Solvency
Requirement
Other Liabilities
Resilience Reserve
Inadmissable
Assets Reserve
Expense Reserves

Capital Adequacy
Capital Adequacy
Requirement
Other Liabilities
Resilience Reserves
Inadmissable Asset
Reserve
New Business
Reserve
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Margins
Solvency

Capital Adequacy
Min.

Max.

Mortality

110% Best Est

110%

140%

Disability

120% Best Est

120%

150%

Critical
Illness

130% Best Est

130%

160%

Investment
Linked

0.25%

0.5%

2.5%

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Investment Assumptions
Solvency

Capital Adequacy
Minimum Maximum

Gross Redemption
Yield of a 10 year
Govt Security

BE 0.4% BE 3.0%

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Resilience Reserves

The amount that needs to be held before the


happening of a prescribed set of changes in
the economic environment such that after
the changes the company is able to meet the
liabilities of the fund

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Resilience assumptions
Solvency

Capital Adequacy

Equity

1.25%

0.5%+(0.4xYield)

Property

1.25%

2.5%

Interest
Bearing

1.75%

1.0%+(0.2xYield)

Indexed
Bonds

0.6%

1.0%

Currency

10%

15%

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Singapore Valuation of
liabilities

Looking to move to a gross premium basis basis selected by actuary, having regard to
professional guidance (a change from net
premium valuation)

A PAD is added to the best estimate liabilities.

Propose risk free rates are used for nonparticipating business (based on government
bonds).

Can significantly increase liability


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Singapore
Capital requirements
Regulators are proposing a change to the
current traditional framework (3% reserves +
0.2 per mille of sum at risk) that is more in line
with banking sector, is risk based, flexible and
transparent.
New framework will have a fund solvency
requirement (for each fund) (FSR), and an
overall capital adequacy requirement (CAR).

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Singapore
Capital requirements

FSR takes in to account liabilities and risks in


the form of three components:

LC1 - Liability component (as per valuation with margins)


LC2 - Market, Credit and Mismatching Risk
LC3 - Inadmissible asset risk component
FSR = LC1+LC2+LC3 - Value of liabilities

Capital adequacy such that:

Available capital/Required Capital > Specified minimum

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Singapore Fund Solvency


Requirement

Fair Value of Assets

Surplus

Fund Solvency
Requirement

Policy
Liability

LC3

Inadmissible Asset

LC2

Market, Credit &


Mismatching Risk
Component

LC1

Liability
Component

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South Africa Capital Adequacy


Requirements
Gross Premium Valuation Basis
One level of Capital Adequacy
RBC Approach

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OCAR
OCAR = IOCAR grossed up for the effect of
the assumed fall in fair value of the
assets backing it
OCAR = IOCAR/0.7 if assets in equities
assumed to fall 30%
OCAR = IOCAR if assets in cash
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IOCAR
IOCAR = Intermediary Ordinary Capital
Requirements before taking into
account the effect of the assumed
falls in fair value of the assets
covering it Resilience scenario

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Elements of Capital Adequacy


IOCAR = a2 + b2 + ci2 + cii2 + ciii2 + d2 + e2 + f2 + g2 + h2 + i2 + j
a
= Lapse risk
b
= Surrender risk
ci
= Mortality Fluctuation
cii
= Morbidity Fluctuation
ciii
= Medical Fluctuation
d
= Annuitant Mortality
e
= Mortality, Morbidity Medical Assumptions - Capital Adequacy
Requirements; (Mortality 5%, Morbidity 10%, Medical 15%)
f
= Expense Fluctuation (10% last years renewal expenses)
g
= Expense Assumption (policies not valued on a
discounted cash flow basis)
h
= Investment Capital Adequacy Requirement
i
= Foreign Exchange Risk 20% Movements
j
= Any understatement of Liabilities

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Investment Capital Adequacy


Requirements
Greater of:
1. Resilience Capital Adequacy Requirement
volatile market conditions
2. Worse Investment Return Investments
returns 2% lower than assumed in
valuation

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Resilience Capital Adequacy


Asset
Property
Fixed interest
Cash
Equities
Dividend Yield <= 4%
Dividend Yield >= 5%
Other

Fall in fair value


15%
Fall equivalent to a 3%
increase in yields
0%
30%
20%
Interpolate

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Country Comparison
Country
India
UK

Valuation
Gross Premium
Net Premium

Solvency
Formula
Formula but
under review

USA
Australia
South Africa
Canada
Singapore
(Proposed)

Net Premium
Gross Premium
Gross Premium
Gross Premium
Gross Premium

RBC
RBC
RBC
RBC
RBC
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Capital Requirements Internationally


1.
2.
3.
4.
5.

Move to a Gross Premium valuation and Risk


Based Capital Approach.
Margins are generally specified and part of the
solvency calculation.
Methodology is based on projections.
Resilience Reserves focus on both assets and
liabilities.
Resilience Reserves are related to the level of
markets.
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Content
Background
The current situation in India
Developments in other markets
Conclusions and recommendations for India

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Conclusions

Solvency is not a big issue for new companies at the


moment, but this will change as companies get bigger.

Globally move to Gross Premium Valuation and RBC


Solvency

Ensures greater consistency to other financial sectors

Valuation of assets and liabilities consistent

Focuses attention on risk management

Can vary by company.

India has Gross Premium Valuation move to RBC


logical
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Implementation Issues to
consider
Technology
How do we get the know how
Phasing in to existing levels of capital
Setting of the risk charges/parameters
Impact on Business
Big workload on the Regulator and Industry

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Recommendation
IRDA start giving consideration to adopting
a RBC approach to solvency in 3 5 years
The Regulator should involve the Industry
and work together to discuss the
implications of moving to an appropriate
RBC regime for India

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Acknowledgements
We take this opportunity to thank all those
actuaries and Appointed Actuaries in India
who provided us with valuable inputs for
this paper.
All the views expressed in this paper are the
views of the authors and are not necessarily
the views of our employers

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