RISK BASED CAPITAL Concept requirements challenges and impact

RISK BASED CAPITAL - Concept, requirements, challenges and impact on product pricing and valuations A presentation by Nitin K, Anurag G & Shristy A December 15, 2016 Indian Actuarial Profession Serving the Cause of Public Interest

Agenda § Defining RBC § Why Is RBC Required § RBC Framework Setup § RBC - Value At Risk & Formula Based Approaches § Harmonizing RBC: India Perspective § Challenges And Opportunities Of RBC § Impact Of RBC On Product Pricing § Impact Of RBC On Valuation § Impact on Capital Requirements www. actuariesindia. org 2

Defining RBC § Risk-based capital (RBC) represents* an amount of capital based on an assessment of risks that a company should hold to protect customers against adverse developments. § Insurance companies across the globe have moved/are moving towards adopting a regime which makes sufficient allowance for risk in the business Approach • Different methods & formulae used by regulators, managements and rating agencies • May differ by provider type i. e. life / health / property & casualty Representation Interpretation www. actuariesindia. org • Usually expressed in the form of a ratio: RBC Ratio • Ratio of Company’s Total Capital and company’s RBC • Depends upon computation basis • Depends upon the underlying implicit assumptions *Definition from SOA RMTF http: //rmtf. soa. org/riskbased_capital. pdf 3

Why Is RBC Required Current approach of solvency calculation is a factor based method § Broad brush (Approximate) approach § No diversification benefits to Insurer of the business mix / asset mix § No / Limited Incentive for risk management initiatives by Company Benefits of Risk Based Capital Approach: § Holistic approach to risk measurement § Net risk exposure computations § Diversification benefits allowed for § Interactions between risks allowed § Mortality and Longevity risks offsetting the net risk exposure § Incentives for effective risk management practices IRDAI has already taken various steps as a pre-cursor to adopting RBC framework www. actuariesindia. org 4

RBC Framework Setup For adopting a risk based approach, certain key items need to be defined: § Defining Valuation basis – for assets and liabilities § If realistic / fair value / best estimate basis not used, need to recognize that capital is held implicitly in margins for policyholder protection § Calibration of tail events § Most relevant, accurate and complete data should be used § In absence of statistical credibility, extreme tail events may be modelled by assumed distributions § Finalizing the Approach: Va. R And Formula Based Approach § Regulatory guidelines would be driving the eventual implementation www. actuariesindia. org 5

RBC - Value At Risk Approach Requirements Implementation Challenges Advantages • Probability Distribution of individual risks, risk correlation matrices • Impact on company’s available capital • Difficult to calibrate desired confidence level (99. 5% in 1 year) • Much lower confidence level may suffer from low public confidence, low credit ratings • An alternate could be for regulator to define a set of adverse stresses and scenarios to be applied to assets and liabilities • Interaction between assets and liabilities in RBC calculation • Incentivizes asset liability matching (regulatory capital credit) • Diversification benefit to individual capital components while aggregating risks underwritten www. actuariesindia. org 6

RBC – Formula Based Approach Calculated by applying factors to accounting aggregates that represent various risks to which a company is exposed, and then combining the resultant components using a pre -defined formula. E. g. RBC being defined in terms of the Company’s risks exposure: § from its assets § from the type of business that it writes § from the risk of disintermediation § from general business risk Simple to implement in its pure form Distortions may exist Some components could be determined May fail to curtail their risk exposure using other methods E. g. interest rate changes over many alternative interest rate scenarios www. actuariesindia. org 7

Harmonizing RBC: India Perspective Considerations to be made before the framework is finalized: § Standard approach to every risk § Capital calculation not to performed in isolation § Consistency in asset and liability valuation § Adapt international principles and practice. § Be part of supervisory intervention. § Be practical and technically sound § Expert judgment to supplement statistical analysis § Capital calculation should be prudent but not be over conservative *Recommendations of Committee on Road Map for Risk Based Solvency Approach in Insurance Sector 8

Key Challenges Of Adopting RBC By Indian life Insurers § Lack of expertise § Lack of sufficient data § Lack of risk free curve § Difficulty in setting the assumptions § Difficulty in defining the capital threshold levels § Risk of changing the solvency position of the companies under the new approach § Measuring opportunity risk § Consistency in valuation of assets and liabilities § Managing policyholders’ confidence in the system § Maintaining policyholders’ protection www. actuariesindia. org 9

Moving Into The RBC System Transition phase to involve cost and effort § Regulatory intervention required for smooth transition § Handling criticism is key § Adequate guidelines to be in place § Educating senior management and the Board members Opportunities Quantitative impact study § Multiple QISs would be required § Twin peak approach Moving to RBC Opportunities § Insurers can leverage on their risk control measures in place § Efficient product strategy to deploy capital to new business § Some products may become very capital efficient and hence reduction in prices § Maintaining transparency and pragmatism § Consistency across insurers www. actuariesindia. org Challenges Impact 10

Challenges & Opportunities Example - Decision Review System Challenges § To define the rules § Criticism § Need advance technology systems/high Cost § Training /Skills § May not be completely accurate § Evolving rules Opportunities § More Confidence in decisions § Unbiased § Can change some big match outcomes 28% reviews were successful in 2011 world cup www. actuariesindia. org 11

Impact on Product Pricing More Frequent Pricing Variation in profitability will be basis nature of product Market Consistent/equivalent approach for pricing Change in profitability from Traditional approach Some products may look unprofitable and some more profitable § Efficient product strategy to deploy capital to new business § Designing the product structure in such ways that cash flow income/outgo timing are relative lesser mismatched. § Short term products/ less guarantees may be priced. § Allowed for diversification benefits § RBC can be seen business opportunity for eg: some products may become very capital efficient and hence may result in reduction in prices as well. www. actuariesindia. org 12

Impact On Valuation – Assets & liabilities § Total balance sheet approach § Adoption of market consistent/best estimate/similar approach required § Assets and liabilities should be measured on a consistent basis § More realistic quantification of assets, liabilities and solvency requirements Liabilities Assets • Likely to fall as prudence margin are used somewhere else • Emergence of profit • Acceleration of tax • • Diversification advantage Riskiness of assets Concentration risk (by issuer and for each security) Counterparty Risk e. g. reinsurers www. actuariesindia. org 13

Impact On Capital Requirements Liabilities will fall as measured on a realistic basis Required capital will rise due to quantification of explicit risks e. g. market, life, operational etc. Pays Reward for better risk management techniques www. actuariesindia. org 14

Opportunities Approach Diversification Relatively objective and coherent framework for the quantification of assets and liabilities Advantage of diversification is recognized Solvency Capital Requirements Based on risks faced by the Company Documentation Qualitative and Quantitative disclosures Consistency www. actuariesindia. org Consistency between insurers 15

Possible Next Steps • Twin peaks approach: It would require a company to demonstrate its solvency on two bases, or peaks: the existing (regulatory) peak as well as on a new risk-based peak. • Since the current system would be preserved as one of the peaks, policyholder protection could not be weakened. • It would give time to companies and to the Regulator to fully understand the implications of the new system. • Since the current basis of prudential regulation would be retained as the regulatory peak, there would no one-off emergence of surplus as a result of transition. “Capital requirements should be quantified with the aim of protecting policyholder interests in the event of reasonably foreseeable adverse future events. ” Source: IRDAI committee report suggestion 2014 www. actuariesindia. org 16

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