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Americas edition • February 2009

Insurance

Sharing insights on key industry issues*

Insurancedigest

The Americas Insurance digest addresses the key issues that effect the insurance industry. If you would like to discuss any of the enclosed articles in more detail, please contact the individual authors, whose details are listed at the end of each article, or the editor-in-chief.

We also welcome your feedback and comments and enclose a Feedback Fax Reply form. Your feedback will help us to ensure that our publications are addressing the issues that concern you most.

Insurance digest • PricewaterhouseCoopers 1

Editor’s comment 2John Scheid

Managing liquidity and fraud risk in a time of economic crisis 4Bill Chrnelich

Model validation: The new control imperative 10Mary Ellen Coggins and Nick Ranson

Capturing opportunities in a period of transition: How multinational insurers can compete in China 18Mei Dong, Wendy Lai, and Xiaokai Shi

Solvency II: A competitive advantage for European insurers? 24Michael Lockerman and John Roemer

Realizing the competitive potential of reporting convergence 28Mark Batten, Alex Finn, Paul Horgan, and Nick Ranson

Options remain open for federal insurance regulation 38Barbara Law

Trends in the acquisition of insurance companies in run-off 44Mark Shepherd

Valuation of financial intermediaries: Greater transparency through transfer pricing 48Larry Rubin and Randy Tillis

New perspectives on measuring insurance liabilities, risk, and capital 52Michael Lockerman, Larry Rubin, Xiaokai Shi, and Randy Tillis

The use of own credit in the valuation of liabilities 56Katie McCarthy, Nick Ranson, and Larry Rubin

Americas edition • February 2009

Contents

Editor’s Comment

Welcome to the February 2009 edition of Americas Insurance digest.

Few will look back on 2008 – a year of high drama, unprecedented volatility, and sizable losses – with anything other than bitter memories.

The difficulties in the US mortgage market at the beginning of the year snowballed into a crisis of monumental proportions by autumn 2008, decimating all asset classes and leaving two major broker-dealers, Bear Stearns and Lehman Brothers, dead in its wake.

Confidence in banks vanished, liquidity evaporated and the supply of credit all but dried up by October 2008, causing several financial institutions to come perilously close to collapse. Libor rates set record highs on an almost daily basis, credit default swaps for some financial institutions jumped into the thousands of basis points, and there was an exodus from financial stocks and bonds. As a result of all of these factors, insurers were among the many institutions to feel considerable pain.

In response to the crisis, governments across the globe injected capital into the financial system in return for equity stakes. Interest rates were slashed. With ongoing worries about the effects of the credit crunch spreading into the wider economy, capital injections and government funding for a number of institutions are expected to continue well into 2009.

There is now widespread belief that governments will not allow a major financial institution to fail, and accordingly, credit spreads have come down. However, many people both inside and outside the financial services industry are bracing themselves for what could be an extended period of economic decline.

What’s more, many in the industry are awaiting the inevitable regulatory and political backlash. Once Congress and the new US administration decide on steps to stimulate the economy and open up the credit markets, their attention undoubtedly will turn towards a new financial regulatory system.

2009 clearly will be a challenging year for all. While analysis of the current crisis will continue for years, one lesson is already clear: companies that appear to have withstood turmoil best have been very disciplined about

Insurance digest • PricewaterhouseCoopers2

JOHN S. SCHEID: MEMBER, GLOBAL INSURANCE LEAdERSHIP TEAM, AMERICAS INSURANCE GROUP

Editor’s comment


managing strategic risk, holding sufficient capital, and aligning the interests of customers, owners, and managers. Many of them are now planning to utilize their strong position to capture market share.

This issue of Americas Insurance digest explores a number of issues related to the current market and economic calamity. Article authors have attempted to describe the key challenges facing insurers and offer readers practical, constructive solutions.

I hope you find these articles of interest. Please continue to provide us with feedback on the topics you would like to see addressed in future issues. Online copies of this publication and the sister Asian and European editions are available at www.pwc.com/insurance.

All the best in 2009!

John S. Scheid Editor PricewaterhouseCoopers (US)

Tel: 1 646 772 3061 [email protected]

JOHN S. SCHEID: MEMBER, GLOBAL INSURANCE LEAdERSHIP TEAM, AMERICAS INSURANCE GROUP

Managing liquidity and fraud risk in a time of economic crisis

AutHOr: BILL CHRNELICH


Bill Chrnelich examines in detail the key liquidity and fraud risks that insurance company directors and management must be aware of in the current economic environment, and describes how proactive and aggressive management of these risks can help them meet the unexpected.

Insurers need to ask themselves now when they last did a comprehensive ‘Trigger Analysis’ to understand their exposures and opportunities under Armageddon clauses.

MANAgINg LIquIDIty AND FrAuD rISk IN A tIME OF ECONOMIC CrISIS

The current economic crisis is presenting insurers with a number of challenges, the most prominent of which is managing liquidity risk. While few insurers thus far have faced situations as critical as those affecting many banking institutions, the industry has very real concerns about liquidity – not least because it will be very difficult in the current environment to raise capital. In addition, as so often happens in times of economic distress, the risk of fraud – both internal and external – is much greater now than it has been in many years. Even though most insurers already have comprehensive safeguards against fraud, the current environment will put them to the test.

Liquidity risk

With a handful of highly visible exceptions, most of the insurance sector has been spared the worst of the direct liquidity shortfalls. However, the deepening relationship among sectors means that insurers remain exposed to liquidity risk, both directly through their operations and indirectly through impacts on producers, investment managers, broker-dealers, and business partners. In either case, a sudden loss of liquidity could result in the

need for a significant, and painful, infusion of capital. And, finding that capital right now would be a difficult challenge.

Boards and senior management of insurers need to be aware of these risks and implement robust contingency plans, as well as controls and systems, to carefully identify, monitor, and manage them. In particular, experienced executives know that almost every agreement their company has ever entered into has so-called Armageddon clauses. Lawyers include these clauses to protect their clients, but they are often forgotten or unmonitored, because Armageddon is never supposed to arrive. (However, today’s financial market conditions have brought it perilously close.) These clauses can be triggered by a significant rating downgrade, a ‘Material Adverse Change,’ a change in control, or violation of a debt covenant. In some cases, these clauses will work against a company, and in others they will give a company the right of action against others. Insurers need to ask themselves now when they last did a comprehensive ‘Trigger Analysis’ to understand their exposures and opportunities under these Armageddon clauses.

Liquidity risk is a challenge that all insurers have to address

It has been brought on by the ever-expanding credit crisis, and is something which has not been widely seen in the insurance industry since collapses in the markets for high-yield bonds and real estate in the late 1980s.

Insurers have multiple liquidity risk exposures. For example, in recent years, several publicly-traded insurers have borrowed heavily to fund stock buyback programs, or to fund acquisitions. This debt often is on the balance sheet of the public holding company, whose only significant source of cash is dividends from its regulated insurance subsidiaries. As the insurance operations experience a perfect storm of declining business, pressure from rating agencies to increase capital, Other than Temporary Impairment (OTTI) charges eroding surplus, and their own liquidity strains, it may not be possible to pay dividends to the holding company.

The ongoing trend of rating downgrades is also having an effect. In some cases Guarenteed Investment Contracts (GICs), general guarantees, support


letters, credit default swaps, and other agreements have clauses requiring collateral posting in the event of a two- or three-notch drop in an insurer’s rating. Reinsurance treaties often allow for rescission if ratings drop too far. For reinsurers, this could mean returning significant amounts of premiums in cash or liquid investments to rescinding cedants.

Some insurers have been seeking new capital, including access to the Troubled Asset Relief Programme (TARP). If too large a portion of the capital is in new hands, change-in-control can be triggered. Many agreements have clauses giving counterparty rights upon a change in control, and tax laws at all levels (including local property transfer taxes) can trigger significant tax costs. In addition, there is an ever present threat of large CAT losses; earthquakes know no season. Replenishing capital lost to CATS will be very difficult under current credit market conditions. Moreover, a very recent and unusual risk for insurance companies is the real possibility that their ‘unauthorized’ reinsurers (off-shore reinsurers) may not be able to renew lines of credit supporting the letters of credit that insurers must have in order to recognize the reinsurance benefits in their statutory capital. Without the reinsurance benefits, RBC levels could be breached, ratings could take a hit, and dividend-paying capacity could evaporate. The

good news is that the NAIC and key states should provide some relief in this area.

Life insurers are not immune to these problems, either. Although most of them use asset/liability management (ALM) programs to measure their liquidity risk, many of these programs are conducted annually and may not reflect current market conditions. Not only could valuations be out of date, but cash inflows and outflows may need to be recalibrated. For example cash inflows could decline because of reduced prepayment speeds on mortgage-backed securities, failure of bullet mortgage loans to repay, delinquent rents on investment real estate, or a severe decline in the sales of variable products tied to the stock market. On the other hand, cash outflows could accelerate due to surrenders of Bank-owned Life Insurance (BOLI)/Corporate-owned Life Insurance (COLI) policies, surrenders or withdrawals of annuities, an up-tick in policy loan requests, or defaults under securitizations such as AAA deals, European Medium Term Notes, or Trust Preferred deals.

Insurers also could be affected by the financial condition of their business partners, such as Managing General Agents (MGAs), investment managers, and insurance brokers. These partners could go into bankruptcy or receivership while owing debts to an insurer. They also could take advantage of the insurer by delaying cash transfers to meet their own immediate operating cash needs. In addition, there

is a risk that a business partner could engage in fraud. (See the PricewaterhouseCoopers1 Point of View, ‘Insurance Company Fraud Risk’) They also need to understand their exposure to receivables from reinsurers and other business partners.

Insurers also are exposed to risk related to their invested capital. The liquidity, performance and safety of many investments are in question. Although most insurers have by now reviewed their portfolios to identify problematic direct holdings, they may not fully understand their exposure through assets included in partnerships such as hedge funds. In addition, the valuation of many holdings, particularly less-liquid derivative products, is far from clear. The uncertainties over mark-to-market accounting, including controversies over Financial Accounting Standards Board fair value accounting guidance under FAS 157 and FAS 159, have only added ambiguity to these calculations.

Insurers need to take aggressive and proactive steps to identify, monitor, and mitigate liquidity risks

They should begin by identifying potential problem spots. For example, they should carefully review all of their significant agreements, determine what occurrences could trigger a default or cash call, and take steps to prevent such events wherever possible. They also should re-evaluate their ability to renew expiring credit facilities, and

closely test the performance of sidecars and other standby capital vehicles intended to protect liquidity. Similarly, they should update their ALM programs to reflect current conditions and valuations. These reviews may lead to a decision to increase the amount of liquid investments on hand – and, as importantly, decide what a liquid investment is in today’s environment.

during periods of tightened liquidity, it is crucial that management prepare contingency plans for unforeseen developments. For example, they may want to delay share repurchases, have solid lines of credit available, or be able to address an event of default or cash call before it triggers a domino effect elsewhere. directors also should review projected holding company and insurance subsidiary cash flows and contingencies for shortfalls. Often, cash outflows are fixed whereas cash inflows require action, approval, or agreement, all of which take time.

While many insurers may have identified the investment risks in their own portfolios, they also need to carefully monitor the risks extant in indirect investments made through partnerships and joint ventures. They also need to be current with accounting guidance for valuation, in order to be able to assess potential OTTI charges on their holdings.

Liquidity risk is an ongoing challenge, and insurers understand better than anyone the importance of managing it.

MANAgINg LIquIDIty AND FrAuD rISk IN A tIME OF ECONOMIC CrISIS continued

1 ‘PricewaterhouseCoopers’ refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a seperate and legal entity.

7Insurance digest • PricewaterhouseCoopers

While the unexpected always can occur, liquidity risks associated with ordinary operations can frequently be mitigated through proactive, ongoing, and collaborative initiatives and robust management. directors and managers need to identify potential risks early on through rigorous due diligence, implement corrective measures, and establish contingency plans. This will not be easy or inexpensive. And, of course, once these risks are understood and plans are in place, the SEC will expect full disclosure to help investors understand the risks and what management is doing about them.

Fraud risk

In the current economic downturn, insurance companies face many of the same risks as other financial services companies. However, one of those risks – fraud risk – has aspects which are unique to insurance. Most insurers already have in place robust controls and systems to identify, monitor, and manage fraud risk, and protect themselves, their policyholders, and their shareholders from risks. However, the current environment will put those measures to the test.

Economic downturns historically feature increased risk of fraud-related losses. Insurers need to focus on the leading sources of fraud, both internal and external, including policyholders, business partners, and employees.

Perhaps the most common fraud risk comes from false claims made by policyholders; for example,

homeowners who have over-leveraged the equity in their houses. With falling housing values, about one in six US homeowners – 12 million households – currently possess property that is worth less than what they owe on the mortgage. Unscrupulous owners may try to cover losses through insurance claims, and second homes and investment properties are especially at risk of arson or other criminal actions. The risk is not only from homeowners: small business owners, unable to obtain credit, may resort to arson or false claims to raise money.

Business partners provide another source of fraud risk

In recent years, insurers have outsourced many basic functions. They hire third-party administrators (TPAs) to process claims, rather than handle them in-house. However, insurers often grant TPAs effective control over a company’s checkbook as a means of expediting claims payment. In such circumstances, TPAs could use the insurer’s funds to cover their own operating costs or debt payments.

Insurers also have retained managing general agents (MGAs), especially for specialized lines or ‘program business’ in which they lack in-house expertise. However, MGAs could apply underwriting guidelines more loosely to under-price new business in order to make sales. In two or three years’ time (when claims begin to flow), the MGA and the company’s commissions may be gone. Moreover, in the past, MGAs also

have delayed reporting claims and slowed premium transfers to take advantage of the float.

Because retail agents operating on commission make most insurance sales, they face the temptation to skirt guidelines to increase sales. In the current market, there have been cases in which agents have created false statement balances for their customers, with the agent pocketing the money. Agents also have colluded in false valuations. It has been more than ten years since the Insurance Marketplace Standards Association (IMSA) was established to provide assurance over ethical sales practices in the life insurance industry. It is likely that some companies have not remained fully compliant with IMSA sales practices, or have even had an IMSA review. With the huge drop in the equity markets, there will surely be plaintiffs’ lawyers claiming that their clients did not understand the risks in the variable policies they were sold.

Other business partners, such as investment managers, also could engage in fraud for their own ends. People whose incomes are tied to performance will not want to see their income drop too far. Alternative investments will be especially exposed to deferred recognition of declining value.

An insurer’s own employees present another source of fraud risk

They may be in financial distress because of investment losses, excessive debt, or reduced income. The risk is not limited to lower-paid employees: even senior executives may be at risk. The recent evaporation of trillions of dollars of personal wealth is unprecedented. Many executives may have lost most of their life’s savings, and there have been well-publicized examples of senior executives needing to sell company stock to meet margin calls. In addition, some executives have purchased second or third homes as investments. As interest rates reset, or bullet mortgages become due, they may suffer financial reversals and resort to fraudulent behavior, including the acceptance of bribes or embezzlement, ‘borrowing’ from the till, if only until their circumstances change. directors should remember that, no matter how strong their company’s controls are, senior executives often have the ability to circumvent those controls. These are extraordinary times, so extraordinary temporary controls are sensible.

Significantly, a recent, proprietary PricewaterhouseCoopers survey of insurance company directors


‘Liquidity is an illusion. It’s always there when you don’t need it, and rarely there when you do.’

Michael Milken, 1989



and executives found that the boards of directors at 93% of the respondents have not determined whether any of the top five or ten executives in their company are currently in significant personal financial distress. In three years’ time, will directors be accused of being aware of this risk but be unable to demonstrate that they responded to it?

Insurers need to take aggressive, proactive steps to identify, monitor, and mitigate fraud risk from all common sources.

In light of the high risk of • policyholder fraud, insurers need to carefully monitor property claims for evidence of arson or other malfeasance. This is especially true for residences with overextended owners or businesses that are

failing. Some of this is common sense: a fire at a failing business that has recently increased its coverage limits should automatically raise red flags and spur closer investigation;

As a result of problems • with sales compliance in the early 1990s, many insurers strengthened their insurance sales compliance efforts, including compliance monitoring. Insurers need to make certain that they have maintained rigor in executing compliance, and monitor sales efforts by agents;

Insurers need to prevent • business partner fraud by strengthening their insurance sales compliance efforts, monitoring TPA claims processing and expenditures, and carefully examining MGA

activities to make certain that guidelines are being followed. Insurers should not take it for granted that adequate controls are in place; and

Employees, including senior • executives, should not be exempt from scrutiny, both before and after hiring. Insurance company boards should make certain that their financial and operating controls are robust and cannot be circumvented by any one individual. Even in today’s post-Sarbanes-Oxley environment, a single highly placed executive can override systems or approve contracts or claims.

Since internal theft is usually covered by directors’ and officers’ insurance, the real loss in cases of employee fraud is in reputation and a loss of the company’s credibility. That cannot be insured against, so strong steps are needed.

Better screening during hiring, identification of at-risk employees through credit and background checks, and multiple redundant approval systems can help reduce or eliminate internal fraud. Such systems are fairly routine in

investment management firms and in broker-dealers, but less so in the insurance industry.

Strong conflict of interest policies can reduce the opportunity for fraud. In addition, employee assistance programs – including something as basic as a helpline for individuals who may be experiencing financial distress – can help provide overextended employees with the help they need to avoid the temptation to defraud the company.

In many cases, the losses caused by fraud will come when they are least expected

Since these threats are both internally and externally generated, the solutions must be directed at identifying and neutralizing potential threats from both sides of the fence – something that insurers, reluctant to alienate customers, employees, or business partners, have been historically reluctant to do. But the enormity of the threat in the current credit crisis, market turmoil, and possibly an extended economic downturn means that insurers must take proactive steps – now – to protect against fraud.

AUTHOR

Bill Chrnelich Partner, Assurance and Business Advisory Service PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

A recent PwC survey of insurance company directors found that the boards of directors at 93% of the respondents have not determined whether any of the top executives in their company are currently in significant personal financial distress.

Model validation: The new control imperative

AutHOrS: MARY ELLEN COGGINS ANd NICk RANSON


As the current economic crisis has shown, model risk is a real and present danger. design flaws, inappropriate assumptions, poor data quality, and incorrect interpretation of model results can lead to a host of problems. What is worse, errors may remain undetected for long periods of time. However, as Maryellen Coggins and Nick Ranson explain, there are model validation techniques that can help insurers manage model risk and defuse ticking time bombs.

The complexity of some of the models often means that only a small number of employees fully understand their operation; as a result, these ‘black boxes’ are subject to limited independent scrutiny.

MODEL vALIDAtION: THE NEW CONTROL IMPERATIVE

The physicist and ‘father of the A-bomb’ J. Robert Oppenheimer once said of Albert Einstein ‘any man whose errors take ten years to correct is quite a man.’ Unfortunately, the same cannot be said about the often highly complex models that are used in the insurance industry today. Indeed, one of the major risks arising from the use of these models is that errors may remain undetected for long periods, during which time many key decisions may have been taken on the basis of the model results.

One particularly dangerous cause of undetected model errors lies not with the models themselves, but with the way the models are used. Even if the theory underlying a model is ‘correct,’ it still may produce inappropriate results. This may occur, for example, if the assumptions applied in the model are unreasonable or if the limitations of the model results are not fully understood.

A recent New York Times article1 examined the sub prime crisis, and stated, ‘The models, according to finance experts and economists, did fail to keep pace with the explosive growth in complex securities… But the larger failure, they say, was human – in how the risk models were applied, understood and managed.’

Background

Recent changes in the global capital, regulatory, and ratings environments are resulting in a greater emphasis on the use of internal models to demonstrate an understanding of risk exposures, analyze business strategies, and estimate fair values of insurance and financial instruments. The increasing use of these complex models is exposing organizations to a previously unprecedented level of ‘model risk.’ In particular, design flaws, inappropriate assumptions, poor data quality, and incorrect interpretation of model results can lead to sub-optimal decisions in areas such as business planning, product pricing, liability hedging and strategic capital management and allocation.

The situation is exacerbated since, in many areas, the quantitative modeling techniques being used are still in their infancy. In addition, the complexity of some of the models often means that only a small number of employees fully understand their operation and, as such, these ‘black boxes’ are subject to limited independent scrutiny.

A robust model validation framework, including independent validation of high-risk models, can help mitigate this increasing model

risk. It can also facilitate a deeper understanding of a model’s purpose, uses, and limitations, providing management with increased confidence to consider the model results in support of key strategic decisions, which previously would have been taken without the benefit of this additional information.

Model risk in the insurance industry

There are various factors driving the increasingly important role of internal models within the insurance industry. These include:

The growth of products that • require complex valuation models;

The resulting risk management • requirements arising from these more sophisticated products;

The increasing use of models • by senior management to assess business unit performance and thus impact the strategic planning, budgeting and limit-setting processes;

Similarly, the increasing use • of models as a guidance tool for risk-based product pricing and as a key variable in determining incentive-based compensation; and

1 ‘In Modeling Risk, the Human Factor Was Left Out’ by Steve Lohr, New York Times November 5, 2008.


MODEL vALIDAtION: THE NEW CONTROL IMPERATIVE continued

The greater information • demands arising as part of the external disclosures to investors and rating agencies.

All of the above factors result in increased exposure to model risk, for example through:

Inadequate inputs (e.g. • questionable data quality, flawed assumptions);

Invalid internal logic • (e.g. lack of sound methodology or mathematical techniques, inconsistency with market practice, programming errors); and

The inappropriate application • of model results (e.g. through a misunderstanding of a model’s limitations).

Examples of model risk

We do not have to look far to see recent examples of model risk manifesting itself as tangible losses in the financial services sector, or to envisage other areas where it may strike again.

The most prominent example is, of course, the subprime meltdown. We will never know to what extent this problem may have been avoided if stronger model governance frameworks had been in place across the banking industry. However, one significant contributing factor to the issue was the extensive reliance placed on complex valuation models whose assumptions, methodology and limitations were not always fully

understood by senior management within the impacted organizations. Had the models been more fully understood, it seems less likely such a high volume of securitized subprime investments would have been written.

Another example is the losses arising from the 2005 hurricane season within the property and casualty insurance sector. Companies that placed absolute reliance on their catastrophe models without also considering expert judgment were exposed to

significantly larger losses than those which also integrated expert judgment and oversight within their pricing and reserving processes.

On the life side, the increasing use of complex hedging models to help mitigate the risk of

type of model

Pricing and operating • complex products

Measuring exposure to risk, • capital management

Supporting investment • decisions

Valuing tradable assets•

Valuation of a company that • is the subject of a takeover or a merger

Valuing insurance liabilities • (e.g. outstanding claims) and measuring regulatory capital requirements

Source: PricewaterhouseCoopers

Purpose of model

Getting design and price right•

Putting the right hedging • in place

Measuring economic capital•

Managing exposure to risk •

Enabling good investment • decisions

Mark-to-market of investment • portfolio

Financial reporting•

Establishing a rational price • or range of prices for the company to help investors decide whether to support the takeover or merger

Measuring an uncertain • liability affecting reported financial performance

Measuring capital to comply • with regulatory rules

Potential areas impacted by serious model errors

Financial performance•

Customer satisfaction•

Reputation•

Enterprise risk management•

Capital management•



Risk management•


Compliance and risk • management

Investors, with large gains by • one group at the expense of another group



Capital adequacy•

Figure 1 Potential impact of errors in representative insurance models:


guarantees on ever more sophisticated products presents a possible future example. Companies need to ensure they are not placing blind reliance on these hedging models without appropriate oversight, for example to ensure:

The models are functioning • as intended;

The results are being used and • interpreted in accordance with the purpose for which they were generated; and

There are appropriate controls • outside the model (e.g. limits on new business volumes).

A particular area of concern around these models should focus on their reliability in a ‘paradigm shift’ environment. For example, around a third of participants in a recent PwC survey on ERM in the global insurance industry2 stated that the hedging of their guarantees on annuity business was less than 90% effective. While this may not seem unreasonable, it is important to understand the extent to which the unhedged exposure may drive the resulting financial impact in extreme scenarios or under a paradigm shift, such as a major long-term change in the level or structure of interest rates. It is often in these scenarios that protection from hedging is most important.

So, what lessons can be learned from this? In short, modeling is an important part of risk management, but modeling risks is not the same as managing them. Understanding this is the first step in managing model risk.

Managing model risk

Given the significance of model risk to an insurer, what can be done to effectively manage it? Model risk management requires the design and implementation of a robust model governance framework. Such a framework should incorporate several key elements, including:

A descriptive model • validation policy;

defined roles and • responsibilities around model ownership and validation;

A comprehensive enterprise-• wide model inventory with ‘high-risk’ models identified;

Testing to help ensure the • high-risk models are functioning as intended;

Stated expectations for • independent model reviewers;

A process for validating and • approving new models prior to their use;

Ongoing monitoring of model • performance; and

Formal requirements around • model documentation, controls and periodic validation.

Once developed, an insurer’s model governance framework should be routinely reviewed and updated to meet the evolving needs of the insurer and to ensure it effectively incorporates

changes in the complexity of the models required to meet the needs of the organization.

For many insurers, the head of risk management or the chief risk officer (CRO) would be the most logical ‘owner’ of the model validation function. Each complex model would continue to have specific functional model owners who would be responsible for


2 ‘does ERM matter? Enterprise risk management in the insurance industry - A global study’ published in June 2008.


A formal model governance framework helps mitigate model risk by mandating periodic validation of high-risk models. key elements of a best practice model validation framework include:

Establishment of a model validation policy (approved by the Board and/or senior management) requiring periodic validation of key models • and outlining:

– The definition of a ‘model’ that will be applied in the framework

– definition of roles and responsibilities relating to model development, ownership, and validation

– Segregation of duties, organizational structure, and reporting relationships for the model validation function

– The role of internal audit (e.g. as owners of the model validation function or playing a ‘third line of defense’ in the model risk management framework by testing the processes applied by the model validation function)

– Ongoing validation and back-testing requirements for existing models, including the selection of models for validation and the frequency of reviews

– Guidance around key elements of the methodology, standards, and approach to be applied in model validations

– Guidelines for the reporting of model risk exposures and findings arising from model validations

development of a comprehensive enterprise-wide model inventory, capturing information such as:•

– Model purpose and uses

– Model owner

– Model developer(s)

– Model approver (and date of approval)

– Model user(s)

– Model version number

– Whether the model is vendor-supplied or internally developed

– Model platform

– date of last independent model validation (if any)

– Criteria to be used for risk assessment of models

Independent risk assessment to identify ‘high-risk’ models (i.e. those with the greatest potential financial or strategic impact from an • error or misinterpretation of results), based on criteria such as:

– Purpose and use of the model

– High-level qualitative assessment of the potential impact of serious errors in using the model for this purpose in relevant areas (e.g. financial performance, customer satisfaction, reputation, compliance with regulations, risk management, financial reporting, statutory obligations, strategy and financial condition)

– Model complexity and dependencies on other processes

– Qualitative assessment of comfort over data inputs and assumptions applied in the model

– Current level of confidence in the model (e.g. a recent validation increases confidence)

– Qualitative assessment of controls surrounding the model

Use of independent reviewers (including external specialists where appropriate) to validate high-risk models at appropriate intervals•

documentation of a governance framework summarizing ownership of the model register and model validation program (e.g. internal audit • or the CRO) and guidance around the model validation process (selection of models, frequency of reviews, validation approach)

Approval process for new models to be validated before use•

Requirements around model documentation and change control between periodic independent validations•




compliance with the model governance policy created by the CRO, and for ensuring that periodic model validations are performed. It is essential that the technical experts assigned to perform the model validation are independent from those individuals responsible for the model development and/or model management and updates. Since certain complex models may be ‘owned’ by the CRO (e.g. the economic capital model), the CRO would also need to identify an independent team of technical experts to perform periodic model validation. Internal Audit can then provide a ‘third line of defense’ by ensuring that compliance with the model governance policy has been enforced and confirming that all significant validation findings have been addressed.

Model validation

In light of the recently highlighted failures of financial services institutions to develop an understanding of the business purpose and limitations of complex models upon which they relied, senior management teams and boards of directors will have increased expectations for the validation of complex models. This is likely to include seeking solid evidence that complex models have undergone rigorous review and that model limitations are well understood. In addition, as insurers’ ERM programs become increasingly important components of the financial strength assessments performed by rating agencies and regulators, evidence that complex risk and

economic capital models have undergone robust periodic model validation will become essential.

For example, the New York State Insurance department recently issued Circular letter No. 25 regarding Financial Condition Stress Testing. This notifies companies that the department ‘will be commencing a review of insurers’ financial stress testing and scenario analyses.’ It goes on to state ‘Any models utilized by insurers also may be reviewed by the department. In addition, the department will evaluate how such models are independently reviewed within the company by risk management professionals, internal auditors, external auditors, and/or consulting firms.’

While few standards for model validation have been formally established for the insurance industry, insurers can be guided by the broad regulatory guidelines established for the banking industry. For example, the US Comptroller of the Currency Administrator of National Banks in its bulletin ‘OCC 2000-16’ identified the following goals of model validation:

decision-makers should • understand the meaning and limitations of a model’s results;

Model results should be tested • against actual outcomes;

A reasonable effort should be • made to audit model inputs, with input errors addressed in a timely fashion;

Model oversight should be • commensurate with the materiality of the risk;

Model validation should • be independent from model construction;

Responsibility for the model • validation process should be clearly defined; and

Models should be subject to • change-control procedures.

An independent model validation process should ensure a model complies with the insurer’s model governance policy and confirm that the evolving requirements of company boards, senior management and external stakeholders have been satisfied. The more technical components of model validation involve ensuring that a model’s methodology, operation and reporting are appropriate. In addition, validation of model methodology and model operation should provide satisfactory answers to the following questions:

Is the model purpose well • articulated and understood?

Is the model methodology • practical, based upon mathematics that represent good current practice? Are the limitations of the methodology understood?

does the model represent • the business drivers and risk factors that are relevant and material?

does the model reflect • regulation and evolving industry practice?

Are the model assumptions • grounded in past experience, and when appropriate, do they take into account future outlooks and likely trends?

Are expected outcomes • periodically compared with actual outcomes?

Are assumptions promptly • modified to reflect changes in risk profiles, products, and other relevant factors?

Are model inputs appropriate, • complete, and understood?

do model outputs provide the • type of result and reporting needed to meet the stated model purpose?

Are the measures used to • convey model results coherent, stable, and appropriate?

does the model rely on • high-quality data?

Is the model operation • well controlled?

Is there adequate model testing, • including back-testing, stress testing, and benchmarking?

Are the model results • adequately challenged and analyzed?


Importantly, model validation also requires an assessment of the reporting and use of model results. Specifically, model validation should confirm that model results are clearly stated and understood by the decision-maker, that sensitivities and uncertainties are documented with the implications explained, that model limitations

are clearly stated, and that insights derived from the model are conveyed effectively.

Conclusion

Without appropriate oversight, governance, and control, reliance on highly complex models may prove to be an ‘atomic bomb’

for the insurance industry – a view that J. Robert Oppenheimer would surely consider to be a fitting conclusion.

Specific examples of model risk and potential controls to help mitigate these risks include:




AUTHORS

Mary Ellen Cogginsdirector, Assurance and Business Advisory ServicesPricewaterhouseCoopers (US)Tel: 1 617 530 [email protected]

Nick ransondirector, Actuarial & Insurance Management SolutionsPricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Example model risk Potential controls

1. Model foundation & oversight

Inconsistency with the model’s business purpose

Inappropriate model governance

Training to help ensure users understand the purpose and applicability of model results (including key assumptions and any reliances or limitations around the results)

Technical model documentation and training for model operators

Model change controls including segregation of duties, formal test procedures, and documentation requirements

2. Assumptions & inputs

Inadequate controls around processes used to determine model assumptions

Other inappropriate model inputs

Sign-off requirements around the development, review, and approval of assumptions

Reasonableness and sensitivity testing of key assumptions (e.g. mortality, expense, and economic)

Reconciliation controls to help ensure the accuracy, completeness, and timeliness of input assumptions, including controls to ensure the correct assumption sets are applied when the model is run

Similar controls over other non-data inputs (e.g. economic scenario generators), including any assumptions used to derive these inputs

3. data management & verification

Inadequate controls around processes used to collect, deliver and store data

data quality controls (e.g. data entry checks and permitted data ranges)

Reconciliations to check the completeness, and accuracy of processes used to generate model points or other compressed or representative data files

Reconciliation controls to help ensure the accuracy, completeness, and timeliness of input data

Sample testing of data quality, accuracy, and completeness

IT controls to protect data stored and used within the model

4. Model performance & accuracy

Inappropriate model methodology

Model methodology inconsistent with relevant industry rules and guidance

Inconsistency between model specification and the computer code that transforms inputs into estimates

Independent review of methodology and approach underlying the model, together with any relevant mathematical or statistical results

Model testing (including single model point and aggregate results testing) to ensure the model code appropriately reflects underlying methodology and model specifications

Analytical review of results for representative sample of data inputs, including testing of various scenarios if appropriate

Back-testing and calibration-testing procedures where appropriate

Potentially validate model results against independent recalculation for appropriate samples

Results benchmarking (e.g. versus other similar models)

5. Outputs & results

Inadequate controls in place around processes used to analyze and distribute results from the model

Inappropriate reporting of model output to senior management

Analysis of model results prior to distribution

Reconciliation controls around the aggregation of model results with other results or manual adjustments, and the population of results into other systems

Independent review and benchmarking of frequency, content, and target audience of model output reporting

Request feedback from the users of reports and ensure model is appropriately updated to reflect relevant feedback (e.g. to improve usability of results or to correct errors in the model)

Capturing opportunities in a period of transition: How multinational insurers can compete in China

AutHOrS: MEI dONG, WENdY LAI, ANd XIAOkAI SHI


After rapid growth in recent years, the insurance industry in China is pausing to catch its breath. Mei dong, Wendy Lai, and Xiaokai Shi describe the changes in the industry, at regulators, and in the Chinese workforce, and suggest how foreign insurers can meet the challenges and take advantage of the opportunities in this time of transition.

After several years of rapid insurance industry growth, Chinese regulators are now focusing on strengthening supervision and risk management.

CAPturINg OPPOrtuNItIES IN A PErIOD OF trANSItION: HOW MULTINATIONAL INSURERS CAN COMPETE IN CHINA

China’s insurance industry is entering a transitional period characterized by greater focus on risk management and governance

The Chinese insurance industry has experienced tremendous growth in recent years. It reached a milestone in 2004 by accumulating 1 trillion Yuan in assets; within two years, that number doubled, and then grew by an additional one trillion in 2007. In the past seven years, life premiums grew at 23% Compound Annual Growth Rate (CAGR), and Property and Casualty (P&C) premiums grew at 20%.1 By any measure, this growth is extraordinary.

A number of signs now suggest the industry may be entering a period of transition, as companies and regulators assess the risks they have taken during these years of rapid growth and seek to build a stable long-term foundation for expansion. While growth may temporarily slow, this time of transition presents an opportunity for multinational insurers to deepen their presence in China, shape the industry’s

future, and position themselves for the anticipated resurgence of growth in three to five years.

This transitional period is necessary; the Chinese insurance industry is now large enough that companies need to reshape their operations to effectively mature and become more sophisticated businesses. Improving governance and risk management are the key components of the next level of business sophistication, and they will help establish conditions conducive to another cycle of growth.

In addition to internal business evolution, several external factors could accelerate industry reform over the next three to five years.

Changing regulatory focus. • Wu dingfu, Chairman of the China Insurance Regulatory Commission (CIRC), recently signaled in an influential magazine interview that the Chinese regulators will strengthen regulations on supervision and risk management. He said, ‘Several years ago, our main mission was to ‘repair the roads to

make space for more cars. Now, after these last several years, our goal is a simple one: to strengthen supervision, to improve the rules of the road, and strictly enforce them to prevent people from being harmed in accidents.’ He also commented that ‘the insurance sector is at the beginning of a new stage of development.’ Informal conversations and interviews with CIRC officials confirm this. Regulators are proposing and discussing new rules that emphasize solvency, capital requirements, risk management, and governance. This new tone from officials carries particular weight in China, where the government exerts heavy influence on the industry. The most recent PwC survey2 of executives of foreign insurers in China showed they consider regulatory forces the most critical factor influencing insurance business changes.

Insolvency concerns.• Currently, 110 domestic and foreign insurers operate in China. However, one recent press report

1 CIRC 2007 annual market report.2 In 2008, PwC surveyed and interviewed 28 foreign insurance companies in China. The survey report (published in September 2008) is available at:

http://www.pwchk.com/webmedia/doc/633555167808468096_foreign_insurance_cn_sep2008.pdf.


stated that twelve of the companies are experiencing difficulty remaining solvent. Other than the global equity market downturn, the key underlying reasons for this instability are overly aggressive business expansion, underdeveloped self-governance, and lack of sophisticated risk management expertise. Following one particularly high-profile case, CIRC issued new rules enhancing solvency requirements in July 2008. CIRC also is establishing a regulatory framework and procedures for dynamic solvency testing, similar to one which Canada, a mature market, is actively exploring. As a result, Chinese insurers are paying more attention to risk management and governance. Several of them are actively discussing risk management programs, such as economic capital implementation, reinsurance program redesign, and enterprise risk management (ERM).

vulnerable business •concentrations. Investment or savings-like instruments are easily the most popular Chinese insurance products. By 2007, 53% of Chinese life insurance products (including 69% of foreign insurers’ products) were categorized as savings or investments in the form of participating or unit-linked policies.

By concentrating on the investment business, insurers are in direct competition with banks and asset managers, which have the advantage of less stringent regulatory and capital requirements. In addition, China’s stock market has fallen more than 60% in the past year. As well as hurting sales of new products, this downturn also has challenged the financial stability of the industry because, according to the 2007 year-end data,3 the average Chinese insurer has almost 30% of its assets bound to the stock market. However, in a country that has a huge population and a rising middle class, insurance is expected to go beyond investment vehicles to playing a key role in protecting people from unexpected losses. Accordingly, we believe, after this transitional period, the Chinese insurance industry will feature greater protection-focused growth as a wealthier middle class increasingly understands its need for insurance coverage.

the global financial crisis. • The global financial crisis, especially the liquidity failure of AIG and Ping An’s loss of billions of Yuan when the dutch government seized Fortis, is likely to serve as a warning to Chinese insurance companies to review their risk management abilities and

practices. For many years, Chinese insurers looked to US business models to shape their management, organization, and investment policies, as well as their approaches to legal requirements and solvency regulations. However, the financial crisis – particularly as it has unfolded in the US – may suggest to Chinese insurers that the model they have sought to replicate suffers from fundamental flaws. Although it is difficult to predict the long-term impact of the financial crisis on China’s insurance industry, it certainly will force many executives and regulators to re-evaluate the risks the industry is facing, as well as their ability to manage them. For example, the financial crisis may cause Chinese insurers to reconsider the recent trend of establishing independent asset management companies to invest the insurer’s own assets and/or assets from external sources. Such arrangements, if investment risk is highly leveraged, can eventually threaten core insurance operations.

Multinational insurers face a number of challenges competing with domestic rivals

Since AIG started its wholly owned branch in Shanghai in 1992, the number of foreign insurers in China’s insurance

market has increased steadily. Today, 48 foreign insurance companies have established a presence in China, operating in life, P&C, and the reinsurance markets. However, despite steady growth, foreign companies continue to play a comparatively minor role in China, representing only a small fraction of the total market. As of the end of 2007, foreign insurers accounted for only 6% of market share, measured by the total of life and non-life premiums. This is because foreign companies that want to operate in China face a number of internal and external obstacles, including:

Operations complicated by •joint venture partnerships. A foreign insurer hoping to do business in China starts by applying for a business license. If it meets broad official and unofficial criteria, it receives a permit from CIRC. Then, the prospective foreign company must meet further regional and business requirements to receive a business license from the local administration of the Bureau of Industry and Commerce. To establish a life insurance business, foreign companies are required to form a joint venture with a domestic company. The foreign and local companies must share ownership equally. Building a long-term relationship with the partner in a joint venture is a

CAPturINg OPPOrtuNItIES IN A PErIOD OF trANSItION: HOW MULTINATIONAL INSURERS CAN COMPETE IN CHINA continued

3 According to CIRC, as of year-end 2007, China’s insurance total AuM has 18% directly in equity and another 10% in equity funds as indirect exposure to equity market.


complex process and requires mutual understanding of expectations from the outset. For example, most foreign insurers expect short-term losses when starting their businesses in China – a reasonable expectation considering the long-term investment nature of the insurance business. However, foreign insurance companies must convince their local partners, the majority of whom are not financial service players, that the joint venture will prove profitable over the long term. Because China’s economic boom has created a highly competitive market for capital, foreign insurers must convince potential partners of the long-term benefits of investing in the insurance industry.

Challenging business •conditions. Beyond the challenges they face from unusual ownership structure requirements, foreign insurers have to deal with a number of social and personnel issues unique to China, namely:

– Cultural differences can lead to distrust between joint venture partners and conflict over management practices. Joint ventures often have several managers from two different companies with totally different corporate cultures. These managers have diverse cultural backgrounds, and may have different points of view on basic

issues such as markets, products, distribution, and employee compensation.

– Competition for trained and experienced Chinese personnel is intense, particularly for competent managers. In fact, this is considered the most pressing issue for foreign companies in China, according to the recent PwC survey. An influx of foreign insurance companies is expected to drive demand for Chinese insurance experts beyond the capacity of even an expanded employee training programs. Furthermore, retaining top talent is even more difficult than training capable employees. In the authors’ view, better compensation is not a real solution to recruiting and retaining talent. Foreign insurers need to understand that talented and high-performing Chinese employees are driven by more than money. More than previous generations, they have the desire to make a difference, need constant, fresh challenges to remain engaged, and long for professional – not just monetary – success.

– Foreign companies have complex and sometimes contentious relationships with Chinese regulators, which require them to invest more time and effort in having effective regulatory interactions. These sometimes difficult

relationships with regulators also diminish foreign insurers’ influence on the regulatory direction of the industry. For example, foreign insurers often complain about the weight of requests from CIRC. However, we contend that, even though CIRC’s demands may seem onerous, they present an outstanding opportunity for foreign insurers to make their voices heard, as well as help CIRC determine how to better regulate the industry. We also believe that foreign insurers could go a long way toward improving their relationships and stature with regulators if they express their concerns in a common voice by forming a Chinese association of foreign insurers.

– Ongoing social changes affect marketing of insurance products. For instance, the traditionally central role of guanxi, the social relationship between and among individuals or organizations, in shaping business relationships has gradually eroded in urban centers. Insurers must now approach Chinese customers not only through their social groups, but also as individuals. Foreign insurers need to build a broader base of customer segments. As a result, building and leveraging more efficient and diversified distribution channels presents particular difficulties to multinational insurers.


According to a recent PwC survey, foreign insurers in China have stated that finding and keeping competent managers is their biggest challenge.


the transitional period presents real, but fleeting, opportunities for multinationals

On balance, the current, transitional period offers multinational insurers significant opportunities both to seize market share and to influence the future of the industry. There are at least three specific reasons to view the transitional period as a period of optimism and opportunity.

China needs more and better •insurance coverage. One of the most important byproducts of the Chinese economic boom is the rising Chinese middle class. As it builds its wealth, it accumulates valuable personal belongings, such as cars, houses, and other financial assets. The middle class thus continues to drive demand for various insurance products, including both life and non-life products. However, many people in this group still remain unaware of the importance of insurance, or lack the knowledge to choose appropriate insurance products for themselves and their families. If foreign insurance companies continue to target and educate the growing Chinese middle class population, they will benefit from its demand for insurance products. The threat of natural disasters also provides a real opportunity for growth in the Chinese insurance market. China’s P&C insurance system still remains

inefficient in providing effective social buffering in the face of major disasters. A paralyzing snow storm in January 2008 and a catastrophic earthquake in Szechuan province in May 2008 further revealed the inability of the Chinese insurance system to provide proper protection and compensation to natural disaster victims. In the next five years, the Chinese insurance market likely will continue to focus on developing appropriate products that provide coverage for both recovery and reconstruction in the wake of natural catastrophes.

Foreign insurers’ expertise •gives them an advantage. The Chinese insurance industry is maturing in much the same way that insurers in developed countries did decades ago. Insurers from developed countries possess experience and expertise that provide them with an advantage when competing with domestic ones. Most foreign insurers are accustomed to the sophisticated business challenges in a highly regulated and highly competitive global environment. For example, while most Chinese companies have not yet faced severe financial shocks, many large multinationals already posses decades of experience designing and selling sophisticated products that can help them weather various stages in economic and underwriting cycles.

In addition, foreign insurers continue to make advances in areas such as new product development and risk management. They can draw on this experience and culture of innovation to design and sell insurance products uniquely suited to the needs of Chinese consumers. For example, products such as weather derivatives, which are common in the US, are still largely unheard of in China. In light of the unpredictability of the weather, as well as the heavy Chinese reliance on agriculture, the Chinese market is poised for demand growth in this sector. Foreign insurers, with years of experience in developing such products, as well as abundant data and models to support their design, can take a lead in introducing them to Chinese consumers.

the next five years is a •promising time to expand in the Chinese market. Over the next five years, foreign insurers likely will see their last – yet best – opportunity to both influence the regulatory direction of the Chinese insurance industry and obtain strong market share for the long term. The increasing number of well-educated Chinese expatriates who are expected to return home in the next five years represents a competitive pool of human resources – many of whom have spent five


Foreign insurers’ experience designing and selling sophisticated products gives them a pronounced advantage in a developing and underserved market like China.


years or more working at multinational insurers or consulting firms – that foreign insurers can utilize. Within the insurance industry, this talent has extensive industry knowledge and sophisticated business development skills. At the same time, their language ability and understanding of Chinese culture give them a pronounced advantage over foreign executives who plan only short business tours in China. Accordingly, these Chinese expatriates can serve as the ideal links between the local Chinese market and the home offices that operate under Western-style management.

However, this opportunity may not last very long.

– domestic companies are experiencing strong growth and are attracting increasing numbers of talented Chinese employees, both locally and from overseas. It will be even harder for foreign companies to compete in five years’ time because their domestic

competitors will be much stronger then than they are today.

– CIRC is rapidly increasing its regulatory knowledge and skills. Over the next five years, CIRC likely will develop much stronger regulatory capabilities and make major, far-reaching policies and rules. As a result, if they cannot effectively articulate their opinions, foreign insurers will be operating in a considerably more mature Chinese insurance industry, with established rules and regulations tailored to domestic insurers. In order to better align their strategies with the development of the industry, it is very important that they be able to offer their opinions and make their voices heard during this transitional stage. At the same time, they need to make credible and well-coordinated attempts to influence the development of the industry in a manner in line with their own corporate goals.

In conclusion, the next five years is an era of considerable opportunity and some major

challenges for foreign insurers who remain interested in the Chinese insurance market. It is critically important that those insurers take a long-term view, plan their penetration into the Chinese market strategically, vigorously develop their local teams, actively build relationships with local partners, and carefully interact with CIRC. Foreign insurers who take advantage of this transitional period can effectively leverage their global expertise, resources, and best practices, and thus expand their presence in the Chinese insurance market. This includes attracting and retaining top local and overseas talent, building a stronger and broader customer base, exploring efficient distribution channels, constructing a diversified business portfolio, and applying prudent legal compliance with regulations. The companies who best capture the opportunities of this transitional stage will be the ones that enjoy significant long-term success in China in the years to come.


AUTHORS

Wendy LaiSenior Manager, Assurance and Business Advisory Services PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Mei DongAssociate, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Xiaokai ‘victor’ ShiSenior Associate, Actuarial and Insurance Management Solutions (AIMS)PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Over the next five years, foreign insurers likely will see their last – yet best – opportunity to both influence the regulatory direction of the Chinese insurance industry and obtain strong market share for the long term.

Solvency II: A competitive advantage for European insurers?

AutHOrS: MICHAEL LOCkERMAN ANd JOHN ROEMER


despite the fact Solvency II in its current form will apply only to the European Union, North American insurers are encouraged to pay attention to the factors underlying its development. If, as anticipated, Solvency II leads to markedly lower capital charges for EU-based companies, then the Europeans will have a significant competitive advantage over North American companies.

Although it presents a significant implementation challenge, moving to Solvency II could help develop a more informed and forward-looking economic basis for decision-making.

SOLvENCy II: A COMPETITIVE AdVANTAGE FOR EUROPEAN INSURERS?

In May 2007, the IASB issued a discussion paper, ‘Preliminary Views on Insurance Contracts,’ which advocates a ‘current exit value’ approach to the measurement of insurance contracts. The market-consistent approach advocated in the discussion paper is broadly in line with recent developments in prudential regulation, including the Uk’s Individual Capital Adequacy Standards (ICAS) and the anticipated EU Solvency II. As such, it forms part of the accelerating convergence toward an economic framework for evaluating solvency, reporting earnings, and measuring performance.

The asset and liability requirements included in the draft framework for Solvency II, published by the European Commission in July 2007 and updated in February 2008, are in many respects conceptually consistent with the current IASB proposals. Under Solvency II, insurance assets and liabilities would be measured using economic principles, with the resulting capital requirements based directly on risk-based measures. Although Solvency II would at present apply only to European Union insurers, many other jurisdictions are monitoring its developments to assess the competitive impacts and determine what elements might be more widely applied.

the competitive impact of Solvency II

despite the fact Solvency II in its current form will apply only to the European Union, US insurers are encouraged to pay attention to the factors underlying its development, particularly those that potentially have a competitive impact.

Solvency II seeks to map insurers’ regulatory capital requirements against their individual risk profile. This will encourage, if not actually require, companies to enhance risk management, upgrade information systems, and embed risk awareness more closely into the governance, strategy, and business operations. Although it presents a significant implementation challenge, moving to Solvency II could help develop a more informed and forward-looking economic basis for decision-making.

The foundation of the new regime consists of three pillars that are conceptually comparable to Basel II:

Quantitative requirements;1.

Governance and risk 2. management requirements; and

disclosure and transparency 3. requirements.

Assets and liabilities will be valued on a market-consistent basis, conceptually in line with the latest proposals for IFRS Phase II. The standard solvency capital requirement (SCR) will be based on a 99.5% confidence level of remaining solvent within the next 12 months (equivalent to being able to absorb a 1-in-200-year event). The SCR evaluation, which is broadly equated to a BBB rating, should include all material financial and non-financial risks facing the company. Companies then can determine the amount of capital appropriate to a true economic level and calibrate to the target level to meet their desired rating.

In keeping with Basel II’s underlying advanced approach, it is likely that many larger companies will take advantage of the option to use an internal model to calculate their SCR, subject to supervisory approval. For most companies this is expected to result in a lower regulatory capital requirement. Last year’s quantitative impact study for Solvency II (QIS 3) found that non-life companies entering SCRs based on their own models achieved on average a 25% reduction in SCR over the standard formula. For life companies the comparable reduction was 15%.1 Larger groups also can take advantage

1 ‘Solvency II – QIS 3 Report,’ published by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) on 21.11.07.


SOLvENCy II: A COMPETITIVE AdVANTAGE FOR EUROPEAN INSURERS? continued

of lower compliance costs and more flexible capital arrangements by opting for group supervision under Solvency II.

Many industry stakeholders have argued that there has been a disparity between true economic capital and the capital required by traditional regulatory frameworks. In particular, regulatory capital often has been derived from formulas intended to cover a wide range of companies and risk profiles. These factor-based calculations do not reflect the specific risks associated with individual insurers and the effectiveness of the management at them; as a result, capital levels may exceed what is appropriate for many companies. This results in an additional cost (or ‘capital drag’) because companies are compelled to hold more capital than their risk portfolio otherwise would require on a purely economic basis.

By using their own models, companies can incorporate their portfolios’ diversity and diversification with their own experience into a unique but credible capital assessment. They then can apply solvency requirements that are more appropriate to their risks, as well as reduce the disparity between regulatory requirements and the true economic capital they believe they must hold to support their risks. In contrast to Solvency II, US capital requirements are typically based on standard

formulas or include calculations based on prescribed assumptions that may be significantly different from the assumption of a 1-in-200-year event. There are limited provisions to reduce capital based on risk mitigation or diversification between products or marketplaces. Where these risk mitigation provisions exist, their application may be subject to approval by various state regulators. This results in limited and inconsistent application and may impose a significantly larger capital drag than would be expected under the harmonized Solvency II.

The companies most likely to benefit from lower capital charges under Solvency II are larger, diversified insurance groups with effective risk management. Their smaller, less sophisticated mono-line counterparts may find their capital requirements increase on a relative scale. As a result, European companies may face mounting pressure to restructure – shuffling existing groups, moving to a branch structure, or exiting high risk or discontinued lines that may absorb too much capital – to obtain benefits from Solvency II.

Capital drag affects the pricing and profitability of insurance products. For example, if a company prices a product to achieve a 15% return on economic capital and earn 5% on any capital in excess of economic capital, then a solvency regime

that requires only 100% of economic capital would realize this 15% return, while provisions requiring 110% of economic capital would result in a 14.1% return on invested capital. If a company subject to US regulations and a company subject to Solvency II were to offer a life insurance product with identical assumptions and features, then the return on investment for the US-regulated company would be lower or the company would have to charge a higher price to realize the same return. This would be solely due to the costs associated with holding a higher-than-necessary amount of capital.

Companies naturally will seek ways to take advantage of less onerous capital regimes. For years, they also have been entering into financial treaties or agreements in order to avoid or defer high liability or tax requirements; this has been the primary factor behind the growth of the reinsurance sector in Bermuda, the Cayman Islands, Ireland, Luxembourg and Vermont.

However, certain costs, including the expense of establishing and maintaining subsidiary companies, fees paid to other entities, charges associated with the treaties themselves, and possible lack of transparency, have accompanied relocation to these markets. In addition, the level of available credit is another

Last year’s quantitative impact study for Solvency II (QIS 3) found that non-life companies entering standard capital requirements (SCRs) based on their own models achieved on average a 25% reduction in SCR over the standard formula. For life companies the comparable reduction was 15%.


SOLvENCy II: A COMPETITIVE AdVANTAGE FOR EUROPEAN INSURERS? continued

constraint with respect to liabilities. Many treaties or agreements are accompanied by a letter of credit or surplus note equal to the liability credit. The availability of credit can be limited in jurisdictions with more favorable regulatory arrangements, which, coupled with the recent credit crunch, have increased costs and slowed transactions.

despite the costs, letters of credit, surplus notes, and other arrangements are increasingly used in situations in which additional expenses are more than offset by the savings associated with removal of unnecessarily high liability or capital requirements. If insurers that sell products in the United States efficiently transfer risk and capital requirements to a subsidiary operating under Solvency II requirements, then they may be able to reduce

excess capital requirements and increase overall profitability and return on equity.

the potential effects of Solvency II in the uS

developments in the pipeline in the United States may help some insurers to reduce the costs of more onerous domestic capital requirements, but they may not be sufficient to offset the advantages European insurers may realize under Solvency II. If, as anticipated, Solvency II leads to markedly lower capital charges for EU-based companies, then the Europeans will have a significant competitive advantage over US companies.

Effective and forward-thinking US reform could eliminate these disparities. Although this may seem unlikely to many in the industry, there are encouraging signs. Recent developments, such as the Variable Annuity

Commissioners Annuity Reserve Valuation Method (VA CARVM) and NAIC participation in Solvency II discussions indicate that US regulators are interested in certain aspects of Solvency II. In addition, the concept of a federal insurance company charter – something which former US Treasury Secretary Henry Paulson supported – once again is a topic of serious discussion.

The combination of external competitive pressures, internal pressures for financial reform, and insurers’ increased discipline in assessing and measuring risks indicates that the industry’s and regulators’ risk management focus is evolving toward more flexible and less onerous capital requirements. Successful Solvency II implementation may be enough to push US regulators to seriously consider an approach with comparable advantages.

AUTHORS

Michael Lockermandirector, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

John roemerPartner, Assurance and Business Advisory Services PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Developments in the pipeline in the United States may help some insurers to reduce the costs of more onerous domestic capital requirements.

Realizing the competitive potential of reporting convergence

AutHOrS: MARk BATTEN, ALEX FINN, PAUL HORGAN, ANd NICk RANSON


developing a streamlined ‘economic’ framework for reporting and management information could not only ease the implementation of new reporting requirements, but also enhance decision-making and strengthen stakeholder confidence.

Insurers could use these developments as an opportunity to enhance the quality and consistency of reporting to different stakeholders including management, analysts, investors, supervisors, and rating agencies.

rEALIzINg tHE COMPEtItIvE POtENtIAL OF rEPOrtINg CONvErgENCE

Overview: Surer economic footing

From climate change to financial market turmoil, insurers are facing an increasingly complex and uncertain risk and commercial environment. The pressure on returns is further heightened by capital constraints, volatile asset values, the softening of non-life premium rates, and the wider slowdown in the economy.

An effective ‘economic’ framework for management reporting can help companies develop a more informed, assured, and transparent risk-adjusted basis for strategic evaluation and capital allocation. In today’s tough business environment, the potential benefits include more effective use of capital and the ability to identify and swiftly take advantage of limited and hard-to-discern opportunities.

An economic approach to strategic planning and performance management is gaining ground within the insurance industry through the implementation of economic capital and embedded value analyses. In June 2008, the European Insurance CFO Forum

(‘CFO Forum’)1 launched its Market Consistent Embedded Value Principles© (MCEV),2 which are expected to set the standard for embedded value disclosure across the insurance industry (see box ‘Gauging, conveying and corroborating economic value’).

In seeking to convey the prospective value of cash flows on a market-consistent basis, the use of economic frameworks

such as MCEV is paving the way for comparable approaches within the planned EU Solvency II and IFRS standard for insurance contracts (IFRS Phase II). As such, MCEV is road testing many elements of the proposed changes to financial reporting and regulatory disclosure.

The move to a market-consistent approach presents far-reaching implementation challenges,

gauging, conveying and corroborating economic value

MCEV provides baseline principles for measurement and disclosure, which have been agreed by CFO Forum members. It should therefore enhance the consistency and comparability of embedded value reporting.

However, some companies may wish to provide further company-specific disclosures that recognise additional earnings over and above the MCEV baseline. This might include their estimate of the future profit stream from spread-based products such as Uk or US annuities. Under the MCEV principles, anticipated earnings from such contracts are measured at a risk-free rate, though companies would naturally expect a greater return. Additional disclosure would enable them to convey their estimation of future earnings and their explanation for this projection.

In the wake of recent market events, insurers are also facing heightened analyst scrutiny of managements’ own estimation of value. It is therefore important to be able to link MCEV measures and any additional disclosures to how much cash is actually being generated and over what period.

1 The European Insurance CFO Forum is a high-level discussion group that brings together CFOs from leading European insurance companies (www.cfoforum.nl).

2 Copyright © Stichting CFO Forum Foundation 2008.


rEALIzINg tHE COMPEtItIvE POtENtIAL OF rEPOrtINg CONvErgENCE continued

including the need for sophisticated modeling capabilities. Under Solvency II, companies also will need to demonstrate the use of the resulting risk and capital analyses in the management of the business (the ‘use test’). In turn, greater transparency could have critical implications for share values and the cost of capital at a time when analysts, investors, regulators, and rating agencies are taking an ever keener interest in how effectively risk is managed and integrated into decision-making.

Even where they do not apply,3 these developments are likely to set a benchmark for global disclosure that others may need to follow, particularly in relation to risk. The US Securities and Exchange Commission (SEC) is about to launch consultations on a proposed roadmap for the mandatory adoption of IFRS from 2014. Some eligible firms may be able to switch to IFRS as early as the december 2009 year-end. In turn, the International Association of Insurance Supervisors (IAIS) is promoting a risk- and principles-based approach to solvency regulation around the world.4 It is also likely that the prospect of potentially lower capital requirements for groups using internal models under Solvency II may spur their global counterparts to press for a similar risk-based approach to regulation.

Recent market events have led some to question the risk-based capital approach and the modeling that underlies this under Basel II, a framework which has parallels to Solvency II. The problems experienced by many institutions certainly highlight the need for improvement in a number of key areas, including better use of model outputs, more effective stress testing and a better understanding of liquidity risk. However, Solvency II is likely to be more exacting and sophisticated than Basel II, especially in the Pillar 2 principles for governance and embedding, requirements that have led some to characterize the proposed directive as a ‘Basel III’.

Implementation and development of Solvency II and IFRS Phase II are likely to be demanding. The good news is that parallels in the timings (see Figure 1) and bases of valuation (see Figure 2) could open up cost-saving synergies in areas such as data, assumption setting, modeling, and reconciliation. More fundamentally, insurers could use these developments as an opportunity to enhance the quality and consistency of reporting to different stakeholders including management, analysts, investors, supervisors, and rating agencies. A key benefit would be the opportunity to strengthen stakeholder confidence by being able to convey a single

3 Solvency II will primarily affect insurance firms that operate in the European Union. MCEV is a supplementary basis of disclosure geared to life insurance that will only be mandatory for members of the CFO Forum. Significant parts of the world have not currently adopted IFRS.

4 IAIS media release ‘IAIS issues key guidance papers on solvency assessment’, October 22, 2007.

While there are differences in the scope, objectives, and detailed provisions of MCEV, Solvency II and current draft IFRS Phase II proposals, there are sufficient similarities to realize cost-saving synergies in areas such as data, assumption setting, modeling, and reconciliation. The parallels include:

Market-consistent financial assumptions driving • best-estimate liability;

Liability measure includes a risk margin above financial • best-estimate of liabilities;

Current rather than locked-in assumptions;•

diversification of risks across portfolios considered • (to a lesser extent in IFRS).


Figure 2 Parallels between MCEV, Solvency II and IFRS Phase II

Figure 1 Timetable for IFRS Phase II and Solvency II

Solvency II

2007 2008 2009 2010 2011

IFRS Phase II

All dates are estimated based on current knowledge

Draftframeworkdirectivepublished

Frameworkdirectivepublished

Discussionpaper

Exposuredraft

2012 2013

Fullimplementation

ImplementationIFRSpublished




view of the business that more closely reflects the way it is run internally.

As we outline in this paper, closer alignment between certain risk and finance activities will be critical in meeting evolving reporting demands and developing a more risk-sensitive approach to strategic evaluation and capital allocation.

taking full account of risk

The development of an economic framework for management reporting could help insurers to steer a successful course through an increasingly tough risk and commercial environment.

Timely and relevant management information capable of providing a balanced perspective between risk and reward can improve an insurer’s ability to manage the challenging times ahead. However, the supply of data can often be too slow. Moreover, as highlighted in our ERM survey, Does ERM Matter? Enterprise-wide risk management in the insurance industry 2008, many insurers have yet to fully embed risk considerations into business planning and strategic execution.In many cases, management information is also based on inconsistent data, assumptions, and models across multiple valuation bases, which can diminish its usability and credibility at Board level. disparities can often result from different areas of the business using separate data feeds, models and

the real risk-adjusted return: What is an economic approach and how can it provide a more useful measure of value and performance?

An economic management framework seeks to judge the value of rewards in light of the associated risks and capital required to earn them. The value of the profit should reflect the risk and potential for loss to which an organisation was exposed in generating that return. For example, if the earnings from an investment in a volatile or high-risk business line are failing to beat the return from a lower risk counterpart by an appropriate margin, then the former is clearly not a good bet.

MCEV seeks to provide an economic measure of shareholder value, being the sum of the risk-adjusted future profit stream arising from existing business and the adjusted net worth of the enterprise (the realizable market value of the capital and surplus).

Economic capital seeks to gauge the amount of capital needed to meet policyholder obligations within a given level of confidence, taking account of the risks inherent in the business written. As such, economic capital provides management with a useful measure of how much capital is being tied up by a particular risk or set of risks (the confidence levels can be equated to more tangible credit ratings or one in a number of years’ loss probabilities).

While there are therefore important distinctions between MCEV and economic capital, they can be seen as two sides of a performance measurement coin. Bringing the two evaluations together can provide a more telling indicator of performance than many existing formulas.

Performance is typically measured by dividing the profit (numerator) by the required capital investment (denominator). Traditionally, these calculations have not been appropriately adjusted for risk. Examples include statutory or local GAAP profits over rating agency capital.

dividing the change in MCEV (numerator) by economic capital (denominator) can provide a better measure of the trade-off between risk and reward and therefore how well a particular component of the business is performing; how effectively capital is being deployed, and how this equates to an overall risk appetite.

How well developed is this economic approach?

PricewaterhouseCoopers’ recent global survey of enterprise risk management (ERM) in the insurance industry found that an increasing number of smaller and medium-size insurers are joining their larger counterparts in implementing economic capital capabilities.5 Convergence in the approach used to measure economic capital is also evident from the survey results.

However, most participants recognised that they still have some way to go before they realise the full benefits of implementing an economic capital model. Nearly three-quarters did not believe that the output from their economic capital model had gained full acceptance from business units or that it influences day-to-day decision-making. Barely a quarter discerned that their economic capital modeling provides substantial value in defining their risk appetite, setting risk limits or improving strategic planning. Looking to the future, however, most respondents were confident that further development of these capabilities would deliver significant value, including better allocation of capital and more effective assessment of the value of different strategic options.

5 ‘does ERM matter? Enterprise risk management in the insurance industry 2008: A global study’ published in June 2008.



assumptions to generate MCEV, IFRS (or local GAAP) and economic capital information.

The advanced actuarial models being developed to map insurers’ evolving risk profiles are providing valuable insights. As our ERM survey further highlighted, however, making sure that data, assumptions, and model controls are reliable enough to ensure that model analysis is trusted and accepted within the business is proving to be a significant challenge.

An economic framework for management reporting could help companies ensure that decisions reflect the real risk-adjusted returns. It would also enable companies to move from multiple ‘versions of the truth’ to a more streamlined, consistent, and credible basis of evaluation. The result would be a more precise and reliable foundation for risk selection, pricing, reserving, and reinsurance strategies. At a time when margins are coming under increasing pressure and the economic slowdown is limiting business development opportunities, an economic approach could also help companies pinpoint openings that may be missed by their competitors and target investment where it can earn its best return.

However, while greater alignment of risk and finance metrics can be helpful, full operational integration of risk and finance would, in our opinion, be a mistake, as it may

miss the fundamental differences and complementary roles that are essential to the effective running of the business. This includes distinct areas of expertise – financial management in areas such as tax planning, capital raising, and financial engineering; actuarial in areas such as pricing, reserving, and reinsurance; and risk management in fields such as process improvement and the enforcement of limits and controls. More broadly, effective strategic evaluation requires the ability to formulate and challenge prospective decisions from a range of different perspectives,

which may be blurred within a fully integrated approach to risk and finance.

Navigating the storm

Insurers are facing the challenge of regulatory developments that will overhaul risk, capital, and financial reporting. Leading companies are looking at how to turn the necessary investment to their advantage.

Risk and finance teams find themselves weighed down by a welter of financial statements and regulatory returns. The pressure to meet external reporting

understanding the trade-off between risk and reward

Closer cooperation between risk and finance activities in management reporting could help ensure that risk becomes a more visible and telling element of business planning and capital allocation. The overriding aim is the development of common metrics capable of bridging risk and reward (a ‘common language’). The potential benefits include:

Greater application of risk disciplines in key business processes • such as strategy, planning, and valuation;

More robust financial plans and projections (e.g. by challenging • management to consider ranges of upside and downside outcomes it requires them to better define their appetite for earnings volatility);

A more coherent and consistent view of the business from risk • and finance;

Reduced costs – both direct and indirect. For example, greater • alignment of risk and finance could avoid needless duplication in data management, systems and personnel;

Better, faster, and more robust decisions based on common data.•

At a time when margins are coming under increasing pressure and the economic slowdown is limiting business development opportunities, an economic approach could also help companies pinpoint openings that may be missed by their competitors and target investment where it can earn its best return.


5 Solvency II amended draft framework directive, published by the EC on 26.2.08.6 Standard and Poor’s ‘Ratings direct’, 15.05.08.

deadlines means that the analysis and insight that could support more effective decision-making often has to take a back seat.

The challenges are particularly acute for large international groups. Under current IFRS, national accounting practices for liability measurement have been largely left in place, creating a patchwork of often inconsistent valuation bases for subsidiary and group financial statements. Many companies also are forced to work with a number of potentially incompatible legacy systems, a problem that has been compounded by acquisition and consolidation in recent years. Further complications often stem from an inefficient silo-based approach that demarcates risk, finance, and actuarial operations within many companies.

Initially at least, MCEV, Solvency II, and IFRS Phase II could heighten the demands on already hard-pressed reporting functions. key implementation challenges include aligning risk and financial data as part of the market-consistent approach to liability measurement, which is the cornerstone of all three frameworks. Evaluation will require considerable additional risk and financial information and the development of sophisticated and appropriately controlled modeling capabilities. Many international groups also face the prospect of moving from multiple local GAAPs to a single harmonized financial reporting standard.

The overriding aim of IFRS 7 ‘financial instrument disclosure’ is to enable users of accounts to look at the risks insurers run and

their potential impact on the business through the ‘eyes of management’. As such, this standard could be seen as a

forerunner of the ‘use test’ that will form part of Solvency II, under which insurers will be required to demonstrate that their


raising the bar part one: using an internal model under Solvency II

Under Solvency II, insurers can seek approval for use of their own internal model in calculating their solvency capital requirement. Approval depends on their ability to demonstrate that they meet six key tests:5

Use test: Senior management needs to understand, endorse, and use the risk and capital evaluations • from the internal model as a key basis for its business planning and strategic decision-making.

Statistical quality: Evaluations need to be based on timely, reliable, consistent, and comprehensive • risk data and be underpinned by current, credible, and verifiable risk assumptions.

Validation: Evaluations and underlying assumptions need to be regularly sense-checked against • actual experience.

Calibration: Outputs need to be calibrated to a 99.5% value at risk (VAR) or equivalent measure and • benchmarked against market practice.

Attribution: Companies need to regularly check whether the categorization of risk and attribution of • profit/loss in their models reflect the causes and sources of profit/loss within business units.

documentation: Companies need to keep regularly updated records covering the design, operation, • mathematical basis, and underlying assumptions of their model.

raising the bar part two: rating agency financial strength evaluation

Assessment of an insurer’s ERM capabilities and related risk-based capital is now an increasingly significant element of rating agencies’ financial strength evaluations. Recent market events are likely to accelerate this trend.

The approaches being developed by the different rating agencies vary from an explicit score for ERM to its implicit incorporation into the overall ratings assessment. However, all the methodologies seek to gauge whether the entity is holding sufficient capital to match its risk profile, its risk appetite and the relative rigor of its risk management, which is an approach that has parallels with economic capital. Rating agencies are also looking at whether risk considerations are integrated into decision-making and whether the risk analysis that underpins this is sound, an approach that mirrors the use and other key tests built into Solvency II (see box ‘Using an internal model under Solvency II’). Standard and Poor’s has now taken this approach further by offering to assess a selected number of insurers’ economic capital models,6 a move that highlights the growing importance of external validation in demonstrating effective economic management to stakeholders.



publicly disclosed risk and capital evaluations are fully embedded into business planning and capital allocation (see box ‘Using an internal model under Solvency II’). Comparable requirements already exist within many rating agencies’ financial strength evaluations (see box ‘Rating agency financial strength evaluation’). If companies are not using economic capital for IFRS 7 then by definition they are not using it for management of their business and would therefore likely fail the Solvency II use test.

Potential synergies

Common data and systems requirements underpin much of the necessary information that will be required under Solvency II and IFRS Phase II (see Figure 3). Exploiting these synergies will allow insurers to avoid some of the costs, duplication, and potential disruption of applying and managing the frameworks separately. By streamlining and improving the efficiency of the reporting process, risk and finance teams will have more time to provide valuable input into business and strategic decisions.

The move toward an economic basis for external reporting provides companies with a powerful impetus to do the same for management reporting, especially as they will need to demonstrate to regulators and rating agencies that risk awareness is embedded within

the fabric of their business. Convergence of management reporting around a central economic basis also could enhance market confidence by enabling insurers to convey a single view of their business that reflects the way it is run internally. This would be an important step forward for a sector whose

reporting has often been regarded by analysts and investors as opaque and with too many bases of reporting to be intelligible. The potential benefits of these changes include share values that more genuinely reflect the true performance and potential of the enterprise.

Figure 3 developing the common model

IFRS Phase II Solvency II MCEVEconomic

capital

REPORTING

• Data underpinning the accounting models will be common, but

• Need to understand the different outputs that data need to populate

Inputs andAssumptions

Information used in valuation models

Economiccapital

MCEV

Solvency IIPhase II


By streamlining and improving the efficiency of the reporting process, risk and finance teams will have more time to provide valuable input into business and strategic decisions.



‘Typical’ current risk and finance structure

Aligned future risk and finance structure

* Credit, Market, Liquidity, and Operational Risk

Aligned Teams

CROCFO

Finance Data, Assumptions, Systems, and Controls –Offshored or OutsourcedShared Services,

Finance Partners in the Business*

Bus C

InvestorRelations

TreasuryandALM

Risk Data, Assumptions, Systems, and Controls –In house developed tools and teams

Risk,Reporting

and ControlRisk

Committees

Risk and Finance Partnersin the Business

Bus A

Bus B

Bus C

Capital Strategy,Allocation and Planning

External Relations

M&AChangeManagement

Risk Governance andPolicy Centers of Excellence

Market Risk

Credit Risk

Operational Risk/Control

Oversight, Policyand Model

Development

Financial and CapitalStrategy, Planning

and Analysis

Treasury andBalance SheetManagement

CFO

Tax Planningand Compliance

Finance and risk data assumptions, systems and controls make use of consistent data, with supporting applications across finance, risk, tax and regulatory reporting and shared services.

FinancialReporting

andControl

Bus ABus B

Financial Planning,Budgeting Strategy,

and Analysis

TaxPlanning

andCompliance

Oversight,Policy and

ModelDevelopment

Integrated Financial and RiskReporting and Control

CRO

RiskCommittees

Bus C

Bus ABus B

Risk Monitoring and Escalation in

the Business*

Making it happen

developing an effective economic reporting framework requires careful planning and coordination, underpinned by a clear and realizable vision of what companies expect to achieve.

In moving to an economic footing, insurers clearly need to work within the constraints of cost, organizational structure, and ever more pressing implementation deadlines. The assessment of what is achievable and how it can be achieved should ideally be underpinned by

thorough gap and cost-benefit analyses covering such areas as data supply, systems capacity, model control and the availability and training of key personnel. The resulting framework needs to balance management requirements and stakeholder expectations, while articulating

how the business will be managed in the interim to minimize potential disruption.

Banks’ experience of implementing Basel II offers important lessons for insurers. In particular, many institutions underestimated the scale of the


Figure 4 Example of future state with alignment of risk and finance



task – not only in developing appropriate systems, but also in ensuring that they were embedded into governance and decision-making structures, a key aspect of the use test. In some cases, this meant that ambitious plans for the accreditation of internal models had to be shelved in favor of straightforward compliance. Moreover, systems were often designed and developed by technical teams in isolation from the wider organization. Business units need to be involved in planning from the outset to help win their buy-in and ensure that the resulting systems provide useful information that can help enhance their decisions and deliver competitive value.

Laying the foundations

Close alignment between risk and finance functions is the bedrock of an economic approach. Achieving better alignment rests on the standardization and simplification of the reporting, control, modeling, transactional, and data elements of risk and finance, alongside enhanced efficiency through shared services and data warehousing. Figure 4 outlines how this alignment of risk and finance might be structured in practice on governance structures, as well as capital requirements.

Identification and prioritization of the key steps clearly will be crucial (‘establishing a critical path’). For example, the quality of data and validity of assumptions are essential in ensuring the accuracy of models

and would therefore need to be addressed before bringing any newly developed or upgraded models on line.

As part of the operational manifestation of an economic approach, effective ERM can help insurers develop consistent firm-wide procedures for risk identification, measurement, and monitoring (‘informing the input’) and ensure that risk limits and controls reflect the risk appetite and overall strategic objectives of the business (‘enforcing economic behavior’).

Embedding this risk-adjusted economic approach into the business will require risk teams to be involved in decisions from the outset, and an appropriate tone from the top to ensure that effective risk management is a priority. It may also require significant changes in the way performance and related bonuses are judged. In many companies this will require a shift away from targets based on top-line and one-year combined ratio results toward risk-adjusted criteria and long-term growth in shareholder value. In a Uk TV interview in September 2008, Stephen Green, Chairman of HSBC, stressed the importance of ensuring that ‘remuneration schemes operate in a way that is lined up with the long-term interests of the owners of the business. There has been far too much focus on payments that are very short-term focused, people who pick up the tab for short-term profits, without having to bear the costs of long-term impairments.’7

7 BBC News ‘Leading Questions’, September 13, 2008.

How aligned are risk and finance currently?

Alignment can be demonstrated in a number of ways, but one of the key barometers is the consistency of the metrics between risk and finance. However, our global ERM survey revealed that only around a quarter of respondents were confident that they have an efficient basis to link risk with other financial information.

Nonetheless, greater alignment does appear to be moving up the agenda. Over 60% of respondents expect to leverage the development of capital and risk management practices with the requirements of Solvency II and IFRS Phase II. Further, most respondents expect to realize synergies between financial and regulatory reporting in areas such as data modeling and reporting infrastructure. Nonetheless, most participants are only just beginning to achieve these anticipated synergies (see Figure 5).

Figure 5 Areas where companies are looking to exploit the synergies between financial and regulatory reporting

Source: does ERM matter? Enterprise risk management in the insurance industry 2008 (www.pwc.com/insurance)

Percentage of respondents

Integratedreporting

infrastructure

Integratedinformation

system

Integrateddata system

Integrateddata models

Beginning stage in achieving synergies

Intermediate stage in achieving synergies

Advanced stage in achieving synergies

0% 20% 40% 60% 80%



AUTHORS

Mark BattenPartner, Corporate Restructuring PricewaterhouseCoopers (Uk)Tel: 44 20 7212 [email protected]

Alex FinnPartner, Global Capital Markets Group PricewaterhouseCoopers (Uk)Tel: 44 20 7212 [email protected]

Paul HorganLeader, Global Insurance Risk and Capital Team PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Nick ransondirector, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Weighing up the options

The challenges and corresponding opportunities presented by MCEV, Solvency II, and IFRS Phase II can be divided into three components:

Systems and organization: Enhancing the speed, efficiency, consistency, and cost-effectiveness of the reporting process;

Management reporting: Providing a basis for more informed and assured decision-making;

Stakeholder relations: developing more credible, intelligible, and comparable disclosure.

Some insurers may prefer to watch and wait until details of Solvency II and IFRS Phase II are approved. However, what is likely to be a brief timeframe between finalization and implementation could make this a high-risk

option. Any delay or under-estimation of the impact of these changes also could exacerbate an already stressed reporting environment and lead to potential meltdown in the longer term.

A tactical approach that seeks to overlay compliance with the new requirements onto existing systems may be a cost-effective option for some smaller and less complex businesses. However, reliance on ‘band aids’ to patch up key gaps and weaknesses may lead to error and confusion during the transition, especially within larger companies. A piecemeal silo-based approach also may lead to duplication and inefficiency, while making long-term application costlier and harder to sustain.

Many forward-looking insurers are therefore adopting a more strategic approach, which aims to streamline their reporting infrastructure as part of a holistic move to a common economic management framework. The

potential benefits include removing the need for separate models and processes and using investment that will be required anyway as a catalyst for strengthening the quality of management information and decision-making.

In a rapidly evolving and increasingly tough business environment, the potential competitive advantages include the ability to strike a more sustainable balance between risk and reward, more efficient use of capital, and greater assurance for the Board and financial markets.

Options remain open for federal insurance regulation

AutHOr: BARBARA LAW


There has been recurring support both in the US Congress and Treasury for an Optional Federal Charter (OFC), which would create a single federal insurance regulator as an alternative to the current state regulatory system. Barbara Law reviews the arguments for and against an OFC, provides updates on the status of the debate, and shares insight into what the future may hold.

As long as each jurisdiction ultimately remains autonomous in its domestic market, regulatory inconsistencies and redundancies will persist and compliance costs will remain high.

OPtIONS rEMAIN OPEN FOr FEDErAL INSurANCE rEguLAtION

Recent discussions about the federal government’s role in insurance regulation are not novel. US lawmakers and judges have periodically evaluated the appropriate level of insurer oversight. However, the tradition of state insurance regulation, with the National Association of Insurance Commissioners (NAIC) facilitating the regulation of multistate insurers and industry support, has endured without significant challenges since the mid-part of the twentieth century.

Calls for a federal charter

In 1999, the Gramm-Leach-Bliley Act (GLBA) paved the way for US banks to own and operate securities firms and insurance companies. The emergence of a consolidated financial services industry highlighted the high cost of insurance regulatory compliance compared to other financial services sectors which operate pursuant to federal authority. Since then, multistate insurers – particularly life insurers whose products are most akin to securities and other financial products – have been increasingly in favor of federal regulation.

There has been recurring, bipartisan support in Congress for federal insurance regulation in the form of an Optional Federal

Charter (OFC), which would create a single federal jurisdiction to regulate the financial condition and operations of chartered life and property and casualty insurers as an alternative to the current state regulatory system. The US Treasury also recommended an OFC in its March 31, 2008 ‘Blueprint for a Modernized Financial Regulatory Structure’ (Blueprint). Recent legislation calling for an OFC includes:

A single point of entry for • company and producer licensing;

Federal financial and market • conduct exams;

Utilization of statutory • accounting for financial reporting;

A five-year transition period, • during which the Commissioner would monitor solvency utilizing the NAIC’s financial regulation models and blanks;

A reduction or elimination • of product, underwriting and rate controls;

Holding company provisions • consistent with state provisions; and

National consumer protection • through consumer affairs, an insurance fraud division and an ombudsman.

despite these suggested changes, there have been no apparent proposals to preempt state tax law, which uses state-based statutory accounting as a basis. In addition, state P&C laws that mandate access to

In 1945 Congress enacted the McCarran-Ferguson Act, which created a reverse pre-emption allowing states to primarily regulate insurance in most instances. Specifically, the Act states that, ‘No act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance’ … unless such Act specifically relates to the business of insurance. 15 USC § 102(b). McCarran-Ferguson was a significant step in establishing the dominant role of states in this area and creating the environment for the current insurance regulatory framework.


OPtIONS rEMAIN OPEN FOr FEDErAL INSurANCE rEguLAtION continued

certain coverages and require residual market participation would continue.

OFC proponents seek above all to minimize the costs of multijurisdictional compliance. Even those who strongly believe that state governments are the appropriate supervisors of insurers recognize the need to promote and achieve some level of uniformity across US jurisdictions. State commissioners, acting through the NAIC, coordinate regulatory efforts by establishing and administering accreditation programs for financial regulation, promoting model laws and regulations, standardizing financial reporting blanks, proscribing statutory accounting and risk-based capital standards, proscribing common procedures for financial and market conduct exams, and utilizing single-site electronic filing. However, as long as each jurisdiction ultimately remains autonomous in its domestic market, regulatory inconsistencies and redundancies will persist and compliance costs will remain high. Simply put, uniform insurance regulation has been no state’s priority.

the pros and cons of a federal charter

Market and regulatory efficiencies resulting from an OFC may provide opportunities for both reduced expenses and increased revenue. Moreover, there is the potential for cost savings in licensing, distribution channel management, product development, and IT. There also

could be cost savings resulting from holding company and legal entity efficiencies if a single regulator oversees all transactions affecting affiliated legal entities. In turn, the insurance-buying public would enjoy cost savings through premium reductions.

Moreover, in addition to being costly, state regulation has been criticized for stifling product innovation and economic growth. This is due in large part to the unpredictable outcome and length of time associated with the launch of a new policy or contract. Accordingly, many industry participants and observers believe an OFC would increase product speed-to-market and spur competition and new product offerings.

despite the likely advantages of an OFC, industry support has not been universal and state regulators strongly oppose any attempt to introduce a federal counterpart. Arguments in favor of the status quo and against an OFC or federal insurance regulation generally include:

The fact that state-based • regulation has been effective, and is responsive to local markets and consumers;

An OFC or other federal regime • would confuse consumers and simply create another layer of bureaucracy;

A general lack of insurance • expertise at the federal level compared to the state level;

uS jurisdictions

There are 56 insurance jurisdictions in the United States in all, including each of the 50 states, the district of Columbia, and the five US territories. Insurance Commissioner is an appointed position in the majority of jurisdictions. Commissioners are elected to office in eleven states.

Resources available to state insurance departments vary, as do the departments’ approaches to regulation. Thanks to the NAIC financial accreditation program, there is a relatively high degree of uniformity among state laws and regulations that affect holding company transactions, financial solvency, and financial exams, but the degree of regulation in other areas that affect insurer operations is more disparate. This is particularly true with licensing and product development, including rate and policy form approvals, and the market conduct examination process. Moreover, while insurers are generally subject to financial examination solely by their domiciliary state, an insurer may be called upon to submit to a targeted or comprehensive market conduct examination at any time by any state in which it is licensed to transact business.

Market events during the second half of 2008 have fueled continued discussion on the merits of federal versus state insurance oversight, but the context of the debate has changed.



A federal regulator might not • have the resources or expertise to respond to the volume or needs of consumers; and

The suggestion that duel • regulation would promote regulatory arbitrage, spur harmful competition (a ‘race to the bottom’) among jurisdictions, and serve to disadvantage local and regional insurers.

the status of a federal charter

despite the often vigorous debate about it, OFC enactment is not imminent. In fact, the OFC remains little more than a concept. Even so, bipartisan support appears to have endured numerous Congressional hearings that have vetted interested parties’ competing positions. Until very recently, there had been a growing sense even among opponents that the implementation of an OFC would occur during a future legislative session. Familiarity and confidence in the banking system suggested that the enactment of an OFC would not be a radical step for federal lawmakers. This sentiment was reinforced by the Bush administration with the release of the Blueprint and its endorsement of an OFC.

However, in the wake of recent market turmoil and a change in the US political landscape, the future of an OFC is now far from clear. Market events during the second half of 2008 have fueled continued discussion on the merits of federal versus state insurance oversight, but the

context of the debate has changed. Even if the Obama administration and the incoming Congress accept the virtues of centralized insurance regulation, their attention will likely be focused on shoring up financial markets and enhancing consumer protections. It is not clear what this might mean for the prospects of an OFC or insurance regulatory reform generally.

Debate continues

An OFC remains a viable mechanism to introduce a single US insurance regulatory framework, while preserving the current infrastructure for companies that would prefer to continue the relationship they have with their local insurance departments. However, for an OFC to gain acceptance, changes to past proposals may be inevitable. Future OFC legislation may expand sections related to consumer protections and omit provisions that may be construed as deregulation, such as the removal of existing rate and product controls. Even though economists strongly maintain that price restrictions drive up the cost of insurance, it is highly unlikely that Congress would move forward with any measures that might be construed as being anti-consumer. A change such as this, particularly as it affects the P&C industry, might stall any serious consideration of an OFC or invite the consideration of alternative approaches. To date, federal legislators have not been eager to take on regulatory

responsibilities at the level necessary to oversee insurer operations like the states do.

OFC alternatives include:

A mandatory federal regulator • for multistate insurers that would replicate the role currently served by state departments of insurance;

Introducing federal regulation • of solvency and/or holding company matters while preserving state regulation for consumer and market conduct issues;

National standards for • regulating certain areas of insurance, to be administered and enforced by state regulators, including financial and market conduct regulation, rate and policy forms, licensing, reinsurance, surplus lines, and insurer receiverships;

Preserving state regulation but • establishing federal minimal standards from which states could deviate to a limited degree; and

Allowing insurers to elect a • single US jurisdiction as a primarily licensing authority whose laws would then be held to govern that insurer’s national operations regardless of other local standards.

These structures have various levels of support among stakeholders, and some have already been rejected in the past. Yet, it is doubtful that any option would be off the table if the

State insurance regulators are pointing to the relative stability of the insurance industry as proof that monitoring solvency at the state level has been very successful.


AUTHOR

Barbara LawManager, Insurance Regulatory Practice PricewaterhouseCoopers (US)Tel: 1 617 530 [email protected]


federal government is persuaded that some degree of regulatory insurance reform is necessary, and that such reform is best implanted on an institutional or industry basis.

State insurance regulators hope this will not be the case. Amidst bank takeovers and liquidity shortfalls at federally regulated entities, state insurance regulators are pointing to the relative stability of the insurance industry as proof that monitoring solvency at the state level has been very successful. This appears to be a valid point, but to what extent have recent developments reframed the debate beyond traditional turf wars?

Crediting state regulation as a success would be an acknowledgement of the effectiveness of current solvency monitoring mechanisms, such as statutory financial reporting, reliance on risk-based capital formulas, insurer investment provisions, dividend restrictions, and the role of the SVO in asset valuation. But, there is nothing to prevent a federal insurance regulator from permanently adopting the states’ approach under an OFC or other federal regulatory system. Ideally, effective insurance regulation will

not be dependent on the identity or the government level of the administrator or enforcer.

Future discussions regarding the prospect of federal insurance regulation, which may or may not involve an OFC, are likely to be in the context of broad regulatory reforms to the financial services industry as a whole. If reform aims to consolidate and eliminate potentially redundant administrative agencies, reforms may extend beyond state-based regulation or an OFC. As distinctions between financial service products and firms continue to erode, advocates of state insurance regulation may find it increasingly difficult to shield the insurance sector from efforts to streamline regulation.

The modernization of financial services regulation may very well entail a transition away from product or industry-based regulation to a risk-based regulatory scheme where a regulator or regulators would safeguard against market failures across FS sectors. A consolidated form of financial services regulation might take a ‘peaks’ approach, which the Blueprint recommendation recommends and which had been discussed favorably by Paul

Volcker, President Obama’s Economic Recovery Advisory Board chairman. This type of structure delegates regulatory authority based on objective. For example, under a twin peaks approach a single regulator would monitor the financial condition of financial services companies and another would focus on market conduct and consumer protection matters.

All told, there is still considerable uncertainty about the best resolution to the federalism debate in what is a global insurance market. Whatever does (or does not) result, it is fundamental that regulators across financial services share and publically stress the same goals: monitoring solvency and protecting consumers. Attaining these objectives in an environment that maximizes efficiencies and avoids unnecessary costs provides a compelling focus for any regulatory reforms, regardless of government level, or whether insurance-specific or applicable to the financial services industry as a whole. Only when all of this is attained will a regulatory framework fully realize its potential to effectively balance the interests of consumers, investors, and industry.

AutHOr: MARk SHEPHERd

Trends in the acquisition of insurance companies in run-off


Recent sales of insurance and reinsurance companies in run-off have seen twenty to thirty potential bidders and prices that are close to book value; yet transactions in the early 1990s saw few interested parties, each bidding just cents on the dollar. Mark Shepherd explains why prices have increased so much, why the asset class has become so popular, and the future of run-off post-credit crunch.

Discontinued insurance was not alone in seeing rising prices for acquisitions; prior to the credit crunch private equity groups in all sectors sought to outbid each other in ever more leveraged transactions.

trENDS IN tHE ACquISItION OF INSurANCE COMPANIES IN ruN-OFF

To understand trends in the run-off market, it is helpful to analyze how acquisitions have developed over the previous fifteen years.

The early 1990s saw a large number of insurers entering run-off. With few bidders, and apparently continual deterioration in liabilities arising from A&E and the 1987-1992 catastrophes, prices were necessarily low.

One of the earliest pure run-off transactions involved Ludgate Insurance Company. While there had been previous acquisitions of insurers with a significant run-off exposure, the focus of these earlier deals was primarily on restructuring a troubled company so that it could recommence underwriting. What was transformational about Ludgate was that profits were achieved out of managing the run-off rather than through reactivation as an ongoing underwriter.

With the establishment of specialist acquirers such as dukes Place Holdings and Castlewood, other transactions followed in Bermuda, London and the US. However, prior to 2000 it was unusual for transactions to be competitive and prices paid by

acquirers were usually less than 50% – and often less than 25% – of book value.

Various factors changed the market. Insurers enhanced control of their liabilities through improved claims handling, through commutations (as facilitated by events such as the AIRROC/Cavell Rendezvous) and through solvent schemes (which at one level can be viewed as a policyholder-approved mass commutation overseen by a court). In addition, regulators increasingly accepted distributions of capital from insurers in run-off, which occurred first in Bermuda, then in the Uk (particularly with the introduction of the FSA’s ICA regime), and then in Northern Europe.

The strong returns achieved by the early entrants to the market attracted new competitors, the demand for insurance companies in run-off began to exceed supply, and valuations started to rise. At these increased prices, most acquirers were unable to obtain an acceptable rate of return using pure equity funding and therefore sought debt to leverage their investments. Banks became increasingly keen to lend,

their decisions supported by the emergence of predictable cash-flows from capital distributions and a record of successful transactions.

In theory, the use of debt benefits acquirers by increasing return on equity. In practice, with so many buyers in the market, the effect of leverage is to increase prices overall, to the benefit of the seller. Thus, the return to equity ultimately is not substantially enhanced by the use of debt, and the increased risk to equity investors of leveraging transactions is frequently neglected.

discontinued insurance was not alone in seeing rising prices for acquisitions; prior to the credit crunch private equity groups in all sectors sought to outbid each other in ever more leveraged transactions.

So what of post-credit crunch transactions? The first stage of the credit crunch (July 2007-August 2008) certainly affected the largest, most leveraged, private equity transactions, which reduced in volume as liquidity declined. However acquisitions of insurance companies in run-off


AUTHOR

Mark Shepherddirector, Insurance Practice PricewaterhouseCoopers (US)Tel: 1 617 530 [email protected]

trENDS IN tHE ACquISItION OF INSurANCE COMPANIES IN ruN-OFF continued

tend to be smaller and the track record of profitability is strong. The cash-flows arising from investing in an insurance company in run-off are, to some extent, not correlated with the wider economy. Thus the initial stages of the credit crunch appeared to have a limited effect on the acquisition of insurance companies.

However, the second stage of the credit crunch (late August 2008 onwards) may have a greater effect on the market. It is difficult to predict what will happen as 2009 unfolds, but we may get answers to the following questions:

Will the credit crunch reduce • the number of investors bidding on transactions?

Will banks reduce either the • amount that they lend to the sector or as a proportion of any one transaction?

Will banks increase the interest • rate at which they lend?

Will banks continue to view • the run-off acquisition sector as being insulated from the wider economy?

Will a leveraged acquisition fail • to repay its lenders?

The current strong market also reflects the current scarcity of supply. Investors in run-off seek to acquire a legal entity containing the run-off liabilities, and there is currently a finite supply of such companies. Therefore investors are increasingly looking in areas other than the Uk, Bermuda, and the Nordic countries, as evidenced by the deals that took place in the US and Australia during late 2007 and 2008.

The acquisition of run-off liabilities in the US has been constrained previously by the limited willingness of regulators to countenance capital distributions from insurance companies in run-off. However, the sheer shortage of opportunities elsewhere has seen acquirers push up the prices of those US companies offered close to valuations seen in Europe. There has probably never been a better time to be a seller of a US company in run-off.

Outside of the Nordic region, there have been relatively few transactions in Continental Europe to date. This is driven

in part by structural factors – run-off liabilities are often contained within ongoing underwriting entities – and partly due to protection of employment legislation, which can make the closure of an insurance company a drawn out and expensive process. However, the establishment of insurance business transfer processes in all twenty-seven countries of the European Union means that mechanisms exist to separate ongoing business lines from run-off liabilities by portfolio transfer of gross liabilities and supporting assets, thereby creating stand-alone legal entities containing run-off liabilities that are available for acquisition. Another factor likely to influence this process is the restructuring of insurance groups in Europe in preparation for the introduction of Solvency II.

In the US, however, the long-term supply of companies for acquisition is constrained (except in Rhode Island), by the lack of an insurance business transfer mechanism. What we may see in the US, absent the introduction of widespread mechanisms for the mass novation of gross liabilities, are transactions whereby investors provide capital to

insurers in return for taking control of the management of, and profits arising from, run-off liabilities. While currently this can be partly achieved through a loss portfolio transfer reinsurance, retrospective reinsurance to third parties is treated unfavorably under the Risk Based Capital calculation. An investment of capital onto an insurer’s balance sheet has potential advantages for both insurer and investor.

The market for the resolution of run-off liabilities has developed dramatically in the past 15 years and the market for acquisitions has been equally innovative and profitable for investors. Insurers will continue to withdraw from business areas thereby creating new run-off acquisition opportunities and, where there is a potential for a profitable return, institutions will invest. Supply and demand of opportunities and capital will affect the values at which transactions take place but with so much talent and capital deployed in the run-off sector, we can expect continued rapid development of ideas and concepts for the acquisition and resolution of insurers and reinsurers in run-off.


trENDS IN tHE ACquISItION OF INSurANCE COMPANIES IN ruN-OFF continued

AutHOrS: LARRY RUBIN ANd RANdY TILLIS

Valuation of financial intermediaries: Greater transparency through transfer pricing


Insurance companies may not receive fair valuation in the capital markets due to a lack of transparency on how and where they make money. Larry Rubin and Randy Tillis explain how transfer pricing can help provide analytical tools for comparability relative to other financial institutions, and describe how future reporting requirements will increase the availability of information to perform transfer pricing analysis.

By creating a transfer pricing paradigm that captures benefits from decisions or actions, be they RAROC, MCEV, or something in-between, a track record can be established to show how well the different functions have performed.

vALuAtION OF FINANCIAL INtErMEDIArIES: GREATER TRANSPARENCY THROUGH TRANSFER PRICING

Insurance entities are not typically valued like other enterprises. Their ‘price’ in terms of book or market multiples is often much less than other institutions. Based on historical price/Earnings per share (EPS) data from SNL the insurance multiple was 12x to 14x over the past year prior to the recent quarter’s market reactions.

The current, traditional, US reporting structures (STAT and GAAP) provide information on what enterprises have made in aggregate, but do not present information to judge the underlying source of the earnings. We believe that, by using the transfer pricing principles and looking deeply into the functions provided, an insurance company may be able to present a rationale for the value inherent in the company. It will be able to demonstrate to the market that its strengths on the asset and liability side entitle it to be measured similarly to other organizations and receive similar price considerations or multiples. Using such a transfer pricing process can demonstrate the asset, liability, and risk management fees or earnings produced by the company. The following industry example, based on embedded

value, comes from information provided by Swiss Re in its public reporting package.

transfer pricing as measurement

In the first quarter of 2008, Swiss Re disclosed its fund transfer pricing reporting system, ‘Economic Value Measurement’ (EVM). Swiss Re’s EVM system has created one ‘replicating portfolio’ that mimics the company’s insurance liabilities’ characteristics. The value of the replicating portfolio reflects the present value of insurance cash flows arising from underwriting activities (without any investment), discounting at a margin that reflects the risks or costs in pure underwriting activities. Then, the replicating portfolio is ‘lent’ to asset managers as their ‘liability.’ The replicating portfolio also becomes the benchmark for the asset management performance measurement. To the extent that asset managers purely invest in the replicating portfolio, there is no economic value adding, as the same effect will be offsetting on both the liability and asset side. To the extent that asset managers

could beat the benchmark at a risk-adjusted basis, they are adding value to the company. Swiss Re’s EVM system is a powerful tool that has served as one integrated framework in the company’s performance measurement, strategy forming, planning, and other management activities (see Figure 1 overleaf).

By creating a transfer pricing paradigm that captures benefits from decisions or actions, be they Risk-adjusted return on capital (RAROC), market consistent embedded value (MCEV), or something in between, a track record can be established to show how well the different functions have performed. This information then can be summarized to present to management or the market how the liability and risk management function has performed. This information may supplement the risk and capital management disclosures, thereby providing a more complete view of the enterprise.

Future valuation

There are several regulatory events on the horizon that may encourage this functional view.


AUTHORS

Larry rubinPartner, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US) Tel: 1 646 471 [email protected]

randy tillisManager, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 312 298 [email protected]

vALuAtION OF FINANCIAL INtErMEDIArIES: GREATER TRANSPARENCY THROUGH TRANSFER PRICING continued

approaches for reporting or recognizing the profit from liability activities, it does appear that there will be distinct capturing and reporting of the liability side of the balance sheet. Once this information is provided, it would be a short step to produce earnings related to the asset and liability functions. Thus, a transfer pricing framework would provide a view of how earnings are created.

Holistic view

Currently, most insurance entities are considered hard to value because of the lack of information or transparency on how they make money. With increased awareness of enterprise risk management and internal offsetting risk profiles, companies are leveraging their liability expertise to increase earnings, while reducing their overall risk profile or capital needs. While this full company or holistic view is gaining momentum, the need for measurement of the risks and earnings by source becomes even more important. As recent

credit market turmoil has shown, if an insurance company manages risk well but the investment area does not, then the company suffers. Transfer pricing is a tool for distributing the risk premiums earned.

Summary

Over the long run a company can become perceived as a risk manager, an asset manager, or something in between. Accordingly, breaking down earnings into component pieces and aligning them with the company’s underlying skill sets would add value to management, potential investors, and shareholders. The concepts behind transfer pricing will enable this kind of analysis, which will lead to more transparency in the source of earnings and more comparability between insurance entities and with the other financial institutions. This increased comparability should then translate into better multiples or valuation of the company.

Figure 1 Swiss Re’s ‘Economic Value Measurement’

Performancemeasurement

Strategy

Pricing

Trackingrenewals

Planning

Targetsetting

All measurements usedthroughout the performance

cycle are based onEVM methodology

Source: Swiss Re

The recent CFO Forum decisions on adopting MCEV and the IFRS discussion paper on insurance contracts are just two examples of a future where insurance

companies will be required to calculate a market value of insurance liabilities separate from assets. While there may be some disagreement on the final


vALuAtION OF FINANCIAL INtErMEDIArIES: GREATER TRANSPARENCY THROUGH TRANSFER PRICING continued

AutHOrS: MICHAEL LOCkERMAN, LARRY RUBIN, XIAOkAI SHI, ANd RANdY TILLIS

New perspectives on measuring insurance liabilities, risk, and capital


Insurance company financial reporting and performance measurement are going through a significant transformation. Insurers are beginning to look at their business based on what many refer to as the ‘economic value framework.’ Michael Lockerman, Larry Rubin, Xiaokai Shi, and Randy Tillis show how, under this framework, insurance companies can determine the economic value of the capital invested in their business and the economic value of earnings to derive a risk-adjusted return on capital.

Proponents of ‘gain at issue’ contend that insurers should be able to recognize an immediate gain for any premiums expected to be received during the life of a contract that are over and above those implicitly required by the risk margin associated with the business being written.

NEW PErSPECtIvES ON MEASurINg INSurANCE LIABILItIES, rISk, AND CAPItAL

Management creates economic value if return on capital equals or exceeds the cost of capital.

However, it has always been difficult to quantify the financial health of insurance companies in an accurate and timely fashion. Increasingly, insurers who seek to raise capital or meet solvency requirements are trying to add clarity and certainty in order to reassure investors and regulators. These efforts are resulting in a significant transformation of insurance company performance measurement, especially for risk, capital, and liabilities.

Many insurers are beginning to value their business and make strategic decisions based on what many refer to as an ‘economic valuation framework,’ which focuses on tracing the timing and ‘volume’ of values that is created in various activities, such as sales, servicing, investment, and risk management. Companies’ internal needs to facilitate and justify their decision-making, as well as pressures from regulatory and ratings agencies, are driving the adoption and implementation of this economic valuation framework. Regulators are moving their solvency framework to ‘principle-based’ approaches, and accounting standard setters are proposing ‘fair value’ reporting, which should lead to increased comparability.

This change is revolutionary, and very few insiders doubt that the industry is moving toward a ‘next-generation’ view of its business and financial reporting. However, it is never easy to move away from traditional thinking. The industry needs to resolve many critical issues in its move toward a more understandable and comparable valuation and reporting system.

Economic views and market-consistency are the keys toward the move to the next generation. There are many promising economic and fair value concepts and proposals, and now is the time to connect them.

Issues in next-generation reporting

Among the key issues that have emerged regarding the economic valuation of insurance businesses are the ways in which risk margins are calibrated and the recognition of ‘gain at issue’ or ‘no gain at issue.’ Both issues can be traced back to the original purpose of valuation reporting: to accurately reflect changes in shareholders’ value.

In a world with perfect, readily available information and no transaction costs or liquidity concerns, the risk margin for insurance would compensate investors for bearing risk and be reflected in the equilibrium price of the contracts themselves, as is the

case with any other investment transaction. However, the risk margin can be distorted by regulatory restrictions, significant disparities in information, a variety of frictional costs, and complications arising from economically inefficient decision-making by policyholders.

When accounting for market inefficiencies, analysts generally take one of two positions: either there is a ‘gain at issue’ – in which the company creates value simply through the sale of an insurance contract – or there is ‘no gain at issue.’

Proponents of ‘gain at issue’ contend that insurers should be able to recognize an immediate gain for any premiums expected to be received during the life of a contract that are over and above those implicitly required by the risk margin associated with the business being written.

‘Gain at issue’ advocates assert that economic rent, or amounts that exceed compensation for bearing risk, can be generated through inefficiencies in insurance sales, such as insurers’ market knowledge and experience in pricing and policyholders’ inability to fully value all the options and guarantees in their contracts. The sales process itself can result in policyholders paying a higher price which generates economic rent and, therefore, a gain at issue for the insurer.


NEW PErSPECtIvES ON MEASurINg INSurANCE LIABILItIES, rISk, AND CAPItAL continued

On the other hand, those who believe in ‘no gain at issue’ view the premium received as the primary or even the only indication of the appropriate risk margin required by the market.

Many proponents of ‘no gain at issue’ acknowledge the possibility of economic rent, but question whether it can be reliably measured. They have raised other concerns as well, including whether income from ‘gain at issue’ could be recognized in the absence of a legal obligation on the part of a policyholder to pay future amounts that exceed the costs of providing benefits and services.

‘No gain at issue’ advocates also have a logical argument in their favor: the economic rent which would create ‘gain at issue’ theoretically cannot exist in an efficient market – and fair value accounting assumes, ipso facto, that markets in fact are efficient.

The debate over ‘gain at issue’ versus ‘no gain at issue’ is ongoing. Some insights can be gleaned by revisiting the primary purpose of financial reporting: providing investors with comparable information with which to make decisions.

the emergence of market-consistent reporting

The new generation of valuation or financial reporting for insurance companies addresses two major issues that have affected industry valuations: first, the economic view of value creation (i.e., how, when and how much value is created); and second, market consistency (i.e., the transparency, reliability, and comparability of the financial figures used by investors).

Embedded value has long been used, especially in Europe, to measure the underlying risk and value of insurance liabilities. It is calculated by projecting relevant cash flows using both market and non-market assumptions and then determining the present value of future profits using a discount rate typically based on equity returns plus a risk allowance.

However, conventional calculations of embedded value are often flawed because of inconsistent valuation of options embedded in the underlying insurance products and investment assumptions that are not market-consistent. To address these defects, many insurers employ market-consistent embedded value methodologies. These methodologies value guarantees and options using methods consistent with those used for valuing other financial assets, and use a risk-neutral approach to set investment assumptions and discount rates.

Market-consistent embedded valuation has achieved growing momentum in Europe, where more companies are employing it to calculate their embedded value and many investment analysts view it positively. As part of a shift to market-consistent reporting, it has increased transparency and comparability, reducing the information risks assumed by investors.

Interpreting ‘market-consistent economic capital’

Although a market-consistent approach to quantifying economic levels of capital has

not gained wide acceptance, further development, including disclosure of insurers’ methods of calculating economic capital, can enhance valuation and reporting.

In the past, the capital adequacy framework relied on regulatory or rating agency measures; today, the framework is based on the determination of company-specific risks. Although there are a number of different approaches to modeling economic capital, current practice focuses on ‘fat-tailed events’ to set up capital hedging against ‘low-probability, extreme-loss events.’

While economic capital is defined under Solvency II as an amount that would allow an insurer to absorb all losses within a year with a 99.5% probability, it is still unlikely to represent a true level of economic capital, given market realities that make recapitalization after insolvency unlikely.

Instead, it may be more appropriate to define market-based economic capital as the level of capital needed to absorb the first losses of an insurance portfolio, such that an insurer can go to the capital markets to raise the next dollar to fund further losses without paying an additional equity risk premium.

Economic capital commonly is defined as management’s view of the risk of the business. However, similar to the move from embedded value to market-consistent embedded value, in which the market’s view of returns replaced management’s view, economic capital should be based on the market’s view of risk, not management’s.

Considering that economic capital and the cost of capital are both market numbers, the risk margin required to accept insurance risks should be identical between insurers and other market participants wishing to be compensated for taking the same insurance risk. This economic capital model and cost of capital can be used to determine the required return on the liabilities, which indicates the appropriate risk margin demanded by the market.

Any differences between companies would be due to differences that arise in attempting to measure either economic capital or the cost of capital, including information risk; operational risk and frictions; and ‘unknown unknowns.’ Each of these can affect the quality of economic capital modeling.

Information risk stems from limited transparency associated with business complexity and insurers’ unwillingness to fully disclose the information they possess in order to protect their competitive advantage. This lack of transparency is so pervasive that insurers may require a higher risk margin for acquired business than for business they write themselves.

Frictional costs, in which insurers have to operate under higher financial costs and capital requirements, also play a significant role in determining risk margins and valuing insurance liabilities, even though the risk in any purchase price theoretically should compensate the investor only for cash flow uncertainty. Additionally, operational risk – such as potential losses due to fraud, market conduct, rogue traders, failure of operating systems, or physical disruptions – can


NEW PErSPECtIvES ON MEASurINg INSurANCE LIABILItIES, rISk, AND CAPItAL continued

contribute to the margins included by the market, even if such risks are difficult to quantify or model.

Finally, few models reflect ‘black swan’ events, which are rare, high-impact, hard-to-predict events. While difficult to model, such ‘unknown unknowns’ are the major drivers behind many business failures. As Nassim Nicholas Taleb wrote in The Black Swan: The Impact of the Highly Improbable, ‘Almost all consequential events in history come from the unexpected.’

While economic capital modeling may effectively portray the carrier’s risk, it is uniquely calibrated and not transparent to investors, policyholders, or other stakeholders for reasons ranging from the complex nature of the economic modeling process, the intricate nature and longevity of the products, and additional risks that are difficult or impossible to reflect in the cash-flow models.

Moreover, even industry insiders question the quality of their economic capital analyses. A recent survey of insurers by PricewaterhouseCoopers found that 50% of the respondents

believe their economic capital data lack completeness and quality, while 75% believe their data timeliness needs improvement. Moreover, many analysts believe that insurer internal models lack comparability, consistency, and auditability and are too theoretical and subject to management manipulation. Consequently, any further modifications of value measurement would do well to focus on increasing transparency and addressing analyst concerns.

Ultimately, economic capital, and the cost of capital as contemplated and implemented today, is not sufficiently market-based to measure whether an insurer can expect to earn more than its cost of capital. Economic capital modeling is a valuable and powerful tool to understand the risks and rewards of an insurance enterprise, but it has limits: it is not a way to capture all risks or replace business judgment.

rethinking the performance measurement approach

Insurers can best reflect the condition of their businesses through the use of a performance

measurement approach that incorporates the market’s view of risk and the level of compensation the market demands to accept that risk.

In defining an approach to performance measurement, the first step is to determine the appropriate level of economic capital in a way that maximizes transparency and the use of market information.

Several sources can provide guidance. The most direct of these is the minimum capital to satisfy a target debt rating. Other sources include the capital set-aside in securitization deals or in financial reinsurance transactions and the economic capital created from an internal projection of cash flows, which can be adjusted for risk premiums observed in more liquid markets. Through disclosure of methods and assumptions employed, the market ultimately will reach a consensus on such values.

In addition, any changes in these values from one period to the next need to be transparent. depending on the underlying products, companies will need to develop stable and understandable

analytics to enable this work. For example, these analytics could split the market and non-market information or could attempt to address each of the relevant risk margins individually.

Measuring the performance, or change in capital adequacy of an insurer, depends on the type, amount, and transparency of information that is provided to investors, regulators, and the public. Just as in the shift from embedded value to market-consistent embedded value – in which market views replaced management views – economic capital based on a market view of risk can be more transparent and comparable across entities.

The insurance industry has many tools available to assist it in providing clearer, cleaner, and more useful information to interested parties. Whether the approach is ‘gain at issue’ or ‘no gain at issue,’ more information and disclosure around capital needs and risk returns are necessary. With this information, the move to market-based performance measurement can begin in earnest.

AUTHORS

Michael Lockermandirector, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Xiaokai ‘victor’ ShiSenior Associate, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Larry rubinPartner, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

randy tillisManager, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 312 298 [email protected]

AutHOrS: kATIE MCCARTHY, NICk RANSON, ANd LARRY RUBIN

The use of own credit in the valuation of liabilities


Recent reporting trends have been moving toward fair value accounting. katie McCarthy, Nick Ranson, and Larry Rubin discuss how one area that has received a significant level of attention is the reflection of a company’s own credit spread in the valuation of general account liabilities – specifically, whether the discount rate used to value liabilities should reflect the credit characteristics of the instrument being valued rather than using a risk-free rate.

FAS 157 and 159 have come into effect amidst growing globalization, uncertain economic times, declines in real estate values, and the convergence of liquidity and credit crunch concerns.

tHE uSE OF OWN CrEDIt IN tHE vALuAtION OF LIABILItIES

The FASB recently adopted FAS 157 ‘Fair Value Measurements’ which states (in paragraph 15):

‘A fair value measurement assumes that the liability is transferred to a market participant at the measurement date (the liability to the counterparty continues; it is not settled) and that the nonperformance risk relating to that liability is the same before and after its transfer. Nonperformance risk refers to the risk that the obligation will not be fulfilled and affects the value at which the liability is transferred. Therefore, the fair value of the liability shall reflect the nonperformance risk relating to that liability. Nonperformance risk includes but may not be limited to the reporting entity’s own credit risk.’

Additionally proposed IFRS Guidance, as set out in paragraph 232 of the Insurance Contract discussion Paper (the ‘discussion Paper1) states:

‘The current exit value of a liability is the price for a transfer that neither improves nor impairs its credit characteristics. The transferor would not willingly pay the price that a willing transferee would require for a transfer that improves those characteristics.

The policyholder (and regulator, if any) would not consent to a transfer that impairs those characteristics. If an insurer measures its insurance liabilities at current exit value, that measurement should reflect the liability’s credit characteristics.’

Generally actuaries and the insurance industry have been opposed to the use of own credit spread in determining the value of liabilities. In its comment letter to IASB responding to the discussion Paper,2 the Group of North American Insurance Enterprises (GNAIE) wrote that ‘the (discussion Paper) inappropriately requires… consideration of own credit risk in measuring insurance liabilities,’ expanding to note: ‘we believe it is not true that the value of an insurance liability is the price for a transfer of that liability that neither improves nor impairs issuer credit characteristics. The measurement of an insurance liability should not reflect changes in credit characteristics.’

In our opinion, the issue of own credit spread in valuing liabilities receives so much attention due to a failure to recognize that own credit spread should, and in practice does, impact the level of benefits promised by the insurer.

When an adjustment is made to risk-free rates in order to consider own credit spread in the level of benefits for interest-sensitive liabilities (i.e., the crediting policy takes own credit spread into account) and own credit spread is reflected in the discount rate, then, for most insurance liabilities, a change in credit spread has minimal impact on the value of the liability. We will demonstrate this in two simple examples – an investment contract that guarantees a principal balance and periodically pays earned interest (in this case we will use a funding agreement that serves as the collateral for the issuance of a Medium Term Note (MTN) and then generalize for a Single Premium deferred Annuity (SPdA).

The valuation of a GIC-backed MTN is identical to the valuation of a debt offering. At issue, the company promises to pay its cost of funds (COF0) and the value of the payment obligations are discounted at COF0. COFt is the sum of two items at the relevant term of the liability, namely the Risk-free Rate (Rt) and the company’s then current Credit Spread (CSt). As a consequence, the value of the liability at issue is equal to the proceeds received and there is no gain or loss. If the company is able to sell a contract

1 Preliminary Views on Insurance Contracts issued by the IASB in May 2007.2 Letter from GNAIE to IASB dated November 20, 2007.


tHE uSE OF OWN CrEDIt IN tHE vALuAtION OF LIABILItIES continued

company can use the proceeds from the spread between interest paid and interest earned to buy back its obligation in the open market. Conversely, if the company paid more than COF0, it would experience a loss at issue.

In order to convince another party to accept the nonperformance risk on a liability, the insurance company must promise to pay a premium above the Risk-free Rate equal to CS0. Post issue, the credit spread will typically change. One year after issue the Credit Spread is equal to CS1 and the obligations are now valued using a discount rate equal to R1 + CS1. The change in the value of the liability resulting from the change in the credit spread should be equal to the difference between the present value of the future obligation cashflows discounted at (R1 + CS1) and (R1 + CS0). (In this example we are assuming that the liability is a floating rate obligation, if it were a fixed rate obligation, the benefit would be credited at R0 + CS0, but discounted at R1 + CS1. The change in the the liability value is still equal to the difference between the present value of the future obligation cashflows discounted at (R1 + CS1) and (R0 + CS0).) Because the payment of the credit spread is locked in at issue and is not updated to reflect the change in credit spread, there will be a change in the liability value due to the difference between CS1 and CS0. It is the recognition of this change in value through

earnings that has generally been opposed by actuaries and by the insurance industry.

Using the same principles as above, we can construct our example for an single premium deferred annuity (SPdA). Assume a company can sell an SPdA that promises payments to a retail policyholder similar to those of the GIC-backed MTN. As was the case with the GIC-backed MTN, the policyholder would have no option except to hold the contract to maturity. The SPdA differs from the GIC in two ways. First, the policyholder pays a fee to be educated on the merits of the contract (this represents the market-based acquisition costs of the policy, AcqCST. Note that this amount may differ from the actual acquisition expenses incurred by the company). This fee is either subtracted from the contract at issue as a front-end load or financed by the insurance company as a reduction in the interest credited (which we denote by ISA, the Interest Spread for Acquisition costs). The second difference is that, given the smaller size, policyholders typically pay a recordkeeping or service charge (SC). (In effect, these are not really genuine differences as they are captured in the bid-ask spread of a GIC-backed MTN. However, the relative size of the GIC-backed MTN versus the SPdA results in the two factors having a more significant influence in the SPdA example.) Assuming a market-based charge for both of these items, the net amount received at

Figure 1 Projected net cashflows for a simple SPdA product, with no guaranteed crediting rates

0

(2,000,000)

(1,500,000)

(1,000,000)

(500,000)

500,000

1,000,000

1,500,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Year

Scenario 1 Scenario 2 Scenario 3 Scenario 4


that offers a rate lower than the COF0 (i.e., somehow a company can convince an investor to

accept payments that are less than COF0), it would have a gain at issue. This is because the

Scenario Crediting Rate discount Rate

1 Risk-free Rate Risk-free Rate

2 Risk-free Rate Risk-free + Spread

3 Risk-free + Spread Risk-free Rate

4 Risk-free + Spread Risk-free + Spread

The first illustration shows that when the crediting rate is greater than the discount rate (as is the case in scenario 3), there is a loss during the first year, and vice versa. In scenarios 1 and 4, where the crediting rate is equal to the discount rate, there is no gain or loss during the first year.

The second illustration (included within Appendix C) shows the effect of a change in the credit rating during the second year on scenarios 2 and 4. This graph shows that by including changes in credit spread in the interest-credited formula, the effect of a change in rating is offset by the same effect on the discount rate. The change in the cashflows when the credit spread is increased under scenario 2 creates a gain in earnings.

Cashflows under various discount rates



issue (which is equal to the premium (PREM) less AcqCST) can also be valued as the present value at COF0 of the future SPdA benefits and maintenance expenses under the assumption that the account value earns a crediting rate equal to COF0 – ISA – SC, which we refer to as the ‘market value crediting rate’. To the extent a company is able to convince policyholders to receive less than this market value crediting rate, there is a gain at issue. Similarly, to the extent the company pays more than the market value crediting rate, there is a loss at issue (where the loss is a result of the company raising funds to invest a spread at a greater cost than the alternative of the GIC-backed MTN program).

A unique feature of the GIC-backed MTN and the SPdA described above compared to typical insurance liabilities is that the credit spread included in the crediting rate is determined at issue and does not change for the life of the typical insurance obligation. The owner of the Medium Term Note may be able to sell it to another investor but there is no obligation on the part of the insurance company to buy back the liability. However SPdAs in the market and most other insurance obligations typically contain an option that gives the policyholder the right to sell back the obligation to the company and receive all or a percentage of their funds (which is essentially a put option on the contract). In

addition there are often other guarantees, including minimum annuitization rates, interest rate floors etc. To cover the cost of these guarantees companies set aside capital and have a target of the amount to charge policyholders for their cost of capital (COC). Adding the value of guarantees, we determine that the market value crediting rate at issue is equal to COF0 – ISA – SC – COC. discounting benefits plus expenses that are determined based on this crediting rate at COF0 results in the fair value of the liability equal to PREM – AcqCST. Figure 1 demonstrates the effects of various discount/credit rate scenarios.

While the above paragraph discusses the options that are granted to the policyholder, it ignores the options that are granted by the policyholder to the company. In most insurance obligations the policyholder grants the insurance company the right to periodically re-price the obligation subject to the minimum guarantee. In an efficient market, if at time x the company was to re-price its obligations at a rate lower than COFX then it should assume that more policyholders would exercise their put option as they can now get a higher yield for the same risk elsewhere. If the company were to re-price its obligation at a rate higher than COFX it would be paying policyholders a greater rate in order to retain funds for investment than it would pay

Figure 2 Changes in the credit spread

(200,000)

300,000

1,300,000

1,800,000

800,000

1 2 3 4 5 6 7 8 9 10

Year

Scenario 2 Scenario 2 (revised)

Scenario 4 Scenario 4 (revised)

0


One of the primary differences between a guaranteed investment contract and an insurance contract is that in the case of the insurance contact, the policyholder has the right to sell back the policy to the insurer. This ‘sale’ is performed by a cash surrender of the policy.

If there is a change in the risk associated with investing money in a policy with an insurer (e.g. there is a change in the insurer’s credit rating), then the insurer will have to properly compensate the policyholder in order to minimize the number of policyholders that exercise the option of a cash surrender. Specifically, if the company’s credit spread increases, the policyholder will be taking on more risk, and as such should be compensated. (On the other hand, if the company’s credit spread decreases, the policyholder is taking on less risk and will not require as much compensation.)

If there is a change in the credit spread, there will be a change in the interest payments (through a change in the crediting rate given to policyholders). Since the discount rate is also a function of the credit spread this also will change. Because the payments are changed based on the change in credit spread, the obligation should move in a similar manner.


AUTHORS

Nick ransondirector, Actuarial & Insurance Management Solutions PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

Larry rubinPartner, Actuarial and Insurance Management Solutions (AIMS) PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]

katie McCarthySenior Associate Actuarial & Insurance Management Solutions PricewaterhouseCoopers (US)Tel: 1 646 471 [email protected]


if it simply let the policy lapse and issued a new liability, thereby decreasing the funds that should otherwise be available to shareholders. Therefore at time x, the fair value of the liability is the present value of benefits less expenses at COFX where the present value is determined assuming a market value crediting rate equal to COFX – ISA – SC – COC. So for any insurance product where the company retains the option to re-price the liability, change in credit should have minimal impact on the value of the liability. This is further highlighted in Figure 2.

Figure 2 also shows that if the change in credit spread is reflected in both the change in crediting rate and the discounting rate, there will be a minimal effect on the value of the liability (Scenario 4 and Scenario 4 (Revised)).

Both the Group of North American Insurance Enterprises (GNAIE) and the European CRO Forum have stated the view that they do not support using own credit in the valuation of liabilities under IFRS. However there are areas where, under US GAAP, companies have historically used their own credit spread in the valuation of liabilities. If companies selling GIC-backed Medium Term Notes did not use their own credit spread at issue in valuing these contracts, then these contracts would incur a loss at issue. Generalizing the approach used to value GIC-backed Medium Term Notes results in not only recognizing own credit in discounting liabilities but also recognizing own credit in determining the fair value crediting rate. When both adjustments are made the value of the liability is equal to the value of premium received less market-based acquisition costs (i.e. the net deposit).

Further information

For more information about the Americas Insurance digest, please contact the following:

John S. Scheid† Member, Global Insurance Leadership Team, Americas Insurance Group Tel: 1 646 772 3061 E-mail: [email protected]

Eric trowbridge US Insurance Marketing Leader, Americas Insurance Group Tel: 1 410 296 3446 E-mail: [email protected]

Americas Insurance digest

Americas Insurance group

For further information about PricewaterhouseCoopers Americas Insurance Group, please call your contact at PricewaterhouseCoopers or one of the following:

Caroline Foulger† Bermuda Insurance Leader Tel: 1 441 299 7103 E-mail: [email protected]

Bermuda

James J. Scanlan† US Insurance Leader, Philadelphia, PA Tel: 1 267 330 2110 E-mail: [email protected]

Paul veronneau US Insurance Advisory Leader, Hartford, CT Tel: 1 860 241 7568 E-mail: [email protected]

Susan Leonard US Insurance Tax Leader, Los Angeles, CA Tel: 1 213 830 8248 E-mail: [email protected]

David y. rogers US Life Actuarial and Insurance Management Solutions Leader, Boston, MA Tel: 1 617 530 7311 E-mail: [email protected]

John F. gibson US P&C Actuarial and Insurance Management Solutions Leader, New York, NY Tel: 1 646 471 8158 E-mail: [email protected]

uS

george Sheen† Canada Insurance Leader Tel: 1 416 815 5060 E-mail: [email protected]

Canada

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South America

† Member of the Global Insurance Leadership Team

Americas Insurance digest

Amy rose 1 646 471 7630 [email protected]

European Insurance digest

Alpa Patel 44 20 7212 5207 [email protected]

As part of our insurance publications portfolio, we also publish an Asia-Pacific and a European edition of Insurance digest. If you would like to receive copies of one or more of these editions, please contact one of the following, or alternatively visit us online at www.pwc.com/insurance for electronic copies.

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PricewaterhouseCoopers provides industry-focused assurance, tax, and advisory services to build public trust and enhance value for its clients and their stakeholders. More than 155,000 people in 153 countries across our network share their thinking, experience and solutions to develop fresh perspectives and practical advice.

This report is produced by experts in their particular field at PricewaterhouseCoopers to review important issues affecting the financial services industry. It has been prepared for general guidance on matters of interest only, and is not intended to provide specific advice on any matter, nor is it intended to be comprehensive. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers firms do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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For additional copies please contact Amy Rose, PricewaterhouseCoopers (US), on 1 646 741 7630 or at [email protected]. Previous editions are available from our website www.pwc.com/insurance.

Asia Pacific Insurance digest

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