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D S T Dynamic Solvency Testing Some Technical Factors Presentation to One-Day Seminar Held D S T Dynamic Solvency Testing Some Technical Factors Presentation to One-Day Seminar Held by PAI and AAJI Jakarta, December 8, 2005

Introduction • Current economic and investment environments fluctuates a lot – Posing greater uncertainty Introduction • Current economic and investment environments fluctuates a lot – Posing greater uncertainty to financial condition • Solvency testing on future conditions needs to be done – To foresee the financial difficulties at earlier stages – To prepare constructive solutions • Static vs. Dynamic Testing

Introduction • Static Testing – Liabilities are projected separately from the assets • Many Introduction • Static Testing – Liabilities are projected separately from the assets • Many deficiencies as the liability position at one point will affect the assets • Dynamic Testing – Liabilities and assets are combined in projection – Incorporate one or more economic or business scenarios where the assumptions can vary by year of projections – Not meant to give exact results as no absolute correlation among assumptions used – External factors sometime have more significant impact than model assumptions – Projections can be deterministic, dynamic, or stochastic

DST – What is it? ? • A tool to identify: – Possible treats DST – What is it? ? • A tool to identify: – Possible treats to satisfactory financial condition – Actions which lessens the likelihood of the threats – Actions which negate any of those threats if it is materialized • DST is defensive – addresses threats to financial conditions rather than exploitation of opportunity

DST – Scenarios • DST standard requires scenarios testing consisting of: – Base scenario DST – Scenarios • DST standard requires scenarios testing consisting of: – Base scenario – Adverse scenarios – certain forecast period, usually 5 years • Each scenario takes into account: – Not only in-force policies but also policies assumed to be sold during the forecast period – Both insurance and non-insurance operations e. g. Operations of insurer’s trust company subsidiary

DST – Base Scenario • Insurer’s business plan • Its assumptions are expected assumptions DST – Base Scenario • Insurer’s business plan • Its assumptions are expected assumptions consistent with assumptions of policy liability valuation before margins for adverse deviations • Award if base scenario differs from business plan, because: – implies difference in outlook between insurer and actuary – Actuary would accept business plan as base scenario unless business plan’s assumptions are so inconsistent or unrealistic that resulting report would be misleading.

DST – Adverse Scenarios • Adverse scenario is plausible, assumptions about matters to which DST – Adverse Scenarios • Adverse scenario is plausible, assumptions about matters to which financial condition is sensitive – Adverse scenarios vary among insurers and may vary over time for a particular insurer – Selection of appropriate adverse scenarios may require extensive analysis • Main criteria for an appropriate adverse scenario are pertinence to insurer and plausibility of occurrence

DST – Adverse Scenarios • Adverse scenario is plausible, assumptions about matters to which DST – Adverse Scenarios • Adverse scenario is plausible, assumptions about matters to which financial condition is sensitive • Adverse scenarios vary among insurers and may vary over time for a particular insurer • Selection of appropriate adverse scenarios may require extensive analysis • Main criteria for an appropriate adverse scenario are pertinence to insurer and plausibility of occurrence – Example of a pertinent adverse scenario would be an economic downturn for insurer whose investments involve asset deterioration risk or whose marketing is sensitive to economic cycle

DST – Adverse Scenarios • Death Rate – Medical breakthrough which permanent lowers death DST – Adverse Scenarios • Death Rate – Medical breakthrough which permanent lowers death rates – Regulations which limit insurer’s freedom to underwrite – Epidemic increasing death rates • Sickness and accident rates – Increase in disability rates – Decrease in recovery from disability rates – Retrenchment of government of security programs • Withdrawal rates – Decrease in withdrawal rates for lapse supported policies – Increase in withdrawal rates for other individual policies – Loss of a distribution system

DST – Sample of Adverse Scenarios • Interest rate swing – – Parallel swing DST – Sample of Adverse Scenarios • Interest rate swing – – Parallel swing in interest rate curve Non-parallel swing Widening (or narrowing) of interest crediting spreads Change in value of derivatives • Asset deterioration – Increase in default rates – Poor return on equity securities – Prolonged deterioration in real estate returns • Sales – – Loss of distribution system Capital strains from high sales volume Expense strain from low sales volume Increased competition

DST – Sample of Adverse Scenarios • flexible premium policies – adverse variation in DST – Sample of Adverse Scenarios • flexible premium policies – adverse variation in premium patterns for UL type products • Expenses: – Inflation – Low sales • Government action – New taxation – New unfavorable regulation • Reinsurance – Failure of a re-insurer – Increase reinsurance cost • Adverse currency fluctuation

DST – How to Make It Works • We need to build models – DST – How to Make It Works • We need to build models – Liability’s model – Asset’s model • Liability’s model should model all or majority of the products sold and to be sold in the future • Asset’s model should model current assets as well as the expected assets to be purchased in the future • Liability and Asset models should be incorporated

Liability Model • Generally be based on majority of the product portfolio – Limited Liability Model • Generally be based on majority of the product portfolio – Limited time and resources – Insignificant impact of certain group of portfolio • Determining the sample space – Short-term vs. long term business • Depending on the pricing assumptions and nature of the benefit provided • YRT may not be significant issue as we can revise the premium structure • Certain benefits might pose long-term liability to the company

Liability Model • Determining the sample space – UL business • Depending on whethere Liability Model • Determining the sample space – UL business • Depending on whethere is any investment guaranteed • Investment guaranteed portion should be modeled – Group business • Depending on the pricing assumptions and nature of the benefit provided • YRT may not be significant issue as we can revise the premium structure • Certain benefits might pose long-term liability to the company

Liability Model • In-force portfolio – Should be based on the actual portfolio at Liability Model • In-force portfolio – Should be based on the actual portfolio at the valuation date – Assumptions used usually consist of: • Mortality and morbidity • Lapse or persistency • Other related assumptions

Liability Model • New Business – Should include existing products still selling – Should Liability Model • New Business – Should include existing products still selling – Should also include new products to be sold in the near future • May include new pricing assumptions if differ from the existing products – Should make assumptions on: • • Growth rates Products mix Sales weight Seasonal adjustment, if any

Liability Model • Model Validity – The projected results should be compared to the Liability Model • Model Validity – The projected results should be compared to the budget figures – The current production might be taken into account • E. g. Projection made in April 05 should take into account production up to March 05 • Production mix • Sales weight – Both by product and by currency

Asset Model • In-force portfolio – Should reflect the current figures as of validation Asset Model • In-force portfolio – Should reflect the current figures as of validation date • Source from investment department – Should include information on: • • • Coupon/income Coupon frequency Redemption dates MV, BV, and PV of the assets Assets’ currency – Should exclude assets regarded as cash • May include bank deposit < 1 year – Might need to scale up the assets to reflect the sample space taken in liability model

Asset Model • New Purchases / Sales – Should reflect the future re-investment strategy Asset Model • New Purchases / Sales – Should reflect the future re-investment strategy • Separate by types of assets and by currency – Should reflect future yields on the chosen assets • Taking into account current trends, assumed spread to be maintained, term to maturity, and default risks • Model validity – Assumptions should be verified by investment dept – Re-investment strategy should be in line with the overall company’s strategy

Asset Model • Sample of Re-investment Strategy IDR Asset type % Reinvest USD Asset Asset Model • Sample of Re-investment Strategy IDR Asset type % Reinvest USD Asset type % Reinvest Bank Deposit 10% Bank Deposit 25% Gov’t Bond 50% Gov’t Bond 45% Corp. Bond 30% Corp. Bond 40% Stocks 10%

Asset Model • Sample of Yield for Government Bonds YTM Yield (before default) <1 Asset Model • Sample of Yield for Government Bonds YTM Yield (before default) <1 7. 29 5 10. 06 2 3. 71 1 8. 03 6 10. 31 10 6. 67 2 8. 71 7 10. 28 3 N/A 8 10. 38 4 9. 84 9 10. 49 10 10. 44

Combining the Models • Deterministic Projection – Assumptions are pre-determined at the valuation date Combining the Models • Deterministic Projection – Assumptions are pre-determined at the valuation date – Usually no changes during the projection period – Not suitable for fluctuate economic conditions • Dynamic Projection – Used to project the effect of one or more economic or business scenarios simultaneously; – Scenarios are usually vary by year of projection;

Combining the Models • Stochastic Projection – Much more advance approach, but might not Combining the Models • Stochastic Projection – Much more advance approach, but might not be fully applicable – Calculations on stochastic variables are repeated for as many simulation as required • Example of stochastic variables: investment return vs. expense inflation – Stochastic models: the Wilkie (1995) model, the Jump Equilibrium by Andrew Smith of Bacon & Woodrow, a simple Random Walk model.

Combining the Models Dynamic Projection • General ideas: – Liability and asset projections need Combining the Models Dynamic Projection • General ideas: – Liability and asset projections need to be combined – The projections are run one period at a time; • The projections are run parallel; • The projected results are combined usually at the end of each projection period – Impact from liabilities projection to the assets – Need to determine a set of assumptions when combining the projections: • Bonus rate to be declared; • Valuation interest rates; • Investment strategy; etc.

Combining the Models Dynamic Projection – In the first run: • In-force and assumed Combining the Models Dynamic Projection – In the first run: • In-force and assumed 1 st year new business is incorporated; • Net cash flow at the end of projection period should incorporate assumptions set up specifically for the projection period-end – Such as assumptions on bonus to be declared, re-investment strategy, production volume, pricing, and mix of future new business • Net cash flow after adjustments will be used to buy investment vehicles based on re-investment strategy; • Figures at the end of 1 st year projection will then be set up as the initial figures for the 2 nd year projection;

Combining the Models Dynamic Projection – In the next run: • In-force and assumed Combining the Models Dynamic Projection – In the next run: • In-force and assumed new business is incorporated; • Assets projected included assumed new assets purchased at the end of last period; • Figures at the end of 2 nd year projection will then be set up as the initial figures for the 3 rd year projection and so on;

Combining the Models Dynamic Projection – Verifying the models and assumptions: • Projected results Combining the Models Dynamic Projection – Verifying the models and assumptions: • Projected results at the end of 1 st projection year should be in line with the company budget; • Might need to re-adjust the assumptions to be in line with the budget

Interpreting the Results • The projected results should be interpreted based on the assumptions Interpreting the Results • The projected results should be interpreted based on the assumptions used; – Best estimate assumptions • Should analyze the impact on total assets, premium income, profit, premium reserve, solvency ratio, and surplus; • Need to explain the reasons of significant deviation, if any; • Need to incorporate the major products characteristics; – Lapse supported products; – Investment-type products; – Savings products;

Interpreting the Results – Assumptions for Adverse Scenarios • Should analyze the impact on Interpreting the Results – Assumptions for Adverse Scenarios • Should analyze the impact on total assets, premium income, profit, premium reserve, solvency ratio, and surplus; • Need to explain the trend changes as compared to base scenario; • Need to incorporate all adverse assumptions;

Interpreting the Results – Assumptions for Adverse Scenarios • examples; – Increase in new Interpreting the Results – Assumptions for Adverse Scenarios • examples; – Increase in new business will have effect on the products with heavy first year strains; – Decrease in lapse will have negative impact on surplus if major products sold are lapse-supported products – Decrease in investment return usually has negative impact on surplus. However, the impact could be significant if the majority of products are investment-guaranteed;

Interpreting the Results – Recommendations to Board of Directors • Should clearly state the Interpreting the Results – Recommendations to Board of Directors • Should clearly state the main concerns and their primary causes; – – Investment issues; Operation issues; Strategic marketing issues; Product issues; • Proposed remedies should be general; – Broad enough for management to expand the idea; – Actuaries are not supermen – know everything exactly; – Sometime only needs the shareholders’ commitment; – What matters at the end is to control the expenses as budgeted;

Thank You Thank You