Economic Capital - Overview and Recent Trends: ERM Symposium April 24, 2006

Economic Capital Overview and Recent Trends
ERM Symposium April 24, 2006
Hubert Mueller, (860) 843-7079 Hubert.Mueller@TowersPerrin.com
2006 Towers Perrin
Overview
Aggregation
2005 Towers Perrin
Proprietary and Confidential Not for use or disclosure outside Towers Perrin and its clients
OVERVIEW AND RECENT TRENDS
ERM Governance and Economic Capital Governance policies, procedures, tools, resources ERM Framework decision criteria Economic Capital metrics Analytics tools
1. 2. 3.
An appropriate governance structure should be in place to articulate the policies and procedures for managing the enterprise, supported by appropriate tools and resources An ERM framework should specify the firms decision criteria for risk taking and capital utilization The analytics should generate the appropriate financial measures required for making business decisions
2006 Towers Perrin
The concept of EC was developed in the banking sector
Basel I requires holding appropriate levels of capital for different financial risks S&P AAA rating requires banks to hold capital at the 99.90% level Basel II expands the concept to operational risks Quarterly reporting of operational risk exposure Insurance companies have picked up the EC concept only in the last several years Rating agencies are starting to give credit for internal models Regulatory changes are accelerating pace of change Larger companies are setting up proprietary stochastic models The European CRO Forum is in the process of recommending standards for the acceptance of internal models for compliance with the new Solvency II capital standards
2006 Towers Perrin
When calculating EC, three alternative approaches are commonly used to measure risk: Risk of ruin, VAR and TVAR
Financial results from a series of Stochastic Scenarios
+
1) TVAR captures the full extent of losses in the event of ruin
3) Risk of ruin is the probability of loss given the capital held
100% Cumulative Probability
2) VAR quantifies the capital required to withstand losses at a particular probability level
Required Economic Capital (REC) = sufficient surplus capital to cover potential losses, at a given risk tolerance level
2006 Towers Perrin Proprietary and Confidential Not for use or disclosure outside Towers Perrin and its clients
When calculating EC, financial services companies use a range of different confidence levels
Most insurers use expected shortfall risk (CTE or TVAR) or risk of ruin Variable annuity RBC is based on CTE90 level Most banks use VAR Choice of confidence level and implied rating: Most European insurers are using one-year confidence levels ranging from 99.5% to 99.99% European regulators appear to be converging towards a one-year 99.5% confidence level for Solvency II Confidence levels are typically linked to a target risk appetite and financial strength rating Where longer time horizons are used, a lower multi-year confidence level can be justified (e.g., AA over five years vs. AA over one year) Moodys and S&P have suggested using 99th percentile for AA financial strength rating Fitch is using a 98.2 CTE level for AA rating
2006 Towers Perrin
Definitions of EC: Best estimate liability approach Economic Capital is The level of assets, in addition to the Best Estimate Liability, required to pay future policyholder benefits at the chosen Security Factor Economic Capital covers the volatility in: The runoff of existing business The future business (pricing risk) Best Estimate Liability is The best estimate projection of non-investment cash flows Discounted at the asset returns under the best estimate economic scenario Security Factor is Based on a risk of ruin level that is consistent with the companys financial strength rating Commonly used in North America
Economic Capital Reserve margins
Pricing risk Runoff risk Needed Assets Best Estimate Liability
Statutory reserve
Definitions of EC: Market-consistent balance sheet approach
Economic Capital is Measured as the difference in market-consistent net assets between normal conditions and stressed conditions The stress tests applied are each calibrated to a probability level over a one-year time horizon, consistent with the companys Normal conditions Stressed conditions financial strength rating Separate stresses are applied to cover a variety of market, credit and insurance risks that might occur over the projected time horizon Results are aggregated using a correlation matrix approach
Net assets MV Assets MCV Liabs MV Assets Net assets MCV Liabs
Net assets
Net assets
Economic Capital
Normal
Stressed
Commonly used in Europe

The calculation of EC should include all material risks
Overall Risk Profile
Risk Aggregation
Market Risk Interest Rates Equities Real Estate
Credit Risk Defaults Spreads Counterparty
Liquidity Risk Asset/Liability Risk Hedging Programs
Insurance Risk Mortality Lapses Reserves
Operational Risk Distribution Systems People
2006 Towers Perrin
There is no right or wrong approach to building an economic capital model
Decision 1: Period for assessment
Decision 2: Definition of capital
Decision 3: Measure of risk
Decision 4: Risks to include
Decision 5: Decision 6: Quantification Aggregation methodology
One year
Statutory
Risk of ruin
Market Credit
Stochastic modelling Stress Testing Factor based
Additive
n years
GAAP
VAR Insurance
Variance/ Covariance Stochastic
Run-off of portfolio
Economic
TVAR or CTE
Operational Liquidity
Six key decisions need to be made, and the approach taken should reflect the nature of the company and managements objectives
2006 Towers Perrin
By combining models, insurance companies are able to measure diversification benefits
Enterprise Diversification Benefit

Economic Capital
Sum of P/C Segments
P/C diversification effect Aggregated P/C Business Cross Sector diversification effect Aggregated Total
Sum of Life/Health Segments
Life/Health diversification effect
Aggregated Life/Health Business
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Recent developments encouraging the use of EC
Basel II Solvency II/European CRO Forum OSFI regulation for segregated funds (CAN) C-3 Phase II: RBC for variable annuities (VA) U.S. Proposed stochastic reserves for VAs and UL products U.S. GAAP SOP 03-1: explicit reserves for guarantees U.S. General need to develop risk profiles and perform hedging analysis Measuring Economic Value/Market Consistent Embedded Value (MCEV) Measuring exposure to catastrophic events Demands and increasing scrutiny by rating agencies/regulators Calculating EC is becoming an important tool for insurers in guiding risk-based decision making
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The European CRO Forum is establishing guidelines for admissibility of internal EC models for Solvency I
European Chief Risk Officer Forum is establishing guidelines for calculation of EC and diversification of risk Principles for Regulatory Admissibility of Internal Models (June 2005) Solvency Capital should be set to ensure a standardized likelihood of economic loss to policyholders Internal models should be based on adverse movement in Economic Value of (Assets Liabilities), calibrated to a target annual level of 99.5% probability of solvency All material risks affecting the balance sheet should be modeled Internal risk models should be fully implemented inside the company, and reviewed (at least) annually The CRO Forum advocates the admissibility of diversification benefits In December 2005, the CRO Forum published a subsequent report discussing suggested solutions to major issues in Solvency II EC is to be based on a market-consistent approach
2006 Towers Perrin
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All major US rating agencies are developing or enhancing their capital adequacy models Standard & Poors (S&P) is currently enhancing its capital adequacy model to reflect changes brought about by the proposed CTE 90 capital for VA RBC Required capital will only be based on the stochastic model (not Standard Scenario) CTE level will be calibrated to rating category Partial credit for hedging, no phase-in EC will be incorporated into S&Ps overall ERM framework by the fall of 2006 Fitch is also revising their VA capital adequacy model to incorporate CTE methodology E.g., AA Fitch rating will require capital based on CTE(98.22) level Partial credit for hedging will be provided AM Best and Moodys are also in the process of enhancing their capital adequacy models
2006 Towers Perrin
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Leading-edge companies maximize value by relating decisions on the risks they take to decisions on the capital they use
Value Creation
Return on Risk
Value Management
Capital Costs
Portfolio of Enterprise Risks Risk Structure
Capital Adequacy Risk and Capital Management
Portfolio of Capital Resources Capital Structure
How much capital do I need?
What type of capital do I need?
Economic Capital
2005 Towers Perrin
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Overview
Aggregation
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AGGREGATION
Aggregation approaches can significantly reduce capital requirements, but must be demonstrably robust Approach 1. Approximate analytical approach using standalone economic capital and correlations 2. Use marginal distribution functions, correlations and aggregate using Monte Carlo simulation 3. Build/approximate joint distribution function and solve analytically/by numerical integration Advantages Quick to execute High degree of accuracy Can attribute diversification easily Easy to understand More accurate Disadvantages Accuracy of the approximation is poorer the more varied the risk distributions Difficult to build Time consuming to run many simulations Difficult to disaggregate Most accurate Almost impossible to build joint distribution in practice Cannot attribute diversification benefits back to risks and businesses
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AGGREGATION
One aggregation approach is to combine risks based on statistical measures of their variances and covariances
Asset Class 1
Product Class 1
Asset Class 2
Covariance Matrix
Product Class 2
Asset Class 3
Product Class 3
Fundamental construct Each risk is reduced to a statistical distribution of financial outcomes Linkages between risks described via a covariance matrix Aggregate result obtained either analytically or via Monte Carlo simulation
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AGGREGATION
One fundamental approach is to combine risks based on statistical measures of their variances and covariances
The key to this approach is the specification of a correlation matrix Correlations based on available empirical evidence, informed judgment, conservatism Covariances usually assumed to be constant across distribution, facilitating simplified analytic solutions
Correlation Matrix
18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1
0 0.2 0.4 0.6 0.8 1
In its most simplistic implementation: Each risk is assumed to be normally distributed Correlation between risks is assumed to be linear Then the Economic Capital for each risk can be combined by the formula Aggregate Capital = i j ij Ci C j
1 2 3 4 5 6 7 8
-0.2
9 10 11 12 13 14 15 16 17 18
Where Ci is the economic capital required for the ith risk at the required confidence level and ij is the correlation coefficient between ith and jth risk While convenient analytic solutions are desirable, they may require simplifying assumptions that are too approximate In these situations, statistical aggregation can still be accomplished, but may require Monte Carlo simulation
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AGGREGATION
An alternative approach is to develop a structural risk model, and then link all asset and product behavior to it
Asset Class 1
Product Class 1
Asset Class 2
Economic Scenario Generator
Product Class 2
Asset Class 3
Product Class 3
Fundamental approach Each systemic risk is described by a stochastic equation in the ESG; linkages between systemic risks are also built into the equations ESG generates scenarios, representing plausible sets of future conditions All assets and products are subjected to common set of scenarios, with their behavior linked to systemic variables Aggregate results can be obtained additively by scenario
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AGGREGATION
Typically at the product level and up, financial behavior of the product and associated assets are linked to ESG variables Economic Scenario Generator
Inflation Interest Rates Credit Costs Currency Exchange GDP
Projected Financials Asset Behavior Models

Risk Profile = Distribution of Future Financial Results
Product Behavior Models
Company Strategy
Investments Products Capital/Structure Reinsurance/Hedging Operating
Aggregation upward is accomplished by adding risk profiles scenario by scenario

Probability
Catastrophes and Random Claims
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AGGREGATION
Both approaches require correlation assumptions; differences are in what is correlated and where in the analysis
Method
Statistical Correlation Approach Structural Scenario Approach
Risk Driver
Correlation assumptions applied within BU model Related by SDE,* including correlations
Risk
Statistics describe risk
BU Capital
Calculated on BU tail statistics
Aggregation
Apply aggregation equation with correlation adjustment to BU capital Sum BU results to get aggregated tail scenario value
Scenarios determine risk
Calculated on BU tail scenarios
Complexity of interactions between risks can influence choice of method: Correlation matrix captures relationship between two risks, but that may not be sufficient for more complex risk dynamics Example: multi-trigger products with payoffs that are functions of event risk, financial risk and policyholder behavior Statistical correlation approach requires correlation factors to be used as inputs in two places: Risk drivers within the BU economic capital calculation BUs at the aggregate economic capital calculation Correlations between risk drivers (systemic variables) represent only one factor in SDE; correlations between BUs emerge from the scenarios and can be evaluated against experience
*Stochastic differential equations.
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Introducing a Global, Integrated, Insurance Capital Platform

Jeff Mohrenweiser Manager of Insurance Modeling / Quantitative Applications Jeff.Mohrenweiser@FitchRatings.com
ERM SYMPOSIUM April 24, 2006
View of Insurer-developed Economic Capital Models Fitchs Economic Capital Modeling Decisions How to assess Economic Capital Models
Fitch Ratings
April 11, 2006
Risk Assessment - Fitch Ratings Criteria (est. 1996)

Industry Review Organization Review
Parent financial strength and financial flexibility Upstream dividend requirements Potential need to divert capital to underperforming affiliates Business synergies Formal guarantees or support agreements
Management Review
Strategic vision Appetite for risk Credibility of track record for meeting expectations Controls and risk management capabilities Depth, breadth and succession plans Key executives accomplishments
Operational Review
Distribution mix Market position Franchise value Expense efficiency Underwriting and pricing experience Product mix Administrative / technology capabilities
Financial Review
Level of orderly competition Industry competitive advantage Barriers to entry / exit Regulatory, legal and accounting environment
Operating performance Capital adequacy Investment quality Asset / liability and liquidity management Financial flexibility
Our business is to provide credit opinions, not solvency requirements.

Fitch Ratings April 11, 2006 2
FITCHS VIEW OF ECONOMIC CAPITAL MODELS The Long and Winding Road
Principal-based reserving
Solvency II
C3-II ECR
C3-I
Fitch Ratings
April 11, 2006
Industry Observers face many challenges with Company Capital Models

Stochastic Europe
Progress
U.S.
Methodology
Factor-based
Transparency
Calibration Organization Assumptions
Resources
Tools
Comparability Monkey Wrenches

GAAP Bermuda IFRS Reinsurers Multi-lines Enterprise Aggregation Multi-nationals
Accounting Consolidated Statutory
Correlation
Risks
Pension Deficits Available Capital
Methodology Discounting Time Horizon Goodwill DAC
DATA
FITCHS ECONOMIC CAPITAL MODEL
Global, Integrated, Stochastic Tool
Fitch Ratings
April 11, 2006
A Standardized Platform v. Model v. Philosophy

Stochastic platform with interactive surveys using consistent assumptions
Current regulatory models
Optimal Spot for Fitch is Vertical
Insurers internal capital philosophy
Simpler
Less than vertical is unresponsive > Arbitrary adjustments > Incomplete scope
Complexity
Past vertical is inefficient > Too much data > Too much time > Lack of comparability
April 11, 2006 7
Fitch Ratings
Philosophy of the Fitch Platform

An analytical tool, not a rating machine
In some cases, the rating opinion may be HIGHER or LOWER than the model result
Need consistency
Between products Between sectors Between countries
Efficient, yet Robust

Exposures based on public data sources Assumptions based on industry v. company credibility Create an open box
Fitch Ratings
April 11, 2006
Some Platform Decisions

Item Definition Fitch Decision
Role of Capital
Define the purpose of capital when establishing a capital standard Time period over which a company will assume additional risk producing positions Sources of risk producing exposure
Limit the risk that assets are insufficient to pay claims over the lifetime of policyholder obligations. Include run-off of current obligations and one-year of new business on relevant products. Includes ALM (Market, Interest), Credit, Reserve, Underwriting and Natural Catastrophe Items generating risk exposure will be allowed to fluctuate over the run-off of liabilities - annual time step with maximum of 30 years. The model will focus on Conditional Tail Expectation (CTE) but also produce additional risk measures such as Value of Risk (VaR), Comparables. Calibrated primarily using bond default data along with rule of thumb measures.
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Treatment of New Business Risk Elements in Model Modeling Time Horizon
Time period over which risk exposure sources will vary and generate volatility
Risk Measures
Statistical measure to determine relative risk from risk distributions generated by allowing risk exposure sources to vary over the risk exposure horizon Methodology for tuning results of the capital model to meaningful capital indications
Model Calibration
Fitch Ratings
Modeling Methods Risk Elements Captured

ALM (Market) Risk
Incorporates risk-free yield curve (bonds, mortgages), real estate and equity returns (DAX, FTSE, CAC). Use a proprietary, integrated scenario generator. Life: Use MoSes platform.
Credit Risk
Incorporates defaults, migration and spread volatility Use common market indices to establish parameters for asset type and quality Over 50 asset buckets. Stochastically model reinsurer default risk
Reserve Risk
Use Mack Method Utilize several checks to ensure data integrity If checks fail, use Industry assumptions leveraged by Underwriting Risk parameters. Incorporates reserve adequacy analysis
Underwriting Risk
Use a collective risk model of frequency and severity of losses. Relies on ELR, Attachments, Limits Factors one year of new business.
Catastrophe Risk
P/C: Use AIR (Catrader) software. Life: Use Lee-Carter methodology trend, volatility, shocks
Aggregator
Each Company will potentially have unique risk curves
Consistent economic scenario set Similar Cat event set Correlated random numbers
Fitch Ratings
April 11, 2006
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Dashboards Industry Comparisons

GOOD
R E S E R VE R IS K
BAD
BAD
US - Al l Ot h e r US - Au t o P D US - Sp e c i a l P r o p US - P r o d Li a b - C M US - P r od Li a b - Oc c US - R e i ns B US - R e i ns A&C US - In t e r n a t i on a l US - Ot h Li a b - C M US - Ot h Li a b - Oc c US - Sp e c Li a b US - M e d M a l - C M US - M e dM a l - Oc c US - C M P US - WC
GOOD
US - C AL US - P P A Li a b US - H/ O &F/ O
A s s e t R e t u rn
0% 2 5% 50 % 75% 10 0 %
ESTIMATED RISK CHARGES Risk Driver Exposure Asset 22,528,280 Underwriting 14,463,360 Net Reserve 13,695,190 Reinsurance Credit 4,321,680 Catastrophe 3,452,285 A&E 4,134,638 UNDIVERSIFIED REQUIRED CAPITAL SAMPLE Value-at-Risk 99.90 99.00 97.50 12,535,283 4,540,239 2,762,578
CATASTROPHE RISK
Est. Req Cap 2,010,000 1,460,000 3,100,000 40,000 610,000 1,160,000 8,380,000 Asset Risk
Risk Charge 9% 10% 23% 1% 18% 28% -17%
10 0 %
75%
50 %
Diversification Liability Risk Benefits Asset v. Liability Total Benefit 1,156,680 7,223,320 Req Cap:
2 5%
-1% -11% 16%

0% 2 50 50 0 10 0 0 Y e a r Ev e nt 2 50 0 50 0 0 10 0 0 0
Fitch Ratings
April 11, 2006
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Capital Assessment Score Comparing what is needed versus what is available

REQUIRED CAPITAL FITCH AVAILABLE CAPITAL
9 ,0 0 0 ,0 0 0 8 ,0 0 0 ,0 0 0 7,0 0 0 ,0 0 0 6 ,0 0 0 ,0 0 0 5,0 0 0 ,0 0 0 4 ,0 0 0 ,0 0 0 3 ,0 0 0 ,0 0 0 2 ,0 0 0 ,0 0 0 1,0 0 0 ,0 0 0 0
Defined by Balance Sheet Assessment
BBB-
BBB BBB+
A-
A+
AA-
AA
AA+
AAA
Defined by Model Results

Calibrating Results Historical Bond Default Experience

Probability of Default
Thresholds need to be:

Realistic Transparent Meaningful
B
Avoid arbitrariness
BB
BBB
A AA AAA 0 5 10 15 Time Horizon 20 25 30
Fitch Ratings
April 11, 2006
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ASSESSING INTERNAL CAPITAL MODEL PLATFORMS No one shoe fits all
Fitch Ratings
April 11, 2006
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Analytical Tool: No perfect solution

Fitch Capital Model
Weighting based on Credibility and Transparency of Company Model and type of business
Establishes Minimum Requirement
Provides Discussion Insights
Capital Adequacy
Regulatory Requirements
Creates Consistent Principles
Fitch Ratings
Insurers Internal Capital Models
April 11, 2006
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Basic Precepts
Sophistication should match the complexity of the enterprise Platform needs to be fully vetted
Inputs Models Outputs
INPUT DESIGN IMPLEMENTATION
MODELING METHODS
Transparency
A Standardized Platform breaks down a complicated process, involving many resources over several years Garbage in, Garbage out
Whats in the Toolbox?
OUTPUT CRITERIA
Cant manage what you cant measure
Fitch Ratings
April 11, 2006
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Review of Company Capital Models

Understanding of the Model
Tools used (Excel, Moses etc.) and Risks Captured Model Methodology (Monte Carlo Simulation, Closed Form Solutions, Factors) Time horizon and calibration
Model Development and Use

Who developed and what data was used? How is it being maintained and updated? Who runs the model? How often is the model run?
Model Methodology
Discount rate (portfolio rate, risk free?) Source of Generated Economic Scenarios and Parameterization Available Capital Definition
Outputs of the model

Breakdown of capital requirements by risk/geography Integration into Risk management framework
Important Points to Note: Capital Model Issues

Diversification credit
If correlation between risks is less than one then capital required is less than sum of parts
Value at Risk v Conditional Tail Expectation (VAR v CTE)

VAR is more intuitive but not a coherent risk measure
Available capital
Depends on accounting regime - important not to double count some elements included as part of required capital
Aggregation of results
How to sum results between entities and across regions
Calculation of correlations
What experience was used? Where is the expert opinion?
Role of Rating Agencies after Solvency II

Some differences but no major changes expected:
Internal Capital models will be a useful input to the rating process Regulation and Risk management may improve for companies
Will Rating agencies still be Important?

Many companies want to be better than BBB if this is the standard set by regulators Regulators do not disclose their view of financial strength Regulators are only one party forming a view as to financial strength, other views (e.g. from rating agencies) helpful for the market Rating agencies evaluate financial strength from a bondholder standpoint in addition to policyholders
Fitch Ratings
April 11, 2006
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Summary
Infancy stage of Economic Capital Models There is general consensus but no consistency Substantial challenges
Resources Understanding Pay back
Necessity
Insurance is the risk-assuming business Statistics: The only science that enables different experts using the same figures to draw different conclusions. Evan Esar, American Humorist (1899 1995)
Fitch Ratings
April 11, 2006
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Economic Capital A Regulatory Perspective

ERM Symposium, April 24, 2006
NAIC Risk Focused Surveillance Framework

Adopted June 14, 2004
Framework Cycle
Risk Focused Examinations Off-Site Risk-Focused Financial Analysis Internal/External Changes Priority System (CARRMEL) Supervisory Plan Insurer Profile Summary
Financial Condition Examiners Handbook

Examination Objectives:
Accuracy (AC) Recorded transactions and account balances are mathematically accurate, are based on correct amounts and have been classified into the correct account. Completeness (CO) All transactions and account balances that should be recorded in the Annual Financial Statement were recorded. Compliance (CM) Business transactions and affairs have been conducted in accordance with state insurance codes, other state laws or department directives. Cutoff (CT) All transactions are recorded in the correct accounting period. Existence (EX) Recorded transactions occurred and are not fictitious and recorded assets and liabilities existed as of the balance sheet date. Obligation (OB) and Ownership (OW) Recorded liabilities are obligations of the company and recorded assets are the rights of the company at the balance sheet date. Valuation (VA) Assets and liabilities are valued in accordance with state statute and NAIC accounting guidance. Presentation and Disclosure (PD) The elements of the Annual Statement are properly classified and all disclosures are accurately included in the Annual Statement.
CARRMEL
Priority System Based on Ratios and Analysis to Measure:
Capital Adequacy Asset Quality Reinsurance Reserves Management Earnings Liquidity
Off-Site Risk-Focused Financial Analysis

Financial Analysis includes:
Risk Assessment Results Financial Analysis Handbook Process Ratio Analysis (IRIS, FAST, Internal Ratios) Actuarial Analysis Update with internal/external changes
Sample Management Letter

Confidential Document:
The Board of Directors (Board) has a duty to ensure that XYZ Insurance Company is operated in a safe and sound manner in the best interest of the policyholders. The ABC Department of Insurance (the Department) is charged with the responsibility to protect insurance consumers and other creditors.

The Department has identified the following risks and concerns that impact the Companys overall financial position and need to be addressed by the Board: Capital Adequacy, Earnings, Pricing, Underwriting
Insurance Department would insert description of concerns.
Corporate Governance/Risk Management

Insurance Department would insert description of concerns.

Action to be Taken by the Board and Management
Provide key performance indicators and goals utilized by management and the Board to monitor the progress and effectiveness of the 200X business plan. Provide the companys three-year business and financial plan. The financial projections should be on a statutory basis and approved by the Board. The plan should include a projected income statement, balance sheet, statement of cash flow, as well as a risk based capital calculation for all three years. Key business assumptions and projections utilized in the forecast should be fully described.
Risk-Based Capital
1. 2. 3. 4. 5. 1. 2. 3. 4. 5. 6. Asset Risk-Affiliates Asset Risk-Other Insurance Risk Interest Rate Risk and Health Credit Risk Business Risk > 250% > 200% to <250% > 150% to < 200% > 100% to < 150% > 70% to < 100% < 70% No action level Trend test level Company action level Regulatory action level Authorized control level Mandatory control level
Risk-Based Capital Plan

The RBC plan is a comprehensive financial plan which 1) identifies the conditions in the insurer which contribute to the Company Action Level Event; 2) contains proposals of corrective actions which the insurer intends to take and would be expected to result in the elimination of the Company Action Level Event; 3) provides projections of the insurers financial results in the current year and at least the four succeeding years, both in the absence of proposed corrective actions and giving effect to the proposed corrective actions, including projections of statutory operating income, net income, capital and/or surplus. The projections for both new and renewal business might include separate projections for each major line of business and separately identify each significant income, expense and benefit component; 4) identifies the key assumptions impacting the insurers projections and the sensitivity of the projections to the assumptions; and 5) identifies the quality of, and problems associated with, the insurers business, including but not limited to its assets, anticipated business growth and associated surplus strain, extraordinary exposure to risk, mix of business and use of reinsurance in each case, if any.
RBC Checklist
Determine whether concerns exist regarding the insurers risk-based capital position. Review the Five-Year Historical Data Schedule, Risk-Based Capital Analysis.
Is the ratio of Total Adjusted Capital divided by Authorized Control Level Risk-Based Capital less than or equal to 250%?
Yes
No
Has there been a significant change (XX%) in the ratio of Total Adjusted Capital divided by Authorized Control Level Risk-Based Capital from the prior year?
Yes Yes Additional procedures:
No No
Has the Authorized Control Level Risk-Based Capital increased by more than YY% from the prior year?
If required by statute, obtain a copy of the insurers RBC Plan and review. Review all items that generate significant RBC charges to ensure that these factors have been considered in the overall analysis of the insurer.
Forecast: Life RBC

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LR001 Jurat Page LR002 Bonds LR003 MEA LR004 Mortgages LR005 Stock LR006 Separate Accounts LR007 Real Estate LR008 Other LT Assets LR009 Sch. BA Mortgages LR010 Concentration Factor LR011 Stock Concentration Factor LR012 Miscellaneous Assets LR013 Replications LR014 Reinsurance LR015 Off-Balance Sheet LR016 Health Premiums LR017 Underwriting Risk-Exper. LR018 Underwriting Risk - Other LR019 Managed Care Credit LR020 Long-Term Care LR021 Health Claim Reserves LR022 Life Insurance LR023 Premium Stabilization LR024 Interest Rate Risk LR025 Credit Risk LR026 Business Risk LR027 Calculation of Tax Effect LR028 Calculation of ACL LR029 Capital Notes LR030 Total Adj. Capital LR031 RBC Level of Action LR032 Trend Test LR033 Additional Info. Req. LR034 Sensitivity Tests - ACL LR035 Sensitivity Tests - TAC LR036 Affiliated Summary LR037 Affiliated Crosschecking LR038 Affiliated Detail LR039 Modco Bonds - Ceded LR040 Modco Bonds - Assumed LR041 Modco All Other - Ceded LR042 Modco All Oth - Assumed LR043 C-3 Exemption Test All Other Data
2005 Changes to Life RBC

LR024 Interest Rate Risk and Market Risk Line (35)
Source is company records.
Line (33) Instruction

Enter in Column (3) the pre-tax interest rate risk results of cash flow testing per the Appendix 1a methodology. Line (33) should only be completed if the answer to Line (14) or Line (22) of LR043 Exemption Test: Cash Flow Testing for C-3 RBC is Yes or if the company chooses to do C-3 RBC cash flow testing on a continuing basis. Once a company chooses to use the C-3 RBC cash flow testing method to calculate RBC it must continue to do so unless regulatory approval from the domiciliary jurisdiction is received to go back to the factor-based method.
Line (23) was added to LR043 Exemption Test: Cash Flow Testing for C-3. Cash Flow Testing for C-3 RBC
LR043 Exemption Test: a company may be required to perform cash flow testing to determine its RBC requirement. A practical method of measuring the degree asset/liability mismatch exists
https://www.actuary.org/life/phase2.asp
C3 Phase II Q&A audio from the NAICs 2005 winter meeting

http://www.actuary.org/life/phase2_session.asp http://www.naic.org/documents/committees_e_capad_winter05_PhaseII_ QAsession.pdf The speakers for the Q&A session included: Philip Barlow, chairman of the NAICs Life RBC Working Group John Bruins, ACLI Larry Bruning, chairman of the NAICs C3 Phase II Results Subgroup Tom Campbell, chairperson of the Academys Variable Annuity Work Group Lou Felice, chairman of the NAICs Capital Adequacy Task Force, which oversees the Life RBC Working Group Larry Gorski, vice chairperson of the Academys Capital Adequacy Subcommittee and chair of the Academys Experience Studies Subcommittee
2006 Life RBC Agenda

Variable annuity (C-3 Phase II) - monitoring and refinements to modeling approach Expanding C-3 Phase I cash flow testing to all insurers with at least $100 million of admitted assets Finalize modified coinsurance dividend liability issue How unauthorized reinsurance impacts the ceding companys risk-based capital requirements Expansion of the modeling approach to life products (C-3 Phase III) and other products Recognition of effective hedges in risk-based capital
AAA Medicare Part D Subgroup December 2005

B. Recommended Factors for 2006-07. For the period 2006-07, during which the initial level of Risk-Corridor Protection applies Underwriting Risk Factors for Standard Coverage:
Initial Factor 0.141 Excess Factor 0.109
Discount Factors for Standard Coverage:

Risk-Corridor Protection only 0.500 Reinsurance Coverage and Risk-Corridor Protection 0.650 Underwriting Risk Factor for Supplemental Benefits 0.120
Principle-based Approach
Captures all of the material risks, benefits and guarantees in the contract using basic risk analysis and risk management techniques
Provides an appropriate level of conservatism that is consistent with the objectives of statutory reporting Only requires a modeling and or stochastic approach be used when necessary to properly capture the risks of the contract For some products, a deterministic, single scenario approach is adequate to capture the risks of the contract
For products with, material tail risk of a high level of uncertainty in cash flows arising from policy owner options in the contract, a stochastic approach may be necessary A stochastic approach does not require that all assumptions be stochastically modeled
New Long-Term Care Page

A new page LR020 Long-Term Care was added to the RBC formula for yearend 2005 risk- based capital. Previously, the risk-based capital charge for long-term care business had been based on premiums only. Now, the RBC charge will be based on a combination of premiums and a twoyear premium to loss ratio multiplied by total claims. The premiums will be multiplied in a tiered factor calculation as follows: Other Long-Term Care Premium Pre-tax Factor First 50 Million Over 50 Million 0.154 0.046
LTC (cont.)
A ratio of premiums to claims is calculated for the current year and prior year. For the loss ratios to be used, the current year and prior year premiums must be greater than zero. In addition, the current and prior year claims incurred must be greater than or equal to zero. Otherwise, the current year incurred claims are used instead of the two-year loss ratio multiplied by the current year premiums.
LTC (cont.)
The result of the claims ratio or the current years incurred claims is multiplied by tiered factors as follows: If Current Year LTC Premium Positive: Negative or Zero: Long-Term Pre-Tax Pre-Tax Care Claims Claim Factor Claim Factor First 35 Million Over 35 Million 0.385 0.569 0.123 0.185
The LTC premium charge and claim charge would be combined and then reduced by 35% on the tax adjustment page.
Non-Cancelable Long-Term Care Business

All non-cancelable long-term care business receives one standard charge based on premiums on LR016 Health Premiums.
Only premiums and not claims are not used to calculate RBC for non-cancelable long-term care.
The non-cancelable long-term care business should be excluded from the new Long-Term Care page that was added for 2005.
Non-cancelable long-term care premium receives a pre-tax RBC charge of 15.4%. The after-tax factor is approximately 10%.
LR003 Industry Normalized Loss Ratio

The Industry Normalized Loss Ratio shown on LR003 Mortgage Experience Adjustment Factor Line (12) was estimated to be approximately 0.014% for year-end 2005. However, that factor was not be finalized until around December 2, 2005. It is easy to forget to replace the preliminary factor with the final one. The ratios for the current and previous risk-based capital reports are as follows:
Year End 2005 0.013% Year End 2004 0.018% Year End 2003 0.020% Year End 2002 0.024% Year End 2001 0.032% Year End 2000 0.043% Year End 1999 0.060%
LR018 Workers compensation carve-out business

Workers compensation carve-out business factors were changed for page LR018 Underwriting Risk
Other Lines (4), (5) and (6.3). This is due to the factors for the calculation being phased in over a three-year period as follows: 2004 2005 2006 Factors Factors Factors Line (4) Net Premiums Written 0.121 0.243 0.364 Line (5) Claim Liability and Reserve 0.116 0.231 0.347 Line(6.3) Unaffiliated Reinsurance Recoverables 0.020 0.040 0.060
Annual Statement
Five-Year Historical Data (publicly available) Current and four previous years Risk-Based Capital Analysis
Authorized control level risk-based capital Total adjusted capital Trend of ratios indicates stability, growth, or decline
Principles-based Peer Review

Same qualifications as valuation actuary?
Precept 2: Only perform services when qualified Keep current with changes in standards of practice
Should not review own work

Precept 7: Avoid conflict of interest (some exceptions)
Independence
Should be defined in regulation or qualification standard SEC and NAIC definitions may differ

Economic Capital - Overview and Recent Trends: ERM Symposium April 24, 2006

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Economic Capital - Overview and Recent Trends: ERM Symposium April 24, 2006

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Economic Capital Overview and Recent Trends

ERM Symposium April 24, 2006

Hubert Mueller, (860) 843-7079 Hubert.Mueller@TowersPerrin.com

2006 Towers Perrin