Capital Adequacy Assessment for Insurers
Second Exposure Draft
TO: Members of Actuarial Organizations Governed by the Standards of Practice of the Actuarial Standards Board and Other Persons Interested in Capital Adequacy Assessment
FROM: Actuarial Standards Board (ASB)
SUBJ: Proposed Actuarial Standard of Practice (ASOP), Capital Adequacy Assessment for Insurers
This document contains the second exposure draft of a proposed actuarial standard of practice titled Capital Adequacy Assessment for Insurers. Please review this exposure draft and give the ASB the benefit of your comments and suggestions. Each response will be acknowledged, and all responses will receive appropriate consideration by the drafting committee in preparing the final document for approval by the ASB.
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Capital Adequacy Assessment for Insurers
Actuarial Standards Board
1850 M Street, NW, Suite 300
Washington, DC 20036
The ASB posts all signed comments received to its website to encourage transparency and dialogue. Unsigned or anonymous comments will not be considered by the ASB nor posted to the website. The comments will not be edited, amended, or truncated in any way. Comments will be posted in the order that they are received. Comments will be removed when final action on a proposed standard is taken. The ASB website is a public website, and all comments will be available to the general public. The ASB disclaims any responsibility for the content of the comments, which are solely the responsibility of those who submit them.
Deadline for receipt of responses in the ASB office: March 1, 2018
When the Actuarial Standards Board’s Enterprise Risk Management (ERM) Task Force (now Committee) started work on ASOP No. 46, Risk Evaluation in Enterprise Risk Management, and ASOP No. 47, Risk Treatment in Enterprise Risk Management, it was intended that those standards would, in addition to providing general guidance to actuaries performing ERM work, provide support as building blocks for a standard on actuarial opinions regarding the still-developing own risk and solvency assessment (ORSA) process.
Starting in 2012, insurance regulators began implementing the ORSA process throughout the world. Specifically, the ORSA process is a part of the Insurance Core Principles (ICP) set out by the International Association of Insurance Supervisors (IAIS) and required by most U.S. states. A key feature of ORSA is that it requires a formal assessment of capital adequacy be a part of an insurer’s ERM program. However, what is included in a capital adequacy assessment varies significantly across the industry. Given the disparity in current practices, the ASB determined that a separate ASOP covering capital adequacy assessments was needed to supplement ASOP Nos. 46 and 47.
In addition to satisfying regulatory requirements, risk-taking enterprises will, on occasion, want to assess their capital adequacy. The purpose of this proposed standard is to provide additional guidance specifically to actuaries preparing an assessment of capital adequacy, whether for a specific regulatory requirement or for general management purposes.
The ASB released an exposure draft of this ASOP in September 2016 with a comment deadline of January 31, 2017. Nine comment letters were received and considered in developing modifications that are reflected in this draft. For a summary of the issues contained in these comment letters, please see appendix 2. In general, the suggestions helped improve the clarity of the standard.
Key Changes from the First Exposure Draft
1. Added risk retention groups and public entity pools to the scope.
2. Eliminated the term “complex insurance organization” and clarified how the ASOP applies to insurers that are part of a group or operate across jurisdictions.
3. Modified definitions of risk capital threshold and risk capital target definitions, and added a definition of valuation basis.
4. Eliminated references to liquidity and fungibility and added timing and variability of cash flows to section 3.1, General Considerations.
Request for Comments
The ASB appreciates comments on all areas of this proposed ASOP and would like to draw the readers’ attention to the following areas in particular:
1. Given the expanded scope, is the level of guidance appropriate?
2. With respect to companies that have operations in multiple jurisdictions or as part of a group, does the exposure draft provide appropriate guidance?
3. Do the changes in the exposure draft necessitated by eliminating liquidity and fungibility provide adequate guidance?
4. Are there situations in which the definition of capital in this standard would not be appropriate for a capital adequacy assessment?
5. Are the revised definitions of risk capital target and risk capital threshold clear and appropriate?
The ASB reviewed the draft at its September 2017 meeting and approved its exposure.
|ERM Committee of the ASB
|Frank D. Pierson, Chairperson
|Max J. Rudolph
|Joan A. Hentschel
|David N. Ingram
|David K. Sandberg
|John W.C. Stark
|Actuarial Standards Board
|Maryellen J. Coggins, Chairperson
|Christopher S. Carlson
|Kathleen A. Riley
|Beth E. Fitzgerald
|Barbara L. Snyder
|Darrell D. Knapp
|Cande J. Olsen
|Ross A. Winkelman
The Actuarial Standards Board (ASB) sets standards for appropriate actuarial practice in the United States through the development and promulgation of Actuarial Standards of Practice (ASOPs). These ASOPs describe the procedures an actuary should follow when performing actuarial services and identify what the actuary should disclose when communicating the results of those services.
PROPOSED ACTUARIAL STANDARD OF PRACTICE
CAPITAL ADEQUACY ASSESSMENT FOR INSURERS
STANDARD OF PRACTICE
Section 1. Purpose, Scope, Cross References, and Effective Date
This actuarial standard of practice (ASOP) provides guidance to actuaries when performing professional services with respect to a review of the resiliency of an insurer through a capital adequacy assessment.
This standard applies to actuaries involved in capital adequacy assessment work for life or health insurers, including fraternal benefit societies and health benefit plans, property and casualty insurers, mortgage and title insurers, financial guaranty insurance companies, risk retention groups, public entity pools, captive insurers, and similar entities or a combination of such entities, when affiliated (collectively, referred to as “insurer”).
The scope of this standard includes capital adequacy assessment work related to the design, performance, or review of a capital adequacy assessment, whether for an insurer’s internal or external stakeholders (for example, a regulator).
If the actuary departs from the guidance set forth in this ASOP in order to comply with applicable law (statutes, regulations, and other legally binding authority), or for any other reason the actuary deems appropriate, the actuary should refer to section 4.
1.3 Cross References
When this ASOP refers to the provisions of other documents, the reference includes the referenced documents as they may be amended or restated in the future, and any successor to them, by whatever name called. If any amended or restated document differs materially from the originally referenced document, the actuary should consider the guidance in this ASOP to the extent it is applicable and appropriate.
1.4 Effective Date
This standard is effective for work commenced on or after four months after adoption by the Actuarial Standards Board.
Section 2. Definitions
The terms below are defined for use in this actuarial standard of practice.
2.1 Adverse Capital Event
A modeled or actual event that either a) causes capital to be significantly less than the risk capital target(s) or b) causes capital to be less than the risk capital threshold(s).
The excess of the value of assets over the value of liabilities, which depends on the valuation basis chosen.
2.3 Capital Adequacy Assessment
An assessment of capital of an insurer relative to its risk capital targets or risk capital thresholds.
Affiliated group of individual organizations, of which at least one is an insurer.
2.5 Risk Appetite
The level of aggregate risk that an organization chooses to take in pursuit of its objectives.
2.6 Risk Capital Target
The preferred level of capital based on specified criteria, which is expressed as a function of a measure of risk. This can result in a single value or a range. There may be multiple risk capital targets based on different risk metrics at any one time. Any risk capital target is a function of, and aligned with, the insurer’s risk tolerance.
2.7 Risk Capital Threshold
The minimum level of capital necessary for an organization to operate effectively based on specified criteria and expressed as a function of a measure of risk. There may be multiple risk capital thresholds based on different risk metrics at any one time. Any risk capital threshold is a function of, and aligned with, the insurer’s risk tolerance.
2.8 Risk Profile
The risks to which an organization is exposed over a specified period of time.
2.9 Risk Tolerance
The aggregate risk-taking capacity of an organization.
2.10 Valuation Basis
An accounting or economic framework for the recognition and measurement of assets and liabilities.
Section 3. Analysis of Issues and Recommended Practices
3.1 General Considerations
In designing, performing, or reviewing a capital adequacy assessment, the actuary should reflect the impact of the following:
a. the insurer’s risk profile and capital;
b. the business and risk drivers, including the legal, regulatory, and economic environments in which the insurer operates, as well as any past and anticipated changes or trends in those drivers;
c. the insurer’s strategy and plans and the likelihood of their successful execution;
d. the timing and variability of projected liability-related and asset-related cash flows, including the marketability and availability of assets and other financial resources;
e. the timing and intensity of future calls on capital and the means and ability to replenish capital in a timely manner;
f. current or available resources, including those available from affiliated entities as well as the capabilities of the insurer and affiliated entities;
g. the effect on capital adequacy of changes, or projected changes, in the risk profile;
h. correlation of risks and events, diversification benefits, and the uncertainty of the interdependence between risks;
i. projections of future economic conditions; and
j. parameter uncertainty.
3.2 Additional General Considerations
In designing, performing, or reviewing a capital adequacy assessment, the actuary should consider the following:
a. the insurer’s definition of risk, the primary risk metric(s) used in the risk management system of the insurer, the risk identification process, the risks identified by the insurer, relevant management risk reports, and the limitations of the analytical tools and processes that will be used by the insurer to evaluate and quantify each risk;
b. the insurer’s risk appetite and risk tolerance, as discussed in ASOP No. 46, Risk Evaluation in Enterprise Risk Management, including any conflicts between the risk profile and the risk appetite and how the risk appetite and risk profile are expected to change over time;
c. inconsistencies between the capital adequacy assessment and information contained in publicly released reports the actuary considers relevant, such as annual statements, reserve analyses, and rate filings, and the rationale for any inconsistencies;
d. prior capital adequacy assessments;
e. if the insurer is part of a group:
1. availability of capital among the entities in the group;
2. intra-group transactions, including, for example, dividends, reinsurance, and guarantees;
3. transfers of risks from the group to each individual organization, for example, reinsurance with aggregates or limits on a multi-company basis; and
4. transfers of risks from each organization to the group and the degree to which the group manages capital adequacy for each individual organization or primarily at the group level; and
f. management actions in response to adverse capital events (see section 3.7).
If the actuary finds any of the above items to be material and relevant to the capital adequacy assessment, the actuary should document and disclose them.
3.3 Valuation Bases Underlying a Capital Adequacy Assessment
When designing or reviewing a capital adequacy assessment, the actuary should review the selected valuation bases for assets and liabilities to determine whether they are consistent with and appropriate for the intended use of the capital adequacy assessment. When doing so, the actuary should consider the following:
a. criteria used by management for making risk and other financial decisions;
b. any differences between the selected valuation bases and any mandated valuation bases;
c. the time horizon(s) considered by management in decision-making;
d. the characteristics and implications of the selected valuation bases; and
e. any restrictions on assets or capital that are not otherwise reflected in the valuation bases.
3.4 Risk Capital Target or Risk Capital Threshold
When the actuary assists in the design of or the review of the appropriateness or applicability of risk capital target(s) or risk capital threshold(s), the actuary should take into account the following (on a historical, current, and prospective basis, as appropriate):
a. the valuation bases;
b. the principal’s objectives for capital (such as maintaining minimum ratios of regulatory or rating agency capital, insurer stability, acquisition plans, or infrastructure investment) and reasons they could change;
c. normal and adverse environments;
d. the time horizon over which the capital is assessed;
e. the methods used to aggregate results, including diversification benefits and the uncertainty of the interdependence among the risks; and
f. alignment with any existing risk appetite and risk tolerance.
3.5 Additional Considerations Regarding Risk Capital Target or Risk Capital Threshold
When the actuary assists in the design of or the review of the appropriateness or applicability of risk capital target(s) or risk capital threshold(s), the actuary should consider the following:
a. the approach used to determine the “sufficient” level of capital (such as models based on factors, historical averages, and economic capital), as well as the uncertainty inherent in the approach;
b. the relative merits of using a range for the risk capital target versus a single number;
c. whether the insurer will be able to access additional capital if and when needed, including the availability and sources of capital among affiliates;
d. the risk capital targets and risk capital thresholds that are in use by affiliates; and
e. the relationship of risk capital targets and risk capital thresholds established by management and external stakeholders (such as rating agencies and regulators), as well as regulatory capital requirements, to the current capital and risks of the insurer.
3.6 Selecting Scenario Tests and Stress Tests
When an actuary includes scenario tests and stress tests in a capital adequacy assessment, the actuary should follow applicable guidance for scenario testing and stress testing in ASOP No. 46 and ASOP No. 47, Risk Treatment in Enterprise Risk Management. In addition, the actuary should consider the following:
3.6.1 Types of Tests
One or more forms of scenario tests or stress tests such as the following:
a. Deterministic—Tests to challenge the insurer in specific ways based on its unique exposures. For example, emerging risks may be considered using deterministic stress tests;
b. Stochastic—Tests chosen from one or more sets of stochastically generated scenarios;
c. Combination—Tests where multiple events happen simultaneously or sequentially; and
d. Reverse—Reverse-engineered tests that create an adverse capital event.
3.6.2 Level of Adversity
Different levels of adversity such as the following:
a. periods of normal volatility;
b. plausible adverse conditions; and
c. extremely unlikely catastrophic events.
3.6.3 Sensitivity Testing
The actuary may use sensitivity testing as part of a capital adequacy assessment. For example, sensitivity testing can be used to determine the applicability of the results of the scenario tests and stress tests under changing conditions, including the passage of time, as well as testing the materiality or impact of different assumptions.
3.7 Incorporating Management Actions
When management actions are incorporated into a capital adequacy assessment, the actuary should consider the following:
a. effectiveness and applicability of prior management actions, given changes between when such actions were taken and the projection period, for example:
1. the magnitude of the impact of the prior action compared with the impact needed in the projection;
2. the differences in risk environment, including differences in the insurer’s business and operations, and the legal and regulatory environment;
3. differences in the insurer’s enterprise risk management program and risk profile; and
4. differences in the insurer’s financial strength;
b. feedback from board members or management;
c. legal, regulatory, and execution timing requirements;
d. experience of other insurers and non-insurance firms who took similar actions, if available; and
e. expected reactions of regulators and other stakeholders.
3.8 Insurers that Operate in Multiple Jurisdictions
When the actuary is designing, performing, or reviewing a capital adequacy assessment of an insurer that individually or as part of a group operates in more than one jurisdiction, the actuary should reflect the impact of the following factors:
a. different regulatory regimes that might apply to different parts of the insurer or different entities (including non-insurance organizations) of the group, including:
1. cooperation and existence or non-existence of memorandums of understanding between regulators;
2. differing requirements for capital, scenario and stress tests, and financial reporting structures;
3. expected regulatory changes in some jurisdictions;
4. differing amounts of regulatory oversight;
5. impact of rules, restrictions, and time-lags on capital availability;
6. differing definitions of “insurance company” and “regulated entity”;
7. differing valuation bases; and
b. political risk, variations in taxation, and variations in approach to litigation in various regulatory regimes.
3.9 Additional Considerations Regarding Insurers that are Part of a Group
When the actuary is designing, performing, or reviewing a capital adequacy assessment of an insurer that is part of a group, the actuary should consider the following, if applicable:
a. level of complexity and extent of information available across all entities in the group;
b. levels of autonomy in selecting capital strategies for individual organizations within the group; and
c. the impact of varying ownership interests, including the following:
1. ownership splits, particularly between customers and shareholders;
2. shares listed on multiple stock exchanges; and
3. ownership concentrations.
3.10 Reliance on Data or Other Information Supplied by Others
When relying on data or other information supplied by others, the actuary should refer to the following ASOPs for guidance: ASOP No. 23, Data Quality; ASOP No. 41, Actuarial Communications; and, if applicable, ASOP No. 38, Using Models Outside the Actuary’s Area of Expertise (Property and Casualty). When relying on projections or supporting analysis supplied by others, the actuary should disclose both the fact and the extent of such reliance. In addition, the actuary should refer to ASOP No. 23, deeming such projections or supporting analysis as data covered by ASOP No. 23.
Section 4. Communications and Disclosures
4.1 Actuarial Communication
When issuing an actuarial communication subject to this standard, the actuary should consider the intended purpose of the capital adequacy assessment and refer to ASOP Nos. 23, 41, 46, 47, and, if applicable, 38. In addition, consistent with the intended purpose or use, the actuary should disclose the following in an appropriate actuarial communication:
a. the businesses (insurance or non-insurance) that are included or excluded (and reasons for exclusion) in the assessment;
b. material changes in the considerations listed in section 3.1 from a prior report, if any;
c. the key current and future business and risk drivers, including the legal, regulatory, and economic environments in which the insurer operates (see section 3.1[b]);
d. the key elements of business and risk management strategies included in the capital adequacy assessment (see section 3.1[c]);
e. a discussion of the timing and variability of projected liability-related and asset-related cash flows, including the marketability and availability of assets and other financial resources (see section 3.1[d]);
f. a discussion of future calls on capital, and the insurer’s means and ability to replenish it (see section 3.1[e]);
g. the treatment of interdependence and diversification (see section 3.1[h]);
h. the basis for projections of future conditions (see section 3.1[i]);
i. a discussion of the sensitivity of any assumption used to gauge the materiality of alternative assumptions, including any sensitivity tests of the parameters used in stochastic models (see section 3.1[j]);
j. the selected valuation bases for assets and liabilities, and why they are appropriate (see section 3.3); and
k. any limitations of the analysis.
4.2 Additional Actuarial Communication
Consistent with the intended purpose or use, the actuary should make the following disclosures in addition to those in section 4.1:
a. if information regarding prior sources and uses of capital was available, the actuary should disclose the extent to which such information was reflected in the capital adequacy assessment, including any reasons for deviations from past trends in such sources and uses;
b. if the actuary had access to publicly available or internal reports and analyses, the actuary should disclose any material differences between such reports and analyses and the assumptions underlying the capital adequacy assessment (see section 3.2[c]);
c. if the insurer is a part of a group, the actuary should describe how being part of the group is reflected in the capital adequacy assessment (see sections 3.2[e] and 3.9);
d. if the actuary had a role in the design of or reviewed the risk capital targets or risk capital thresholds, the actuary should disclose his or her role and the rationale underlying the design or the results of his or her review (see sections 3.4 and 3.5);
e. if the actuary performed scenario or stress tests as part of the capital adequacy assessment, the actuary should summarize the tests, including the type and levels of adversity, and the results of the tests (see section 3.6);
f. if the capital adequacy assessment reflects specific management actions, the actuary should describe the actions, their impact on the capital adequacy assessment, and whether the actions could be effectively implemented in a timely manner (see section 3.7); and
g. if the insurer operates, either individually or as part of a group, in multiple jurisdictions, the actuary should describe how operating in the various jurisdictions is reflected in the capital adequacy assessment (see section 3.8).
4.3 Additional Disclosures
The actuary should also include the following, as applicable, in an actuarial communication:
a. the disclosure in ASOP No. 41, section 4.2, if any material assumption or method was prescribed
b. the disclosure in ASOP No. 41, section 4.3, if the actuary states reliance on other sources and thereby disclaims responsibility for any material assumption or method selected by a party other than the actuary; and
c. the disclosure in ASOP No. 41, section 4.4, if, in the actuary’s professional judgment, the actuary has otherwise deviated materially from the guidance of this ASOP.
Note: This appendix is provided for informational purposes but is not part of the standard of practice.
Enterprise risk management (ERM) has been the focus of the insurance industry, including insurers, regulators, and rating agencies, for some time. In response to this increased attention to ERM, the Actuarial Standards Board (ASB) created the ERM Task Force (now Committee), which developed ASOP No. 46, Risk Evaluation in Enterprise Risk Management, and ASOP No. 47, Risk Treatment in Enterprise Risk Management. These two ASOPs provide guidance to the actuary for overall ERM work.
Historically, most insurers did not undertake formal assessments of capital adequacy. Instead, they tended to use rules of thumb (for example, premium to surplus ratios) or relied on regulatory rules (for example, risk-based capital ratios) or rating agencies (for example, A. M. Best’s Capital Adequacy Ratio). Many companies also relied on stress tests or what-if analyses to assess capital levels. Insurance regulators designed deterministic stress tests that reflected potential experience beyond the range of an insurer’s normal operations. Over time, deterministic stress tests were developed for a wide variety of assumptions.
Starting in 2012, insurance regulators began implementing the own risk and solvency assessment (ORSA) process throughout the world. Specifically, the ORSA process is a part of the Insurance Core Principles (ICP 16) set out by the International Association of Insurance Supervisors (IAIS) and required by most U.S. states. A key feature of ORSA is that it requires a formal assessment of capital adequacy be a part of an insurer’s ERM program.
Given the new ORSA requirements and the increasing demands from regulators, rating agencies, and other external stakeholders, insurers are under pressure to perform formal, more sophisticated capital adequacy assessments. These formal capital adequacy assessments typically involve considerations of complex contingencies in determining the impact of adverse experience on the insurer and its capital adequacy, making this a process that will usually involve actuaries in some or all of the assessment process.
Company practice in making these assessments varies significantly. Some companies have created their own stochastic models (or use commercially available software) that simulate underwriting results across all lines of business and geographies, as well as economic conditions and investment results. These models typically incorporate the insurer’s strategic plan and may include complicated feedback loops that reflect management’s responses, if any, to specific situations (for example, underwriting results, a recession, multiple catastrophic events, a pandemic). They may also include predictions of how regulators and rating agencies may react to changes in the financial condition of the insurer. Other models may analyze capital adequacy at very high levels of aggregation and have limited or no feedback loops (i.e., they analyze specific management actions one at a time).
Larger insurers may have whole departments focused on analyzing the global economy. For smaller insurers, this work may be tasked to a specific individual or may be outsourced to consultants. In many of these insurers, actuaries and non-actuaries are involved in these analyses and the building of the models.
Rating agencies and regulators are concerned with individual company and group-wide capital adequacy. Many insurers are part of complex, multi-national organizations (including insurers and non-insurers) that span many different accounting, financial, and regulatory regimes. The relationships among the members of a group and the differences among these regimes can have a significant impact on capital adequacy and the group’s ability to fulfill its promises to its customers. In most countries, ORSA requires groups operating in multiple countries to perform a group-wide assessment of their capital adequacy across all jurisdictions.
Comments on the First Exposure Draft and Responses
The first exposure draft of this proposed ASOP, Capital Adequacy Assessment for Insurers, was issued in September 2016 with a comment deadline of January 31, 2017. Nine comment letters were received, some of which were submitted on behalf of multiple commentators, such as by firms or committees. For purposes of this appendix, the term “commentator” may refer to more than one person associated with a particular comment letter. The Enterprise Risk Management Committee carefully considered all comments received, reviewed the first exposure draft, and proposed changes. The ASB reviewed the proposed changes and made modifications where appropriate.
Summarized below are the significant issues and questions contained in the comment letters and responses.
The term “reviewers” in appendix 2 includes the Enterprise Risk Management Committee and the ASB. Also, unless otherwise noted, the section numbers and titles used in appendix 2 refer to those in the second exposure draft.
Click here to view comments on the first exposure draft.
Click here to view comments on this second exposure draft.