LPS 115 Capital Adequacy: Insurance Risk Charge

This Prudential Standard sets out the method for calculating the Insurance Risk Charge.

The Insurance Risk Charge for a statutory fund provides a buffer against the risks of adverse experience or changes to best estimate assumptions with regards to:

mortality;

morbidity;

longevity;

lapses;

servicing expenses; and

other insurance risks such as option take-up rates.

The Insurance Risk Charge for a statutory fund is the reduction, if any, in the capital base that would occur if the adjusted policy liabilities were changed to an amount equal to the stressed policy liabilities determined under this Prudential Standard.

The Insurance Risk Charge for the general fund of a friendly society is the servicing expense reserve as defined in paragraphs 52 to 55.

There is no Insurance Risk Charge for the general fund of a life company other than a friendly society.

The stressed policy liabilities for non-participating benefits must be determined in the same way as the risk-free best estimate liability (RFBEL), but using ‘stressed assumptions’ instead of best estimate assumptions in respect of mortality, morbidity, longevity, lapses, servicing expenses and any other insurance risks such as take-up rates for non-financial options.

The stressed policy liabilities for participating benefits must be determined in the same way as the participating policy liability (PPL), but using stressed assumptions instead of best estimate assumptions in respect of mortality, morbidity, longevity, lapses, servicing expenses and any other insurance contingencies such as take-up rates for non-financial options.

Stressed assumptions must be used in determining the stressed policy liabilities for existing claims which have not yet been finalised, claims that have been incurred but not reported, and claims that are expected to be incurred in future.

The stressed policy liabilities must provide for adjusted policy liabilities (calculated using the stressed assumptions) to be funded 12 months from the reporting date for those policies that are projected to remain in force at that date. This test must be applied separately for the following groups:

non-participating benefits without entitlement to discretionary additions;

non-participating benefits with entitlement to discretionary additions; and

participating benefits.

The stressed policy liabilities must be determined at sub-group level if the policy benefits for a sub-group of policies are determined by reference to the performance of particular assets that the life company has allocated to the liabilities for that sub-group.

Any tax benefits that would arise as a result of increasing the policy liabilities from the adjusted policy liabilities to the stressed policy liabilities should be assumed to be realisable for the purpose of determining the Insurance Risk Charge. An adjustment must be made to the prescribed capital amount when the capital charges are aggregated, if some or all of the tax benefits cannot be offset against deferred tax liabilities.

When determining the impact of each individual stress margin, and when determining the stressed policy liabilities, a life company must make allowance for the actions that it would expect to take in response to each type of stress, subject to the restrictions described below.

These actions may include, but are not limited to:

reducing termination values;

reducing discretionary additions to benefits;

increasing premium rates;

increasing the fees deducted from policies; and

reducing the fees payable by a friendly society benefit fund to its management fund.

The allowances for management actions must be appropriate, justifiable and equitable in each of the scenarios. Any representations made in the relevant product disclosure documents must be taken into account in determining the management actions that would be applied. Management actions must satisfy policy owners’ reasonable expectations.

Termination values cannot be assumed to be reduced below minimum termination values.

Premium rate and fee increases cannot be assumed to occur within 12 months of the reporting date.[3] The 12 month period must be extended to allow for the time it would take for the life company to increase premium rates or fees in response to stresses occurring over the 12 month period. Any contractual guarantees that may restrict the timing and amount of premium rate or fee increases must be recognised.

Premium rate or fee increases cannot be assumed as a response to the random mortality stress, the random morbidity stress or the event stress.

The present value of any assumed premium or fee increases (determined using stressed assumptions) cannot exceed the increase in the present value of claims and expenses incurred after the date at which the premium or fees increases are assumed to become effective. This test must be applied to each group of policies that would be affected by the assumed premium or fee increases.

The management actions for friendly societies must be in accordance with the existing rules of the benefit fund and not the broader range of management actions that may be accessed through a process of amending those rules.

The stressed assumptions must be determined by a life company, by applying ‘stress margins’ to the best estimate assumptions. The stress margins must reflect the risk that outcomes may be worse than the best estimate assumptions.

The following stress margins are required:

mortality random stress;

morbidity random stress;

mortality future stress;

morbidity future stress;

event stress;

longevity stress;

lapse stress;

servicing expense stress; and

other insurance contingencies.

The stress margins for random, future, event and longevity risks must be adjusted to allow for diversification between these risks as described in the section starting at paragraph 40.

The mortality random and future stresses must only be applied to life policies where an increase in future mortality rates would increase net cash outflows from the life company. The longevity stress must only be applied to life policies where an increase in future mortality rates would reduce net cash outflows from the life company.

The stress margins, before the adjustment for diversification, must be determined at a 99.5 per cent probability of sufficiency over a 12 month period. This means that, in the assessment of the Appointed Actuary, there is no more than a 0.5 per cent probability that the actual cost of claims will exceed the stressed estimate.

For each type of stress, different margins may be applied to different types of policies. For example, there may be different morbidity random stresses for lump sum policies and disability income insurance policies. For disability income insurance policies, separate margins must be applied to the best estimate claim incidence and claim termination assumptions.

The ‘random stress’ margins, before the adjustment for diversification, must be determined by the Appointed Actuary, having regard to the nature of the mortality and morbidity risks to which the company is exposed. The margins for random stresses must be applied for 12 months from the reporting date. Each random stress must reflect the uncertainty arising due to adverse fluctuations in experience, but excluding the impact of single events such as pandemics, terrorist attacks and natural catastrophes that could cause large numbers of claims. The size of these margins will depend on factors such as the number of expected claims, the distribution of sums insured, and the impact of existing reinsurance arrangements.

The ‘future stress’ margins, before the adjustment for diversification, must be determined by the Appointed Actuary, having regard to the nature of the mortality and morbidity risks to which the company is exposed.

The margins for future stress must be applied from the reporting date for the remaining term of the liabilities. They must allow for the possibility that the best estimate assumptions may need to be changed in 12 months time, either because they were misestimated at the reporting date or because adverse trends have been identified during this period. The size of the margin will depend on the adequacy of the investigations used to determine the best estimate assumptions, and the range of adverse factors that could affect trends in claims experience.

The ‘event stress’ allows for the impact of single events that could commence in the 12 months following the reporting date and cause multiple claims. These events could include pandemics, terrorist attacks and natural catastrophes and may affect either or both mortality and morbidity experience. The Appointed Actuary must determine an appropriate event stress that provides a 99.5 per cent probability of sufficiency with respect to single events that could potentially commence over the following 12 months.

The event stress, before adjustment for diversification, must at a minimum include a pandemic scenario with the following impacts on mortality and morbidity claims experience:

annual mortality rates at each age increase by 0.5 per thousand for the two years following the reporting date;

an annual incidence rate of total disablement at each age, as a result of the event, of 10 per cent of lives insured for the two years following the reporting date;

of those lives becoming disabled as a result of the event, half remain disabled after 14 days, one quarter remain disabled after 30 days and none remain disabled after 60 days; and

if disability continues to the end of the policy waiting period, one month’s benefit will be paid. For waiting periods other than zero, 14, 30 or 60 days, interpolation must be used to find the proportion of policies for which a benefit will be paid.

The pandemic scenario may be assumed to reduce the stressed policy liabilities for policies subject to longevity risk. However the outcome of applying the pandemic scenario must not result in stressed policy liabilities being less than adjusted policy liabilities for any of the product groups defined in paragraph 16.

The ‘longevity stress’, before adjustment for diversification, is a 20 per cent decrease in the best estimate mortality rate for each age from the reporting date for the remaining term of the liabilities.

The impact of applying each of the random, future, event and longevity stresses must be determined in isolation as the increase to:

the RFBEL for non-participating benefits; and

the PPL for participating benefits.

The stressed policy liabilities must be determined using ‘adjusted stress margins’ and management actions for the random, future, event and longevity risks. The adjustments are to allow for diversification between risks. The method for determining the adjusted stress margins and management actions is described in the following paragraphs.

The combined impact of the random, future, event and longevity stresses, after allowing for correlations between these stresses must be determined using the formula:

where:

Ax is the capital charge for insurance stress x, summed over all policies in the statutory fund;

Σx,y is the sum over all combinations of stresses; and

Corrx,y is the correlation between stresses x and y

The specified correlation matrix is:

The adjusted stress margins must be determined so that when the adjusted stress margins and management actions for the random, future, event and longevity stresses are applied simultaneously, the increase in RFBEL and PPL equals the combined impact of the individual stresses, as determined using the formula in paragraph 41.

If the stressed RFBEL or stressed PPL changes in a linear relationship with changes in the stressed margin, the adjusted stress margin can be determined by multiplying the unadjusted stress margins by a diversification factor. The diversification factor is determined by taking the combined impact of the individual stresses, as determined using the formula in paragraph 41, and dividing this amount by the sum of the individual stress impacts.

If the relationship between stressed RFBEL or stressed PPL, and stressed margin is not linear, an alternative method of determining the adjusted stress margin must be used that satisfies the requirements of paragraph 43. An alternative method must always be used for determining the adjusted stress margin for Disability Income Insurance claim termination rates.

The stress margin for lapses[4] must be determined by the Appointed Actuary, having regard to the nature of the company’s lapse risks. The stress must be determined so that the Insurance Risk Charge for the statutory fund has a 99.5 per cent probability of sufficiency over a 12 month period. The lapse stress may allow for correlations with other insurance stresses, with the exception of servicing expenses. The lapse stress may vary for different types of policy. A decision as to whether to increase or reduce lapse rates must be made for each type of policy depending on whether an increase or reduction would increase the stressed policy liabilities.

The stress margin for servicing expenses is a 10 per cent increase to the best estimate of future unit costs for servicing expenses.

The stress need not be applied to any component of the statutory fund expenses which is contractually agreed for the life of the policy, for example, renewal commission. The stress need not be applied to the fees payable by a friendly society benefit fund to its management fund.

Unit costs must cover the expected maintenance cost of servicing each policy in the twelve months following the reporting date.

If the Best Estimate Assumption depends on a service agreement or other contractual arrangement which does not adequately reflect the long term, sustainable costs of operating the business, the stress of 10 per cent must be increased to make up for the shortfall between actual and long term, sustainable costs.

The Appointed Actuary must determine an appropriate stress margin for risks arising from any other contingencies not specifically mentioned above. These risks may include, but are not limited to, changes to take-up rates on insurance options and premium dormancy rates. The stress must be determined so that the insurance risk charge for the statutory fund has a 99.5 per cent probability of sufficiency over a 12 month period. The stress may include allowance for correlations with other insurance stresses, with the exception of servicing expenses.

The Insurance Risk Charge for the general (management) fund of a friendly society is the servicing expense reserve. The servicing expense reserve must be determined as:

three times the deficiency (if any) expected to arise over the 12 months subsequent to the reporting date, between expected management fees in that period and expected servicing expenses relating to its life insurance activities; plus

any additional deficiency that would arise if expected servicing expenses were increased by 10 per cent.

Where an allocation of the expenses of the management fund relating to life insurance activities into expense categories is not undertaken by a friendly society, servicing expenses are to be taken as 50 per cent of the total expenses related to the life insurance business.

If the management actions assumed in response to the asset risk or insurance risk stresses include a reduction in management fees paid by a benefit fund to the management fund, the reduced management fees must be used when determining the servicing expense reserve.

Any tax benefits that would arise as a result of including the servicing expense reserve in the liabilities of the friendly society for tax purposes should be assumed to be realisable for the purpose of determining the Insurance Risk Charge. An adjustment must be made to the prescribed capital amount when the capital charges are aggregated, if some or all of the tax benefits cannot be offset against deferred tax liabilities.

APRA may, by notice in writing to a life company, adjust or exclude a specific requirement in this Prudential Standard in relation to that life company.

On application by a life company, APRA may grant transitional relief from the obligation for the life company to comply with any requirement in this Prudential Standard. Any relief granted by APRA under this paragraph will have effect until no later than 31 December 2014.