IRDA - Economic Capital

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Dr. R.KannanMember (Actuary)^tt7

A-01. ur fafch A SITfrIN S U R A N C E R E G U L A T O R Y A N D

Si DEVELOPMENT AUTHOR I TY

Cir No: IRDA/ACT/CIR/LIF/049/3/2010

ToAll CEOs of Life Insurance Companies

Economic Capital

11th March, 2010

In the last two / three meetings with the Appointed Actuaries of lifeinsurance companies, it has been clearly told that they have to initiate theprocess of calculation of economic capital and submit the same along with theAppointed Actuaries' Annual Report beginning the actuarial valuation for theyear ending March 2010.

In this context the basic reference material is the "Report of theCommittee to draw the road map for moving towards Economic Capital andmarket consistent embedded value for life insurance industry in India ( June 8,2009)" constituted by the Institute of Actuaries of India for this purpose.

While annexure -1 of this circular gives the background of theEconomic capital in a brief summary form, annexure -2 gives the related tableand other details required in this context.

Whenever the appointed actuaries deviate from the suggested practicethey have to explain the rationale of the same and give further details.

This circular comes into effect for the actuarial valuation of theliabilities for the life insurers since March end 2010. Please note that at this

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stage it is envisaged that this exercise will be done on an annual basis,coinciding with the actuarial valuation for the March end position.

On the basis of experience the contents of the circular would bereviewed on or before October 30, 2010.

R . K a n n anMember (Actuary)

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Annexure-1 : i Background information on Economic capital "Typically, Economic Capital is calculated by determining the amount of capital that

the insurer nerds to ensure that its realistic balance sheet stays solvent over a certaintime period with a pre - specified probability. E.g. the Economic Capital may bedetermined asthe minimum amount of capital required to make 99 . 5% certain that theinsurer remains solvent over the next twelve months."

"The word economic' indicates the fact that it measures risk in terms of economicrealities rather than Regulatory or accounting rules which may have been designed tosupport non economic principles. This word also indicates that part of themeasurement process involves converting a risk distribution into the amount of capitalthat is required to support the risk, in line with the insurer's target financial strength(e.g. credit rajing)"

"Regulatory Capital on the other hand is the amount of capital a regulator hasdetermined an insurer needs to hold, but is generally not as specific to the insurer asEconomic Capital would be. The Regulatory capital for particular risks would becalculated mo}e broadly and the definition of risk would be a systemic one, rather thanan insurer specific one"

"At its most basic level, Economic Capital can be defined as sufficient surplus to coverpotential losses, at a given risk tolerance level, over a specified time horizon"

[}etermining Economic Capital

$m

0

Ranked dist r ibut ion of present values o f future prof its f rom each simulat ion

...., . rnausllllllllli1dfflI lIUIU1IEconomic Capital: At the enterprise level, EC is typicallydef ined as " Sufficient surplus capital tocover potent ial losses at a g iven r isk

tolerance level, over a speci f ied t imehorizon"

Selected r isktoleranceSource: Til l inghast

Cumulative probability

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"There are other definitions of EC: Sufficient surplus to meet potential negative cash flows and reductions in

value of assets or increase in value of liabilities at a given level of risktolerance , over a specified time horizon.

Excess of the market value of the assets over the fair value of liabilitiessquired to ensure that obligations can be satisfied at a given level of risktolerance , over a specified time horizon.

S u f f i c i e n t s u r p l u s t o m a i n t a i n s o l v e n c y a t a g i v e n l e v e l o f r i s k t o l e r a n c e ,o v e r a s p e c i f i e d t i m e h o r i z o n "

"While Definitions 1 and 3 refer to sufficient surplus, Definition 2 focuses on thecharacteristics) of market value of assets and fair value of liabilities that define thissurplus. All ^,hese broad definitions imply that all risks are to be taken into account.Although the definitions vary slightly, some common themes that tie them together are:

Sufficient surplus to cover adverse outcomes; A given level of risk tolerance and risks covered; A specified time horizon"

"In calculating EC there are some key decisions to be made and the approach takenshould reflect the nature of the company's risks as well as management's risk toleranceand objectives;. The following are suggested at this stage:

Decision 1

Decision 2Decision 3

Time Horizon:

Measure of Risk:Type of risks to beconsidered:

One Year

Value at Risk Insurance Operational Market Credit Liquidity

Decision 4 Quantification Stochastic simulation / Stress TestingMethodology /Approaches toimplementation:

Decision 5 Statistical Correlation: Aggregation/Diversification

Decision 6 Target level of security: Eg 99.5% or 99.9%

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Annexure-2 Dletails of the calculations including guidance pointsThis section provides a brief explanation of the section requirements of the

template. The statutory solvency balance sheet items are self explanatory and in totalshould be same as reported as part of filing annual return submissions to the authority. Allamounts to be filled in INR 000s

Insurers should mention the quantification method e.g. stress testing/Stochasticsimulation/Factorlbased method used to quantify individual components. Insurers shouldparameterize and quantify individual risk based on their own assessments and views aboutparticular risks. Participants are also encouraged to add additional rows to the table toincorporate furthe4 details

1. Liabilities

1.1. Policyholder liabilities . Policyholder liabilities should reflect marketconsistent values on a realistic basis. .1.2. Anyther liabilities (if any ) not classified in 1.11.3. Other economic adjustments depend upon the methodology adopted and

maw include among other items such as cost of options and guarantees1.4. Fot statutory valuation, while valuing the liabilities the technical rate is

taken as the sum of risk free rate and a risk margin . This risk margin variesfrojn insurer to insurer based on their own experience viz., portfolioperformance, variability in the yield , claims experience, surrender, lapsesetc; But, for economic capital calculation, keeping in line with internationalpractice, the valuation of liabilities should be done at risk free interest ratewhich could be the yield on 10 year Government of India security.

2. Capital requirements

The relevant sections contain example parameters and example quantificationmethodologies for illustrative purposes only. Participants should parameterize andquantify risks based on their own risk assessments2.1. Insurance risk. Insurance risk includes components like mortality,

morbidity, longevity, persistency, catastrophe, expenses, inflation etc.2.1.1. Mortality/Morbidity risk: The total economic required capital (ERC) for

Mgrtality/Morbidity should be input in the economic capital column. Thistotal amount should be further detailed in the following table. The format isprovided here as an example. For example, the quantification method(Decision 4) for individual risks should be clearly mentioned and therelevant parameters stated.

Table 2.1 . 1 R isk Risk ca pita l Quant if icat ion Quant if icat ioncom onents method ecision4 ParametersMortality Refer Appendix of Refer Appendix of econom ic capital andeconomic capital and MCEV re ort 6 IOAI

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MCEV report byIOAI

Longevity e. g. +10% improvement in mortality rates forannul businessMorbid i ty e.g. Stress testin g e . g . +10% increase in m orbid i tyCatastrophe e.g. factor based e . g. 1.5 per thousand applied on death sum at

r iskTotal Same as 2. 1 .1

f rom the maint a b l e

2.1.2. Lapse/Surrender etc risk: The Lapse/Surrender/Withdrawals/Top-ups ECRshould be input in the economic capital column. This total amount shouldbe further detailed in the following table. The format is provided here as anexample.

Table 2. 1 .2 R is k R is k capital Q u an tif ication m ethod Quatttiticationc o m o ne nts ( ecision 4 arametersLapse t rend e .g . St ress testing e . g . + 2 0 % i n c r e as e or -20% decrease in lapse rates

whichever is onerousSurrender shock e.g. Factor Ba sed e .g . +50% of sur render s train ( Surrender Value in

force l ess economic provisionsithdrawal, To u

Total Same as 2 .1 . 2from them ain t able

2.1.3. Expense/Inflation risk: The total Expense/Inflation ECR should be input inthee economic capital column. This total amount should be further detailedin the following table The format is provided here as an example.

Table 2 . 13 Riskcomponents

Risk capital Quantification method(Decision 4) Quantificationparameters

Expense and e.g. Suess testing e . g . +10% increase in expenses and 1% increase ininflation or inflation rateo r

e. g . Factor based e...75%of l iabil i t iesSame as 2 .1 . 3

Expense/Inflation from theECR m ain t able

2.1.4. Insurance other risk components: The insurance other risk ECR should beinput in the risk based capital column. This total amount should be furtherdetailed in the following table. The format is provided here as an example.

Table 2 .1.4 Riskcomponents R is k ca pita l Q ua ntific atio n m eth od(Decision 4) Quant if icat ionparametersXXxX

Same as 2 .1 . 5Insurance other risk from theECR main table

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2.1.5. A Simple arithmetic aggregation of all insurance risk components withoutaccounting for diversification.

2.2. Market risk. Market risk includes components like interest rates, equity returnsetc.

2.2.1. Interest rate risk: The Interest ECR should be input in the economic capitalcolumn. This total amount should be further detailed in the following table.The format is provided here as an example. For example, the quantificationmethod (Decision 4) for individual risks should be clearly mentioned andthe relevant parameters stated.

Table 2.1.1 Riskco m p onents Risk Capital Quant if icat ionmethod (Decisio Quant if icat ionparametersInterest rate risk e.g. Stochastic e.g. 1000 simulations using short rate mean

simulations reverting interest model with a mean reversionlevel of 7% and a volatility of 15 %

Interest ECR Sam e as 2 . 2 .1from the main

t a b l e

2.2.2. Equity risk: The Equity ECR should be input in the economic capitalcolumn. This total amount should be further detailed in the following table.The format is provided here as an example. For example, the quantificationmethod (Decision 4) for individual risks should be clearly mentioned andthe relevant parameters stated.

Table 2 . 1.1 R isk Risk ca pita l Quanti f icat ion Quant if icat ionco m po nents method (D ecision 4 ParametersEquity risk e. . Stress testing e. . 60% fall in e quitiesEquity ECR Same as 2.12

from the maint a b l e

2.2.3. Foreign Currency Exchange risk: The Forex ECR should be input in the riskbased capital column. This total amount should be further detailed in thefollowing table. The format is provided here as an example. For example,the quantification method (Decision 4) for individual risks should be clearlymentioned and the relevant parameters stated. It is recognized that,presently, this item may not be relevant or may be immaterial for most ofthe, insurance companies in India.

Table 2.1,1 Risk R is k c a pita l Quantification Quantificationco m p onents method (D ecision 4) ParametersForex risk e. g. Stress test ing e. . 10% fluctuation in domestic currencyForex ECR Sam e as 2 2 3

from the maintable

2.2.4. Property risk : The Property ( i.e. real estate) ECR should be input in theeconomic capital column . This total amount should be further detailed inthe' following table . The format is provided here as an example. For

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example, the quantification method (Decision 4) for individual risks shouldbe clearly mentioned and the relevant parameters stated.

Table 2.1.1 R i s kco m ponents Risk capita l Quant if icat ionmethod ecision 4) Quant if icat ionParametersProperty risk e.g. Stress testing e.g. change in rental yields; e.g. change inmarket valuesProperty ECR Same as 2 .2.4

from the maintable

2.2.5. Other Market risk components: The Other Market risk ECR should be inputin ',the economic capital column. This total amount should be furtherdetailed in the following table. The format is provided here as an example.

T able 2 .IA Riskcomponents

Risk capital Quantification method(Decision 4) Quantificationparameters

xxxx

Sam e as 2 . 2 . 6Market other risk from theEC R main table

2.2.6. A simple arithmetic aggregation of all insurance risk components withoutaccounting for diversification.

2.3. Operational risk . Operational Risk is the risk of loss resulting from inadequate orfailed internal process, controls, controls, people, and systems or from externalevents

The Operational ECR should be input in the economic capital column. This totalamount should be further detailed in the following table. The format is providedhere as an example. For example, the quantification method (Decision 4) forindividuat risks should be clearly mentioned and the relevant parameters stated.

I ' . T ab le .1 . 1 Risk Risk capital Quantification Quantificationum oaents method (Decision parameters4)Operational risk e.g. factor based e.g factor applied on head count or expenses oreconomiccapital

Operation ECR Same as 2.3 fromthe main table

2.4. Credit risk. Risk of default and change in the credit quality of issuers ofsecurities, risk of counterparty defaultThe credit risk ECR should be input in the risk based capital column. This totalamount should be further detailed in the following table. The format is providedhere as an example. For example, the quantification method (Decision 4) forindividualrisks should be clearly mentioned and the relevant parameters stated.

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Section D e s c r ipt ionStatutory

solvency 31"March 2010

E c o no m iccapital 31 "March 2010 (to be filledB riefin by the in s urershe insuresurers as per ECR providd)

Total =Row(1 . 1)+ =Row(1.1)+1 Liabilities Row(1.2)+ Row(1.2)+

Row 1 .3 Row 1.3co ponennSpread riskDefault risk

C red i t risk ECR Same as 2.4 fromthe main table

method (Decision I)e . g . stress testinge.g. factor based

parameterse .g . 2% widening o f bond spreads

e.g. probability of default applied oncounterparties

2.5. simple arithmetic aggregation of all risk components viz. insurance, market,operational and credit risk ECR without accounting for diversification.

2.6. Impact of Aggregation/Diversification of above risks: Anaggregation/diversification of all risk components has to be quantified. Thestatistical) correlation methodology (Decision 5) along with the relevant parametersand matrices should be mentioned here.

Please see the liable below and this will give a form at for final presentation ofeconomic capita figures, for each of the item explained above:

Insurers required to mention main principles to arrive at thePolicyholder value of economic liabilities like the valuation method, target

1 . 1 liabilities percentiles, my margins etc.Insurers required to list components of any other liabilities (if1. 2 Other liabilities any) not already included above

Insurers required to list components of other economicadjustments ( i f any)Separately, insurers are required to mention whether implicitand explicit guarantees are accounted for and their method of

Other economic estimation e.g. stochastic, scenario based, closed form solution1.3 ad jus tments or an other appropriate methodCapital Insurers required to mention target level of security, time-

req ui remen ts horizon and the measure of risk while quantifying their2 =Row (2. 6 ) =Row ( 2 .6) economic capital (Decisions 1, 2 and 6 )2.1 Insurance risk =Row 2.1 . 7 =Row 2.1.7

InputMortality/Mor

Mortality/Morbi bidity risk2.1.1 dity risk EC R Additionally, please fill in table 2.1 .1Input

Lapse/Surrender Lapse/Surren2.1.2 risk der risk ECR Additionally, Please fill in table 2.1.2Input

Expense/inflatio Expense/inflat2 . 1 . 3 n r i s k ion risk ECR A d d i t i o n a l l y , P l e a s e f i l l i n t a b l e 2 . 1 . 3Input

Lo ng ev i ty2.1.4 Longevity risk risk ECR Additionally, Please fill in table 2.1.4

InputAny other Insuranceinsurance risk Other risk

2.1.5 component ECR Additionally, Please fill in table 2.1.5 (If anArithmeticaggregation of =Sum ofinsurance risk above Rows

2.1.6 componen ts 2.1.1 to 2.1.5

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2. 2 Market risk =Row 2.2 . 7 =Row 2.2.7I n p u t I n t e r e s t

2.2.1 Interest rate risk risk ECR Additionally, Please fill in table 2.2.1Input Equity2.2.2 Equity risk risk ECR Additionally, Please fill in table 2.2.2Input Forex

2.2.3 Forex risk risk ECR Additionally, Please fill in table 2.2.3InputProperty risk2.2.4 Property risk EC R Additionally, Please fill in table 2.2.4

A ny o th er Input Ma r ketmarket risk Other risk

2.2.5 component ECR Additionally, Please fill in table 2.2.5 (If any)Arithmeticaggregation of =Sum ofmarket risk Rows 2.2.1 to

2.2 .6 componen ts 2 .2 .5

2.3 Operational Input Additionally, please fill in table 2.3risk Operational

risk ECR2.4 Credit risk Input Credit Additionally, please fill in table 2.4

risk ECR2.5 Total of all risk Row(2.1)+

categories Row(2.2)+Row(2.3)+Row 2.4

2. 6 Aggregation/Dive r s i f i c a t i o neffect of aboverisks

2.7 2.5 minus 2.6Total of all riskc a t e g o r i e s a f t e radjustment fora g g r e g a t i o n / d i versification

2.8 Tota l Assets I plus 2.7Required

2.9 To ta l AssetsAvailable on anEconomic Basis

2.10 Total ofstatutoryliabilities and150% of RSM

2.11 Tota l Assets onan IRDA Basis

Calculate A) 2,9 divided by 2.8 and also B) 2.11 divided by 2.10.

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IRDA - Economic Capital