Liability Valuation for General Insurers

Objective and Key Requirements of this Standard

This Prudential Standard establishes a set of principles for the consistent measurement and reporting of the insurance liabilities of all general insurers.

The appropriate valuation of insurance liabilities is one of the most important issues facing an insurer and its Board. It is important for the financial soundness of the insurer, and ultimately for the protection of policyholders, that insurance liabilities are valued in a realistic and consistent manner. It is ultimately the responsibility of the insurer’s Board and senior management to place an appropriate valuation on the insurer’s liabilities, after considering actuarial and other advice.

In developing this Standard, regard has been had to the requirements of AASB 1023 and to the merits, to both the preparer and user of the accounts, of establishing an integrated financial reporting framework for the insurance industry, ie a reporting framework that responds to the objectives of the statutory and general purpose reporting regimes and avoids, to the extent possible, dual reporting by the industry. At this stage, it is possible that for some insurers, there will be some inconsistency between this Prudential Standard and AASB 1023. From APRA’s perspective, we believe this to be unavoidable if our prudential objectives are to be met.

The key requirements of this Prudential Standard are:

The Board of an insurer that is required to have an Approved Actuary must obtain written advice from the Approved Actuary on the valuation of its insurance liabilities. This requirement is designed to aid Boards to perform their duties by ensuring they are adequately informed. It does not preclude a Board from obtaining advice from other sources (eg senior management, auditors and consultants).
Insurance liabilities include both the insurer’s Outstanding Claims Liabilities, and its Premiums Liabilities. Outstanding Claims Liabilities relate to all claims incurred prior to the calculation date, whether or not they have been reported to the insurer. Premiums Liabilities are future claim payments arising from future events insured under existing policies, assessed on a prospective basis.
The Approved Actuary must provide advice on the valuation of insurance liabilities at a given level of sufficiency – that level is 75% (or, in some circumstances, the central estimate plus one half of the coefficient of variation). In other words, the valuation of insurance liabilities provided by the Approved Actuary must include a risk margin over and above the central estimate.
Insurance liabilities are to be valued on a discounted basis. The rate to be used in discounting is the risk-free rate; ie the gross redemption yield of a portfolio of sovereign risk securities with a similar expected payment profile to the insurance liabilities for a given class (eg the yield on Commonwealth Government securities should be used for Australian dollar liabilities).
It is ultimately for the Board of the insurer to determine the appropriate valuation of insurance liabilities. However, in circumstances where the Board decides not to accept the Approved Actuary’s advice, or to otherwise adopt a valuation of insurance liabilities (higher or lower) that is not in accordance with the principles of this Standard, this must be disclosed to APRA. Details should also be included in the insurer’s published annual financial accounts.

Details on these requirements are contained below. Additional requirements relating to Approved Actuaries and Approved Auditors, including eligibility criteria and reporting requirements, are set out in GPS 220 Risk Management.

Prudential Standard

This Prudential Standard, made under section 32 of the Insurance Act 1973 (the Act), applies to all general insurers authorised under the Act.
In determining the value of insurance liabilities, not all insurers will be required to have an Approved Actuary.[28] However, irrespective of whether actuarial advice is sought or required, an insurer’s liabilities must be valued in accordance with the principles of this Standard.

The Role of the Approved Actuary in Valuing Insurance Liabilities

Subject to certain exceptions set out in Guidance Note GGN 220.1 Governance, an insurer must appoint an actuary (Approved Actuary) in accordance with the Act, and have this appointment approved by APRA. As well as any other responsibilities that may be assigned by APRA, the Approved Actuary must provide written advice to the Board of the insurer on the value of insurance liabilities in accordance with this Standard. Unless APRA provides written approval for less frequent advice, this must at a minimum occur on an annual basis to coincide with the preparation of the insurer’s yearly statutory accounts. The Board of an insurer is free to seek more frequent advice if it believes this is to be appropriate.

Valuation of Insurance Liabilities

Where an insurer includes in its accounts a value for insurance liabilities which is inconsistent with the advice received from the Approved Actuary, or is not determined in a manner consistent with the principles of this Standard, the insurer must notify APRA in writing, and should include within its published annual financial accounts:

(a) the reasons for not accepting the Approved Actuary’s advice, or for not determining the insurance liabilities in a manner consistent with this Standard; and

(b) details of the alternative assumptions and methodologies used for determining the value of the insurance liabilities.

In determining the value of its insurance liabilities, an insurer (after taking advice from its Approved Actuary, where necessary) must determine a value for both its Outstanding Claims Liabilities and its Premiums Liabilities for each class of business.[29]
The Outstanding Claims Liabilities relate to all claims incurred prior to the calculation date, whether or not they have been reported to the insurer. The most significant component of the insurance liabilities for long tail business is the Outstanding Claims Liabilities. The value of the Outstanding Claims Liabilities must include an amount in respect of the internal expenses that the insurer expects to incur in settling these claims. The Outstanding Claims Liabilities are to be determined both net and gross of expected reinsurance recoveries.
The Premiums Liabilities relate to future claim payments arising from future events insured under existing policies. For short tail business, the Premiums Liabilities are of greater relative significance. The value of the Premiums Liabilities must include an amount in respect of the internal expenses that the insurer expects to incur in administering the policies and settling the relevant claims. The Premiums Liabilities are to be determined on a fully prospective basis; both net and gross of expected reinsurance recoveries (as a result, there is no need to separately report a deferred acquisition cost asset).
Subject to the requirements of this Standard, the valuations of an insurer’s Outstanding Claims Liabilities and its Premiums Liabilities must be realistic estimates, determined having regard to considerations of consistency with the basis for valuing assets, and the requirements of relevant Australian Accounting Standards.
The valuation of insurance liabilities for each class of business must comprise:

(a) a central estimate value of the Outstanding Claims Liabilities;

(b) a central estimate value of the Premiums Liabilities; and

The value of the insurance liabilities (for both Outstanding Claims Liabilities and Premiums Liabilities) is the sum of the central estimate and the risk margin.

The valuation of insurance liabilities should reflect the individual circumstances of each insurer. Notwithstanding this, to ensure that valuation processes are consistent and sufficiently rigorous across the industry, the risk margin should be established on a basis that is intended to secure the insurance liabilities of the insurer at a given level of sufficiency – that level is 75 per cent.
Due to the highly skewed nature of some insurance distributions, the level of sufficiency established in paragraph 10 may result in a value regarded as insufficient for prudent purposes. Therefore, the risk margin should not be less than one half of the coefficient of variation for the insurance liabilities of the insurer.

Determination by Class of Business

The principles for determining the central estimate values of the Outstanding Claims Liabilities and the Premiums Liabilities are, subject to considerations of materiality and the professional judgement of the Approved Actuary, to be applied to each class of business of the insurer.
For the purpose of disclosing the values of the insurance liabilities in the accounts, risk margins should be shown separately in relation to the Outstanding Claims Liabilities and the Premiums Liabilities. Risk margins should also be shown separately for each class of business.
Where the Approved Actuary thinks it appropriate, allowance for diversification and/or reinsurance should be made in determining the risk margin. The justification for and method of determining such diversification allowance and reinsurance recoveries should be clearly documented and reported by the Approved Actuary.
The value of the insurance liabilities (both for Outstanding Claims Liabilities and Premiums Liabilities) reported by the insurer will be the aggregate of the liabilities determined for each class of business.
In practice, the process of determining the central estimate values of the insurance liabilities should be undertaken on the basis of a class of business. However, this should not prevent the Approved Actuary from undertaking the necessary analysis on a basis which is more suitable, taking into account the nature of the data and the particular circumstances of the insurer.

The Central Estimate

For the purposes of paragraph 9, the central estimate is intended to reflect the mean value in the range of possible values for the outcome (that is, the mean of the distribution of probabilistic outcomes). The determination of the central estimate should be based on assumptions as to future experience which reflect the experience and circumstances of the insurer and which are:

(a) made using judgement and experience;

(b) made having regard to reasonably available statistics and other information; and

It should be recognised that where experience is highly volatile, model parameters estimated from the experience can also be volatile. The intention is for the central estimate to reflect as closely as possible the likely future experience of the insurer. To this end, judgement may be required to limit the volatility of the assumed parameters to that which is justified in terms of the credibility of the experience data.
The central estimate will generally be measured as the present value of the future expected payments. This measurement process will involve prospective calculations and modelling techniques, and will require assumptions in respect of the expected future experience, taking into account all factors which are considered to be material to the calculation, including:

(a) discount rates (see paragraphs 29-31);

(b) claims escalation;

(d) the pattern of claims run-off.

This is equally applicable to the determination of the gross insurance liabilities and the estimation of reinsurance recoveries.

In establishing the central estimate assumptions, due regard should be had to the materiality of:

(a) the class of business being considered; and

(b) the effect of particular assumptions on the determined result.

Many of the assumptions should be consistent for the estimation of the Outstanding Claims Liabilities and the Premiums Liabilities. Where there are differences, the reasons must be clearly documented.

The Risk Margin

For the purposes of paragraph 9, the risk margin is the component of the value of the insurance liabilities that relates to the inherent uncertainty in the central estimate. The risk margin does not relate to the risk associated with the underlying assets, including asset-liability mismatch risk. As the risk margin represents an additional component of the liability value, it is therefore aimed at ensuring that the value of the insurance liabilities is established at an appropriate and sufficient level (as defined in paragraphs 10-11).
Risk margins should be determined on a basis that reflects the experience of the insurer. Professional judgement will be needed to determine the risk margins for the insurer as a whole, and for each class of business. In determining risk margins, regard should be had to the objective of this Standard, any other guidance or any relevant professional standards.
In considering the methodology and assumptions to be used in determining the risk margin for a class of business, regard should be had to a range of factors, including:

(a) the robustness of the valuations models;

(b) the reliability and volume of the available data;

(d) the particular characteristics of the class of business.

Estimation of the coefficient of variation may, itself, present technical difficulties with some components of the uncertainty in the central estimate not permitting statistical analysis. Generally, estimation of the coefficient of variation will require judgement as well as technical analysis. As with other aspects of this Standard, regard should be had to the intent underlying the valuation of insurance liabilities in making these judgements.
The risk margin should normally be determined having regard to the uncertainty of the net insurance liabilities, but consideration should also be given to any additional uncertainty related to the estimate of reinsurance recoveries.
While the risk margin plays a role in achieving an appropriate pattern of profit emergence for a class of business, it is not appropriate to use the risk margin as a tool for smoothing the effect of changes in assumptions or valuation methods.
From year to year, risk margins would generally be a constant percentage of the central estimate for each class of business, unless there has been a material change in uncertainty. Such changes may include changed reinsurance arrangements, changes in the insurer’s gross risk profile or volume of business, or structural changes, eg legislative requirements.

The Discount Rate

The value of an insurer’s liabilities is typically independent of the value of the underlying assets. For this reason, a discount rate that is observable, market-based and objective is most appropriate.
The rate to be used in discounting the expected future claims payments for a class of business is the gross redemption yield, as at the calculation date, of a portfolio of sovereign risk securities with a similar expected payment profile to the insurance liabilities for that class (eg Commonwealth Government securities for Australian dollar liabilities).
Where the expected payment profile of the liabilities cannot be matched - for example, because the duration is too long - a discount rate regarded as consistent with the intention of this Standard should be assumed.

Methodologies for the Valuation of Insurance Liabilities

It is not the purpose of this Standard to be prescriptive in terms of the methods to be adopted for the valuation of the insurance liabilities. The appropriateness of any methodology will depend on:

(a) the class of business;

(b) the nature, volume and quality of the available data;

(d) considerations of materiality.

Where an Approved Actuary provides advice on the valuation of insurance liabilities, it is considered necessary that, subject to considerations of materiality, comprehensive actuarial analyses and modelling techniques will be employed. While the principles of establishing the central estimate and risk margin in respect of each class of business are described in this Standard, it remains the professional responsibility of the Approved Actuary to determine an appropriate methodology. Guidance Note GGN 210.1 Actuarial Opinions and Reports on General Insurance Liabilities contains a range of suggested methodologies that may help the Approved Actuary in calculating insurance liabilities. GGN 210.1 should be used as interim guidance until the Institute of Actuaries of Australia releases its own professional standards and guidance notes in this area.
Approximate methods may be employed in the valuation of the insurance liabilities, subject to the principles of this Standard and where the result so produced is not material or not materially different from that which would result from a full valuation process. Short tail business, for example, may justify the use of approximate methods to the extent that future expected claims are not discounted. Similarly, an approximate method which Mortgage Lenders insurers might adopt in the valuation of insurance liabilities, is to establish case estimates for reported claims, and to construct a premium earning pattern designed to hold back premium so that it is earned in line with expected claims reporting patterns.
An insurer may use an approximate method to assess if its Unearned Premium Provision (UPP), less the value of its Deferred Acquisition Expense (DAC), is a reasonable approximation of its Premiums Liabilities. If the assessment suggests that the insurer’s Premiums Liabilities would not be materially higher from a more detailed investigation then the insurer may use its UPP less its DAC as the central estimate of its total Premiums Liabilities after adjusting for the profit margin in the UPP. For the purposes of this assessment, materiality should be judged in terms of the impact on the balance sheet and solvency of the insurer. In considering the appropriateness of such an approach, the Approved Actuary should have regard to, among other things:

(a) any recent assessments of outstanding claims undertaken by the Approved Actuary since the previous calculation date of the insurer;

(b) trends in, and the stability of, the insurer’s net combined ratios and net loss ratios over the previous three accident years, including the current year, relative to the level the insurer needs in order to achieve its required return on capital. The Approved Actuary should make adequate allowance for working losses, large claims and catastrophes;

(c) trends in, and the stability of, the insurer’s profits over the previous three financial years, including estimates of the likely profit for the current year. The Approved Actuary should make adequate allowance for working losses, large claims and catastrophes;

(d) the insurer’s experience with respect to premium rate changes over the previous three years per unit of exposure, eg significant premium rate increases in classes that have had historically high loss ratios. The Approved Actuary should also consider the impact of major changes to the insurer’s underwriting and claims management systems;

(e) trends in the rate of growth in exposure for the insurer over the previous three years. The Approved Actuary should analyse premium growth arising from increases in exposure, adjusted for acquisitions, divestment of portfolios, new classes etc;

(f) recent trends and likely developments in the insurer’s reinsurance arrangements and rates; and

(g) proper allowance for claims handling, policy administration and other management expenses.

The onus for justification of the appropriateness of any approximate method rests with the Board of the insurer and, where relevant, the Approved Actuary. Where an Approved Actuary has been involved in the valuation of the insurance liabilities, then the Approved Actuary must report in his/her written advice on the reasons for, and the effect of, any approach to the determination of risk margins other than one consistent with paragraphs 22-28.

Estimation of Reinsurance Recoveries

Reinsurance refers to arrangements where some part of individual or aggregate insurance risks are ceded to another insurer or insurers. This includes cessions of direct writing insurers to reinsurers or other direct writing insurers, as well as retrocessions of reinsurers to their parent insurers or other reinsurers. Reinsurance recoveries are amounts expected to be recovered under arrangements in relation to the Outstanding Claims Liabilities and the Premiums Liabilities.
The valuation of net (of reinsurance) insurance liabilities is to be determined in accordance with the principles of this Standard. The principles of this Standard should be applied with similar robustness to the valuation of gross (of reinsurance) insurance liabilities.
In practice, the estimation of the value of the insurance liabilities may be either undertaken on a gross basis, with a separate estimate of the value of reinsurance recoveries, or on a net basis. Where the process is undertaken on a net basis, it is still necessary to value separately estimates of the gross liability and the recovery amounts.
In determining the estimate of reinsurance recoveries, the principles of this Standard must be complied with. Where the advice of an Approved Actuary is required in regard to the valuation of the insurance liabilities, the Approved Actuary should also consider the estimation of reinsurance recoveries. Actuarial judgement should be used in the application of the principles of this Standard in those circumstances.
The estimation of the value of reinsurance recoveries would normally be undertaken on the basis of a class of business. However, there are certain forms of reinsurance where recoveries depend on the combined claims experience of several classes.

Claims Escalation

Appropriate allowance must be made for future claims escalation when determining the central estimates of both the Outstanding Claims Liabilities and the Premiums Liabilities. Future claims payments may increase over current levels as a result of either or both of:

(a) wages or price increases (inflation); or

(b) court awarded interest, other environmental or economic causes (superimposed inflation),

and appropriate allowance must be made in both respects. Claims payments include third party costs incurred in settling those claims such as investigation, medical and legal fees, etc.

Non-Reinsurance Recoveries

Non-reinsurance recoveries are amounts that may be recovered under arrangements other than reinsurance arrangements. These would include salvage, subrogation and sharing agreements. The treatment of non-reinsurance recoveries should be consistent with that required by relevant Australian Accounting Standards.

Materiality

Particular values are considered material to the overall result of a calculation when their misstatement or omission would cause the result to be misleading to the users of the information. Materiality tests assess the significance of the particular value by relating it to the amount of the overall result (the base amount) to which it contributes.
Materiality will always be a matter requiring exercise of judgement. It should be recognised that the level at which a difference becomes material can be considerably lower than a statistically significant difference. In these circumstances, careful exercise of judgement is required.

Reporting Requirements

Paragraphs 25 to 31 of Guidance Note GGN 220.1 set out details on the content of an Approved Actuary’s report on liabilities.

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Objective and Key Requirements of this Standard

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