The Central Estimate
- Class of Business
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The estimation of insurance liabilities for a company is likely to require subdivision of risks into classes or sub-classes of business with similar characteristics. This subdivision requires an appropriate balance between homogeneity and statistical reliability.
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It is the responsibility of the actuary to determine the most appropriate subdivision for the purpose of analysis and projection. However, the value of insurance liabilities must be assessed and reported for each class of business specified by APRA.
- Analysis
- Policy and claim experience should be analysed on an individual policy or claim basis or on the basis of cohorts of similar claims. Depending on the nature of the class of business being examined and the availability and reliability of data, this analysis should consider the development over time of claim payments in relation to some or all of the following measures of exposure:
(a) number of policies;
(b) earned premium;
(c) numbers of claims:
(i) reported;
(ii) continuing;
(iii) settled;
(iv) finalised; and
(v) reopened etc.
(d) prior payments;
(e) case estimates; and
(f) reported incurred costs.
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It may be necessary for some models to analyse and consider the development of these exposure items.
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The claim experience need not necessarily be analysed in a fashion that distinguishes claims of different status such as reported, IBNR and reopened.
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In some cases, it may be necessary for an actuary to estimate future, or unclosed, premiums for policies underwritten up to the reporting date. The actuary should consider the delay between when the business is underwritten and when premiums are received and factors that influence this delay. The division between the amount of unclosed premium that is earned and unearned should also be considered. The principles in this Guidance Note with respect to Outstanding Claim Liabilities also apply, where relevant, to unclosed premiums.
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The focus of GPS 210 is for estimates of insurance liabilities that are net of reinsurance and other recoveries. Ordinarily, analysis and valuation of outstanding claims will be on a gross basis, with separate estimates for reinsurance and other recoveries. The analysis of reinsurance and other recoveries should be appropriate to the circumstances. The estimation of reinsurance recoveries may require separate deterministic or stochastic analysis of large claims, large events or aggregate costs that approach or exceed reinsurance retentions. In some circumstances, however, it may be more suitable for the analysis and valuation to consider the net of reinsurance experience and add an allowance for reinsurance recoveries to arrive at the gross estimate.
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The actuary should initially assume that reinsurance recoveries will be made in full. Under the capital adequacy framework, the risk that recoveries will not be received from the reinsurer is part of the investment risk for the company. Where there is a known material risk that one or more reinsurers will fail to meet their obligations, the actuary should separate reinsurance recoveries into amounts recoverable from each of those reinsurers to enable the appropriate investment and concentration risk charges to be made as prescribed by GPS 110 Capital Adequacy. If material, the actuary should also assess the potential range of amounts unrecoverable from reinsurers, based on the uncertainty of individual and aggregate gross losses.
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The analysis should consider factors both internal and external to the company that may have influenced the observed patterns in historical experience. Such factors, and changes to them, may include, but are not limited to:
(a) underwriting strategies;
(b) mix of business;
(c) policy coverage, including deductibles, limits and exclusions;
(d) legislation;
(e) economic and social trends;
(f) claim management procedures; and
(g) reinsurance programs.
Valuation Model
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The actuary is responsible for the selection of an appropriate valuation model, having regard to the availability and reliability of the data and the key drivers of claim cost as revealed by the data analysis or consistent with the nature of the class of business.
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The actuary may investigate more than one valuation model for the estimation of insurance liabilities, then select one or blend the results from more than one as considered most appropriate.
- Claim Experience Assumptions
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The selection of claim experience assumptions should have regard to the adopted valuation model or models and the analysis of experience. These assumptions should include trends, other than inflation as measured by standard economic indicators, in claim experience considered suitable for the projection of outstanding claim payments. These trends include the impact of social, economic, environmental, legislative and court precedent factors; often referred to as superimposed inflation.
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Escalation due to wage or price inflation should also be allowed for.
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Models vary depending on whether certain trends are explicit in the model or are implicitly allowed for by other assumptions. Where trends are implicit, this should be discussed in the report.
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Where a sequence of explicit inflation or superimposed inflation rates are used, or where different inflation or superimposed inflation rates are used in different parts of the model, the equivalent single, level rate should be stated in the report.
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In some cases, there may be an insufficient amount of claim experience data on which to reliably base assumptions for the selected model or models. The actuary may give partial or full weight to assumptions drawn from industry data, if satisfied that such an approach is appropriate. For classes where claims are reported slowly, or where there is little early information about the severity of claims, it may be appropriate to give partial or full weight to some or all of the premium assumptions or, if there are no such assumptions explicit, to assumptions based on expected actuarial loss ratios applied to the premiums charged.
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All claim experience assumptions should be reviewed with each valuation of insurance liabilities and updated, if necessary, as considered appropriate. The actuary should be satisfied that the claim experience assumptions adopted at each valuation are realistic in the context of data known at that time. Changes required to assumptions must not be spread over more than one valuation, but this does not prevent the actuary from placing appropriate credibility on the claim experience that has emerged since the previous valuation, when determining such changes.
- Discount Rate
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GPS 210 prescribes how the discount rate assumption is to be determined. This discount rate is the gross effective yield on a portfolio of sovereign fixed coupon and redemption value securities, in the currency of, and with a payment profile matching as far as possible, the expected payment profile. For all Australian insurance liabilities, the fixed interest securities to be used are Commonwealth Government Treasury notes and bonds. It is acceptable to use either the average rate or a series of discount rates taken from the corresponding yield curve.
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Sovereign fixed interest securities are typically not available to exactly match projected payments. There are usually gaps in the maturity dates available and the longest dated such security may not be long enough. It is appropriate to smooth, interpolate and extrapolate from the observed yields in the sovereign bond market.
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If the actuary applies a sequence of discount rates for future periods, the corresponding average discount rate should be calculated for each class of business and stated in the report. The discounted mean term for each class of business should also be stated in the report.
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Where the value and timing of unclosed premiums have been projected, discounting should also be applied.
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Discounting may be disregarded where the effect of discounting does not materially change the resulting central estimate.
- Claim Administration Expenses
- An appropriate allowance should be made for the future costs of claim administration that are not allocated to individual claims and, therefore, not included in the data on which the claim experience assumptions were based. The allowance for claim administration expenses should be made after consideration of historical levels of claim administration expenses, organisational structure, internal and outsourced functions and future administrative developments. It should be noted that expenses are incurred in the making of gross payments as well as making recoveries. It should also be noted that expense levels are often higher for older, more complex claims. While this may be encompassed in an average rate for an active portfolio, allowance for escalating expenses may be needed for a closed portfolio. The complexity of the approach used to determine an appropriate allowance for claim administration expenses should be commensurate with its likely materiality.
- Central Estimate
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The actuary is responsible for ensuring that the valuation calculations are carried out accurately. The actuary must also be satisfied that the overall valuation process and estimates are reasonable. The actuary should quantify the impact of any changes to the valuation basis since the previous actuarial valuation conducted for the purpose of compliance with GPS 210. Explanation of the impact of material changes should be included in the actuary’s report.
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GPS 210 requires that a central estimate of the Outstanding Claim Liabilities be reported. For the purpose of GPS 210, this should be thought of as a requirement for the mean of a notional probability distribution of outcomes, without regard to whether the insurer has sufficient capital to meet all of the possible outcomes. Where the actuary is of the view that the estimate is not such a notional mean, the reasons for this should be explained in the report, and an alternative central estimate should be provided and explained. Such explanations will usually be in the context of the analysis of uncertainty. It should be noted that, in the context of general insurance, the mean is typically larger than either the median or the mode, so that reporting either the median or the mode is likely to result in underestimation. These differences are usually larger for gross than for net estimates.