Rewriting the Malaysian Risk-Based Capital (RBC) for underwriters and claims handling personnel.
A Weblog from the past on RBC framework as seen from the eyes of a General Insurance underwriter……
Compared to the previous solvency margin methodology, this RBC is abit tricky from operations perspectives so much so underwriters and claims practitioners should acquire a reasonable level of understanding in order to prevent the company from slipping trouble waters. Unfortunately this is not happening for our industry, most if not all underwriters and claims practitioners are not made to play any strategic part in this new regime. It is still very much a “finance and accounting” forte, and the Central Bank is not driving the message across yet. This I believe is a carry-over effect from the days of the solvency-margin regime but time is surely changing as in RBC, the biggest chunk of the capital charges are related to General Insurance Liabilities ie. Premium Liabilities and Claims Liabilities. So why are senior underwriters having limited access to documentation, not to mention the zero contact time with the actuary and their actuarial investigation and analysis. Why are claims personnel have limited or almost no knowledge of how the actuary made assumptions and their computational methodology in arriving at the IBNR figures? Why are there premium deficiencies and how can underwriters work toward unplugging the root cause of a particular portfolio?
This blogpost attempts to put some basic understanding in perspectives for benefits of underwriters and claims practitioners…..
So what is Risk-Based Capital (RBC) in short?
It is really about the need to have the correct amount of capital to support the business that the insurer has written into its books. This means there must be adequate capital for an insurer to meet its obligations to existing policyholders and also to continue writing new business in the future in any adverse conditions. The capital requirement is generally computed by applying the RBC regimented risk charges on those prescribed exposures, namely credit, market, technical reserve and operational risks.
How to get started?
It is not difficult to understand the objective of RBC but it can be quite tricky if we are to go into the mechanism in working out whether the capitalavailable to the company is adequate to support the risks underwritten. Welcome to the journey through the working intricacies surrounding the RBC framework.
Firstly always remember the following important formula:
|Capital Adequacy Ratio (CAR)||=||Total Capital Available (TCA) / Total Capital Required (TCR) x 100%|
Always remember, the Central Bank had as of now imposed that the supervisory CAR (or SCAR) must be > 130% otherwise the company must raise more capital in order to continue doing business.
Simply what is TCA?
Simplistically, you can get these details from the company’s financial statement or more specifically, the balance sheet. To make our brain think simple just add up the following:
- Fully Paid-up shares capital
- Retained profits
In a nutshell, the total should give you the TCA. Forget those complicated stuff like tier-1 and tier-2 capital as they will suffocate you…. You can counter-check with this equation: Equity (E) = Asset (A) – Liability (L). TCA should be approx. that to E.
Simply what is TCR?
TCR is the aggregate of the total capital charges for the insurance fund and total capital charges for all assets in the shareholders or working fund. We can simply illustrate the computation of TCR with the following diagram:
|The TCR items||General Insurance (GI) Fund||Shareholders’ (SH) Fund|
|Credit Risk capital charges (CRCC)||Total of all charges in respect of GI fund on credit||Total of all charges in respect of SH fund on credit|
|Market Risk capital charges (MRCC)||Total of all charges in respect of GI fund invested||Total of all charges in respect of SH fund invested|
|General Insurance Liabilities(GCC):
(a) Claims Liability risk capital charges
(b) Premium Liability risk capital charges
|Total of all charges in respect of GI fund as reserves requirement||Non-applicable|
|Operational Risks capital charges (ORCC)||Apply 1% on GI fund||Apply 1% on SH fund|
|Total Capital||Total of risk charges under GI Fund||Total of risk charges under SH fund|
(Summary of Table I) Some Notes – General Insurance Funds relate to the total of Claims Liabilities and Premium Liabilities that need to be computed and certified by a qualified actuary. These funds are separated from the Shareholder funds as depicted in any financial statements. Thus there is no computation of capital risk charges for General Insurance Liabilities under column “Shareholders’ Fund”. All the calculations will be eventually summarized within the above Table.
Illustrating the TCR items:
(1) Credit Risk Capital Charges (CRCC) aims to mitigate risk of losses resulting from assets default and related loss of income, and the inability or unwillingness of a counterparty to fully meet its contractual financial obligations.
Simple formula to work out the Capital charges for credit risks:
|CRCC||=||Exposure to counterparty x Credit risk charge|
Filter off those special purpose vehicles related securities, debt obligations and the likes from our thoughts as we only need to focus on Table II (Risk charges for other assets), items (c), (d), and (e).
|Item||Types of exposure||Risk charges|
|(c)||Receivables from and reinsurance deposits with (re)insurers licensed under the Insurance Act 1996||1.6%|
|(d)||Receivables from and reinsurance deposits with (re)insurers not licensed under the Insurance Act 1996, with the following rating:|
|(v) Unrated or with lower rating||12%|
|(e)||Outstanding premiums, agent balances and other receivables due from:|
|(i) other licensees under the Insurance Act 1996 or agents||4%|
Underwriters need to be focused on item (d) as this item involves making choices on the (re)insurers when placing facultative reinsurance outward and approving the panel of treaty reinsurers.
In (c), the framework provides for a fixed credit capital charge of 1.6% for all (re)insurers licensed under the Malaysian Insurance Act 1996 irregardless whether these (re)insurers have any internationally recognised rating or otherwise. Therefore risks that were facultative reinsured to local insurers, the capital risk charge in respect of credit risks shall be 1.6% – incidentally, risks ceded to Tahan would merely attract a 1.6%, far cry when compared to risks having been ceded to syndicates at Lloyds’!
The Parental Guarantee – Coming back to item (d), the framework did provide some leeways for reinsurers licensed under the Labuan Offshore Insurance Act 1990 (Lofsa). If these reinsurers can provide a “parental” guarantee (explicit and irrevocable by their Home Office) with at least an A- rating to fully support their Labuan operations in event of financial difficulties shall be subjected to only a risk charge (1.6%) equivalent to that of a reinsurer licensed under the Insurance Act 1996. It is a known fact that most registered reinsurers are actually branches, thus not sure why is there any need for such parental guarantee – NOT very clear….
However, what do you think about Labuan Re? They cannot provide any parental guarantee…..as they are the parent themselves. Can Labuan Re provide their own guarantee in this respect? Looks illogical and there is no provision for this! Anyway, the industry irrespective of the framework applies the risk charge at 1.6%… Looks like they had been given an unofficial waiver…..
It is good to know in recent days, Lloyds’ syndicates that do not have any registered operation in the country are treated as foreign reinsurers – they can no longer hide and gain the Lofsa status via the Lloyds’ Labuan banner.
What about item (e)? This applies to debts or outstanding due from intermediaries or from direct (or corporate) accounts. Underwriters and Claims practitioners must play a more proactive role in reviewing any such outstanding before adopting any decision, ie. Enforcement of Premium warranty cancellation, full premium payment must be in before settlement of a claim or issuance of renewal notices……
(2) Market Risk Capital Charges (MRCC) aims to mitigate risks of financial losses arising from:
- the reduction in the market value of assets due to exposure to equity, interest rate, property and currency risks,
- the non-parallel movement between the value of liabilities and the value of assets backing the liabilities due to interest rate movement,
- concentrations of exposures to particular counterparties or asset classes
Simple formula to work out the Capital charges for Market risks:
|MRCC||=||market exposures x market risk charges|
Underwriters need not be too concerned with MRCC – a simple understanding that TCR items relate to Equity, Property, Interest Rate, Currency, Financial derivatives, collective investment schemes, etc should suffice. However, if we write a substantial number of risks with limit of coverage involving foreign currency, then we should raise this up with the Finance people and also it is appropriate if we acquire a thorough understanding of the company’s treaty programme in respect of currency clause or currency fluctuation clause.
(3) The General Insurance Liabilities Risk Capital Charges (GCC) aims to address risks of under-estimation of the insurance liabilities and adverse claims experience developing over and above the amount reserves already provided, be it related to claims or unexpired risks. These are where actuaries are heavily involved in. The RBC currently set the actuarial computation at the 75% level of confidence.
Simple formula to work out the Capital Charges for General Insurance Liabilities Risks:
|GCC||=||[Unexpired risk reserves (URR) x URR(Risk Charges)]
+[Claims liability (CL) x CL(Risk Charges)]
What is Unexpired Risk Reserves or URR in short? You can simply just call it “Premium Liabilities” or PL.
The URR Risk Charges and CL Risk Charges are as follow:
|Class||Risk Charge applicable on
|Risk charge applicable on
Premium Liabilities (URR)
|1||Motor – ACT||25%||37.5%|
|2||Motor – Others||20%||30%|
|4||Marine, Aviation & Transit – Cargo||25%||37.5%|
|5||Marine, Aviation & Transit – Hull||30%||45%|
|6||Contractors’ All Risks & Engineering||25%||37.5%|
|8||Medical and Health||25%||37.5%|
|10||Workmen’s Compensation & Employers’ Liability||25%||37.5%|
|11||Bonds, Offshore Oil & Gas related and Others||20%||30%|
Most important to Underwriters & Claims Practitioners – This part of TCR is perhaps the most important to underwriters and claims practitioners. Underwriters with a better understanding of these will be able to work towards steering the company into attaining a more viable or strategic portfolio mix – so that premium growth and underwriting profitability can be better realised and optimised. This simply means as the company works towards realising its growth target, such growth should not be at the expense of its capital.
However, before we work out the relevant capital charges it is important that we have a reasonable good understanding of what CL and PL or URR mean… or perhaps also peppered it with some basic understanding of how actuary makes assumption and methodology adoption.
On Claims Liabilities – Most underwriters and claims practitioners should have a reasonable understanding of what “Claims Liabilities (CL)” is all about. CL refers to the obligation, whether contractual or otherwise, to make future payments in relation to all claims that have been incurred as at balanced sheet date and includes provision for claims reported, claims incurred but not reported (IBNR), claims incurred but not enough reserved (IBNER) and also direct and indirect claims expenses.
Claims personnel will work towards preparing the “case-reserves”, which include handling expenses for all claims reported, determine the final payment amount and reviewing the case reserves of all known outstanding claims as realistic as possible. The total of these reserves established within any period is then subject to valuation by professional qualified actuary with the prescribed valuation bases that aim to secure an overall level of sufficiency of claims reserves at best estimate value and then apply a “Provision of Risk Margin for Adverse Deviation” (PRAD) to arrive at the 75% confidence level. The actuary will make numerous assumptions in arriving at the Ultimate Loss Amount from the total case reserves derived. From thereon, they will determine whether is there additional IBNR and IBNER, or even the handling expenses are required to be added on (or topping up) as part of the total CL.
On Premium Liabilities or Unexpired Risk Reserves (URR) – The other component is Premium Liabilities (PL) which refers to the reserves for unexpired risks (URR) and includes liabilities for all benefits, claims and expenses, acquisition costs, maintenance costs and exposures after the end of the particular accounting period on which the actuarial investigation is conducted. In short we can summarise PL as:
|PL = URR = Unearned Premium Reserves (UPR) + premium deficiency reserves|
What is UPR? Underwriters should be familiar with UPR or more specifically, unearned premium reserves. The usual computation method is the use of 1/24th method reduced by the actual commission payable except for marine cargo, which is calculated by applying 25% to the net premium without any deduction for acquisition costs. If you have a habit of reading your company’s finance accounts, you should see this reported as part of the NOTES to the accounts….
What is a premium deficiency reserve? If there is a portfolio loss then premium deficiency needs to be factored into the equation, otherwise, UPR = URR + unrealised profit. Please check the relationship between URR and UPR (Our latest addition 13th March 2012). We can rephrase it as “unallocated expenses and deferred acquisition costs”. Before we can get to the quantum of deficiency in premium reserves, the actuary must have worked out the best estimate ultimate loss ratio (to have some idea, refer to PL….). From this best estimate, an additional % loading is imposed (ie. 4%) for policy administration expenses expected. This ratio is then further adjusted by the actuary to account for the actual deferred acquisition cost that the company has factored into the calculation of the UPR earlier on. The final adjusted ultimate loss ratio is then applied to the UPR to derive an estimate of the URR, ie. URR = UPR + premium deficiency reserves = UPR x ULR (Adjusted).
Now, you have finally arrived…..at what should be the amount for Premium Liabilities or URR and the Claims Liabilities. But, please ensure that you separate out these into: (1) Business within Malaysia, (2) Business outside Malaysia. Don’t worry or be bothered if you are having a hard time digesting what I have said, these are not for us to know in detail, they are for the actuary to work them out, and indeed they will work out or rather massage up another level, ie. at 75% level of confidence.
At 75% level of confidence, is the RBC framework hurting the insurers? Insurers are expected to be ready since they have had numerous years preparing themselves for this eventuality. But in reality, insurers writing substantial motor business have their CAR severely challenged. In simple terms, most insurers in the past have the habit of massaging their claims case reserves in order to prop up a show for the year-end financial reporting. At 75% confidence level and with the fast rising industry loss ratio for third party bodily injury claims, any actuary is not about to make assumptions that could compromise their professional position. Therefore if the claims practitioners do not have an inkling of how their decision on claims reserving can impact the company’s CAR, they need to be shot! They must know, time is an essence and interest works on a compounding basis over time…. The old phrase, “Let’s sleeping dogs lie” must surely goes…..
The Underwriters’ Position – With reasonable understanding of how those relevant risk charges (refer to the table above) are applied on this actuarial-computed amount to derive the total of General Insurance Capital Charges underwriters should be in a better position to deal with individual risks or a portfolio of risks coming for underwriting mention. If an LSR risk has a higher than normal loss ratio or adverse loss exposure, underwriters must make attempt to resist it, and if a portfolio of risks is showing signs or trends of deterioration, then underwriters must make attempts to arrest the deterioration otherwise the reality would surely sinks in after those actuarial computation. If there are sizeable risks requiring fronting by insurer, it is important to understanding the claims related impact of those risks. Risks having long tail claims settling nature must be properly scrutinised – you can imagine the amount of capital charges in respect of outstanding claims due from your aviation reinsurer(s) in an event of a major air disaster – claims could run into USD100 million and time taken for final settlement may takes more than 36 months if there involves third party liability claims! In the next 36 months your company would be hit by a 30% risk charge applied on the claims reserves due from your reinsurer(s), and this can be crippling in terms of the RBC framework! Worst still what if the risk was substantially placed to a single reinsurer and that reinsurer is having financial constraints? Thus, it is best practice not to put all eggs into one basket….
From the capital risk charges applicable to the Premium Liabilities, underwriters may want to avoid aviation, marine hull and professional liability risks, simply because they attract a much higher risk charge, ie. at 45% unless those risks are clearly of the better grade. Writing substandard risks under such category is also likely to produce a double whammy in the guise of the capital risk charges applicable on the claims liabilities, at 30% if there are claims incurred. With this “45% & 30%” capital risk charges, it would wear out the capital of the insurer fast if it has underwritten a large portfolio of such risks. It is not too difficult to understand the effects by looking at the Table III.
(4) Operational Risk Capital Charges (ORCC) aims to mitigate the risk of losses arising from inadequate or failed internal processes, people and systems. This is the simplest as the authority has not come up with the more established and internationally recognised methods for doing so……thus the formula: ORCC = 1% of total asset. In this case we can work it out as “Total Asset = Total Shareholders’ Fund + Total General Insurance Fund”
From the TCR table (above), you can have the figure for TCR which is equal to CRCC + MRCC +GCC + ORCC. Now you already have all the charges total-up into TCR, then apply this to the formula of “TCA / TCR x 100%”. However, what is most important here is not the final amount in respect of the TCR and TCA calculations but really about how underwriters can minimise further TCR build-up within the underwriting books on one hand…. and how claims practitioners can work towards ensuring that the claims case reserves are always adequately (especially those risks having long-tailed complexities) provided so that the company need not have to go through any IBNR-related “shocks”.
For the full document on RBC framework:
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