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Duties of the actuary
- make an annual investigation of the insurer’s recent and current financial position as revealed by DCAT for various scenarios
- make a report of each investigation in writing to the insurer’s BoD with possible actions
- make an interim investigation if there is a material adverse change in circumstances
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Key elements of DCAT
- development of a base scenario
- analysis of the impact of adverse scenarios
- identification and analysis of the effectiveness of various strategies to mitigate risks
- report on the results of the analysis and recommendations to the insurer’s mgt and BoD
- opinion signed by the actuary on the financial condition of the insurer
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Typical approach
- review of operations for the recent years (3) and financial position at the end of each year
- development and modelling of base scenario for the forecast period consistent with the insurer’s business plan
- assessment of the risk categories and identification of those that are relevant to the insurer’s circumstances, using sensitivity testing
- selection of plausible adverse scenarios that are likely to significantly impact surplus, including modelling of ripple effects and stress testing (how far risk factor has to change)
- selection of at least 3 scenarios showing the greatest surplus sensitivity
- identification of possible management actions and the impact of these on the insurer’s financial condition for each scenario
- identification of possible regulatory actions for each scenario that causes the insurer to fall below the minimum regulatory capital level
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Base scenario
- realistic set of assumptions used to forecast the insurer’s financial position
- consistent with the insurer’s business plan
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Plausible adverse scenarios
- scenario of adverse, but plausible, assumptions about matters to which the insurer’s financial condition is sensitive
- varies among insurers and over time for a particular insurer
- scenario testing may be required to determine sensitivity to each risk
- don’t assume additional capital, unless adverse factors are in mgt’s control (e.g. high sales)
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Ripple effects
- event or incident that occurs when an adverse scenario triggers a change in one or more interdependent assumptions or risk factors
- includes adjustments to assumptions, likelihood of changes in planned capital injections, or expected response insurer / policyholders / regulators / rating agency
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Integrated scenarios
- type of adverse scenario that results when two or more adverse scenarios are combined
- resulting integrated scenario would be realistic and plausible (95th or 99th percentile)
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Stochastic vs deterministic approach
- stochastic: risk are modelled where loss distribution can be inferred
- deterministic: adverse scenarios are selected judgementally by actuary
- combination: model risk and use results to derive deterministic scenario
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Satisfactory financial condition
- insurer is able to meet all its future obligations under base and adverse scenarios
- insurer meets minimum regulatory capital requirement under base scenario
- if not met, report with and without capital enhancements and assumed mgt actions
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Sections of the DCAT report
- executive summary: results, risks, commentary on previous recommendations
- DCAT opinion: signed opinion on future financial condition
- introduction: role of AA, purpose and scope of DCAT, overview of process / methods
- capital adequacy measurement: minimum, satisfactory, threat definition, materiality
- background discussion: nature of business, financial position, key events, market
- base scenario: model used, assumptions, consistency with business plan, key results
- adverse scenarios: risk, assumptions, ripple effects, previous year’s comparison, actions
- conclusions and recommendations: summary of results, highlights of risks
- appendices: detailed financial results like balance sheet, income statement
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Risks associated with derivative instruments
- market risk: liquidity (cancel when desired or at favourable price) + basis risk (price behaviour not acting as expected, undoing intended hedging benefits)
- default / credit risk: loss incurred due to default in making full payment when due
- management risk: inadequate mgt supervision and understanding, systems, controls…
- legal risk: derivative agreement is not binding as intended
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Injection of capital for DCAT in MCT
- DCAT: ok if satisfied it's the intent of entity making it, and that actuary has no reason to believe that such injections are not within the means of that entity
- MCT: no, unless adverse factor is more under management control, such as higher sales
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Risks - Claims frequency and severity
- single catastrophic event: natural disasters
- single large claim: full PML
- social inflation: inflation resulting from change in likelihood of claimants bringing suits
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Risks - Policy liabilities
- selection of inadequate loss development factors: new product
- class actions and other mass torts: effective retroactively
- change in mix of business: shift to longer tailed LOBs
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Risks - Inflation
- significant, rapid and sustained increase in general rate of inflation
- significant temporary increase in the cost of labour and materials following cat
- severe recession in the economy
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Risks - Premium (lower volume)
- entry of a new and strong competitor / increased competitiveness
- loss of a key distributor, or even an entire distribution channel
- inability to implement planned premium rate increase
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Risks - Premium (higher volume)
- withdrawal or failure of major competitors from a market
- unexpected new business from a large client
- premium rates set to low compared to competition
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Risks - Reinsurance
- reinsurer insolvency: (non-)affiliated, rating, (non-)registered, concentration or reinsurance
- increase in reinsurance rates or reduction in reinsurance commission
- disputes over policy conditions
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Risks - Investment
- significant change in yield curve
- increase in the default rate on debt securities
- decrease in return and/or value of equities/real estate/subsidiary
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Risks - Government and political
- rate freeze or rollback of rates on LOBs in which rates are subject to regulatory approval
- nationalization or privatization of a LOB in a jurisdiction
- change to legislation that creates or restricts distribution channels
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Risks - Off-balance sheet
- structured settlement: exposed to credit risk
- contingent liabilities or losses: tax, litigation
- letters of credit and pledged assets: default risk
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Risks - Related company
- reduction in reliance on the parent company for financial support
- increase in the provision of financial support to the parent
- high level of dependency on group operational resources
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Ripple Effects
- forced sale or liquidation of assets, rating agency downgrade
- claim frequency and severity: post-event inflation following catastrophe
- policy liabilities: increase in ultimate claim costs and claim expenses
- inflation: rapid and sustained increase in interest rates, increase in operating expenses, reinsurance rates on swing-rated contracts
- premium, lower volume: increase in fixed expense ratio, shift in portfolio mix
- premium, higher volume: higher loss ratio on new business due to inadequate pricing, shift in portfolio mix, higher expenses short term (hiring employees, increased overtime)
- reinsurance: increase in reinsurance rates arising from need to obtain replacement coverage, reduced availability of reinsurance
- investment / off-balance sheet: significant cash flows affecting liquidity, negative change on derivative positions
- government: regulatory monitoring, increased reinsurance rates or non-availability
- related company: mgt focus on group rather than company priorities, regulator action
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Management actions
- review reinsurance coverage, type and/or terms at renewal
- implement rate changes, when possible
- review target mix of business by LOB or jurisdiction
- policy liabilities: review reserving and claim setting guidelines
- premium, higher volume: review distribution channel, restrict / withdraw from markets
- reinsurance : change the reinsurance structure, retain a greater proportion of business to decrease reinsurance cost, change reinsurers
- investment / off-balance: sell or reinvest assets, change investment strategy
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