Historical compilation

as at 1 June 2006

Record of resolutions of the Life Insurance Actuarial Standards Board: actuarial standards

Life Insurance Act 1995, s 109(9)

This compilation was prepared on 1 June 2006 taking into account amendments made by Life Insurance (actuarial standards) determination No. 1 of 2006 dated 28 March 2006, which varied actuarial standards 2.04, 3.04 and 7.02 effective 30 March 2006 – see Note 1. 

This compilation reflects the position at the time of preparation on 1 June 2006. 

Prepared by the Australian Prudential Regulation Authority on behalf of the Life Insurance Actuarial Standards Board.

Record of resolutions of the Life Insurance Actuarial Standards Board: actuarial standards

Life Insurance Act 1995, s 109(9)

On 5 December 2005, at a meeting held under section 109 of the Act, the Life Insurance Actuarial Standards Board (LIASB) RESOLVED:

Making of new actuarial standards

1.   under subsection 101(1) of the Act, to MAKE the following actuarial standards (each of which is set out in the Schedule):

1.    Actuarial Standard 1.04: Valuation of Policy Liabilities (for the purposes of subsection 114(2) of the Act);

1.    Actuarial Standard 2.04: Solvency Standard (for the purposes of subsection 65(1) of the Act);

1.    Actuarial Standard 3.04: Capital Adequacy Standard (for the purposes of subsection 70(1) of the Act);

1.    Actuarial Standard 6.03: Management Capital Standard (for the purposes of subsection 73B(1) of the Act); and

1.    Actuarial Standard 7.02: General Standard (for general purposes); and

Revocation of old actuarial standards

2.   under subsection 101(1) of the Act, and subsection 33(3) of the Acts Interpretation Act 1901, to REVOKE the following actuarial standards made on 28 March 2002:

(a) Actuarial Standard 1.03: Valuation of Policy Liabilities;

1.      Actuarial Standard (Friendly Society) 1.02:  Valuation of Policy Liabilities;

1.      Actuarial Standard 2.03: Solvency Standard;

1.      Actuarial Standard 3.03: Capital Adequacy Standard;

1.      Actuarial Standard 6.02: Management Capital Standard; and

1.       Actuarial Standard 7.01: General Standard; and

General provisions relating to when the new actuarial standards will begin to apply and the old actuarial standards will cease to apply

3. that, subject to paragraph 4:

(a) the new actuarial standards referred to in paragraph 1 will apply in relation to:

(i)  a reporting requirement in respect of a period ending on or after 31 December 2005; and

(ii)  a measurement or valuation as at 31 December 2005, or as at a time after that date; and

(b) the revoked actuarial standards referred to in paragraph 2 will continue to apply in relation to:

1.                  a reporting requirement in respect of a period ending before 31 December 2005; and

1.                a measurement or valuation as at a time before 31 December 2005;

but otherwise will cease to apply;

Special provisions as to measurement of friendly society liabilities

4.   that, despite paragraph 3, a friendly society must apply:

(a) Actuarial Standard 1.04: Valuation of Policy Liabilities in relation to:

(i)  a reporting requirement in respect of a period ending on or after 31 May 2006; and

(ii) a measurement or valuation as at 31 May 2006, or as at a time after that date; and  

(b) Actuarial Standard (Friendly Society) 1.02:  Valuation of Policy Liabilities in relation to:

(i)  a reporting requirement in respect of a period ending before 31 May 2006; and

(ii) a measurement or valuation as a time before 31 May 2006

but otherwise cease to apply Actuarial Standard (Friendly Society) 1.02:  Valuation of Policy.

Dated 5 December 2005

[signed]       [signed]

Timothy Jenkins      Michelle van den Berg

Chairperson      Secretary

LIASB      LIASB

Note: Actuarial Standard 4.02: Minimum Surrender Values and Paid-Up Values and Actuarial Standard 5.02: Cost of Investment Performance Guarantees, which were made on 28 March 2002, shall remain in force.

Interpretation

In this instrument:

the Act means the Life Insurance Act 1995;

reporting requirement means a requirement in the Act, prudential rules, or prudential standards made under the Act (and any requirement that may be imposed under s 13 of the Financial Sector (Collection of Data) Act 2001) which requires that an amount be calculated or determined by reference to an actuarial standard.

Schedule

(1)  Actuarial Standard 1.04

DECEMBER 2005

Actuarial Standard 1.04

VALUATION OF POLICY LIABILITIES

Life Insurance

Actuarial Standards Board

TABLE OF CONTENTS

          Page

INTRODUCTION

The Standard

Application of the Valuation Standard

PART A – CONTRACT CLASSIFICATION AND POLICY LIABILITIES IN RESPECT OF LIFE INVESTMENT CONTRACTS

SECTION 1 Contract Classification and Application

SECTION 2 Policy Liabilities in Respect of Life Investment Contracts

PART B – PRINCIPLES FOR DETERMINING POLICY LIABILITIES IN RESPECT OF LIFE INSURANCE CONTRACTS

SECTION 3 The Principles of the Valuation

SECTION 4 The Valuation of Policy Liabilities

SECTION 5 The Best Estimate Liability

SECTION 6 Profit Carriers and Profit Margins

SECTION 7 Acquisition Expenses

PART C – METHODOLOGIES FOR DETERMINING POLICY LIABILITIES IN RESPECT OF LIFE INSURANCE CONTRACTS

SECTION 8 New Business - Calculation of Profit Margins and Acquisition Expense Recovery Components

SECTION 9 Reporting Date Recalculations - Benefits Providing no Discretionary Entitlement to Share in the Investment Experience of Assets Backing them.

SECTION 10 Reporting Date Recalculations - Benefits Providing a Discretionary Entitlement to Share in the Investment Experience of Assets Backing them.

SECTION 11 Loss Recognition

SECTION 12 Reinsurance

PART D – GENERAL REQUIREMENTS FOR ALL FORMS OF POLICY AND ACTUARY’S STATEMENT

SECTION 13 Allocation of Expenses

SECTION 14 Materiality

SECTION 15 Initial Calculation of Policy Liability

SECTION 16 Statement Relating to the Valuation

INTRODUCTION 

 The Standard

The actuarial standard for the valuation of policy liabilities is established under the Life Insurance Act 1995 (the Act), and is an integral component of the financial reporting regime for life insurance companies implemented under that Act.

A valuation of the policy liabilities of a company is performed at least once a year as part of the regulatory reporting of the company.  The value of the policy liabilities appears in the regulatory financial statements in the balance sheet of the company.  The increase (or decrease) in policy liabilities of the company over the financial year contributes directly to the operating profit.

Important in the development of an integrated financial framework for the life industry were considerations of:

      methodologies for determining the policy liabilities of the life company in respect of Life Insurance Contracts which are consistent with objectives of realistic profit reporting;

      proper and timely release of profit arising in respect of Life Insurance Contracts over the life of the business;

      in respect of Life Investment Contracts, measurement of policy liabilities that follows the requirements of relevant accounting standards (to the extent that the financial reporting of Life Investment Contracts under such standards is appropriate for the purposes of the Act);

      requirements for disclosure of this information in a transparent and comparable format; and

      approaches to prescribing minimum capital requirements to support those liabilities and provide an indicator of the financial position of the company.

The actuarial standard for the valuation of policy liabilities addresses the first three of these issues, with a concern for the objectives of disclosure and reporting.  The issue of capital requirements is addressed by separate actuarial standards - the Solvency Standard, the Capital Adequacy Standard and the Management Capital Standard.

Accordingly, this actuarial standard prescribes:

• in respect of Life Investment Contracts, that the valuation of policy liabilities is to generally comply with the requirements of the relevant accounting standards, and
• in respect of Life Insurance Contracts, a set of principles, and in accordance with these principles an actuarial methodology, for the valuation of the policy liabilities of the life company.

Application to Friendly Societies

The Act was amended in 1999 to extend its application to friendly societies that undertake life insurance business.  However, previous versions of this standard were only applicable to life companies (registered under the Act) other than friendly societies.  A separate standard applied to friendly societies.

For reporting periods commencing on or before 31 December 2004 friendly societies were exempted from the general purpose financial reporting standards applying to life companies by virtue of ASIC Class Order 99/1225.  That class order was rescinded with effect for reporting periods commencing on or after 1 January 2005.  It is therefore appropriate that regulatory financial reporting requirements be similarly aligned with effect from the application date of this revised standard and that this Standard applies to Friendly Societies. 

With the rescinding of the ASIC class order, it is appropriate, for the purposes of applying the Valuation Standard, for benefits provided in benefit funds where there is a provision for distribution of unallocated surpluses to policy owners to be valued as if they were participating.  Benefits provided under benefit funds where is no provision for distribution of unallocated surpluses to policy owners are to be valued as if they were non-participating. 

Application of the Valuation Standard

The Valuation Standard is made for the purposes of section 114 of the Life Insurance Act 1995.

It applies:

1.    in respect of all life insurance business (including life insurance business carried on outside Australia) of a registered life company (including a life company which is a friendly society); and
2.   in respect of the life insurance business of an eligible foreign life insurance company, other than life insurance business carried on outside Australia; and
3.    to a valuation of the policy liabilities of the company made for the purposes of the Act; and
4.   for all valuations made in respect of periods ending on or after 31 December 2005 in the case of life insurance companies (other than friendly societies) and on or after 31 May 2006 in the case of friendly societies.

Except for paragraph 1.5, it will continue to apply until replaced.  Unless the Valuation Standard is replaced at an earlier date, paragraph 1.5 will cease to apply to valuations made in respect of reporting periods ending on or after 31 December 2009. 

The Standard is written in the context of Australian legislation and bases of taxation.  Appropriate adjustment should be made, for example to allow for different bases of taxation, where this Standard is being applied to overseas business.

PART A – CONTRACT CLASSIFICATION AND POLICY LIABILITIES IN RESPECT OF LIFE INVESTMENT CONTRACTS

For the purposes of this Standard and reporting under the Act, policy liabilities in respect of life investment contracts are to be determined in accordance with the relevant accounting standards, subject to any available options being restricted to the fair value based options.

SECTION 1 Contract Classification and Application

APRA’s Prudential Rule 49 clarifies the basis on which policies written by life insurers are to be classified for the purpose of regulatory financial reporting.  In particular it distinguishes between those policies issued by life companies that meet the definition of a Life Insurance Contract for regulatory reporting purposes and those that do not (referred to as “Life Investment Contracts”). 

Prudential Rule 49 also identifies key components of policies written by life companies and stipulates the circumstances in which such components must be unbundled for regulatory reporting purposes. 

1.1 For the purposes of this standard, an unbundled component of a policy is to be treated as if it were a stand-alone policy.  After allowing for unbundling, Life Insurance Contracts (including contracts with Discretionary Participation Features) and any associated Life Investment Contracts must be dealt with in separate Related Product Groups.

1.2 After allowing for any unbundling, the Policy Liability in respect of a Life Insurance Contract (including a contract with Discretionary Participation Features) must be determined in accordance with the requirements of Parts B and C of this standard. 

1.3 After allowing for any unbundling, the Policy Liability in respect of a Life Investment Contract must be determined in accordance with Section 2 of Part A of this standard. 

1.4 Section 2 of Part A of this standard is not to be used for the purposes of calculating the Solvency Liability under the Solvency Standard or the Capital Adequacy Liability under the Capital Adequacy Standard.  For those purposes, the prospective valuation methodology outlined in Parts B and C of this standard will apply to all elements of the life insurance business issued by the  company, regardless of how it is classified, albeit using assumptions as specified in the Solvency Standard or the Capital Adequacy Standard. 

1.5 Where the Actuary determines, and can demonstrate to the satisfaction of APRA, that the calculation of the Policy Liability in accordance with paragraph 2.1 would reduce the retained profits of the statutory fund to such an extent that it would unreasonably hinder the distribution of surplus assets from that fund, then, for policies that were in force at 31 December 2005, the Policy Liability may, with APRA’s agreement, be determined in accordance with the requirements of Parts B and C of this standard.

1.6 Part D of this standard applies to all of the life insurance business issued by the company for the purposes of the Act.  

SECTION 2 Policy Liabilities in Respect of Life Investment Contracts

Life Investment Contracts consist of at least one Financial Instrument, being the element that gives rise to a financial asset or financial liability.  They may also contain additional elements in respect of management services, embedded derivatives or participation features. 

The net contractual obligations under a Life Investment Contract which arise under the Financial Instrument Element of the contract (and any associated management services that are not unbundled) is referred to as the Life Investment Contract Liability, consistent with the terminology adopted under AASB 1038.

Life Investment Contracts with Discretionary Participation Features that are regulated under the Life Insurance Act 1995, are treated in their entirety as if they were Life Insurance Contracts and so are not subject to this section of the standard.  They may, however, still be subject to certain minimums or disclosures the quantification of which is subject to this section of the standard. 

Embedded derivatives within a Life Investment Contract are financial instruments and must be allowed for within the Financial Instrument Element for the purpose of this Valuation Standard. 

Policy Liability of a Life Investment Contract

2.1 The Policy Liability in respect of a Life Investment Contract is determined as

Policy Liability =   LICL + MSE

where

LICL = the Life Investment Contract Liability, being the liability arising in respect of the Financial Instrument Element

MSE = the net liability (asset) in respect of the Management Services Element. 

Life Investment Contract Liability

2.2 The Life Investment Contract Liability, being the component of the Policy Liability that arises under a Life Investment Contract issued by an Australian life insurance company that relates to the Financial Instrument Element (and any associated management services that are not unbundled), is to be determined in accordance with the fair value through profit and loss provisions of the relevant accounting standards (whether or not the Financial Instrument Element is measured on that basis in the general purpose financial statements). 

Management Services Element

2.3 The Policy Liability that arises under a Life Investment Contract is to include the net amount of all liabilities and assets arising in respect of the Management Services Element of the contract.  These liabilities or assets include, but need not be limited to, the value of Deferred Fee Revenue and Deferred Acquisition Costs. The measurement of these liabilities and assets is to be in accordance with the relevant accounting standards. 

Reinsurance of Life Investment Contracts

2.4 The Policy Liability is determined gross of reinsurance (as defined for the purposes of the Act).  The recognition and measurement of outwards reinsurance that does not involve the transfer of Insurance Risk are to be undertaken separately in accordance with the fair value through profit and loss provisions of the relevant accounting standards (whether or not they are reported on that basis in general purpose financial statements). 

PART B – PRINCIPLES FOR DETERMINING POLICY LIABILITIES IN RESPECT OF LIFE INSURANCE CONTRACTS

SECTION 3 The Principles of the Valuation

Overview

The purpose of this part of the standard in prescribing a set of principles for the valuation of the policy liabilities in respect of life insurance contracts is to achieve the two essential objectives of:

      determining, as at the reporting date, a realistic determination of the policy liabilities of the company in respect of Life Insurance Contracts; and

      providing for the emergence of profit in respect of Life Insurance Contracts as it is earned.

The Best Estimate Liability

The first of these objectives may be met by determining a best estimate value of the liabilities being the value of the expected future contractual payments to policy owners on the basis of best estimates of future income and outgo.

The Profits

The second of these objectives may be met by determining a best estimate value of the expected future profits to emerge under the policies.  The explicit provision for future profits, through Bonuses and/or Profit Margins, is a mechanism to facilitate the release of profit as it is earned through the provision of services and the receipt of the related income.

The sum of the Best Estimate Liability and the value of the expected future profits is called the Policy Liability.

It is not the purpose of this Standard to prescribe a single methodology for the valuation of policy liabilities in respect of Life Insurance Contracts.  The principles of the Standard will normally be achieved by adopting a projection methodology.  However, it is recognised that alternative approaches - such as an accumulation methodology - may in some cases be appropriate in achieving the principles.

3.1 It is the principles which are paramount in determining the Policy Liability; methodology is incidental to the principles.  Projection or accumulation methodologies may be appropriate provided the Actuary can demonstrate that the principles have been met.

3.2 The Policy Liability must provide for both:

1.    a best estimate value of the liability of the company in respect of obligations under Life Insurance Contracts; and
2.   a uniform emergence of profit in respect of Life Insurance Contracts relative to one or more appropriate Profit Carriers.

3.3 While Profit Carriers are an explicit component of the valuation where a projection approach is used, the Profit Carriers are implicit where an accumulation approach is appropriately used.

3.4 The profit emerging in the reporting period must recognise both:

1.    the expected profits  for the period; and
2.   the Experience Profit for the period.

3.5 The valuation method must provide for the emergence of profit when it is earned. The emergence of earned profit must not be deferred; nor must unearned profit be prematurely recognised.

3.6 Profits are earned on the later of:

1.    the provision of a service to the policy owner; and
2.   the receipt (or recognition) of income relating to that service.

3.7 When the valuation results in expected future profits for a Related Product Group that are below the Adequacy Threshold for that product group, the value of the shortfall must be recognised immediately as a loss.

3.8 Subject to circumstances covered by paragraph 3.7, profit for the period must not otherwise be affected by a change in the Best Estimate Assumptions in respect of future periods, except that:

1.    where previously recognised losses exist for a Related Product Group and that change in Best Estimate Assumptions results in expected future profits emerging, the present value of those profits must be released to the extent necessary to offset those previously recognised losses; or

1.   where that change is in the Best Estimate Assumption for the discount rate (and future investment earnings and related economic assumptions, where relevant) due to market changes only, and the benefit has no discretionary entitlement to share in investment experience, the present value of the expected future profits which are generated by the change must be released.

Where the change in Best Estimate Assumptions would result in a release of expected future profits otherwise than as above, the present value of those profits must not be released, but respread to emerge as a uniform proportion of the appropriate Profit Carrier(s).

3.9 In determining the Best Estimate Liability and Best Estimate Assumptions, the Actuary must have regard to the impact on the liability of the distribution of potential future outcomes. Where the benefits being valued contain options that may potentially be exercised against the company, or the potential liability outcomes have an adverse asymmetrical distribution, then the Best Estimate Liability must include an appropriate value in respect of those options and/or asymmetries.

3.10 Approximate methods may be used in determining the Policy Liability of the company where the result so produced is not material or not materially different from that which would result from a full valuation process.  In particular, the special circumstances of Reinsurers are recognised as warranting approximate methods.

SECTION 4 The Valuation of Policy Liabilities

Overview

Benefits for life companies other than friendly societies are either Participating Benefits or Non-Participating Benefits.  Due to the different nature of these benefits, different approaches are required to the valuation of policy liabilities.

Participating Benefits

Where Participating Benefits are provided the policy owner is entitled to share in the profits of the business.

The participation process is managed by the life company, through the declaration of Bonuses.  Company practice, and ultimately the requirements of the Act, control the relationship between policy owner and shareholder entitlements to profits.

The profit for Participating Benefits includes provision for:

      Bonuses (policy owner profits); and

      Shareholder Profits.

Non-Participating Benefits

Where Non-Participating Benefits are provided, profit is entirely the entitlement of the shareholder.

The contractual arrangements in respect of the Non-Participating Benefits may entitle the policy owner to additions to the benefit, at the discretion of the company, reflecting the investment experience of the assets backing the benefit.  While this is not a distribution of profit, the determination of the additions may involve similar management processes to the distribution of bonus for Participating Benefits.  Accordingly, similar valuation methods may be appropriate.

Friendly Society Benefits

Friendly society benefits are neither participating nor non-participating. 

For the purpose of applying the Valuation Standard, benefits provided under benefit funds where there is a provision for distribution of unallocated surpluses to policy owners are to be valued as if they were participating.  Benefits provided under benefit funds where is no provision for distribution of unallocated surpluses to policy owners are to be valued as if they were non-participating. 

4.1 Participating Benefits

4.1.1 In respect of Participating Benefits, profit must include the policy owners’ share of profits.  The valuation of the policy liabilities must, therefore, make allowance for the best estimate at the reporting date of:

1.    the  value of expected future Policy Owner Profit Share; and
2.   the value of expected future Shareholder Profit Share.

4.1.2 Declarations of Bonus are an appropriation of profit for participating business.  Accordingly, current year Best Estimate Bonuses are excluded from the Policy Liability, allowing the emergence of this amount as Operating Profit in the period.

4.1.3 The relationship between the assumed allocation of profit to policy owners and shareholders respectively must, in respect of each future year, be consistent with:

1.    the policy conditions; and
2.   the company’s practice or stated philosophy.

4.2 Non-Participating Benefits

4.2.1 In respect of Non-Participating Benefits, the valuation of policy liabilities must make allowance for the best estimate at the reporting date of the value of expected future Shareholder Profit Share.

4.2.2 Where a Non-Participating Benefit includes an entitlement, at the discretion of the company, to share in the investment experience of the assets backing the benefits, the valuation of the policy liabilities must make allowance for the best estimate at the reporting date of the present value of current year and expected future Discretionary Additions.

Consistency with Asset Values

4.3 Where the basis of asset valuation used for the regulatory financial statements is not consistent with the basis of asset valuation implicit in the valuation of the liabilities, the Actuary must make appropriate adjustments to the Policy Liability.

Reinsurance of Life Insurance Contracts

4.4 The Policy Liability is determined gross of reinsurance (as defined for the purposes of the Act), although the gross Policy Liability may be calculated by first determining the necessary components on a net of reinsurance basis and then adjusting the result by the amounts of the corresponding components of the Reinsured Policy Liability. 

SECTION 5 The Best Estimate Liability

Overview

The Best Estimate Liability is determined as the value of the expected future payments and receipts under the policy, gross of reinsurance, based on obligations at the reporting date.

Note that the benefit obligations projected include all contractual benefits.  In particular, in the case of Participating Benefits they include Bonuses declared prior to (but not on, or after) the date of valuation.

In projecting the expected future cash flows, the Actuary makes assumptions about the expected future experience, taking into account all factors which are considered to be material to the calculation, including:

      investment earnings

      inflation

      taxation

      expenses

      mortality and morbidity

      policy discontinuance.

The Actuary’s assumptions must reflect a best estimate of the likely experience.

5.1 In accordance with the principles of section 3, where the valuation of the policy liabilities involves assumptions as to future experience, the assumptions used must be Best Estimate Assumptions.

5.2 In establishing Best Estimate Assumptions, due regard must be had for the materiality of:

1.    the benefits being considered; and
2.   the effect of particular assumptions on the determined result.

5.3 Valuing Liability Options

5.3.1 The Best Estimate Liability and Best Estimate Assumptions are to have regard to any options or asymmetrical distribution of liability outcomes. 

5.3.2 Where the distribution of potential liability outcomes is equally likely to result in a gain or loss, then it will normally be sufficient to adopt the mean of the assessed distributions of future experience for the Best Estimate Assumptions and calculate the Best Estimate Liability accordingly.

5.3.3 However, the Actuary needs to consider and assess the extent that variations in the assumptions may be correlated, and/or may compound one another, in adverse circumstances. In such cases the Best Estimate Assumptions must be adjusted so that the Best Estimate Liability is representative of the mean of the distribution of the potential liability outcomes.

5.3.4 Where the benefits contain options that may be exercised against the company, then either the value of those options must be determined (via a suitable option pricing  method) and added to the Best Estimate Liability, or the Best Estimate Assumptions adjusted so as to appropriately capture the value of the options as part of the Best Estimate Liability.

5.3.5 The requirements throughout this standard in respect of Best Estimate Assumptions and Best Estimate Liabilities are to be interpreted in this context.

Investment Earnings

5.4 Where the cash flows to be valued depend on future investment earnings, the Best Estimate Assumption for investment earnings must reflect the expected investment earnings applicable to the actual assets on which the cash flows depend.

5.5 The Discount Rate

5.5.1 The gross rate used to discount expected future cash flows must, to the extent the benefits under the policy are contractually linked to the performance of the assets held, reflect the expected investment earnings applicable to the assets backing the benefit being valued.  Otherwise, a Risk Free Discount Rate is to be used. 

5.5.2 This does not preclude the use of discount rates that make allowance for assumptions that are expressed as a percentage of the value of assets, rather than allowing for those assumptions explicitly in the projection.  This practice may apply in respect of certain expenses, taxes or profit margins.

5.6 Taxation

5.6.1 For business where tax is based only on profits, liabilities may be determined gross of tax.  Otherwise, appropriate allowance must be made for the effect of taxation.

5.6.2 Where allowance for tax on investment earnings is required, it must be made in accordance with Best Estimate Assumptions, but based on an asset profile which would be expected to yield a return equal to the discount rate assumption in paragraph 5.5.1.

5.7 Servicing Expenses

5.7.1 The Best Estimate Assumption for Maintenance Expenses must be sufficient to cover the expected maintenance cost of servicing each policy, in respect of in force business, in the year following the reporting date.  The expected maintenance cost of servicing each policy is the expected Maintenance Expenses appropriately adjusted for one-off expenses.

5.7.2  The Best Estimate Assumption for Investment Management Expenses must be sufficient to cover the cost of managing an asset profile which would be expected to yield a return equal to the discount rate assumption in paragraph 5.5.1.

5.7.3 Where Servicing Expense assumptions are expressed in monetary amounts, the assumptions beyond the coming year must be adjusted in line with best estimate inflation assumptions.

Acquisition Expenses

5.8  The Best Estimate Assumption for Acquisition Expenses at Commencement must be the greater of:

1.    Establishment Fees received at Commencement; and
2.   actual Acquisition Expenses incurred, less expenses which the Actuary considers to be ‘one-off’ in nature.

  Both must be consistently adjusted for tax in accordance with paragraph 5.6.

Other Assumptions

5.9 The Best Estimate Assumption in respect of all other assumptions used in the valuation of policy liabilities, must be assumptions about future experience which:

1.    are made using professional judgement, training and experience; and
2.   are made having regard to reasonably available statistics and other information; and
3.    are neither deliberately overstated nor deliberately understated.

SECTION 6 Profit Carriers and Profit Margins

Overview

Policies are written with the expectation of producing profits. Profit Carriers are selected and Profit Margins determined when a policy commences to enable the appropriate emergence of the expected shareholder profit over the term of the benefits. (Policy owner profit emerges through Bonuses.)  This is achieved as follows:

where the Profit Carrier is a financially measurable indicator of either:

      the expected cost of the services provided to the policy owner; or

      the expected income item relating to the services.

The range of services which may be provided to the policy owner, includes:

      insurance of mortality, morbidity (or similar risks)

      generation of investment income

      setting up the policy (selling or acquisition)

      ongoing administration

      investment management

      provision of bonuses

Selection of the profit carrier is critical in determining the magnitude and timing with which profits are released.

6.1 Profit Margins

6.1.1 In accordance with the principles of section 3, the appropriate release of expected future shareholder profits is provided for in valuing the policy liabilities, either explicitly or implicitly, through the incorporation of Profit Margins.

6.1.2 A Profit Margin must be expressed, explicitly or implicitly, as a uniform proportion of one or more appropriate Profit Carrier(s).

6.2 Profit Carriers

6.2.1 The appropriate Profit Carrier(s) must be related to the services provided to policy owners by the company.  The Actuary, in selecting the appropriate Profit Carrier(s), must consider:

1.    the services and income items applicable to the benefit; and
2.   the relative risks of services, or of costs, to the company; and
3.    the relative timing of the provision of the services and the receipt or recognition of income for those services.

6.2.2 Provision of capital to meet Solvency and Capital Adequacy Requirements is not a service for this purpose.

6.2.3 Acquisition is a service for this purpose only when explicit Establishment Fees are received.

6.2.4 The practical implications of selecting multiple profit carriers should be considered relative to the materiality of the results.  Where multiple Profit Carriers are used, for ease of computation it may be desirable to retain a constant Profit Margin for all but one of the Profit Carriers selected, allowing the Profit Margin in respect of that remaining Profit Carrier to be the only variable.

6.2.5 Profit Carrier(s), once chosen, must be used consistently for a Related Product Group unless in the Actuary's judgement the Profit Carrier(s) are no longer appropriate.

6.2.6 Where Profit Carrier(s) are changed this must not result in a release of profit at the date of change.  This is achieved by equating the values of Best Estimate Shareholder Profits before and after the change in determining the new Profit Margins.

SECTION 7 Acquisition Expenses

Overview

A company normally incurs Acquisition Expenses and possibly receives Establishment Fees when it acquires new business.

Where new business is written with the expectation of producing profits, then, if the Establishment Fees are less than the actual Acquisition Expenses, there will be an expectation of receiving future income, part of which goes to meeting the unrecouped Acquisition Expenses.

The principles for the allocation of expenses to Acquisition Expenses are set out in section 13.  Acquisition Expenses are defined in terms of the activities related to the acquiring of new business.  The acquisition of new business can generally be considered to include activities of the company such as product marketing, sales, underwriting and administration, undertaken prior to and at the point of issuing the policy and establishing it in the policy records of the company. 

The new business expected to derive from a particular expense may not necessarily be acquired in the same period in which the expense occurs.  The new business must, however, be expected to arise as a result of that expenditure.  To the extent the expenditure has only a tenuous link with the acquisition of new business - for example, general growth and development expenses – it is not considered to be an acquisition expense.

7.1 To the extent that Acquisition Expenses are not recovered by the Establishment Fees, they must be charged against expected future profits, provided that these profits are sufficient to recover them.  Any Acquisition Expenses which cannot be recovered from Establishment Fees or expected future profit will emerge as a loss at issue.

7.2 Appropriate allowance must be made in this process for tax on both Establishment Fees and Acquisition Expenses.

7.3 Where expected future profits for a Related Product Group are insufficient to recover unrecouped Acquisition Expenses, the loss must be recognised in accordance with the processes of section 11.

7.4 Where a projection approach is used to calculate the Policy Liability, the expected income which is used to recover Acquisition Expenses is incorporated as a reduction in the Best Estimate Liability calculation.  Accordingly, Acquisition Expense Recovery Components are an implicit component of the valuation.  

7.5 Where an accumulation approach is used to calculate the Policy Liability the value of the unrecouped portion of Acquisition Expenses which is to be recovered from future income must be explicitly allowed for as a reduction in the liability by using Acquisition Expense Recovery Component(s).

PART C – METHODOLOGIES FOR DETERMINING POLICY LIABILITIES IN RESPECT OF LIFE INSURANCE CONTRACTS

Overview

If the Best Estimate Assumptions made at Commencement remain valid through the policy term, and if experience under the benefit exactly reflects those expectations, the methodologies should ensure that profit emerges at each reporting date as:

      investment earnings (net of tax) on any retained profits and shareholder capital; plus

      release of the expected profits (net of tax) in respect of the valuation period.

In reality, actual experience in the valuation period will likely differ from that expected, and to this extent there will emerge an experience profit (or loss).

Further, as experience changes, the Best Estimate Assumptions as to the future may change.

The principles of this standard require that the present value of profit resulting from a change in non-economic Best Estimate Assumptions of the Actuary, must not be released immediately at the reporting date, but rather must be released appropriately over the future life of the benefit.

Appropriate profit emergence is achieved through a methodology which involves recalculation at each reporting date of the expected future profit.  Profit Margins and Acquisition Expense Recovery Components are determined as required to ensure the appropriate release of those future profits.

In the case of benefits with an entitlement to share in the investment experience of the assets backing them, the methodology must deal specifically with investment experience profits to allow its release over the future life of the benefit as:

      in the case of Participating Benefits (including friendly society benefits under benefit funds where there is a provision for distribution of unallocated surpluses to policy owners), future Bonuses and Shareholder Profits; or

      in the case of Non-Participating Benefits, future Discretionary Additions.

Note that in this Part, discussions of the detail of the methodologies for calculating policy liabilities will typically be in terms of a benefit.  A policy may incorporate multiple benefits.  Further, certain processes described in this Part may be performed at a Related Product Group level, which incorporates multiple (like) policies.

While recalculation processes described in this Part will normally be considered for a Related Product Group, the Actuary may group benefits at a lower level where this is supported by company practice or stated philosophy and is done consistently over time.

SECTION 8 New Business - Calculation of Profit Margins and Acquisition Expense Recovery Components

8.1 Profit Margins

8.1.1 Where explicit Profit Margins are required, they are determined by dividing:

1.    the value at Commencement of the expected future profits from the benefit;  by
2.   the value at that date of the appropriate Profit Carrier(s).

8.1.2 The value at Commencement of expected future profits must be determined on the basis of Best Estimate Assumptions.

8.1.3 The Best Estimate Assumptions, with the exception of the Acquisition Expense assumption, must be determined as at a single date, but that date may be:

1.    the beginning of the reporting period; or
2.   the date of commencement of the business; or
3.    the end of the reporting period.

8.1.4 The Acquisition Expense assumption will be determined at the end of the reporting period.

8.2 Treatment of Losses

8.2.1 If the projection reveals a value of expected future profit at Commencement for new business in a Related Product Group that is below the Adequacy Threshold, then that loss must either be recognised, or dealt with in accordance with the provisions of paragraph 8.2.2.  Any losses at Commencement so recognised must be accumulated.  If the Related Product Group subsequently generates profits above the Adequacy Threshold, the cumulative losses must be offset (see section 11).

8.2.2 Alternatively, new business may be grouped with existing in force business for the same Related Product Group for the purpose of calculating Profit Margins.  Where new business is so grouped, any losses at Commencement for that new business cannot be accumulated or subsequently offset.

8.2.3 The approach used by the Actuary for treatment of losses on new business must be applied consistently over time.

8.3 Acquisition Expense Recovery Components

8.3.1 Where explicit Acquisition Expense Recovery Components are required, they are determined at Commencement by dividing:

1.    the Best Estimate Assumption for Acquisition Expenses at Commencement (to the extent not recovered by Establishment Fees); by
2.   the present value at that date of the appropriate Acquisition Expense Recovery Carrier(s).

8.3.2 The Acquisition Expense Recovery Carrier(s) must reflect the element of the premium or other income item, including surrender penalties, designed or intended to recover Acquisition Expenses.

8.3.3 Appropriate adjustment to Acquisition Expenses and Acquisition Expense Recovery Components will be needed where Acquisition Expenses are expected to be incurred in a year other than the year of issue.  Any adjustment by the Actuary must have regard to Acquisition Expenses accrued or deferred in the accounts.

SECTION 9 Reporting Date Recalculations - Benefits Providing

no Discretionary Entitlement to Share in the

Investment Experience of Assets Backing them.

Overview

A change in the discount rate (and other related economic assumptions) at the reporting date may occur because of:

      changes in the market conditions; and/or

      other changes (such as a change in the mix of assets backing the benefits that are dependent on investment performance).

The recalculation process described in this section results in the Policy Liability reflecting the effect of changes in discount rates (and other related economic assumptions) due to market conditions only . The effect of other changes in discount rates or other assumptions is spread over the future benefit term, through the recalculation process.

Where the only change in the Best Estimate Assumptions is a change in the discount rates (and other related economic assumptions) due to a change in market conditions, the recalculation process will result in the Profit Margins and Acquisition Expense Recovery Components being unchanged.

9.1 Recalculation of Profit Margins

9.1.1 Where Profit Margins are determined at Commencement, the principles of section 3 require a recalculation of those Profit Margins at each subsequent reporting date to ensure that future expected profits are neither released prematurely nor deferred inappropriately.

9.1.2 The methodology detailed below produces results in accordance with the principles of section 3.  Other methods may be appropriate where the Actuary can demonstrate that the principles have been met.

9.1.3 A recalculation of Profit Margins at the reporting date may be carried out as follows:

1.    derive the  value of expected future profits at the reporting date as:

and

1.   recalculate the Profit Margins as:

Where

Basis 1 uses the Best Estimate Assumptions and Profit Margins at the previous reporting date, except for the discount rate and related economic assumptions - see paragraph 9.2; and

Basis 2 uses the Best Estimate Assumptions at the current reporting date.

9.2 Discount Rate

9.2.1 The discount rate (and related economic assumptions) used for calculations on Basis 1 is determined as that used at the previous reporting date adjusted only to the extent that there have been changes in market conditions.

9.2.2 A consistent approach is to be used in respect of economic assumptions related to the discount rate; for example, the investment earnings and inflation assumptions.  

9.3 Recalculation of Acquisition Expense Recovery Components

9.3.1 Where Acquisition Expense Recovery Components are determined at Commencement the principles of section 3 require a recalculation of those components at each subsequent reporting date to ensure that future expected profits are neither released prematurely nor deferred inappropriately.

9.3.2 The methodology detailed below produces results in accordance with the principles of section 3.  Other methods may be appropriate where the Actuary can demonstrate that the principles have been met.

9.3.3 A recalculation of Acquisition Expense Recovery Components at the reporting date may be carried out as follows:

1.    derive the  value of the expected future acquisition expense recoveries at the reporting date as:

 Acquisition Expense Recovery Components

  multiplied by

 Value of Acquisition Expense Recovery Carrier(s)                               (on Basis 1);

and

1.   recalculate the Acquisition Expense Recovery Components as:

Where

Basis 1 uses the Best Estimate Assumptions at the previous reporting date, except for the discount rate and related economic assumptions - see paragraph 9.2; and

Basis 2 uses the Best Estimate Assumptions at the current reporting date.

SECTION 10 Reporting Date Recalculations - Benefits Providing a Discretionary Entitlement to Share in the Investment Experience of Assets Backing them.

Overview

The recalculation methodology described in this section establishes how the Policy Liability changes and, hence, how profit emerges over the period for discretionary business. The objective of the methodology is to determine Operating Profit in accordance with the framework of the Act.

For a Participating Benefit (including a friendly society benefit under a benefit fund where there is a provision for distribution of unallocated surpluses to policy owners), two important aspects of this framework are;

1.     The allocation of Operating Profit is a distinct process from the distribution of retained profits. It is the value of declared Bonuses and shareholder transfers out of the fund which are distributions of retained profits (inclusive of the Operating Profit allocated in the period)

It is the Operating Profit which is the amount allocated between policy owners retained profits (or unallocated surplus in the case of friendly societies) and shareholders retained profits.

1.     Operating Profit includes shareholder profit and policy owner profit. It comprises:

• the value of current period Best Estimate Bonuses (including best estimate interim and terminal bonuses and the value of best estimate reversionary bonuses) and Best Estimate Shareholder Profits; and
• non-investment Experience Profit.

For Non-Participating Benefits which have an entitlement to discretionary additions, the approaches described in this section may be applied for recalculating Discretionary Additions and Profit Margins.  The section is to be interpreted by substituting “discretionary addition” for “bonus”.  It must be recognised that the “discretionary addition” is not a “bonus”, and consequently the cost of any “discretionary addition” in the current period forms part of the Policy Liability at the reporting date, while the cost of any “bonus” in the current period is an allocation and distribution of current period operating profit and does not form part of the Policy Liability at the reporting date.

It is noted that for Participating Benefits (but not Non-Participating Benefits which have an entitlement to discretionary additions), the recalculation methodology means a change in assumptions (predominantly non-investment assumptions) may affect current year profit, through changes in the rate of Best Estimate Bonus. In these specific circumstances, this result is considered appropriate and in compliance with the intent of the principles of section 3.

10.1 Recalculation of Profit Margins

10.1.1 Where Profit Margins are determined at Commencement, the principles of section 3 require a recalculation of those Profit Margins at each subsequent reporting date to ensure that future expected profits are neither released prematurely nor deferred inappropriately.

10.1.2 The methodology detailed below is deemed to produce results in accordance with the principles of section 3.  Other methods may be appropriate where the Actuary can demonstrate that the principles have been met.

10.1.3 A recalculation of Profit Margins at the reporting date may be carried out as follows:

1.    derive the  value of expected future policy owner and shareholder profits at the reporting date as:

and

1.   recalculate the Profit Margins as:

Where

Value of Supporting Assets is calculated according to paragraph 10.2;

Basis 2 uses the Best Estimate Assumptions at the current reporting date;

Value of current period Bonuses is determined as the cost of Bonus according to paragraph 10.3; and

The relationship between Bonuses and Shareholder Profits must be in accordance with paragraph 4.1.3.

10.2 Value of Supporting Assets

10.2.1 The Value of Supporting Assets is determined as:

1.    the Policy Liability at the end of the previous reporting period;  plus
2.   the cost of declared Bonuses at the end of the previous period;  plus
3.    the actual policy related cash flows and investment experience as reported in the regulatory financial statements; less
4.   the expected Shareholder Profits emerging over the period and the non-investment Experience Profit.

10.2.2 The Value of Supporting Assets must be calculated so as to attribute no value of assets to terminated benefits.

10.3 Cost of Bonus

10.3.1 The cost of Bonus at the reporting date (whether best estimate or declared) must reflect the cash value to the policy owners of those Bonuses at the reporting date.

10.3.2 Where Bonus at the reporting date does not acquire an immediate cash value, but rather value vests in the policy owner over some defined period of time, the Actuary, in determining the cost of Bonus, must allow an appropriate value for that unvested Bonus.

10.3.3 Terminal bonus is included in the calculation of cost of Bonus to the extent it is immediately vested in the policy owner and is guaranteed.

SECTION 11 Loss Recognition

Overview

Where at a reporting date the value of future profits for a Related Product Group falls below the Adequacy Threshold for that Related Product Group, the resulting shortfall is not spread over the benefit term (as are expected future profits above the Adequacy Threshold) but is recognised as an immediate loss at that date.  This is in accordance with the principles of section 3 and is achieved by setting the relevant Profit Margins to an amount such that the value of future profits is equal to the Adequacy Threshold at the reporting date.  This process is carried out for each Related Product Group.

A record of cumulative losses is kept for each Related Product Group.  Before a Related Product Group can have a value of future profits in excess of the Adequacy Threshold, cumulative losses must have been offset.  Once cumulative losses have been eliminated for the Related Product Group it will return to a position of adequate future profits.

11.1 A record of the cumulative amount of losses recognised in accordance with the principles of section 3 must be maintained for each Related Product Group.

11.2 Cumulative losses may be run-off in accordance with the run-off of the business of the relevant Related Product Group.
 

11.3 If at a reporting date it is established, in respect of a Related Product Group which has cumulative losses recorded, that future profits are now expected the present value of that profit must be utilised:

1.    firstly, in offsetting the cumulative losses; and then
2.   to the extent available, in producing Profit Margins in excess of the Adequacy Threshold.

11.4 There must be no release of profit as a consequence of the combining of Related Product Groups.  Where there is grouping of previously separate Related Product Groups, the Policy Liability of the combined Related Product Group must equal the sum of the Policy Liability of the two separate groups immediately prior to the grouping. Cumulative losses that previously existed in respect of the separate groups must be extinguished, except in the case where cumulative losses existed for both separate Related Product Groups.

11.5 The Adequacy Threshold for the Value of Future Best Estimate Bonuses and Shareholder Profits under Related Product Groups in respect of benefits that are contractually linked to the performance of the assets held (i.e.  where a risk free discount rate is not used to discount future expected cash flows) is equal to the difference between:

1.    the Best Estimate Liability on Basis 2 (either in accordance with paragraph 9.1.3 or paragraph 10.1.3, whichever is applicable), but using a risk free discount rate (or rates) based on the current observable, objective rates that relate to the nature, structure and term of the future liability cash flows; and
2.   the Best Estimate Liability on Basis 2.

11.6 For all other Related Product Groups the Adequacy Threshold is zero.

SECTION 12 Reinsurance

12.1 Outwards reinsurance that meets the definition of a Life Insurance Contract is to be measured as if it were a negative liability, even though the measurement result may be recognised as an asset in the company’s financial statements.  For this purpose the Reinsured Policy Liability will therefore consist of both a Reinsured Best Estimate Liability and the Value of Reinsured Profit Margins.  For the purpose of this standard, inwards reinsurance is to be treated the same as direct insurance business.

12.2 The principles of this standard apply to both the calculation of the gross Policy Liability and the Reinsured Policy Liability.  In particular, where future profits are expected to arise in respect of a reinsurance arrangement (looked at from the reinsurer’s perspective) the present value of those future profits is to be included in the Reinsured Policy Liability as Value of Reinsured Profit Margins.  However, where losses are expected, these are to be recognised, except as allowed under paragraph 12.5.

12.3 If the reinsurance relates directly and solely to the direct insurance business of a single Related Product Group then the reinsurance may be included within that same Related Product Group for the purposes of Section 11 of this standard.  If the reinsurance does not relate directly and solely to the direct insurance business of a single Related     Product     Group     then     the     reinsurance   must   be

   appropriately allocated to Related Product Groups for the purposes of Section 11 of this Standard.  That allocation must reflect:

1.    the insurance and financial risks to which the reinsurance relates; and
2.   an appropriate relationship between those risks and the Related Product Groups.

12.4  In undertaking the allocation described in paragraph 12.3 regard must be had for a diligent assessment of:

1.    the purpose of the company in entering the reinsurance; and
2.   the contribution of that reinsurance to the business of the company;

while retaining the integrity of the principles of section 3 of this Standard.

12.5 As a result of the allocation of reinsurance business to Related Product Groups, losses expected in relation to the reinsurance business need only be recognised if they exceed the value of expected future profits in respect of the associated direct insurance business in the Related Product Group, and vice versa.  However, the Profit Margins in respect of the reinsurance must continue to be determined separately from the Profit Margins in relation to the associated direct insurance business. 

PART D – GENERAL REQUIREMENTS FOR ALL FORMS OF POLICY AND ACTUARY’S STATEMENT

SECTION 13 Allocation of Expenses

Overview

Allocation of the expenses of the company is integral to the principles of this standard for the determination of the emergence of profit.  The methodologies of this standard require the expenses of the company to be allocated both into the expense categories (e.g. acquisition, maintenance and investment management) and into related product groups covering both Life Insurance Contracts and Life Investment Contracts.

For those expenses not able to be directly allocated, a process of apportionment between the expense categories and between product groups is necessary.  This section provides a set of principles within which the allocation is undertaken, and against which the mechanics of the apportionment process are assessed.  It is not the objective of this section to be prescriptive either in terms of the mechanics of the apportionment process or in the specifics of the allocation of particular types of expenses.

It is acknowledged that the allocation of certain expenses to expense categories or particular products will require greater judgement than others.  Allocation of such expenses must be based on a considered analysis of the particular circumstances of the company – the objective in incurring that expense and the outcome achieved.  If at the end of this process there remains doubt as to the appropriate expense category, the expense must be allocated to maintenance expenses.

There will be circumstances in which an expense derives from an activity outside the normal business activities of the company and is not recurrent in nature.  It is appropriate to recognise the one-off nature of such expenses in undertaking the allocation for the purposes of this standard.

The principles described in this section are equally applicable to the circumstances of allocation of the actual expenses and the expected expenses of the company.

In respect of Life Investment Contracts, Acquisition Expenses will need to be further split between those that may be deferred in accordance with relevant accounting standards, and those that are to be treated as overheads.  However, for the purposes of the Solvency Standard, the Capital Adequacy Standard and the Management Capital Standard, Acquisition Expenses in respect of Life Investment Contracts as determined by this expense allocation are to include acquisition overheads. 

13.1 Expenses for each Related Product Group are to be allocated to the following Expense Categories:

1.    Acquisition Expenses;
2.   Maintenance Expenses;
3.    Investment Expenses; and
4.   One-Off Expenses.

13.2 Each Expense Category must include all relevant expenses whether direct or indirect and in aggregate the Expense Categories must include the total expenses of the company (including acquisition overheads in respect of Life Investment Contracts) other than one-off expenses determined in accordance with paragraph 13.10.  Total expenses for this purpose are total operating expenses as disclosed in the financial statements.

13.3 Each Related Product Group must include all relevant expenses whether direct or indirect and in aggregate the Related Product Groups must include the total expenses of the company.  It is considered appropriate for this purpose to treat the shareholders’ retained profits and capital as if it were a notional Related Product Group.

13.4 To the extent that an expense is directly attributable to a particular Expense Category or a particular Related Product Group, it must be so allocated.

13.5 It is recognised that there are circumstances where arrangements (internal or external) provide for the limitation of the expenses borne by a particular product group.  Such arrangements, to the extent substantiated as bona fide by the Actuary, may be reflected in the final allocation of expenses provided transparency of the allocation process is retained.

13.6 An expense which is not directly attributable to a particular Expense Category or Related Product Group must be appropriately allocated.   That allocation must reflect:

1.    the Functional Activities to which the expense relates; and
2.   an appropriate relationship between those Functional Activities and both the Expense Categories and the Related Product Groups.

13.7 In undertaking the allocation described in paragraph 13.6 regard must be had for a diligent assessment of:

1.    the purpose of the company in incurring a particular expense; and
2.   the contribution of that expense to the business of the company;

while retaining the integrity of the principles of section 3 of this Standard.

Apportionment Process

13.8 Processes of apportionment will be required, to a greater or lesser extent, in undertaking the allocation of expenses.  These processes must be based on recent analyses of the operations of the life business and the identification of appropriate Expense Drivers and related expense apportionment ratios.

13.9 Service Agreements 

13.9.1 Where activities of the company are being provided externally, through a service agreement or other contractual arrangement, the allocation of the company’s expenses relating to those activities must be reasonably consistent with the principles of this section.  Where the service company fees are unreasonable as a basis for the allocation, the Actuary must determine an alternative allocation applying the principles of this section on a ‘look through’ basis.

13.9.2 The information required to undertake this allocation should be sought from the service provider.  Where practical difficulties arise in accessing the required information other methods, such as reference to appropriate industry benchmarks, may be employed.

13.10 One-Off Expenses

13.10.1 It is appropriate, in the context of expense allocation undertaken for the purposes of this Standard, to recognise one-off expenses.  To achieve such recognition an expense must be, of itself:

1.    material in accordance with the provisions of section 14; and
2.   not incurred as part of the normal ongoing operations of the company; and
3.    not regularly recurring in nature.

13.10.2 One-off expenses, while allocated to Expense Categories for financial reporting purposes, need not be explicitly allocated (to Expense Categories or Related Product Groups) for the purposes of this Standard.

13.11 Friendly Societies

13.11.1 For expense allocation purposes a friendly society is to be regarded as two separate companies, namely:

1.    the Management Fund in isolation; and
2.   the sum of all the Benefit Funds.

SECTION 14 Materiality

Overview

Particular values or components are considered material to the overall result of a calculation when their mis-statement or omission would cause that result to be misleading to the users of the information.

Materiality tests assess the significance of the particular value/component by relating it to the amount of the overall result to which it contributes.

14.1 The Policy Liability determined in accordance with this standard is subject to materiality standards applied at a statutory fund level.

14.2 The base amount for materiality purposes is:

1.    in respect of components of the profit and loss statement, the operating profit; and
2.   in respect of components of the regulatory balance sheet, the difference between the assets of the statutory fund and the sum of the Policy Liabilities and Other Liabilities of that fund.

14.3 While materiality must be applied at the statutory fund level, so that appropriate values are placed on the policy liabilities of each fund, the materiality of the statutory fund relative to the size of the company overall may be taken into account.

14.4 While assessing materiality will always be a matter of professional judgement, the following quantitative thresholds are generally to be used:

1.    variations in amounts of 10% or more of the base amount may be presumed material; and
2.   variations in amounts of 5% or less of the base amount may be presumed immaterial.

SECTION 15 Initial Calculation of Policy Liability

Overview

When Policy Liabilities are first calculated in accordance with the latest version of this Standard, the calculation of Profit Margins and/or Acquisition Expense Recovery Components for in force business should have regard to the history of that business.  Best Estimate Bonuses should be determined consistently.

Alternative approaches may be appropriate, and the choice of approach will be a matter for professional actuarial judgement.  In making that judgement consideration should be given to :

      the available data; and

      the type of benefit; and

      the duration the business has been in force; and

      materiality.

15.1 In first applying the latest version of this Standard to in force Related Product Groups, the Actuary must seek to determine a reasonable estimate of the position, at the beginning of the reporting period, that would have existed had the latest version of this Standard been applied since Commencement.

15.2 Where the valuation of policy liabilities in respect of Life Insurance Contracts, and reporting of profit, has previously been undertaken on a basis consistent with the principles of a then current version of the Valuation Standard it may be appropriate that those previous calculations be acknowledged as satisfying the principles of this section, provided that:

1.    the Value of Future Best Estimate Bonuses and Shareholder Profits that would be determined under this standard exceeds the Adequacy Threshold; and
2.   the result is not considered to be materially different from that which would arise under a strict application of paragraph 15.1.

SECTION 16   Statement Relating to the Valuation

Overview

In order to provide transparency of the company’s financial statements, it is required that full disclosure be made by the Actuary in respect of the processes employed in accordance with this Standard.

Regard must be had for the disclosure requirements prescribed in the standards of the Australian Accounting Standard Board that are relevant to life insurance business (in particular AASB 1038) and the relevant requirements of APRA through Prudential Rules under the Life Act.

Financial Statements

16.1 At each reporting date the Actuary must provide for inclusion in the regulatory financial statements a summary of the significant elements of the calculation processes and significant assumptions used in deriving the results.

Financial Condition Report

16.2 As at each reporting date the Actuary must provide in the investigation report required by section 113 or 115 of the Act, details of the calculation processes and the assumptions used in deriving the results.

(2)  Actuarial Standard 2.04

DECEMBER 2005

Actuarial Standard 2.04

SOLVENCY STANDARD

Life Insurance

Actuarial Standards Board

TABLE OF CONTENTS

          Page

INTRODUCTION

The Standard

Application of the Solvency Standard

PART A – PRINCIPLES

SECTION 1 The Solvency Standard

SECTION 2 Scenarios of Adverse Conditions

SECTION 3 The Liability Risks

SECTION 4 The Prescribed Solvency Assumptions

SECTION 5 Asset Risks

PART B – METHODOLOGIES

SECTION 6 Determination of the Solvency Requirement

SECTION 7 The Solvency Liability

SECTION 8 Minimum Termination Value

SECTION 9 The Expense Reserve

SECTION 10 The Inadmissible Assets Reserve

SECTION 11 The Resilience Reserve

SECTION 12 Transitional Arrangements

SECTION 13 Materiality

PART C – ACTUARY’S STATEMENT

SECTION 14 Statement Relating to the Determination

ATTACHMENT 1 – SOLVENCY ASSUMPTIONS

INTRODUCTION

The Standard

The Solvency Standard is established under the Life Insurance Act 1995 (the Act), and is an integral component of the financial reporting regime for life insurance companies implemented under that Act.

The Act establishes a two tier capital requirement on the statutory funds of the life company with each tier considering the capital requirements in a different set of circumstances.  The first tier is intended to ensure the solvency of the company.  The second tier is intended to secure the financial soundness of the company as a going concern.  It is expected,  in most circumstances, that this second tier will provide an additional buffer of capital above this minimum requirement.  However it will not always transpire that an additional buffer is necessary.

This standard looks at the first tier capital requirement.

The stated purpose of the solvency standard in the Act is:

“to ensure, as far as practicable, that, at any time, the financial position of each statutory fund of a life company is such that the company will be able, out of the assets of the fund, to meet all policy and other liabilities referable to the fund at that time as they become due.”

Therefore, the purpose of the Solvency Standard is to prescribe the minimum capital requirement of a statutory fund to ensure that under a range of adverse circumstances the company would be expected to be in a position to meet (guaranteed) obligations to policy owners and other creditors.

The minimum capital requirement - the Solvency Requirement - will be disclosed in both the regulatory financial statements (in accordance with Prudential Rule 35) and the general purpose financial statements (in accordance with accounting standard AASB 1038 Life Insurance Contracts) of the company and will be used as an indicator of the financial position of the company.

To facilitate comparability across the industry, the standard adopts a primarily prescriptive approach to the determination of the Solvency Requirement.

Application to Friendly Societies

The Act was amended in 1999 to extend its application to friendly societies that undertake life insurance business.  This standard is applicable to all life companies (registered under the Act) including friendly societies.  In its application, the standard will, at times, make distinction between life companies that are friendly societies and other life companies.

Interaction with Management Capital Standard

It is noted that certain risks related to the life business of a friendly society are incurred in the management fund.  Such risks are recognised and provided for in the Management Capital Standard.

Further, life companies other than friendly societies may count an amount of the net assets of the shareholders’ fund in offsetting some aspects of the Solvency Requirements of the statutory funds (refer to section 9 for detail).

Therefore, the Solvency Standard, Capital Adequacy Standard and the Management Capital Standard involve a degree of interaction and should be considered together.

          Application of the Solvency Standard

The Solvency Standard is made for the purposes of section 65 of the Life Insurance Act 1995.

It applies:

1.    in respect of all life insurance business of a registered life company, other than that written in a statutory fund which includes only business written overseas in  one or more Approved Countries; and
2.   in respect of the life insurance business of an eligible foreign life insurance company, other than life insurance business carried on outside Australia; and
3.    at all times from 31 December 2005.

The Standard is written in the context of Australian legislation and bases of taxation.  Appropriate adjustment must be made, for example to allow for different bases of taxation, where this Standard is being applied to overseas business. 

PART A – PRINCIPLES

SECTION 1 The Solvency Standard

Overview

Assets and liabilities of a life company are valued and disclosed in its regulatory financial statements on realistic, going concern, market value consistent bases.

The realistic financial position of the company may be assessed by a comparison of the value of assets and the value of policy and other liabilities so determined.

However, the prudent regulation of the life insurance industry requires that the level of security offered to policy owners exceeds that implied by a realistic basis of calculation.  The Solvency Standard requires that the statutory fund of a life company have available net assets in excess of the realistic value of liabilities to provide for the security of the policy owners’ entitlements under a range of adverse conditions.

The Solvency Requirement is determined by considering the various risks undertaken in the statutory fund which could impact the security of the policy owners’ entitlements, and requiring the provision of a prudent level of reserve against such risks.

These risks, and an assessment of the prudent provision, are considered in the context of a fund closed to new business, and which is either operating in a run-off situation or is to be transferred to another insurer.  The practical ramifications of the fund in this position, including circumstances that arise when it is operating as either "just solvent" or "just insolvent" in terms of this standard, are to be considered.

It is not the intention of the standard to provide absolute security to policy owners.  To attempt to do so would be prohibitive to the viability of the industry and hence not in the best interest of the policy owners.  Rather, the prescribed reserves provide for a range of adverse but reasonably possible conditions.

1.1 At any time, the value of the assets of the statutory fund of a life company must be of an amount considered sufficient to meet the obligations of the company at that date, to policy owners and creditors referable to the fund, under a range of adverse conditions.  The amount of assets so required is referred to as the Solvency Requirement.

1.2 The Actuary, in determining the Solvency Requirement must consider the company’s obligation to policy owners in respect of:

1.    guaranteed benefits under the policy in accordance with the policy document and the law; and
2.   any additional guarantees or obligations implied by the promotional material of the company.

SECTION 2 Scenarios of Adverse Conditions

Overview

In assessing the Solvency Requirement of a statutory fund consideration is given to:

      the risks which may affect the value of the liabilities under policies; and

      the risks which may affect the value of the assets supporting those liabilities.

The Solvency Requirement broadly comprises the following components:

The Solvency Liability

A calculation of the value of the guaranteed liabilities under the policies on the basis of assumptions which are more conservative (anticipate a more adverse experience) than best estimate assumptions.

The Other Liabilities

The value of the liabilities of the statutory fund to other creditors, but excluding approved subordinated debt arrangements and amended as required to satisfy the principles of this Standard.  In particular, where such other liabilities relate to future cash flows that are uncertain, then their assessment is to be based on assumptions that are more conservative than best estimate, as per the Solvency Liability.

The Expense Reserve

Provision for the overrun of expenses that may occur where a statutory fund that is forced to operate as a closed fund incurs delays in implementing any significant change to the expense structure of the business.  This risk is not otherwise anticipated in the Solvency Liability determination.

The Inadmissible Assets Reserve

A reserve against the risks associated with:

      assets, the value of which is dependent on the ongoing conduct of business;

      holdings in associated or subsidiary Financial Services entities; and

      concentrated asset exposures.

The Resilience Reserve

Mismatching of asset and liability exposures necessitates the provision of a reserve for adverse movements in the asset values to the extent they will not be matched by a corresponding movement in the liabilities.

When determining the impact of the various risks and adverse conditions on the financial position on the fund, it is required to assess their impact consistently on all assets and liabilities affected. This includes both beneficial and adverse combined effects.

2.1 The Solvency Requirement must provide for a value of the liabilities of the statutory fund in respect of obligations to policy owners and creditors, on a basis that is more conservative than best estimate and that considers scenarios of adverse experience.

2.2 In adopting a basis more conservative than best estimate and the associated scenarios of adverse experience, the Actuary must consider the ability of the fund to be closed to new business and for its obligations to policy owners and creditors to be met as they fall due with a high level of confidence.  The prescribed requirements set out within this Standard are designed to allow the obligations of the fund to be reliably met under circumstances where a judicial manager would most expeditiously seek for them to be secured.  The Actuary should regard that as being achieved by a transfer of all of the assets and liabilities of the fund to a third party who would then be responsible for meeting the obligations as they fall due, out of the transferred assets.  If the Actuary considers that the circumstances of the fund are such that the obligations under the fund are more likely to be secured by some other means, then the Actuary may need to establish additional reserves for any additional risks or costs that might be incurred under that scenario and that are not otherwise reflected in the prescribed requirements of this Standard.

2.3 In determining the Solvency Requirement the Actuary must allow for the consequences of closing the statutory fund to new business and subsequently meeting the obligations of the fund in the context of the circumstances assumed under paragraph 2.2.  This may include an increase in voluntary discontinuances, a loss of contribution to expenses, a loss of future tax deductions and a change in the value of tax assets and tax liabilities, a loss of value of business related assets and any adverse impacts under reinsurance or other contracts. This must include the potential impact on the obligations and assets in circumstances where the value of fund assets is less than the Solvency Requirement under this standard.

2.4 The Solvency Requirement is, in principle, to be based on the net realisable market values of the assets and other liabilities of the statutory funds, including allowance for realisation costs and, if considered appropriate under the relevant adverse scenarios, discounting of all future cash flows.

2.5 In considering scenarios of adverse experience and adopting a basis for the Solvency Requirement, the Actuary must allow for all material risks associated with both the liabilities and the assets of the fund, including the interdependencies between these risks that the Actuary considers might apply under such adverse conditions. This is regardless of whether such risks are discussed in the rest of this Standard or not.

2.6 Where the particular combination of risks affecting a company is not explicitly considered within this Standard, the Actuary must establish additional amounts within the Solvency Requirement, beyond the amounts prescribed. The additional reserve must reflect the purpose and principles of the Standard. It must provide a level of reserving that is consistent with that applying under this Standard in respect of the risks explicitly considered under this Standard. For this purpose, the Actuary may regard the prescribed requirements set out within this Standard, when applied to a typical life company with the combination of risks explicitly considered in this Standard, as designed to provide a level of reserves which broadly meets the following requirements:

1.    Able to cover a combination of adverse circumstances that would be expected to arise once every 200 years;
2.   Allowing a general time frame of 12 months in which the circumstances arise and the actions under (c) and (d) below follow;
3.    The reserve required at the end of the period in (b) is able to be determined in accordance with the Solvency Requirement of this Standard, but allowing for the implementation of plausible risk reduction actions by management at, or after, that time (for example, raising premium rates, exiting risky asset positions or other arrangements as would be permitted).  This includes allowance for discretions in line with paragraph 3.2. For those risks that cannot be eliminated, sufficient reserve will still be required as set out in this Standard; and
4.   Allowance for management corrective action during the period in (b) is considered to be limited to highly reliable actions only, with conservative response time allowances.

2.7 The criteria of paragraph 2.6 are to be applied allowing for the benefit of any diversification across all risks affecting the company.  For the purposes of paragraph 2.6, those risks requiring additional resilience reserves to be established under section 11.10 using the principles of paragraph 5.2.5 are considered to be adequately addressed by those additional reserves. 

2.8 The guideline in paragraph 2.6 is intended as a guide when allowing for risks that are not explicitly dealt with under the prescribed basis in this Standard. It is not intended as an alternative basis for issues that are otherwise and adequately dealt with in the prescribed basis.  For the avoidance of doubt, the Solvency Requirement must not be less than that calculated using the basis prescribed in the rest of the Standard, but may be more where there are material risks that are not explicitly dealt with under the prescribed basis.

2.9 In considering scenarios of adverse experience and adopting a basis for the Solvency Requirement, the use of discretions and of policy owner retained profits that are assumed by the Actuary must be appropriate, justifiable and equitable.

2.10 It is the principles that are paramount in determining the Solvency Requirement; methodology is incidental to the principles. However, this does not override the requirement of paragraph 2.8 that the Solvency Requirement must not be less than that calculated using the prescribed basis.

SECTION 3 The Liability Risks

Overview

The risks associated with the liabilities under policies are discussed in this section.

The risks pertaining to each element of the solvency liability include the risk of mis-estimation of the mean, the risk of deterioration of the assumed mean, the risk of adverse statistical fluctuations about the mean and the risk of unexpected changes in the underlying distribution of experience.

Available discretions in policies may mitigate the effects of some of the liability risks for the company.  Discretions typically fall into one of the following categories:

• reductions in Bonuses or Discretionary Additions;
• increases to expense charges where the maximum level is linked to an inflation index;
• one-off increase to expense charges, subject to the contractual maximum; and
• increases to premium rates, either in line with insurance claims experience or at the company’s discretion (including rider premiums on contemporary products).

Equally, some assets, such as reinsurance, may react in response, favourably or unfavourably, to changes in the liabilities. These effects are to be taken into account.

3.1 The Solvency Liability

3.1.1 The Solvency Liability must make provision for the risks pertaining to each element in respect of which an assumption is required in valuing the policy liabilities.

3.1.2 The minimum assumptions to reflect these risks - the Solvency Assumptions - are prescribed (see Section 4).  The Solvency Liability for a Related Product Group must not be less than the respective Best Estimate Liability.

3.1.3 Where the benefits under the policy are dependent on the performance of the underlying net assets and related liabilities, the Solvency Liability must, in principle, be aligned with the net realisable market value of those assets and related liabilities.

3.2 Allowance for Discretions

3.2.1 In assessing the amount of the Solvency Liability the Actuary must only assume the application of discretions available under policies where the application is considered appropriate, justified and equitable:

1.    under the adverse conditions being assumed; and
2.   having regard to the principles in paragraph 1.2.

3.2.2 The extent and timing of the assumed application of discretions must be consistent with normal company practice in the circumstances of the adverse scenario being considered. 

3.2.3 In applying the provisions of this section to friendly societies, discretions must be taken to be those discretions explicitly provided for in the existing rules of the benefit fund and not the broader discretions that may be accessed through a process of amending those rules. Any representations made in the relevant product disclosure documents must also be taken into account in determining the level of discretion to be applied.

3.3 Other Liabilities

3.3.1 Where the other liabilities of the statutory fund (other than a deficit in respect of a defined benefit superannuation fund to which the entity, or an associated entity, is an employer sponsor) are determined based on estimates of future cash flows, these must be reassessed and discounted to the valuation date, on a basis consistent with the overall scenario of adverse experience being considered (per Section 2 and as reflected in the Solvency Liability).

3.3.2 Where the entity, or an associated entity, is an employer sponsor of a defined benefit superannuation fund and the other liabilities of the statutory fund include a deficit in respect of that fund, and the deficit has been determined using the corridor approach as defined under accounting standard AASB 119 Employee Benefits, the deficit is to be reduced (increased) by the amount of any Unrecognised Actuarial Gains (losses).

3.4 Expense Reserve

3.4.1 The Solvency Requirement must provide for a reserve against the risk of an overrun in the Acquisition Expenses of the statutory fund.

3.5 Termination Value Minimums

3.5.1 The Solvency Requirement must provide that:

1.    for a Related Product Group, a minimum value is held in respect of the Solvency Liability equal to the total Minimum Termination Value for all policies in the group; and
2.   for the statutory fund, a minimum value is held in respect of all liability risks equal to the total Current Termination Value for all policies in the fund.

3.5.2 It is not appropriate to assume application of discretions in respect of Current Termination Values in the processes for assessing liability risks.

3.6 Reinsurance

3.6.1 In order for the credit and inadmissible asset risks involved with reinsurance arrangements to be properly identified and assessed, the requirements of this Standard are to apply on a gross of reinsurance basis, with the gross liability requirements and any related reinsurance values separately quantified. That is, the solvency liability and the impact of the risks, adverse scenarios and termination value minimums are to be assessed on a gross of reinsurance basis.

3.6.2 Any reinsurance arrangements are to be valued and assessed on a basis consistent with their associated gross liabilities under the scenario or test being considered. For example, if the related gross liability requirement is assessed under a termination value scenario, a similar approach is to be taken with the reinsurance. 

3.6.3 Where a reinsurance arrangement gives rises to an asset of the fund in the context of the scenario or test applicable, the value of the arrangement is to be treated as an asset of the fund within this Standard. The credit that can be taken for that reinsurance asset is then subject to the asset inadmissibility rules of this Standard (see paragraph 5.1.6).

3.6.4 A corresponding treatment is to apply in the context of other similar risk mitigating arrangements and contracts, that while not legally reinsurance, have similar effects.

SECTION 4 The Prescribed Solvency Assumptions

Investment Earnings & Liability Discount Rates

4.1 For both policies that are Life Insurance Contracts and policies that are Life Investment Contracts, the Solvency Assumption for gross investment yield and liability discount rate will be as determined in paragraph 5.5.1 of the Valuation Standard, but subject to a maximum rate of the Mid Swap Rate.

4.2 Servicing Expenses

4.2.1 In the case of a friendly society, the margin to be included in the Solvency Assumption for Servicing Expenses is Nil: the servicing expense risk is borne, and hence provided for, in the management fund.  (Refer to the Management Capital Standard.)

4.2.2 For all other companies, the Solvency Assumption for Maintenance Expenses must include a margin of 2.5% above the greater of the unit costs required to cover:

1.    the actual maintenance cost of servicing each policy in the twelve months prior to the valuation date; and
2.   the expected maintenance cost of servicing each policy in the twelve months subsequent to the valuation date.

4.2.3 The Solvency Assumption for Investment Management Expenses must be based on an asset profile which under the adverse circumstances of the Solvency Liability would be expected to yield a return equal to the Solvency Assumption for gross investment yield referred to in paragraph 4.1. The Solvency Assumption must also include a margin of 2.5% above this base requirement.  However, if the life company has contractually agreed to pay a higher Investment Management Expense regardless of the asset profile adopted, then this higher expense must be assumed.

4.2.4 The risk margin for Servicing Expenses must not be applied to any component of those expenses which is contractually agreed for the life of the policy, for example, renewal commission.

4.2.5 When determining Servicing Expenses for each policy, the allocation of the total expenses of the company must be undertaken in accordance with the principles established in section 13 of the Valuation Standard.

4.2.6 In particular, where a service agreement or other contractual arrangement exists, the Actuary must assess the adequacy of the expenses thereunder in reflecting the long term, sustainable costs (both quantum and allocation) of operating the business and adjust the Solvency Assumption accordingly. (Refer to paragraph 13.9.1 of the Valuation Standard).

4.2.7 Where the entity, or associated entity, is the employer sponsor of a defined benefit superannuation fund, and a surplus exists in the fund which is being utilised to reduce contributions to the fund, consideration needs to be given, when determining the expected servicing costs, to the extent to which that contribution reduction would continue in the context of the scenario being considered.

Inflation Rate

4.3 The Solvency Assumption for inflation must be that rate of inflation implied by the difference, at the valuation date, between the yield on National Government Guaranteed Securities and the real yield on an equivalent indexed bond (for a term consistent with that of the liability cash flows).  This assumption is to be applied to all future cash flows that are subject to inflation, including Maintenance Expenses (as applicable).

4.4 Taxation

4.4.1 Allowance for tax on investment earnings must be made in accordance with Best Estimate Assumptions, but based on an asset profile which under the adverse circumstances of the Solvency Liability would be expected to yield a return equal to the Solvency Assumption for gross investment yield referred to in paragraph 4.1 above.

4.4.2 The allowance for tax on other than investment items must be made in accordance with Best Estimate Assumptions.

4.5 Insurance Claims

4.5.1 The Solvency Assumptions for probabilities of death, disablement and other contingent events on which the payment of insurance claims are to be based, are shown in Attachment 1.

4.5.2 Appropriate assumptions must be applied, on a basis considered consistent with the assumptions in Attachment 1, in respect of claims which have been incurred but not reported (IBNRs) and claims which have been reported but not admitted (RBNAs).

4.5.3 Margins for Specialised Risks

The Actuary is to make appropriate specific allowance for material specialised risks.

4.6 Voluntary Discontinuances

4.6.1 The Solvency Assumption for the rate of voluntary discontinuances (including partial surrender) for a Related Product Group must reflect an adverse change in experience of 25% of the Best Estimate Assumption.

4.6.2 The Solvency Assumption for rates of premium dormancy and conversion of policies to paid up status must reflect an adverse change in experience of 25% of the Best Estimate Assumption.

4.7 Options Provided To Policy Owners

4.7.1 The Solvency Assumption in relation to experience after the exercise of an option must allow for appropriate risk margins applied to Best Estimate Assumptions.

4.7.2 The Solvency Assumption for the take up rate of the option must reflect an adverse change of 10% of the Best Estimate Assumption.

Education Bond Business

4.8 If the rate of take up of scholarships under Education Bond Business affects total scholarship payments, then the Solvency Assumption for the rate of take up of scholarships must reflect an adverse change of 10% of the Best Estimate Assumption.

4.9 Investment-Linked Policies

4.9.1 A risk margin must be included to reflect the additional risks that may be borne by the company in conducting investment-linked business.  Subject to paragraph 4.9.5, the prescribed margin is 0.25%.

4.9.2 The prescribed margin must be applied to the Solvency Liability as determined immediately prior to the inclusion of this margin.

4.9.3 The prescribed margin must also be applied to the Minimum Termination Value as determined immediately prior to the inclusion of this margin.

4.9.4 The prescribed margin must not be applied to the Current Termination Value in paragraph 6.1(e).

4.9.5 In the case of a friendly society, the prescribed margin for investment-linked business is Nil: the risk is borne, and hence provided for, in the management fund.  (Refer to the Management Capital Standard.)

SECTION 5 Asset Risks

Overview

The risks associated with the assets supporting the liabilities are discussed below.

Adverse Market Movements

To the extent that the value of liabilities is not directly linked to the value of the underlying assets, an adverse movement in the value of the assets effectively reduces the level of reserves supporting the liabilities.  It is prudent that a company recognise this risk and hold sufficient reserves such that the obligations to policy owners and creditors would still be able to be met following an adverse market movement.

The risk of adverse market movements is one of many potentially offsetting risks.  It is presumed that, for the asset and liability profile of a typical life insurer, a Resilience Reserve set at the level of sufficiency described in section 5.2 will, with additional reserves determined independently in respect of other risks, produce an overall Solvency Requirement at the level of sufficiency described in paragraph 2.6.

Asset Liquidation

Certain assets are disclosed in the regulatory financial statements at a value which may be dependent on the ongoing operation of the business.  On the cessation of business, the value of those assets would likely be less.  A reserve is required against that part of the value of such assets which would not be realisable in the adverse circumstance of a wind-down or transfer of business.

Holdings in Associated and Subsidiary Financial Services Entities

Associated and subsidiary Financial Services entities may be exposed to essentially the same environmental and systemic risks as the life insurer. The value of such an entity in excess of its net tangible assets cannot therefore be relied upon to meet the capital requirements of the life insurance company under adverse circumstances. Furthermore, the value taken for such a holding is not to double count any legislated capital requirement of the entity itself.

Asset Concentration

Diversification is an important principle of prudent investment.  To the extent the asset exposure of a statutory fund is excessively concentrated in a particular asset, or with a particular obligor, a reserve is required against the part of the value of that exposure considered by the Actuary to be excessive.

Credit Risks

In general, it is considered that the combined effect of adopting the net market value of the assets and the reserves for asset concentration would address the average costs of default and marketability/liquidity risks.

Where a fund has significant exposure to non-sovereign credit risks the Actuary is to provide an appropriate reserve allowance for such credit risks, along with any other asset risks.

Liquidity Risks

The Actuary’s general responsibility in assessing and advising management on the financial operations of the company would include consideration of liquidity risks.

Overall Asset Risks

Notwithstanding the prescribed limits of this Standard, the Actuary must have regard to the particular circumstances of the company.  If in the opinion of the Actuary the overall portfolio of assets of the statutory fund has too little diversification, is too illiquid or has too great an exposure to one obligor of low credit standing, the Actuary must increase the reserves appropriately.

Furthermore, the asset and other liability values disclosed in the regulatory financial statements may not be equal to the net market values of those assets and other liabilities, allowing for realisation costs. A reserve for the difference between the reported and net realisable market values of the assets and other liabilities is to be included. However, no reserve is needed in respect of those assets backing liabilities which are directly linked to the net value of the assets and other liabilities as reported in the regulatory financial statements and where the liabilities would correspondingly change if the reported net values were changed.

Note:

It is not the intention of these reserves to limit the investment practices of life companies.  Rather it is to ensure that the risks associated with particular investment strategies are appropriately assessed and provided for.

5.1 Reserve for Inadmissible Assets

5.1.1 The Solvency Requirement must provide a reserve - the Inadmissible Assets Reserve - in respect of:

1.    an asset which has a value that is dependent upon the continuation of the business;
2.   holdings in an associated or subsidiary entity which is a Financial Services entity;
3.    non-realisable (in the context of the solvency tests) intangible assets;
4.   the risks arising from asset concentration;
5.    reinsurance assets which may not be fully recoverable in the context of the solvency tests; and
6.     alignment necessary to ensure assets and other liabilities are based on net market value .

5.1.2 Assets Used for the Conduct of Business

The Inadmissible Assets Reserve must provide for the risk that, in the context of the run-off of the business of a statutory fund closed to new business, the value of the asset differs from the value disclosed in the regulatory financial statements.

5.1.3 Holdings in Associated and Subsidiary Entities which are Financial Services Entities

Where the associated or subsidiary entity is a Financial Services entity the Actuary must establish a reserve to the extent that the value of the entity exceeds its net tangible assets.

Furthermore, where the associated or subsidiary entity is subject to prudential regulation which requires the maintenance of minimum capital, (e.g. a financial institution or a health insurance institution), the Actuary must establish a further reserve to the extent that the net tangible assets of the entity are required to meet that capital requirement and are not, therefore, available to support the life insurance company.

5.1.4 Non-Realisable Intangible Assets

The Solvency Requirement must provide a reserve equal to the value of any intangible assets held that are related to the business of the statutory fund itself and are not independently realisable, for example deferred acquisition costs assets.

5.1.5 Asset Concentration Risks

The Solvency Requirement must provide a reserve against the adverse impact of a concentration of funds in a particular asset, with a particular obligor or with related parties.

5.1.6 Allowance for Reinsurance

To the extent that a reinsurance arrangement represents an asset of the statutory fund under the scenario of adverse experience being considered, then it is to be treated as such and is to be subject to the asset inadmissibility and resilience reserve rules of the Standard. In applying the asset concentration limits of the Standard:

a) All exposures to a reinsurer or reinsurance group are to be considered a single counterparty exposure (within the practical context of the application of the limits concerned); and

b) Where arrangements with a reinsurer involve both liability and asset components, these may be taken as a single net exposure to the extent they are subject to a legally enforceable right of off-set.

5.1.7 Alignment to Net Market Value

The Inadmissible Assets Reserve must, in principle, include the net difference between the value disclosed in the regulatory financial statements and the net realisable market value of all assets and financial liabilities (other than policy liabilities) of the statutory fund.

5.2 Resilience Reserve

5.2.1 The Actuary must assess the resilience of the statutory fund and provide for an appropriate reserve - the Resilience Reserve.

5.2.2 Resilience is assessed as the ability of the statutory fund to sustain shocks to the economic environment in which it operates and which are likely to result in an adverse movement in the value of the assets relative to the value of the liabilities.

5.2.3 In determining the value of the liabilities in the post shock environment the Actuary must only assume the application of discretions available under policies where the application is considered appropriate, justified and equitable:

1.    under the adverse conditions being assumed; and
2.   having regard to the principles in paragraph 1.2.

5.2.4 It is considered appropriate, for this purpose, for the Actuary to assume the full application of discretions available in respect of the Termination Value under the policies.

5.2.5 The Resilience Reserve as determined under the prescribed rules of Section 11 is based on the impact of market changes on the position of a statutory fund with a simple asset and liability profile.  Where the fund is materially exposed to changes in investment market conditions that are not captured by the application of the prescribed rules, a corresponding additional provision must be made by the Actuary. The additional reserve must reflect the purpose and principles of the Standard. It must provide a level of reserving that is consistent with that applying under this Standard in respect of the changes in investment market conditions explicitly considered under this Standard. For this purpose, the Actuary may regard the prescribed requirements set out within this Standard, when applied to the asset and liability profile of a typical life office, as designed to provide a level of reserves which broadly meets the following requirements:

1.    Able to cover adverse changes in investment market conditions that would be expected to arise once every 20 years;
2.   Allowing a general time frame of 12 months in which the circumstances arise and the actions under (c) and (d) below follow;
3.    The reserve required at the end of the period in (b) is able to be determined assuming that a matched asset and liability profile is achieved and that the Solvency Requirement of this Standard is otherwise satisfied at, or after, that time.  This includes making allowance for discretions in line with paragraph 3.2; and
4.   Allowance for management corrective action to achieve a matched asset and liability profile during the period in (b) is considered to be limited to highly reliable actions only, with conservative response time allowances.

5.3 Asset Exposure

5.3.1 The Actuary in assessing the asset risks:

1.    must take account of the effective exposure of the fund to various asset classes, regardless of the physical asset holdings of the fund; and
2.   must consider exposure to counterparty risks including, but not limited to, futures and options, swaps, hedges, warrants, forward rate and repurchase agreements; and
3.    must take account of the underlying exposure of the fund to assets by adopting a “look through” approach in respect of each unlisted or controlled investment entity that represents more than 1% in value of the statutory fund.  For this purpose, an investment entity is an entity whose assets are solely investments, where the sole purpose of the entity is investment activities and where the investor investing in that entity has security directly linked to those assets; and
4.   must, where investments covered by (c) are geared,  treat the debt as if it were a liability of the life insurance company, with appropriate allowance made for the sensitivity of the underlying assets and liabilities to market movements; and
5.    may adopt the ‘look through’ approach as set out in paragraphs (c) and (d) above where the investment is in a listed unit trust. Alternatively, the Actuary is required to treat the holding as a single investment in the equity investment class as defined in the General Standard; and 
6.     must assess the characteristics of the remaining admissible component of an investment where, following application of Section 10 of this Solvency Standard, only part of the investment is admissible, by looking through to the underlying assets and liabilities where necessary and applying the Resilience Reserve requirements of Section 11 accordingly.

5.3.2 As indicated in paragraph 5.2.5, the Resilience Reserve calculation assumes largely generic asset structures.  Where the Actuary can demonstrate that an asset can be disaggregated into two or more identifiable sub-assets, the Actuary may treat the sub-assets separately and hence categorise them into different asset sectors according to their substance for the purpose of applying the Resilience Reserve requirements in Section 11, provided that it is demonstrated to APRA’s satisfaction that:

1.    The substance of the sub-assets warrants their proposed asset sector categorisation;
2.   The entire cash flows of the overall asset are fully reflected by the aggregated sub-assets;
3.    The resilience parameters adopted appropriately reflect the substance of the sub-assets;
4.   Where the sub-asset is equivalent in nature to an interest bearing security it is appropriately credit risk rated;
5.    The resilience shocks applied to the sub-assets do not give a result in aggregate less than the prescribed shock for the overall asset under a scenario where all yields rise;
6.     The diversification factor is not reduced (i.e. the diversification factor is to be calculated assuming that the asset is not disaggregated);
7.    The requirements of paragraphs 5.2.5 and 5.3.1 continue to be satisfied; and
8.   The overall asset continues to be treated as a single counterparty exposure for the purposes of Section 10.

PART B – METHODOLOGIES

SECTION 6 Determination of the Solvency Requirement

6.1 The Solvency Requirement for a statutory fund is to be calculated as follows:

6.2 Where the Actuary is satisfied that the total Solvency Liability for a Related Product Group will be less than the total Minimum Termination Value, no calculation in part (a) of paragraph 6.1 is required.

6.3 Where the Actuary is satisfied that the total Minimum Termination Value for a Related Product Group will be less than the total Solvency Liability, no calculation in part (b) of paragraph 6.1 is required.

6.4 Although reinsurance arrangements or other similar risk mitigation arrangements (per paragraph 3.6.4) that represent an asset of the fund under the scenario or test being considered are to be assessed as a asset under this Standard (per paragraph 3.6), to the extent the value of such an arrangement under this Standard differs from its value reflected in the financial statements of the fund, the difference is to be included as an offset or addition as appropriate within paragraphs 6.1(a), (b), (c) and (e) above. The inclusion of part or all of such a reinsurance asset within these calculation steps above does not negate its consideration for inadmissibility reserving (per paragraph 10.5).

6.5 Allowance must be made by the Actuary in each of the steps in the above calculation process, as appropriate, for claims which have been incurred but not reported (IBNRs) and claims which have been reported but not admitted (RBNAs).

6.6 The performance of each subsequent step in the calculation process described in paragraph 6.1 must not reduce the progressive result from its amount at the completion of the previous step, with the exception of step 6.1(g), in circumstances where the Reserve for Inadmissible Assets is negative as a result of the alignment to Net Market Value under paragraph 10.6, and step 6.1(i).

6.7 The overall solvency calculation methodology involves systematically considering the values and risks underlying the reported values set out in the regulatory financial statements and assessing appropriate reserving adjustments or margins for each. The methodology requires that all such reserving adjustments are allowed for by means of increases to the Solvency Requirement rather than decreases in the value of the assets against which the Solvency Requirement is compared.

SECTION 7 The Solvency Liability

7.1 For both policies that are Life Insurance Contracts and policies that are Life Investment Contracts the Solvency Liability is determined by using the methods used to determine the Best Estimate Liability, as prescribed in section 5 of the Valuation Standard, but:

1.    allowing for current and future Bonuses subject to the appropriate application of discretions; and
2.   adopting prescribed Solvency Assumptions.

7.2 Where the benefits under the policy are dependent on the performance of the underlying net assets and related liabilities, the Solvency Liability (before application of Termination Value minima) must be aligned with the net realisable market value of those assets and related liabilities. However, to the extent that the Solvency Liability adopted for this Standard in respect of that policy is based on asset values disclosed in the regulatory financial statements and would correspondingly change in value if such net realisable asset or related liability values were adopted for the financial statements, then this adjustment may be ignored in respect of that policy, along with the equivalent adjustment under paragraph 10.6.

SECTION 8 Minimum Termination Value

8.1 The Minimum Termination Value must be determined at the reporting date as the greater of:

1.    the lowest Termination Value that the company is obliged to pay; and
2.   the amount calculated in accordance with the Surrender Value Standard.

8.2 For the purposes of the calculation in paragraph 6.1(b) the Minimum Termination Value, in respect of investment-linked business, must include the prescribed margin to reflect the additional risks for this business, as specified in paragraph 4.9.

8.3 Determination of the Termination Value

8.3.1 Where the Termination Value is determined as the amount paid on voluntary termination, the Actuary, in determining the lowest termination value, must have regard for:

1.    any contractual guarantees or obligations, implied by promotional material, to the policy owner; and
2.   legislated minimum surrender value payments required by the Act.

8.3.2 If the company’s obligation under the policy involves:

1.    deferred payment of the termination value;
2.   payments by instalment over a period; or
3.    payment in the form of an income stream;

then the Termination Value must be determined as the present value of those future payments, using assumptions consistent with this Standard. Tax relief on payments may be taken into account if available under the relevant scenario and if the corresponding calculation of the best estimate liability is based on valuing net of tax payments.

8.3.3 If there is an unsettled lump sum insurance claim on a policy, the best estimate of the amount potentially payable, taking appropriate account of claims settlement costs is to be counted as the Termination Value.

8.3.4 Where appropriate, the determination of the Termination Value at the reporting date is to include allowance for Bonuses declared as at that date.

8.3.5 For the purposes of calculating the Termination Value at the reporting date, no allowance is to be taken for any additional tax relief that may arise because of an assumed termination of the policy and/or payment of the difference between the Termination Value and the policy liability.

8.3.6 For investment linked business, the unit price published or promulgated on the reporting date is to be used in determining Current Termination Value.

SECTION 9 The Expense Reserve

9.1 In the case of a friendly society, the Expense Reserve is Nil: the risks related to expense overrun are borne, and hence provided for, in the management fund. (Refer to the Management Capital Standard.)

9.2 For other life companies, the Expense Reserve is determined as:

9.3 The multiple ‘M’ is the net of tax multiple based on a gross multiple of 1 adjusted for the tax deductibility of expenses only to the extent that a tax deduction would reasonably be expected to be realised on ceasing new business.

9.4 Fixed acquisition expenses, for this purpose, are to be determined as the total actual Acquisition Expenses for the statutory fund for the 12 months prior to the valuation date less the variable expenses included in that amount.

9.5 Variable expenses, for the purposes of paragraph 9.4, are to be determined as those expenses otherwise included in fixed acquisition expenses to the extent it can be demonstrated that the expenses are not contracted, are abnormal, are easily eliminated or are sufficiently matched to income. Examples of variable expenses may include commission, advertising costs and direct marketing expenses.

9.6 Offset Statutory Capital applies in the case of a life company which is neither a friendly society nor an eligible foreign life insurance company. It is the amount of Statutory Capital which is appropriately utilised in meeting the expense reserve requirements of the statutory fund.

9.7 The Expense Reserve must not be less than zero.

SECTION 10 The Inadmissible Assets Reserve

10.1 The Inadmissible Assets Reserve for the statutory fund is determined as the sum of:

1.    the reserve prescribed in respect of assets used in the conduct of business;
2.   the reserve prescribed in respect of holdings in associated and subsidiary entities which are Financial Services entities;
3.    non-realisable (in the context of the solvency tests) intangible assets;
4.   the reserve prescribed in respect of asset concentration risks and reinsurance asset recoverability; and
5.    the alignment necessary to ensure assets and other liabilities are based on net market value.

10.2 Assets Used in the Conduct of Business

10.2.1 The prescribed reserve for assets used in the conduct of business is determined as the amount by which the stated value of the asset in the financial statements exceeds the value the asset would have in a run-off or transfer situation.

10.2.2 For the purpose of paragraph 10.2.1, the value to be ascribed to certain assets is subject to the following specific requirements:

1.    Loans to Directors, Employees, Advisers and Related Parties

In respect of money loaned or advanced on an unsecured basis, no value is to be ascribed to the debt.

In respect of money loaned or advanced on a secured basis, the value to be ascribed to the debt must not exceed the amount of the security.

1.   Policy Loans (including premiums due but not received)

The value of any debt due to the company which is secured on a policy of insurance issued by the company must not exceed the Current Termination Value of the policy.

This does not apply in the case of premiums due from a registered life company under a contract of reinsurance (which is considered in paragraph 10.5 below).

1.    Computer Software

The value of computer software owned by the company must not exceed the known resale value of that software.  If the resale value of the software is not known, then a zero value must be assumed.

1.   Future Income Tax Benefits

The value of a future income tax benefit due to the company must not exceed the value of any income tax benefit that would accrue and be realised in the scenarios being contemplated.

1.    Defined Benefit Superannuation Fund Surpluses

Where the entity is an employer sponsor of a defined benefit superannuation fund, no value is to be ascribed to any surplus of that fund which might otherwise be recognised as an asset of the statutory fund.

1.     Holdings in Associated and Subsidiary Entities Other Than Financial Services Entities

Where the operations of an associated or subsidiary entity that is not a Financial Services entity are wholly dependent on those of the life insurance company, or the entity is itself an operational entity of the group to which the life insurance company belongs, then the value ascribed to the entity must not exceed its net tangible assets.

Otherwise, to the extent that such an entity has a degree of financial or operational independence from the life insurance company that could lead to it having some value in excess of net tangible assets under adverse circumstances affecting the life company, such additional value may be admissible. The admissible amount must only reflect the likely realisation value of the entity in the scenario contemplated, taking into account the likely circumstances of the sale (e.g. perception of a forced sale, capacity to separately sell entity, and anticipated supply/demand for such entities).

The value ascribed to such an entity that is financially and operationally independent of the life insurance company must not exceed the value in the regulatory financial statements.

In any case, the value ascribed to the entity need not be less than zero, provided that there is no recourse to the life company in relation to the entity’s obligations.

10.3 Holdings in Associated and Subsidiary Financial Services Entities

10.3.1 The prescribed reserve in respect of holdings in associated and subsidiary entities that are Financial Services entities is to be determined by the Actuary as the amount by which the value of the entity in the regulatory financial statements exceeds its net tangible assets.  This reserve is to be further increased by the amount of any prudential capital requirements of the entity in the jurisdiction in which it operates.  The total reserve required need not be more than the value of the entity in the regulatory financial statements, provided that there is no recourse to the life company in relation to the entity’s obligations.

10.3.2 To the extent the benefits under the policy are contractually linked to the performance of the assets held, these assets include holdings in associated and subsidiary entities, and

1.    those holdings take the form of equities as part of an index, or typical balanced, investment portfolio; and
2.   the extent of the exposure to those holdings is consistent with the stated investment objective of the fund; and
3.    those holdings comply with Section 43 of the Life Insurance Act: and
4.   the Actuary is satisfied that there has been appropriate disclosure to policy owners of the risks to which they are exposed;

 no reserve is required under paragraph 10.3.1.

10.4 Intangible Assets

10.4.1 The regulatory financial statements of the statutory fund may include intangible assets such as deferred acquisition cost assets, deferred origination cost assets, the value of in-force business and any goodwill asset. Where the values of such assets are not realisable independent of the business in-force, such assets are to be treated as inadmissible.

10.5 Asset Concentration Risks and Reinsurance Recoverability

10.5.1 Except as allowed under paragraph 10.5.2, the prescribed reserve for asset concentration risks is determined as the amount by which the value of any single asset (aggregating, where necessary, individual assets that are exposed to common risks, such as strata titles in the same property) or single credit exposure (with a particular obligor or related party) exceeds the following limits:

VASF = value of the assets of the statutory fund as per the regulatory financial statements.

10.5.2 In the case of a Specialist Reinsurer, the following increased admissible asset limits apply in respect of retrocessions by that Specialist Reinsurer to an overseas parent, associated, or subsidiary company which, with APRA’s agreement, has been identified as an appropriate retrocessionaire for the purpose of this paragraph:

1.    where the retrocessionaire has a current counterparty grade of 1, 2 or 3 per Attachment 1 of the General Standard – No limit;
2.   where the retrocessionaire does not have a current counterparty grade of 1, 2 or 3 per Attachment 1 of the General Standard, but had such a grade at the time the retrocession arrangement was entered into;

1.           within the first 3 months after the downgrade below grade 3 – No limit.
2.        within the next 9 months - 65% of the reinsurance asset.
3.      within the second 12 months after the downgrade - 35% of the reinsurance asset; and
4.      thereafter, the retrocession arrangements are to be treated as per paragraph 10.5.1.

1.    in all other circumstances, the retrocession arrangements are to be treated as per paragraph 10.5.1.

10.5.3 Notwithstanding the prescribed limits of paragraph 10.5.1, if in the opinion of the Actuary the overall portfolio of assets of the statutory fund has too little diversification, is too illiquid or has too great an exposure to obligors of low credit standing, the Actuary must add to the reserve for inadmissible assets an amount considered appropriate to adequately protect the interests of the policy owners.   In particular, where the fund has a significant cumulative exposure through different classes of assets to a single obligor or related obligors the Actuary is to reduce the limit for that obligor in respect of any particular asset class by the exposure to that same obligor that is allowed as admissible in respect of all lower asset classes (assuming a hierarchy of classes from (a) (highest) to (m) (lowest) in paragraph 10.5.1.).

10.5.4 Where the policy liabilities are in respect of investment-linked benefits linked to the asset or credit exposure in question and the Actuary is satisfied that there has been full disclosure to policy owners of the risks to which they are exposed, no reserve is required under paragraph 10.5.1.

10.5.5 Where the asset or credit exposure is in respect of bank bills or bank deposits, bank for this purpose means:

1.    a deposit taking institution authorised by APRA under the Banking Act 1959; and

b) in the case of overseas business, a bank in the same country as that in which the business is written, provided that country has capital requirements in respect of banking business comparable to those in the Banking Act 1959.

10.5.6 Where the reserve in respect of inadmissible assets is reduced by deferred tax provisions or other liabilities relevant to the inadmissible portion of the asset the reduction must only be to the extent those provisions/liabilities are assessed as likely to be realised.

10.5.7 In order for an insurance or reinsurance arrangement to qualify for treatment under subparagraph 10.5.1(f), (g), (h) or (i), or paragraph 10.5.2, it must, subject to a 6 month grace period from risk inception, comprise an executed and legally binding contract.  Draft or incomplete documentation can at best qualify under paragraph 10.5.1(m).

10.6 Alignment to Net Market Value

10.6.1 The Inadmissible Assets Reserve is to include the net difference between the value disclosed in the regulatory financial statements and the net realisable market value (irrespective of whether this difference is positive or negative) of all assets and financial liabilities (other than policy liabilities) of the statutory fund. Net realisable market value means the mid market value (or equivalent estimated fair value) less (plus for liabilities) any marginal transaction costs that would be incurred on realisation.

10.6.2 To the extent that the liabilities adopted for this Standard are based on asset values disclosed in the financial statements and would correspondingly change in value if such net realisable asset or related liability values were adopted for the financial statements, then this adjustment may be ignored in respect of those assets and liabilities along with the equivalent adjustment in paragraph 7.2. This adjustment is also not required in respect of assets already deemed inadmissible under this Standard.

SECTION 11 The Resilience Reserve

11.1 The Resilience Reserve is determined as the additional amount that needs to be held before the happening of a prescribed set of changes in the economic environment, such that after the changes the admissible assets of the company are able to meet the policy owner and other liabilities of the statutory fund, including the assessed liability risks in accordance with this Standard.

11.2 While the Resilience Reserve is determined at a statutory fund level, it is recognised that the prescribed set of changes (the adverse scenario) which determines the Resilience Reserve for each particular fund may differ depending on the type of business and other circumstances of that fund.  In determining the Resilience Reserve of a particular statutory fund, it is permitted to recognise the potential release of Resilience Reserves from other statutory funds as a consequence of the particular adverse scenario being considered.  However, to the extent such recognition is taken, the Actuary must ensure that:

a) it is limited to the amounts that would be readily available from other statutory funds while leaving each of those funds complying with the capital adequacy standard after the adverse scenario assumed; and

b) the potential release from other statutory funds is only recognised once in reducing the Resilience Reserves of the company; and

c) the total Resilience Reserves of the company, when reductions across all statutory funds are taken together, must not be less than that which would result from the application of the resilience calculation at the company level.

11.3 The Resilience Reserve is determined by reference to the Admissible Assets of the statutory fund. It is not necessary to hold resilience reserves for that part of an asset which is inadmissible nor the free assets (in excess of the Solvency Requirement) of the fund.  It is not permitted to hypothecate assets to particular liabilities of the fund.

11.4 The Resilience Reserve allows explicitly for the beneficial implications for asset risks of diversification across asset sectors.

11.5 Determination of Resilience Reserve

11.5.1 The Resilience Reserve is determined in accordance with the following formulae:

where

RR = resilience reserve

L = the liability held for the statutory fund for solvency purposes to reflect all liability risks (including other liabilities ie as at step 6.1(f)) prior to the prescribed change in economic environment and asset values

L’ = value of that liability after the prescribed change

f = A” / A

A = value of admissible assets of the statutory fund prior to the prescribed change

A’ = value of those assets at the Adjusted Yield.

A”  = adjusted value of assets (A’) reduced by the sum of the Adverse Exchange Movement factor and the Credit Risk Default Factors.

where

DF = the diversification factor

E, P   the proportionate holding of assets in the asset sectors Equities and Property respectively each multiplied by the factor for that sector:

  (Prescribed Increase in Yield / Current Yield)

F, I  the proportionate holding of assets in the asset sectors Interest Bearing and Indexed Bonds respectively each multiplied by the factor for that sector:

   (Asset Value at Current Yield / Asset Value at Yield after prescribed increase) - 1

Note  1. DF is determined in the scenario of a prescribed increase in yields across all sectors, and is used to determine the Adjusted Yield in that and all other scenarios.

  2. In determining F, cash is included in the interest bearing sector.

11.5.2 Where the policy owner liabilities of the statutory fund move in harmony with the assets supporting them, the Resilience Reserve in respect of those liabilities can be zero.  A Resilience Reserve may be required, however, in respect of the Other Liabilities of the fund.

11.5.3 While for the determination of A’ the most adverse scenario must be assumed, in determining the diversification factor the dynamics of that formula require that an increase in yields across all sectors be used (regardless of the fact that for certain classes of business this may not reflect the most adverse scenario).

11.5.4 The Resilience Reserve must not be less than zero.

11.6 Prescribed Yield Change

11.6.1 Subject to paragraph 11.6.2, the prescribed changes to the economic environment are movements, up or down, in yields as per the table below, which reflect corresponding movements in the value of instruments within those respective sectors:

11.6.2 The prescribed reduction (but not increase) in yield for the Interest Bearing investment sector must not exceed 20% of the current Mid Swap Rate as determined for the purposes of paragraph 4.1.

11.6.3 Yield, as referred to in this Section 11, is determined in respect of the holdings of the statutory fund and is to be taken to mean:

1.    for Equities, dividend yield based on the dividend yield under the ASX200 Index as at the valuation date, unless the Actuary justifies otherwise;
2.   for Property, rental yield, based on most recent leases in force and determined net of expenses;
3.    for Interest Bearing Securities, redemption yield (running yield in the case of irredeemable securities); and
4.   for Indexed Bonds, real yield.

11.7 Credit Risk

11.7.1 An addition to the resilience reserves is to be made for credit risk in respect of interest bearing and indexed bond assets, including cash deposits and floating rate assets.  This will be achieved by a reduction in the value of assets under the relevant adverse scenario.  The change will not affect the value of liabilities under the adverse scenario unless the benefits under the policies are contractually linked to the performance of the assets held. 

11.7.2 In calculating A”:

1.    The applicable Credit Risk Yield Movement from the table below is first included in the Adjusted Yield as determined in paragraph 11.5.1 to determine A’. The duration used for this purpose may differ from that used to determine sensitivity to interest rate shocks (e.g. floating rate instruments not immediately redeemable may be regarded as dead short for the application of the prescribed yield change, but may have a longer term for the credit risk yield movement, depending on the extent to which credit risk deterioration can be mitigated).
2.   Each of the values determined in a) above (i.e. A’) is then reduced by the sum of the applicable Credit Risk Default Factor taken from the table below and the Adverse Exchange Movement factor from the table in paragraph 11.6.1.

11.7.3 In calculating the Adjusted Yield under paragraph 11.5.1 the Credit Risk Yield Movement is always positive, even though the Prescribed Yield Change may be positive or negative, depending on the relevant adverse scenario being tested. 

11.8 Determination of L’

11.8.1 In determining the change to the discount rate for valuing the liabilities, it is the Prescribed Yield Change for the interest bearing investment sector determined under paragraphs 11.6.1 and 11.6.2 which is relevant.  The Adjusted Yield as defined in paragraph 11.5.1 (including diversification and credit risk adjustments) is relevant only for asset values or for changes to the benefits to be valued where those benefits are contractually linked to the performance of the assets held.  In the case of changes to those benefits to reflect the combined effect of the Adjusted Yield, the Credit Risk Default Factor and the Adverse Exchange Movement factor allowance may be made for discretions in accordance with paragraphs 5.2.3 and 5.2.4.

11.8.2 In determining the Resilience Reserve required, other assets and liabilities whose value is dependent on the value of investment assets, such as tax assets and liabilities, must be adjusted in a manner consistent with the action the company would take were asset values to change by the prescribed amount.  However, in scenarios where asset values are assumed to fall, any resulting tax benefit may only be taken into account to the extent that the Actuary is satisfied that the tax benefit would actually be realised on the company ceasing business.

11.8.3 In calculating L’ no adjustment is required for any potential impact that the Prescribed Yield Change would have on the value of a deficit held in respect of a defined benefit superannuation fund for which the entity, or an associated entity, is an employer sponsor. 

11.9 Application of Prescribed Yield Changes

11.9.1 In applying the prescribed yield changes of paragraph 11.6 to the determination of A’ and L’, the Actuary must address the worst combination of rising or falling yields for the different asset sectors to which the business is realistically exposed.  At the very least, the following two scenarios must be tested:

1.    rising fixed interest yields (investment categories Interest Bearing and Indexed Bonds) and rising equity/property yields (investment categories Equities and Property), and
2.   falling fixed interest yields (investment categories Interest Bearing and Indexed Bonds) and rising equity/property yields (investment categories Equities and Property).

11.9.2 Where the circumstances of the fund are such that other scenarios are potentially relevant then they must also be tested.

11.10 Other Asset Exposures

11.10.1 Paragraph 5.2.5 outlines the principles to be followed where the fund is materially exposed to changes in investment market conditions that are not captured by the application of the prescribed rules of this section, and where a corresponding additional provision must be made.  In this regard, the Actuary needs to consider the impact on the fund of significant adverse changes in investment markets such as:

1.    changes in the slope and shape of the yield curve, especially those that can give rise to difficulties with the reinvestment of assets backing long term liabilities; and
2.   changes in yield, volatility and correlation parameters  that would be reflected in the fair value of derivative assets or analogous provisions in the liabilities.

11.10.2 The Actuary must also consider whether the impact of credit risk is adequately provided for through the combination of the prescribed asset concentration limits in paragraph 10.5 and the credit risk adjustments of paragraph 11.7 noting that the prescribed credit risk adjustments presume that the asset portfolio is highly diversified.  If credit risks are not adequately provided for, for example because of a lack of diversification, the Actuary is to adopt lower concentration limits or employ other additional reserving requirements.

SECTION 12 Transitional Arrangements

Overview

The Solvency Requirement determined in accordance with this Solvency Standard AS 2.04 may be significantly different from the equivalent amount determined in accordance with the previous version AS 2.03.  To allow life companies that are significantly affected sufficient time to implement any necessary changes for either reducing the Solvency Requirement or increasing the amount of assets in the Statutory Fund to cover the new Solvency Requirement it is appropriate to allow some short term transitional arrangements. 

These transitional arrangements will be in the form of a reduction to the amount of the Solvency Requirement, such reduction reducing to zero over the transitional period. 

12.1 Where, at the date of introduction of this Standard, the amount of the Solvency Requirement determined prior to allowing for any Transitional Adjustment (i.e. after step 6.1(h)) exceeds the Solvency Requirement that would have resulted at the same date from application of the previous version of this standard (AS 2.03) by an amount exceeding the Transitional Materiality Limit, the Actuary may, with APRA’s agreement, apply a Transitional Adjustment to the Solvency Requirement in accordance with the provisions of this section.

12.2 The Transitional Adjustment is determined at the date of calculation as:

where

SR = the Solvency Requirement determined prior to allowing for any Transitional `Adjustment (i.e. after step 6.1(h)) as at the date of calculation

SR’ = the Solvency Requirement that would have resulted at the same date from application of the previous version of this standard (AS 2.03)

t = the period from the calculation date to the Transition End Date

n = the period from application date of this Solvency Standard to the Transition End Date.

SECTION 13 Materiality

Overview

Particular values or components are considered material to the overall result of a calculation when their mis-statement or omission would cause that result to be misleading to the users of the information.

Materiality tests assess the significance of the particular value/component by relating it to the amount of the overall result to which it contributes.

13.1 The Solvency Requirement determined in accordance with this standard is subject to materiality standards applied at a statutory fund level.

13.2 The base amount for materiality purposes is the difference between the assets of the statutory fund and the Solvency Requirement of that fund.

13.3 While materiality must be applied at the statutory fund level, the materiality of the statutory fund relative to the size of the company overall may be taken into account.

13.4 In applying the materiality standards described in paragraphs 13.1 and 13.2:

1.    it is appropriate to use as the base amount for materiality purposes a rolling average of the base amount provided that the average so derived is a function of not less than three and not more than five years experience and is reflective of the current and anticipated future experience; and
2.   it is appropriate, as the base amount approaches zero, for alternative key indicators to be used in establishing materiality.

13.5 While assessing materiality will always be a matter of professional judgement, the following quantitative thresholds are generally to be used:

1.    variations in amounts of 10% or more of the base amount may be presumed material; and
2.   variations in amounts of 5% or less of the base amount may be presumed immaterial.

PART C – ACTUARY’S STATEMENT

SECTION 14 Statement Relating to the Determination

14.1 In respect of any determination of the Solvency Requirement the Actuary must provide in the investigation report required by section 113 or 115 of the Act, details of the calculation processes and the assumptions used in deriving the results.

ATTACHMENT 1 – SOLVENCY ASSUMPTIONS

Notes

(1) A reference in the above to the Defined Table is a reference to the table prescribed by the LIASB for this purpose from time to time.As at the issue date of the Standard the Defined Tables are:

  For Insured Lives IA 95-97

  For Annuitants IM/IF80, for calendar year 1980 Ultimate              For Disability Income              IAD 89-93

(2) Where policies are issued on underwritten sub-standard terms (including in the case of structured settlements), those terms are to be given effect in determining the Solvency Liability through an appropriate adjustment to the Defined Table.   If the terms of the rating are not readily expressed in this form, the Solvency Assumption must be taken as:

1.     110% of Best Estimate for insured lives and annuitants in deferment; and
2.    90% of Best Estimate for annuitants.
    

(3) Where policies for insured lives and annuitants in deferment are issued on non underwritten terms, the Solvency Assumption must be taken as 110% of Best Estimate subject to a minimum of the relevant prescribed Solvency Assumption.

(4) Allowance for annuitant mortality improvements after 1996 is to be made as follows:

qx.t  =  qx.o *RF(x.t)

where:  qx.t  is the “improved” qx for age x at time t years after 1996

 RF(x.t) =  0.975t for   x  60

 =  ( 0.975 + 0.0005 * (x - 60) ) t  (max of 1) for   x > 60

(5) For annuities issued on non underwritten terms and in the course of payment, the use of the assumptions set out in this note is subject to a minimum related to the Best Estimate assumptions.  The Solvency Liability is to be determined as the greater of that calculated using

1.     the assumptions set out in this attachment, and
2.    90% of Best Estimate

with the comparison done in aggregate across all the annuities in the Related Product Group.

(6) The reliance on Best Estimate base for disability income is subject to a minimum related to the company’s own experience.  That minimum, to be determined by the Actuary, is to be expressed by reference to the Defined Table (as x% of the Defined Table).  Where the company’s own recent experience over not more than the last 3 years can be demonstrated to be statistically credible, that experience is to be calibrated to the Defined Table and applied as a minimum on the current Best Estimate base.  Where the company’s available experience has little or no credibility (e.g. small portfolios or new products), x% is to be taken as 150%.  Where the company’s experience has some, but less than full, credibility, a factor between the apparent x% and 150% is to be adopted based on a suitable credibility weighting method.

(7) The Claims Cost Liability for disability income policies is the component of the liability for active lives in respect of claims.

(3)  Actuarial Standard 3.04

DECEMBER 2005

Actuarial Standard 3.04

CAPITAL ADEQUACY STANDARD

Life Insurance

Actuarial Standards Board

TABLE OF CONTENTS

          Page

INTRODUCTION

The Standard

Application of the Capital Adequacy Standard

PART A – PRINCIPLES

SECTION 1 The Capital Adequacy Standard

SECTION 2 Scenarios of Adverse Conditions

SECTION 3 The Liability Risks

SECTION 4 The Capital Adequacy Assumptions

SECTION 5 Asset Risks

SECTION 6 The New Business Reserve

PART B – METHODOLOGIES

SECTION 7 Determination of the Capital Adequacy Requirement

SECTION 8 The Capital Adequacy Liability

SECTION 9 Current Termination Value

SECTION 10 The Inadmissible Assets Reserve

SECTION 11 The Resilience Reserve

SECTION 12 The New Business Reserve

SECTION 13 Transitional Arrangements

SECTION 14 Materiality

PART C – ACTUARY’S STATEMENT

SECTION 15 Statement Relating to the Determination

ATTACHMENT 1 – CAPITAL ADEQUACY ASSUMPTIONS

INTRODUCTION 

The Standard

The Capital Adequacy Standard is established under the Life Insurance Act 1995, and is an integral component of the financial reporting regime for life insurance companies implemented under that Act.

The Act establishes a two tier capital requirement on the statutory funds of the life company with each tier considering the capital requirements in a different set of circumstances.  The first tier is intended to ensure the solvency of the company.  The second tier is intended to secure the financial soundness of the company as a going concern.  It is expected in most circumstances that this second tier will provide an additional buffer of capital above this minimum requirement.  However it will not always transpire that an additional buffer is necessary.

This standard looks at the second tier capital requirement.

The stated purpose of the capital adequacy standard in the Act is:

“to ensure, as far as practicable, that there are sufficient assets in each statutory fund of a life company to provide adequate capital for the conduct of the business of the fund in accordance with this Act and in the interests of the owners of policies referable to the fund.”

Therefore, the purpose of the Capital Adequacy Standard is to prescribe the capital requirement of a statutory fund to ensure that the obligations to, and reasonable expectations of, policy owners and creditors are able to be met under a range of adverse circumstances, in the context of a viable ongoing operation.

This capital requirement - the Capital Adequacy Requirement - is not required to be disclosed in either the regulatory financial statements (in accordance with Prudential Rule 35) or the general purpose financial statements (in accordance with accounting standard AASB 1038 Life Insurance Contracts) of the company.  It will, however, be disclosed to the Australian Prudential Regulation Authority (on a confidential basis) and will be used as an important indicator of the longer term financial position of the company, and a trigger for closer regulatory monitoring in respect of short term solvency.

This Standard adopts a less prescriptive approach (than the Solvency Standard) to the determination of the Capital Adequacy Requirement in recognition of the differing business strategies of companies.  Reliance is placed on the professionalism of the Actuary for appropriate assessment of the Capital Adequacy Requirement of a company in accordance with the principles of this Standard.

Application to Friendly Societies

The Act was amended in 1999 to extend its application to friendly societies that undertake life insurance business.  This standard is applicable to all life companies (registered under the Act) including friendly societies.  In its application, the standard will, at times, make distinction between life companies that are friendly societies and other life companies.

Interaction with Management Capital Standard

It is noted that certain risks related to the life business of a friendly society are incurred in the management fund. Such risks are recognised and provided for in the Management Capital Standard.

Further, life companies other than friendly societies may count an amount of the net assets of the shareholders’ fund in offsetting some aspects of the Capital Adequacy Requirements of the statutory funds (refer to section 12 for detail).

Therefore, the Solvency Standard, Capital Adequacy Standard and the Management Capital Standard involve a degree of interaction and should be considered together.

Application of the Capital Adequacy Standard

The Capital Adequacy Standard is made for the purposes of section 70 of the Life Insurance Act 1995.

It applies:

1.    in respect of all life insurance business of a registered life company, other than that written in a statutory fund which includes only business written overseas in  one or more Approved Countries; and
2.   in respect of the life insurance business of an eligible foreign life insurance company, other than life insurance business carried on outside Australia; and
3.    at all times from 31 December 2005.

The Standard is written in the context of Australian legislation and bases of taxation.  Appropriate adjustment must be made, for example to allow for different bases of taxation, where this Standard is being applied to overseas business.

PART A – PRINCIPLES

SECTION 1 The Capital Adequacy Standard

Overview

The Solvency Standard requires that the statutory fund of a life company has available a minimum level of net assets in excess of its liabilities - the Solvency Requirement - to provide for the security of the policy owners’ guaranteed entitlements under a range of adverse conditions.

However, the prudent regulation of the life insurance industry requires that the level of security offered to policy owners exceed that of a standard which secures solvency.  The Capital Adequacy Standard requires that each statutory fund has available sufficient additional assets to provide confidence in the longer term financial strength of the fund.  A fund that is capital adequate would have the ability to write new business, in an unfettered manner, with the expectation of remaining solvent into the future.

The Capital Adequacy Requirement is determined by considering the various risks undertaken within the statutory fund which could impact the longer term security of the policy owners’ entitlements, and requiring the provision of a prudent level of reserve against such risks.

These risks, and an assessment of the prudent provision, are considered in the context of an ongoing operation; a fund open to new business and meeting policy owner expectations in a competitive market.

A statutory fund that meets the Capital Adequacy Requirement would be considered by the Australian Prudential Regulation Authority to be a financially strong fund - however this does not imply an absolute guarantee of security to policy owners.

1.1 At any time, the value of the assets of the statutory fund of a life company must be of an amount considered sufficient to allow the company to continue to meet, into the future, its:

1.    obligations to, and the reasonable expectations of,  policy owners referable to the fund; and
2.   obligations to creditors referable to the fund.

The amount of assets so required is referred to as the Capital Adequacy Requirement.

1.2 The Actuary, in determining the Capital Adequacy Requirement must consider, in respect of both existing and expected future policy owners, the company’s liability in respect of:

1.    the guaranteed benefits under the policy in accordance with the policy document and the law; and
2.   any additional guarantees or obligations implied by the promotional material of the company; and
3.    the reasonable expectations of the policy owners in respect of benefits under the policy in accordance with past practice of the company.

1.3 The Actuary, in determining the Capital Adequacy Requirement, must make an assessment of the effect of the company’s realistic new business plans on the future solvency of the statutory fund.

SECTION 2 Scenarios of Adverse Conditions

Overview

In assessing the Capital Adequacy Requirement of a statutory fund consideration is given to:

      the risks which may affect the value of the liabilities under policies; and

      the risks which may affect the value of the assets supporting those liabilities.

The Capital Adequacy Requirement broadly comprises the following components:

      the New Business Reserve.

The Capital Adequacy Liability

A calculation of the value of the liabilities under the policies on the basis of assumptions which are more conservative (anticipate a more adverse experience) than best estimate assumptions.

The Other Liabilities

The value of the liabilities of the statutory fund to other creditors, but excluding approved subordinated debt arrangements and amended as required to satisfy the principles of this Standard.  In particular, where such other liabilities relate to future cash flows that are uncertain, then their assessment is to be based on assumptions that are more conservative than best estimate, as per the Capital Adequacy Liability

The Inadmissible Assets Reserve

A reserve against the risks associated with:

      holdings in associated or subsidiary Financial Services entities; and

      concentrated asset exposures.

The Resilience Reserve

Mismatching of asset and liability exposures necessitates the provision of a reserve for adverse movements in asset values to the extent they will not be matched by a corresponding movement in the liabilities.

When determining the impact of the various risks and adverse conditions on the financial position on the fund, it is required to assess their impact consistently on all assets and liabilities affected. This includes both beneficial and adverse combined effects.

The New Business Reserve

Provision for planned business operations over a prescribed future period of three years, with the intention of securing the continued solvency of the fund over that period.

2.1 The Capital Adequacy Requirement must provide for a value of the liabilities of the statutory fund in respect of obligations to policy owners and creditors, on a basis that is more conservative than best estimate and that considers scenarios of adverse experience.

2.2 The Capital Adequacy Requirement is, in principle, to be determined on a basis that is consistent with the net realisable market values of the assets and other liabilities of the statutory funds, including allowance for realisation costs and, if considered appropriate under the relevant adverse scenarios, discounting of all future cash flows.

2.3 In considering scenarios of adverse experience and adopting a basis for the Capital Adequacy Requirement, the Actuary must allow for all material risks associated with both the liabilities and the assets of the fund, including the interdependencies between these risks that the Actuary considers might apply under such adverse conditions. This is regardless of whether such risks are discussed in the rest of this Standard or not.

2.4 Where the particular combination of risks affecting a company is not explicitly considered within this Standard, the Actuary must establish additional amounts within the Capital Adequacy Requirement, beyond the amounts prescribed. The additional reserve must reflect the purpose and principles of the Standard. It must provide a level of reserving that is consistent with that applying under this Standard in respect of the risks explicitly considered under this Standard. For this purpose the Actuary may regard the prescribed requirements set out within this Standard, when applied to a typical life company with the combination of risks explicitly considered in this Standard, as designed to provide a level of reserves which broadly meets the following requirements:

1.    Able to cover a combination of adverse circumstances that would be expected to arise once every 400 years;
2.   Allowing a general time frame of 12 months in which the circumstances arise and the actions under (c) and (d) below follow;
3.    The reserve required at the end of the period in (b) is able to be determined in accordance with the Capital Adequacy Requirement of this Standard, but allowing for the implementation of plausible risk reduction actions by management at, or after, that time (for example, raising premium rates, exiting risky asset positions or other arrangements as would be permitted).  This includes allowance for discretions in line with paragraph 3.2. For those risks that cannot be eliminated, sufficient reserve will still be required as set out in this Standard; and
4.   Allowance for management corrective action during the period in (b) is considered to be limited to highly reliable actions only, with conservative response time allowances.

2.5 The criteria of paragraph 2.4 are to be applied allowing for the benefit of any diversification across all risks affecting the company.  For the purposes of paragraph 2.4, those risks requiring additional resilience reserves to be established under section 11.11 using the principles of paragraph 5.2.5 are considered to be adequately addressed by those additional reserves.

2.6 The guideline in paragraph 2.4 is intended as a guide when allowing for risks that are not explicitly dealt with under the prescribed basis in this Standard.  It is not intended as an alternative basis for issues that are otherwise and adequately dealt with in the prescribed basis.  For the avoidance of doubt, the Capital Adequacy Requirement must not be less than that calculated using the basis prescribed in the rest of the Standard, but may be more where there are material risks that are not explicitly dealt with under the prescribed basis.

2.7 In determining the Capital Adequacy Requirement, the availability of tax deductions and the values placed on tax assets and tax liabilities, need to reflect what is assessed as likely to be realised in the underlying scenario, subject to the overriding requirement set out in paragraph 9.7.

2.8 In considering scenarios of adverse experience and adopting a basis for the Capital Adequacy Requirement, the use of discretions and of policy owner retained profits that are assumed by the Actuary must be appropriate, justifiable and equitable.

2.9 It is the principles that are paramount in determining the Capital Adequacy Requirement; methodology is incidental to the principles.  However, this does not override the requirement of paragraph 2.6 that the Capital Adequacy Requirement must not be less than that calculated using the prescribed method.

SECTION 3 The Liability Risks

Overview

The risks associated with the liabilities under policies are discussed in this section.

The risks pertaining to each element of the capital adequacy liability include the risk of mis-estimation of the mean, the risk of deterioration of the assumed mean, the risk of adverse statistical fluctuations about the mean and the risk of unexpected changes in the underlying distribution of experience.

Available discretions in policies may mitigate the effects of some of the liability risks for the company.  Discretions typically fall into one of the following categories:

• reductions in Bonuses or Discretionary Additions;
• increases to expense charges where the maximum level is linked to an inflation index;
• one-off increase to expense charges, subject to the contractual maximum; and
• increases to premium rates, either in line with insurance claims experience or at the company’s discretion (including rider premiums on contemporary products).

Equally, some assets, such as reinsurance, may react in response, favourably or unfavourably, to changes in the liabilities. These effects are to be taken into account.

3.1 The Capital Adequacy Liability

3.1.1 The Capital Adequacy Liability must make provision for the risks pertaining to each element in respect of which an assumption is required in valuing the policy liabilities.  The assumptions, including the risk margins, are referred to as the Capital Adequacy Assumptions.

3.1.2 The margin for risk included in each Capital Adequacy Assumption is to be determined by the Actuary as the appropriate level within the quantitative range prescribed.  The Actuary is to determine the appropriate margin after consideration of the qualitative factors. (See section 4).

3.1.3 The Capital Adequacy Assumption must not be less than the minimum in the prescribed range, but may be less than the corresponding Solvency Assumption.  The risk margin included in the Capital Adequacy Assumption may be greater than the high margin in the prescribed range.

3.1.4 Where the benefits under the policy are dependent on the performance of the underlying net assets and related liabilities, the Capital Adequacy Liability must, in principle, be aligned with the net realisable market value of those assets and related liabilities.

3.2 Allowance for Discretions

3.2.1 In assessing the amount of the Capital Adequacy Liability the Actuary must only assume the application of discretions available under policies where the application is considered appropriate, justifiable and equitable:

1.    under the adverse conditions being assumed;
2.   having regard to the principles in paragraph 1.2; and
3.    having regard, in the case of participating business, to the provisions of the Life Insurance Act which govern the purpose of policy owners’ retained profits and distributions there from.

3.2.2 The extent and timing of the assumed application of discretions must be consistent with normal company practice in the circumstances of the adverse scenario being considered.

3.2.3 It would normally be expected that the Capital Adequacy Liability in respect of a participating category of business would not be less than the total of the relevant Policy Liabilities (less the component representing the value of expected future Shareholder Profit Share, after allowing for the effect of the adverse conditions being assumed) plus policy owners’ retained profits.  However, if the Actuary is satisfied that, after allowing for the application of discretions as in paragraph 3.2.1, less than this total amount is required to satisfy the reasonable benefit expectations of the relevant in force policyholders, then the excess may be regarded as being available to support the Capital Adequacy Requirements of any non-participating categories of the statutory fund provided that this support is on commercial terms.   

3.2.4 In applying the provisions of this section to friendly societies, discretions must be taken to be those discretions explicitly provided for in the existing rules of the benefit fund and not the broader discretions that may be accessed through a process of amending those rules.  Any representations made in the relevant product disclosure documents must also be taken into account in determining the level of discretion to be applied.

3.3 Other Liabilities

3.3.1 Where the other liabilities of the statutory fund (other than a deficit in respect of a defined benefit superannuation fund to which the entity, or an associated entity, is an employer sponsor) are determined based on estimates of future cash flows, these must be reassessed and discounted to the valuation date on a basis consistent with the overall scenarios of adverse experience being considered (per Section 2 and as reflected in the Capital Adequacy Liability).

3.3.2 Where the entity, or associated entity, is an employer sponsor of a defined benefit superannuation fund and the other liabilities of the statutory fund include a deficit in respect of that fund, and the deficit has been determined using the corridor approach as defined under accounting standard AASB 119 Employee Benefits, the deficit is to be reduced (increased) by the amount of any Unrecognised Actuarial Gains (losses).

Termination Value Minimums

3.4 The Capital Adequacy Requirement must provide that, for a Related Product Group, a minimum value is held in respect of the Capital Adequacy Liability equal to the total Current Termination Value for all policies in the group.

3.5 Reinsurance

3.5.1 In order for the credit and inadmissible asset risks involved with reinsurance arrangements to be properly identified and assessed, the requirements of this Standard are to apply on a gross of reinsurance basis, with the gross liability requirements and any related reinsurance values separately quantified. That is, the Capital Adequacy Liability and the impact of the risks, adverse scenarios and termination value minimums are to be assessed on a gross of reinsurance basis.

3.5.2 Any reinsurance arrangements are to be valued consistent with their associated gross liabilities under the scenario or test being considered. For example, if the related gross liability requirement is assessed under a termination value scenario, a similar approach is to be taken with the reinsurance.

3.5.3 Where a reinsurance arrangement gives rises to an asset of the fund in the context of the scenario or test applicable, the value of the arrangement is to be treated as an asset of the fund within this Standard. The credit that can be taken for that reinsurance asset is then subject to the asset inadmissibility rules of this Standard (see paragraph 5.1.5).

3.5.4 A corresponding treatment is to apply in the context of other similar risk mitigating arrangements and contracts, that while not legally reinsurance, have similar effects.

SECTION 4 The Capital Adequacy Assumptions

4.1 Investment Earnings & Liability Discount Rates

For both insurance contracts and investment contracts, the Capital Adequacy Assumption for gross investment yield and liability discount rate will be as determined in paragraph 5.5.1 of the Valuation Standard, but subject to a maximum rate of the Mid Swap Rate.

4.2 Quantitative Range for Margins for other Assumptions

4.2.1 The quantitative range prescribed in respect of the margins for risk to be included in each of the Capital Adequacy Assumptions is set out in Attachment 1.

4.2.2 The margin must be applied such as to produce a more conservative estimate of the liability than best estimate.

4.2.3 The Capital Adequacy Assumption for inflation must be consistent with the Capital Adequacy Assumption for investment earnings, subject to it being no less than the Best Estimate Assumption for inflation.  This assumption is to be applied to all future cash flows that are subject to inflation, including Maintenance Expenses.

4.2.4 Allowance for tax on investment earnings must be  appropriate to the adverse circumstances of the Capital Adequacy Liability and must be based on an asset profile which under the adverse circumstances of the Capital Adequacy Liability, would be expected to yield a return equal to Capital Adequacy Assumptions for gross investment earnings referred to in paragraph 4.1 above. The allowance for tax on other than investment items must be made in accordance with Best Estimate Assumptions.

4.3 Qualitative Factors for Assessing Margins

4.3.1 In assessing the margin for Capital Adequacy Assumptions the Actuary must have regard for the particular circumstances of the company.  The margin adopted must, in the Actuary’s opinion, appropriately reflect the level of risk for the Related Product Group.

4.3.2 The qualitative factors relevant to the Actuary’s considerations will vary depending on the assumption being assessed, but should at least include the following matters:

1.    the availability of relevant and reliable data on which to base the assessment;
2.   the currency and reliability of relevant company experience investigations;
3.    the stability of, or emerging trends in, the company’s experience over time; and
4.   the extent to which relevant company policy (investment policy, underwriting policy etc) is clearly defined and adhered to.

4.3.3 Where all of the qualitative factors indicate that the risk exposure is low, then a margin closer to the Minimum Margin may be adopted.  Where the qualitative factors indicate that the risk exposure is high, then a margin closer to the High Margin should be used.  The result should be that if two statutory funds with differing risk profiles both hold assets equal to the Capital Adequacy Requirement then the probability of ruin should be comparable for each fund.

4.4 Servicing Expenses

4.4.1 In the case of a friendly society, the margin to be included in the Capital Adequacy Assumption for Servicing Expenses is Nil: the servicing expense risk is borne, and hence provided for, in the management fund.  (Refer to the Management Capital Standard.)

4.4.2 For other life companies, a risk margin must be included for Servicing Expenses.  The margin must not be applied to any component of those expenses which is contractually agreed for the life of the policy, for example, renewal commission.

4.4.3 When determining Servicing Expenses for each policy, the allocation of the total expenses of the company must be undertaken in accordance with the principles established in section 13 of the Valuation Standard.

4.4.4 In particular, where a service agreement or other contractual arrangement exists, the Actuary must assess the adequacy of the expenses thereunder in reflecting the long term, sustainable costs of operating the business and adjust the Capital Adequacy Assumption accordingly. (Refer to paragraph 13.9.1 of the Valuation Standard).

4.4.5 The Capital Adequacy Assumption for Investment Management Expenses must be based on an asset profile which under the adverse circumstances of the Capital Adequacy Liability would be expected to yield a return equal to the Capital Adequacy Assumption for gross investment yield referred to in paragraph 4.1. The Capital Adequacy Assumption must also include a margin for risk above this base requirement.  However, if the life company has contractually agreed to pay a higher Investment Management Expense regardless of the asset profile adopted, then this higher expense must be assumed.

4.4.6 Where the entity, or associated entity, is the employer sponsor of a defined benefit superannuation fund, and a surplus exists in the fund which is being utilised to reduce contributions to the fund, consideration needs to be given, when determining the expected servicing costs, to the extent to which that contribution reduction would continue in the context of the scenario being considered.

4.5 Investment-Linked Policies

4.5.1 In the case of a friendly society, the margin to be included for investment-linked business is Nil: the additional risks that may be borne by the company in conducting investment-linked business are borne, and hence provided for, in the management fund.  (Refer to the Management Capital Standard.)

4.5.2 For life companies other than friendly societies, a risk margin must be included to reflect the additional risks that may be borne by the company in conducting investment-linked business.

SECTION 5 Asset Risks

Overview

The risks associated with the assets supporting the liabilities are discussed below.

Adverse Market Movements

To the extent that the value of liabilities is not directly linked to the value of the underlying assets, an adverse movement in the value of the assets effectively reduces the level of reserves supporting the liabilities.  It is prudent that a company recognise this risk and hold sufficient reserves such that the obligations to policy owners and creditors would still be able to be met following an adverse market movement.

The risk of adverse market movements is one of many potentially offsetting risks.  It is presumed that, for the asset and liability profile of a typical life insurer, a Resilience Reserve set at the level of sufficiency described in section 5.2 will, with additional reserves determined independently in respect of other risks, produce an overall Capital Adequacy Requirement at the level of sufficiency described in paragraph 2.4.

Holdings in Associated and Subsidiary Financial Services Entities

Associated and subsidiary Financial Services entities may be exposed to essentially the same environmental and systemic risks as the life insurer. The value of such an entity in excess of its net tangible assets cannot therefore be relied upon to meet the capital requirements of the life insurance company under adverse circumstances. Furthermore, the value taken for such a holding is not to double count any legislated capital requirement of the entity itself.

Asset Concentration

Diversification is an important principle of prudent investment.  To the extent the asset exposure of a statutory fund is excessively concentrated in a particular asset, or with a particular obligor, a reserve is required against the part of the value of that exposure considered by the Actuary to be excessive.

Credit Risks

In general, it is considered that the combined effect of adopting the net market value of the assets and the reserves for asset concentration would address the average costs of default and marketability/liquidity risks.

Where a fund has significant exposure to non-sovereign credit risks, the Actuary is to provide an appropriate reserve allowance for such credit risks, along with any other asset risks.

Liquidity Risks

The Actuary’s general responsibility in assessing and advising management on the financial operations of the company would include consideration of liquidity risks.

Overall Asset Risks

Notwithstanding the prescribed limits of this Standard, the Actuary must have regard to the particular circumstances of the company.  If in the opinion of the Actuary the overall portfolio of assets of the statutory fund has too little diversification, is too illiquid or has too great an exposure to one obligor of low credit standing, the Actuary must increase the reserves appropriately.

Furthermore, the asset and other liability values disclosed in the regulatory financial statements may not be equal to the net market values of those assets and other liabilities, allowing for realisation costs. A reserve for the difference between the reported and net realisable market values of the assets and other liabilities is to be included. However, no reserve is needed in respect of those assets backing liabilities which are directly linked to the net value of the assets and other liabilities as reported in the regulatory financial statements and where the liabilities would correspondingly change if the reported net values were changed.

Note:

It is not the intention of these reserves to limit the investment practices of life companies.  Rather it is to ensure that the risks associated with particular investment strategies are appropriately assessed and provided for.

5.1 Reserve for Inadmissible Assets

5.1.1 The Capital Adequacy Requirement must provide a reserve - the Inadmissible Assets Reserve - in respect of:

1.    holdings in an associated or subsidiary entity which is a Financial Services entity;
2.   non-realisable (in the context of the capital adequacy tests) intangible assets;
3.    the risks arising from asset concentration;
4.   reinsurance assets which may not be fully recoverable in the context of the scenarios of adverse experience; and
5.    alignment necessary to ensure assets and liabilities are based on net market value.

5.1.2 Holdings in Associated and Subsidiary Entities which are Financial Services Entities

Where the associated or subsidiary entity is a Financial Services entity the Actuary must establish a reserve to the extent that the value of the entity exceeds its net tangible assets.

Furthermore, where the associated or subsidiary entity is subject to prudential regulation which requires the maintenance of minimum capital (e.g. a financial institution or a health insurance institution), the Actuary must establish a further reserve to the extent that the net tangible assets of the entity are required to meet that capital requirement and are not, therefore, available to support the life insurance company.

5.1.3 Non-Realisable Intangible Assets

The Capital Adequacy Requirement must provide a reserve equal to the value of any intangible assets held that are related to the business of the statutory fund itself and are not independently realisable, for example deferred acquisition costs assets.

5.1.4 Asset Concentration Risks

The Capital Adequacy Requirement must provide a reserve against the adverse impact of a concentration of funds in a particular asset, with a particular obligor or with related parties.

5.1.5 Allowance for Reinsurance

To the extent that a reinsurance arrangement represents an asset of the statutory fund under the scenarios of adverse experience being considered, then it is to be treated as such and is to be subject to the asset inadmissibility and resilience reserve rules of the Standard. In applying the asset concentration limits of the Standard:

1.    All exposures to a reinsurer or reinsurance group are to be considered a single counterparty exposure (within the practical context of the application of the limits concerned); and
2.   Where arrangements with a reinsurer involve both liability and asset components, these may be taken as a single net exposure to the extent they are subject to a legally enforceable right of off-set.

5.1.6 Alignment to Net Market Value

The inadmissible assets reserve must, in principle, include the net difference between the value disclosed in the regulatory financial statements and the net realisable market value of all assets and financial liabilities (other than policy liabilities) of the statutory fund.

5.2 Resilience Reserve

5.2.1 The Actuary must assess the resilience of the statutory fund and provide for an appropriate reserve - the Resilience Reserve.

5.2.2 Resilience is assessed as the ability of the statutory fund to sustain shocks to the economic environment in which it operates and which are likely to result in an adverse movement in the value of the assets relative to the value of the liabilities.

5.2.3 In determining the value of liabilities in the post shock environment the Actuary must only assume the application of discretions available under policies where the application is considered appropriate, justifiable and equitable:

1.    under the adverse conditions being assumed; and
2.   appropriate having regard to the principles in paragraphs 1.2 and 3.2.

5.2.4 It is considered appropriate, for this purpose, for the Actuary to assume the full application of discretions available in respect of the Termination Value under the policies.

5.2.5 The Resilience Reserve as determined under the prescribed rules of Section 11 is based on the impact of market changes on the position of a statutory fund with a simple asset and liability profile.  Where the fund is materially exposed to changes in investment market conditions that are not captured by the application of the prescribed rules, a corresponding additional provision must be made by the Actuary.  The additional reserve must reflect the purpose and principles of the Standard. It must provide a level of reserving that is consistent with that applying under this Standard in respect of the changes in investment market conditions explicitly considered under this Standard. For this purpose, the Actuary may regard the prescribed requirements set out within this Standard, when applied to the asset and liability profile of a typical life office, as designed to provide a level of reserves which broadly meets the following requirements:

1.      Able to cover adverse changes in investment market conditions that would be expected to arise once every 100 years;
2.      Allowing a general time frame of 12 months in which the circumstances arise and the actions under (c) and (d) below follow;
3.       The reserve required at the end of the period in (b) is able to be determined assuming that a matched asset and liability profile is achieved and that the Capital Adequacy Requirement of this Standard is otherwise satisfied at, or after, that time.  This includes making allowance for discretions in line with paragraph 3.2; and
4.      Allowance for management corrective action to achieve a matched asset and liability profile during the period in (b) is considered to be limited to highly reliable actions only, with conservative response time allowances.

5.3 Asset Exposure

5.3.1 The Actuary in assessing the asset risks:

1.    must take account of the effective exposure of the fund to various asset classes, regardless of the physical asset holdings of the fund; and
2.   must consider exposure to counterparty risks including, but not limited to, futures and options, swaps, hedges, warrants, forward rate and repurchase agreements; and
3.    must take account of the underlying exposure of the fund to assets by adopting a “look through” approach in respect of each unlisted or controlled investment entity that represents more than 1% in value of the statutory fund.  For this purpose, an investment entity is an entity whose assets are solely investments, where the sole purpose of the entity is investment activities and where the investor investing in that entity has security directly linked to those assets; and
4.   must, where investments covered by (c) are geared, treat the debt as if it were a liability of the life insurance company, with appropriate allowance made for the sensitivity of the underlying assets and liabilities to market movements; and
5.    may adopt the ‘look through’ approach as set out in paragraphs (c) and (d) above where the investment is in a listed unit trust. Alternatively, the Actuary is required to treat the holding as a single investment in the equity investment class as defined in the General Standard; and
6.     must assess the characteristics of the remaining admissible component of an investment where, following application of Section 10 of this Capital Adequacy Standard, only part of the investment is admissible, by looking through to the underlying assets and liabilities where necessary and applying the Resilience Reserve requirements of Section 11 accordingly.

5.3.2 As indicated in paragraph 5.2.5, the Resilience Reserve calculation assumes largely generic asset structures.  Where the Actuary can demonstrate that an asset can be disaggregated into two or more identifiable sub-assets, the Actuary may treat the sub-assets separately and hence categorise them into different asset sectors according to their substance for the purpose of applying the Resilience Reserve requirements in Section 11, provided that it is demonstrated to APRA’s satisfaction that:

1.      The substance of the sub-assets warrants their proposed asset sector categorisation;
2.      The entire cash flows of the overall asset are fully reflected by the aggregated sub-assets;
3.       The resilience parameters adopted appropriately reflect the substance of the sub-assets;
4.      Where the sub-asset is equivalent in nature to an interest bearing security it is appropriately credit risk rated;
5.       The resilience shocks applied to the sub-assets do not give a result in aggregate less than the prescribed shock for the overall asset under a scenario where all yields rise;
6.        The diversification factor is not reduced (i.e. the diversification factor is to be calculated assuming that the asset is not disaggregated);
7.      The requirements of paragraphs 5.2.5 and 5.3.1 continue to be satisfied; and
8.      The overall asset continues to be treated as a single counterparty exposure for the purposes of Section 10.

SECTION 6 The New Business Reserve

6.1 The Capital Adequacy Requirement must provide for a reserve in respect of any additional capital required to ensure that the statutory fund will be able to meet the Solvency Requirement over the next three years, given:

1.    levels of projected business over that period in accordance with the realistic business plans of the company; and
2.   experience during that period in accordance with Best Estimate Assumptions.

PART B – METHODOLOGIES

SECTION 7 Determination of the Capital Adequacy Requirement

7.1 The Capital Adequacy Requirement for a statutory fund is to be calculated as follows:

7.2 Where the Actuary is satisfied that the total Capital Adequacy Liability for a Related Product Group will be less than the total Current Termination Value, no calculation in part (a) of paragraph 7.1 is required.

7.3 Where the Actuary is satisfied that the total Current Termination Value for a Related Product Group will be less than the total Capital Adequacy Liability, no calculation in part (b) of paragraph 7.1 is required.

7.4 Although reinsurance arrangements or other similar risk mitigation arrangements (per paragraph 3.5.4) that represent an asset of the fund under the scenario or test being considered are to be assessed as a asset under this Standard (per paragraph 3.5), to the extent the value of such an arrangement under this Standard differs from its value reflected in the financial statements of the fund, the difference is to be included as an offset or addition as appropriate within paragraphs 7.1(a), (b) and (c) above. The inclusion of part or all of such a reinsurance asset within these calculation steps above does not negate its consideration for inadmissibility reserving (per paragraph 10.5).

7.5 Allowance must be made by the Actuary in each of the steps in the above calculation process, as appropriate, for claims which have been incurred but not reported (IBNRs) and claims which have been reported but not admitted (RBNAs).

7.6 The performance of each subsequent step in the calculation process described in paragraph 7.1 must not reduce the progressive result from its amount at the completion of the previous step, with the exception of step 7.1(e), in circumstances where the Reserve for Inadmissible Assets is negative as a result of the alignment to Net Market Value under paragraph 10.6, and step 7.1(i).

7.7 The overall capital adequacy calculation methodology involves systematically considering the values and risks underlying the reported values set out in the regulatory financial statements and assessing appropriate reserving adjustments or margins for each. The methodology requires that all such reserving adjustments, are allowed for by means of increases to the Capital Adequacy Requirement rather than decreases in the value of the assets against which the Capital Adequacy Requirement is compared.

SECTION 8 The Capital Adequacy Liability

8.1 For both insurance and investment contracts, the Capital Adequacy Liability is determined by using the methods used to determine the Best Estimate Liability, as prescribed in section 5 of the Valuation Standard, but:

1.    allowing for current and future Bonuses subject to the appropriate application of discretions; and
2.   adopting Capital Adequacy Assumptions.

8.2 Where the benefits under the policy are dependent on the performance of the underlying net assets and related liabilities, the Capital Adequacy Liability (before application of the Current Termination Value Minimum) must be aligned with the net realisable market value of those assets and related liabilities. However, to the extent that the Capital Adequacy Liability adopted for this Standard in respect of that policy is based on asset values disclosed in the regulatory financial statements and would correspondingly change in value if such net realisable asset or related liability values were adopted for the financial statements, then this adjustment may be ignored in respect of that policy, along with the equivalent adjustment under paragraph 10.6.

SECTION 9 Current Termination Value

9.1 The Current Termination Value must be determined as the Termination Value on the reporting date. For investment linked business, the unit price published or promulgated on the reporting date is to be used.

9.2 Where the Termination Value is determined as the amount paid on voluntary termination, the Actuary must have regard for the reasonable expectations of policy owners based on the company’s current practice at the reporting date.

9.3 The Current Termination Value must not be less than the Minimum Termination Value determined in accordance with the Solvency Standard (except that in the case of investment-linked business, the Minimum Termination Value for this purpose does not include the prescribed risk margin specified in that standard).

9.4 If the company’s obligation under the policy involves:

1.    deferred payment of the termination value;
2.   payments by instalment over a period; or
3.    payment in the form of an income stream;

then the Termination Value must be determined as the present value of those future payments, using assumptions consistent with this Standard. Tax relief on payments may be taken into account if available under the relevant scenario and if the corresponding calculation of the best estimate liability is based on valuing net of tax payments.

9.5 If there is an unsettled lump sum insurance claim on a policy, the best estimate of the amount potentially payable, taking appropriate account of claims settlement costs and reinsurance recoveries, is to be counted as the Termination Value.

9.6 Where appropriate, the determination of the Termination Value at the reporting date is to include allowance for Bonuses declared as at that date.

9.7 For the purposes of calculating the Termination Value at the reporting date, no allowance is to be taken for any additional tax relief that may arise because of an assumed termination of the policy and payment of the difference between the Termination Value and the policy liability.

SECTION 10 The Inadmissible Assets Reserve

10.1 The Inadmissible Assets Reserve for the statutory fund is determined as the sum of:

1.    the reserve prescribed in respect of holdings in associated and subsidiary entities which are Financial Services entities;
2.   defined benefit superannuation fund surpluses;
3.    non-realisable (in the context of the capital adequacy tests) intangible assets; 
4.   the reserve prescribed in respect of asset concentration risks and reinsurance asset recoverability; and
5.    the alignment necessary to ensure assets and other liabilities are based on net market value.

10.2 Holdings in Associated and Subsidiary Financial Services Entities

10.2.1 The prescribed reserve in respect of holdings in associated and subsidiary entities that are Financial Services entities is to be determined by the Actuary as the amount by which the value of the entity in the regulatory financial statements exceeds its net tangible assets.  This reserve is to be further increased by the amount of any prudential capital requirements of the entity in the jurisdiction in which it operates.  The total reserve required need not be more than the value of the entity in the regulatory financial statements, provided that there is no recourse to the life company in relation to the entity’s obligations.

10.2.2 To the extent the benefits under the policy are contractually linked to the performance of the assets held, these assets include  holdings in associated and subsidiary entities and:

1.      those holdings take the form of equities as part of an index or typical balanced investment portfolio; and
2.      the extent of the exposure to those holdings is consistent with the stated investment objective of the fund;
3.       those holdings comply with Section 43 of the Life Insurance Act; and
4.      the Actuary is satisfied that there has been appropriate disclosure to policy owners of the risks to which they are exposed;

 no reserve is required under paragraph 10.2.1.

10.3 Defined Benefit Superannuation Fund Surpluses

 Where the entity is an employer sponsor of a defined benefit superannuation fund, no value is to be ascribed to any surplus of that fund which might otherwise be recognised as an asset of the statutory fund.

Intangible Assets

10.4 The regulatory financial statements of the statutory fund may include intangible assets, such as deferred acquisition cost assets, deferred origination cost assets, the value of in-force business and any goodwill asset.  Where the values of such assets are not realisable independent of the business in-force, such assets are to be treated as inadmissible.

10.5 Asset Concentration Risks and Reinsurance Recoverability

10.5.1 Except as allowed under paragraph 10.5.2, the prescribed reserve for asset concentration risks is determined as the amount by which the value of any single asset (aggregating, where necessary, individual assets that are exposed to common risks, such as strata titles in the same property) or single credit exposure (with a particular obligor or related party) exceeds the following limits: