Communication on the results of the horizontal analysis of costs used in the valuation of technical provisions

NBB_2017_32 – 29 December 2017 Communication – p. 1/7 Boulevard de Berlaimont 14– BE-1000 Brussels tel. +32 2 221 27 31 – fax + 32 2 221 31 36 company number: 0203.201.340 RPM Brussels www.nbb.be

Communication
Brussels, 29 December 2017
Reference: NBB_2017_32 your contact:
Bart Maselis tel. +32 2 221 34 82 – fax +32 2 221 31 36 bart.maselis@nbb.be

Communication concerning the results of the horizontal analysis of costs used in the valuation of technical provisions

Scope
Belgian insurance or reinsurance companies subject to the Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings.

Summary/Objectives
This communication sets out the findings of the horizontal analysis conducted by the Bank in 2016 and 2017 with seven insurance companies regarding the costs used in the valuation of technical provisions. This communication also contains clarifications on the current regulations, which should lead to a uniform application of the regulatory provisions.

Legal Basis x Article 133 of the Law on the status and supervision of insurance or reinsurance undertakings of 13 March 2016 (hereinafter the Law). x Article 31 of Delegated Regulation 2015/35 (hereinafter the Delegated Regulation). x Annex 2 of Implementing Regulation 2015/2450 regarding the templates for reporting information to supervisory authorities (hereinafter the Implementing Regulation for reporting templates). x Guidelines 29 to 34 of Circular NBB_2016_26 on guidelines regarding the valuation of technical provisions (hereinafter the best estimate circular).

Structure
A. Summary
B. General findings and regulatory clarifications

Communication – p. 2/7 NBB_2017_32 – 29 December 2017 Horizontal Analysis of Costs A. Summary

Context
In 2015, external actuarial experts conducted, on behalf of the Bank, an assessment for the seven largest insurance companies of the adequacy of the best estimate of technical provisions (hereinafter the best estimate). The horizontal analysis of costs included in the best estimate follows this exercise. This analysis is based on the results of a questionnaire completed by the insurance companies concerned.

Objective
The purpose of the horizontal analysis was to analyze the methods applied by insurance companies to allocate and project costs included in the best estimate, to compare them to determine a level playing field, and to examine whether practices in this area comply with regulations. The analysis also served to gauge the transparency of methods and the comparability of reporting.

Timing
The questionnaire was sent on 5 April 2016. Responses were received and analyzed between October 2016 and March 2017. During the third quarter of 2017, the findings were discussed informally with the insurance companies concerned and some auditors. On 20 September 2017, Assuralia, the IREFI, and the IAŇBE were consulted.

General Conclusion

1. The Solvency II regime establishes a series of new definitions and requirements for the allocation and projection of costs. Some insurance companies have initiated the process to adapt their systems and methods.
2. There are differences in how the insurance companies concerned allocate and project costs. Moreover, the practices of insurance companies are not fully compliant with all regulatory provisions. This may result in the best estimate being significantly underestimated. This publication sets out the general findings in this regard.
3. The regulation, as currently worded, may sometimes leave room for interpretation or may prove insufficiently explicit, particularly regarding reporting instructions. This is why this publication also contains supplementary clarifications regarding the current provisions. These clarifications should lead to a uniform application of regulatory provisions, primarily for elements that may have a material impact on the amount of the best estimate.
4. For most companies, the Bank expects that implementing the clarifications will take some time. For this reason, insurance companies must define a realistic action plan to implement the necessary changes within a reasonable timeframe. This action plan must be made available to the Bank. The insurance companies concerned by the horizontal analysis were asked to submit this action plan by 31 May 2018 at the latest. Prior to the effective implementation of the required adaptations, the Bank also expects insurance companies to assess the possible impact using prudent methods.
5. Solvency II reporting is currently insufficient to carry out a complete analysis of the allocation and projection of costs. The Bank does not, however, require supplementary reporting, but expects insurance companies to have adequate documentation.
6. The Bank expects the statutory auditor and the actuarial function to integrate the points raised in this communication into their audit plans.

NBB_2017_32 – 29 December 2017 Communication – p. 3/7 B. General findings and regulatory clarification A. Allocation of Costs

1. Clear, consistent, and granular definition of costs
   Finding: Several insurance companies lack clarity, consistency, and granularity in the definition of cost items (and potential underlying activities).
   Clarification 1: Insurance companies must define cost items (and potential underlying activities) clearly, consistently, and granularly, in order to comply with regulations regarding the allocation and projection of costs. In particular, the granularity must be sufficient to satisfy the various clarifications set out in this publication.

2a. Realistic allocation of costs
Finding: Most insurance companies attempt to allocate costs realistically to different product lines, but there is nevertheless heterogeneity in the methodologies applied and their degree of realism. For some insurance companies, a significant part of the allocation is still carried out based on a flat-rate key or as a function of profitability.
Clarification 2a: In application of Article 31, § 2, of the Delegated Regulation, the insurance company is required to allocate costs realistically. This means, in particular, that the allocation of overhead costs should rely as little as possible on a purely flat-rate allocation key or be based on profitability measures, certainly up to a level of granularity corresponding to product lines. If the allocation nevertheless relies on a flat-rate allocation key or lacks granularity, and this applies to a significant portion of costs, then the insurance company must demonstrate that the chosen method is prudent for determining the best estimate. In this regard, it is necessary to check whether there is no excessive allocation of costs to short-term activities of non-life lines.

2b. Objective allocation of costs
Finding: Several insurance companies allocate costs for certain items (particularly for sales/commercialization and management activities) using methods whose objectivity is difficult to demonstrate. Specifically, some costs are assigned to a particular item following consultation with a manager or expert, rather than based on a measure of the actual time required for a task or a realistic estimate in man-days. Clarification 2b: To allocate costs in the most realistic manner possible, the insurance company is required – in application of Article 31, § 2, of the Delegated Regulation – to proceed in the most objective and transparent manner possible. This means, particularly regarding personnel costs, that the allocation of costs should ideally be based on a standardized measure of working time (e.g., man-days). If the insurance company does not have a tool allowing for an objective measure of working time, it may resort to surveys, but these must, as much as possible, be conducted according to standardized procedures and models.

3. Definition and reporting of overhead costs and cost categories
   Finding: Several insurance companies continue to define and report cost categories according to the concepts of Belgian GAAP, rather than according to the instructions of the S.05.01 reporting template in Annex 2 of the Implementing Regulation for reporting templates. Moreover, it frequently happens that "overhead costs" are not defined and reported in a separate category.
   Clarification 3: Insurance companies are required to define and report cost categories, including overhead costs, in accordance with the instructions of the Implementing Regulation for reporting templates. This means, in particular, that costs related to IT, logistics, and buildings, as well as to commercialization and product development, must be recorded as overhead costs.

Communication – p. 4/7 NBB_2017_32 – 29 December 2017
4. Correct allocation of overhead costs to other cost categories
Finding: Among the insurance companies concerned, it is observed that the amount of costs allocated to acquisition costs varies from one to two. This can be explained by various reasons. First, some insurance companies allocate overhead costs to each of the cost categories, either on a flat-rate basis or based on a comparison with competitors. Moreover, some insurance companies do not – or do so insufficiently transparently – distinguish between sales and commercialization costs for new contracts and for the existing portfolio (retention). Finally, marked differences are observed between insurance companies regarding the allocation of costs for general management and human resources. Clarification 4: Insurance companies must ensure that, in application of Article 31, § 1, of the Delegated Regulation, overhead costs are correctly allocated to each of the cost categories, with particular attention to the allocation to acquisition costs. The flat-rate allocation of overhead costs to different cost categories is not realistic. An allocation method consisting of allocating, in a first step, certain overhead costs to one or another cost item, and whereby these cost items are defined with sufficient granularity so that it is subsequently possible to adequately allocate these overhead costs to each of the cost categories defined by the aforementioned article, may nevertheless be considered realistic. If a company wishes to use another method, it must be demonstrated periodically that this method does not result in an excessive allocation of costs to acquisition costs.

Where applicable, when called upon to determine whether an expense should or should not be considered as an acquisition cost, insurance companies are required to clearly demonstrate which expenses are incurred for new contracts, and which are for the existing portfolio and/or customer retention (retention), particularly regarding sales and commercialization costs. Insurance companies are also required to allocate to administration costs the overhead costs related to human resources and general management, unless activities related to new contracts can be isolated precisely.

5. Adjustments for non-recurring costs
   Finding: Some insurance companies make an adjustment for non-recurring costs, and the way this adjustment or correction is made can vary considerably.
   Several insurance companies consider, from an accounting perspective, that costs for major strategic projects (such as software development) are an investment which they then record on their balance sheet. Solvency II regulation, however, does not allow intangible assets to be taken into account in available own funds. These costs disappear from the cost base, which is why they are considered non-recurring. Although amortization is not a cash flow, some insurance companies use it as an estimate of future non-recurring costs.

Moreover, some insurance companies consider other costs, such as costs related to regulation, as non-recurring and also remove them from the cost base. A number of insurance companies remove from this base costs related to restructuring.
No insurance company explicitly takes into account future cost reduction measures – for example following the implementation of a more efficient IT system – even if this is considered in some cases.

NBB_2017_32 – 29 December 2017 Communication – p. 5/7 Clarification 5: In application of Article 31, § 4, of the Delegated Regulation, the insurance company must always consider, in determining the costs taken into account for the calculation of the best estimate, that there will be new contract subscriptions. Moreover, the Implementing Regulation for reporting templates provides, in particular, that overhead costs include costs for improving internal processes, for example an investment in the support system needed by the insurance company (purchase of a new IT system, development of new software...). Costs related to the implementation of new regulations and restructuring can also be considered, by definition, as overhead costs.

It is therefore expected of insurance companies that they systematically incur costs to renew systems (software) or implement regulations, even if the projects or regulations are not yet known.
If these future "non-recurring" costs, such as software system renewal, regulation implementation, or restructuring, are already known and related to insurance activity, they must be taken into account in determining the best estimate. If the magnitude of non-recurring costs has fluctuated significantly in previous years, the insurance company must take this into account to assess the level of non-recurring costs for the entire projection horizon.

Where costs are capitalized from an accounting perspective, the insurance company must base itself on the expected actual cash flows. Accounting choices made and amortization cannot, a priori, play any role in this regard. Amortization cannot be taken as a reference for estimating future non-recurring costs except in certain specific circumstances, particularly in cases of stability in the history of non-recurring costs and in the accounting rules applied. The final calibration must be clearly supported and documented.

In their projections, insurance companies cannot take into account future cost reduction measures, unless these measures have been included in the plan of "future management decisions" which has been established in full compliance with the provisions of Article 23 of the Delegated Regulation. This implies, in particular, the formal approval of a detailed plan by the decision-making bodies of the company. Furthermore, insurance companies cannot take into account the impact of cost reduction measures on future cash flows unless this impact can be determined unambiguously and in a sufficiently prudent manner. Costs related to the implementation of cost reduction measures must also be included in the best estimate.

B. Projection of Costs
6. Adjustments regarding "contract boundaries"
Finding: Several insurance companies indicated that part of the costs (administrative) – as currently managed in accounting systems – concern costs related to premium renewals falling outside the "contract boundaries" as defined by the Solvency II regime. This concerns, for example, costs related to salary increases for group insurance contracts, or contracts with renewable single premiums. Several insurance companies also argued that premium increases received, which are intended to cover the cost of renewals, cannot be included further.

Several insurance companies have therefore applied an explicit correction to the cost base, but significant differences are observed among the reasoning and estimation methods used. Some insurance companies, on the other hand, have applied no correction.

Moreover, some insurance companies apply an implicit correction, notably by using (partially) for Life administration costs, premiums as a cost driver for projections. This method also results in costs decreasing in projections due to "contract boundaries" as defined by the Solvency II regime.

Communication – p. 6/7 NBB_2017_32 – 29 December 2017 Clarification 6: The Implementing Regulation for reporting templates explicitly provides that costs related to contract renewals must be defined as acquisition costs.

Rather than applying corrections, insurance companies must determine the costs of contract renewals as precisely as possible. This means that insurance companies must allocate to acquisition costs, in a granular manner, the different cost items (and potential underlying activities) related to contract renewals, as well as the associated overhead costs. This, taking into account the "contract boundaries" as defined by Solvency II regulation.

Due to the concept of "contract boundaries," it is not realistic to use premiums as a cost driver for Life insurance activities.

7. Temporal coincidence between cost cash flows and underlying claim cash flows
   Finding: Several insurance companies do not take into account the requirement of Guideline 32 of the best estimate circular. This guideline provides that they should allocate costs to the projection of cash flows so that the schedule of cost cash flows is consistent with the schedule of other cash inflows and outflows necessary to settle insurance and reinsurance obligations.

Clarification 7: Insurance companies must apply Guideline 32 of the best estimate circular. This means that for Life business, unit costs and cost drivers for different types of benefits – such as deaths, surrenders, and terminations – must be determined and modeled separately.

8. Modeling of costs in non-life
   Finding: Most insurance companies project non-life claim costs based on a general comparable method (such as the so-called "New York" method or the "paid-to-paid" method), within which the insurance company often proceeds by simply determining a flat-rate cost/claim ratio, with costs evolving according to claims. There are many differences between insurance companies regarding how this method is applied, and differences are also observed in the treatment of administrative costs. Sometimes administrative costs evolve according to claims and sometimes according to expected premiums.

Clarification 8: Article 31, § 1, of the Delegated Regulation provides, in particular, that costs should be allocated realistically to the parts of the best estimate to which they relate. Insurance companies must therefore, in their projection of non-life costs, clearly justify, for all cost categories, the choice of the cost driver, with particular attention to administrative costs.

Insurance companies are also required to periodically evaluate, notably using back tests, whether the chosen method and underlying assumptions correspond to reality or, at the very least, whether they are prudent.

9. Inflation
   Finding: All insurance companies apply an inflation rate in the projection of cost cash flows, but there are significant differences between them regarding how to proceed in this matter. Some insurance companies use inflation based on an index and others on market instruments. Some insurance companies also make an explicit distinction between, on the one hand, costs that vary according to salaries, and on the other hand, other costs. Finally, some insurance companies use stochastic projections and others do not.

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NBB_2017_32 – December 29, 2017 Communication – p. 7/7

Clarification 9: In application of Article 133, § 2, of the Law, and of orientation 33 of the best estimate circular, insurance companies must take inflation into account in a manner that maintains consistency with economic assumptions. In this regard, insurance companies must explicitly determine which type of inflation is most appropriate for cost projection. To do this, they must examine which inflation rate applies to which types of costs (for example, for costs that vary according to salaries). Insurance companies are also required to periodically evaluate, notably using back tests, whether the chosen method and underlying assumptions correspond to reality or, at the very least, are prudent.

10. Tests

Finding: Most insurance companies do not perform back tests, nor variance analyses on unit costs or underlying methods and assumptions. Some insurance companies have performed limited sensitivity tests.

Clarification 10: Insurance companies must regularly perform back tests on unit costs and the main underlying assumptions and methods for cost projection, and report on them, in accordance with Article 138 of the Law.

11. Documentation

Finding: Insurance companies have prepared the necessary documentation in response to the questionnaire, but for some, this documentation is insufficient and not permanently available.

Clarification 11:
In application of Article 265, § 1, first paragraph, b, of the Delegated Regulation, and for the purpose of adequate monitoring, insurance companies must adequately document the methodology for cost allocation and projection, and keep it permanently available to the Bank. The documentation must include at least the following aspects:

• a detailed documentation of the cost allocation and projection methodology, including:
  • all assumptions and expert judgments applied;
  • a transparent list and definition of cost items and activities;
  • the allocation of cost items and activities to different cost categories;
  • the allocation keys applied and the values assigned to them;
  • the QRT S.05.01 report but after the allocation of overheads to other categories (any corrections must be included in the "other costs" item).
• documentation demonstrating compliance with the clarifications set out in this publication.

A copy of this is sent to the auditor(s), approved auditor(s) of your establishment.

Please accept, Madam, Sir, our distinguished greetings.

Jan Smets
Governor