The actuarial professional plays a key role in strategic decision-making by the shareholders of different private-sector companies in the insurance, reinsurance and financial services sector, as well as in other industries that drive the economies of Latin American countries.
The actuarial organizations in the region, and the profession as a whole, have much to contribute with respect to the public policies adopted by the countries in the region.
This article will discuss the practical application of actuarial models designed to provide the shareholders of companies in different private sector industries, or those with executive roles in the public sector, tools for strategic decision-making.
INCORPORATIONS, MERGERS AND ACQUISITIONS OF INSURERS AND REINSURERS
Regulations in Latin America
The insurers and reinsurers that operate in Latin American countries must meet certain requirements. Whenever they are incorporated, merged, or subject to a takeover, the oversight bodies require them to submit certain information, including an indication of the type of company, which must be consistent with current laws and regulations. In some countries, such as Chile for example, certain requirements have been established related to contracting credit rating agencies and the minimum credit ratings that insurers must maintain in order to be allowed to operate.
Other standard requirements include the submission of information on the company, including:
- Company name
- Actual and established domicile
- Articles of incorporation and company bylaws
- A description of the building or facilities, indicating whether they are acquired, leased or built
- An opening statement of financial position
- Status of minimum share capital
- Insurance plans and technical/contractual elements through which the company will operate
- List of shareholders, capital to be contributed and percentage of shareholdings
- Organizational structure and the personnel it will operate with
- Estimated expenses of organization, incorporation and installation
- Reinsurance policies
- Corporate governance, and more.
A requirement that is common to all countries in the region is certification of a minimum amount of capital, which varies depending on the country and the specific characteristics of the company in terms of the insurance branches and plans it intends to commercialize, the size of the operation, and other elements of the business. For example, in Argentina, insurance entities must certify minimum capital as whichever is highest between the following three parameters: a) 16% of Premiums and Surcharges; b) 23% of Claims; c) Minimum Amount by Branch, in Argentinian pesos (updated to maintain a constant currency value). Some countries, such as Brazil, have more evolved arrangements in terms of defining capital based on risk (of the Solvency 2 type). In Brazil, the minimum capital required to operate as an insurer is whichever is greatest between the base capital and risk capital, calculated based on a formula. However, in most Latin American countries, minimum capital requirements are established based on criteria similar to those of Argentina (of the Solvency 1 type).
Regulations for the Submission of a Business Plan
In most Latin American countries, the oversight bodies require insurers to submit a business and financial plan, which must include forecasts over a certain number of years (usually three). They also usually require the plan to include a report issued by an actuary and an auditor, who must be independent from the entity and registered with the oversight body. The main objective of the presentation is to demonstrate the company’s viability to the satisfaction of the oversight body.
In some cases, there are minimum guidelines for preparing business and financial plans, as well as specific requirements for the forecast of statements of financial position, income statements and market evolution statements.
Deterministic Model Decisions Based on Expected Values
In the framework of an incorporation, acquisition or merger, or any other situation that requires a valuation of the future business of an insurance company, a forecast of its expected results must be submitted. This implies forecasting the balance sheet, income statement, cash flow and technical results. The items to be forecasted include both aspects related to specific insurance activities that are strictly of an actuarial nature (such as premiums, reserves, claims and reinsurance), specific commercial elements of the insurance business (policies, investments, etc.) and general elements of the overall corporate activity (expenses and taxes).
In forecasting, some items are of known fixed amounts (such as rent, salaries, depreciation, loans or fixed-rate investments), while others have random values. Some of the items may also be interdependent; for example, claim events depend on the amount of risk exposure, which depends on assumptions about the productivity of the commercial area and its capacity to attract customers. Consequently, the approach taken to assess such items with random outcomes is of utmost importance.
Notwithstanding the above, the regulations established by the various oversight bodies in the region require the insurers/reinsurers to develop a business plan using a deterministic approach. It consists of assessing items or entities based on their expected value. An opinion on a forecast based on this approach requires calculating the possible values of the variables and their respective probabilities. For example, it is possible to determine the number of claim events in a year, and the associated amount of claims to be paid, based on the insured’s age and probability of death, as indicated in a mortality table, and on the company’s portfolio information (actual or expected/assumed).
The deterministic approach required by the different Latin American oversight bodies, as presented above, is easy to implement and explain, and it yields, on average, an accurate result for the calculated item. Despite the benefits of this approach, it is also necessary to point out its statistical limitations because it only addresses an expected “average” value. In other words, this model does not adequately explain the probability of obtaining a value greater or smaller than a given amount.
This is an important limitation in terms of risk management, but it is also a limitation for the regulatory agency, which must prioritize the interests of the weakest party in the contractual relationship, which at the time of taking out an insurance policy, are the insured and the beneficiaries. For this reason, we believe that the Latin American oversight bodies should require the insurers/reinsurers to submit a business plan with a stochastic approach that helps determine how the operations of the newly incorporated insurer/reinsurer would be affected by deviations in the different random variables that are being estimated. To accomplish this, it is suggested to use actuarial techniques for the stochastic modeling of such business plans, such as the dynamic risk model, which incorporates the use of “simulations” and the use of adequate modeling programming languages.
Stochastic Model Assessment of the Probability of Deviation from the Expected Values and Its Implications
Based on the previous point and the aforementioned limitations of the deterministic approach for preparing economic and financial forecasts, we suggest the development of a stochastic approach, which should be required by the Latin American oversight bodies for insurers/reinsurers to include within their business plans.
Given that many of these items are the result of the operations of several random variables, obtaining an exact result in algebraic form can be very challenging. For this reason, the main mechanism for performing valuations under this approach is the simulation. For each scenario “B,” each variable is simulated to calculate a result for the period. This process is repeated B times, which means that B different outcomes are found, which will comprise a probability distribution of the results.
This practice is demanding in computational terms, but it is relatively easy to implement.
Conceptually, this can be applied to setting insurance rates, but even when it is performed using the deterministic methodology proposed by the oversight body (as in the case of life insurance in most Latin American countries), the forecast operating results of the company must logically assume that the behavior of mortality rates, frequency or intensity does not have to follow the expected value. The most important variable from the technical perspective is the claims rate (who will die, under which policies and for which amount), and it is the variable on which the company has most knowledge. However, it is possible to assign a probability distribution to any non-fixed item for which the behavior is known or can be assumed.
Lastly, the same methodology, but applied individually to each variable, can help one understand the marginal effect each one has on the outcome, which is also a valid tool for assessing the areas that require most attention. For example, the starting point could be the deterministic scenario, to then apply a simulation approach to different interest rate scenarios, whose probabilities can be assigned by a model, in order to understand the outcome as a function of the behavior of this factor.
This approach is highly versatile in terms of application, because it enables a better quantification of the risks. In the case of a start-up company, it enables providing an estimate, not on the expected result of the first years, but on its probability of success (of not going bankrupt, of achieving a result that is positive enough to continue with its expansion plans, etc.), thereby assisting in the review of the business plan (adjusting the expense or commercial structure). This would help regulators avoid difficulties when authorizing the operation of a company that is not very solid. In a merger or acquisition, this approach allows one to form a complementary analysis with other valuation mechanisms.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.
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