Insurance Companies to Face Stricter Controls on Arbitrary Loss Ratio and Business Expense Assumptions

Financial Authorities Announce "Advanced Actuarial Supervision Plan" for the Insurance Industry
Loss Ratio Assumptions for Coverages with Less Than Five Years of Experience Data Must Be Conservative
Inflation Rates to Be Reflected in Business Expense Assumptions

Going forward, cases where insurance companies arbitrarily assume loss ratios and business expenses to inflate their performance are expected to decrease significantly.

On January 20, the Financial Services Commission announced that it had established an "Advanced Actuarial Supervision Plan for the Insurance Industry."

In 2023, the International Financial Reporting Standard (IFRS 17), which requires insurance liabilities to be measured at fair value, and the insurance soundness standard based on it, the Korea Insurance Capital Standard (K-ICS), were introduced. As a result, insurance companies must now evaluate insurance liabilities and estimate future profits and losses based on discount rates and loss ratios at the time of closing.

However, as companies' expectations about the future are reflected in this process, discrepancies have arisen in the assumptions made by each company, leading to criticism regarding the appropriateness of actuarial assumptions. This is because excessively optimistic actuarial assumptions can inflate short-term performance and shift risks to the future.

In response, the Financial Services Commission and the Financial Supervisory Service, together with related institutions, have established basic principles to consistently and systematically refine actuarial assumptions from a long-term perspective. Based on these principles, they have prepared guidelines for loss ratio and business expense assumptions, which have raised concerns about underestimating insurance liabilities. Measures have also been developed to strengthen internal controls within insurance companies and to improve supervisory systems to ensure substantive compliance with the basic principles and guidelines.

The overarching principle for establishing actuarial assumptions is to use the "Best Estimate" method, which explicitly estimates future cash flows using neutral probability-weighted values. To ensure adherence to this principle, three detailed principles have been set: "neutrality," "prudence," and "comparability." Two supplementary principles have also been proposed to ensure substantive compliance and effectiveness: "strengthening internal controls" and "enhancing market discipline."

The loss ratio assumption refers to the expected trend of the loss ratio by coverage (insured risk) over elapsed periods. Insurance companies use loss ratio assumptions to predict cash inflows and outflows related to premiums and claims, and reflect these in their insurance liabilities as present values. Previously, for new coverages where experience data had been accumulated for less than five years, companies sometimes applied loss ratios from similar coverages or used arbitrarily optimistic loss ratios. This led to concerns that insurance liabilities were being underestimated and that excessive sales competition could be triggered through new coverages that had not been statistically validated. Going forward, for new coverages, the use of similar coverage loss ratios will not be permitted. Instead, the loss ratio assumption must be set at the higher of a conservative loss ratio (90%) or the actual loss ratio of the highest-level coverage. The financial authorities explained that setting the conservative loss ratio at 90% reflects the safety loading (about 10%) included in the reference premium rate used by insurers when calculating premiums.

Assumptions for premium renewals for products other than indemnity insurance have also been made more realistic. Currently, for renewable products, insurers set a target loss ratio and base their loss ratio assumptions on the premise of premium renewals. This has led to criticism that insurance liabilities may be underestimated by assuming significant future premium increases. Going forward, the target loss ratio must be set at the higher of the conservative loss ratio (same standard as for new coverages) or the actual loss ratio.

The timing of applying the final loss ratio will also be rationalized. Currently, after a certain number of years have elapsed since a product was sold, insurers apply a single final loss ratio, taking into account factors such as insufficient statistics. In most cases, the timing for applying the final loss ratio is uniformly set for all coverages, regardless of actual statistical data. There have also been cases where the range of changes in the final loss ratio is arbitrarily limited, resulting in the under-reflection of recent significant deteriorations in actual loss ratios. Going forward, insurers will be required to determine the timing for applying the final loss ratio for each coverage based on actual statistical data. Deliberately minimizing the impact of adverse changes in observed loss ratios will be prohibited.

The calculation units for loss ratios have also been subdivided. Currently, even when sufficient experience data is available, insurers have varied in the extent to which they subdivide calculation units, sometimes integrating multiple coverages to derive loss ratio assumptions. This has reduced comparability between insurers' loss ratio assumptions. Going forward, calculation units for loss ratios will be subdivided when statistical sufficiency and significance requirements are met. These requirements will be set and managed by each insurer, and the appropriateness of existing calculation units will be verified retrospectively each year when actuarial assumptions are calculated.

The financial authorities have also established guidelines for business expense assumptions. Business expense assumptions refer to the expected trend of business expenses by cost item over elapsed periods. As with premiums and claims, cash flows related to business expenses associated with insurance contracts are discounted and reflected in insurance liabilities.

Going forward, inflation rates will be reflected in business expense assumptions. Previously, some insurers did not reflect inflation rates in their business expense assumptions, raising concerns about the underestimation of insurance liabilities. Now, when calculating business expense assumptions, insurers must reflect inflation rates based on the Bank of Korea's inflation target, among other factors. Exceptions will only be allowed if insurers provide a reasonable basis for not reflecting inflation rates and document this justification.

Overhead costs must now be recognized over the entire insurance contract period. Overhead costs refer to indirect costs that are incurred across multiple insurance products, services, and departments, and are difficult to directly allocate or trace to specific cost drivers. Currently, insurers classify overhead costs by cost item (such as acquisition or maintenance expenses) according to their own allocation standards. This results in differences in the period over which costs are recognized depending on the classification of cost items. Even for costs classified as long-term, such as maintenance expenses, the recognition period may differ depending on the type of cost driver. If insurers arbitrarily adjust cost items or cost drivers to shorten the cost recognition period, there is a risk that insurance liabilities will be underestimated. Going forward, overhead costs must be recognized over the entire insurance contract period. Exceptions will only apply when insurers can prove a reasonable basis for shortening the cost recognition period and document this justification.

Internal controls within insurance companies will also be strengthened. Previously, important matters related to actuarial assumptions were not always documented, or only basic information was recorded, limiting proper control, verification, and accountability. Going forward, all experience data, calculation and adjustment methods, calculation results, and related decision-making processes pertaining to the derivation of assumptions must be documented and applied consistently. If the documented content is not applied, the specific grounds for this decision and the responsible person must be clearly stated.

Self-inspection and management by insurance companies will also be strengthened. Currently, actuarial assumptions are calculated and verified in a closed manner, mainly by the actuarial department, which has been criticized for limiting proper control. Going forward, when actuarial assumptions are calculated or changed, the compliance or audit department must verify consistency with the documented information. If actuarial assumptions are to be changed during the year, the reasons, details, and financial impact must be reported to the Risk Management Committee (a committee within the board of directors).

An actuarial assumptions report system will also be introduced. Previously, there was no regular reporting obligation for actuarial assumptions, and insurers were only required to submit information to supervisors upon request, with the scope specified as needed. Even then, there was no standardized management format across insurers, limiting cross-verification and comparability. Now, insurers will be required to report actuarial assumption-related matters to the Financial Supervisory Service annually. This will enable standardized data collection on actuarial assumptions across insurers and enhance analysis, such as the detection of outliers.

Disclosure obligations related to actuarial assumptions will also be strengthened. Currently, only limited information, such as the overall loss ratio of an insurer, is disclosed, limiting the provision of neutral and comparable information for users. Going forward, disclosure items will be expanded, including the publication of loss ratio assumptions by major coverage.

A Financial Services Commission official stated, "For the loss ratio and business expense guidelines, we will distribute practical standards containing detailed provisions within the first quarter of this year and apply them starting from the second quarter's closing. Strengthening internal controls and improving the supervisory system will be implemented in the second quarter after relevant regulations are revised."