Risk management in main risk types

Insurance-related

The Liberty Group (Liberty) board of directors acknowledges its responsibility for establishing and communicating appropriate risk and control policies, and ensuring that adequate risk management processes are in place. Liberty has a number of committees which deal with the various policies for accepting insurance risks, including selection and approval of risks to be insured, use of limits and avoiding undue concentrations of risk, underwriting strategies to ensure the appropriate risk classification and premium levels, among others, as detailed below.

Responsibility for risk management

A Liberty group risk management committee, being a committee of the Liberty board, is in place to assist the board in discharging its risk management obligations.

The principal objectives of Liberty’s risk management committee are to:

• review Liberty’s risk philosophy, strategy, policies and processes recommended by executive management;
  
• review compliance with risk policies and with the overall risk profile of Liberty;
  
• review and assess the integrity of the processes and procedures for identifying, assessing, recording and monitoring risk;
  
• review the adequacy and effectiveness of Liberty’s risk management and its implementation by management;
  
• ensure that material corporate risks have been identified, assessed and receive attention; and
  
• provide the board with an assessment of the state of risk management within Liberty.

A significant part of Liberty’s business involves accepting and managing risk. Primary responsibility for risk management at an operational level rests with the executive committee. Management and various specialist committees are tasked with integrating the management of risk with the day-to-day activities of Liberty.

These committees are outlined below.

• Audit and actuarial committee – principal objectives (pertaining to risk) are as follows:
  
  

–	act as an effective communication channel between the board on one hand and the external auditors and the head of internal audit on the other;
–	satisfy the board that adequate internal, financial and operating controls are being identified, addressed and monitored by management; and
–	enhance the quality, effectiveness, relevance and communication value of the published financial statements and other public documentation of a financial nature issued by Liberty.

• Capital management committee – is responsible for the management and investment of Liberty’s capital.
• Asset/liability matching committee – focuses on the matching of assets and liabilities. It also oversees the high-level mix parameters for various products and portfolios, and is tasked with agreeing benchmarks and mandates for performance of each investment portfolio in conjunction with the asset managers.
• Product approval committee – assesses whether all new products conform to Liberty’s predetermined requirements and standards, such as meeting policyholder needs; appropriate margins; investment backing; legal, underwriting and taxation considerations; and, where appropriate, currency risks; as well as Liberty’s administrative capabilities for managing these products.
• Underwriting committee – reviews underwriting standards and claims experience as well as monitoring reinsurance retention limits and stop loss limits.

Management of insurance and financial risk on contractual obligations to policyholders

Liberty issues contracts that expose it to insurance risk or financial risk, or in some cases, both of these. Set out below are Liberty’s objectives in managing risks from insurance contracts and its policies for mitigating those risks.

The Capital Adequacy Requirement (CAR) as part of the risk management framework

CAR is intended to approximate a risk-based capital measure. It is calculated based on a number of stress tests, specified in actuarial guidance, PGN 104, which are intended to provide approximately a 95% confidence level that the insurer will be able to meet all obligations over time under a variety of scenarios.

Liberty is in the process of developing economic capital models to better understand its capital requirements and the underlying risks, in order to continually improve the management of these risks.

Market risk

Liberty is exposed to market risk through its financial assets, financial liabilities (investment contracts and borrowings), and insurance liabilities. In particular, the key financial risk is that the proceeds from its financial assets are not sufficient to fund the obligations arising from its insurance and investment contracts. The most important components of this financial risk are interest rate risk, equity price risk and currency risk. These risks arise from open positions in interest rate, currency and equity products, all of which are exposed to general and specific market movements.

Liberty manages these positions within an asset liability management (ALM) framework that aims to match assets to the liabilities arising from insurance and investment contracts by currency, nature and term. For each distinct category of liabilities in terms of the ALM framework, a separate asset profile is maintained. In some instances, segregated portfolios of assets are held for books of business within these broad categories.

Interest rate and equity price risk

These risks have very different impacts on the various categories of business used in Liberty’s ALM framework. Interest rate and equity price risk are discussed together since they interact on certain types of liabilities.

(a)	Guaranteed maturity values Embedded derivatives in the form of guaranteed maturity values are attached to a significant portion of unit linked business. Liabilities arising from these embedded derivatives are valued in accordance with valuation techniques described in actuarial guidance PGN 110, issued by the Actuarial Society of South Africa. These liabilities are essentially put options on the underlying unit linked liabilities and as such are sensitive to movements in interest rates and equity prices. Liberty is investigating ways in which this interest rate and equity risk exposure could be more closely hedged than it is at present.
(b)	Guaranteed annuity options Guaranteed annuity options (GAOs) give the policyholder the option to convert the maturity proceeds of a retirement annuity into an annuity at a pre-defined rate. GAOs are no longer sold on new business. As in the case of guaranteed maturity values, liabilities arising from these embedded derivatives are valued in accordance with valuation techniques described in PGN 110. GAOs expose Liberty to significant interest rate risk. Liberty is investigating ways in which interest rate and equity risk exposure on GAOs could be more closely hedged. To some extent the upside equity risk exposure on GAOs can be offset against the downside equity price risk exposure on guaranteed maturity values.
(c)	Unit linked business For unit linked contracts, Liberty holds the assets on which the unit prices are based. As a result, there is no mismatch. Gross unit liabilities are however reduced by the present value of future expenses and risk claims less the present value of future charges for purposes of this matching exercise. Some interest rate, equity price, credit and currency risk is consequently retained on this business to the extent that present value of future expenses and risk claims less the present value of future charges do not move in line with gross unit liabilities. Within this category of business there are insurance contracts with minimum guaranteed death benefits and universal life type contracts in terms of which the sum at risk depends on the fair value of the underlying investments. These contract features mean that fluctuations in market prices affect Liberty’s exposure to mortality risk.
(d)	Non-participating annuities Non-participating annuities have benefit payments that are fixed and guaranteed at inception of the contract (although a small proportion of the business provides inflation related increases on annuities in payment). These liabilities are backed largely by fixed income securities, with other assets held only to support the longest dated cashflows arising from a portion of these liabilities. Liberty’s primary financial risk on these contracts is the risk that interest income and capital redemptions from the financial assets backing the liabilities is insufficient to fund the guaranteed benefits payable. Liberty monitors interest rate risk in this business by comparing the modified duration and convexity of the investment portfolio and the liabilities issued.

(e)	Long-term insurance contracts with discretionary participating features (DPF) Liberty has a number of books of long-term insurance contracts with DPF, most of which have been acquired from other insurers. Each book of business is backed by a distinct asset profile, often as a result of conditions included in the Scheme of Transfer in terms of which the business was acquired. The assets backing these liabilities are generally segregated from Liberty’s other assets to ensure that the assets are used exclusively to provide benefits for the relevant policyholders. Liberty recognises the full value of the backing assets as a liability. However, Liberty only bears interest rate risk in relation to the guaranteed benefits under these contracts, and not in respect of the DPF component of the liability. Furthermore, Liberty is only exposed to equity price risk on this business to the extent that equities are held to back the guaranteed portion of the liability.
(f)	Guaranteed capital bonds Guaranteed capital bonds have benefit payments that are fixed and guaranteed at inception of the contract. The ALM framework dictates that assets are selected to provide a cash flow match to these liabilities. There is consequently very little interest rate risk on these products and no equity price risk. On this business the risk of a change in tax laws is mitigated through policy terms and conditions which enable this risk to be passed back to the policyholder.

Currency risk

Offshore assets are held in policyholder assets to match the corresponding liabilities. As a result, the group is exposed to currency risk through maturity guarantees issued on contracts invested in offshore portfolios. Maturity guarantees are no longer offered on new business invested in offshore portfolios. The rand denominated value of management fees derived from these contracts is also subject to currency risk. Strengthening of the rand against the offshore currencies reduces the value of management fees and increases the liability in respect of embedded derivatives on this business.

Insurance risk

Insurance risk is the risk that future claims and expenses will exceed the value placed on insurance liabilities. It occurs due to the uncertainty of the timing and amount of future cash flows arising under insurance contracts. The timing is specifically influenced by future mortality, morbidity, and withdrawal rates about which assumptions are made in order to place a value on the liabilities. Deviations from assumptions will result in actual cash flows differing from those projected in liability calculations. As such, each assumption represents a source of uncertainty.

Policyholder behaviour risk

Policyholders have the option to discontinue or reduce contributions or withdraw benefits prior to expiry of the contract term. As a result, policyholder behaviour contributes to insurance risk. The main risk posed by this behaviour is the risk that expenses and commissions incurred early in the term of the contract but priced to be recovered by means of ongoing charges over a longer period are not recovered prior to the decision by the policyholder to cease or reduce contributions.

On contracts where a withdrawal benefit is payable, this risk is mitigated by conditions built into policy contracts which enable Liberty to recoup these unrecovered expenses by means of a lump sum charge. However, the Pension Funds Adjudicator has recently challenged the practice of levying charges of this sort on retirement annuity contracts, by issuing a number of determinations against life insurers, including Liberty. This is symptomatic of growing consumer dissatisfaction with this practice. Charges of this sort will therefore be limited in terms of an industry agreement with National Treasury. This will increase Liberty’s exposure to the risks associated with policyholder behaviour.

Mortality and morbidity risk

Procedures to control and manage the underwriting risks at a Liberty level are in operation, of which the more significant are discussed below.

The statutory actuary reports annually on the actuarial soundness of the premium rates in use and the profitability of the business, taking into consideration the reasonable benefit expectations of policyholders. All new premium rates are approved and authorised by the statutory actuary prior to being issued. Regular investigations into mortality and morbidity experience are conducted. Catastrophe insurance is in place for single event disasters. Assumptions are made concerning the expected deaths and disabilities (including disease claims) that will occur in each future time period. The significant classes of business most affected by mortality and morbidity risk are:

(a)	Life annuity business In terms of life annuity business, the life insurer undertakes to pay a series of future payments contingent on the policyholder’s survival. The most significant insurance risk on these liabilities is continued medical advances and improvements in social conditions that will lead to increases in longevity. A proportion of both group and individual disability income business is reinsured on a proportionate quota share basis, so a proportion of all annuities arising from disability income claims are reinsured. No additional reinsurance is purchased in respect of this class of business.
(b)	Group mortality and morbidity business The risks for this class of business are very similar to those for individual insurance business. The most important differences result from the greater correlation between individual risks on group schemes because lives assured work in the same location, industry etc. For this reason, Liberty attempts to ensure that a diversified portfolio of schemes is insured.
(c)	Individual insurance business Individual insurance contracts are those issued to individuals where death or disability is the insured risk. The most significant factors that could increase the frequency of mortality claims are epidemics, such as AIDS and Asian bird flu, or lifestyle changes such as eating, drinking and exercise habits, resulting in earlier or more claims than expected. The health condition and family medical history of applicants are assessed at inception of new contracts as part of the underwriting process with premiums and terms and conditions being varied accordingly. Special risks, such as hazardous pursuits and unusual medical conditions, are also assessed at underwriting stage. The underwriting committee determines underwriting guidelines concerning authority limits and procedures to be followed.

Credit risk

Credit risk is the risk that a counterparty to a financial instrument will fail to discharge an obligation and cause Liberty to incur a financial loss.

Provisions of the Long Term Insurance Act 1998 have the effect of limiting exposure to individual issuers due to the inadmissibility of assets for regulatory purposes if specified limits are breached. Credit ratings of reinsurers are taken into account in reinsurance placement decisions. Credit exposure to reinsurers is also limited through the use of a number of reinsurers. Scrip lending counterparties are restricted to appropriately accredited institutions.

Liberty has no significant concentration of credit risk in terms of insurance and other receivables due to the relative significance of the total value and the wide spread of individual debtors. Derivative counterparties and cash transactions are limited to high credit quality financial institutions. Liberty has policies that limit the amount of the credit exposure to any one financial institution.

Liberty is exposed to tenant default within its investment property portfolio. This exposure risk is mainly attributable to policyholders and the shareholder exposure is limited to management fees and profit margins. The managed diversity of the property portfolio and the existence of multi-tenanted buildings significantly reduces exposure to this credit risk.

Liquidity risk

Net cash flows are closely monitored. Over the last few years Liberty has experienced positive net cash flows. In addition, Liberty has significant credit lines over and above the liquid assets held to meet cash demands.

Liquidity requirements and cash resources are monitored on a monthly basis by the capital management committee.

Embedded derivatives not valued at fair value

Guaranteed maturity values, guaranteed annuity options and a return of contributions on death are features of insurance contracts written by Liberty. These are valued in accordance with PGN 110.