Risk Based Capital TestsLife and General Insurers

OSFI International Advisory Group

IAIS-FSI-ASSAL Training SeminarRegional Seminar on Capital Adequacy and Risk-based Supervision

6 – 11 May 2007Rio de Janeiro, Brazil

Ralph LewarsSenior AdvisorInternational Advisory Group

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Capital

A. Why is capital important?

B. What is risk?

C. Risk Based Capital calculations

D. Risks included in capital tests

E. Supervisory framework/risk assessment

F. Dynamic capital adequacy testing

G. Future developments

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Capital

A. Why is capital important?

Policyholders pay money up front for a promise to pay in future.

Capital especially important for financial institutions

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Capital

A. Why is capital important ?

For supervisors capital is an important measure to determine where to allocate supervisory resources

Good overall measure of safety and soundness

Provides the opportunity to reduce on-site supervisory activities

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Capital

A. Why is capital important ?

Cushion to absorb unforeseen/unanticipated losses

Losses accrue firstly to shareholders rather than policyholders

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Capital

A. Why is capital important ?Accounting capital vs regulatory capital

Accounting capital = assets – liabilities

Regulatory capital = adjusted accounting capital

Balance Sheet

Assets

Liabilities

Capital

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Capital

B. What is risk?

Definition “ a chance of encountering harm or loss; hazard; danger”

Insurers are in the business of accepting risks

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Capital

B. What is risk?

In the context of capital tests a financial loss resulting in the reduction of capital available to absorb unforeseen/unanticipated losses

Reduction in the cushion available to safeguard policyholder funds

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Capital

B. What is risk?

Insurance owners/executives risk appetite usually greater than supervisors which creates challenges when discussing level of risks and need for margins in capital tests

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Capital

C. Risk Based Capital Calculations

What is required to calculate ????

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Capital

C. Risk Based Capital Calculations

Requirements

1. Instructions

2. Regulatory capital return

3. Regulatory balance sheet

4. Details balance sheet assets, liabilities and off balance sheet exposure

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Capital

C. Risk Based Capital Calculations

1. Instructions

legislation

regulation

guideline

other written document i.e. circular

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Capital

C. Risk Based Capital Calculations

1. Instructions

OSFI instructions in guidelines

guidelines/instructions available for banks, life and general insurers

guidelines available on OSFI web-site

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Capital

C. Risk Based Capital Calculations

1. Instructions

Facilitate similar approach to risks among banks, life and general insurers

Facilitate similar risk weights for similar risks

Guidelines ensure flexibility

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Capital

C. Risk Based Capital Calculations

1. Instructions

General insurers (MCT) approximately 50 pages

Since 2002

Minimum

Capital

Test

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Capital

C. Risk Based Capital Calculations

1. Instructions

Life insurers (MCCSR) approximately 160 pages

Since 1992

Minimum

Continuing

Capital

Surplus

Requirement

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Capital

C. Risk Based Capital Calculations

2. Regulatory capital return – General Insurers

MCT – 1 page with approx 10 worksheets

Return included with financial statement return

Filed quarterly

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Capital

C. Risk Based Capital Calculations

2. Regulatory capital return – Life insurers

MCCSR – approx 35 pages

Separate return not included with financial statement return

Filed quarterly

Year end return verified by external auditor and appointed actuary

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Capital

C. Risk Based Capital Calculations

3. Regulatory balance sheet – General Insurers

standard formatAssets – approx 25 items

Liabilities – approx 20 items

Capitals retained earnings – approx 5 items

GAAP - GROSS BASIS - BEFORE REINSURANCE

year end balance sheet audited

technical reserves certified by appointed actuary

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Capital

C. Risk Based Capital Calculations

3. Regulatory balance sheet – Life Insurers

standard formatAssets – approx 15 items

Liabilities – approx 15 items

Capitals retained earnings – approx 5 items

GAAP - NET BASIS - AFTER REINSURANCE

year end balance sheet audited

technical reserves certified by appointed actuary

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Capital

C. Risk Based Capital Calculations

4. Details – balance sheet assets, liabilities, and off balance sheet exposures

General & Life Insurers• Some details are provided in

standard returns while others reviewed while on site

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Capital

C. Risk Based Capital Calculations

Target ratio for both Life and non-life 150% (Metric)

Capital available / Capital required * 100

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Capital

C. Risk Based Capital Calculations - Capital available

A L

C

Balance Sheet

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Capital

C. Risk Based Capital Calculations - Capital available

Capital 3 main features:• Permanent• Subordinated• Free of mandatory charge

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Capital

C. Risk Based Capital Calculations - Capital available

Tier 1 Tier 2 (c)

Best Good/Acceptable

Capital Spectrum

General vs Life insurers

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Capital

D. Risks included in capital tests - Capital required

Risks in assets reported on balance sheet

Risks in off balance sheet transactions/ contracts

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Capital

D. Risks included in capital test – Capital required

A L

C

Balance Sheet

Off Balance Sheet exposure

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Capital

D. Risks included in capital tests – Capital required

Asset default applies to life and general insurers balance sheet assets

Calculate margins (capital required) for potential losses due to asset default

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Capital

D. Risks included in capital tests – Capital required

The higher the probability of default the higher the margin (capital required) for asset default

Asset default factors have been developed for all types of assets

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Capital

Asset Value Factor Capital Required

Cash 100 .00% 0

Corporate bonds (I/G) 100 2.00% 2

Preferred shares (I/G) 100 4.00% 4

Commercial mortgage 100 8.00% 8

Common shares 100 15.00% 15

Oil and gas properties 100 35.00% 35

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Capital

D. Risks included in capital tests – Capital required

Actuarial estimates/provisions are underestimated applies to life and general insurers

Calculate capital required for potential losses due to actuarial estimates/provisions being underestimated

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Capital

D. Risks included in capital test – Capital required

AL

C

Balance Sheet

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Capital

D. Risks included in capital tests – Capital required

Two largest actuarial estimates/provisions for general insurers are:

Unearned premiums and unpaid losses risks

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Capital

Actuarial estimate Value Factor Capital Required

Unearned premiums

Property 100 8.00% 8

Liability 100 8.00% 8

Unpaid losses

Property 100 5.00% 5

Liability 100 15.00% 15

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Capital

D. Risks included in capital tests - Capital required

The actuarial estimates/provisions for life insurers are:Segregated funds riskMortality riskMorbidity riskLapse riskInterest margin pricing risk Changes in interest rate environment risk

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Capital

D. Risks included in capital tests - Capital required

Segregated funds….risk of loss arising from guarantees embedded in segregated fundsFactor-based; Modelling approach allowed upon OSFI blessing Type of fund money market vs exotic aggressive equityResets/ratchets75% - 100% guarantees

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Capital

D. Risks included in capital tests - Capital required

Mortality/morbidity/lapse risks, assumptions will be wrong

Guaranteed term mortality cost cannot be changed

Length of the premium guarantee remaining

Length of benefit period remaining

Duration of policyholder liabilities

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Capital

D. Risks included in capital tests - Capital required

Interest margin pricing risk, interest margin losses with respect to investment and pricing decisions on in force business

Factors .5% or 1% on policy liabilities

Communication problems investment and pricing personnel

Lack of sufficient volumes new bonds and mortgage investment opportunities

Change in investment spread relationship

between different investments

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Capital

D. Risks included in capital tests - Capital required

Changes in interest rate environment, loss resulting from asset depreciation arising from interest rate shifts

Factors from .5% to 10% on policy liabilities

Factors vary by product type and premium guarantee period

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Capital

D. Risks included in capital tests - Capital required

A L

C

Balance Sheet

Off Balance Sheet Exposure

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Capital

D. Risks included in capital tests - Capital required

Off balance sheet commitments risk, major risk is credit risk

Guarantees, letters of credit, forward agreements, put options, etc…

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Capital

D. Risks included in capital tests - Capital required

Off balance sheet commitments risk

Notional amount of instrument is multiplied by a credit conversion factor 100%, 50%, 20%, etc…

Resulting amount is treated as a balance sheet asset/instrument and assigned a counter party risk factor

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Capital

E. Supervisory framework/risk assessment

Because a regulatory risk based capital test cannot capture all risks supervisor cannot rely on capital test alone

Capital test not forward looking

Supervisor must gather information on other risks and risk mitigation

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Capital

E. Supervisory framework/risk assessment

Risk based supervisory methodology where inherent risks and risk management control functions are assessed to come up with an overall assessment of an insurer

Operational risk, strategic risk and reputational risks are important risk not captured in capital tests

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Capital

E. Supervisory framework/risk assessment

To reflect risks such as high operational risk not captured in capital test and or weak management control functions the target capital ratio (150%) can be increased

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Capital

F. Dynamic capital adequacy testing (DCAT)

Stress testing of basic assumptions underlying an insurer business projections

Process developed by Canadian Institute of Actuaries

DCAT report filed annually

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Capital

F. Dynamic capital adequacy testing (DCAT)

Since 1992 for life insurers

Since 1998 for non-life insurers

Results of DCAT help establish target capital ratio

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Capital

G. Future developmentsHarmonization of insurance capital tests IAIS Review of accounting and actuarial standards required before harmonization can startOngoing refinements with new products, risks, type of capital being issued, etc.MCCSR/Basel II internal ratings based approach

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Thank you