CIA Annual Meeting Assemblée annuelle de l’ICA June 29 & 30, 2006 Ÿ Les 29 et 30 juin 2006 Ottawa, Ontario Session Gen 6 – Economic and Regulatory Capital

BACKGROUND Session Gen 6 – Economic and Regulatory Capital International direction is towards comprehensive model based Risk Based Capital frameworks: Basel II for Banks IAA/IAIS Research Paper Large Insurance Holdco’s are interested in moving to this type of framework for internal/external capital adequacy Significant interest and conceptual support for this direction in Canada from key constituents: Holdco’s OSFI CIA CLHIA AMF Assuris CIA Risk & Capital Committee established the Solvency Framework Sub-Committee (SFSC) in fall 2004 to develop a model based framework in Canadian context Session Gen 6 – Economic and Regulatory Capital

Solvency Framework Sub-committee - SFSC Sub-committee of the Risk Management and Capital Requirements Committee Members Denise Lang – Chair Bill Beatty Wally Bridel Arshil Jamal Jean-Guy Lapointe Les Rehbeli Sylvain St-Georges Chris Townsend Stuart Wason Michael White Session Gen 6 – Economic and Regulatory Capital

Advisory Committee Created– Fall 2005 Existing Group New Group Created MCCSR Advisory Committee CIA Solvency Framework Sub-Committee Technical work – Methodology and Model development Assess and advise on broader solvency framework issues The existing group, the CIA Solvency Framework sub-committee, that I’ve discussed will be expanding as the work moves from principle development to technical methodology and model development. We’ll need companies to make resources available and use models that they have developed to test the approaches as they are designed. We anticipate the need to develop several working groups to focus on various issues once the priorities and timeframe are resolved. A new risk based capital advisory committee has been proposed to help assess broader issues with representation from key stakeholders. This committee will be formed during the summer and will help us determine the priorities and time frame for this work. Also, in the sub-committee’s draft paper, the mandate was broad and the initial timeframe very aggressive. Once we have direction from the advisory committee we’ll rework the mandate and develop plans for future work. Senior representation from key constituents/stakeholders in industry, regulators, others Supported by companies and regulators through making technical resources available Session Gen 6 – Economic and Regulatory Capital

MCCSR Advisory Committee - MAC Includes representatives from regulators, industry and CIA Membership Co-Chairs: Bob Hanna OSFI, Simon Curtis CIA OSFI: Allan Brender, August Chow, Bernard Dupont, Jean-Guy Lapointe, AMF: Isabelle Larouche, Assuris: Mike Hale, Stuart Wason CIA: Denis Ricard, Denise Lang CLHIA: Jim Witol Industry: John Brierley, Al Edwards, Allen Loney, Bev Margolian, Mike Stramaglia, Doug Tozer, Bob Willis Session Gen 6 – Economic and Regulatory Capital

What is Economic Capital? Why develop? Comprehensive coverage of all risks measured on a consistent basis model the risk distribution on a projected basis – stochastic modeling necessary when significant tail risk Confidence level sufficient to ensure solvency and viability level linked to financial strength and desired credit rating Enable better business decisions through: Consistent measurement of risk and return (RAROC – Risk Adjusted Return on Capital) Understanding which products are adding value and the value contribution of various businesses Understanding the impact of diversification Allows company to appropriately optimize regulatory capital Influence regulators and regulatory capital developments Session Gen 6 – Economic and Regulatory Capital

Industry Development of Economic Capital Most large insurers are developing economic capital frameworks Frameworks reflect all risks although degree of sophistication in the modeling often varies by risk Total Balance Sheet approach is typically used (determine TBSR) Primary risk measure is either CTE or percentile (VaR) Time Horizon used by many companies is 1 year but some use a lifetime horizon – Terminal provision is critical in a 1 year horizon The confidence level is higher for shorter time horizons, e.g. if CTE95 is a reasonable capital level using a lifetime horizon, a 1 year horizon might use CTE99 for the first year with a CTE70 terminal provision calculated at the end of the year for the remaining life of the business. Session Gen 6 – Economic and Regulatory Capital

Industry Development of Economic Capital Risk mitigation and pass-through are typically reflected need to consider effectiveness of mitigation in the tail scenarios (e.g. will the instruments required for hedging be available and at what cost?) Companies are reflecting diversification benefits and risk concentrations - typically using correlation matrices or copulas rather than integrated models Stochastic techniques are used for some or all financial risks (market, credit and insurance), particularly risks with skewed distributions Less advanced techniques are typical for operational risks and little consensus in how to determine appropriate capital for operational risk Session Gen 6 – Economic and Regulatory Capital

What has been accomplished? SFSC started by surveying industry practices and developing CIA principles – OSFI also created a set of principles MAC has reached agreement on Key Principles SFSC - developed papers on implementation issues, time horizon, risk measure, terminal provision, pass-through and risk mitigation Working hypothesis is 1 year time horizon, CTE basis with appropriate terminal provision at the end of 1 year Preliminary timeline for development sketched out Working groups on model risk and ALM/Market Risks have been established and work is in progress MAC has also discussed framework issues, standardized versus advanced approaches, communication, etc. Session Gen 6 – Economic and Regulatory Capital

TBSR and the Terminal Provision The TBSR in a 1-year time horizon is the amount of assets required to: withstand adverse experience at a very high confidence (CTE) level over the 1-year horizon, and have “sufficient assets” at the end of the year to enable the company to meet its remaining obligations (i.e. an appropriate terminal provision). Theoretically, this leads to stochastic upon stochastic calculations. Practically, we anticipate the need to develop appropriate approximations. The terminal provision has to cover the expected costs for the remaining life of the obligations plus provide an appropriate margin. Different methods to determine the appropriate margin are currently being discussed. Session Gen 6 – Economic and Regulatory Capital

Key Principles for the Solvency Framework On risk measurement Consider all risks Determine assets and liabilities on a consistent basis for risk measurement purposes Be practical, but technically sound Reflect existing risks on going concern basis and consider winding-up and re-structuring Use measures (e.g. CTE) that are comparable across risks and products Session Gen 6 – Economic and Regulatory Capital

Key Principles for the Framework (Cont’d) On risk management 6. Ensure that capital is prudent 7. Encourage good risk management 8. Adapt international principles and best practices Session Gen 6 – Economic and Regulatory Capital

Key Principles for the Framework (Cont’d) On Risk Monitoring Allow comparison of similar risks across Financial Institutions 10. Be transparent, validated and based on credible data 11. Use reliable processes with assumptions sustainable in times of stress 12. Be part of intervention levels for supervisory action Session Gen 6 – Economic and Regulatory Capital