Risk & Capital Management A Regulator’s Perspective Stuart Wason Senior Director Actuarial Division, OSFI June 16, 2008

2 Topics Global trends Implications for regulators Canadian developments Risk & capital management issues

3 Global trends International standards setters –International Accounting Standards Board (IASB) –International Association of Insurance Supervisors (IAIS) –International Actuarial Association (IAA) ERM –Widespread growth in practices and development of the art/science –Risk management as a profession –CRO Forum influence –Internal risk model development

4 Implications for regulators 1.Move to total balance sheet approach for risk assessment and capital requirements –Switch from old “liability” plus “capital requirement add-on” approach –Allows independence from accounting definition of liabilities –Consistent with ERM, economic capital and internal risk model developments –TBS now endorsed/adopted by IAA, IAIS, Solvency II, OSFI etc. –Regulators need to develop new processes, expertise, disclosures etc.

5 Required capital to be determined indirectly: Required = Total Asset - GAAP Policy Capital Requirement Liabilities Assets Liabilities & Capital solvency buffer expected asset requirement margins required capital GAAP policy liabilities best estimate policy liability total asset requirement Total Asset Requirement free assets

6 Implications for regulators 2.Shift to reliance and principles based supervision –IASB insurance contract liability likely to be best estimate + risk margin –Capital requirements will increasingly rely on full internal (or partial) models to better capture risks –Internal and external reviews will be needed to give assurance on integrity of work –Regulators need to design appropriate approvals processes (use test; governance test; sufficiency test) and retain staff with appropriate expertise

7 Implications for regulators 3.Assessing risks over the risk horizon –Lifetime? –Shorter shock period (e.g. one year) at high confidence level frequently used for capital and solvency assessment purposes –How should provision be made for remaining risks after one year (a.k.a. terminal provision) –Need for longer term risk management horizon (say 3-5 years) as part of supervisory review (e.g. own risk solvency assessment [ORSA] and dynamic capital adequacy [DCAT])

8 Implications for regulators 4.Consider differences between insurer and bank capital requirements –Credit risk –Market risk –Insurance risk –Operational risk –Risk diversification

9 Canadian developments Emergence of IASB standards for insurance accounting means that CICA will cease to be an accounting standards setter for insurers by 2011 Introduction of IFRS by Canadian insurers will necessitate a change in the methods used to determine their capital requirements

10 Canadian IFRS developments OSFI has identified 17 standards that have key differences between IFRS and Canadian GAAP impacting financial institutions IFRS 4 will redefine what is an insurance versus investment contract Insurance contracts standard will define how these contracts are to be valued

11 Other IFRS to watch for Fair Value Measurements Revenue Recognition Derecognition/Consolidation Financial Statement Presentation Conceptual Framework Liabilities & Equity Improvements to Financial Instruments

12 Canadian capital developments Advanced probabilistic models, –Now used by larger insurers for internal risk & capital management –Allowed and encouraged in Solvency II –Existing Canadian solvency framework is generally not capable of reflecting advanced products and risk mitigation –Internal models are allowed by Basel II Current standard approach –Originally designed and calibrated many years ago before market values used –Market risk component uses simple factor –No allowance for diversification or concentration –Increasingly includes fairly complex to calculate elements (i.e. no longer a “standard” approach?) –Not suitable for IASB insurance liabilities

13 Canadian timeline Work on non-life (P&C) issues commences -Finalize market & credit risk advanced approach -Finalize framework for risk aggregation for advanced approach -Draft life insurer standard approach ready for QIS Further QIS on revised life insurer standard approach -Life insurer standard approach finalized Implementation measures necessary for new standard approach put in place 201? -New standard approach takes effect January 1, 201? -Approval of new advanced approach for large insurers?

14 Canadian vision concepts Future solvency financial requirements should: –take into account all credit, market, underwriting & operational risks –recognize all cash flows from all of the assets and liabilities –value the cash flows consistently and realistically –reflect the risk mitigation strategies used by the insurer –consider the dependencies within risks and between risks and recognize when appropriate and measurable –ensure that insurer assets are sufficient, with high degree of confidence, to withstand adversity emerging over a defined regulatory control time horizon (e.g. might be one year) –ensure that there are sufficient assets at the end of the defined time horizon to provide for the: transfer of the remaining obligations to another insurer or run-off of the remaining obligations

15 Canadian Vision Minimum Asset Requirement Target Asset Requirement Regulatory control level Determined using “standard” approach (e.g. 66% of “standard”) Threshold investment grade security level – regulator going concern level Determined using “advanced” or “standard” approach Target 1 year CTE(99) sufficiency

16 Canadian Vision Uses company models Sophisticated scenario modeling integrated with ERM Measures all risks & risk mitigation Risk dependencies modeled Requires regulatory approval Encouraged for large insurers, technically able insurers & those with complex risks Selection of advanced approach separate for credit, market, insurance and operational risk Industry formulaic, factor based or stress scenario Not as advanced but developed to be consistent & reflect key risks & mitigation of advanced approach Risk dependencies partially recognized Designed to produce an appropriate requirement across the industry Advanced ApproachStandard Approach

17 Canadian design issues Risk horizon: One year (working hypothesis) Risk measure: CTE (working hypothesis: CTE99) Hedgeable risks valued after one year at post-stress market consistent valuations Non-hedgeable risks valued after one year at post- stress BEL + post-stress risk margin (working hypothesis: CTE based) How will standard approach differ from advanced (internal model) approach? CTE = Conditional Tail Expectation or Tail VaR BEL = Best Estimate Liability

18 Framework Comparison Solvency IICanada Cover All Risks  Company Risk Profile  Two Tiers SCR and MCR TAR and MAR Standard vs Advanced  Use of Approximations Significant implementing assumptions and approximations being contemplated Extent of approximations unclear Total Asset Requirement Defines both technical provisions and capital required Defines total asset requirement directly Risk Horizon  Risk Measure  VAR 99.5%  CTE99% Risk Margins  Implicit in MV if Hedgeable, with ability criteria only  CoC MVM if Non-Hedgeable  Does NOT reflect post-stress distribution  Implicit in MV if Hedgeable; with ability and intent criteria  RW CTE if Non-Hedgeable  Reflects post-stress risk distribution Frameworks align  Frameworks differ

19 Risk & capital management issues Guidance is needed to narrow the range of practice w.r.t. the IASB insurance accounting standard and insurer capital models Decisions will be needed regarding the tradeoffs to be made in the new Canadian insurer capital framework in consideration of Solvency II and Basel II (e.g. diversification) New IFRS and capital frameworks will likely alter stakeholder views of insurer profitability, earnings volatility and soundness Need to define the resources for the industry and regulator to implement these changes in sufficient time (as early as 2011 for some aspects)

20 Risk & Capital Management A Regulator’s Perspective Stuart Wason Senior Director Actuarial Division, OSFI June 16, 2008