1. Canadian Institute of Actuaries L’Institut canadien des actuaires
2006 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2006

2. Appointed Actuary Seminar CIA Risk & Capital Committee Session

3. Today’s Agenda Update on current committee activities - Denis Ricard
Overview of CIA Involvement in Development of “Next Generation” Capital Regimes for Canada - Simon Curtis
DCAT – A perspective on “The Good, Bad & Ugly” - Stuart Wason

4. Session PD-9
Update from the Committee on Risk Management and Capital Requirements Denis Ricard

5. Progress report 1. MCCSR opinion 2. DCAT Education Note
3. Life Solvency Framework
4. Ongoing: existing regulatory capital formulas
5. DCAT pandemic scenario
6. P&C subcommittee

6. 1. MCCSR opinion New standard of practice and educational note
Opinion: "I have reviewed the calculation of the Minimum Continuing Capital and Surplus Requirement ratios of [Company name] as at [Date]. In my opinion, the calculation of the components of the required and available capital has been determined in accordance with the regulatory guidelines, and the components of the calculation requiring discretion were determined using methodologies and judgment appropriate to the circumstances of the company."
Effective year-end 2006

7. 2. DCAT Education Note Address P&C practice appropriately
Consistent wording of DCAT section of SOP
Best practices emerging from 2003 survey
Approval expected this fall for DCAT of next year

8. 3. Life Solvency Framework
Goal is to develop a revised solvency framework that builds on a model based approach to capital adequacy

9. Committees' structure to date to date
M.A.C.
(MCCSR Advisory Committee)
R.M.C.R.
(Risk management and capital requirements)
S.F.S.C.
(Solvency Framework SubCommittee)
Working Groups
ALM/Market Risk Methodology
Capital based Best Practices Guidance

10. MAC (MCCSR Advisory Committee)
Not only CIA driven
Representatives from:
Industry
Regulators
CIA
CLHIA
Assuris
Provide guidance in developing the new framework

11. SFSC (Solvency Framework SubCommittee)
A subcommittee of the CIA Risk and Capital Requirements committee
Provide the manpower and get the work done to develop the new framework
Priorities and Timeline: started in 2005; short/mid/long term deliverables have been identified
Deliverables so far:
Papers on timeline, risk horizon and terminal provision

12. SFSC (Solvency Framework SubCommittee) (cont'd)
Key immediate priorities:
Build understanding and consensus on the overall methodology for model based capital requirements
ALM/Market Risk Methodology
Capital Model Best Practices Guidance

13. 4. Ongoing support and review of existing regulatory capital formulas
Wording with OSFI/AMF to address issues in current risk based capital formulas
Issues to review are:
Liquidity and corresponding role of cash value & negative reserves in regulatory requirements
Proper treatment of health risks - e.g. Critical illness and LTC
Mortality component: fine-tuning of current rules

14. 5. DCAT pandemic scenario
Assist the AA in determining a "standardized" scenario related to avian flu pandemic
Some addition to the DCAT educational note
Just started
To be finalised by year-end for next year DCAT

15. 6. P&C subcommittee Focus on P&C issue
More fully engaging P&C actuaries and better liaising with P&C FRC

16. Session PD-9
Overview of CIA Involvement in Development of “Next Generation” Capital Regimes for Canada Simon Curtis

17. CIA Initiatives
In 2005 CIA Risk and Capital Committee established a task force to specifically develop an advanced Model Based Capital Framework
Key Drivers of this initiative include
Emerging International focus in this area
Large Canadian Life insurers are developing economic capital frameworks based on advanced models
Canadian regulators are interested in moving in this direction over time consistent with IAIS direction
A number of concerns with respect to existing regulatory framework (eg lack of covariance and diversifications impacts) can only be addressed by moving in that directions

18. Committee/Working Group Structure in Canada
OSFI/AMF
Regulatory Capital
CIA Risk and Capital
Committee and Task Force
MAC - MCCSR
Advisory Committee
Technical work on advanced
models
Supported by companies
and regulators through making
technical resources available
Joint industry/ OSFI Committee
assessing direction and advising
on longer term solvency framework
Senior representation from industry,
regulators, other stakeholders
Industry
Economic Capital

19. What Does CIA Hope to Achieve?
Consistency in economic capital frameworks developed by life insurers
Stronger professional practices with consistent frameworks
Reasonable consistency between economic and revised regulatory capital frameworks for life insurance
Minimize model development
Adoption of capital frameworks that consistently and appropriately measure all risks, and allow for aggregation of risks with appropriate recognition of diversification/ co-variance benefits and risk mitigation
Lack of recognition of diversification/co-variance benefits and lack of full recognition of risk mitigation are viewed as significant inhibitors to good risk management

20. Key Priorities / Timeline
2006
Agree on key capital model framework principles with industry/regulator
Agree on modeling best practices guideline
Agree on working framework for “technical” aspects of the model (time horizon, confidence level, terminal value measure, role of risk neutral vs real world basis, risk mitigation)
2007
Finalize market risk
Substantially complete work on credit risk
Substantially complete work on framework for risk aggregation across risks (diversification, covariance)
Complete work on insurance risks & Operations Risk

21. Key Principles for the Solvency Framework Agreed Between Stakeholders
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
Ensure that capital is prudent
Encourage good risk management
Adapt international principles and best practices
Allow comparison of similar risks across Financial Institutions
Be transparent, validated and based on credible data
Use reliable processes with assumptions sustainable in times of stress
Be part of intervention levels for supervisory action

22. Technical Framework Vision
An integrated Total Balance Sheet Approach (TBSR) is to be used
Capital = Modeled – Reserve Held
TBSR
TBSR is determined using a one year time horizon with appropriate residual value
One year TBSR is based on Stochastic modeling using CTE (expected shortfall) metric using 1% worst outcomes (greater than 99.5% confidence level)

23. Technical Framework Vision
One year Time Horizon/CTE metric approach could change if international standards/practice move decisively in another direction
Regulatory concern exists around developing a reliable capital adequacy disclosure metric in TBSR approach since capital depends on reserves, and reserve model allows some discretion

24. CTE (Expected Shortfall) vs Var (Confidence Level)
Pros
Easier to Explain
Consistent with bank model
Works for losses with normal/near normal distribution
Uses all information from loss distribution rather than one point
Is a coherent measure
Cons
Is not a coherent measure
Does not use information about losses in extreme tail
Tends to break down for skewed distributions, where mean loss maybe a tail event
Are outlier results reasonable to reflect in metric?
Var
CTE
Var is easy to use with management, but may not work well for non normally distributed risks that are not uncommon in insurance world

25. One Year versus Lifetime Risk Metric
Primary driver of One Year perspective is consistency with international insurance (IAA/IAIS) and banking (Basel II) approach
One Year and Lifetime approaches can be calibrated to consistent levels of general conservatism
One Year Lifetime
CTE 99 Metric CTE 95 Metric
with CTE (60-80)
Residual

26. One Year versus Lifetime Risk Metric
Both One Year and Lifetime Perspectives Have Advocates
One Year
√ consistent with broader risk management (eg. Basel II, VAR)
√ focuses risk analysis and management on actionable timeframe
√ appropriate residual valve methodology can reflect long term risks
√ long term models overweight very subjective analysis of catastrophic long term risk modeling
Lifetime
√ consistent with traditional actuarial approaches (eg. Segregated fund guarantees)
√ some long term risk exposures cannot truly be captured in shorter term metric
√ it is difficult to develop reliable residual values for 1 year metric

27. Residual Value - Issues
Technically, proposed framework requires a “stochastic on stochastic” calculator since first year paths and residual value on each path should be determined stochastically
Accepted that first year paths must be generated stochastically
Practitioners suggest need for practical compromise in developing approximations or closed form solutions to residual values
Does this need to approximate residual values call into question the one year approach given risks are long term?

28. Residual Value – Issues
Should residual values be determined on “real world” or “risk neutral” assumptions
Some consensus that risk neutral/market consistent assumptions should be used for risks where risk could be hedged or otherwise closed off
Real world assumptions would be appropriate for other risks (for instance most of all insurance risks)

29. Residual Value – Issues
Degree of conservatism in residual value will substantially impact overall result. There are a number of alternatives
CTE based metric in CTE (50) – CTE (80) range
Confidence level metric based on expected cost plus percentage of standard deviation
Confidence level metric based on fixed percentile (eg 84th percentile while is normal standard deviation)
Statutory reserves
Approach (3) has issue that relationship to expected cost
may vary significantly particularly for non normal risks and
approach (4) has similar issue

30. Observations on Economic Capital Modeling Trends in Canada
Companies are reflecting diversification benefits and risk concentrations
Typically using correlation matrices or copulas rather than integrated models
Risk mitigation and pass-through are typically reflected
need to consider company practice/market constraints on pass through
need to consider risk mitigation effectiveness in tails
Experience in Canada with factor or formula approaches that attempt to reflect risk characteristics has not been satisfying
difficult to keep approaches current
data collection and manipulation challenges can be significant
Stochastic and advanced modeling techniques are generally being developed for all economic risks (market, credit) and insurance risks with skewed and measurable distributions (eg minimum guarantees)
Stochastic techniques also being contemplated for more mainstream insurance risks (eg mortality) but no one has implemented such models yet
Operational risk has not yet been addressed

31. “The Good, the Bad, the Ugly”
PD9
“The Good, the Bad, the Ugly”
(The Sequel)
Stuart Wason
2006 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2006

32. Assuris’ DCAT Role
Assuris receives the DCAT Reports of all its members
Assuris’ primary interest in DCAT is as a detection tool to assist in the early identification of emerging company and systematic risks
Reports reviewed as part of our detection role and to develop guidance for practitioners.

33. PD-9 Best Practices on DCAT
What’s being done well (The Good)
the technical modeling of the base case
the generation of risk scenarios – a few highly creative integrated scenarios
identification of the most significant risks
appropriate use of the standard opinion

34. PD-9 Best Practices on DCAT
What should be improved (The Bad)
Linkage to business plans
not well elaborated
72 % of reports are dated September or later so presume results are part of planning process
surprisingly little discussion of updating for interim results
Comparison of results to previous DCAT
frequently not done, reduces credibility
explaining the changes should provide Board more insight into risk and operations

35. PD-9 Best Practices on DCAT
What should be improved (The Bad)
Limited testing of non-insurance risks which is not surprising, but
credit risk less than 5% of scenarios
operational risk usually related to expenses and/or changing sales volumes
Scenario building practices too varied
integrated versus ripple effects
similar risks stressed differently
additional guidance on building and use should be in Education Note (e.g. pandemic)

36. PD-9 Best Practices on DCAT

37. PD-9 Best Practices on DCAT
What should be improved (The Bad)
Weak scenario selection
Limited number of scenarios
No integrated scenarios
Varying levels of detail provided by parents and subsidiaries

38. PD-9 Best Practices on DCAT
What must be improved (The Ugly)
Readability from a Board perspective
Good technical information in most cases but frequently not Board “friendly”
Lack of executive summary; limited highlighting of key points
Limited guidance for discharging duties as a Director, most notably
Demonstration of risk management governance and process with respect to significant risks
Quantification of mitigation approaches
Could use a risk management guidance note in addition to DCAT Education Note

39. PD-9 Best Practices on DCAT
What must be improved (The Ugly)
Allowance for supervisory action
Great inconsistency in explanation and interpretation of regulator intentions (e.g. most often 150% level described as requiring “more reporting”)
Varying response to anticipated changes in required capital formulae (e.g. change in TAAM to BV assets)

40. PD-9 Best Practices on DCAT
What must be improved (The Ugly)
Allowance for capital and management actions and policyholder behavior
Poor (or no) indication of shareholder capital practice, binding commitments or expectations
Some reports show return of capital to shareholder (based on target MCCSR) rather than ending MCCSR
Wimpy scenarios that do not sufficiently stress the company, perhaps due to a reluctance to show weakened results

41. PD-9 Best Practices on DCAT

42. PD-9 Best Practices on DCAT
In conclusion
DCAT’s are ok, could be better
Need to focus on usefulness to Board as part of Directors’ and AA’s roles in governance and risk management
There are major opportunities to expand DCAT in terms of communication and dealing with the full range of risks.