1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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