1. Risk Based Capital Tests Life and General Insurers OSFI International Advisory Group IAIS-FSI-ASSAL Training Seminar Regional Seminar on Capital Adequacy and Risk-based Supervision 6 – 11 May 2007 Rio de Janeiro, Brazil Ralph Lewars Senior Advisor International Advisory Group

2. 2 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

3. 3 Capital A.Why is capital important? Policyholders pay money up front for a promise to pay in future. Capital especially important for financial institutions

4. 4 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

5. 5 Capital A.Why is capital important ? Cushion to absorb unforeseen/unanticipated losses Losses accrue firstly to shareholders rather than policyholders

6. 6 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

7. 7 B. What is risk? Definition “ a chance of encountering harm or loss; hazard; danger” Insurers are in the business of accepting risks

8. 8 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

9. 9 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

10. 10 Capital C. Risk Based Capital Calculations What is required to calculate ????

11. 11 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

12. 12 Capital C. Risk Based Capital Calculations 1. Instructions legislation regulation guideline other written document i.e. circular

13. 13 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

14. 14 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

15. 15 Capital C.Risk Based Capital Calculations 1. Instructions General insurers (MCT) approximately 50 pages Since 2002 Minimum Capital Test

16. 16 Capital C.Risk Based Capital Calculations 1. Instructions Life insurers (MCCSR) approximately 160 pages Since 1992 Minimum Continuing Capital Surplus Requirement

17. 17 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

18. 18 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

19. 19 Capital C. Risk Based Capital Calculations 3.Regulatory balance sheet – General Insurers standard format Assets – 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

20. 20 Capital C. Risk Based Capital Calculations 3.Regulatory balance sheet – Life Insurers standard format Assets – 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

21. 21 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

22. 22 Capital C. Risk Based Capital Calculations Target ratio for both Life and non-life 150% (Metric) Capital available / Capital required * 100

23. 23 Capital C.Risk Based Capital Calculations - Capital available A L C Balance Sheet

24. 24 Capital C.Risk Based Capital Calculations - Capital available Capital 3 main features: Permanent Subordinated Free of mandatory charge

25. 25 Capital C.Risk Based Capital Calculations - Capital available Tier 1 Tier 2 (c) Best Good/Acceptable Capital Spectrum General vs Life insurers

26. 26 Capital D.Risks included in capital tests - Capital required Risks in assets reported on balance sheet Risks in off balance sheet transactions/ contracts

27. 27 Capital D.Risks included in capital test – Capital required A L C Balance Sheet Off Balance Sheet exposure

28. 28 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

29. 29 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

30. 30 Capital AssetValueFactorCapital Required Cash100.00%0 Corporate bonds (I/G)1002.00%2 Preferred shares (I/G)1004.00%4 Commercial mortgage1008.00%8 Common shares10015.00%15 Oil and gas properties10035.00%35

31. 31 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

32. 32 Capital D.Risks included in capital test – Capital required A L C Balance Sheet

33. 33 Capital D. Risks included in capital tests – Capital required Two largest actuarial estimates/provisions for general insurers are: Unearned premiums and unpaid losses risks

34. 34 Capital Actuarial estimateValueFactorCapital Required Unearned premiums Property 1008.00%8 Liability 1008.00%8 Unpaid losses Property 1005.00%5 Liability 10015.00%15

35. 35 Capital D. Risks included in capital tests - Capital required The actuarial estimates/provisions for life insurers are: Segregated funds risk Mortality risk Morbidity risk Lapse risk Interest margin pricing risk Changes in interest rate environment risk

36. 36 Capital D. Risks included in capital tests - Capital required Segregated funds….risk of loss arising from guarantees embedded in segregated funds Factor-based; Modelling approach allowed upon OSFI blessing Type of fund money market vs exotic aggressive equity Resets/ratchets 75% - 100% guarantees

37. 37 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

38. 38 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

39. 39 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

40. 40 Capital D.Risks included in capital tests - Capital required A L C Balance Sheet Off Balance Sheet Exposure

41. 41 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…

42. 42 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

43. 43 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

44. 44 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

45. 45 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

46. 46 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

47. 47 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

48. 48 Capital G.Future developments Harmonization of insurance capital tests IAIS Review of accounting and actuarial standards required before harmonization can start Ongoing refinements with new products, risks, type of capital being issued, etc. MCCSR/Basel II internal ratings based approach

49. 49 Thank you