1. 2007 General Meeting Assemblée générale 2007 Montréal, Québec 2007 General Meeting Assemblée générale 2007 Montréal, Québec Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

2. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for Cost of Capital Presenter: Stéphane Levert, FSA, FCIA

3. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital What is Cost of Capital? How to Price for Cost of Capital Example: ROI = 15% Capital = 18% (12% x 150%) t = 30% i = 4% x = 3.1% of premium This is the profit charge needed Based on MCCSR

4. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Purpose of MSSCR Definition Art. 515(1) of Insurance Companies Act Says a company shall maintain adequate capital and adequate and appropriate forms of liquidity – Intended to absorb fluctuations above PfAD Risk-based Measurement is formula-based

5. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Some situations... Benefits other than Life and LTD ASO Reinsurance ceded Reinsurance assumed Aggregate stop-loss insurance

6. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Benefits other than Life and LTD MCCSR factors 12% for Health and Dental 9% for Weekly Indemnity Which one is more risky, really? Lack of recognition that WI may be longer term?

7. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital ASO business Main assumption in industry: ASO benefits expose carriers to no risk Required capital = 0 However carriers usually charge profit & risk charge Solution: Use 8% MCCSR factor as for receivables? Reality: Risk that client will default Risk that admin. charges don’t cover actual expenses

8. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Reinsurance ceded Industry practice: 100% capital credit for registered reinsurers OSFI/AMF require additional guarantees for non-registered reinsurers Credit risk of Canadian reinsurers not recognized Especially vulnerable in case of catastrophe Compliance with Investment Policy (IP) Sometimes, exposure to a single reinsurer exceeds IP’s guidelines re: exposure to credit risk of a single issuer

9. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Reinsurance assumed Industry practice: Sometimes use primary carrier’s reserves Poor reflection of assets backing reserves under CALM Risk exposure data not always current Assumes that pricing done properly

10. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Aggregate stop-loss insurance Example: Life Insurance For a client, pool aggregate claims in excess of 120% of premium Monthly rate = $0.18/$1,000 Close to 3,000 employees Average volume = $70K Group Life Premium = $425K “notional” cost of capital = 6.1% of premium Pricing: Stop-loss charge = 12% … in this case = $51K

11. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Aggregate stop-loss insurance Premium = $425K Aggregate limit 120% = $511K Stop-loss risk premium = $51K

12. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Aggregate stop-loss insurance Premium = $425K Aggregate limit 120% = $511K Stop-loss (120%) premium = $51K Aggregate limit 150% = $638K Stop loss risk premium = $30K

13. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Aggregate stop-loss insurance MCCSR - Current practice varies widely Impact on pricing Current S-L charges: 1% to 20% of premium Required Cost of Capital “should” be between 4% and 8% Adequately recognized in the market? Case can be made that MCCSR should be equal to that which would have been help in absence of the aggregate stop-loss mechanism Purpose of MCCSR… Carrier is really assuming most of the risk

14. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Measure of risk? – To some extent – For some benefits, current MCCSR formula may not be sufficient – For others, formula more than sufficient – Overall, probably a good relative measure of risk Alternatives? – Currently: deterministic approach – Future: stochastic modeling?

15. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Measure of capital? – Typically, shareholders must invest more than MCCSR – Examples: Systems and infrastructure Human resources (including training) Off-balance sheet risks – Extremes: what if only ASO?...

16. 2007 General Meeting Assemblée générale 2007 2007 General Meeting Assemblée générale 2007 Pricing for cost of capital Conclusion – MCCSR is only a formula – Important to think and evaluate each situation according to its circumstances Questions?