PD-34: Capital Models OSFI Guidance

Canadian Institute of Actuaries

General Meeting

Ottawa

November 2009

Topics for Discussion

Guidance on models– Background– Basic solvency framework– Likely timeframes for implementation of an internal

models approach– Statement of intent– Comments– OSFI concerns and issues

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Background

• MCCSR Advisory Committee (MAC) to develop proposals for a new solvency assessment framework based on internal models

• Vision Paper in 2007

• Spring 2008: MAC requested & OSFI agreed to provide specific guidance

• Sept 2008- February 2009: Discussion of draft guidance at MAC meeting

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Background

Guidance provides information on:

– 10 specific areas (the ones discussed during the spring)

– the interaction of the new internal models approach with the new standard approach

– basic policy governing the transition to an internal models approach

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Basic Solvency Framework

• Components of new solvency framework:– Standard approach– Internal models approach

• Standard approach to be used:– by all companies to determine the company’s

regulatory minimum capital requirement and– by companies without approval to use internal models

to determine supervisory target required capital amounts

• Internal models approach to be used:– by companies with approval to use internal models to

determine supervisory target required capital amounts subject to OSFI-defined floors

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Basic Solvency Framework

• Capital requirements under both approaches to be determined using a Total Asset Requirement method subject to limitations with respect to:– the amount of the liability offset in the

determination of capital amounts and– the flexibility of companies to set supervisory

targets

• Capital and capital ratios will continue to be used in the supervisory process to:– assess a company’s solvency and – make decisions on the appropriate level of

intervention

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Likely Timeframes for Implementation of Internal Models

• OSFI’s expectation is that it will be 2014 or later before any company receives approval to use an internal model to determine the regulatory capital requirement for any risk

• The precise date when OSFI will begin to approve the use of internal models will depend on:– the availability and completeness of comparative data and

results from across the industry,– the robustness of the models themselves and– other factors outlined in the Guidance document.

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Statement of Intent

• OSFI has requested that each company represented on the MAC indicate whether it:– intends to use the findings of the MAC to

• develop internal models for regulatory capital requirements and

• ultimately apply to OSFI to use such models to determine its regulatory capital requirement when OSFI indicates that such applications will be considered, or

– is monitoring the proceedings of the MAC but does not intend to develop or implement internal models for regulatory capital at this time

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Comments

• About 10 cos said they may use IM• Majors concerns on cap on liabilities,

diversification, risk mitigation and investment policies

• Shorter timing expected• Models to be too simple compared to the std

approach

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Model scope and degree of standardization

• Market risks: – Internal stoch. Scen. Generators if appropriate for OSFI

• Credit risks:– Based on Basel II AIRB formula with internal parameter inputs

(e.g., PD, LGD, EAD, M) subject to OSFI-specified criteria

• Insurance risks:– Internal models subject to OSFI-specified criteria on calibration,

experience data, and parameters (e.g. improvement of mortality)

– OSFI may provide a list of appropriate models or prohibit some models

• Policyholder Behavior Risk:– As for insurance risks

• Expense risk: model not defined yet• Operational risks: no model permitted

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TAR calculation

• Start with the market risk based on scenarios

• Add each other risk on a stand-alone basis calculation

• One year Time Horizon + Terminal Provision (TP)

• Equivalent Risk Standard – CTE level to be confirmed after QISs

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Combination of Risks • Diversification, correlation and

concentration (DCC) within and across risk categories:– key components of sound risk management – during periods of market stress, risks that may have

appeared to be uncorrelated or weakly correlated turn out to be strongly correlated

– DCC within risk maybe allowed if justified– more work on DCC accross risks

• On a consolidated basis:– movement of capital among different legal entities can

become more difficult during periods of market stress – models to take into account the impact that

restrictions on the movement of capital among different legal entities 12

Terminal Provision:• a function of the experience during the initial time period • reflects the actions that third party could be expected to

take to reduce and/or mitigate risk at the end of the initial time period.

• a standard investment strategy is followed by all companies

• limits on mean reversion and requirements on yield curve inversion

• fixed certain CFs simply discounted at risk-free rates• ins. risks BE options to decide:

– company experience with no deterioration over time,

– company experience with some deterioration over time,

– industry experience with some deterioration over time, or

– a mixture of company and industry experience, with or without deterioration over time

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Risk Mitigation

• may recognize contracts that it has entered into as of the valuation date

• management action that may be recognized – the exercise of options that the company holds – the implementation of a standard investment

strategy at the end of the initial time period

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Prerequisites (Basic Requirements)

• Technology: robust and safe systems• Resources: highly qualified and sufficient staff • Management

– board and senior management approval of models – appropriate risk management practices and delegation

• Controls– independent review – Controls systems

• Financial conditions– greater than the supervisory target capital – DCAT base capital and scenarios

• Additional requirements– sufficient volume of business and– robust contingency plans.

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Approval and transition• Large companies will be encouraged, not required, to

use internal models (IM). • IM on a company-by-company and risk-by-risk basis,

subject to restrictions. • IM should measure risks and capital by legal entity,

(correlation and diversification among risks). • Systems should be fully integrated. • 4 to 12 quarters of parallel runs per risk will be required• Transition period of min. 2 yrs in addition to parallel

runs. • Maximum annual reductions in supervisory target

capital • Minimum capital requirement by the standard approach

and floors on target capital• Meet the conditions and requirements for IM approval

on an ongoing basis 16