risk based capital tests life and general insurers osfi international advisory group iais-fsi-assal...
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Risk Based Capital TestsLife and General Insurers
OSFI International Advisory Group
IAIS-FSI-ASSAL Training SeminarRegional Seminar on Capital Adequacy and Risk-based Supervision
6 – 11 May 2007Rio de Janeiro, Brazil
Ralph LewarsSenior AdvisorInternational Advisory Group
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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
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Capital
A. Why is capital important?
Policyholders pay money up front for a promise to pay in future.
Capital especially important for financial institutions
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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
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Capital
A. Why is capital important ?
Cushion to absorb unforeseen/unanticipated losses
Losses accrue firstly to shareholders rather than policyholders
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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
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Capital
B. What is risk?
Definition “ a chance of encountering harm or loss; hazard; danger”
Insurers are in the business of accepting risks
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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
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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
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Capital
C. Risk Based Capital Calculations
What is required to calculate ????
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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
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Capital
C. Risk Based Capital Calculations
1. Instructions
legislation
regulation
guideline
other written document i.e. circular
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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
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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
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Capital
C. Risk Based Capital Calculations
1. Instructions
General insurers (MCT) approximately 50 pages
Since 2002
Minimum
Capital
Test
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Capital
C. Risk Based Capital Calculations
1. Instructions
Life insurers (MCCSR) approximately 160 pages
Since 1992
Minimum
Continuing
Capital
Surplus
Requirement
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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
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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
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Capital
C. Risk Based Capital Calculations
3. Regulatory balance sheet – General Insurers
standard formatAssets – 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
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Capital
C. Risk Based Capital Calculations
3. Regulatory balance sheet – Life Insurers
standard formatAssets – 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
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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
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Capital
C. Risk Based Capital Calculations
Target ratio for both Life and non-life 150% (Metric)
Capital available / Capital required * 100
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Capital
C. Risk Based Capital Calculations - Capital available
A L
C
Balance Sheet
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Capital
C. Risk Based Capital Calculations - Capital available
Capital 3 main features:• Permanent• Subordinated• Free of mandatory charge
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Capital
C. Risk Based Capital Calculations - Capital available
Tier 1 Tier 2 (c)
Best Good/Acceptable
Capital Spectrum
General vs Life insurers
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Capital
D. Risks included in capital tests - Capital required
Risks in assets reported on balance sheet
Risks in off balance sheet transactions/ contracts
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Capital
D. Risks included in capital test – Capital required
A L
C
Balance Sheet
Off Balance Sheet exposure
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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
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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
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Capital
Asset Value Factor Capital Required
Cash 100 .00% 0
Corporate bonds (I/G) 100 2.00% 2
Preferred shares (I/G) 100 4.00% 4
Commercial mortgage 100 8.00% 8
Common shares 100 15.00% 15
Oil and gas properties 100 35.00% 35
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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
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Capital
D. Risks included in capital test – Capital required
AL
C
Balance Sheet
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Capital
D. Risks included in capital tests – Capital required
Two largest actuarial estimates/provisions for general insurers are:
Unearned premiums and unpaid losses risks
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Capital
Actuarial estimate Value Factor Capital Required
Unearned premiums
Property 100 8.00% 8
Liability 100 8.00% 8
Unpaid losses
Property 100 5.00% 5
Liability 100 15.00% 15
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Capital
D. Risks included in capital tests - Capital required
The actuarial estimates/provisions for life insurers are:Segregated funds riskMortality riskMorbidity riskLapse riskInterest margin pricing risk Changes in interest rate environment risk
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Capital
D. Risks included in capital tests - Capital required
Segregated funds….risk of loss arising from guarantees embedded in segregated fundsFactor-based; Modelling approach allowed upon OSFI blessing Type of fund money market vs exotic aggressive equityResets/ratchets75% - 100% guarantees
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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
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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
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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
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Capital
D. Risks included in capital tests - Capital required
A L
C
Balance Sheet
Off Balance Sheet Exposure
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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…
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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
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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
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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
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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
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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
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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
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Capital
G. Future developmentsHarmonization of insurance capital tests IAIS Review of accounting and actuarial standards required before harmonization can startOngoing refinements with new products, risks, type of capital being issued, etc.MCCSR/Basel II internal ratings based approach
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Thank you