CIA Annual Meeting

1. CIA Annual Meeting LOOKING BACK…focused on the future

2. TOPICS TO BE ADDRESSED Denise Lang • Background - Framework for MCCSR Evolution Sylvain St-Georges • Need for Change • Purpose of Capital Denise Lang • Principles for Risk Based Economic Capital 2

3. DENISE LANG Background - Framework for MCCSR Evolution • CIA Solvency Framework Sub-Committee • Role of the Advisory Committee • Strand Approach to MCCSR Evolution • Key Issues for the Advisory Committee 3

4. Background • International direction is towards comprehensive model based Risk Based Capital frameworks: Basel II for Banks IAA/IAIS Research Paper • CIA Risk & Capital Committee has established the Solvency Framework “Sub-Committee” to develop a model based framework in Canadian context • Have articulated the need for change, purpose of capital and key principles for risk based capital discussing with stakeholders and gathering feedback • Currently working through practical implementation issues and defining the key elements supporting each principle 4

5. Background • 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 Compcorp 5

6. Existing Group New Proposed Group CIA Solvency Framework Sub-Committee Risk Based Capital Advisory Committee Assess and advise on broader solvency framework issues Technical model development • Supported by companies and regulators through making technical resources available • Senior representation from key constituents/stakeholders in industry, regulators, others 6

7. Role of the Advisory Committee • Forum to build consensus of key stakeholders on direction/framework for fundamentally changing the solvency assessment framework • Advise CIA Technical Work Group on consistency of emerging technical proposals with broader solvency assessment framework objectives • Help remove roadblocks to work of the CIA Technical Group • Input to regulators 7

8. The “Strand” Approach to MCCSR Evolution Strand 1 Strand 2 Strand 3 • Introduction of advanced model based approaches for specific risks • Example: • C3 risk, C1 risk • “Maintenance” changes within existing framework • Example: • Mortality factors • Introduction of comprehensive model based framework Short Term (2005, 2006) Medium Term (2006+) Longer Term (2009/2010?) Advisory Committee 8

9. Key Issues for the Advisory Committee • Dual advanced (model) vs. basic (factor?) approaches to accommodate sophisticated and less sophisticated organizations • Significant competitive/market issues • Cost and infrastructure implications for advanced models • How to develop meaningful capital ratio metrics in a TBSR (Total Balance Sheet Requirement) world? • Priority risks for “advanced modeling” treatment 9

10. Key Issues for the Advisory Committee (Continued) • Dealing with current “topical” issues: • Role of negative reserves/CSV deficiencies in ongoing capital adequacy model (i.e. can liquidation risk issues be addressed within the same framework or not?) • Impact of emerging 2007 CICA standard changes (asset fair value rules) • Reinsurance ceded • Operational Risk in MCCSR • Diversification/Concentration Risk in MCCSR 10

11. SYLVAIN ST-GEORGES The Need for Change The Purpose of Capital 11

12. Need for Considering Change • Recent external developments: • ERM and Economic Capital frameworks • International insurance accounting standards • Growing use of stochastic approaches • New tests and solvency assessment approaches developed by other countries 12

13. Need for Considering Change • Developments in Canada: • CALM • DCAT • New components (Seg funds, Lapse, Index-linked products, Mortality) • Supervision framework based on risks • Prescribed target capital level based on the minimum level 13

14. Need for Considering Change • Weaknesses in the current framework: • Risks not all explicitly treated • Certain risks not appropriately reflected by factor approach • Risk mitigation should be taken into consideration more explicitly, including hedging and risk diversification • Regulatory target levels set implicitly to reflect risks not covered but their magnitude in relation to other risks can vary significantly by company 14

15. Need for Considering Change • Right time to consider a complete change to the Canadian solvency assessment framework: • Pending external pressures and need to further improve the current approach • Long lead times to develop, test and implement a framework • Need to be proactive to maintain Canadian solvency framework in the lead 15

16. Purpose of Capital • Risk based capital formula • Ensure the appropriateness and strength of the total balance sheet (TBS) • In a TBS world, capital required is the difference between the TBSR and the reserves • Distinction between capital and reserves is important considering the large impact reserves have on earnings and the purpose of capital as a basis to measure ROE (sub-committee is not focussing on this distinction at this time) 16

17. Purpose of Capital • Owners’ primary concerns: • Sufficient to gain the necessary confidence(marketplace, policyholders, investors and regulators) • Not so conservative that the company is at a competitive disadvantage • Basis to measure the rate of return • Finance new business development • Protect their investment during periods of adverse experience 17

18. Purpose of Capital • Regulators/policyholders perspective: • Safeguard when bad things happen • Motivate a company to avoid undesirable levels of risk • Promote a risk measurement and management culture • Alert supervisors to emerging trends • Provide a tool to assume control of a failing companyand to transfer portfolio to another carrier 18

19. DENISE LANG Principles for Risk Based Economic Capital 19

20. Principles for Risk Based Economic Capital • Articulate proposed future direction • Based on best practices and principles used internationally • Assume Risk Based Capital is part of an overall framework that includes • Regulatory Oversight • Governance and Risk Management Practices • Disclosure • Other Risk Analysis (e.g. DCAT, liquidity management, etc.) 20

21. Principle #1 – A risk-based economic capital approach will be used to determine the Total Balance Sheet Requirement (TBSR). • Focus is the TBSR at an appropriate confidence level. • TBSR effectiveness is independent of accounting basis. • Capital required is the TBSR less the amount provided in the liabilities. • Ultimately economic approaches to solvency assessment should create a ‘level playing field’. 21

22. Principle #2 – All risks should be reflected. • All types of risks (e.g. market, credit, insurance, operational) and all controlled entities should be considered. • Off-balance sheet risks included. • Methodology and degree of rigour will vary by risk. • Reasonable estimates for risks difficult to quantify. • Arbitrary increase in required MCCSR ratio for risks not included doesn’t reflect different risk levels by company. • Better to reflect risks directly, even if simple approaches used for some risks. 22

23. Principle #3 – The determination of amounts of assets, liabilities and TBSR should be based on consistent methodology. • Necessary to ensure a proper assessment of capital adequacy. • Required to determine an effective overall financial strength measure. 23

24. Principle #4 – The framework must be practical and contain enough flexibility to be effectively implemented by companies of all sizes. • Will develop a standardized and one or more advanced approaches for each risk. • Build on current tools to the extent possible. • Standardized defined so any company can implement. • Risk models will be required for most advanced approaches. • Standardized approach will be based on results from testing done with more advanced models. 24

25. Principle #5 – The TBSR should encourage and reward good risk management practices. • Framework should reflect the true risks of the company. • Pass-through - Risk sharing with policyholders and room to adjust for adverse experience will be considered. • Risk Mitigation strategies (e.g. hedging, reinsurance) and the risks created by mitigation will be considered. • Aggregation methodology should reflect correlation, diversification and concentration of risks. • Credit in capital requirements for strong, demonstrable risk management practices will provide an incentive to make ongoing improvements. 25

26. Principle #6 – The TBSR should reflect existing risks on a going concern basis. • Focus is protecting the rights of inforce policyholders. • Consistent with international best practices. • Existing risks include all current commitments. • Future new business and implications of liquidation scenario recognized and tested in DCAT or other supplements to capital. 26

27. Principle #7 – The primary risk measure (i.e. CTE) should be appropriate and consistent across all risks and products. • Risk Measure (ie. CTE level), time horizon and terminal value must be internally consistent. • A minimum regulatory requirement and an appropriate economic TBSR to be determined for each company. • Economic TBSR level set by company based on desired financial strength and credit rating. • Economic TBSR at a higher confidence level than the minimum regulatory requirement. 27

28. PRACTICAL IMPLEMENTATION ISSUES • Important to identify practical implementation issues before developing the details of the framework. • Currently thinking through how to address the issues identified to date. These issues are: • Standardized versus advanced approaches - When will advanced be allowed, encouraged or required? When will choice be restricted? How to minimize arbitrage? • Advanced Model Standards – What will standards look like? Who will prescribe? Criteria to use models? Resource requirements? 28

29. PRACTICAL IMPLEMENTATION ISSUES (continued) • Implementation costs – For small companies? Mid-sized companies? Large companies? • How to meet the needs of companies of all sizes? • Impact on supervision? – Insurer/supervisor relationship? Potential supervisor issues? Life versus P&C? Potential volatility of TBSR? Minimize potential pro-cyclicality? How to recognize and encourage effective risk management? • For more details check the Solvency Framework Sub-committee’s CIA web page. 28