Capital Levels in the Canadian Property/Casualty Insurance Industry

1. Capital Levels in the Canadian Property/Casualty Insurance Industry Peter Carayannopoulos Mary Kelly Wilfrid Laurier University

2. Agenda • Motivation. • Canadian marketplace. • Areas of investigation: • Capital holdings and firm risk. • Regulatory changes in 2003 and the distribution of capital in the industry • Conclusions.

3. Motivation • Look at holdings of Canadian p/c insurers taking regulatory framework as given. • Do capital holdings reflect firm risk? • What is initial impact of changes in solvency requirements in 2003? • Little research undertaken on capital holdings of Canadian p/c insurers.

4. Areas of Investigation • What firm characteristics influence capital holdings between 1990 & 2004? • What is the impact of the new MCT test on: • The level of capital holdings? • The relationship between capital holdings and firm characteristics? • The relationship between capital holdings and a firm’s portfolio of assets and liabilities?

5. P/C Insurance in the Canadian Economy • Over 200 private insurance companies in Canada organized in approximately 120 groups. • A small industry: • $35.9 million in premiums in 2003, • $71 billion in assets in 2003. • 2.6% of world wide p/c insurance premiums. • Market share of top 10 firms around 55%.

6. Regulation of Insurers • OSFI regulates solvency via level of capital, adequacy of reserves, prudent investment strategies. • Provincial regulators monitor products and practices. • Firms may also be subject to provincial solvency requirements.

7. MAT Value asset levels on liquidation basis Assets Available = total assets held by firm less those non-admitted or otherwise not available. Assets Required = total liabilities + required margin – recoverables. MAT statistic is MCT Value asset levels on on-going basis. Capital required based on both asset and liability risk. Asset risk: type of security, maturity and grade. Liability risk: unearned premium reserve, NPW by line. Calculation of capital required / capital available must exceed 150% to pass test. Recommended targets of 170% - 210%. Minimum Asset Test (MAT) vs. Minimum Capital Test (MCT) • Firm must have positive ratio to pass test. • Higher ratio needed to avoid regulatory oversight

8. Summary of Insurer Data1990 - 2004

9. Distribution of Capital Levels • Capital level measure by Surplus / NPW • 5% had capital levels below 0.33, 7% had capital levels 10. • Firms with higher Surplus / NPW more likely to be mutual insurers.

10. Determinants of Capitalization • Amount of capital a firm should carry depends on: • Probability of insolvency. • Agency costs. • Asymmetric information / growth opportunities. • Product market interactions.

11. What Are Determinants of Capitalization?

12. Capital Holdings Conclusions • Most of variability explained by size • Possible interpretations • Firms determine capital holdings by adding a margin to the regulatory requirements rather than on the basis of risk characteristics. • US market is significantly different from Canadian market.

13. Introduction of MCT • Timeline: • Trial basis for 2001 and 2002. • Implementation in 2003. • Goals: • Harmonize solvency requirements across provinces. • Capital neutral across industry. • Align capital holdings with firm risk. • Evaluate risk based on both asset and liability holdings.

14. Level of Capital Holdings and MCT

15. Level of Holdings & MCT Conclusions • Positive coefficient for implementation period suggests that capital holdings haveincreased. • Cannot reject hypothesis that there is no difference between implementation period and test period indicator. • Cannot reject hypothesis that capital holdings increases as a response to 9/11 and NOT impending MCT test.

16. MCT and Firm Risk • Do firms hold greater capital since 2003 because firm risk has changed? • Introduce interaction effects for risk characteristics and implementation period. • Results: • Implementation variable becomes insignificant. • No change in significance of other risk characteristics. • No interaction effects are significant at 5% level. • At 10% level, cross effect of Herfindahl index by region and implementation is significant and negative.

17. MCT, Asset and Liability Risk • Are capital holdings aligned with asset and liability risk? • Liability risk: • Firms that u/w liability and automobile AB should hold more capital. • Firms that u/w personal property and automobile physical damage should hold less capital. • Asset risk given below

18. MCT, Asset and Liability Risk

19. Asset and Liability Risk • Firm size still explains bulk of variability in surplus holdings. • There is some alignment between portfolio risk and amount of surplus held.

20. Conclusions • First long term study into capital holdings of Canadian p/c insurers → more work is needed. • Risk characteristics do not greatly influence capital holdings of Canadian insurers (as opposed to U.S. experience). • Firm size is most relevant indicator of surplus holdings. • Surplus holdings have increased since the introduction of MCT (but may be related to 9/11). • MCT does not appear to do a better job of aligning capital holdings with firm risk.

21. Questions?