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Ralph Lewars Senior Advisor International Advisory Group

Risk Based Capital Tests Life and General Insurers OSFI International Advisory Group IAIS-FSI-ASSAL Training Seminar Regional Seminar on Capital Adequacy and Risk-based Supervision 6 – 11 May 2007 Rio de Janeiro, Brazil. Ralph Lewars Senior Advisor International Advisory Group. Capital.

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Ralph Lewars Senior Advisor International Advisory Group

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  1. Risk Based Capital TestsLife and General InsurersOSFI International Advisory GroupIAIS-FSI-ASSAL Training SeminarRegional Seminar on Capital Adequacy and Risk-based Supervision6 – 11 May 2007Rio de Janeiro, Brazil Ralph Lewars Senior Advisor International Advisory Group

  2. Capital • Why is capital important? • What is risk? • Risk Based Capital calculations • Risks included in capital tests • Supervisory framework/risk assessment • Dynamic capital adequacy testing • Future developments

  3. Capital • Why is capital important? • Policyholders pay money up front for a promise to pay in future. • Capital especially important for financial institutions

  4. Capital • 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

  5. Capital • Why is capital important ? • Cushion to absorb unforeseen/unanticipated losses • Losses accrue firstly to shareholders rather than policyholders

  6. Balance Sheet Liabilities Assets Capital Capital • Why is capital important ? Accounting capital vs regulatory capital Accounting capital = assets – liabilities Regulatory capital = adjusted accounting capital

  7. Capital B. What is risk? • Definition “ a chance of encountering harm or loss; hazard; danger” • Insurers are in the business of accepting risks

  8. 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

  9. 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

  10. Capital C. Risk Based Capital Calculations • What is required to calculate ????

  11. Capital C. Risk Based Capital Calculations Requirements • Instructions • Regulatory capital return • Regulatory balance sheet • Details balance sheet assets, liabilities and off balance sheet exposure

  12. Capital C. Risk Based Capital Calculations 1. Instructions • legislation • regulation • guideline • other written document i.e. circular

  13. 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

  14. Capital • 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

  15. Capital • Risk Based Capital Calculations 1. Instructions • General insurers (MCT) approximately 50 pages • Since 2002 Minimum Capital Test

  16. Capital • Risk Based Capital Calculations 1. Instructions • Life insurers (MCCSR) approximately 160 pages • Since 1992 Minimum Continuing Capital Surplus Requirement

  17. Capital C. Risk Based Capital Calculations • Regulatory capital return – General Insurers • MCT – 1 page with approx 10 worksheets • Return included with financial statement return • Filed quarterly

  18. Capital C. Risk Based Capital Calculations • 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

  19. Capital C. Risk Based Capital Calculations • Regulatory balance sheet – General Insurers • standard format Assets – 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

  20. Capital C. Risk Based Capital Calculations • Regulatory balance sheet – Life Insurers • standard format Assets – 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

  21. Capital C. Risk Based Capital Calculations • 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

  22. Capital C. Risk Based Capital Calculations Target ratio for both Life and non-life 150% (Metric) Capital available / Capital required * 100

  23. Capital • Risk Based Capital Calculations - Capital available Balance Sheet L A C

  24. Capital • Risk Based Capital Calculations - Capital available • Capital 3 main features: • Permanent • Subordinated • Free of mandatory charge

  25. Capital Spectrum Tier 2 (c) Tier 1 Best Good/Acceptable General vs Life insurers Capital • Risk Based Capital Calculations - Capital available

  26. Capital • Risks included in capital tests - Capital required • Risks in assets reported on balance sheet • Risks in off balance sheet transactions/ contracts

  27. Capital • Risks included in capital test – Capital required Balance Sheet L A C Off Balance Sheet exposure

  28. 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

  29. 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

  30. Capital

  31. 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

  32. Capital • Risks included in capital test – Capital required Balance Sheet L A C

  33. Capital D. Risks included in capital tests – Capital required • Two largest actuarial estimates/provisions for general insurers are: • Unearned premiums and unpaid losses risks

  34. Capital

  35. Capital D. Risks included in capital tests - Capital required • The actuarial estimates/provisions for life insurers are: • Segregated funds risk • Mortality risk • Morbidity risk • Lapse risk • Interest margin pricing risk • Changes in interest rate environment risk

  36. Capital D. Risks included in capital tests - Capital required • Segregated funds….risk of loss arising from guarantees embedded in segregated funds • Factor-based; Modelling approach allowed upon OSFI blessing • Type of fund money market vs exotic aggressive equity • Resets/ratchets • 75% - 100% guarantees

  37. 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

  38. 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

  39. 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

  40. Capital • Risks included in capital tests - Capital required Balance Sheet L A C Off Balance Sheet Exposure

  41. Capital D. Risks included in capital tests - Capital required • Off balance sheet commitments risk, majorrisk is credit risk • Guarantees, letters of credit, forward agreements, put options, etc…

  42. 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

  43. Capital • 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

  44. Capital • 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

  45. 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

  46. 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

  47. 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

  48. Capital • Future developments • Harmonization of insurance capital tests IAIS • Review of accounting and actuarial standards required before harmonization can start • Ongoing refinements with new products, risks, type of capital being issued, etc. • MCCSR/Basel II internal ratings based approach

  49. Thank you

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