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Capital Levels in the Canadian

Property/Casualty Insurance Industry

Peter CarayannopoulosMary KellyWilfrid Laurier University

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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.

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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.

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Areas of Investigation

1. What firm characteristics influence capital holdings between 1990 & 2004?

2. What is the impact of the new MCT test on:

a. The level of capital holdings?b. The relationship between capital holdings

and firm characteristics?c. The relationship between capital holdings

and a firm’s portfolio of assets and liabilities?

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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%.

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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.

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Minimum Asset Test (MAT) vs. Minimum Capital Test

(MCT)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%.

Assets available - assets required100

assets required for test purposesx

• Firm must have positive ratio to pass test.

• Higher ratio needed to avoid regulatory oversight

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Summary of Insurer Data1990 - 2004

Number Strictly Cdn Insurers 64

Number Of Mutual Insurers 50

Number Of Firms 268

Number Of Observations 2358

Average Median

Surplus To NPW Ratio 3.51 0.93

2 Year U/W Results 108.2% 105.5%

% Liability And AB To Total NPW 34.78% 37.33%

% Personal Property & Auto PD To Total NPW

47.19% 48.21%

% Asset Portfolio In Gov’t Bonds 68.37% 68.77%

NPW ($1000 Cdn) $113,440

$32,753

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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.

Firm characteristics Surplus / NPW <1

Surplus / NPW > 1

Statutory Assets $94.2 mil $59.2 mil

2 year avg u/w ratio 106.54% 109.92%

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Determinants of Capitalization

• Amount of capital a firm should carry depends on:– Probability of insolvency.– Agency costs.– Asymmetric information / growth

opportunities.– Product market interactions.

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What Are Determinants of Capitalization?

Explanatory VariableExpected

RelationshipCoefficie

nt

Regional Diversity + 0.405

Product Diversity + -0.503

Reinsurance Usage - 0.002

Var. of Past Experience + -0.014*

Firm Size - -2.561*

Canadian Insurer + -3.197*

2 Year U/W Ratio + 0.0063

Investment Risk Ratio + 0.010*

Claims Settlement Length - 0.0029

Mutual Insurer + or - 2.512

Growth Prospects + -0.015

% Liability and AB + 0.738*

% Personal Property and Auto PD - 0.0025

R2 33.4%

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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.

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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.

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Level of Capital Holdings and MCTExplanatory Variable Expected Relationship

Coefficient

Regional Diversity + 0.339

Product Diversity + -0.551

Reinsurance Usage - 0.0019

Var. of Past Experience + -0.0139*

Firm Size - -2.606*

Canadian Insurer + -3.349*

2 Year U/W Ratio + 0.0082

Investment Risk Ratio + 0.010*

Claims Settlement Length - 0.0024

Mutual Insurer + or - 2.533

Growth Prospects + -0.016

% Liability and AB + 0.716*

% Personal Property and Auto PD - 0.003725

Test Period Indicator 0 0.794

Implementation Period Indicator 0 1.408*

R2 33.7%

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Level of Holdings & MCT Conclusions

• Positive coefficient for implementation period suggests that capital holdings have increased.

• 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.

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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.

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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

Asset Class Percentage of Book Value held as Reserve

Cash 0%

Government Bonds 0%

Commercial Bonds 0.5% to 8% depending on maturity and grade.

Mortgage Loans 4% to 8% depending on residential versus commercial

Preferred Shares 4% to 15% depending on grade of shares

Common Shares 15%

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MCT, Asset and Liability Risk

Explanatory VariableExpected

Relationship

Coefficient

Interaction Effect Coefficie

nt

Firm Size - -2.833* 0.7263

Proportion of NPW from Liability & AB

+ 0.791* -0.04170

Proportion of NPW from Auto Damage and Personal Property

- -0.0025 -0.00253

Proportion of Assets as Gov’t Bonds 0 0.1079* 0.1079

Proportion of Assets as Comm. Bonds

+ -0.1036* -0.04687

Proportion of Assets as Mortgage Loans

+ 0.5730* -0.3175*

Proportion of Assets as Preferred Shares

+ 0.1363* -0.0297

Proportion of Assets as Common Shares

+ 0.1165* -0.0950*

Implementation Period Indicator 0 0.7936 0.7263

R2 33.3%

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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.

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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.

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Questions?