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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?