Office of the Superintendent Bureau du surintendantof Financial Institutions Canada des institutions financières Canada

Dynamic Capital Adequacy Testing

Michael Hafeman

Assistant Superintendent, Specialist Support Sector

IAIS Annual Conference – Santiago, Chile – October 10, 2002

2

OSFI’s Approach

• Promote understanding and management of risks by companies’ boards of directors and senior management

• Establish capital requirements

• Assess performance and strength

• Promote effective disclosure

3

Dynamic Capital Adequacy Testing – DCAT

• Process of projecting and analyzing the trends of a company’s capital adequacy under a variety of future scenarios

4

Purpose of DCAT

• Assist board of directors and senior management in planning and risk management

• Defensive in nature• Identify

– Plausible threats to satisfactory condition– Actions which lessen likelihood of threats– Actions which mitigate a threat if it occurs

5

Historical Context

• OSFI began developing risk-based capital requirements for Life in mid-1980s

• Actuaries (CIA) developed a forward-looking approach to assessment

• Life capital and DCAT requirements since 1992

• P&C DCAT since 1998; new risk-based capital requirements from 2003

6

DCAT Process

• Development of base scenario

• Identification and examination of possible threats

• Development of plausible adverse scenarios

• Projection and analysis of capital adequacy

• Reporting of results

7

Base Scenario

• Normally, consistent with the business plan

• All scenarios include inforce policies, forecast sales, and non-insurance operations

• Realistic assumptions

• Forecast period is usually 5 years for life companies and 2 years for P&C companies

• Modeling software is available

8

Plausible Adverse Scenarios

• Adverse, but plausible, assumptions about matters to which an insurer’s financial condition is sensitive

• Stress testing to assess plausibility

• Differ among insurers

• May change over time for an insurer

9

Threats to Consider – Life

• Mortality • Morbidity• Persistency• Cash flow mismatch• Deterioration of asset

values• New business

• Expense• Reinsurance• Government and

political action• Off-balance sheet• Others, if material

10

Threats to Consider – P&C

• Frequency and severity

• Pricing• Misestimation of

policy liabilities• Inflation• Interest rate• Premium volume

• Expense• Reinsurance• Government and

political action• Off-balance sheet• Others, if material

11

Refinements Required

• Integrate scenarios, if the probability of an adverse scenario is high

• Consider ripple effects– Impact on other base assumptions– Company’s response to adversity– Regulatory action, e.g., where minimum capital

is not met– Policyholder actions

12

Reporting

• Primarily for board of directors and senior management

• Copy of report is sent to OSFI

• At least base scenario and three most risky scenarios must be tested and reported annually

• Professional opinion is required

13

Capital Adequacy Targets

• Actuarial standard for satisfactory opinion:– Meet minimum regulatory capital requirement under

the base scenario

– Meet all future obligations under the base scenario and all plausible adverse scenarios

• OSFI expects more – acceptable capital levels• OSFI encourages active discussions amongst the

actuary, board and management of any scenarios where minimum capital is not met

14

More Information

• OSFI – www.osfi-bsif.gc.ca

• Canadian Institute of Actuaries – www.actuaries.ca– Standard of Practice, Dynamic Capital

Adequacy Testing, December 1998– Educational Note, Dynamic Capital Adequacy

Testing – Life and P&C, June 1999

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DCAT Case Study

• Company in weakened position in 1992, due to investment losses

• DCAT used to develop business plan to improve solvency position within five years

• DCAT used to test viability of business plan under plausible adverse scenarios

Forming a Business PlanMCCSR Ratio

Level of New Business (MCCSR ratio)

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997Year

MC

CS

R R

ati

o

Lower new sales Level New Sales

Double New Growth No New Business

Forming a Business PlanAvailable Surplus

Level of New Business (Available Surplus)

60,000

70,000

80,000

90,000

100,000

110,000

1992 1993 1994 1995 1996 1997

Year

Le

ve

l of

Av

aila

ble

S

urp

lus

Lower new sales Level New Sales

Double New Growth No New Business

Forming a Business PlanAnnual Income

Level of New Business (Annual Income)

3,000

6,000

9,000

12,000

15,000

18,000

21,000

1992 1993 1994 1995 1996 1997

Year

Lev

el o

f A

nn

ual

Inco

me

Lower new sales Level New Sales

Double New Growth No New Business

Business Plan – Base Scenario

CHOSEN BASE SCENARIO: Lower New Sales

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997Year

MC

CS

R R

atio

Base Scenario

Scenario 1: Mortality

Worsening Mortality: 3% per annum

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997

Year

MC

CS

R R

atio

Base Scenario Worsening Mortality

Scenario 2: Morbidity

Worsening Morbidity: 3% per annum

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997

YEAR

MC

CS

R R

AT

IO

Base Scenario Worsening Morbidity

Scenario 3: PersistencyMCCSR Ratio

Worsening Withdrawal Rates: (2 or 0.5)MCCSR Ratio

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997

YEAR

MC

CS

R R

AT

IO

Base Scenario Withdrawal

Scenario 3: PersistencyAvailable Surplus

Worsening Withdrawal Rates: (2 or 0.5)Available Surplus

60,000

70,000

80,000

90,000

100,000

110,000

120,000

1992 1993 1994 1995 1996 1997YEAR

Le

ve

l of

Av

aila

ble

S

urp

lus

Base Scenario Withdrawal

Scenario 3: PersistencyAnnual Income

Worsening Withdrawal Rates: (2 or 0.5)Annual Income

4,000

6,000

8,000

10,000

12,000

14,000

16,000

1992 1993 1994 1995 1996 1997Year

Lev

el o

f A

nn

ual

In

com

e

Base Scenario Withdrawal

Scenario 4: Interest Rate Risk

Interest Rate Risk

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997

Year

MC

CS

R R

ati

o

Base Scenario Increasing 0.6% per annum

Decreasing -0.6% per annum

Scenario 5: Credit Risk

Credit Risk

20

40

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997

Year

MC

CS

R R

atio

Base Scenario

Doubled Asset Defaults

Doubled Asset Defaults & Default Provisions

Scenario 6: Expenses

Unit Expenses inflate 3% more than base rate

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997

Year

MC

CS

R R

ati

o

Base Scenario Expenses

Scenario 7: Integrated Scenario

Integrated: Doubled Asset Default & Provisions with Worsening Mortality

20406080

100120140160180

1992 1993 1994 1995 1996 1997

YEAR

MC

CS

R R

ati

o

Base ScenarioDoubled Defaults & Doubled ProvisionsWorsening MortalityIntegrated: Asset defaults & Worsening mortality

Scenario 8: Ripple Effects

Ripple Effect Scenarios: Higher Sales with Higher Expenses

20

40

60

80

100

120

140

160

180

1992 1993 1994 1995 1996 1997

YEAR

MC

CS

R R

AT

IO

Base Scenario Higher Sales Higher Sales and Expenses

Scenario 9: Ripple Effects

Worsening Morbidity with Premium Change

80

100

120

140

160

1992 1993 1994 1995 1996 1997

YEAR

MC

CS

R R

AT

IO

Base ScenarioWorsening Morbidity no premium changePremium change with 2 year lagPremium change w 1 year lag

DCAT Case Study: Base Scenario versus Actual Outcome

BASE SCENARIO vs. ACTUAL OUTCOME

60

80

100

120

140

160

180

200

1992 1993 1994 1995 1996 1997YEAR

MC

CS

R R

AT

IO

Base ScenarioActual Outcome