MCCSR in Canada: MCCSR in Canada: What Comes Next?What Comes Next?

PD 11 – Vancouver CIA Meeting June 28th, 2007

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Today’s AgendaToday’s Agenda

1. The Evolving Landscape for RBC in Canada- Simon Curtis

2. Update on CIA Advanced Modeling Work- Michael White

3. OSFI Perspective on Key Issues- Allan Brender

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The Evolving Landscape forThe Evolving Landscape for Risk Based Capital Risk Based Capital

AdequacyAdequacy

Simon Curtis June 28th, 2007

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Why is the Landscape Changing?Why is the Landscape Changing?

Factor based models are no longer viewed as adequate are too inflexible to accurately capture most risks do not capture emerging product or risk issues do not give sufficient information on level of risk covered provide limited information to management do not capture diversification/aggregation impacts on risk

Tools are becoming available to more accurately model risk stochastic tools that can generate and process thousands of

scenarios to generate probability distribution of outcomes advanced probabilistic models based capital frameworks are

frequently called “economic capital” frameworks

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Where is Pressure for Change Where is Pressure for Change Coming From?Coming From?

Company Management Bank Sector

Advanced Probabilistic

Models

Banking has moved to more advanced capital models for Solvency (Basel II) and internal management

Companies require models for internal capital/risk management

“Economic Capital”

Rating Agencies

Rating agencies are requiring development and wide internal use of advanced models to sustain high ratings and are moving to use these models themselves

International Insurance Solvency

European Insurance Industry/Regulators are adopting advanced models as part of “Solvency II” framework

Existing Framework Limitations

Existing framework increasingly incapable of reflecting advanced products and risk mitigation

OSFI

OSFI wishes to move industry towards advanced models/enhanced risk based framework consistent with international insurance and banking developments

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Key Attributes of Economic Key Attributes of Economic Capital ModelsCapital Models

Comprehensive coverage of all risks measured on a consistent basis

Risk distributions modeled or determined for all risksstochastic models used where significant tail risksanalytic techniques may be used for simpler risksspecific quantifications of confidence levels

Focus is generally on total balance sheet requirement for risks “capital” falls out as “total requirement – balance

sheet provisions”Risk diversification/aggregation reflected

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What does Economic Capital What does Economic Capital Achieve?Achieve?

Enable better business decisions through: consistent measurement of risk and return for existing

and emerging risks understanding which products are adding value and the

value contribution of various businesses understanding the impact of diversification/aggregation of

risk Allows companies to appropriately set internal and

regulatory capital targets consistent measurement and explicit risk quantification

allows understanding of key solvency risk exposures target capital levels linked to financial strength objectives

and desired credit rating Influence regulators and regulatory capital

developments

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Industry Development of Industry Development of Economic Capital – Current StateEconomic Capital – Current State Most large insurers are developing economic capital

frameworks Frameworks reflect all risks although degree of

sophistication in the modeling often varies by risk Total Balance Sheet approach is typically used Primary risk measure is either CTE or percentile (VaR) Time Horizon used by many companies is 1 year but

some use a lifetime horizon – Terminal provision is critical in a 1 year horizon the confidence level is higher for shorter time horizons, e.g. if

CTE95 is a reasonable capital level using a lifetime horizon, a 1 year horizon might use CTE99 for the first year with a CTE70 terminal provision calculated at the end of the year for the remaining life of the business

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Industry Development of Industry Development of Economic Capital – Current StateEconomic Capital – Current State

Risk mitigation and pass-through are typically reflected need to consider effectiveness of mitigation in the tail scenarios

(e.g. will the instruments required for hedging be available and at what cost?)

Companies are reflecting diversification benefits and risk concentrations – typically using correlation matrices or copulas rather than integrated models

Stochastic techniques are used for investment related financial risks (market and credit), particularly risks with skewed distributions

Stochastic techniques are being contemplated, but generally not yet developed for insurance risks

Less advanced scenario techniques are typical for policyholder behaviour risks and little consensus in how to determine capital for operational risk

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Evolving the Regulatory Capital Evolving the Regulatory Capital FrameworkFramework

OSFI/CIA jointly have established MCCSR Advisory Committee (MAC) to develop framework for how regulatory capital regime in Canada can evolve to reflect emerging capital adequacy measurement techniques

Goals of industry/CIA include reasonable consistency between economic and revised

regulatory capital frameworks for life insurance ensuring the Canadian industry/profession keep pace

with international developments in this area adoption of a framework that appropriately measures all

risks and appropriately reflects impacts of risk aggregation/diversification and risk management

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Key Committees in Canada Established to Key Committees in Canada Established to Oversee Development of New Solvency Oversee Development of New Solvency

FrameworkFramework

Regulatory Capital

CIA Risk and Capital

Committee Task Force

(“SFSC”)

MCCSR

Advisory Committee

(“MAC”)

Industry

Economic Capital

Technical work on advanced modeling framework

Supported by companies and regulators through making technical resources available

Joint industry/Regulatory Committee assessing direction and advising on longer term solvency framework for Life Insurers

Senior representation from industry, regulators, Assuris

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Key MilestonesKey Milestones2006 Agreement on solvency framework principles Agreement on working framework for “technical” aspects of the

capital model (time horizon, confidence level, terminal value measure, role of risk neutral vs. real world basis, risk mitigation

2007 Agreement on advanced modeling best practices guidelines Agreement on “Vision” for structure of future regulatory solvency

regime Finalize market risk advanced approach Substantially complete work on framework for risk aggregation

across risks (diversification, covariance)

2008 Finalize credit risk advanced approach Finalize framework for risk aggregation across risks (diversification,

covariance) for advanced approach2009 Finalize insurance risks and operations risk advanced approaches

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Key Principles for the Solvency Key Principles for the Solvency Framework Agreed Between Framework Agreed Between

StakeholdersStakeholders1. Consider all risks2. Determine assets and liabilities on a consistent basis for risk

measurement purposes3. Be practical, but technically sound4. Reflect existing risks ongoing concern basis and consider

winding-up and re-structuring5. Use measures (e.g. CTE) that are comparable across risks and

products6. Ensure that capital is prudent7. Encourage good risk management8. Adapt international principles and best practices9. Allow comparison of similar risks across Financial Institutions10.Be transparent, validated and based on credible data11.Use reliable processes with assumptions sustainable in time of

stress12.Be part of intervention levels for supervisory action

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MAC “VISION” for Life Insurer MAC “VISION” for Life Insurer Solvency FrameworkSolvency Framework

Minimum AssetRequirement

Target AssetRequirement

regulatory control level

determined using “standard” approach

threshold investment grade security level – regulator going

concern level

determined using “advanced” approach or scale up of standard

approach minimum

likely to target 1 year CTE(99) sufficiency level

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MAC “VISION” – Advanced vs. MAC “VISION” – Advanced vs. Basis ApproachesBasis Approaches

Advanced Approach Standard Approach

• uses company models• sophisticated scenario modeling

integrated with insurer risk management

• measures all risks, including risk mitigation

• risk dependencies within and between risks modeled (correlation, concentration)

• use of advanced approaches requires regulatory approval

• advanced approach to be encouraged for large insurers, technically able insurers, and insurers with complex risks

• selection of advanced vs. standard approach may be made separately for credit, market, insurance and operational risk

• industry formulaic or factor based• while not as advanced, developed

to be consistent and reflect all key risks and risk mitigation of advanced approach

• risk dependencies within risks only partially recognized

• designed to produce appropriate requirement across the industry

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MAC “VISION” - Technical FrameworkMAC “VISION” - Technical Framework– Total Asset Requirement– Total Asset Requirement

Required capital is determined indirectly as difference between modeled total asset requirement and balance sheet provisions

Required = Total Asset - Balance SheetCapital Requirement Policy Liabilities

AssetsLiabilities &

Capital

solvency buffer

expected asset requirements

margins

required capital

CGAAP policy liabilities

best estimate policy liability

total asset requirement

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MAC “Vision” - Technical FrameworkMAC “Vision” - Technical Framework- Total Asset Requirement- Total Asset Requirement

Key Advantages of Focus on Total Asset Requirement automatically adapts to different accounting regimes takes into account levels of conservatism in policy liabilities removes disconnects between liabilities/capital

Key Challenges disclosure metrics need to be thought through carefully (a

company with relatively more conservatism in margins may appear to be “capital light” when looking only at capital): disclose margin + capital?

increased model risk for total asset requirement approach as opposed to stand alone capital

difficulty in developing “simple” standard approaches to a total asset requirement as opposed to stand alone capital

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MAC “Vision” - Technical Framework MAC “Vision” - Technical Framework - One Year Stress Test Metric- One Year Stress Test Metric

Total asset requirement is determined as assets required to withstand extreme event over one year period with residual value sufficient to run-off or sell the business

One year approach with residual value can be calibrated to consistent level of general conservatism as a lifetime run-off approach – appropriate determination of residual value is key

One YearCTE99 Metric with

CTE(60-80) Residual

Lifetime CTE95 Run-Off Metric

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MAC “Vision” – Technical MAC “Vision” – Technical FrameworkFramework

- One Year Stress Test Metric- One Year Stress Test Metric

One Year

• consistent with broader risk management (e.g. Basel II, VAR)

• focuses risk analysis and management on actionable timeframe

• appropriate residual value methodology can reflect long term risks

• long term models overweight very subjective analysis of catastrophic long term risk modeling

Both One Year and Lifetime Perspectives Have Advocates

Lifetime

• consistent with traditional actuarial approaches (e.g. Segregated fund guarantees)

• some long term risk exposures cannot truly be captured in shorter term metric

• it is difficult to develop reliable residual values for 1 year metric

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MAC “Vision” - Technical FrameworkMAC “Vision” - Technical Framework- One Year Stress Test Metric- One Year Stress Test Metric

Technically proposed framework for residual values requires a “stochastic on stochastic” calculator since first year paths and residual value on each path should be determined stochastically

Year 1 PathTake CTE(99) resultwith residual values

Path dependentResidual values

Run off at CTE(60)-CTE(80)

result is based on CTE(99) outcome of 1 year paths with calculated residual values

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MAC “Vision” – Technical FrameworkMAC “Vision” – Technical Framework- Residual Value- Residual Value

Residual value based on available close out strategy for the risk

availability of robust market prices

lack of robust market prices

directly use these prices (e.g. risk neutral prices for certain market risks)

actuarial modeling using “real world assumptions:

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MAC “Vision” – Technical FrameworkMAC “Vision” – Technical Framework- Residual Value- Residual Value

Accepted that first year paths must be generated stochastically

Practitioners suggest need for practical compromise in developing approximations or closed form solutions to residual values because of complexity of stochastic on stochastic

Does this need to approximate residual values call into question the one year approach given risks are long term?

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Looking Forward – Where are Looking Forward – Where are Current Initiatives Going?Current Initiatives Going?

Progress has been slow advanced frameworks taking significant time to develop credit and market risk unlikely to be fully completed until 2008,

insurance, aggregation and operational risks not until 2009 resource crunch (a few companies providing most of resources) no agreed plan yet on how “standard” approach will be developed momentum has slowed

The regulatory burden for adopting advanced techniques is likely to be heavy significant independent vetting significant parallel testing significant calibration and on-going control/reporting requirements unclear how regulator will resource to meet its needs and whether

companies will view the trade off of effort versus benefit favourably

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Looking Forward – Where are Looking Forward – Where are Current Initiatives Going?Current Initiatives Going?

Updated framework may need to be implemented “risk” by “risk” rather than big bang approach risk by risk approach leads to difficulties in assessing end state

impact, and there may be tendency to move on items leading to capital increases rather than reductions first

Current “moratorium” on MCCSR changes is leading to significant backlog of issues reinsurance counter-party risk currency risk Others

Credit for risk diversification is likely to be contentious issue between industry and regulators has already emerged as issue in Europe in both Basel II and

Solvency II regulator reluctant to give credit for risk diversification in tail

scenarios (to what extent do observed correlations survive in tail events)

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Looking Forward – Where are Looking Forward – Where are Current Initiatives Going?Current Initiatives Going?

2011 and the expected move to IASB accounting standards is likely a “hard” date for a significant change to existing MCCSR IASB reserves will not consider C1/C3

risk and will not be asset adequacy based

Regulatory RBC (MCCSR) will likely need to make up for this gap up

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Key PapersKey Papers

CIA – Risk & Capital Committee

• Time Horizon Paper (lifetime vs. 1 year)

• Risk Measure Paper (CL vs. CTE)

• Terminal Provision Paper

• Key Principles for Reflecting Pass-through and Risk Mitigation

• Guidance Note for Risk Assessment Models

OSFI/MCCSR Advisory Committee

• Initial Communication to Industry on establishment of Advisory Committee, key principles and timeline (April 2006)

• Canadian Vision for Life Insurer Solvency Assessment (May 2007)

Available on CIA website Available on OSFI website

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