Risk & Capital ManagementA Regulator’s Perspective

Stuart Wason

Senior Director

Actuarial Division, OSFI

June 16, 2008

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Topics

• Global trends• Implications for regulators• Canadian developments• Risk & capital management issues

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Global trends

• International standards setters– International Accounting Standards Board (IASB)– International Association of Insurance

Supervisors (IAIS)– International Actuarial Association (IAA)

• ERM– Widespread growth in practices and

development of the art/science– Risk management as a profession– CRO Forum influence– Internal risk model development

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Implications for regulators

1. Move to total balance sheet approach for risk assessment and capital requirements– Switch from old “liability” plus “capital

requirement add-on” approach– Allows independence from accounting definition

of liabilities– Consistent with ERM, economic capital and

internal risk model developments– TBS now endorsed/adopted by IAA, IAIS,

Solvency II, OSFI etc.– Regulators need to develop new processes,

expertise, disclosures etc.

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Required capital to be determined indirectly:

Required = Total Asset - GAAP Policy Capital Requirement Liabilities

AssetsLiabilities & Capital

solvency buffer

expected asset requirement

margins

required capital

GAAP policy liabilities

best estimate policy liability

total asset requirement

Total Asset Requirement

free assets

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Implications for regulators

2. Shift to reliance and principles based supervision– IASB insurance contract liability likely to be best

estimate + risk margin– Capital requirements will increasingly rely on full

internal (or partial) models to better capture risks

– Internal and external reviews will be needed to give assurance on integrity of work

– Regulators need to design appropriate approvals processes (use test; governance test; sufficiency test) and retain staff with appropriate expertise

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Implications for regulators

3. Assessing risks over the risk horizon– Lifetime?– Shorter shock period (e.g. one year) at high

confidence level frequently used for capital and solvency assessment purposes

– How should provision be made for remaining risks after one year (a.k.a. terminal provision)

– Need for longer term risk management horizon (say 3-5 years) as part of supervisory review (e.g. own risk solvency assessment [ORSA] and dynamic capital adequacy [DCAT])

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Implications for regulators

4. Consider differences between insurer and bank capital requirements– Credit risk– Market risk– Insurance risk– Operational risk– Risk diversification

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Canadian developments

• Emergence of IASB standards for insurance accounting means that CICA will cease to be an accounting standards setter for insurers by 2011

• Introduction of IFRS by Canadian insurers will necessitate a change in the methods used to determine their capital requirements

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Canadian IFRS developments

• OSFI has identified 17 standards that have key differences between IFRS and Canadian GAAP impacting financial institutions

• IFRS 4 will redefine what is an insurance versus investment contract

• Insurance contracts standard will define how these contracts are to be valued

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Other IFRS to watch for

• Fair Value Measurements• Revenue Recognition• Derecognition/Consolidation• Financial Statement Presentation• Conceptual Framework• Liabilities & Equity• Improvements to Financial Instruments

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Canadian capital developments

• Advanced probabilistic models,– Now used by larger insurers for internal risk & capital

management– Allowed and encouraged in Solvency II– Existing Canadian solvency framework is generally not

capable of reflecting advanced products and risk mitigation

– Internal models are allowed by Basel II• Current standard approach

– Originally designed and calibrated many years ago before market values used

– Market risk component uses simple factor– No allowance for diversification or concentration– Increasingly includes fairly complex to calculate

elements (i.e. no longer a “standard” approach?)– Not suitable for IASB insurance liabilities

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Canadian timeline

2008- Work on non-life (P&C) issues commences- Finalize market & credit risk advanced approach- Finalize framework for risk aggregation for advanced

approach- Draft life insurer standard approach ready for QIS

2009- Further QIS on revised life insurer standard approach- Life insurer standard approach finalized

2010- Implementation measures necessary for new standard

approach put in place201?

- New standard approach takes effect January 1, 201?- Approval of new advanced approach for large insurers?

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Canadian vision concepts

Future solvency financial requirements should:

– take into account all credit, market, underwriting & operational risks

– recognize all cash flows from all of the assets and liabilities – value the cash flows consistently and realistically – reflect the risk mitigation strategies used by the insurer – consider the dependencies within risks and between risks

and recognize when appropriate and measurable – ensure that insurer assets are sufficient, with high degree of

confidence, to withstand adversity emerging over a defined regulatory control time horizon (e.g. might be one year)

– ensure that there are sufficient assets at the end of the defined time horizon to provide for the:

• transfer of the remaining obligations to another insurer or

• run-off of the remaining obligations

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Canadian Vision

Minimum Asset

Requirement

Target Asset Requirement

Regulatory control level

Determined using “standard” approach

(e.g. 66% of “standard”)

Threshold investment grade security level – regulator

going concern level

Determined using “advanced” or “standard” approach

Target 1 year CTE(99) sufficiency

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Canadian Vision

• Uses company models• Sophisticated scenario modeling

integrated with ERM• Measures all risks & risk

mitigation• Risk dependencies modeled• Requires regulatory approval• Encouraged for large insurers,

technically able insurers & those with complex risks

• Selection of advanced approach separate for credit, market, insurance and operational risk

• Industry formulaic, factor based or stress scenario

• Not as advanced but developed to be consistent & reflect key risks & mitigation of advanced approach

• Risk dependencies partially recognized

• Designed to produce an appropriate requirement across the industry

Advanced Approach Standard Approach

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Canadian design issues

Risk horizon: One year (working hypothesis)

Risk measure: CTE (working hypothesis: CTE99)

Hedgeable risks valued after one year at post-stress market consistent valuations

Non-hedgeable risks valued after one year at post-stress BEL + post-stress risk margin (working hypothesis: CTE based)

How will standard approach differ from advanced (internal model) approach?

CTE = Conditional Tail Expectation or Tail VaR

BEL = Best Estimate Liability

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Framework Comparison

Solvency II CanadaCover All Risks

Company Risk Profile

Two Tiers SCR and MCR TAR and MAR

Standard vs Advanced

Use of ApproximationsSignificant implementing

assumptions and approximations being contemplated

Extent of approximations unclear

Total Asset Requirement

Defines both technical provisions and capital required

Defines total asset requirement

directly

Risk Horizon

Risk Measure VAR 99.5% CTE99%

Risk Margins

Implicit in MV if Hedgeable, with ability criteria only

CoC MVM if Non-Hedgeable Does NOT reflect post-stress

distribution

Implicit in MV if Hedgeable; with ability and intent criteria

RW CTE if Non-Hedgeable Reflects post-stress risk

distribution

Frameworks align Frameworks differ

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Risk & capital management issues

• Guidance is needed to narrow the range of practice w.r.t. the IASB insurance accounting standard and insurer capital models

• Decisions will be needed regarding the tradeoffs to be made in the new Canadian insurer capital framework in consideration of Solvency II and Basel II (e.g. diversification)

• New IFRS and capital frameworks will likely alter stakeholder views of insurer profitability, earnings volatility and soundness

• Need to define the resources for the industry and regulator to implement these changes in sufficient time (as early as 2011 for some aspects)

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Risk & Capital ManagementA Regulator’s Perspective

Stuart Wason

Senior Director

Actuarial Division, OSFI

June 16, 2008