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Dynamic Capital Adequacy Testing

Dynamic Capital Adequacy Testing

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Dynamic Capital Adequacy Testing

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  1. 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. Mortality Morbidity Persistency Cash flow mismatch Deterioration of asset values New business Expense Reinsurance Government and political action Off-balance sheet Others, if material Threats to Consider – Life

  10. 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 Threats to Consider – P&C

  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

  15. 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

  16. Forming a Business PlanMCCSR Ratio

  17. Forming a Business PlanAvailable Surplus

  18. Forming a Business PlanAnnual Income

  19. Business Plan – Base Scenario

  20. Scenario 1: Mortality

  21. Scenario 2: Morbidity

  22. Scenario 3: PersistencyMCCSR Ratio

  23. Scenario 3: PersistencyAvailable Surplus

  24. Scenario 3: PersistencyAnnual Income

  25. Scenario 4: Interest Rate Risk

  26. Scenario 5: Credit Risk

  27. Scenario 6: Expenses

  28. Scenario 7: Integrated Scenario

  29. Scenario 8: Ripple Effects

  30. Scenario 9: Ripple Effects

  31. DCAT Case Study: Base Scenario versus Actual Outcome