Dynamic Capital Adequacy Testing

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Dynamic Capital Adequacy Testing

• Michael Hafeman
• Assistant Superintendent, Specialist Support
  Sector
• IAIS Annual Conference Santiago, Chile
  October 10, 2002

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OSFIs 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

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Dynamic Capital Adequacy Testing DCAT

• Process of projecting and analyzing the trends of
  a companys capital adequacy under a variety of
  future scenarios

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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

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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
• PC DCAT since 1998 new risk-based capital
  requirements from 2003

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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

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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 PC companies
• Modeling software is available

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Plausible Adverse Scenarios

• Adverse, but plausible, assumptions about matters
  to which an insurers financial condition is
  sensitive
• Stress testing to assess plausibility
• Differ among insurers
• May change over time for an insurer

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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

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Threats to Consider PC

• 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

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Refinements Required

• Integrate scenarios, if the probability of an
  adverse scenario is high
• Consider ripple effects
• Impact on other base assumptions
• Companys response to adversity
• Regulatory action, e.g., where minimum capital is
  not met
• Policyholder actions

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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

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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

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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 PC, 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

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Forming a Business PlanMCCSR Ratio
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Forming a Business PlanAvailable Surplus
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Forming a Business PlanAnnual Income
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Business Plan Base Scenario
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Scenario 1 Mortality
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Scenario 2 Morbidity
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Scenario 3 PersistencyMCCSR Ratio
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Scenario 3 PersistencyAvailable Surplus
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Scenario 3 PersistencyAnnual Income
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Scenario 4 Interest Rate Risk
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Scenario 5 Credit Risk
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Scenario 6 Expenses
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Scenario 7 Integrated Scenario
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Scenario 8 Ripple Effects
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Scenario 9 Ripple Effects
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DCAT Case Study Base Scenario versus Actual
Outcome