Section C & D Flashcards
ICA: Section 165: Duties of the Directors of the Company
40 - ICA
• Directors shall supervise the management of the business and affairs of the company
• Duties
1. Establish an audit committee
2. Establish a conduct review committee
3. Establish procedures regarding conflicts of interest (and a committee to monitor this)
4. Establish a policy for dividends and bonuses
5. Establish procedures to provide required disclosures (and a committee to monitor this)
6. Establish investment and lending policies
7. Appoint the actuary of the company
ICA: Section 203: Audit Committee
40 - ICA
• To consist of at least three directors
• Majority of members must be unaffiliated directors; none may be officers or employees
• Must report to the directors, before approval of annual statement and returns is given
• May call a meeting of the directors to consider any matter of concern
• Duties
1. Review the annual statement before approved by directors
2. Review returns of the company specified by the Superintendent
3. Require, review, evaluate, and approve internal control procedures
4. Review investments and transactions that could adversely affect company
5. Meet with auditor to discuss annual statement, or other indicated transactions
6. Meet with actuary to discuss parts of annual statement prepared by actuary
7. Meet with chief internal auditor and management regarding internal control procedures
ICA: Section 331: Annual Financial Statement
40 - ICA
• The directors shall place before shareholders at every annual meeting:
- Comparative annul financial statements, for the last and previous years
- Appointed Auditor’s Report
- Appointed Actuary’s Report
- Description of the roles of the auditor and actuary
- Further information required by the by-laws of the company
• Annual Statement to contain
- Balance sheet
- Income statement
- Statement of Change in Financial Position
- Statement of Changes in Shareholder’s Equity
- Statement of Changes for Participating Accounts
• Statements to be prepared in accordance with GAAP from CICA, unless Supt. specifies otherwise
ICA: Section 346: Auditor’s Examination
40 - ICA
- Auditor to make an examination so as to report on financial statements
- Exam conducted in accordance with GAAP based on CICA, unless Supt. specifies otherwise
- Can use the actuary’s valuation for year-end and increases in policy liabilities
ICA: Section 357: Notice of Appointment (AA)
40 - ICA
(1) A company shall notify the Superintendent in writing of the appointment of the actuary
ICA: Section 359: Officer Precluded (AA)
40 - ICA
• CEO/COO or CFO can be appointed, but must be authorized by the Superintendent
• CEO
o Can hold position no longer than six months
• CFO
o Authorization may contain limitations and conditions, e.g. time limitation
o Audit committee must provide OSFI a written statement that it is satisfied that both duties will be performed adequately and independently
ICA: Section 360: Revocation of Appointment (AA)
40 - ICA
(1) The company (directors) may revoke the appointment of the actuary, but must notify the Superintendent in writing
ICA: Section 362-364: Filling Vacancy (AA)
40 - ICA
- Directors must notify Superintendent and fill the position
- Actuary must submit a written statement to the directors and Superintendent explaining the circumstances and reasons why, in the actuary’s opinion, the revocation or resignation occurred
- Replacement actuary must request the statement from prior actuary regarding resignation/revocation before accepting the position (must not accept until after receiving the statement or until 15 days have passed)
ICA: Section 365: Actuary’s Valuation and Report
40 - ICA
• AA to value actuarial and other policy liabilities at year-end or other matters specified by Superintendent
o Made in accordance with generally accepted actuarial practice
• Superintendent may appoint an outside actuary to do this, at companies expense
o Company to provide access to records and information the actuary views as needed
o Communication in response to the actuary will not result in civil liability
• AA must submit report, 21 days prior to annual meeting, indicating whether the AR fairly presents the results of the valuation
ICA: Section 368: AA Report to Directors
40 - ICA
AA to meet with the directors of the company, or audit committee, at least once a year, to report on the financial position of the company and expected future financial condition
ICA: Section 369: AA Report to Officers
40 - ICA
• AA to report, in writing, to the CEO and CFO any matters with material adverse effects on the financial condition of the company requiring rectification
o AA should provide a copy of the report to the directors
o If suitable action, in the actuary’s opinion, is not taken, AA should send report to the Superintendent
ICA: Section 370: Qualified Privilege
40 - ICA
• Qualified privilege given to the actuary’s oral or written statements - has no civil liability for statements made in good faith
ICA: Section 464: Declaration of Policy Dividend or Bonus
40 - ICA
- Directors may declare such
- The directors must consider the actuary’s report before declaring
- Should not declare a dividend, bonus, or other benefit if in contravention of this Act or other regulation
ICA: Section 465: Regulations
40 - ICA
• Governor in Council may enact regulation limiting extent of a company’s reinsurance
ICA: Section 476-478, 516: Specific Restrictions
40 - ICA
- Shall not enter into any debt obligation if the total debt and stated capital of the company would exceed the prescribed percentage of total assets (L+S>A)
- Shall not guarantee another’s obligation (unless that of a subsidiary with an unqualified obligation to the company)
- Shall not lease personal property in Canada
ICA: Section 517: Notice of Value of an Asset
40 - ICA
Superintendent to notify the company auditor, actuary, and audit committee the value of an appraised asset that differs materially from the company’s value of that asset
ICA: Section 581: Conditions for Order of a Foreign Company
40 - ICA
• Superintendent shall not approve a foreign insurer unless it has:
1. Assets having a prescribed value (at least $5M)
2. Appointed an actuary and an auditor
3. Established a location where chief agency will be situated
• Superintendent may put conditions or limitations on a company
• For foreign entities, AA and Auditor largely similar to domestic sections (replace officers with chief agent)
What is the BCAR formula?
03 - AM Best BCAR
BCAR (Best’s Capital Adequacy Ratio) = Adjusted Surplus / Net Required Capital
Underwriting leverage is generated from:
03 - AM Best BCAR
- Current premium writings
- Reinsurance recoverables
- Loss reserves
- Consider factors unique to the company
Balance sheet strength depends on 3 types of leverage
03 - AM Best BCAR
- Underwriting
- Financial
- Asset
What does financial leverage measure?
03 - AM Best BCAR
exposure to debt
What does asset leverage measure?
03 - AM Best BCAR
exposure of surplus to investment, interest rate, and credit risks
Describe the Investment Risk category of BCAR
03 - AM Best BCAR
• Three main components
- Fixed-income securities
- Equities
- Interest Rate
- Capital charges are applied to different asset classes based on the risk of default, illiquidity, and market-value declines in both equity and fixed income securities
- Canadian model incorporates an interest-rate risk component that considers the market value decline in a company’s fixed-income portfolio as a result of rising interest rates
Describe the Credit Risk category of BCAR
03 - AM Best BCAR
- Capital charges for receivable balances,recoverables from reinsurance (registered and unregistered) and affiliates to reflect third-party default risk
- May be modified for: Collateral offsets for reinsurance balances; Quality of reinsurers; Dependence on reinsurance program; Premium receivables from agents, brokers, policyholders and installment premium balances; Funds held by residual markets; Other miscellaneous receivables
Describe the Underwriting Risk category of BCAR
03 - AM Best BCAR
• Two components
1. Loss and Loss-Adjustment Expense Reserves - Risk inherent in a company’s loss reserves, Adjusted for estimated reserve deficiency, payout pattern, discount rate
2. Net Premiums Written - Based on pricing risk in company’s mix of business
• Components may be increased for “excessive” growth in exposure
• Limited credit for a well-diversified book
What is the largest risk category in a company’s BCAR ? What is the smallest?
03 - AM Best BCAR
- Underwriting risk, typically two-thirds of a company’s gross required capital
- Investment, credit and underwriting risk comprise more than 99% of gross required capital
- Less than 1% is for off-balance sheet risk
Describe the Additional Business Risk category of BCAR
03 - AM Best BCAR
Additional business risk for off-balance-sheet items:
- Non-controlled assets
- Gurantees for affiliates
- Contigent liabilities
- Pension and other post-employment obligations
What are the three broad risk categories that NRC supports
03 - AM Best BCAR
- Investment
- Credit
- Underwriting
What additional stress testing is done on a company’s BCAR score?
03 - AM Best BCAR
- Stress tests include above-normal catastrophes, decline in equity markets, and a rise in interest rates
- Best will also stress a company’s BCAR for a second catastrophe event (natural catastrophes and/or man-made events such as terrorism)
What are the adjustments to reported surplus within the Canadian BCAR model?
03 - AM Best BCAR
o Goodwill and other intangible assets are eliminated
o Adjustments related to equity embedded in loss and LAE reserves, fixed-income securities, and common stocks
o Adjustments to reflect the pricing risk inherent in UPR and non-balance sheet risks
What are the drivers of the underwriting risk component of the BCAR formula?
03 - AM Best BCAR
- Mix of business
- Size of surplus
- Stability of loss development
- Profitability
- Loss-reserve adequacy
- Length of claims payout
o BCAR is generally lower if higher underwriting leverage, greater indicated reserve deficiencies, and unstable or unprofitable business
What are the drivers of investment risk, interest-rate risk, and credit risk in BCAR?
03 - AM Best BCAR
BCAR is generally lower if aggressive investment portfolio, pyramided capital, excessive credit risk or excessive dependence on reinsurance
What distortion is caused by the “square root” rule in BCAR?
03 - AM Best BCAR
o More capital-intensive UW risk components are accentuated disproportionately while less capital-intensive asset risk components are diminished in their relative contributions to NRC.
o AM Best counteracts this shortfall by using other distinct capital measures
What is gross required capital and what does the covariance adjustment represent in NRC?
03 - AM Best BCAR
Gross required capital is the capital to support all risks were they to develop simultaneously. The covariance adjustment in NRC reflects the assumed statistical independence of the risk components and serves to reduce a company’s overall required capital (Generally by 35% to 45%)
Identify four adjustments included in the calculation of the loss and loss-adjustment expense reserve factor for BCAR but NOT in OSFI’s formula
03 - AM Best BCAR
- Reserve deficiency of a company
- Size of a company
- Volatility of a company’s case incurred LDFs
- Growth in a company’s exposure
- Diversification benefits
Identify two differences between BCAR’s net written premium factor and that of OSFI’s formula
03 - AM Best BCAR
- BCAR uses different risk factors by line of business, OSFI applies the same factor
- OSFI’s fomula applies a risk on the max of NUPR and 30% of NWP
- BCAR includes diversification benefits, OSFI does not
Difference between the CDN BCAR and American BCAR.
03 - AM Best BCAR
Canadian BCAR is based on the consolidated P&C1 and P&C 2 reports. This creates a stand-alone BCAR for subsidiaries. If the parent company is the reason for a weaker BCAR then a stand-alone BCAR for the parent-only insurer can be created based on additional information supplied by the parent company.
Discuss the reasons catastrophe loss is a primary threat to financial strength
05 - AM Best Catastrophe
- Can have a significant, rapid and unexpected impact
- Increasing frequency and severity of catastrohpes has made this event more important (Need stronger capitalization to support risk; shift in frequency expectations; concentrated population growth in urban settings; losses across exposures thought to be uncorrelated
Identify and brielfy explain AM Best’s three keys to strong catstrophe risk management
05 - AM Best Catastrophe
- Data Quality
o Proper coding of exposure; Geocoded properties; Timely information capture and auditing; Current Insurance-to-Value; Prevention of data manipulation - Monitor Exposure
o Understand PML; Use catastrophe models and “what-if” testing for highly concentrated risk areas; Monitor aggregate exposure; Consider potential tail-risk scenarios - Controls
o Catastrophe management integrated with UW; Monitoring should be a continual process; Use of reinsurance; Specific aggregate limits are established
Discuss the baseline treatment of catastrophes in BCAR
05 - AM Best Catastrophe
• Reduce surplus by the larger of
o a 1-in-100-year hurricane/windstorm PML
o a 1-in-250-year earthquake PML
o a recent actual large loss
In addition to requiring a company to maintain capitalization that can withstand the impact to surplus of a severe event, why does AM Best perform a further stress test
05 - AM Best Catastrophe
It is inteneded to be a reasonable reflection of the stressed risk profile. Insurers are not required to withstand two major events
Desribe the BCAR methodology for a natural catastrophe stress test
05 - AM Best Catastrophe
- Subtract net after-tax PML of the 1st event from surplus
- Reinsurance recoverables are increased by 40% of difference between gross and net pre-tax loss of the 1st event
- 40% of net pre-tax PML of 1st event is added to existing reserves - Captures potential for adverse development
- The after-tax net PML for an additional event is deducted from risk-adjusted surplus
a. Where hurricanes are major risk, PML is same for 2nd event
b. When earthquakes are main exposure, 2nd event reduced to 1 in 100 year event
What level of tolerance surrounds the stress tested BCAR? What are the key factors regarding this tolerance?
05 - AM Best Catastrophe
• Stress-tested BCAR can fall a maximum of 30 points below published guidelines
• Tolerance is based on
o Perceived financial flexibility (+)
o Historical volatility of operating performance and the balance sheet (-)
o Exposure to multiple events (-)
o Business profile and risk management (+/-)
What are contingent commissions?
11 - CCIR
Commissions that are not exclusively attributable to premium volume and thus are non-deferable
What are non-deferrable commissions?
11 - CCIR
Commissions that cannot be readily identified as exclusively relating to and varying with the acquisition of premiums and are therefore not recoverable
What are policy acquisiton expenses?
11 - CCIR
Expenses incurred on the acquisition of new and renewal business
The P&C Return must be prepared on a consolidated or unconsolidated basis?
11 - CCIR
Consolidated
What is a premium deficiency?
11 - CCIR
Exists where the unearned premiums will not be sufficient to discharge all the expected liabilities that will accrue on policies, including all expenses associated with servicing of the policies
10.60 Adjusted Equity
11 - CCIR
Total Equity – Non-controlling Interest – Capital required for catastrophes – Capital required for Unregistered reinsurance
Similar to MSA, if not the same
10.60 Net Investment Income From Insurance Operations
11 - CCIR
= Min[(Investment Yield) x (A + B + C + D - E - F), Net Investment Income]
o A = Average net unpaid claims and AE for the year
o B = average net unearned premiums for the year
o C = average unearned commissions for the year
o D = Average premium deficiency for the year
o E = Average DPAE for the year end for the year
o F = average receivables from agents/brokers, policyholders, and instalment premiums for the year
10.60 Agents and Brokers Balances and Amounts Due from Subsidiaries & Associates =
11 - CCIR
= (Receivables-unaffiliated agent and brokers + Receivables-subsidiaries, associates and joint ventures) / Adjusted Equity
10.60 Claims Development as a % of AE
11 - CCIR
=Excess or Deficiency Amount (Runoff) / Adjusted Equity
20.20 Liabilities and Equity: Notes to keep in mind
11 - CCIR
Unpaid Claims and LAE should be on GROSS basis
20.30 Notes Regarding Statement of Income
11 - CCIR
Other - Net Premiums Earned [08]: includes ph dividends and rating refunds (experience rating refunds and retro credits are not to be deducted from WP and must be treated as a payment to phs the same way as dividends to phs);
Other - Revenue [44]: include interest income on deposits made by reinsurers, investment income from facility/pools, refunds from reinsurers, interest from financing activities
20.30 Net Income (before tax)
11 - CCIR
Net Income before Tax = Underwriting Income + Net Investment Income + Other Revenue & Expenses
20.30 Total Underwriting Revenue
11 - CCIR
= NPW + Decr. (incr.) in NUP + Service Charges
= NPE + Service Charges
20.30 Total Claims and Expenses
11 - CCIR
Total Claims and Expenses = Net Claims and Adjustment Expense + Acquisition Costs + General Expense + Taxes
20.30 Underwriting Income/ Net Operating Income
11 - CCIR
= Total Underwriting Revenue – Total Claims and Expense
= Net Premiums Earned x (1 – Claims Ratio – Expense Ratio) – Taxes
20.30 Net Investment Income
11 - CCIR
Net Investment Income = Income on Investments + Realized Gains on Investments – Investment Expense
20.30 Total Equity
11 - CCIR
Total Equity = Shares Issued and Paid + Contributed Surplus + Retained Earnings + Reserves + Accumulated Other Comprehensive Income
20.30 Change in Retained Earnings
11 - CCIR
Incr. (Decr.) in Retained Earnings = Net Income – Dividends Declared to Shareholders – Increase in Reserves Required
20.10/20.20 Total Equity
11 - CCIR
Total Equity = Total Assets - Total Liabilities + Net Income
20.10/20.20 Total Assets
11 - CCIR
Total Assets = Cash + Bonds & Debentures + Preferred Shares + DPAE + Recoverable from Reinsurers + Receivables
20.10/20.20 Total Liabilities
11 - CCIR
Total Liabilities = Unearned Premiums + Unpaid Claim and Adjustment Expenses
20.10/20.20 Total Comprehensive Income
11 - CCIR
Total Comprehensive Income = Net Income + Other Comprehensive Income
20.42 AOCI Notes
11 - CCIR
All amounts should be reported on an after tax basis
30.71 MCT Capital Required: Treatment of DPAE Commissions
11 - CCIR
=MAX[(Balance Sheet Value of Commissions – UEComm)*35%,0]
30.71 MCT Capital Required: Treatment of Other Assets and Equipment (Excluding Goodwill, Intangibles, & Computer Software)
11 - CCIR
=35% * MIN[Total Other Assets and Equipment, 1% of Total Assets] NOTE: if assets greater than 1% then report as 100% capital required factor and subtract from capital available.
60.30 Investment Income on Unpaid Claims of Prior Years: How are amounts reported in this column?
• (Average net unpaid claims and adjustment expenses of prior years) x (investment yield)
• If (A+B+C+D-E-F) > Average Total Investments [Cash + Investment Income due and accrued + Total Investments]
o Multiply the investment yield by Average Total Investment / (A+B+C+D-E-F)
60.40 Net Claims and AE – Run Off: Excess/Deficiency
11 - CCIR
= Opening Unpaid claim and AE & IBNR – Claims Paid for each Subsequent Year – Ending UCAE & IBNR
60.40 Net Claims and LAE – Run Off: Excess/Deficiency Ratio
11 - CCIR
= Amount of Excess/Def. / (Opening Unpaid claim and LAE & IBNR)
60.41 Net Claims and AE – Run Off - Discounted: Investment Income from unpaid claims and adjustment expense & INBR
11 - CCIR
Investment Income from UCAE & INBR = [Average Net UCAE & IBNR] x [Investment Yield Selected]
Under what condition is an SIR receivable admissible for statutory test purposes? Hhow can the regulator ensure the condition is met?
11 - CCIR
- For an SIR receivable to be admissible, regulators need to be satisfied with its collectibility, i.e., the policyholder is solvent and has proven the ability to pay the retention
- The regulator can request acceptable collateral
A P&C insurer would not be required to show the claim liability for structured settlements in its AR if certain conditions are applied. List the 4 conditions.
11 - CCIR
- The insurer owns an annuity with payments irrevocably directed at the claimant
• Non-commutable, non-assignable and non-transferable - It provides no current or future benefit to the insurer
- The insurer is released by the claimant from its obligation
- The insurer remains liable if required payments are not made
10.60 Return on Equity
11 - CCIR
ROE = 2 x (Net Income after Tax) / (Beg + End Equity)
10.60 Investment Yield
11 - CCIR
Yield = 2 x NII / (Vb + Ve -I)
where V = Cash + Investment Income Due and Accrued + Total Investments
70.38 Reinsurance Ceded to Unregistered Insurers: Margin Required for Reinsurance Ceded
11 - CCIR
Margin Required for Reinsurance Ceded =
+ Unearned premiums ceded to assuming insurer
+ Outstanding losses recoverable from assuming insurer
+ 10% margin on unearned premiums ceded and outstanding losses recoverable
+ Receivable from assuming insurer
- Payable to assuming insurer
- Non-owned deposits held as security from assuming insurer (vested in trust)
- Letters of credit held as security from assuming insurer (vested in trust)
Reasons for 150% MCT supervisory target
56 - OSFI MCT
- Provides a cushion above the minimum requirement
- Facilitates OSFI’s early intervention process
Why should an insurer establish an internal target capital ratio sufficiently high?
56 - OSFI MCT
- To absorb unexpected losses beyond those covered by the supervisory target
- Provide adequate time for management to resolve financial problems that arise before OSFI intervention
• If an insurer falls or anticipates falling below their internal target, must inform OSFI and outline their plans, subject to OSFI’s approval, to return to their internal target
What is the formula for Minimum Capital Required of the MCT
56 - OSFI MCT
• Minimum capital requirements are calculated on a consolidated basis
Minimum capital required =
+ Capital required for Insurance Risk (chapter 4)
• Capital required for unpaid claims and premium liabilities
• Catastrophe reserves
• Margin required for reinsurance ceded to unregistered reinsurers
+ Capital required for Market Risk (chapter 5)
• Capital required for… interest rate risk, foreign exchange risk, equity risk, real estate risk, other market risk exposures
+ Capital required for Credit Risk (chapter 6)
• Capital required for… counterparty default risk on balance sheet assets, counterparty default risk on off-balance sheet exposures, collateral held for unregistered reinsurance and SIR
+ Capital required for Operational Risk (chapter 7)
- Diversification Credit (chapter 8)
÷ 1.5
MCT: Define Insurance Risk
56 - OSFI MCT
- Risk from the potential for claims or payouts to be made to the policyholder or beneficiaries
- Uncertainties around the ultimate amount of net cash flows, and the timing of the receipt and payment of these cash flows
What are the components of Insurance Risk in the MCT
56 - OSFI MCT
- Capital required for unpaid claims and premium laibilities (includes A&S business)
- Catastrophe Reserves (Earthquake and nuclear)
- Margin for reinsurance ceded to unregistered reinsurers
MCT: Margin for Unpaid Claims
56 - OSFI MCT
• Margin applied to the net amount at risk less PfAD
MCT: Margin for Premium Liabilities
56 - OSFI MCT
• Margin applied to the greater of net premium liabilities less PfAD and 30% of net premiums written for the past 12 months
A registered reinsurer is
56 - OSFI MCT
- Incorporated federally
- Incorporated provincially, but approved by the Superintendent
- Foreign insurer that is authorized by the Superintendent
MCT: Reduction to capital available from unregistered reinsurance
56 - OSFI MCT
Max( 0, Unearned Premiums Ceded + OS Losses Recoverable + Receivables - Payables - Non-Owned Deposits - Letters of Credit)
MCT: Margin for unregistered reinsurance
56 - OSFI MCT
- Margin = 15% of unearned premiums ceded and losses recoverable
- Margin Required = Margin - Credit
- Credit = Max( 0, Non-owned deposits + Letters of Credit + Payables - Unearned premiums ceded - OS Losses recoverable - Receivables) ÷ 1.5
What are the requirements for collateral for unregistered reinsurance?
56 - OSFI MCT
- Must materially reduce risk from credit quality of unregistered reinsurance
- Consists of non-owned deposits and letters of credit
- LOCs limited to 30% of ceded uneared premium and OS losses recoverable, applied to the aggregate exposure
What is excess collateral and how does it affect a company’s MCT?
56 - OSFI MCT
- Non-owned deposits and letters of credit that are greater than the unregistered reinsurance requirements
- Reduces capital required
Compute excess collateral and the reduction in capital required
56 - OSFI MCT
- Unregistered Reinsurance Exposure = Margin x (UEP ceded + OS Loss Recoverable) + Receivables - Payables
- Total Collateral = Non-owned deposits + Letters of Credit
- Excess Collateral = Total Collateral - Unregistered Reinsurance Exposure
• Reduction to Capital Required = Ratio of (Excess Collateral / Total Collateral) x Total Capital Required (Indv. Collateral Amount x Risk Factor)
What is the requirement for an SIR to be admissible?
56 - OSFI MCT
OSFI must be satisfied with its collectability or may require collateral
What financial resources are available to cover earthquake risk exposure?
56 - OSFI MCT
- Capital & Surplus - Up to a maximum of 10% of capital and surplus
- Earthquake Premium Reserve - Voluntary accumulation of EQ premiums
- Reinsurance Coverage
- Capital Market Financing - requires supervisory approval
How are earthquake reserves handled in the MCT calculation?
56 - OSFI MCT
- Earthquake Reserves = 1.25 x (EPR + ERC)
- Earthquake reserve is added to total capital requirement
- Earthquake Reserve Component = {Earthquake Risk Exposure} - {Financial Resources Available} >= 0
- ERC must be greater than 0
- Earthquake Risk Exposure = CountrywidePML500 x (year - 2014) / 8 + Max (EastCanadaPML420, WestCanadaPML420) x (2022-year) / 8
- CountrywidePML500 = (EastCanadaPML500^1.5 + WestCanadaPML500^1.5) ^(1/1.5)
- Gross PML is used for regulatory purposes
- If insurer does not use an earthquake model or a technique approved by OSFI then CountryWidePML = Max (EastCanadaPTIV - applicable deductibles, WestCanadaPTIV - applicable deducibles), where PTIV is Property Total Insured Value
- Financial Resources Available = Capital & Surplus + EPR + Reinsurance Cover + Capital Market Financing
- If the EPR is not required as a financial resource to cover capital requirements, EPR can be deducted from capital available instead of added to capital required
MCT: Nuclear Reserve
56 - OSFI MCT
- Additional provision of 100% of NPW, net of commissions, x1.25
- May reverse after 20 years
MCT: Accident & Sickness Business
56 - OSFI MCT
- Margins for risk that mortality and morbidity rates will be wrong
- Margins to be included in MCT’s margin for unpaid claims and premium liabilities
- Apply factors to unpaid claims and unearned premiums
MCT: Define Market Risk
56 - OSFI MCT
Risk from changes in rates or prices in various markets
List and describe the components of Market Risk in the MCT
56 - OSFI MCT
- Interest Rate Risk - Risk of economic loss resulting from market changes in interest rates
- Foreign Exchange Risk - Risk of loss resulting in fluctiations in currency exchange rates
- Equity Risk - Risk of economic loss due to flucuations in the prices of common shares
- Real Estate Risk - Risk of economic loss due to changes in the value of property or in the amount and timing of cash flows from investments in real estate
- Other Market Risk - other assets exposed to asset value fluctuations
MCT: Interest rate risk margin
56 - OSFI MCT
- To compute, apply a duration and interest rate shock factor to the fair value of interest rate seinsitive assets and liabilities
- Margin is the difference between the change in value of interest rate sensitive assets and the change in value of interest rate sensitive liabilities
- Interest rate sensitive assets/liabilities are those which their fair value will change with movements in interest rates
• Measure economic impact of a ?y change in interest rate
• ?y interest rate shock factor is 1.25%
A. Change in the interest rate sensitive asset portfolio = Duration of Portfolio x ?y x Fair Value of Portfolio
B. Change in the interest rate sensitive liabilities = Duration of Liabilities x ?y x Fair Value of Liabilities
C. Change in the allowable interest rate derivatives = ? Effective dollar duration of allowable interest rate derivatives for change ?y
D. Capital requirement for an interest rate shock factor increase of ?y = Max( A – B + C , 0 )
E. Capital requirement for an interest rate shock factor decrease of ?y (i.e. -?y) = Max( A – B + C , 0 )
• Interest rate risk margin = Max (D, E)
What are allowable interest rate derivatives that affect the interest rate risk
56 - OSFI MCT
• Derivatives with cash flows dependent on future interest rates and may hedge and insurer’s interest rate risk
• Only “plain-vanilla” interest rate derivatives may be included in interest rate risk
o Future and forward interest rate and bond contracts and currency swaps
• Insurers must be able to demonstrate that interest rate hedge reduces risk
Define Duration
56 - OSFI MCT
- Percentage change in an asset or liability given a change in interest rate
- Measure of the sensitivity in value to a change in interest rates
Modified Duration
56 - OSFI MCT
• Assumes intrest rate changes do not change expected cash flows
= [1/(1+yield)] x sum of [t x PVCF@t / Market value]
Effective Duration
56 - OSFI MCT
• Recognizes that interest rate changes may change expected cash flows
= [ V(-) - V(+) ] / [ 2 x V(0) x ?y ]
Dollar Duration
56 - OSFI MCT
• Change in dollar value of an asset or liability for a given change in interest rates
= duration x dollar fair value x ?y
Portfolio Duration
56 - OSFI MCT
• Weighted average of duration of assets or liabilities in a portfolio
= w1D1 + w2D2 + … + wkDk
Duration of allowable interest rate deriviates
56 - OSFI MCT
Should be using effective dollar duration because the insurer is hedgin the dollar interest rate exposure
MCT: Foreign Exchange Risk Margin
56 - OSFI MCT
- Foreign Exchange Risk Margin = 10% of the greater of (the aggregate net long positions in each currency, |the aggregate net short positions in each currency|)
- Net Spot Position = Assets - Liabilites (Long position if assets > liabilities)
MCT: Equity Risk Margin
30% risk factor on investments in common shares and joint ventures (with less than 10% ownership)
MCT: Real Estate Risk Margin
56 - OSFI MCT
Risk factors applied to “held for own use” and “held for investment purposes” real estate
MCT: Margin on Other Market Risk Exposures
56 - OSFI MCT
10% risk factor applies to other assets (other assets exposed to asset value fluctuations)
MCT: Discuss the Credit Risk component of MCT capital required
56 - OSFI MCT
- Definition: Risk of loss arising from a counterparty’s potential inability or unwillingness to fully meet contractual obligations due to an insurer
- All on- and off- balance sheet exposures are subject to risk factors
- Risk factors correspond to either external credit rating or prescribed risk factors
- Collateral and other forms of credit risk mitigators may reduce exposure
- Components of credit risk include: Loan loss/principal risk, pre-settlement/replacement risk, settlement risk
MCT: Capital requirement for Balance Sheet Assets
56 - OSFI MCT
- Risk factors depend on external credit rating and the remaining term to maturity
- Effective Maturity (M) = Sum ( t x CF@t) / Sum (CF@t)
MCT: Capital requirement for Off-Balance Sheet Exposure
56 - OSFI MCT
= ([Credit equivalent amount of instrument at reporting date] - [value of eligible collateral securities or guarantees]) x [factor reflecting nature and maturity of instrument] x [factor reflecting counterparty risk]
• Credit equivalent amount varies by type of instrument
MCT: Define Operational Risk
56 - OSFI MCT
- Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events
- Includes legal risk, but excludes strategic and reputation risk
MCT: Operational risk margin
56 - OSFI MCT
- Operational risk margin = Min { 30% x CR(0) , [8.5% x CR(0) + 2.5% x P(w) + 1.75% x P(a) + 2.5% x P(c) + 2.5% x P(?) ] + Max[ 0.75% P(aig), 0.75% x P(cig) ] }
- CR(0) is total capital required for the reporting period (Before the operational risk margin and diversification credit)
- P(w) is direct premium written, in the past 12 months
- P(a) is assumed premiums written, in the past 12 months, arising from third party reinsurance
- P(aig) is assumed premiums written, in the past 12 month, arising from intra-group pooling
- P(c) is ceded premiums written, in the past 12 month, arising from third party reinsurance
- P(cig) is ceded premiums written, in the past 12 month, arising from intra-group pooling
- P(?) is growth in gross premiums written, in the past 12 months, above a 20% threshold
Discuss the four components of Operational Risk
56 - OSFI MCT
- Capital Required - reflecting overall riskiness of an insurer
- Premium Volume - Risk factors for assumed/ceded premiums arising from Intra-Group Pooling Arrangements (IGPA) caputres operations risks associated with pooling premiums in a group
- Year-over-year Premium Growth beyond Threshold - Companies with premium growth beyond 20% threshold subject to additional capital requirements
- Cap on Operational Risk Margin (30% of Capital Required) - dampens operational risk for insurers with a high-volume/low-complexity business with high levels of reinsurance
MCT: Diversification Credit
56 - OSFI MCT
- Losses across some risk categories not perfectly correlated, so an explicit credit for diversification is permitted
- Diversification Credit = A + I - ?(A^2 + I^2 + [ 2 x R x A x I ])
- A is the Asset Risk Margin (sum of Credit Risk and Market Risk)
- I is the Insurance Risk Margin
- R is the correlation factor between A and I (equal to 50%)
What are the four primary considerations in measuring capital adequacy
56 - OSFI MCT
- Availability: extent to which capital is fully paid and available to absorb losses
- Permanence: when capital element is available
- Absence of encumbrances and mandatory servicing costs
- Subordination: is capital element subordinated to the rights of policyholders and creditors in an insolvency or winding-up
MCT: Capital Available =
56 - OSFI MCT
• Qualifying category A common shares
• Contributed surplus
• Retained Earnings
o Less: Accumulated net after-tax fair value gains (losses) due to changes in the company’s own credit risk
o Less: Unrealized net after-tax fair value gains (losses) on own use properties at conversion to IFRS – cost model
o Add: Accumulated net after-tax fair revaluation losses in excess of gains on own use properties – revaluation model
• Earthquake reserves
o Less: EPR not used as part of financial resources to cover exposure
• Nuclear Reserves
• General contingency reserves
• Accumulated other comprehensive income (losses)
o Less: Fair value gains (losses) on cash flow hedges; Fair value gains (losses) due to changes in own credit risk; Unrealized gains on own-use properties – revaluation surplus; Impact of shadow accounting
• Net qualifying category B instruments
• Qualifying category B instruments
o Non-cumulative perpetual preferred shares
o Other
• Net qualifying category C instruments
o Preferred shares
o Subordinated debt
o Less: Accumulated amortization of category C instruments for capital adequacy (Subject to straight-line amortization in the final five years prior to maturity)
• Non-Controlling Interests
MCT: Deductions to capital available
56 - OSFI MCT
o Investments in non-qualifying subsidiaries, associates, and joint ventures (with >10% ownership) - Interests in and loans considered as capital
o Unsecured unregistered reinsurance exposures and self-insured retentions
o DPAE associated with A&S business
o Goodwill and other intangible assets
o Deferred tax assets, except those eligible for the 10% risk factor and those netted with associated deferred tax liabilities if related
o Defined benefit pension fund assets and liabilities (unless OSFI written prior approval)
o Investments in own capital instruments (treasury stock)
o Reciprocal cross holdings in the common shares of insurance, banking, and financial entities
• Items that are deducted from capital available will be subject to a 0% risk factor for capital required purposes
What are the limits to category B and C capital in capital available?
56 - OSFI MCT
- 40% limit (of total capital available) for category B and C capital instruments, excluding AOCI
- 7% limit (of total capital available) for category C capital instruments, excluding AOCI
- Exclusion of category C capital takes precedence over exclusion of category B capital
Potential asset risks
56 - OSFI MCT
asset default; loss of market value
What is credit risk? What is actuarial risk?
56 - OSFI MCT
- Credit risk is risk from un-collectability of funds or the amount expected to be returned differ from what was actually returned
- Actuarial risk accounts for the possible abnormal negative variation in the amounts calculated by actuaries.
MCT 2014: Capital Available =
56 - OSFI MCT
Capital Available = Unadjusted EQ + Market Adjustments - Assets with 100% Capital Requirements
• Assets with 100% Capital Requirements: SIR, Goodwill/intangibles, non-qualifying subsidiaries, associates, join ventures >10% ownership, DPAE that doesn’t fall into 0% or 35% factor, other assets>1% total assets
List and describe the 6 principle functions of reinsurance
10 - Blanchard & Klann
- Increase large line capacity
• Insurer wants to limit per policy exposure, but portions of the market demand greater coverage - Provide catastrophe protection
• Insurer desires to reduce its potential loss from a catastrophic event - Stabilize loss experience
• Annual loss experience fluctuations may be greater than management desires - Provide surplus relief
• Reinsurance reduces net leverage ratios - Facilitate withdrawal from a market segment
• Management desires to exit a market and do so quicker than through runoff - Provide underwriting guidance
• Insurer wishes to enter a new market, but does not feel comfortable with its own expertise
Effects of Using Reinsurance to Increase Large Line Capacity (Quota share)
10 - Blanchard & Klann
- Surplus - no impact other than requirement for credit risk
- Loss Reserves - increase due to increased premium volume and slower development of larger claims
- Unearned Premiums - increase in proportion to written
- Leverage Ratios - net ratios change slightly, gross ratios will increase significantly
- Income Statement - little change, riskier book and cost of reinsurance may increase volatility
Effects of Using Reinsurance for Catastrophe Protection (XOL contract)
10 - Blanchard & Klann
- Surplus - Decreases if no cat occurs, but is increased if a cat does occur
- Loss Reserves - No impact if no cat, Net loss reserves are reduced if a cat occurs
- Leverage Ratios - If no cat, biggest impact is from reduction of surplus, if cat occurs net ratios ate protected
- Income statement - Decrease in investment income, UW income is protected
Effects of Using Reinsurance to Stabilize Loss Experience (Aggregate XOL contract)
10 - Blanchard & Klann
- Surplus - will decrease but will be more stable
- Loss reserves - smaller and more stable
- Net UEP reserves - decrease from reinsurance premium
- Leverage ratios - higher, but more stable
- Income statement - investment and uw income lower, but more stable
Effects of Using Reinsurance for Surplus Relief (Flat quota share)
10 - Blanchard & Klann
- Surplus will only increase when ceded business is not profitable
- Leverage ratios improve
- Income is reduced
Effects of Using Reinsurance to Facilitate Withdrawal from a Market Segment (cede 100% of UEP and loss reserves)
10 - Blanchard & Klann
- Surplus - decreases if business was profitable, less volatile
- Loss Reserves and UEP will disappear
- Leverage Ratios - left over risk is reinsurance collectability risk
- U/W income is reduced if profitable business, but less volatile
Effects of Using Reinsurance for Underwriting Guidance (quota share)
10 - Blanchard & Klann
Similar to Increasing Large Line Capacity
- Surplus - no impact other than requirement for credit risk
- Loss Reserves - increase due to increased premium volume and slower development of larger claims
- Unearned Premiums - increase in proportion to written
- Leverage Ratios - net ratios change slightly, gross ratios will increase significantly
- Income Statement - little change, riskier book and cost of reinsurance may increase volatility
List the four key principles to risk transfer
23 - CIA Reinsurance
- Several approaches can be used to assess the existence of risk transfer
- Professional judgment will be required when assessing the existence of risk transfer
- The entire agreement, consisting of the reinsurance contract and all written and verbal agreements and correspondence, must be considered in assessing the existence of risk transfer
- The existence of risk transfer must be assessed at inception of the contract and every time a change is made to the contract that significantly alters the expected future cash flows
List 6 Limitations of Risk Transfer (Terms set in advance)
23 - CIA Reinsurance
- Profit Sharing
- Adjustability of Reinsurance Premiums/Commissions
- Pre-Set Limits to timing of payments
- Expected Duration of Contract
- High-Front End Reinsurance Commissions
- Counter-parties
List 2 Limitations of Risk Transfer (Experience Based Renewals)
23 - CIA Reinsurance
- Future Terms based on past experience – try to recover past losses
- Forced Renewals – contract is in deficit and the cedant is obligated to cede future business to the reinsurer until losses are eliminated
What are the “Other Issues” listed in the CIA Reinsurance that may limit risk transfer?
23 - CIA Reinsurance
- Side Agreements – agreements not directly incorporated into the contract
- Mirroring and Communication – reinsurer’s actuary and the insurer’s actuary should have similar view of risks and those risks being transferred. Since there is no mirroring environment, the actuaries must have good communication
- Bifurcation – separating contracts into basic constituents, identifying parts that are insurance based and parts that are not. Reinsurance contracts are not intended to be bifuricated and are only valid in their entirety
- Reinsurance Counter-party Risk – credit risk from the reinsurer. Determine if a credit provision is needed.
Describe the qualitative assessment for the existence of risk transfer
23 - CIA Reinsurance
In order to determine if risk transfer exists:
- See if there is “reasonably self-evident” risk transfer which means that it is intuitively obvious that the contract protects the cedant from future events that could adversely effects the cedant’s financial position. Does not focus on the probability of events. Restricted to contracts that (i) are done at arms length; and (ii) have no risk limiting features.
- If the conditions for 1. do NOT exist then the actuary would consider expanding the qualitative assessment or a quantitative assessment. Usually require substantially more documentation to prove risk transfer exists
Standards for risk transfer, under both GAAP and SAP, require
36 - Freihaut & Vendetti
- Reinsurer assumes significant insurance risk under the reinsured portion of the contract
- It is reasonably possible that the reinsurer may realize a significant loss
List and describe the components of insurance risk
36 - Freihaut & Vendetti
- Underwriting Risk - Uncertainties around the ultimate amount of net cash flows
- Timing Risk - Timing of the receipt and payment of those cash flows
Expected Reinsurer Deficit (ERD)
36 - Freihaut & Vendetti
ERD = (probability of underwriting loss) x (NPV of average severity of underwriting loss)
What is the “substantially all” exemption for a reinsurance contract to be exempt from risk transfer requirements?
36 - Freihaut & Vendetti
• Narrow exemption to requirement of significant loss when reinsurer assumes substantially all the insurance risk of reinsured portions of a contract
o Allows reinsurance on inherently profitable business, e.g., straight quota share
When is documentation required for risk transfer?
36 - Freihaut & Vendetti
Required for every reinsurance contract for which risk transfer is not “reasonably self-evident”