Basel II – Implications for Insurers and Actuaries CS 7C: ERM Symposium, Chicago April 27, 2004 Allan Brender

About OSFI Canadian federal regulator of financial institutions Deposit takers: banks, trust cos., credit unions Insurance cos.: life, P&C, fraternals Some pension plans OSFI is an integrated regulator

OSFI and the Basel Accord Superintendent Nick Le Pan is vice-chairman of the Basel Committee and heads the Accord Implementation Group OSFI’s Capital Division and Credit Division have been very active participants in the design of the Accord

OSFI and the Basel Accord OSFI’s Capital Markets Division approves banks’ internal models for the calculation of required capital with respect to the trading block of assets OSFI and the major Canadian banks have been acquiring significant resources and doing a lot of work to implement the Internal Ratings-Based (IRB) approach

Cross-sector Influences The use of asset rating classes in the insurance capital requirement (MCCSR, MCT) has influenced the design of Basel II The use of internal models for the calculation of required capital with respect to segregated fund (variable annuity) guarantees offered by life insurance companies has been adapted from banking

Internal Models in Basel II Continuation of requirements for the trading block IRB approaches for credit risk: foundation and advanced IRB approaches for operational risk: advanced measurement

Internal Models in Basel II Internal models can only be used if : They are backed by a strong associated risk management system They are used in regular operations of the bank They are approved by supervisors Once a bank adopts an IRB approach, it cannot revert to a standardized approach

An Example – Credit Risk The capital requirement for credit risk is based upon PD probability of default (frequency) LGD loss given default (a proportion) EAD exposure at default (LGDEAD is severity) M effective maturity

An Example – Credit Risk Under the foundation approach, a bank uses its own data to calculate PD and standard values for LGD, EAD, and M Under the advanced approach, a bank uses its own data to determine all of PD, LGD, EAD, and M The capital requirement is a formula calculation based upon these quantities Commercial credit risk models (e.g. KMV, CreditMetrics) are not used

Actuaries and Credit Risk Canadian Practice Actuaries provide for asset defaults when determining policy liabilities There is little public data on the level of defaults, especially as related to asset rating classes

Actuaries and Credit Risk Canadian Practice The Canadian Institute of Actuaries (CIA) conducts surveys of default assumptions used by actuaries The CIA survey causes assumptions to be more uniform but does not provide confidence they are correct

Actuaries and Credit Risk Canadian Practice The banks’ work with IRB approaches will cause pressure on actuaries and the insurance industry to improve their assumptions Note that OSFI’s Credit Division works with all federally regulated financial institutions

Influences on Actuaries and Insurers Improve quality of statistical studies used to determine rates for asset defaults, mortality and morbidity, lapses, expenses, etc. Strong emphasis on risk management Operational risk: not the same as for banks but the risks must be recognized and provided for e.g. Product design

Influences on Actuaries and Insurers Three Pillar approach to solvency Tiered structure of available capital

Influences on Banks Expected future financial condition reporting (DCAT, DFCA, DFA, DST) to the Board by the CRO Make full use of distributions instead of formulas involving means and specified constants

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