1. IAIS – ASSAL Training Seminar April 28, 2009 David Oakden
Key Principles for the Future Direction of Canadian Regulatory Capital Framework
IAIS – ASSAL Training Seminar
April 28, 2009
David Oakden

2. New Canadian Capital Framework
Target Date 2014
Internal Models
Canadian Version of Solvency II
We Believe that Principles are Universal
Include Lessons Learned from the Financial Crisis
Canadian regulators and insurance companies have been working together on a new capital framework for several years. It is anticipated that this framework will use internal models and it will be the Canadian response to Solvency II. As a result of the financial crisis we put the project on hold and reviewed all of our key decisions in light of the lessons learned from this crisis. As a result of this process we have developed a number of key principles which will guide all of our work going forward. Today I would like to share these principles with you in the hope that you will find them useful when reviewing or revising your solvency frameworks. We would also welcome any comments or suggested additions/modifications to these principles.

3. Encourage Good Risk Management
Reward companies that manage risks properly
Models should be used internally to manage risks
Cherry picking not allowed
The first and most important principle is that this new framework should encourage good risk management practices in insurance companies. The primary purpose of the models is to aid companies in measuring and understanding their risks. Establishing capital levels is secondary. Companies who manage and control their risks and can clearly demonstrate this should be rewarded with a capital level which reflects their true risk.

4. Encourage Capital Planning Avoid Pro-cyclicality
Encourage buffers during times of profitable growth
Capital requirements should not exacerbate the effect of the business cycle
Create sufficient capital for the industry
Pro-cyclicality is one of the lessons learned by the bankers as a result of the crisis. We can learn from their experience and build up capital buffers when times are good which we can draw down when the cycle turns. We also need to look at systemic risks and while systemic risks for insurance differ from systemic risks for banking additional capital is needed for the systemic risks.

5. Consider All Risks Risk Categories
Insurance
Market
Credit
Liquidity
Operational
Should reflect risk mitigants, reinsurance, diversification and concentration
No diversification between categories without conclusive evidence
Clearly we need to consider all risks, including risks that might not fall into the above categories. Consistent with our objective to encourage good risk management we must also reflect risk mitigants.
Diversification credits are a controversial issue. Solvency II provides credits while Basel II does not. One learning from the current crisis is that correlations in the tail can be much stronger that correlations when times are good. For that reason we will require strong support for any diversification credit between categories. Diversification within categories must also be supported.

6. Measure Assets and Liabilities on a Consistent Basis
Off balance sheet items must be included
As we will be using a total balance sheet approach it is critical that assets and liabilities be valued on a consistent basis. It should be noted that this is not the case for current accounting rules in most of the world. For example the US (and most other countries) do not discount P & C liabilities while the assets are carried at market values. We think that we have it right in Canada.
Off balance sheet items also present risks and their impact must be included.

7. Be Practical, Yet Technically Sound
A standard approach for every risk
Internal models are permitted
Standardized assumptions where they are not dependent on company specific assumptions
Immaterial risks could be based on a standardized approach
There should be a standard approach for every risk which will usually, but not always, be a factor based approach. Companies should be free to use the standard approach for some risk categories, however, we do not want companies to cherry pick. This will also permit medium sized companies to model some risks and not require them to model all risks. To the extent that there is an advantage to companies that use internal models this will help minimize the difference.

8. Reflect Risks on a Going Concern Basis but Reflect Winding-up Costs
Risks should be considered on a going concern basis
Future new business and renewals have to be considered
Capital must be sufficient to cover winding-up costs
Terminal liabilities
At first glance these objectives appear to be contradictory, however, capital must be sufficient to cover winding-up costs. This could be accomplished by adding a provision to cover winding-up costs or it could be incorporated by using a higher terminal provision on the provisions. It is the scenarios in the tail that will drive the capital requirement. As the level of losses will be higher in these scenarios the liabilities should also reflect this higher level of losses.

9. Use Measures that are Compatible Across Risks and Products
Possible measures
VAR
CTE
A common time horizon should be used by all institutions
Companies capital targets should exceed regulatory requirements
Economic cycles
Desired ratings
Risk management philosophy
Most experts prefer CTE, however, VAR is easier to calculate. Both have the advantage that it is easy to combine the results for the different risk categories.
In most cases a one year time horizon is used but for some risks, e.g. Seg Fund guarantees, a longer horizon is needed.
Companies need to establish internal targets above the regulatory minimums. This will result in two or more capital levels for most companies.
Currently Canada has three levels:
A minimum level below which we will take control of the company
A supervisory target at which we will take strong regulatory action.
A target level which is the company’s internal target.
Solvency II has two levels, a minimum and a target.

10. Use a Total Asset Requirement
Capital and reserve margins should be considered on an integrated basis
Any decrease in reserve margins must be offset by an increase in capital and vice versa
There are two basic approaches for capital. The add-on approach where capital requirements are calculated directly. Or the total asset approach where the total requirement for liabilities and surplus is calculated and liabilities are subtracted to get the surplus. In Canada we rely GAAP accounting. Since we do not control the accounting the TA approach protects us because any accounting change will be automatically offset by a capital change. Currently almost all countries use the add-on approach but we believe that the total asset approach is better, even when the supervisor controls statutory accounting.

11. Ensure that Capital is Prudent
While the Total Asset Approach is used there must be a minimum capital requirement
Leverage ratios and other relevant measures complement a risk based capital test
Another lesson form the current crisis is that we can never place all our reliance on models. There must be an objective minimum requirement. We should also continue to use leverage ratios as a consistency check to the results of the models.

12. Consider International Principles and Practices
The insurance market is global
Must comply with IAIS Standards and Principles
Clearly as a member of the IAIS Exco I would support this. The world, however, is getting smaller and it is important that capital requirements be similar around the world.

13. Allow Comparisons of Similar Risks Across Financial Institutions
Banks and Life and P & C Insurance companies should hold comparable levels of capital for similar products
Capital framework should recognize differences in the nature of business
Certainly asset related risks should be the same. Monoline insurers assume banking risk and we need to avoid capital arbitrage. In spite of this there will always be differences and we do need to recognize the different nature of the business.

14. Transparent, Validated and Based on Credible Data
Users should have ability to analyze models
Minimum standards for data and inputs to models are necessary
Data is subject to audit
Professional Standards (e.g. Actuarial) should be considered
There may be a need for additional standards
As regulators we need to be able to audit the models. The data used to calibrate the models is very important. We can also rely of professional bodies to develop standards.

15. Use Reliable Processes with Assumptions Sustainable in Times of Stress
Rules for using models should be clear
A review process should be implemented
The results should be replicable
Material changes will be subject to approval

16. Be Part of Intervention Levels for Supervisory Action
Minimum and target capital levels should be established
These levels will define possible supervisory interventions
The capital level for intervention should be sufficiently high to allow supervisory action at an early stage
Companies need to establish internal targets above the regulatory minimums. This will result in two or more capital levels for most companies.
Currently Canada has three levels:
A minimum level below which we will take control of the company
A supervisory target at which we will take strong regulatory action.
A target level which is the company’s internal target.
Solvency II has two levels, a minimum and a target.

17. Questions