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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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