Capital Levels in the Canadian
Property/Casualty Insurance
Industry
Peter Carayannopoulos
Mary Kelly
Wilfrid Laurier University
1
Agenda
• Motivation.
• Canadian marketplace.
• Areas of investigation:
– Capital holdings and firm risk.
– Regulatory changes in 2003 and the
distribution of capital in the industry
• Conclusions.
2
Motivation
• Look at holdings of Canadian p/c insurers
taking regulatory framework as given.
– Do capital holdings reflect firm risk?
• What is initial impact of changes in
solvency requirements in 2003?
• Little research undertaken on capital
holdings of Canadian p/c insurers.
3
Areas of Investigation
1. What firm characteristics influence capital
holdings between 1990 & 2004?
2. What is the impact of the new MCT test
on:
a. The level of capital holdings?
b. The relationship between capital holdings and
firm characteristics?
c. The relationship between capital holdings and a
firm’s portfolio of assets and liabilities?
4
P/C Insurance in the Canadian
Economy
• Over 200 private insurance companies in
Canada organized in approximately 120
groups.
• A small industry:
–
–
–
–
$35.9 million in premiums in 2003,
$71 billion in assets in 2003.
2.6% of world wide p/c insurance premiums.
Market share of top 10 firms around 55%.
5
Regulation of Insurers
• OSFI regulates solvency via level of capital,
adequacy of reserves, prudent investment
strategies.
• Provincial regulators monitor products
and practices.
• Firms may also be subject to provincial
solvency requirements.
6
Minimum Asset Test (MAT) vs.
Minimum Capital Test (MCT)
•
•
•
•
MAT
Value asset levels on
liquidation basis
Assets Available = total assets
held by firm less those nonadmitted or otherwise not
available.
Assets Required = total
liabilities + required margin –
recoverables.
MAT statistic is
•
•
•
•
•
Assets available - assets required
x100
assets required for test purposes
• Firm must have positive ratio
to pass test.
• Higher ratio needed to avoid
regulatory oversight
•
MCT
Value asset levels on on-going
basis.
Capital required based on
both asset and liability risk.
Asset risk: type of security,
maturity and grade.
Liability risk: unearned
premium reserve, NPW by
line.
Calculation of capital required
/ capital available must exceed
150% to pass test.
Recommended targets of
170% - 210%.
7
Summary of Insurer Data
1990 - 2004
Number Strictly Cdn Insurers
64
Number Of Mutual Insurers
50
Number Of Firms
268
Number Of Observations
2358
Average
Median
3.51
0.93
2 Year U/W Results
108.2%
105.5%
% Liability And AB To Total NPW
34.78%
37.33%
% Personal Property & Auto PD To Total
NPW
47.19%
48.21%
% Asset Portfolio In Gov’t Bonds
68.37%
68.77%
$113,440
$32,753
Surplus To NPW Ratio
NPW ($1000 Cdn)
8
Distribution of Capital Levels
• Capital level measure by Surplus / NPW
• 5% had capital levels below 0.33, 7% had capital
levels 10.
• Firms with higher Surplus / NPW more likely to
be mutual insurers.
Firm characteristics
Surplus /
NPW <1
Surplus /
NPW > 1
Statutory Assets
$94.2 mil
$59.2 mil
2 year avg u/w ratio
106.54%
109.92%
9
Determinants of Capitalization
• Amount of capital a firm should carry
depends on:
– Probability of insolvency.
– Agency costs.
– Asymmetric information / growth
opportunities.
– Product market interactions.
10
What Are Determinants of Capitalization?
Explanatory Variable
Expected Relationship
Coefficient
Regional Diversity
+
0.405
Product Diversity
+
-0.503
Reinsurance Usage
-
0.002
Var. of Past Experience
+
-0.014*
Firm Size
-
-2.561*
Canadian Insurer
+
-3.197*
2 Year U/W Ratio
+
0.0063
Investment Risk Ratio
+
0.010*
Claims Settlement Length
-
0.0029
+ or -
2.512
Growth Prospects
+
-0.015
% Liability and AB
+
0.738*
% Personal Property and Auto PD
-
0.0025
Mutual Insurer
R2
33.4% 11
Capital Holdings Conclusions
• Most of variability explained by size
• Possible interpretations
– Firms determine capital holdings by adding
a margin to the regulatory requirements
rather than on the basis of risk
characteristics.
– US market is significantly different from
Canadian market.
12
Introduction of MCT
• Timeline:
– Trial basis for 2001 and 2002.
– Implementation in 2003.
• Goals:
– Harmonize solvency requirements across
provinces.
– Capital neutral across industry.
– Align capital holdings with firm risk.
– Evaluate risk based on both asset and liability
holdings.
13
Level of Capital Holdings and MCT
Explanatory Variable
Expected Relationship
Coefficient
Regional Diversity
+
0.339
Product Diversity
+
-0.551
Reinsurance Usage
-
0.0019
Var. of Past Experience
+
-0.0139*
Firm Size
-
-2.606*
Canadian Insurer
+
-3.349*
2 Year U/W Ratio
+
0.0082
Investment Risk Ratio
+
0.010*
Claims Settlement Length
-
0.0024
+ or -
2.533
Growth Prospects
+
-0.016
% Liability and AB
+
0.716*
% Personal Property and Auto PD
-
0.003725
Test Period Indicator
0
0.794
Implementation Period Indicator
0
1.408*
Mutual Insurer
R2
33.7%14
Level of Holdings & MCT
Conclusions
• Positive coefficient for implementation
period suggests that capital holdings have
increased.
• Cannot reject hypothesis that there is no
difference between implementation period
and test period indicator.
• Cannot reject hypothesis that capital
holdings increases as a response to 9/11
and NOT impending MCT test.
15
MCT and Firm Risk
• Do firms hold greater capital since 2003
because firm risk has changed?
• Introduce interaction effects for risk
characteristics and implementation period.
• Results:
– Implementation variable becomes insignificant.
– No change in significance of other risk
characteristics.
– No interaction effects are significant at 5% level.
– At 10% level, cross effect of Herfindahl index by
region and implementation is significant and negative.
16
MCT, Asset and Liability Risk
• Are capital holdings aligned with asset and liability risk?
• Liability risk:
– Firms that u/w liability and automobile AB should hold more
capital.
– Firms that u/w personal property and automobile physical
damage should hold less capital.
• Asset risk given below
Asset Class
Percentage of Book Value held as Reserve
Cash
0%
Government Bonds
0%
Commercial Bonds
0.5% to 8% depending on maturity and grade.
Mortgage Loans
4% to 8% depending on residential versus commercial
Preferred Shares
4% to 15% depending on grade of shares
Common Shares
15%
17
MCT, Asset and Liability Risk
Explanatory Variable
Expected
Relationship
Coefficient
Interaction
Effect
Coefficient
Firm Size
-
-2.833*
0.7263
Proportion of NPW from Liability & AB
+
0.791*
-0.04170
Proportion of NPW from Auto Damage and
Personal Property
-
-0.0025
-0.00253
Proportion of Assets as Gov’t Bonds
0
0.1079*
0.1079
Proportion of Assets as Comm. Bonds
+
-0.1036*
-0.04687
Proportion of Assets as Mortgage Loans
+
0.5730*
-0.3175*
Proportion of Assets as Preferred Shares
+
0.1363*
-0.0297
Proportion of Assets as Common Shares
+
0.1165*
-0.0950*
Implementation Period Indicator
0
0.7936
0.7263
R2
33.3%
18
Asset and Liability Risk
• Firm size still explains bulk of variability in
surplus holdings.
• There is some alignment between
portfolio risk and amount of surplus held.
19
Conclusions
• First long term study into capital holdings of Canadian
p/c insurers → more work is needed.
• Risk characteristics do not greatly influence capital
holdings of Canadian insurers (as opposed to U.S.
experience).
• Firm size is most relevant indicator of surplus holdings.
• Surplus holdings have increased since the introduction of
MCT (but may be related to 9/11).
• MCT does not appear to do a better job of aligning
capital holdings with firm risk.
20
Questions?
21