Office of the Superintendent
of Financial Institutions Canada
Bureau du surintendant
des institutions financières Canada
Dynamic Capital Adequacy Testing
Michael Hafeman
Assistant Superintendent, Specialist Support Sector
IAIS Annual Conference – Santiago, Chile – October 10, 2002
OSFI’s Approach
• Promote understanding and management of
risks by companies’ boards of directors and
senior management
• Establish capital requirements
• Assess performance and strength
• Promote effective disclosure
2
Dynamic Capital Adequacy
Testing – DCAT
• Process of projecting and analyzing the
trends of a company’s capital adequacy
under a variety of future scenarios
3
Purpose of DCAT
• Assist board of directors and senior
management in planning and risk
management
• Defensive in nature
• Identify
– Plausible threats to satisfactory condition
– Actions which lessen likelihood of threats
– Actions which mitigate a threat if it occurs
4
Historical Context
• OSFI began developing risk-based capital
requirements for Life in mid-1980s
• Actuaries (CIA) developed a forwardlooking approach to assessment
• Life capital and DCAT requirements since
1992
• P&C DCAT since 1998; new risk-based
capital requirements from 2003
5
DCAT Process
• Development of base scenario
• Identification and examination of possible
threats
• Development of plausible adverse scenarios
• Projection and analysis of capital adequacy
• Reporting of results
6
Base Scenario
• Normally, consistent with the business plan
• All scenarios include inforce policies,
forecast sales, and non-insurance operations
• Realistic assumptions
• Forecast period is usually 5 years for life
companies and 2 years for P&C companies
• Modeling software is available
7
Plausible Adverse Scenarios
• Adverse, but plausible, assumptions about
matters to which an insurer’s financial
condition is sensitive
• Stress testing to assess plausibility
• Differ among insurers
• May change over time for an insurer
8
Threats to Consider – Life
•
•
•
•
•
• Expense
• Reinsurance
• Government and
political action
• Off-balance sheet
• Others, if material
Mortality
Morbidity
Persistency
Cash flow mismatch
Deterioration of asset
values
• New business
9
Threats to Consider – P&C
• Frequency and
severity
• Pricing
• Misestimation of
policy liabilities
• Inflation
• Interest rate
• Premium volume
• Expense
• Reinsurance
• Government and
political action
• Off-balance sheet
• Others, if material
10
Refinements Required
• Integrate scenarios, if the probability of an
adverse scenario is high
• Consider ripple effects
– Impact on other base assumptions
– Company’s response to adversity
– Regulatory action, e.g., where minimum capital
is not met
– Policyholder actions
11
Reporting
• Primarily for board of directors and senior
management
• Copy of report is sent to OSFI
• At least base scenario and three most risky
scenarios must be tested and reported
annually
• Professional opinion is required
12
Capital Adequacy Targets
• Actuarial standard for satisfactory opinion:
– Meet minimum regulatory capital requirement under
the base scenario
– Meet all future obligations under the base scenario and
all plausible adverse scenarios
• OSFI expects more – acceptable capital levels
• OSFI encourages active discussions amongst the
actuary, board and management of any scenarios
where minimum capital is not met
13
More Information
• OSFI – www.osfi-bsif.gc.ca
• Canadian Institute of Actuaries –
www.actuaries.ca
– Standard of Practice, Dynamic Capital
Adequacy Testing, December 1998
– Educational Note, Dynamic Capital Adequacy
Testing – Life and P&C, June 1999
14
DCAT Case Study
• Company in weakened position in 1992,
due to investment losses
• DCAT used to develop business plan to
improve solvency position within five years
• DCAT used to test viability of business plan
under plausible adverse scenarios
15
Forming a Business Plan
MCCSR Ratio
Level of New Business (MCCSR ratio)
180
MCCSR Ratio
160
140
120
100
80
60
1992
1993
1994
1995
1996
1997
Year
Lower new sales
Double New Growth
Level New Sales
No New Business
Forming a Business Plan
Available Surplus
Level of New Business (Available Surplus)
Level of Available
Surplus
110,000
100,000
90,000
80,000
70,000
60,000
1992
1993
1994
1995
1996
Year
Lower new sales
Double New Growth
Level New Sales
No New Business
1997
Forming a Business Plan
Annual Income
Level of Annual Income
Level of New Business (Annual Income)
21,000
18,000
15,000
12,000
9,000
6,000
3,000
1992
1993
1994
1995
Year
Lower new sales
Level New Sales
Double New Growth
No New Business
1996
1997
Business Plan – Base Scenario
CHOSEN BASE SCENARIO: Lower New Sales
MCCSR Ratio
180
160
140
120
100
80
60
1992
1993
1994
1995
Year
Base Scenario
1996
1997
Scenario 1: Mortality
Worsening Mortality: 3% per annum
180
MCCSR Ratio
160
140
120
100
80
60
1992
1993
1994
1995
1996
Year
Base Scenario
Worsening Mortality
1997
Scenario 2: Morbidity
Worsening Morbidity: 3% per annum
MCCSR RATIO
180
160
140
120
100
80
60
1992
1993
1994
1995
1996
YEAR
Base Scenario
Worsening Morbidity
1997
Scenario 3: Persistency
MCCSR Ratio
Worsening Withdrawal Rates: (2 or 0.5)
MCCSR Ratio
MCCSR RATIO
180
160
140
120
100
80
60
1992
1993
1994
1995
1996
YEAR
Base Scenario
Withdrawal
1997
Scenario 3: Persistency
Available Surplus
Worsening Withdrawal Rates: (2 or 0.5)
Available Surplus
Level of Available
Surplus
120,000
110,000
100,000
90,000
80,000
70,000
60,000
1992
1993
1994
1995
YEAR
Base Scenario
1996
Withdrawal
1997
Scenario 3: Persistency
Annual Income
Worsening Withdrawal Rates: (2 or 0.5)
Annual Income
Level of Annual
Income
16,000
14,000
12,000
10,000
8,000
6,000
4,000
1992
1993
1994
1995
1996
Year
Base Scenario
Withdrawal
1997
Scenario 4: Interest Rate Risk
Interest Rate Risk
MCCSR Ratio
180
160
140
120
100
80
60
1992
1993
1994
1995
1996
1997
Year
Base Scenario
Decreasing -0.6% per annum
Increasing 0.6% per annum
Scenario 5: Credit Risk
MCCSR Ratio
Credit Risk
180
160
140
120
100
80
60
40
20
1992
1993
1994
1995
1996
Year
Base Scenario
Doubled Asset Defaults
Doubled Asset Defaults & Default Provisions
1997
Scenario 6: Expenses
Unit Expenses inflate 3% more than base rate
180
MCCSR Ratio
160
140
120
100
80
60
1992
1993
1994
1995
1996
Year
Base Scenario
Expenses
1997
Scenario 7: Integrated Scenario
MCCSR Ratio
Integrated: Doubled Asset Default & Provisions
with Worsening Mortality
180
160
140
120
100
80
60
40
20
1992
1993
1994
1995
1996
1997
YEAR
Base Scenario
Doubled Defaults & Doubled Provisions
Worsening Mortality
Integrated: Asset defaults & Worsening mortality
Scenario 8: Ripple Effects
Ripple Effect Scenarios: Higher Sales with Higher
Expenses
180
MCCSR RATIO
160
140
120
100
80
60
40
20
1992
1993
1994
1995
1996
1997
YEAR
Base Scenario
Higher Sales
Higher Sales and Expenses
Scenario 9: Ripple Effects
Worsening Morbidity with Premium Change
MCCSR RATIO
160
140
120
100
80
1992
1993
1994
YEAR
1995
1996
Base Scenario
Worsening Morbidity no premium change
Premium change with 2 year lag
Premium change w 1 year lag
1997
DCAT Case Study: Base Scenario versus
Actual Outcome
BASE SCENARIO vs. ACTUAL OUTCOME
200
MCCSR RATIO
180
160
140
120
100
80
60
1992
1993
1994
1995
YEAR
Base Scenario
Actual Outcome
1996
1997