Capital Levels in the Canadian Property/casualty Insurance
Industry
Peter Carayannopoulos and Mary Kelly
School of Business and Economics
Wilfrid Laurier University
Waterloo, ON, Canada
Abstract: There has been a long debate in the Canadian property/casualty insurance
industry regarding statutory capital requirements. In the past, Canadian property/casualty
insurers have often viewed statutory capital requirements as excessive, whereas the regulator
has been concerned more with short and long term capital adequacy. Using data from 1990 –
2004, we examine whether the level of capital held by insurers is driven by the regulatory
regime or determined optimally by a firm’s exposure to risk. We find that the variables that are
relevant predictors of capital holdings of U.S. insurers do not explain holdings of Canadian
insurers. This provides an indication that firms determine their capital holdings by adding a
margin to the minimum regulatory requirements rather than on the basis of their risk
characteristics. Changes to the Canadian regulatory capital requirements were introduced in
2003, in order to match more effectively degree of risks to capital requirements. This study
attempts to answer the question whether capital holdings of insurers have changed under the
new regime. Our results suggest that capital holdings of insurers have increased since the
introduction of the new requirements and insurers have not realigned their capital holdings with
expected risk characteristics. Overall we find that firms that wrote more liability coverages held
more surplus. Firms that invest more in mortgages and common stock hold more surplus but
this impact has decreased since regulatory changes in 2003. However, more work is needed to
move toward a “true” risk based capital system.
Both
authors are at School of Business and Economics, Wilfrid Laurier University, Waterloo, ON N2L 3C5,
CANADA; fax: (519) 884-0201. Carayannopoulos can be contacted at (519) 884-0710, ext. 3613 or
[email protected]. Kelly’s phone and e-mail information is (519) 884-0710, ext. 2551 and [email protected]. The
authors thank the National Research Program in Financial Services and Public Policy at the Schulich School of
Business, York University for their financial support.
Determinants of Capital Holdings
1
INTRODUCTION
There has been a long debate in the Canadian property/casualty industry regarding
statutory capital requirements. In the past, Canadian property/casualty insurers have often
viewed statutory capital requirements as excessive and unrelated to an insurer’s true risk,
whereas provincial and federal regulators have been concerned more with short and long term
capital adequacy. In addition, firms operating in several provinces also faced multiple solvency
tests – both at the federal level and within the provinces in which they operated.
Most industry observers agree that over-capitalization is expensive. When firms are overcapitalized, shareholders do not receive the return on equity that they deserve; firms do not
receive the optimal level of tax breaks; and managers act inefficiently. In particular, industry risk
managers have conjectured that weak underwriting results occur when a firm holds too much
capital. Premium levels are not raised quickly enough in response to increasing claims costs if a
firm can rely on surplus to cover any short fall.
Regulators are more concerned with the costs of under-capitalization. When firms are
under-capitalized, there is an increased likelihood of distress which leads to an increased cost
of capital, eroding an insurer’s competitive position. The presence of a federal guarantee
program, called Property and Casualty Insurance Compensation Corporation (PACCIC) in
Canada, increases the incentives of firms to remain under-capitalized and take on more risk as
the cost of its potential bankruptcy is spread across all solvent property/casualty insurers.
World wide, regulators, academics and industry officials have been concerned with the
proper level of capital needed to satisfy the sometimes conflicting goals of solvency and
profitability. The evolution of capital holdings of insurers, related solvency requirements and risk
characteristics of Canadian insurers are the focus of this paper.
First we want to examine whether or not solvency holdings for Canadian insurers are
aligned with the risk of each insurer. An international study of capital requirement for
property/casualty insurers commissioned by the Insurance Bureau of Canada (2003) found that
minimum capital requirements required by Canadian regulations is nearly double that which
must be held in the U.S., and more than double of minimum capital holdings required in Japan,
U.K., Germany, and France. In a recent study of Canadian property/casualty insurance firms,
Carayannopoulos and Kelly (2005), using one year of data, examine the relationship between a
firm’s capital holdings, its risk characteristics and the minimum capital it needs to hold to pass
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Determinants of Capital Holdings
the federal regulatory capital test. They find that firm characteristics related to financial distress,
agency costs, and asymmetric information that have been shown to influence the level of capital
holdings in the U.S. property/casualty insurance market (Cummins and Nini, 2002), do not
explain the level of reserve capital held by Canadian firms. Based on the above observations,
one might conjecture that minimum solvency requirements in Canada might be perceived as
“too high” and that firms operate at a certain margin above the regulatory threshold rather than
whatever “appropriate” level of capital should be as determined by their risks.
We explore the capital holdings of Canadian property/casualty insurers relative to
regulatory requirements and firms’ risk exposures. Using data from 1990 to 2004, our results
indicate that characteristics that have been found to be relevant predictors of capital holdings of
U.S. property/casualty insurers do not adequately explain variations in the amount of capital
held by Canadian insurers. Measuring capitalization as the ratio of surplus to net premiums
written (NPW), we find that approximately one quarter of variation in surplus holdings is
explained by the size of the firm – larger firms, ceteris paribus, carry less capital for each dollar
of premium written. Firms that write more liability and auto accident benefit coverages carry
more capital for each dollar of premium written. Also, firms that hold more of their assets in
common shares also hold more capital per dollar of premium written.
Based on the lack of explanatory power of the independent variables, we conjecture that
that either firms operate at a predetermined margin above the regulatory threshold and that the
regulatory regime is the major determinant of capital holdings or the U.S. and Canadian
insurance marketplaces are sufficiently different to the extent that the broad characteristics that
explain risk in the U.S. market do not capture the risk faced by Canadian insurers.
In addition, the paper explores the impact of the 2003 solvency changes in both the level
and the determination of capital held by Canadian property/casualty insurers. It is possible, that
the determinants as well as the amount of capital holdings have changed significantly in the
post-2003 era. No study to date, however, has investigated the impact of these changes within
the Canadian property/casualty insurance regulatory setting.
Federal and provincial regulators stressed that these new solvency requirements were
meant to be neutral across the industry – some firms would need to hold more capital and some
would need to hold less capital, but overall capital requirements should be unchanged. We
examine whether or not capital requirements are different given the new regime, and, more
importantly, we assess whether the new requirements have done a better job aligning regulatory
capital with the risk insurers face. Our results suggest that, overall, firms held more capital after
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Determinants of Capital Holdings
2002, although we have no evidence that this is because firms’ risk characteristics have
changed since 2002. We also cannot reject the hypothesis that capital holdings have risen as a
response to market changes post 9/11.
Finally, the 2003 regulatory changes asserted that firms that underwrite riskier lines of
business or hold investments in riskier assets should hold more surplus. We find some support
that firms did this before the regulatory changes. Indeed, after 2003, the amount of surplus held
in relation to the amount of mortgage loans and common stock held fell. One plausible
explanation is that historically Canadian insurers overestimated the risk associated with these
assets. When the 2003 solvency changes prescribed the amount of surplus that firms must hold
with respect to its risky assets, firms were better able to assess investment risk.
Since regulatory reform is so recent, more work is required in assess the impact of the
reforms on both the level of capital held by insurers and the relationship between firm risk and
capital held. We conjecture that more work is still needed to move towards a “true” risk based
capital system.
2
THE CANADIAN INSURANCE MARKET
In Canada, the property/casualty insurance market is very competitive with over 200 active
companies organized in approximately 120 groups, which are highly regulated both at the
provincial and federal levels. Canada's property/casualty insurance industry is the least
concentrated of the financial services industries in Canada. Market share of the 10 leading
property/casualty insurance groups in Canada was slightly under 55 percent in 2004,
considerably lower than the level of concentration in the banking industry, where the six leading
firms accounted for more than 90 percent of that industry's assets. In the Canadian life
insurance industry, there are 105 firms and the three largest firms held just under 60 percent
market share.
Unlike the United States, solvency oversight is undertaken at the federal level for federally
regulated insurers. The Office of the Superintendent of Financial Institutions (OSFI) oversees
the solvency of federally regulated insurers. “OSFI's mission is to protect the rights and interests
of depositors, policyholders, pension plan members and creditors of financial institutions, and to
advance and administer a regulatory framework that contributes to public confidence in a
competitive financial system.”1 Insurance products and practices are regulated at the provincial,
1
OSFI Mission Statement. Accessed January 4, 2005 at http://www.osfi-bsif.gc.ca/eng/about/mission/index.asp .
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Determinants of Capital Holdings
not federal level. Historically, insurers also needed to meet solvency requirements in each
province in which they operated.
It is telling of fundamental Canadian / U.S. differences to note that the National Association
of Insurance Commissioners (NAIC), whose mission is to assist state insurance regulators in
the United States, lists promoting the solvency of insurance institutions as its fourth (out of five)
regulatory goals. The most important goal is protect the public interest.2 OSFI’s main objective is
also to protect public interest, noting that the first way to do so is to identify institution-specific
risks and trends that could cause undue loss.3 Perhaps then, it is not surprising that Canadian
insurers face much higher capital requirements than insurers in many other nations.
Before 2003, the key test of surplus adequacy / insolvency risk was the minimum asset test
(MAT) for Canadian insurers and the deposit adequacy test (DAT) for foreign insurers. Briefly,
the MAT/DAT compares a firm’s allowable assets levels under statutory accounting rules to
what the firm needs to cover all its liabilities by a preset safety margin. The test statistic reports
the difference between allowable and required capital holdings divided by required capital
holdings. Firms need to achieve a statistic of 100 to pass the test. Firms that pass the test, but
have a test score below 110, are monitored more closely and face more stringent reporting
requirements than firms that pass the test by a sufficient amount. Many firms, not wishing to
face excessive regulatory oversight, set target capital levels to achieve test scores well in
excess of 110, so that they could sustain several years of poor experience and still stay above
this threshold.4
The minimum capital test (MCT) for Canadian insurers and the branch adequacy of assets
test (BAAT) for foreign insurers introduced in 2003, harmonized solvency requirements for most
insurance companies (one province, Quebec, still maintains a separate solvency test based on
the MAT). Primarily, the test was developed to better reflect the risk of both an insurer’s assets
and liabilities. The test adjusts for the default risk of asset holdings of insurers and corrects for
the differences in capital risks across the various lines of property/casualty insurance written in
Canada. One key goal of the MCT is to be neutral across the industry (Kovacs, 2002). While
some firms would see an increase in required capital levels, other firms would see a reduction in
required capital levels, resulting in a zero net change for the industry.
2
NAIC Mission Statement. Accessed on January 4, 2005 at http://www.naic.org/about/mission.htm .
OSFI Mission Statement. Accessed January 4, 2005 at http://www.osfi-bsif.gc.ca/eng/about/mission/index.asp .
4 Private conversations with industry executives.
3
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Determinants of Capital Holdings
Considering both on and off balance sheet items, the MCT calculates both the amount of
allowable capital held by the firm and the amount of capital needed to offset the riskiness of the
firm’s assets and liabilities. The test produces a statistic of capital required / total capital
available. The minimum acceptable result is 150 percent, but OSFI requires insurers to set
targets between 170 percent and 210 percent. (Baker, 2005).5
Regulators also measure an insurer’s capitalization by its insurance risk ratio. The
insurance risk ratio, which is the ratio of net premiums written (NPW) to surplus, is a measure of
the company’s ability to absorb financial shocks. OSFI allows for up to a 3 to 1 ratio.6 The
inverse of the insurance risk ratio (surplus to NPW) can be used as a measure of excess
capitalization with 0.33 as the minimum benchmark.
Table 1 reports summary statistics for 268 insurers for the years 1990 - 2004.7 These
statistics are calculated using financial results reported by MSA Researcher database for
insurers licensed in Canada that operated for at least one year between 1990 and 2004. Of
these 268 insurers, 169 were operating in 2004. Of those that ceased operations, most ceased
business operations in Canada (but maintained operations elsewhere worldwide) or merged or
amalgamated with another insurer. Less than 10 were liquidated, taken over by regulators or
otherwise wound up.
We remove from the database all observations with incomplete data. This leaves a sample
of 2358 data points. Sixty-four insurers, accounting for one-fifth of observations in our database,
have no external capital resources outside of their Canadian insurance operations. These are
insurance companies that are not part of an international insurer, like Aviva, nor owned by a
bank, like RBC Insurance, nor are they part of a larger financial conglomerate, like Kingsway
Financial.
< Insert Table 1 about here>
Average and median values are shown due to a significant number of large observations for
some variables. The average and median amounts of net premiums written were $113.4 and
$32.8 million respectively. The average and median surplus to NPW ratios were 3.51 and 0.93,
while the average and median 2-year underwriting ratios were 108.15 percent and 105.50
percent respectively.
5A
6
7
more detailed description of both the MAT and MCT is given in Appendix 1.
This test is equivalent to the U.S. Kenney ratio.
We undertake our analysis at the firm and not group level as solvency scores are filed at the firm level.
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2.1
Capital Holdings of Canadian Insurers
It is believed by many market participants that regulatory capital thresholds are excessive
and impose constraints to profitability. If firms hold this belief, one would expect the major
determinant of capital holdings to be the regulatory requirements themselves and not a firm’s
risk characteristics. Regardless of risk characteristics, firms would operate at a capital level high
enough above the regulatory threshold to avoid an increase in regulatory oversight.
Because solvency requirements change during our sample period, we use surplus to NPW
as a measure of capital holdings for each firm. Table 2 gives the distribution of surplus to NPW
for our sample. Five percent of the sample had capitalization levels below the minimum
acceptable level of 0.333, and almost 7 percent had surplus to NPW observations greater than
10.
< Insert Table 2 about here>
Firms that carry more surplus per premium dollar written are (statistically) significantly
smaller. The statutory asset holdings of firms with surplus to NPW ratios less than 1 is $94.2
million compared to $59.2 million for firms with surplus to NPW ratios greater than 1. Firms with
surplus to NPW ratio greater than 1 also write less business, and are more likely to be mutual
insurers. Firms with surplus to NPW ratios less than 1 have marginally lower (but statistically
significant) 2 year average underwriting ratios; 106.54 percent versus 109.92 percent.
3
CAPITAL HOLDINGS AND FIRM RISK
Following Cummins and Nini (2002) and Carayannopoulos and Kelly (2005), we examine
firm characteristics that have been shown to affect U.S. property/casualty insurers’ capital
holdings to see if the capital holdings of Canadian insurers are similarly influenced. These
characteristics fall mainly in four general categories: financial distress, agency costs,
asymmetric information and growth opportunities, and product-market interaction.
Using OLS regression analysis,8 we examine whether capital holdings of Canadian
property/casualty insurers holdings, as measured by the surplus to premium ratio, are
influenced by the same or similar characteristics that affect U. S. insurers.
8
We use a clustering technique which accounts for the fact that the observations are independent across companies,
but not between observations of the same insurer over time. This technique corrects the variance covariance matrix
of the estimators but not the estimated coefficients in the regression equation (Rogers, 1993).
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Determinants of Capital Holdings
3.1
Explanatory Variables and Proxies
A more detailed description of the characteristics, proxies used in the regression and
expected hypotheses are presented next, grouped in the categories used in Cummins and Nini
(2002) and Carayannopoulos and Kelly (2005).
3.1.1
Financial Distress
Financial distress is costly and firms may attempt to minimize the possibility of insolvency
by holding excess capital above and beyond regulatory requirements. The likelihood of financial
distress depends on many factors including those given below. In particular, we test the
following hypotheses:
FD1: Firms that are less diversified geographically or by lines of business hold more
capital. The Herfindahl indices of premiums written by region and premiums written by
product line are used to measure diversification.9
FD2: Firms that cede a greater portion of their book of business hold less capital.
Premiums ceded as a percentage of gross premiums written (GPW) is used to measure
reliance on reinsurance.
FD3: Firms that are higher risk will hold more capital. The standard deviation of the rate
of return on equity (ROE), as provided by MSA Researcher, over the past five years is the
proxy variable for riskiness.
FD4: Smaller firms hold more surplus per dollar of premium written. Firm size is
measured as the logarithm of the firm’s net premiums written.
FD5: Canadian insurers, without international or other resources, will hold more excess
capital. An indicator variable that takes the value of one if the firm is a purely Canadian
insurer and zero otherwise is used.
FD6: Insurers with poorer past underwriting results, as determined by the two year
underwriting ratio, hold higher levels of capital, if they view poor past experience as a
harbinger of poor future results (especially in jurisdictions where the ability to increase rates
is restricted).
FD7: Firms that hold more of their assets in equities face a higher investment risk and
9
The Herfindahl index for each firm is the sum of the squares of direct written premiums for each region (or line of
business) divided by the square of total direct written premiums for the firm. A larger index signifies greater
concentration.
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Determinants of Capital Holdings
therefore hold more capital. The investment risk ratio, which is the portion of the firm’s
assets invested in common stock, is used to measure the amount of equities held by firms.
3.1.2
Agency Costs
Agency issues are conflicts between owners and managers and conflicts between owners
and policyholders. Increasing leverage reduces owner – manager agency issues but increases
owner – policyholder agency problems (Jensen and Meckling, 1976). Thus we would expect a
firm to hold more capital if owner – policyholder conflict is more severe. The owner – manager
conflict is more severe for longer tailed lines of business. The longer the time to claims
settlement, the greater the potential for perquisite consumption by the manager. Rational
owners mitigate against this by increasing the leverage of the firm. We test the following
hypotheses:
AC1: Firms that write a greater proportion of longer tailed business will hold less capital.
Following the literature, we use the proxy of the ratio of unearned premium reserves plus
loss reserves over net incurred losses to measure the amount of long tailed business.
AC2: There are two conflicting effects arising from ownership structure. One might
expect that owner – policyholder conflict would be greater, and the owner – manager
conflict less, for stock companies than for mutual companies. But mutual insurers have
difficulty in both raising and dispersing capital. Thus we conjecture that ownership will
impact the amount of capital held by insurers.
3.1.3
Asymmetric Information and Growth Opportunities
The pecking order theory of financing (Myers and Majluf, 1984) suggests that firms with
greater information asymmetries and greater future growth opportunities rationally hold more
internally generated funds, since this is the preferred method by which to finance new
investments. We test the following hypotheses:
PO1: Insurers that face greater information asymmetries hold more capital. We use the
standard deviation of past ROE as a proxy for asymmetric information.
PO2: Insurers with more growth opportunities domestically hold more capital. Following
the literature, we use the past growth (over five years) in premiums as a proxy for growth
opportunities.
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Determinants of Capital Holdings
3.1.4
Product-Market Interaction
Cummins and Nini (2002) conjecture that commercial lines insurance buyers are more
concerned with insurer financial quality than personal lines consumers. As such signaling
financial stability is more important to insurers that compete in commercial markets. Canadian
regulators, in drafting the MCT, consider that insurers that underwrite more liability (automobile
and commercial) and automobile accident benefits face with higher risk, and firms that
underwrite relatively more first party automobile property damage (collision and comprehensive)
and personal property coverages face lower risks. Therefore we hypothesize that::
PM1: Firms that underwrite more liability and automobile accident benefits coverages
hold greater amounts of surplus.
PM2: Firms that underwrite more first party automobile property damage (collision and
comprehensive) and personal property coverages hold lower amounts of capital per
premium dollar written.
3.2
Empirical Results
Regression results are presented in Table 3.
< Insert Table 3 about here >
Approximately one third of variation in surplus to NPW is explained by the independent
variables, with the majority of variation explained by the size of the firm.10 As expected larger
firms, ceteris paribus, carry less capital for each dollar of premium written. Firms that write more
liability and auto accident benefit coverages carry more capital for each dollar of premium
written. Also, as anticipated, firms that hold more of their assets in common shares also hold
significantly more capital per dollar of premium written.
We note that Canadian insurers hold significantly less capital than their international
counterparts. We conjecture that this is because international firms and Canadian
conglomerates are subject to a variety of external forces that do not impact Canadian insurers
and are unrelated to the risk inherent in the Canadian insurance market. International firms may
choose to hold more capital in Canada for various reasons such as: differences in taxation rates
between international markets, differences in international regulation or if growth opportunities in
the Canadian market is greater than in other markets.
10
A regression of the surplus to NPW ratio on firm size alone produces a R 2 statistic of 26 percent. A regression
using the remaining risk characteristics but excluding firm size yields a R 2 statistic of 9 percent.
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Determinants of Capital Holdings
Also unexpected, the relationship between surplus held and firm risk’s, as measured by the
deviation of the rate of return on equity, is marginally, but significantly negative. Because firms
with greater variance in ROE also had poorer underwriting experience,11 we conjecture that
firms with higher variability are using surplus to pay claims, thus reducing surplus over time.
3.3
Discussion
Overall we find that some of the characteristics that have been found to be relevant
predictors of capital holdings of U.S explain about one-third of the variation in the amount of
capital held by Canadian insurers. Firm size is the most relevant predictor of capital holdings,
and the remaining characteristics explain very little variation in capital holdings. We conjecture
that either firms operate at a predetermined margin above the regulatory threshold and that the
regulatory regime is the major determinant of capital holdings or the U.S. and Canadian
insurance marketplaces are sufficiently different to the extent that the broad characteristics that
explain risk in the U.S. market do not capture the risk faced by Canadian insurers.
4
THE IMPACT OF CHANGES IN SOLVENCY REGULATION.
In 2000, OSFI introduced its first version of the MCT, asking companies to voluntarily
complete the test using 1999 data. Based on the test results, companies were given the
opportunity to comment on the test so that changes could be implemented. For the 2001 and
2002 annual statements, insurers filed MCT scores in parallel with the traditional MAT scores
but only MAT scores were used for solvency compliance. Starting with 2003, insurers were
required to file MCT scores on a compliance basis.
Using OLS regression, we test 3 broad regulatory aims in this section. First, given that
regulators stressed the new solvency requirements were meant to be neutral across the
industry, we examine whether or not the level of capital holdings per dollar of premium written
changed after the implementation of the MCT. Secondly, one of the goals of the MCT is to align
capital holdings with firm risk. Thus, we examine whether or not the MCT aligns capital holdings
with the risk characteristics discussed in Section 3.1. Finally, the MCT evaluates an insurer’s
risk arising from its portfolio of investments and the lines of business which it underwrites. We
examine the relationship between a firm’s assets and liabilities and the amount of capital it holds
before and after the introduction of the MCT.
11
The correlation between the standard deviation of ROE over the past 5 years and the 2 year underwriting ratio is
17 percent.
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Determinants of Capital Holdings
4.1
Levels of Capital Holdings
Federal and provincial regulators emphasized that the new solvency requirements were
meant to be neutral across the industry – some firms would need to hold more capital and some
would need to hold less capital, but overall capital requirements should be unchanged. Based
on this, and the time frame of the introduction of the test, we introduce the following two
indicator variables: Implementation Period – which takes the value 1 for the years 2003 and
2004 and zero otherwise – and Test Period – which takes the value 1 for years 2001 and 2002
and zero otherwise.
Using these variables we test the following hypotheses
CH1: After accounting for the risk characteristics discussed in Section 3.1, there is no
statistical change in the level of capital holdings over the time period 1990 to 2004.
CH2: After accounting for the risk characteristics discussed in Section 3.1, there is no
statistical difference in the level of capital holdings by firms held during the implementation
period and the test period.
4.1.1
Empirical Results
Using OLS regression, we regress surplus to NPW on the same risk characteristics as
given in Section 3.1, adding the indicator variables for the both the test and implementation time
periods. We are interested in whether or not the two indicator variables are significantly different
from zero, and significantly different from each other. Significant coefficients would indicate that
firms, across all risk characteristics, have altered their level of capital holdings in response to
the MCT. Regression results are presented in Table 4.
< Insert Table 4 about here >
We find evidence that, in fact, capital holdings per dollar premium written have increased
since the MCT came in to force. The indicator variable for the implementation period is positive
and significantly different from zero. The indicator variable for the test period, although positive,
is not statistically different from zero suggesting that firms did not change their capital holdings
during the test period then MCT scores were filed in parallel.
Using a Wald test, we examine the hypothesis CH2, and find that, despite the significance
of indicator variable for the implementation period, we cannot reject the hypothesis that there is
no difference between the indicator variables denoting the test and the implementation period.
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Determinants of Capital Holdings
We concede that it is possible that firms have systematically increased their capital holdings
in light of 9/11 and the hardening of the reinsurance market at this time. If this were the case,
then the observed results for CH1 and CH2 would not contradict this hypothesis. Thus we
introduce a post 9/11 indicator variable that takes the value 1 for the years 2001 to 2004, and
zero otherwise. When we regress the surplus to NPW ratio on the firm characteristics in Section
3.1, the implementation period indicator and the post 9/11 period indicator, we find that the post
9/11 variable is positive and significant and the implementation period indicator becomes
insignificant. Thus we cannot reject the hypothesis that the build up of capital in the Canadian
insurance industry has arisen from industry reaction to 9/11.
4.2
MCT and Risk Characteristics
In addition to the possibility that firms have increased their capital holdings in light of 9/11, it
is possible that firms hold greater capital since the introduction of the MCT because their risk
profile has changed since 2003. We introduce interaction terms to account for potential changes
in the risk characteristics given in Section 3.1 since 2003 and examine the following hypothesis.
MCT1: Changes in firms’ risk characteristics since 2003 are responsible for the increase in
capital held by insurers.
4.2.1
Empirical Results
To test MCT1, we regress surplus to NPW on the same risk characteristics as given in
Section 3.1, adding the indicator variable for the implementation time period and the interaction
effect variables for the implementation variable and all the risk characteristics. If this hypothesis
MCT1 is valid, we expect that the implementation period indicator would then become
insignificant, and some of the interaction effect coefficients to be significant. Regression results
are presented in Table 5.
< Insert Table 5 about here >
When the interaction effects are introduced, the coefficient representing the implementation
time period is insignificant, providing support to the hypothesis MCT1. We find that the risk
characteristics that were significant in the original regression in Section 3 are still significant in
this regression. That is firm risk, as measured by the standard deviation of the rate of return on
equity, firm size, the investment risk ratio, whether the firm is a Canadian insurer with no
additional resources and the amount of liability premiums written are the only significant
variables. At 5 percent significance, no interaction effects are significant. However the cross
effect of the Herfindahl index by region and implementation period is significant and negative at
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Determinants of Capital Holdings
a 10 percent level. Thus insurers that were less geographically diversified (higher index) had
lower capital holdings in 2003 and 2004 than in the previous years.
4.3
MCT, Asset and Liability Portfolio Risk
The key difference between the MCT and the MAT is the alignment of statutory capital to
the liabilities and assets of the insurer. Statutory holdings under the MAT were based on a firm’s
total written premiums, unearned premiums and loss reserves. Statutory capital holdings under
the MCT are related to a firm’s premium by line of business and to the types of assets that it
holds. In this section, we test whether or not historically capital holdings of insurers have been
aligned with their portfolios of liabilities and assets. On the liability side, following Section 3.1.4,
we hypothesize that:
PR1: Firms that underwrite more liability and automobile accident benefits coverages
hold greater amounts of surplus.
PR2: Firms that underwrite more first party automobile property damage (collision and
comprehensive) and personal property coverages hold lower amounts of surplus
The MCT recognizes that risk also arises from investing in risky assets. In particular the
MCT assigns risk loadings to different asset classes as given in Table 6.
<Insert Table 6 about here >
We look at the proportion of government bonds, commercial bonds, mortgage loans,
common and preferred shares in the portfolio of assets held by each insurer, and examine the
following hypotheses:12
PR3: The amount of surplus held by each insurer is unrelated to the proportion of the
insurer’s portfolio held in government bonds.
PR4: Insurers that hold more commercial bonds hold more surplus per dollar premium
written.
PR5: Insurers with a greater proportion of mortgage loans in their portfolio of assets
hold more capital.
PR6: Insurers with a large proportion of preferred shares in their portfolio of assets hold
more capital.
12
Risk categories under the MCT further separate out assets by maturity and grade. Reporting requirements for
insurers changed in 2003 with the introduction of the MCT. Prior to 2003, insurers did not report asset maturity and
grade.
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Determinants of Capital Holdings
PR7: Insurers with a greater proportion of common shares in their portfolio of assets
hold the most surplus per dollar premium written.
4.3.1
Empirical Results
Using OLS regression, we regress surplus to NPW on a firm’s liability and asset mix.
Because of its significance in earlier regressions, we include the explanatory variable firm size
in the regressions. Regression results are given in Table 7
<Insert Table 7 about here>
As expected, the size of the firm is negatively and significantly related to the surplus to
NPW ratio of the firm. On the product side, firms that underwrote more liability and accident
benefit coverages held more surplus. We find no significant relationship between the amount of
personal property and first party automobile physical damage written and the amount of surplus
held per premium dollar written.
On the asset side, firms that hold more government bonds (than cash) hold more surplus.
This is unexpected because the federal regulator assigns government bonds the same risk level
as holding cash. Thus if insurers were to do the same, the amount of surplus should not be
impacted by the amount of government bonds held. Firms that held more mortgage loans,
preferred shares and common shares (over cash) also held more surplus. This follows from the
design of the MCT – if these assets are considered more risky than holding cash, then firms
should hold more surplus to compensate for this risk.
Given the asset and liability mix of the firms, we find no evidence that firms altered the
amount of capital held after the introduction of the MCT – that is the coefficient for
implementation variable is not statistically different from zero. However several cross effects are
significant. We find that there is a significant and negative interaction effect between the
proportion of both mortgage loans and common shares held by the insurer and its surplus to
NPW ratio. The overall relationship between surplus to NPW and these two ratios is still positive
after 2003, but lower than the pre-2003 period.
We conjecture that perhaps historically insurers overestimated the risk associated with
holding common stock and mortgage loans. With the regulations introduced in 2003, firms were
better able to assess the risk of these assets and subsequently reduced their capital holdings
relative to their holdings of mortgage loans and common shares.
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Determinants of Capital Holdings
4.4
Discussion
This section examined the impact of the MCT on the level of capital holdings and firm risk.
We first find that, although capital holdings have increased in the industry since the introduction
of the MCT, we cannot separate out the effect of the regulatory changes from the impact of 9/11
and the subsequent market cycle on the capital holdings of insurers. We cannot reject the
hypotheses that changes in company risk also account for the increase in capital holdings since
2003. Quite simply, more years of data are required.
If the risk characteristics given in Section 3.1 indeed drive the risk of Canadian insurers, we
have no evidence that the MCT does a better job than the MAT of aligning firms risk with capital
holdings. Again, we conjecture that either the risk characteristics of Canadian insurers are
significantly different from their American counterparts, or the solvency requirements are too
high. Firms simply hold an amount of capital larger than the amount required by the solvency
requirements to reduce the possibility of increased regulatory oversight.
And finally, we look at the relationship between the composition of an insurer’s book of
business and investment portfolio and the amount of capital it holds. Overall, firms that hold
riskier assets and sell riskier insurance coverages hold more capital per premium dollar written.
5
CONCLUSIONS AND DIRECTIONS FOR FUTURE WORK
The relationships among capital holdings and risk factors that underpin the Canadian
property/casualty industry are greatly complicated and research to-date has done very little in
explaining them. We view this study as a step towards this direction. We hope that our results
will lead to a continued dialogue on capital holdings for property/casualty insurers in Canada
that will eventually enhance our understanding on the subject matter.
We first explore the relationship between capital holdings of property/casualty insurers in
Canada and a number of firm specific characteristics that measure the risk faced by insurance
companies. We find that some of the characteristics that have been found to be relevant
predictors of capital holdings of U.S explain about one-third of the variation in the amount of
capital held by Canadian insurers. Firm size is the most relevant predictor of capital holdings,
and the remaining characteristics explain very little variation in capital holdings. We conjecture
that either firms operate at a predetermined margin above the regulatory threshold and that the
regulatory regime is the major determinant of capital holdings or the U.S. and Canadian
insurance marketplaces are sufficiently different to the extent that the broad characteristics that
explain risk in the U.S. market do not capture the risk faced by Canadian insurers
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Determinants of Capital Holdings
We then examine the impact of the MCT on the surplus holdings of Canadian
property/casualty insurers. We find that capital holdings of Canadian insurers have increased
since the introduction of the MCT. However it is possible that this increase in surplus holdings is
a response to 9/11 and subsequent market changes. It is also possible that changes in each
insurer’s risk profile account for the increase in capital holdings since 2003.
We have no evidence that the MCT does a better job than the MAT of aligning firms risk
with capital holdings. As above, we conjecture that either the risk characteristics of Canadian
insurers are significantly different from their American counterparts, or the solvency
requirements are too high. And finally, we look at the relationship between the composition of an
insurer’s book of business and investment portfolio and the amount of capital it holds. Overall,
firms that hold riskier assets and sell riskier insurance coverages hold more capital per premium
dollar written.
Although unique in a Canadian setting, this study is only a first step in developing an
understanding of capital holdings of Canadian insurers. A longer time frame is needed to fully
assess the impact that the MCT has had on capital holdings. In order to assess whether or not
Canadian solvency requirements are truly “too high”, additional work could examine the
statutory capital requirements of other countries, particularly the U.K and U.S. requirements,
and compare them with Canadian requirements. Such work will form a foundation for future
research in the convergence of solvency requirements for property/casualty insurers and will be
of considerable importance since the movement towards international convergence of
supervisory oversight and capital standards in the banking industry will eventually be echoed in
property/casualty insurance markets within the next decade.
REFERENCES
Baker, J. (2005). Swimming in Capital Again. Canadian Underwriter 72(10): 40.
Carayannopoulos, P. and M. Kelly (2004). Determinants of Capital Holdings: Evidence from
the Canadian Property/casualty Insurance Industry. Journal of Insurance Regulation 23(2):4565.
Cummins, J.D. and G.P. Nini (2002). Optimal Capital Utilization by Financial Firms:
Evidence from the Property-Liability Insurance Industry. Journal of Financial Services Research
21: 15-53.
Insurance Bureau of Canada (2003). International Capital Requirements for the P&C
Insurance Industry: A Summary Report.
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Determinants of Capital Holdings
Jensen, M.C. and W. H. Meckling (1976). Theory of the Firm: Managerial Behaviour,
Agency Costs, and Ownership Structure. Journal of Financial Economics 3: 305-360.
Kovacs, P. (2002). Weighing in MCT. Canadian Underwriter 69(12): 24, 26.
Myers, S.C. and N.S. Majluf (1984). Corporate Financing and Investment Decisions when
Firms Have Information that Investors Do Not Have. Journal of Financial Economics 13: 187221.
Rogers, W. H. (1993). Regression Standard Errors In Clustered Samples. Stata Technical
Bulletin 13: 19–23. Reprinted in Stata Technical Bulletin Reprints 3: 88–94.
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Determinants of Capital Holdings
TABLES AND FIGURES
Table 1 – Summary Statistics of Insurer Data
Number of Canadian insurers without external capital resources
Number of mutual insurers
Surplus to NPW ratio
2 year underwriting ratio
Percentage of Liability & Auto AB to Total NPW
Percentage of Personal Property & Auto PD to Total NPW
Proportion of Investment Portfolio held as Government Bonds
Proportion of Investment Portfolio held as Commercial Bonds
Proportion of Investment Portfolio held as Preferred & Common Stocks
NPW (Cdn $1000)
Average
3.51
108.15%
34.78%
47.19%
68.37%
14.01%
11.59%
113,440
64
50
Median
0.93
105.50%
37.33%
48.21%
68.77%
10.54%
2.81%
32,753
Table 2 – Distribution of Surplus to NPW
Surplus to NPW
<0%
0 - 0.250
0.250 - 0.333
0.333 - 0.450
0.450 - 0.600
0.600 - 0.750
0.750 - 1.00
Number of Observations
5
38
86
287
385
215
218
Surplus to NPW
1.000 - 2.000
2.000 - 3.000
3.000 - 5.000
5.00 - 7.500
7.500 - 10.000
10.000 - 50.000
50.000 - 100.000
Preliminary Draft
Number of Observations
502
183
149
98
30
136
26
18
Determinants of Capital Holdings
Table 3 – Firm Risk and Capital Holdings of Insurers
Hypothesis
FD1
FD1
FD2
FD3 / PO1
FD4
FD5
FD6
FD7
AC1
AC2
PO2
PM1
PM2
Explanatory Variable
Herfindahl Index of Premiums Written by Region
Herfindahl Index of Premiums Written by Product
Line
Premiums Ceded as a Percentage of GPW
Standard Deviation Of ROR Over Past 5 Years
Firm Size (log NPW)
Indicator Variable – Canadian Insurer
Two Year Average Underwriting Ratio
Investment Risk Ratio
Unearned Premium Reserves + Loss Reserves
Net Incurred Losses
Indicator Variable – Mutual Insurer
2 Year Average Growth in NPW
Proportion of NPW from Liability and Accident
Benefits
Proportion of NPW from Auto Damage and
Personal Property
Expected
Relationship
+
Coefficient
0.405
+
-0.503
+
+
+
+
0.002
-0.014*
-2.561*
-3.197*
0.0063
0.010*
-
0.0029
+ or +
2.512
-0.015
+
0.738*
-
0.0025
R2
33.4%
*
Significant at 5% level
Table 4 – Impact of MCT on the Level of Capital Holdings
Explanatory Variable
Herfindahl Index of Premiums Written by Region
Herfindahl Index of Premiums Written by Product Line
Premiums Ceded as a Percentage of GPW
Standard Deviation Of ROR Over Past 5 Years
Firm Size (log NPW)
Indicator Variable – Canadian Insurer
Two Year Average Underwriting Ratio
Investment Risk Ratio
Unearned Premium Reserves + Loss Reserves
Net Incurred Losses
Indicator Variable – Mutual Insurer
2 Year Average Growth in NPW
Proportion of NPW from Liability and Accident Benefits
Proportion of NPW from Auto Damage and Personal Property
Test Period Indicator
Implementation Period Indicator
R2
*
Expected
Relationship
+
+
+
+
+
+
Coefficient
.0339
-0.551
0.0019
-0.0139*
-2.606*
-3.349*
0.0082
0.010*
-
0.0024
+ or +
+
0
0
2.533
-0.016
0.716*
0.0037
0.794
1.408*
33.7%
Significant at 5% level
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Determinants of Capital Holdings
Table 5 – MCT, Firm Risk and Capital Holdings of Insurers
Explanatory Variable
Expected
Relationship
+
+
+
+
+
+ or -
Coefficient
Herfindahl Index of Premiums Written by Region
0.414
Herfindahl Index of Premiums Written by Product Line
-0.349
Premiums Ceded as a Percentage of GPW
0.002
Standard Deviation Of ROR Over Past 5 Years
-0.138*
Firm Size (log NPW)
-2.660*
Indicator Variable – Canadian Insurer
-3.241*
Two Year Average Underwriting Ratio
0.010
Investment Risk Ratio
0.012*
Unearned Premium Reserves + Loss Reserves
0.0003
Net Incurred Losses
Indicator Variable – Mutual Insurer
+ or 2.936**
2 Year Average Growth in NPW
+
-0.0167
Proportion of NPW from Liability and Accident Benefits
+
0.797*
Proportion of NPW from Auto Damage and Personal Property
0.0041
Implementation Period Indicator
0
3.638
Interaction Effects of Implementation Indicator and Firm Characteristics
Herfindahl Index of Premiums Written by Region
+
-3.737**
Herfindahl Index of Premiums Written by Product Line
+
-2.296
Premiums Ceded as a Percentage of GPW
-0.0002
Standard Deviation Of ROR Over Past 5 Years
+
-0.268
Firm Size (log NPW)
0.2812
Indicator Variable – Canadian Insurer
+
0.875
Two Year Average Underwriting Ratio
+
-0.127
Investment Risk Ratio
+ or 0.009
Unearned Premium Reserves + Loss Reserves
0.166
Net Incurred Losses
Indicator Variable – Mutual Insurer
+ or -2.691
2 Year Average Growth in NPW
+
-0.0934
Proportion of NPW from Liability and Accident Benefits
+
-0.0341
Proportion of NPW from Auto Damage and Personal Property
0.0018
R2
34.6%
*
Significant at 5% level
**
Significant at 10% level
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Determinants of Capital Holdings
Table 6 – Asset Class and Reserves Held under MCT
Asset Class
Cash
Government Bonds
Commercial Bonds
Mortgage Loans
Preferred Shares
Common Shares
Percentage of Book Value held as Reserve
0%
0%
0.5% to 8% depending on maturity and grade.
4% to 8% depending on residential versus commercial
4% to 15% depending on grade of shares
15%
Table 7 – MCT, Lines of Business underwritten and Asset Portfolio Risk
Hypothesis
PR1
PR2
PR3
PR4
PR5
PR6
PR7
PR8
Explanatory Variable
Expected
Relationship
+
Coefficient
Firm Size
Proportion of NPW from Liability and Accident Benefits
Proportion of NPW from Auto Damage and Personal
Property
Proportion of Assets held as Government Bonds
0
Proportion of Assets held as Commercial Bonds
+
Proportion of Assets held as Mortgage Loans
+
Proportion of Assets held as Preferred Shares
+
Proportion of Assets held as Common Shares
+
Implementation Period Indicator
0
Interaction Effects of Implementation Indicator and Firm Characteristics
Firm Size
Proportion of NPW from Liability and Accident Benefits
Proportion of NPW from Auto Damage and Personal
Property
Proportion of Assets held as Government Bonds
Proportion of Assets held as Commercial Bonds
Proportion of Assets held as Mortgage Loans
Proportion of Assets held as Preferred Shares
Proportion of Assets held as Common Shares
R2
*
Significant at 5% level
Preliminary Draft
-2.833*
0.791*
-0.0025
0.1079*
-0.1036*
0.5730*
0.1363*
0.1165*
0.7936
0.7263
-0.04170
-0.00253
0.1079
-0.04687
-0.3175*
-0.0297
-0.0950*
33.3%
21
Determinants of Capital Holdings
APPENDIX 1
MAT TEST AND MTC CALCULATIONS
Minimum Asset Test (MAT)
The MAT is calculated as
excess of assets available over assets required
 100 . A firm
assets required for test purposes
must have a positive ratio to pass this test.
The assets available for test purposes are calculated using statutory accounting principles.
Available assets equal the total assets held by firm plus the excess of market over book value
less those assets non-admitted or otherwise not available. Non-admitted assets include such
assets excess investment in real estate, deferred policy acquisition expenses (i.e. amortizing
the cost of writing a policy over several years), and amounts that should be recovered from
other insurers but would not be if firm went bankrupt today.
Assets required for test purposes are calculated as total liabilities plus a required margin
less amounts recoverable from reinsurance. The required margin is the largest of the three
margins calculated below:

A margin on liabilities equal to
15%  unpaid claims & Loss Adjustment Expenses + unearned premiums+ self insured retention

A margin on written premiums (GPW) equal to
15% GPW +min(5% GPW, $500,000)  1-reinsurance ratio 

A margin on average gross incurred claims over the past three years (claims) equal to
22% claims +min(7% claims, $500,000)  1-reinsurance ratio  ,where
the reinsurance ratio is

Amount of these claims ceded 
defined as min  50%,
.
gross claims incurred over last year 

Minimum Capital Test (MCT)
The MAT (or DAT for foreign insurers) was replaced by the MCT (or BAAT for foreign
insurers) in 2003. The MCT applies risk based factors to calculate necessary reserves for all onbalance sheet assets, off balance sheet assets and liabilities. Assets are valued (to an extent) at
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Determinants of Capital Holdings
book value. The calculation of capital for claims incurred depends on the riskiness of the line of
business. And the margin required on unearned premiums is 8%.
The capital available is calculated as equity plus subordinated indebtedness and
redeemable preferred shares plus investments less adjustments to market less assets with a
capital requirement of 100%. This last term accounts for 100% of the decline in market values
from the original book values and 50% of the growth in market values from the original book
values of assets other than real estate. For real estate, 100% of the net decline in market values
from the original book values is used to lower the statutory capital available.
Also deducted from capital available are amounts such as investments in some subsidiaries
and affiliates, future income tax debits and goodwill and other intangible assets.
The minimum capital required is calculated based on the riskiness of balance sheet items,
unearned premiums and unpaid claims, catastrophe exposure, reinsurance ceded to
unregistered insurers and off-balance sheet exposures. The size of the margin that must be
held depends on the riskiness of the asset or liability. For example, for assets, no additional
capital must be held to cover the risk of cash and Canadian government bonds. Reserves worth
0.5% of book value must be held on investment grade bonds. And reserves of 15% must be
held on common shares, real estate and below investment grade preferred shares.
The margin required on unpaid claims depends on the line of business – with more variable
lines of business requiring greater risk based capital. The margin required varies between 5%
(commercial and personal property and first party automobile insurance property damage) to
15% (liability, marine, etc.)
The catastrophe risk margin is 100% of net premiums written for nuclear risk. Earthquake
coverage depends on the company’s exposure in earthquake zones.
Amounts that must be held to cover the risk of unregistered reinsurers depend on amount
of premiums ceded and the expected losses payable by the reinsurer.
Off-balance sheet items that may require capital margins include structure settlements,
letters of credit, derivatives and repurchase agreements. The factor that must be applied ranges
from 0% to 100% depending on the maturity, cancelability, and credit rating of the exposure.
In addition to OSFI requirements that insurers set target ratios of capital available / capital
required between 170% and 210%, provinces may also set targets for insurers which operate
within that province. For example, in Ontario, the provincial regulator
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Determinants of Capital Holdings
…expects each insurer to establish a target capital level, and maintain ongoing
capital, at no less than the supervisory target of 150% MCT. This expectation is
similar to the Office of the Superintendent of Financial Institutions (OSFI)'s. FSCO
expects that each insurer will establish a target capital level that provides an excess
above minimum requirements, in order to cope with volatility in markets and
economic conditions, innovations in the industry, consolidation trends and
international developments, as well as to provide for risks not explicitly addressed in
the calculation of policy liabilities or the MCT. Also, FSCO may, on a case-by-case
basis, establish in consultation with an insurer an alternative supervisory target level
based upon that individual insurer's risk profile.13
13
http://www.ontarioinsurance.com/english/insurance/mincapitaltest.asp accessed January 2006.
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