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54th Annual Canadian Reinsurance Conference

Breakout Session #5

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Session DescriptionThere is a global “tsunami” of change in regulation and supervisory frameworks and standards for all financial institutions that will greatly influence future capital standards for the Canadian life insurance industry. Many driving forces are contributing to a new paradigm of dramatically increasing challenges in capital planning and pricing for capital requirements. The panel will outline emerging developments in regulation and supervision affecting future capital standards in Canada as well as internationally, give a regulator's view for the necessity for and benefits of this revolution and give a reinsurer's view on how this revolution will impact capital planning and reinsurance pricing and capacity.

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Driving Forces & Emerging Developments

Regulator’s View of Necessity & Benefits of this REvolution

Reinsurer’s View of Impact on Capital Planning, Pricing & Capacity

Questions

Agenda Item Panel

Steven W. EassonCLHIA

Bernard DupontOSFI

Bernard NaumannMunich Re

All

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Steven W. EassonCLHIA

Driving Forces & Emerging Developments

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Driving Forces

Member of G20

Member of FSB

International Convergence

Financial Crisis G20 / Finance Ministers /Financial Stability Board (FSB)

Global comparability

G20 / Finance Ministers / FSB

Trend to more risk-based/principles based standards

Global Convergence (a la Basel) Territories and Sectors

IAIS Adherence/Cooperation

Advances in actuarial and capital theory; increased complexity and globalization of products

Improve risk sensitivity

FinancialReporting

Capital

International Canada

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Emerging Developments

IFRS mandated in April 2008 Adopted pre-crisis

“Phase 1”: 2011

“Phase 2”: 2013+

International Financial Reporting Standards (“IFRS”)

IASB/FASB joint project

IAIS Papers

Solvency II

NAIC

Basel “III”

Life Insurer Solvency AssessmentFramework (next generation to replace MCCSR)

“Solo”/“Holdco” capital, Stress Tests “Reinsurance Response Paper”

FinancialReporting

Capital

International Canada

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International – Financial Reporting 2008 Financial Crisis – G20 meetings

Washington, London, Pittsburgh, Toronto (June 2010) Washington Declaration: Finance Ministers to implement principles for reform

Create high quality accounting standards Basis of loan loss provisions to improve

IASB’s International Financial Reporting Standards Insurance Contracts – IASB committed to finalize June 2011 Other Standards of interest

Financial Instruments (IFRS 9); IAS37; Credit Risk; Fair Value

IASB/FASB joint project Commitment to achieve convergence, but the Boards at times disagree on standards and will convergence happen “on plan”?

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International - Capital International Association of Insurance Supervisors (“IAIS”) Papers

Insurance Core Principles Standards Guidance Papers Target date for revised ICP’s – October 2011

Group Supervision – “Supervisory Colleges” Group vs. Solo Capital requirements Common Assessment Framework (“ComFrame”) for Internationally Active

Insurance Groups

Solvency II Total Minimum and Target Capital Requirement “Market consistent” valuation of assets and liabilities Not just better risk based Capital Standards – Supervision just as important “Third Country Equivalence” – Reinsurance Supervision

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International – Capital (continued) NAIC

Solvency Modernization Initiative (“SMI”) Reinsurance Regulatory Modernization Act of 2009

FSB “Basel III” (Dec ’09 Draft)

Revisions to definitions of “Tier” capital and liquidity standards Tier 1 – emphasis on common equity and retained earnings

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Canadian – Financial Reporting AcSB declared adoption of IFRS in April 2008

i.e. pre-crisis and pre-G20 declaration.

“Phase I”: 2011 Canadian Asset Liability Method (“CALM”) continues to qualify under IFRS4 “Gross” Accounting for Reinsurance

“Phase II” : 2013 or Later Insurance Contracts Exposure Draft – will be released in June 2010? Discount Rate - Huge Issue

Basis still uncertain “De-linking” of asset and liability valuations Insurance Contract Policy liabilities – potential dramatic increases Earnings volatility – potential dramatic increases

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Canadian - Capital “ Life Insurer Solvency Assessment”

More risk based than MCCSR Total Minimum and Target Asset Requirement Standard Factor Approach; Internal Models Approach TBSR = “IFRS liabilities” plus Solvency Buffer

Solo/Holdco capital standards; Stress Tests

Reinsurance Response Paper More “principles” based “Expanded and reinstituted” Guideline B3 – to be released soon

Consolidation of Revoked Guideline B3 (Unregistered Reinsurance) Draft Guideline B3 (Sound Reinsurance Practices and Procedures) Draft Guideline B13 (Reinsurance Agreements)

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Bernard DupontOSFI

Regulator’s View of Necessity & Benefits of this REvolution

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Overview

• Pressure from everywhere to redesign capital requirements

• Vision of Future Framework: allowing the use of internal models for determining regulatory capital

• MCCSR standardized approach: redesign the test to use more risk-based techniques

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Driving Forces

Financial crisis• Lessons learned:

– Capital requirements do not always react as expected

– Lack of willingness to test and report on difficult situations

– Events are linked together more than we think

• Lower the guard in the long run?

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Driving Forces

International Developments

• IAIS – Bring convergence to various jurisdictions’

requirements• But high level requirements only

– Common Assessment Framework for insurers– Will we be forced to adopt these

requirements?

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Driving Forces

• Solvency II– European capital test, greatly improving

supervisory rules

• Basel II– Allows the use of internal ratings for capital

purposes, as they provide an incentive for better management and understanding of the risks

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Driving Forces

• IFRS and CIA standards– Convergence of accounting rules

• Solvency Modernisation Initiative (USA)

• Awareness and more sophisticated valuation techniques available

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Vision of Future Framework

• A minimum capital requirement, based on a standardised approach, will apply to all companies in Canada

• Standardized approach likely to be similar to current MCSSR methodology

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Vision of Future Framework

• For companies meeting minimum criteria set by OSFI, the target capital requirement will be based on internal models (one risk at a time)– Subject to limits on possible annual reduction– Based on a Total Asset Requirement basis

• For others, the target capital requirement will be based on a standardised approach

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Vision of Future Framework

• Companies will need to demonstrate their compliance with OSFI’s requirements– Criteria for the use of models in development– 3 years of parallel runs– No diversification between risks

• Reporting and disclosure requirements will need to be in place

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Vision of Future Framework

• First risks being looked at for life insurers:– Market risk– Credit Risk

• Earliest expected implementation date:– 2014/2015

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Implementation of IFRS

General principles:

- Reduce MCCSR modifications to a minimum until phase II

- When the company is given the option to retain the current accounting methodology, retain current MCCSR treatment.

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Implementation of IFRS

• Allow IFRS valuations using IAS 39 for non-insurance contracts and non-insurance components bifurcated from insurance contracts into capital

• Own-use Property:– Unrealized revaluation gains and losses will not be

included in capital.– Impact at time of adoption of fair value and valuations

changes going forward will both be excluded from regulatory capital.

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Implementation of IFRS

• Investment Property:– OSFI will require that any fair value gains or losses

upon transition and subsequent revaluation gains and losses be recognized in regulatory capital.

• Phase-in period of 2 years for most insurers

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MCCSR Standardized Approach• Standardized Approach Working Group created: participants:

OSFI, AMF, Assuris• Start modifying existing MCCSR elements that will be most

impacted by IFRS Phase II– Market and credit risk: Reserves will no longer contain

provisions to cover potential losses– Market risk: Companies required to remeasure capital

under shocks applied to interest rates and other market risk factors

– Credit risk: More refined factors, derived from Basel IRB model, based on rating and time to maturity

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MCCSR Standardized Approach

• Calibrate the elements once the results from QIS are available

• Recalibrate the elements once the results from modelling are available

• Modifications expected to be in place for 2012 or 2013

• Work on other MCCSR elements after phase II developments if necessary

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Mortality Improvement

• CIA Standard expected to be in place in 2011 allowing mortality improvement to be taken into account

• OSFI will reverse the impact on capital until the capital requirements have been assessed appropriately, likely including a QIS in 2010

• New capital requirement might be in place in 2012

• Overall review of mortality requirements after IFRS Phase II

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Reinsurance Counterparty Risk

• Reinsurance rules being changed to better reflect risks of counterparties and collateral– Need to ensure rules are consistent with those for

other types of credit risk

• Credit risk factors to be applied to reinsurance recoverables from registered reinsurers

• Credit risk charge for collateral used in unregistered reinsurance to be included in ceding company’s capital required

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Implementation Challenges

• Many moving targets being chased at the same time

• Limited amount of resources to deal with these issues

• Increase complexity of products and valuation techniques

• Impact and priorities different for the various stakeholders

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Bernard NaumannMunich Re

Reinsurer’s View of Impact on Capital Planning, Pricing and Capacity

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Required MCCSR Capital (2009)

37%

31%

17%

15%

Insurer Required Capital

Asset Default

Insurance

C-3

Seg Funds

Source: OSFI

14%

86%

Reinsurer Required Capital

Asset Default + C3 + Seg FundsInsurance

How Does Capital Affect Pricing?

• After-Tax Internal Rate of Return (AT IRR) used as Primary Pricing Measure– 10 out of top 10 companies use AT IRR– 6 out of top 10 companies target >=15% AT

IRR– 10 out of top 10 use Canadian CGAAP

Reserves and MCCSR as the capital base in AT IRR calculation

Source: Munich Re’s 2010 Individual Insurance Survey

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Mortality Improvement Assumptions

Expected Insurer / Reinsurer Effect

Reserves Decrease

Capital Increase (set to offset Reserve decrease)

Price Pressure Minimal expected in short term

Comments •After Tax IRR takes into account Capital + Reserves•Net effect on Price Pressure depends how offset is taken into account (tax effected)•OSFI will likely revisit in 2012+

The Actuarial Standards Board has drafted a change to its Standards of Practice to allow mortality improvement assumptions in policy liabilities. This Standard is expected to become effective in 2011.

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Reinsurance Counterparty Risk

Expected Insurer Effect Expected Reinsurer Effect

Reserves No effect No effect

Capital Increase (<1%) Increase (<<1%)

Price Pressure Increase (<<1%) Increase (<<<1%)

Comments •Could solidify a ‘flight to quality’ with the higher rated reinsurers•Minimal effect on reinsurer pricing or capacity

In 2012+, a reinsurance counterparty charge will be implemented for the Life Sector.•The C-1 factor will be applied against ceded reserves and recoverables

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IFRS Phase I Changes

Expected Insurer/Reinsurer Effect

Reserves None

Capital Available capital to decrease e.g. due to increased pension plan liabilities

Price Pressure Minimal

Comments •Despite Gross Accounting of Reinsurance, MCCSR will continue to apply factors on a net basis•Pension plan liabilities increase may be significant

The following changes will be implemented in 2011:•Gross Accounting of Reinsurance•Other (e.g. Full Recognition of Pension Plan Deficits)

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IFRS Phase II Changes

The following changes to be implemented in 2013+:•Removal of CALM – Liabilities and Assets de-linked

Expected Insurer Effect Expected Reinsurer Effect

Reserves Increase Increase; although not as significant as Insurers

Capital Avail capital to decrease Avail capital to decrease

Price Pressure Increase on long-tailed business

Increase on coinsurance business; Minimal on YRT

Comments •Methodology is unknown•Canada is only country where stat res = GAAP res•Expected volatile reserve results = volatile avail cap.•Pressure to move away from long-tailed business

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Solvency II

Expected Foreign Insurer/Reinsurer Effect

Reserves None

Capital Increase on long-tailed business

Price Pressure Increase on long-tailed business

Comments •Pro-cyclicality an issue•Given reinsurers write primarily YRT business, the discounting effect is not as significant as coinsurance•Solvency II seen as a ‘catch-up’ to MCCSR – level international playing field?

Solvency II is not officially planned to be adopted by OSFI•However, for those companies with European parents, Solvency II could be used as a capital base in IRR calculations

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Reinsurance Response Paper

Expected Insurer/Reinsurer Effect

Reserves None (unless B-3 not followed!)

Capital None (unless B-3 not followed!)

Price Pressure None

Comments •B-3 must be followed to receive credit•B-3 to be released in 2010•Increased due diligence on reinsurance usage

The following changes are expected to be implemented in 2010:•Repeal 25% unregistered reinsurance limit (P&C Only)•Repeal 75% fronting limit (P&C Only)•Reinsurance Governance (Guideline on Corp Governance, B-3, B13 “New B-3” Guideline on Sound Reinsurance Practices and Procedures)

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Reinsurance Capacity Speculation

Increased Reinsurance Capacity Decreased Reinsurance Capacity

IFRS II implementation may lead to more capital infused into Canada through reinsurance

Increased price pressure may reduce reinsurance demand

Solvency II may entice other reinsurers to enter Canada

Increased risk management may reduce reinsurance demand

Difficult to say – many moving pieces!

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Reinsurance Pricing Summary

Overall, minimal reinsurance pricing impact for YRT deals.

IFRS II potentially resulting in higher coinsurance terms

2012+ is key due to IFRS II and OSFI’s view on Mortality Improvement in MCCSR

B-3 Implementation is key!

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