Revised Educational Note Dynamic Capital Adequacy Testing Committee on Risk Management and Capital Requirements November 2013 Document 213077 Ce document est disponible en français © 2013 Canadian Institute of Actuaries Members should be familiar with educational notes. Educational notes describe but do not recommend practice in illustrative situations. They do not constitute Standards of Practice and are, therefore, not binding. They are, however, intended to illustrate the application (but not necessarily the only application) of the Standards of Practice, so there should be no conflict between them. They are intended to assist actuaries in applying Standards of Practice in respect of specific matters. Responsibility for the manner of application of Standards of Practice in specific circumstances remains that of the members. Memorandum To: All Members in the Life and Property and Casualty Practice Areas From: Bruce Langstroth, Chair Practice Council Robert Berendsen, Chair Committee on Risk Management and Capital Requirements Date: November 13, 2013 Subject: Revised Educational Note—Dynamic Capital Adequacy Testing The Canadian Institute of Actuaries published its last educational note on Dynamic Capital Adequacy Testing (DCAT) in November 2007. The purpose of this update is primarily to ensure consistency with the November 2011 revision to the Standard of Practice – Dynamic Capital Adequacy Testing – Section 2500. In addition, some new guidance was provided in the reporting section. This educational note has been prepared by the Committee on Risk Management and Capital Requirements in accordance with the Institute’s Policy on Due Process for the Approval of Guidance Material Other than Standards of Practice, and received final approval for distribution from the Practice Council on June 24, 2013. As outlined in subsection 1220 of the Standards of Practice, “The actuary should be familiar with relevant Educational Notes and other designated educational material.” That subsection explains further that a “practice that the Educational Notes describe for a situation is not necessarily the only accepted practice for that situation and is not necessarily accepted actuarial practice for a different situation.” As well, “Educational Notes are intended to illustrate the application (but not necessarily the only application) of the standards, so there should be no conflict between them.” Questions or comments regarding this educational note may be directed to Robert Berendsen at [email protected]. BL, RB 360 Albert Street, Suite 1740, Ottawa ON K1R 7X7  613-236-8196  613-233-4552 [email protected] / [email protected] cia-ica.ca Educational Note November 2013 TABLE OF CONTENTS 1. Introduction ................................................................................................................................ 3 2. Method ....................................................................................................................................... 6 3. Modelling ................................................................................................................................. 13 4. Reporting .................................................................................................................................. 16 Appendix A: Discussion and Analysis of Life Insurer Risk Categories ....................................... 21 Appendix B: Discussion and Analysis of Property & Casualty Insurer Risk Categories ............. 34 3 Educational Note November 2013 1. INTRODUCTION The primary purpose of this document is to provide guidance and support to actuaries of life and property and casualty (P&C) insurers in performing Dynamic Capital Adequacy Testing (DCAT) analyses in accordance with the Standards of Practice – Practice Specific-Standards for Insurers, Section 2500, Dynamic Capital Adequacy Testing. It replaces the November 2007 educational note on Dynamic Capital Adequacy Testing – Life and Property and Casualty. According to subsection 2520 of the Standards of Practice: .01 The appointed actuary should make an investigation at least once during each financial year of the insurer’s recent and current financial position, and financial condition, as revealed by dynamic capital adequacy testing for selected scenarios. .02 The appointed actuary should make a report of each investigation in writing to the insurer’s board of directors (or to their audit committee if they so delegate) or chief agent for Canada. The report should identify possible actions for dealing with any threats to satisfactory financial condition that the investigation reveals. .03 The appointed actuary should also make an interim investigation if there is a material adverse change in the insurer’s circumstances. .04 The appointed actuary should ensure that the investigation is current. The investigation should take into consideration recent events and recent financial operating results of the insurer. [Effective December 31, 2011] .05 The actuary’s investigations would be done with a frequency sufficient to support timely corrective actions by management and the board of directors or chief agent for Canada. DCAT is one of a number of stress-testing processes that would fit within the insurer’s overall risk management process. Stress testing includes scenario testing and sensitivity testing (refer to the glossary in OSFI Guideline E-18 – Stress Testing, or to L’Autorité des marchés financiers (AMF) Stress Testing Guideline, for definitions). Stress testing has the following goals: 1. Risk identification and control—stress testing may be included in an institution’s risk management activities at various levels, for example, ranging from risk mitigation policies at a detailed or portfolio level to adjusting the institution’s business strategy. In particular, it would be used to address institution-wide risks, and consider the concentrations and interactions between risks in stress environments that might otherwise be overlooked. 2. Providing a complementary risk perspective to other risk management tools—stress tests would complement risk quantification methodologies that are based on complex, quantitative models using historical data and estimated statistical relationships. In particular, stress-testing outcomes for a particular portfolio can provide insights about the validity of statistical models at high confidence intervals; for example, those used to determine VaR. As stress testing allows for the simulation of shocks that have not previously occurred, it would be used to assess models’ robustness to possible changes in the economic and financial environment. Stress tests can help to detect vulnerabilities such as unidentified risk concentrations or potential interactions between types of risk that could threaten the viability of the institution, but may be concealed when relying purely on statistical risk 4 Educational Note November 2013 management tools based on historical data. Stress testing can also be used to assess the impacts of customer behavior arising from options embedded in certain products—particularly where the behaviour in extreme events is not well understood. 3. Supporting capital management—stress testing would form an integral part of institutions’ internal capital management where rigorous, forward-looking stress testing can identify severe events, including a series of compounding events, or changes in market conditions that could adversely impact the financial health of the institution. 4. Improving liquidity management—stress testing would be a central tool in identifying, measuring, and controlling funding liquidity risks, in particular for assessing the institution’s liquidity profile and the adequacy of liquidity buffers in case of both institution-specific and market-wide stress events. The DCAT process allows the Appointed Actuary to inform the insurer’s management about the implications that the business plan has on capital and to provide guidance on the significant risks to which the insurer will be exposed. The DCAT process would be viewed as an integral part of the company’s risk management process, not merely as a compliance exercise. The DCAT report would be a result of a regular stress-testing framework. As such, the DCAT can be used by insurers to help set internal target capital ratios (as per the Office of the Superintendent of Financial Institutions’ Guideline A-4, Regulatory and Internal Target Capital Ratios, or as part of the Autorité des Marchés Financiers’ Capital Adequacy Requirements Guideline). In turn, internal target capital ratios developed in accordance with these guidelines would also be considered when preparing the DCAT report. It is essential that the board of directors and senior management are involved in the determination of the stress scenarios and understand the key findings of the stress tests. They would use these findings to develop and implement risk mitigation strategies. Risk concentration would be considered throughout the stress-testing process. Comprehensive stress-testing programs would consider the company’s most material and significant risks (see appendices A and B). DCAT has the following key elements: • Development of a base scenario; • Analysis of the impact of plausible adverse scenarios; • Identification and analysis of the effectiveness of various corrective management actions to mitigate risks; • A report on the results of the analysis and recommendations to the insurer’s management and the board of directors or chief agent; and • An opinion signed by the Appointed Actuary and included in the report on the financial condition of the insurer. The principal goal of this process is the identification of possible threats to the financial condition of the insurer and appropriate risk management or corrective actions to address those threats. The process arms the insurer with useful information on the course of events that may lead to capital depletion and the relative effectiveness of alternative corrective management 5 Educational Note November 2013 actions, if necessary. Furthermore, knowing the sources of threat, it may be advisable to strengthen the monitoring systems where the insurer is most vulnerable. The subsequent sections of this document cover the following: • Method—this section provides guidance on the DCAT process, forecast period, and approaches to developing the base scenario and adverse scenarios, including ripple effects and integrated scenarios; • Modelling—this section identifies key elements to be considered in building a DCAT model used to project the financial results under the base scenario and the adverse scenarios; • Reporting—this section provides guidance on the key elements to be considered in reporting the results of DCAT, along with an outline of a typical report; and • Appendices—Discussion and Analysis of Life Insurer Risk Categories, and Discussion and Analysis of Property and Casualty Insurer Risk Categories. 2. METHOD Process As described in subsection 2520 of the Standards of Practice, the DCAT process is to include: • Reviewing the recent and current financial position of the insurer; • Running a base scenario and several adverse scenarios; and • Reporting the results of the analysis, including details on at least three adverse scenarios. It is fundamental to this process, and to the proper interpretation of the results, to understand that the projected capital position under various scenarios may well become inadequate during the forecast period, especially if the insurer’s corrective management actions have not been assumed to be implemented on a timely basis as results emerge. This is not in itself an indication of current or anticipated difficulties. It is the specific degree and timing of capital depletion that indicate the risks to which the insurer is particularly sensitive. This, together with the results under the base scenario, would guide the insurer as to the necessity of revising the business plan, or preparing for contingencies. To perform the DCAT, it is necessary to have an understanding of the minimum regulatory and supervisory target capital requirements. It is recommended that the Appointed Actuary verify the current regulatory requirements for his or her own company’s situation. Appendices A and B to this educational note provide additional details on the risk categories to be considered in developing the adverse scenarios. The risk areas posing most significant threats would be examined in detail, including ripple effects. Considering the role of the Appointed Actuary as defined in the Standards of Practice, the process to be followed in carrying out this analysis would generally be similar from one insurer to another, with some degree of uniformity in the standard of plausibility of scenarios and approaches taken towards testing. Approach A typical approach would include the following steps: 6 Educational Note November 2013 • Review of operations for the recent years (normally at least three years) and of the financial position at the end of each of them. • Development and modelling of the base scenario for the forecast period—as stated in the standards of practice, this would normally, but not always, be consistent with the insurer’s business plan. • Assessment of the risk categories and identification of those that are relevant to the insurer’s circumstances. Some risk categories may not be relevant and would need no analysis whatsoever. Sensitivity testing may be used to determine the relevant risk categories for the company. • Selection of plausible adverse scenarios requiring further analysis from the relevant risk categories:  Development and modelling of the plausible adverse scenarios that are likely to significantly impact surplus. The scenarios may be single-risk scenarios or integrated scenarios resulting from a combination of single-risk scenarios. The stress tests would apply across business and product lines and cover a range of scenarios, including non-historical scenarios. Sensitivity testing or stress testing may be used to determine the adverse scenarios.  Identification and modelling of associated system-wide interactions and feedback effects (ripple or second-order effects and macroeconomic effects) caused by a change in assumptions triggered by an adverse scenario.  Consideration of stress-testing the adverse scenarios. Reverse stress testing means a determination of just how far the risk factor(s) in question has to be changed in order to drive the insurer’s surplus to negative during the forecast period, and perhaps evaluating if that degree of change is plausible. This type of testing may be useful in understanding interactions among risks and discovering hidden risks. Depending on the insurer’s circumstances, the board of directors or chief agent and management may also be interested in situations that cross other break points, in which case further stress testing may be beneficial. • Selection of at least three scenarios, from those modelled, showing the greatest surplus sensitivity for inclusion in the DCAT report. In addition, any modelled scenario that causes the insurer to fall below the supervisory target capital level during the forecast period would be subject to reporting. • Identification of possible corrective management actions and the impact of these on the insurer’s financial condition for each scenario included in the report. This identification process would facilitate the development of risk mitigation and contingency plans. Any possible constraints on corrective management actions would be taken into account. • Identification of possible regulatory actions for each scenario that causes the insurer to fall below the supervisory target capital requirement. For best practices purposes, it would be preferable also to identify possible regulatory actions that may be triggered as a result of falling below any other thresholds set by the regulator(s). The regulator might ask for other DCAT analyses to be conducted, including additional adverse scenarios and longer forecast periods. Recent and Current Financial Position Paragraph 2520.06 of the Standards of Practice states: 7 Educational Note November 2013 The investigation would review operations of recent years (normally at least three years) and the financial position at the end of each of those years. The review would include the statement of income and source of earnings (if available) for each year and the financial position at the end of each year, including the balance sheet and the results of the applicable regulatory tests of capital adequacy. The Appointed Actuary would analyze recent trends in these statements and would investigate the circumstances and key factors contributing to those trends. It is important for the Appointed Actuary to be aware of the reasons underlying any such recent trends. Forecast Period Paragraph 2520.16 of the Standards of Practice states: The forecast period would begin at the most recent available fiscal year-end balance sheet date. The forecast period for a scenario would be sufficiently long to capture the effect of its adversity and the ability of management to react. The forecast period for a typical life insurer would not be less than five fiscal years. The forecast period for a typical property and casualty insurer would not be less than three fiscal years. As stated in the Standards of Practice, for some adverse scenarios, it may be necessary to use a longer forecast period than the typical one suggested therein, in order to measure properly the full effect, including the ripple effects, of an adverse scenario on the financial condition of an insurer. Materiality Standard The standard of materiality would usually be less rigorous than that used for valuation of the insurer’s policy liabilities and, if practical, the Appointed Actuary would discuss it with the insurer’s management. In selecting a materiality standard, the Appointed Actuary would also give consideration to: • The size of the company. • The financial position of the company. The standard of materiality would become more rigorous in examining a base scenario where capital adequacy is closer to the target regulatory requirement. • The nature of the regulatory test. For example, if the regulatory test is measuring required capital, the materiality standard might be expressed as a percentage of the required capital. For more guidance on materiality, refer to paragraph 1340.04 of the Standards of Practice. Base Scenario According to paragraph 2520.18 of the Standards of Practice: The base scenario would be a realistic set of assumptions used to forecast the insurer’s financial position over the forecast period. Normally, the base scenario would be consistent with the insurer’s business plan. The actuary would accept the business plan’s assumptions for use in the base scenario unless these assumptions are so inconsistent or unrealistic that the resulting report would be misleading. The actuary would report any material inconsistency between the base scenario and the business plan. 8 Educational Note November 2013 The above standard does not necessarily imply that the projected financial results and future financial positions would be identical to the projections prepared at the time the insurer’s business plan was approved. Typically, there is a difference between the timing of the starting balance sheet date for the DCAT analysis and the timing when the business plan was approved. During this time, events may have occurred that lead to definitive changes in assumptions including any ripple effects. As was stated above, the projection of the future financial condition would reflect any material change that has occurred during this time, particularly if the DCAT analysis is done later in the year. Another possibility is that differences in opinion have emerged that lead to different base scenario assumptions from those in the business plan. The report would differentiate between factual changes and subjective changes between the base scenario and the business plan. The projected financial results and future financial positions under the base scenario may continue to be consistent with the business plan while still recognizing: • Distribution assumptions that differ from those expected in the business plan; • Recent management decisions that may have not been anticipated or discussed in the business plan; • Changes in the capitalization of the insurer not expected in the business plan; and • The impact on future experience, where appropriate, due to actual recent experience, assumptions, or decisions as described above. It is expected that significant deviations from assumptions in the business plan approved by the directors, as well as significant deviations in the results for the forecast period, would be documented in the report. Where differences in the base scenario are not due to a recent reforecast of the business plan, the Appointed Actuary would run the business plan as an additional scenario to ascertain the deviations in the results and would explain the rationale for the changes. There will be some situations where capital injections are a basic part of an insurer’s business plan. A simple example is when the business plan calls for an insurer to grow quickly with capital injections to support this growth. Another example is the case of an insurer that is intending a major initiative in a new sphere of operations, and is intending to raise capital externally in support of that venture. The Appointed Actuary would still be able to sign the usual DCAT opinion, even though the business plan and the DCAT base scenario call for capital injections, if the Appointed Actuary is satisfied that any such capital injections are the intent of the entity making the injection, and has no reason to believe that such injections are not within the means of that entity. In order to avoid presenting misleading results, clear reporting of assumptions made regarding capital injections is essential. Plausible Adverse Scenarios According to paragraphs 2520.19 and 2520.20 of the Standards of Practice: A plausible adverse scenario would be a scenario of adverse, but plausible, assumptions about matters to which the insurer’s financial condition is sensitive. Plausible adverse scenarios vary among insurers and may vary over time for a particular insurer. and 9 Educational Note November 2013 The actuary would consider material, plausible risks or events to the insurer. Reverse stress testing can help assess whether certain risk factors need to be tested, on the grounds that certain risk factors could never deteriorate to the point where it would be a threat to the insurer’s financial condition. The actuary can thereby determine whether a material, plausible risk or event exists for the insurer over the forecast period. Appendices A and B list and describe in detail the most common risk categories for life and P&C insurers respectively. Paragraphs 2520.21 and 2520.22 of the Standards of Practice state that “the actuary would consider threats to capital adequacy under plausible adverse scenarios that include, but are not limited to, the risk categories” that are listed in the appendices. The Appointed Actuary would consider whether the circumstances of the insurer result in the need to examine other risk categories. For relevant risk categories, the Appointed Actuary would select one or more plausible adverse scenarios to be modelled. When stochastic models with reasonable predictability are available, an adverse scenario would be considered plausible if it reflects the 95th to 99th percentile of outcomes. Generally, a 95th percentile or greater result would be required for a scenario to be deemed adverse, but less than or equal to a 99th percentile for the scenario to be deemed plausible. However, in some circumstances the Appointed Actuary may feel it is appropriate to examine higher percentile outcomes. For risks where no stochastic models with predictive capabilities are available, the Appointed Actuary would consider the variability in historical results and credibility of data, among other things, in selecting plausible adverse scenarios. It is expected that each of the adverse scenarios selected would be in the range of a 95th to 99th percentile outcome. An alternative approach for selecting adverse scenarios is reverse stress testing. This involves, first, determining how far the risk factor(s) in question has to be changed in order to drive the insurer’s surplus negative during the forecast period, and then evaluating whether that degree of change is plausible. Likewise, the Appointed Actuary may adjust the level of the risk factor to get a scenario result that is in the 95th to 99th percentile range. Depending on the insurer’s circumstances, the board of directors or chief agent and management may also be interested in scenarios that cross other break points, in which case further stress testing may be beneficial. Any differences between the business plan and the base scenario would, typically, also affect all adverse scenarios. The adverse scenarios would build on the assumptions and actual experience that is already reflected in the base scenario, particularly if the base scenario already reflects some adverse conditions that have been experienced during the first part of the year. If the base scenario does not reflect adverse experience already seen (because this is projected to improve in the future), the adverse scenarios would not be more favorable than the actual adverse impact already experienced by the insurer. The Appointed Actuary would select three or more adverse scenarios from those modelled, showing the greatest surplus sensitivity to be examined in further detail, including more detailed reflection of the associated ripple effects. Any modelled scenario that causes the insurer to fall below the supervisory target capital level during the forecast period would be subject to further examination and reporting. Depending on insurer circumstances, it may be beneficial to also examine any adverse scenario from those modelled that puts the insurer very close to the supervisory target capital level. Again, the stress testing approach, but now taking fuller account of ripple effects, may be used to assess sensitivity. 10