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Insurers should use more realistic capital stress tests: OSFI


October 1, 2007   by Canadian Underwriter


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Insurers will have to do much more realistic, believable capital stress testing in the wake of the damage done to Canadas asset-based commercial paper market, Canadas federal insurance regulator says.
Canadas Superintendent of Financial Institutions, Julie Dickson, talked about the effects of the collapse of the U.S. subprime mortgage market earlier this year in her speech to about 300 people attending the National Insurance Conference in Montreal.
The U.S. subprime mortgage collapse has squeezed Canadas asset-based commercial paper market. Dickson acknowledged the asset-based commercial paper market is only marginally related to the activities of insurance companies, but the insurance industry will nevertheless feel the effects in the form of more rigorous capital stress testing required as a result of recent scandals in that market.
While the P&C industry has not been directly affected by what [has happened] in the commercial paper market you may think its irrelevant but there are some lessons to be learned here, Dickson said.
Specifically, insurers can expect the Office of Superintendent of Financial Institutions (OSFI) to focus on gauging the financial strength of institutions, because thats our job, Dickson said. That includes rigorous capital stress testing and liquidity testing.
Stress testing shows at what point a company can withstand extraordinarily high loss ratios somewhere near the 99th percentile.
Dickson said insurers do some excellent stress testing, but some companies tests she described as less than stellar.
Some stress tests have underestimated the risk of a financial disaster scenario, Dickson observed, while there is at least one example of a company that wildly overestimated its risk, resulting in significant tax implications.
Weve seen companies using a certain percentage decline in equity markets [as a baseline for their stress tests] in [the] current year when the market has already declined by that amount by the time we get the file, so that wasnt much of a stress, said Dickson.
She added one actuarial report based its disaster-scenario solvency test on a 95% loss ratio. When asked why they didnt use a 99 percentile, when most actuaries use the 99 percentile, we were told: That would show a near-insolvency situation.
In one case, Dickson noted, a company with a 40% loss ratio presumed a ludicrous scenario of a 200% loss ratio for the purpose of a stress test. The result, predictably enough, was insolvency, which had implications for a large deferred tax asset.
In short, a completely accurate scenario for analysis should be convincing [and] the risks should be clearly managed.