CIA.DCAT

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Dynamic Capital Adequacy Testing is a stress-testing technique. It is a critical tool for OSFI in assessing the financial condition of an insurer. Poor DCAT results will cause OSFI to intervene.   Forum

Pop Quiz

Consider this important question: Based on a DCAT analysis involving base & adverse scenarios, when can the AA report that an insurer is in good financial condition?

Answer:

for the BASE scenario: must have MCT > 150%   (all years in forecast period)
for the BASE scenario & all PAS: must have A > L   (all years in forecast period)
(Note that PAS = Plausible Adverse Scenarios, A = Assets, L = Liabilities)

Now, here's the Pop Quiz:

(a) Given the following, can the AA report that the insurer is in good financial condition?
Scenario Component 2018 2019
Base Scenario MCT Ratio 195% 170%
Capital (A-L) 300m 250m
Adverse Scenario: Earthquake MCT Ratio 195% 145%
Capital (A-L) 300m 225m
(b) Given the following, can the AA report that the insurer is in good financial condition?
Scenario Component 2018 2019
Base Scenario MCT Ratio 195% 170%
Capital (A-L) 300m 250m
Adverse Scenario: High Inflation MCT Ratio 195% 145%
Capital (A-L) 300m -10m

Note: This pop quiz is very similar to E 2016.Fall #19b

BattlePlan

Based on past exams, the main things you need to know (in rough order of importance) are:

  • adverse scenario: examples, ripple effects management actions
  • evaluating the financial condition of an insurer
  • how to select a PAS (Plausible Adverse Scenario)
  • steps in the DCAT process (especially the base scenario)
  • definition of reverse stress-testing
  • definition of social inflation
reference part (a) part (b) part (c) part (d)
E (2018.Spring #19) define:
- Plausible Adverse Scenario
adverse scenario:
- propose & justify 2
adverse scenario:
- ripple effects 2
financial condition:
- evaluate
E (2018.Spring #24) SCENARIO:
- identify AA errors 3
E (2017.Fall #22) financial condition:
- evaluate
define:
- social inflation
adverse scenario:
- off-B/S risk
E (2017.Fall #23) define:
- Plausible Adverse Scenario
adverse scenario:
- premium volume
E (2017.Spring #21) PAS:
- how to select
E (2016.Fall #19) DCAT process:
- base scenario
financial condition:
- evaluate
adverse scenario:
- frequency & severity
adverse scenario:
- policy liabilities misestimation
E (2016.Spring #21) base scenario:
- identify
adverse scenario:
- example
adverse scenario:
- impact on MCT ratio
adverse scenario:
- management actions
E (2015.Fall #20) PAS:
- how to select
adverse scenario:
- ripple effects
adverse scenario:
- management actions
financial condition:
- comment (see OSFI.MCT)
E (2015.Spring #29) financial condition:
- evaluate
adverse scenario:
- various
definition & examples:
- social inflation
E (2014.Fall #26) define:
- reverse stress-testing
E (2014.Spring #25) DCAT filing:
- actuary's actions
DCAT base scenario:
- cash injection
DCAT PAS:
- cash injection
E (2014.Spring #27) define:
- reverse stress-testing
E (2014.Spring #28) financial condition: 1
- evaluate
adverse scenario:
- OSFI intervention
adverse scenario:
- premium risk
adverse scenario:
- frequency & severity
E (2013.Fall #29) DCAT process:
- base scenario
financial condition:
- evaluate
adverse scenario:
- premium risk
adverse scenario:
- policy liabilities risk
E (2012.Fall #29) financial condition:
- evaluate
1 This problem relies on an invalid assumption.
2 This is a GREAT PROBLEM. Make sure you study it thoroughly. It comes up in Risk Categories section of this wiki article at the end of mini BattleQuiz 6
3 This is a good Bloom's Taxonomy problem for learning the DCAT process. It's listed under mini BattleQuiz 7 under old exam problems, but it relates closely to the DCAT "method" discussed here.

In Plain English!

Overall Comments

The old exam questions on DCAT are interesting! They often involve interpreting data related to an adverse scenario. Sometimes you also have to recalculate the MCT ratio for the adverse scenario.

  • Super-Secret Hint: The MCT ratio for the adverse scenario is usually lower than for the base scenario!

This paper is quite long at 46 pages, but you can ignore a big section in the middle (Appendix A: pages 21-33) because it relates to life insurance. The most important definition in this paper is for Plausible Adverse Scenario or PAS for short. The pop quiz above used earthquake and high inflation as examples of a PAS.

Plausible Adverse Scenario: a set of assumptions for an undesirable but reasonably possible event relating to insurer's financial condition

But what do undesirable and reasonably possible mean:

undesirable > 95th percentile on the loss distribution
reasonably possible < 99th percentile on the loss distribution

Putting these terms together means that a PAS should lie between the 95th and 99th on the loss distribution. You can see from the BattleTable above that a very common type of exam question follows this pattern:

  • identify an PAS
  • identify ripple effects
  • identify management actions

The information you need to answer this type of question is in Appendix B - Risk Categories. (Discussed later in this wiki article.)

Sections 1,2: Intro & Method

Here, we answer 2 basic questions:

Question 1: why do we do stress-testing [Hint: risk-complement-Cap-Liq
risk: risk identification & control (stress-testing helps identify and control risk)
complement: stress-testing complements other risk management tools such as Best's Capital Adequacy Ratio as described in BCAR.Cat (may also involve simulation of shocks like earthquakes)
Cap: stress-testing supports capital management
Liq: stress-testing improves liquidity management
This question has been asked on several recent exams: (2016.Fall #20b), (2013.Fall #13a), (2012.Fall #28a) In the BattleCards, these exam references are listed with the OSFI.Stress reading. (There is significant overlap between CIA.DCAT and OSFI.Stress)

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Question 2: how do we do stress-testing
  1. review: REVIEW 3 years operations & financial position @ end of each year
  2. BASE: create the BASE scenario - a set of assumptions on risk factors that are CONSISTENT with business plan (if plan is realistic & consistent) OVER forecast period. See (2016.Fall #19a), (2013.Fall #29a)
  3. risk: RISK CATEGORIES - select relevant risk categories from F-PIP-RIGOR using sensitivity-testing (F-PIP-RIGOR is a memory trick for remembering P&C insurer risk categories, and is discussed later in this article)
  4. PAS: select plausible adverse scenarios from the risk categories identified in step 3 (make sure to also consider ripple effects – discussed in the next section)
  5. report: REPORT scenarios with highest surplus sensitivity & those where surplus < (supervisery capital required)
  6. Action(mgmt): identify management action to facilitate risk mitigation & contingency planning
  7. Action(regulator): identify possible regulatory action for falling below regulatory capital required (& SIGN opinion)

If you think about these steps, they really are just common sense:

(Steps 1,2): Before doing anything, you have to understand the state of your company. This is why you review operations and create a BASE scenario.
(Steps 3,4,5): Then you look at company-specific risks, create a few adverse scenarios (with ripple effects), and write a report
(Steps 6,7): Finally, management uses the report to take action to mitigate the risks. (If the analysis shows bad results, you may need to consider what to do in the case of regulatory action.)

And, as stated above, A.M. Best also provides a different stress-testing methodology in their paper on Catastrophe Analysis. See BCAR.Cat.

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Miscellaneous Items

Other things from Sections 1,2 are concepts relating to the forecast period, base scenario, and plausible adverse scenarios. These are covered in the BattleCards. This next mini BattleQuiz has exam questions that have been asked more than once. There are 2 terms related to Plausible Adverse Scenario that deserve special mention:

ripple effect an event that occurs WHEN an adverse scenario triggers a change in 1 or more independent assumptions Example: a ripple effect of an earthquake may be loss of reinsurance
management action actions that management may take to mitigate adverse ripple effects Example: management may seek alternate reinsurance arrangements

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Section 3: Modeling

Purpose

The purpose of any model is to portray, on a simplified level, a process occurring in the real world. A DCAT model must reproduce these 3 key elements of the Financial Statements:

  1. B/S(A, L, R/E): Balance Sheet items - Assets, Liabilities, Retained Earnings
  2. I/S (revenue, expenses): Income Statement items - revenue, expenses
  3. regulatory measures of capital adequacy: MCT ratio

Model Validation

Once you have a model that outputs these elements, you need to verify that the outputs make sense. This is model validation.

mini Pop Quiz: Given Cash on Hand for the base scenario of models 1 & 2, which model is more likely to be valid?
Model Latest Year Projection Year 1 Projection Year 2 Projection Year 3
Model 1 - Base Scenario (Cash) 20,000 20,800 21,600 22,400
Model 2 - Base Scenario (Cash) 20,000 18,225 23,125 15,800
Answer: Model 1. You can see that the cash in Model 1 is smoothly increasing whereas in Model 2, it is erratic. So, the first thing to look for when validating a model is whether the base scenario exhibits continuity of results from year to year. (This, and other validation items, are contained in the BattleCards.)
This example is somewhat similar to E (2016.Spring #21)

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Other Modeling Topics

Section 3 in the DCAT paper also covers the topics listed below, but they aren't likely exam questions so we'll skip over them for now. If you want to, you can cover them in Level 3: Custom Battles. (That's from the BattlePlan page in the main part of the BattleActs site.)

  • stochastic versus deterministic models
  • how to model ripple effects
  • considerations in model segmentation.

Section 4: Reporting

Alice the Actuary stayed up all night writing her DCAT report.

Question: why did she bother??!!
  • Because her mean boss told her to.
  • Also, because that's how the actuary communicates the state of the company (as well as other information) to the Board of Directors.
  • The "other information" could include risks the company faces as well as ways to reduce that risk.

Readers of the report may also include management and regulators, but they would get a more detailed statistical report than the Board of Directors.

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Appendix B: Risk Categories

What is F-PIP-RIGOR?

F-PIP-RIGOR is my memory trick for remembering the 9 P&C risk categories from Appendix B:
F - P I P - R I G O R
Frequency & Severity - Policy Liabilities Inflation Premiums - Reinsurance & Counter-parties Investment risk Government risk Off-B/S risk Related Company risk
Each of these categories can be used to construct various adverse scenarios. But not all categories will be relevant in all situations. You must use judgment to assess which are most appropriate. The DCAT paper discusses each in detail. In the next section, I'm going to explain how I summarized that discussion.

Example 1: The first 'F'

F = Frequency & Severity Risk. There are 3 important items related to each risk category:
causes: a change in frequency & severity can be caused by...
  • catastrophe
  • social inflation
ripple effects: these may include...
  • post-event inflation
  • loss of reinsurance
management action: to mitigate the risk, management may decide to...
  • raise rates
  • review reinsurance
This is the pattern for learning each of these categories.

Example 2: The 'I' in RIGOR

I = Investment Risk

causes: a change in investment risk can be caused by...
  • significant changes in the yield curve
  • decrease in return on equity investments,...
ripple effects: these may include...
  • forced sale or liquidation
  • significant +/- change in cash flows
management actions: to mitigate the risk, management may decide to...
  • sell assets
  • change investment strategy

Tricks for Memorizing F-PIP-RIGOR

It's a big job to memorize causes, ripple effects, and mgmt actions for all 9 risk categories, but there are a few tricks:

Trick 1: Instead of memorizing the ripple effects for each risk category individually, just memorize some of the common ripple effects. These are:
higher LR (due to higher losses or operating costs) loss of reinsurance post-event inflation forced sale or liquidation mix shift Policyholder actions regulatory action
  • If you're then asked for a ripple effect for a particular adverse scenario, you can take an educated guess and pick a couple of things from this list that seem most appropriate. (2013.Fall #19d)
Trick 2: Do the same thing for management actions. Here are some common management actions:
tighten U/W raise rates review reinsurance sell assets review mix (geography, limit,...)
  • If you're then asked for management actions for a particular adverse scenario, take an educated guess from this list! (2013.Fall #19c)

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Final Words

The best way to learn this paper is to work on the old exam problems at the same time you're learning the BattleCards. The final mini BattleQuiz for this article just contains a bunch of old exam problems.

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BattleCodes

Memorize:

  • conditions that must be satisfied by the DCAT analysis for Alice the Actuary to report that an insurer is in good financial condition.
  • 4 purposes of stress-testing: rsk.compl.C.L
  • 7 steps in stress-testing: rBrPr.Act(MR)
  • defns plausible adverse scenario, reverse stress-testing, ripple effects
  • The 9 P&C risk categories F-PIP-RIGOR
  • common examples of ripple effects (7) & management actions (5)

Conceptual:

  • Explain how the 7 steps of the stress-testing methodology are just common sense.
    • How is this paper, CIA.DCAT, similar to the related paper OSFI.Stress? In what ways are these papers different? (Note that I haven't answered that question in this article. It's something for you to think about after you've covered OSFI.Stress.)
    • What other papers are related to CIA.DCAT? How about OSFI.MCT, the #1 ranked paper on the syllabus.
    • A Bloom's Taxonomy Question: What extra detail does a DCAT analysis provide that the MCT ratio alone does not?
  • See also BCAR.Cat:
    • It's a U.S.-specific reading, but it's interesting to compare and contrast the BCAR stress-test methodology (which has 5 steps) to the 7 steps of the DCAT methodology.
    • (Note that the 5 steps of the BCAR methodology has been asked more than once on past exams, so make sure you learn it when you get to that paper!)

Calculational:

  • Many DCAT problems from past exams are more like case studies than calculation problems. (2016.Fall #19)
    • You may be presented with MCT ratios and other balance sheet metrics for a base scenario & several adverse scenarios.
    • A typical question is whether the insurer is in good financial condition, and to identify possible ripple effects & appropriate management actions.
  • Sometimes a DCAT problem is combined with an MCT problem. (2017.Spring #21), (2016.Spring #21), (2015.Fall #20).
  • Expect about 2 pts from this paper on the exam. This may seem low, but it's important because DCAT often underlies a high-value MCT problem.

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  Forum

POP QUIZ ANSWERS

(a) YES. All conditions are satisfied. (The MCT ratio of 145% for the adverse scenario in 2019 doesn't matter.) (b) NO. The adverse scenario has A-L = -10m < 0 in 2019, which is not allowed.

(It always seemed a bit STRANGE to me that the MCT ratio for the adverse scenario isn't relevant to the appointed actuary's decision! But whatever...)