ICP17.CapAdeq

Don't panic when you open the link to this reading! You are only responsible for the equivalent of 5 pages of material: ICP Statement 17, and ICP Standards 17.1 thru 17.18.

• The layout of this document is explained on p5 under bullet point 7 of the original reading.
• ICP17 is a general framework for calculating capital available versus capital required.
• Note that OSFI's MCT guidelines is a great example of how ICP17 can be implemented.

Pop Quiz

1. In broad terms, what is Solvency II?
2. What are the 4 broad categories of risk considered in OSFI.MCT?

Keywords

capital available (or CapAv), capital required (or CapReq), MCT, Solvency II

In Plain English!

Getting Your Bearings

• Gah! This paper is hard to read! There is the ICP17 Statement, followed by 18 Standards related to the Statement. Here's a breakdown of what it's about:

The ICP17 Statement

• The official ICP17 Statement is as follows:

"The supervisor establishes capital adequacy requirements for solvency purposes so that insurers can absorb significant unforseen losses and to provide for degrees of supervisory intervention."

• That's a mouthful! Let's break this down into the questions that it answers: (who, what, why x 2)
  • who: the supervisor
  • what: establishes CAR (Capital Adequacy Requirements) for solvency purposes
  • why 1: so that insurers can absorb significant unforseen losses
  • why 2: and to provide for degrees of supervisory intervention.

A simpler version of the Statement

Regulating insurers is a good idea. We set capital requirements because we want them to stay solvent. If it looks like they're getting into trouble (can't cover losses) then the supervisor should have a way of intervening.

The Standards

• As a starting point for making sense of these 18 standards, let's group them according to the concept being addressed:

Stds 17.1 - 17.2 (Intro)

• These first two Standards basically restate the ICP17 Statement. The key point is in 17.1, namely that the supervisor requires a total B/S approach in accomplishing the goals from the Statement. (Recall that B/S = Balance/Sheet.)
• Fun Fact! In OSFI.MCT, it's obvious that the methodology uses a total B/S approach. (By now, you should be good at calculating the MCT ratio.) Recall that a good proxy for CapAv (capital available) in the MCT formula is total B/S equity.

Stds 17.3 - 17.5 (SCLs)

• Solvency Control Levels (SCLS): SCLs are supervisory benchmarks for CapReq (capital required). The supervisor compares an insurer's CapAv to these benchmarks, and, if warranted, takes appropriate corrective action.
• There are a couple of GREAT exam questions that could be asked from this section!
  • what is the prescribed control level (PCR): The PCR is a SCL such that if CapAv > PCR, the supervisor takes no action (at least not on capital adequacy grounds)
  • what is the minimum control level (MCR): The MCR is a SCL such that if CapAv < MCR, the supervisor may take the strongest possible action (depends on what, if any, corrective action the insurer may also decide to take)
• PCR & MCR also have specific definitions that are covered in the BattleCards.

Stds 17.6 - 17.9 (RCR Approaches)

• Useful abbreviations:
  • CR: Capital Requirement
  • RCR: Regulatory Capital Requirement
  • NSC: Nature, Scale, & Complexity

• These standards discuss approaches for determinging RCR:
  • The supervisor establishes the RCR in an open & transparent process. (Sunlight is the best disinfectant for corruption & incompetence!!)
    • An insurer may use a 'standard formula' or an 'internal model' (if the internal model better captures the insurer's risk profile.) (From Std 17.6)
  • The supervisor must consider all material risks when establishing RCR, and set appropriate target criteria underlying the models. (For consistency, these target criteria are applied to ALL insurers in a jurisdiction.) (From Stds 17.7 & 17.8)
  • Lastly, Std 17.9 just says that if the supervisor makes variations from the calculated RCR, it should be transparent, and also appropriate to the NSC of the insurer's operations.
    • Challenging Pop Quiz: If you were the supervisor, would it be wise to change the RCR by a bazillion dollars for a small company that insures only snowmobiles in Nunavut?
    • Answer: Um...no. That would NOT be appropriate to the NSC of the insurer's operations. Duh.

Stds 17.10 - 17.11 (Capital Resources)

• These two standards (like the others) are written in a way that makes them hard to understand. The concepts here are actually very easy & obvious. Here is how I understand what 17.10 & 17.11 are saying:
  • First, observe that a typical B/S would have some resources that are high quality (low risk) and some that low quality (high risk).
  • Well...the supervisor has to figure out which is which in assessing CapAv for an insurer. (The high quality assets would be weighted more heavily in the CapAv calculation.)
  • In other words, the supervisor must determine eligibility of the B/S assets, where eligible means high quality & sustainable (That's Std 17.10)
• But then what does quality & sustainability (Q&S) mean? (another good exam Q)
  • It refers to an insurer's ability to absorb losses on both a going-concern and wind-up basis. (That's Std 17.11)

Stds 17.12 - 17.18 (Internal Models)

• There are three more potential GREAT exam questions on the 3 validation tests below. I'll cover these first!
  1. What is the statistical quality test for an internal capital model? (From Std 17.14)
     • It is a quantitative assessment of the internal model. You must check 3 things:
       • Are the inputs/parameters/assumptions appropriate?
       • Is the insurer's overall risk position addressed?
       • Is the data accurate & complete?
  2. What is the calibration test for an internal capital model? (From Std 17.15)
     • Does the internal model satisfy the modeling criteria laid out according to Std 17.12?
  3. What is the use test for an internal capital model? (From Std 17.16)
     • Is the internal model fully embedded into the insurer's risk strategy & operational processes?
• Pop Quiz: What does an internal model calculate?
• Answer: An internal model calculates the RCR (Regulatory CapReq).
  • Note that the standard model also calculates RCR, but the standard model doesn't take into account risk factors specific to the insurer. Standard models are more appropriate for smaller, simpler companies that wouldn't have the resources to construct & validate their own internal model.

• Let's now tie up some loose ends for internal models...
  • 17.12 & 17.13: These say basically that the supervisor sets modeling criteria that an insurer's internal model must follow. Also, that the insurer must get prior supervisory approval by validating it's model against the 3 tests described above.
  • 17.17 & 17.18: The model must be properly documented and will also be monitored to make sure it continues to satisfy supervisory requirements.

Putting It All Together

• The supervisor is just trying to protect the policy holders.
• To do this, he/she sets out capital requirements appropriate to each insurer, then CHECKS that their capital available is higher.
• That's all there is to it! But the devil is in the details - all that 'junk' in the Standards is the framework necessary to make sure its done correctly.

BattleCodes

• Memorize:
  • official version of the ICP17 Statement (make sure you also understand it in terms of who/what/why)
  • defns of PCR & MCR (prescribed and minimum solvency control levels)
  • defn of a high quality & sustainable capital asset
  • defns of the 3 validation tests: statistical quality test, calibration test, use test
• Conceptual:
  • Can you describe in your own words what this reading it about?
  • Do you grasp the structure of the reading: intro, SCLs, RCR approaches, capital resources, internal models
  • Important: Do you see how OSFI.MCT & KPMG.Solv2 are applications of the concepts in ICP17?
• Final Advice:
  • There are many deep questions related to this reading, but those deep questions are NOT likely to appear on the exam.
  • The most likely exam questions would be the memory items listed above.
  • You can probably cover this reading in less than 1 hr, then just practice the BattleCards.

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POP QUIZ ANSWERS

1. Solvency 2 is a principles-based insurance regulatory system TO DETERMINE the required capital levels of insurance companies IN the European Union.
2. OSFI.MCT categories of risk: IMCO (In My Crummy Opinion) - Insurance, Market, Credit, Operational