54 th Annual Canadian Reinsurance Conference Breakout Session

54 th Annual Canadian Reinsurance Conference Breakout Session #5 1

Session Description There 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. 2

Agenda Item Panel Driving Forces & Emerging Developments Steven W. Easson CLHIA Regulator’s View of Necessity & Benefits of this REvolution Bernard Dupont OSFI Reinsurer’s View of Impact on Capital Planning, Pricing & Capacity Bernard Naumann Munich Re Questions All 3

Steven W. Easson CLHIA Driving Forces & Emerging Developments 4

Driving Forces International Financial Reporting Capital Canada Ø Financial Crisis Ø Member of G 20 Ø G 20 / Finance Ministers / Ø Member of FSB Financial Stability Board (FSB) Ø International Convergence Ø Global comparability Ø G 20 / Finance Ministers / FSB Ø IAIS Adherence/Cooperation Ø Trend to more risk-based/ principles based standards Ø Advances in actuarial and capital theory; increased complexity and globalization of products Ø Global Convergence (a la Basel) Ø Territories and Sectors Ø Improve risk sensitivity 5

Emerging Developments International Financial Reporting Ø International Financial Reporting Standards (“IFRS”) Ø IASB/FASB joint project Canada Ø IFRS mandated in April 2008 Ø Adopted pre-crisis Ø “Phase 1”: 2011 Ø “Phase 2”: 2013+ Ø IAIS Papers Capital Ø Solvency II Ø NAIC Ø Basel “III” Ø Life Insurer Solvency Assessment Framework (next generation to replace MCCSR) Ø “Solo”/“Holdco” capital, Stress Tests Ø“Reinsurance Response Paper” 6

International – Financial Reporting Ø 2008 Financial Crisis – G 20 meetings Ø Washington, London, Pittsburgh, Toronto (June 2010) Ø Washington Declaration: Finance Ministers to implement principles for reform Ø Create high quality accounting standards Ø Basis of loan loss provisions to improve Ø IASB’s International Financial Reporting Standards Ø Insurance Contracts – IASB committed to finalize June 2011 Ø Other Standards of interest Ø Financial Instruments (IFRS 9); IAS 37; Credit Risk; Fair Value Ø IASB/FASB joint project Ø Commitment to achieve convergence, but the Boards at times disagree on standards and will convergence happen “on plan”? 7

International - Capital Ø International Association of Insurance Supervisors (“IAIS”) Papers Ø Insurance Core Principles Standards Guidance Papers Ø Target date for revised ICP’s – October 2011 Ø Group Supervision – “Supervisory Colleges” Ø Group vs. Solo Capital requirements Ø Common Assessment Framework (“Com. Frame”) for Internationally Active Insurance Groups Ø Solvency II Ø Total Minimum and Target Capital Requirement Ø “Market consistent” valuation of assets and liabilities Ø Not just better risk based Capital Standards – Supervision just as important Ø “Third Country Equivalence” – Reinsurance Supervision 8

International – Capital (continued) Ø NAIC Ø Solvency Modernization Initiative (“SMI”) Ø Reinsurance Regulatory Modernization Act of 2009 Ø FSB Ø “Basel III” (Dec ’ 09 Draft) Ø Revisions to definitions of “Tier” capital and liquidity standards Ø Tier 1 – emphasis on common equity and retained earnings 9

Canadian – Financial Reporting Ø Ac. SB declared adoption of IFRS in April 2008 Ø i. e. pre-crisis and pre-G 20 declaration. Ø “Phase I”: 2011 Ø Canadian Asset Liability Method (“CALM”) continues to qualify under IFRS 4 Ø “Gross” Accounting for Reinsurance Ø “Phase II” : 2013 or Later Ø Insurance Contracts Exposure Draft – will be released in June 2010? Ø Discount Rate - Huge Issue Ø Basis still uncertain Ø “De-linking” of asset and liability valuations Ø Insurance Contract Policy liabilities – potential dramatic increases Ø Earnings volatility – potential dramatic increases 10

Canadian - Capital Ø “ Life Insurer Solvency Assessment” Ø More risk based than MCCSR Ø Total Minimum and Target Asset Requirement Ø Standard Factor Approach; Internal Models Approach Ø TBSR = “IFRS liabilities” plus Solvency Buffer Ø Solo/Holdco capital standards; Stress Tests Ø Reinsurance Response Paper Ø More “principles” based Ø “Expanded and reinstituted” Guideline B 3 – to be released soon Ø Consolidation of Ø Revoked Guideline B 3 (Unregistered Reinsurance) Ø Draft Guideline B 3 (Sound Reinsurance Practices and Procedures) Ø Draft Guideline B 13 (Reinsurance Agreements) 11

Bernard Dupont OSFI Regulator’s View of Necessity & Benefits of this REvolution 12

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 13

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? 14

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? 15

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 16

Driving Forces • IFRS and CIA standards – Convergence of accounting rules • Solvency Modernisation Initiative (USA) • Awareness and more sophisticated valuation techniques available 17

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 18

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 19

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 20

Vision of Future Framework • First risks being looked at for life insurers: – Market risk – Credit Risk • Earliest expected implementation date: – 2014/2015 21

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. 22

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. 23

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 24

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 25

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 26

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 27

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 28

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 29

Bernard Naumann Munich Re Reinsurer’s View of Impact on Capital Planning, Pricing and Capacity 30

Required MCCSR Capital (2009) Source: OSFI 31

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 32

Mortality Improvement Assumptions 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. 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+ 33

Reinsurance Counterparty Risk 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 Expected Insurer Effect Expected Reinsurer Effect Reserves 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 34

IFRS Phase I Changes The following changes will be implemented in 2011: • Gross Accounting of Reinsurance • Other (e. g. Full Recognition of Pension Plan Deficits) 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 35

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; although not as significant as Insurers Capital Avail capital to decrease Price Pressure Increase on long-tailed business 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 Increase on coinsurance business; Minimal on YRT 36

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 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? 37

Reinsurance Response Paper 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, B 13 “New B-3” Guideline on Sound Reinsurance Practices and Procedures) 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 38

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! 39

Reinsurance Pricing Summary Mortality Improvement Neutral Price Impact Reinsurance Counter Party Charge Minimal Increased Price Impact IFRS I Neutral Price Impact IFRS II Minimal Increased Price Impact (YRT) Solvency II Potential Increase Reinsurance Paper Neutral Price Impact 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! 40