2019 Spring Q18

DulcineaDelCADulcineaDelCA
in OSFI.MCT

Hi,

I have a question about part b. The solution says capital available doesn't change with a decrease in earthquake reserves. Gross capital available is a sum of balance sheet items, one of which is reserves. Earthquake reserve is a type of reserves. Why is capital available not impacted when earthquake reserve decreases?

Thank you!

Comments

  • grahamgraham

    I see what you're saying because earthquake reserves is listed as a component of category A capital. So if earthquake reserves go down, you might think capital available would go down also. But that isn't quite what the question was asking.

    The wording used in the source text and in the exam question is a little misleading. In the exam question, earthquake reserves refers to one of the components of insurance risk, which is part of total capital required. (Earthquake reserves is what you had to calculate in part (a) when they asked for catastrophe risk.) Now, if the value of earthquake reserves calculated in part (a) goes down, they are asking what happens to the components of capital required.

    If you think about it like that, the answer in the examiner's report and in the BattleCards should make more sense.

    But let's take this a step further. If the value of capital required for earthquake reserves goes down, then you might argue that the value of earthquake reserves on the balance sheet should go down also. That's a reasonable conclusion, but the total capital available wouldn't necessarily go down. The earthquake reserves that are released could just go back into retained earnings (which is also a component of capital available) so there would be no net change in capital available.

  • DulcineaDelCADulcineaDelCA

    Thanks Graham! It makes perfect sense. :)

  • sant93sant93

    For part a, why do we assume 10% of capital and surplus? Where did the 10% come from?

  • grahamgraham

    Actually, that came up in my answer to your previous post about a different earthquake problem but I'll elaborate here:

    There is another reading on earthquakes: OSFI.Eqk. That reading discusses the 4 types of financial resources that can be used for earthquake liabilities. Here's a direct link to the section of OSFI.Eqk that discusses that:

    The first financial resource is capital & surplus from the balance sheet, but the amount you can use is limited to 10%. So that's where the 10% comes from. You just had to know that, but you might not have covered that article yet. Exam questions often pull material from more than 1 reading.

  • oxalisoxalis

    Hi Graham,

    Is capital & surplus just another name for equity? from the exam report it looks like the capital & surplus is adding up the same items that constitute equity :
    • common shares
    • contributed surplus
    • retained earnings
    • reserves
    • aoci

    for reserves in particular, sample answer only considered nuclear and contingency reserves, and excluded epr, is epr usually considered under "reserves" or it should be left out? here it makes sense to exclude it since we're adding it back in the total financial resources to cover earthquake exposure

    Thanks

  • grahamgraham

    There have been a few forum discussions on this that I've linked to below. The short answer is that unfortunately this is not explained clearly in the source texts.

    In the 2019.Spring Q18 problem, they are indeed treating "capital and surplus" as the same thing as equity, but their equivalence (or non-equivalence) is never stated anywhere in the readings. In fact, the term "capital and surplus" never appears in the CCIR Annual Statement Instructions. The term appears in the MCT reading in the context of earthquake reserves but never defines it. The term also appears in OSFI's earthquake reading, but again, it is not defined.

    Regarding the EPR, this is not the same thing as earthquake reserves, and EPR is actually a deduction from capital available as noted in section 2.3.1 (bullet point 3) of the MCT source text, which is why it wasn't included with the nuclear and contingency reserves.

    My overall advice is to pay attention to what previous exam problems have done and then follow that model as appropriate if you get a similar question on your exam.

    Here are some relevant discussions that might shed more light:

  • oxalisoxalis

    thank you!!

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