Impact of reinsurer insolvency on MCT (2019F-20d)

AnLaPe

This is a FCT(DCAT) + MCT question.

They asks what the impact would be on the MCT of a scenario that includes a catastrophe and the bankruptcy of a reinsurer (vs a scenario with catastrophe only).

The two sample solutions are:

It will increase the insurance risk as unpaid claim risk increases. Thus, MCT will decrease

and

Capital available would go down. Credit risk would increase, which would increase the capital required. MCT ratio would go down.

The first one makes sense to me, as I assumed in such a scenario, we would essentially calculate the MCT as if the reinsurer did not exist (i.e. ceded liabilities to this reinsurer would be included in the net liabilities, increasing insurance risk).

As for the second solution, I don't quite understand how credit risk would increase. If I'm reading the credit risk section of the MCT paper correctly, the risk factor for receivables from registered reinsurers is a flat 0.7% regardless of financial strength (i.e. does not vary by rating) and 2.5% for unearned premiums recoverable, so I see no way that the credit risk required capital could increase.

In fact, I thought credit risk would decrease, as the receivables from the reinsurer would go to 0, in the same way that ceded liabilities would not be accounted for when calculating insurance risk.

Am I misunderstanding the impact that the insolvency would have on the credit risk?

Thanks!

Staff-T1

So I don't really know what's going through the grader's head here but there could be two things:

• When he says credit risk, he doesn't mean the actual credit risk factor. He means credit risk in the general sense and then the capital required would be higher as you already concluded from your first point.
• Quoting the MCT paper: All on- and off-balance sheet exposures are subject to a specific risk factor that either: 1) corresponds to the external credit rating of the counterparty or issuer or 2) represents a prescribed factor determined by OSFI.

For the second bullet point, it does seem you can change the credit risk factor depending on counterparty risk. I am leaning towards the second point thus.

Finally, I do not see how capital available will go down though.

AnLaPe

I believe receivables from reinsurers falls under the second category (prescribed factor), as per the table on p. 65:

An interpretation that might make some sense, since as you said they say credit risk and not credit required capital, is that since credit risk increases, selected reinsurance MfADs could increase.

Regarding available captal, really not sure about this, but since reinsurance receivables are an asset, they would increase the surplus, since assets, liabilities and equity must stay in balance.

Surplus is one of the component of available capital, so when the receivables go to 0 because of the insolvency, it decreases surplus which decrease available capital.

I'm probably spending way too much time on this 0.5 point problem haha.. In any case, thanks for your input

Staff-T1

But then again, even with a higher reinsurance MFaD your ceded would technically be 0 since the reinsurer has already defaulted so I don't think it will matter here ~ Regarding available capital your answer makes sense! It slipped my mind that it will affect the surplus available. No, I think this is a really good question and shows that you are thinking deeply about the material which bodes well for the actual exam I know I didn't think this deeply about the questions when I was taking it ~

AnLaPe

Oh yeah you are right about the MfAD! Seems to me more and more like the second solution is at best poorly worded, if not outright wrong regarding the market risk and required capital.

Thank you!