Capital Available

Study guide: Exam 6C

Capital Available is the numerator of the MCT ratio: the capital an insurer actually holds that is available to absorb losses. It starts from accounting equity and applies regulatory adjustments and deductions for items that would not in fact absorb a loss, then classifies what remains into quality tiers.

\text{Capital Available} = \text{Category A} + \text{Category B} - \text{Deductions}

• The tiering. Category A is the highest quality — common shares, retained earnings, accumulated other comprehensive income — permanently available and freely usable to absorb losses. Category B and C cover instruments with more limited loss absorbency, such as certain preferred shares and subordinated debt, and are subject to limits relative to Category A.
• Principal deductions: goodwill and intangible assets (cannot be sold to pay claims); deferred tax assets that depend on future profitability (worthless exactly when needed); interests in unconsolidated financial institutions; and certain other assets OSFI does not accept.
• Why equity and capital available differ. The deductions can be large — an acquisitive insurer's goodwill consumes regulatory capital dollar for dollar while leaving accounting equity untouched. This is why a strong balance sheet can still produce a weak MCT ratio.
• It moves with the income statement and with markets. Losses reduce it, dividends reduce it, and unrealised losses on FVOCI investments reduce it through OCI. Under IFRS 17 an onerous group charge reduces it in the year the business is written.
• Loss absorbency is the organising test. Every question about whether an item counts reduces to: would this absorb a loss when the insurer is in trouble? Goodwill would not; a deferred tax asset contingent on profits would not; common equity would.

Building Capital Available An insurer reports equity of \$340 million, comprising common shares \$120 million, retained earnings \$185 million and accumulated OCI \$35 million. It also has \$50 million of subordinated debt qualifying as Category B. Deductions: goodwill \$45 million, intangibles \$22 million, and deferred tax assets dependent on future profitability \$16 million.

Compute capital available, and the effect of a \$30 million unrealised investment loss.

Answer Category A:

\$120\text{M} + \$185\text{M} + \$35\text{M} = \$340\text{M}

Deductions:

\$45\text{M} + \$22\text{M} + \$16\text{M} = \$83\text{M}

Capital available:

\begin{align*}
&= \$340\text{M} + \$50\text{M} - \$83\text{M} \\
&= \$307\text{M}
\end{align*}

Now a \$30 million unrealised loss on FVOCI bonds, recognised in OCI:

\begin{align*}
\text{Accumulated OCI} &= \$35\text{M} - \$30\text{M} = \$5\text{M} \\[4pt]
\text{Capital available} &= \$277\text{M}
\end{align*}

A 10\% fall in capital available from a movement in interest rates, on bonds the insurer intends to hold to maturity and will suffer no realised loss on. If the Base Solvency Buffer were \$180 million, the MCT ratio falls from 171\% to 154\% — close to the supervisory target — for a reason unrelated to underwriting.

The management response is not to sell the bonds (which would realise the loss) but to recognise that the liabilities are also worth less at higher rates. If the insurer has elected the OCI option on its liabilities, the offsetting liability gain also runs through OCI and the net effect is only the duration mismatch — which is the whole reason the option exists.