Internal Target Capital Ratio

Study guide: Exam 6C

The Internal Target Capital Ratio is the MCT ratio an insurer sets for itself, above OSFI's 150\% supervisory target, reflecting risks the standardised formula does not fully capture and the volatility of its own results. It is established through the insurer's ORSA, approved by the board, and it is the level at which management is expected to operate.

• Why it must exceed the supervisory target. The supervisory target is a floor for a typical insurer; a particular insurer may carry catastrophe concentration, long-tail reserve uncertainty, a growth plan, thin reinsurance, or a volatile investment portfolio that the standardised Capital Required formula treats generically. The internal target is where those specifics are priced.
• How it is derived. Working backwards from the insurer's own adverse scenarios: identify the plausible severe events (PML, a reserve strengthening, a market decline, a reinsurer failure), quantify their after-tax effect on Capital Available and on the Base Solvency Buffer, and set the target so that the ratio stays above the supervisory target afterwards.
• It is the first tripwire. Breaching the internal target should trigger management action — a capital plan, reduced distributions, moderated growth — while the insurer is still well above supervisory attention. An internal target that gives no early warning has failed its purpose.
• FCT tests it; ORSA sets it. ORSA is the forward-looking process that determines how much capital the insurer needs; FCT is the scenario testing that checks whether the target holds up. The two are complementary and OSFI expects both.
• A target set too low is a governance finding. OSFI reviews internal targets and challenges those that do not follow from the insurer's own scenarios — an insurer whose ORSA identifies a \$50 million catastrophe exposure and sets a target providing \$20 million of headroom has not done the work.

Deriving an Internal Target An insurer's ORSA identifies three severe but plausible events, each assessed at roughly a 1-in-100 annual likelihood, with after-tax effects on capital available of: catastrophe \$52 million; reserve strengthening \$38 million; equity market decline \$24 million. Its base solvency buffer is \$190 million.

Set the internal target.

Answer Single largest event. To remain at the supervisory target after a \$52 million catastrophe:

\begin{align*}
\text{Required CA} &= 1.50 \times \$190\text{M} + \$52\text{M} \\
&= \$337\text{M} \\[4pt]
\text{Implied target} &= \frac{\$337\text{M}}{\$190\text{M}} = 177\%
\end{align*}

A combination. Events are not perfectly independent — a catastrophe can coincide with a market decline, and a hard year often produces both losses and reserve deterioration. Testing the catastrophe together with the reserve strengthening:

\begin{align*}
\text{Required CA} &= \$285\text{M} + \$52\text{M} + \$38\text{M} \\
&= \$375\text{M} \\[4pt]
\text{Implied target} &= \frac{\$375\text{M}}{\$190\text{M}} = 197\%
\end{align*}

A defensible internal target is around 190–200\%, with the reasoning documented: the single-event test gives the floor, the combined test gives the target, and the difference is a judgement about correlation the board should be asked to approve explicitly.

What would make this wrong. Setting 160\% "because peers are around there" fails the ORSA requirement — the target must follow from this insurer's scenarios. And note the buffer itself would rise after a catastrophe (reinsurance exhausted, risk profile changed), so these calculations are, if anything, optimistic. A careful ORSA models both sides of the ratio.