2013 DCAT Report Approved by Board of Directors October 4, 2013

Transcription

1 2013 DCAT Report Approved by Board of Directors October 4, Dynamic Capital Adequacy Testing Report Basic Compulsory Automobile Insurance

2 TABLE OF CONTENTS 1.0 Executive Summary... 1 SUMMARY OF FINDINGS... 1 MAJOR SOLVENCY ISSUES... 3 REVIEW OF EVENTS SINCE THE PREVIOUS DCAT REPORT... 4 RECOMMENDATION INTRODUCTION ROLE OF THE APPOINTED ACTUARY PURPOSE SCOPE USE AND DISTRIBUTION PROCESS METHOD DATA SOURCES CAPITAL ADEQUACY MANAGEMENT DEFINITION OF THE MINIMUM REGULATORY CAPITAL REQUIREMENT DEFINITION OF SATISFACTORY FUTURE FINANCIAL CONDITION MATERIALITY BACKGROUND DISCUSSION DESCRIPTION OF BASIC RECENT AND CURRENT FINANCIAL POSITION BASE SCENARIO DESCRIPTION OF ECONOMIC ASSUMPTIONS IN THE BASE SCENARIO DISCUSSION OF PRIOR YEAR S DCAT RESULTS, RECOMMENDATIONS, AND MANAGEMENT ACTIONS ADVERSE SCENARIOS SUMMARY OF RESULTS DECLINE IN EQUITY MARKETS HIGH LOSS RATIO COMBINED SCENARIO: HIGH LOSS RATIO AND EQUITY DECLINE SCENARIO SUSTAINED LOW INTEREST RATES SUSTAINED LOW INTEREST RATES COMBINED SCENARIO ANALYSIS OF ALL PROPERTY AND CASUALTY INSURER RISK CATEGORIES APPENDIX A: STOCHASTIC MODELING WEEKLY INDEMNITY ACCIDENT BENEFITS OTHER INDEXED ACCIDENTS BENEFITS OTHER NON-INDEXED PUBLIC LIABILITY COLLISION COMPREHENSIVE PROPERTY DAMAGE OVERALL RESULTS Page i

3 EXHIBITS Exhibit 1 Exhibit 2 Exhibit 3 Exhibit 4 Exhibit 5 Exhibit 6 Base Forecast... E1 Decline in Equity Markets Scenario... E5 High Loss Ratio Scenario... E12 Combined Scenario: High Loss Ratio and Equity Decline... E18 Sustained Low Interest Rate Scenario... E24 Combined Scenario: Sustained Low Interest Rates, High Loss Ratio, Equity Decline... E30 Page ii

4 Rate Stabilization Reserve- RSR.2- Approved 2013 DCAT Report 1.0 Executive Summary Summary of Findings I have completed the annual investigation of the future financial condition of Basic Compulsory Autopac Insurance (Basic) as at February 28, 2013 in accordance with accepted actuarial practice in Canal;la. I have analyzed the forecasted financial positions of the company during the five year forecast period under a series of scenarios. A description of these scenarios and their impact on the company is included within this report. The analysis incorporates assumptions relating to business growth, investments, claims frequency and severity, transfer of capital between lines of business and projects, and other internal and external conditions during the forecast period as well as potential management and regulatory responses to various plausible adverse scenarios. The most significant assumptions are described within this report. In my opipion, the future financial condition of Basic is not satisfactory because there are plausible adverse scenarios that cause Basic retained earnings to fall below zero over the Corporation's five year forecast period. Winnipeg, Manitoba October 4, 2013 Luke Johnston Fellow, Canadian Institute of Actuaries Page 1 Manitoba l'llblk Insurance

5 Base Scenario Historical Results From Statement of Operations and Statement of Retained Earnings (in millions) 2008/ / / / /13 Earned Revenues $715 $744 $768 $780 $775 Total Claims Costs $623 $623 $447 $733 $786 Expenses $104 $117 $121 $130 $129 Investment Income $4 $84 $84 $101 $68 Net Income ($8) $88 $284 $19 -$72 IIF Transfers $16 $2 $0 $0 $0 Rebates/Surcharges $0 $0 -$322 -$14 $0 IFRS Adjustments $0 $0 $19 $0 $0 IT Optimization Fund $0 $0 -$65 $65 $0 Retained Earnings* $137 $225 $206 $214 $141 Rate Stabilization Reserve $135 $154 $141 $156 $141 Excess Retained Earnings** $88 $71 $0 $58 $0 * Historical retained earnings include appropriations for the Immobilizer Incentive Fund and the IT Optimization Fund. ** Excess Retained Earnings are retained earnings amounts in excess of the maximum Rate Stabilization Reserve target as ordered by the Public Utilities Board. Base Scenario From Statement of Operations and Statement of Retained Earnings (in millions) Assumes 1.8% Rate Increase in 2014/ / / / / /18 Earned Revenues $787 $835 $881 $922 $963 Total Claims Costs $770 $775 $791 $801 $831 Expenses $125 $131 $134 $139 $144 Investment Income $115 $63 $46 $38 $36 Net Income $5 ($7) $2 $20 $24 Retained Earnings $147 $139 $142 $162 $186 Rate Stabilization Reserve $147 $139 $142 $162 $186 Excess Retained Earnings $0 $0 $0 $0 $0 PUB RSR Range $83-$165 $88-$176 $92-$184 $97-$193 $101-$200 The base forecast assumes that the Corporation s proposed 1.8% rate increase will be approved in 2014/15. The forecast also assumes that all net income is transferred to the RSR up to the Public Utilities Board s (PUB) upper RSR limit. Any amounts above the upper limit are held in excess retained earnings. Except for special circumstances (e.g. the Immobilizer Incentive Fund), excess retained earnings are rebated to policyholders as part of the next General Rate Application (GRA). The base forecast does not include any excess retained earnings or appropriations of Page 2

6 Basic retained earnings. Retained earnings are forecasted to be within the PUB s RSR range over the entire forecast period. Adverse Scenarios The actuarial standards of practice require the actuary to test and report on a minimum of three plausible adverse scenarios posing the greatest threat to the insurer. In addition, the actuary must also report on all adverse scenarios that cause MPI Basic to fall below the Regulator s target capital requirement (see Section 3). The table below summarizes the results from the three most adverse scenarios including assumed management and regulatory action. Adverse Scenarios including Management Action Basic Retained Earnings (in millions) Retained Earnings Adverse Scenarios 2013/ / / / /18 Combined Interest Rate, Equity Decline, High Loss Ratio Scenario $138 $54 $16 ($10) $35 High Loss Ratio $147 $80 $80 $68 $79 Sustained Low Interest Rates Scenario $138 $106 $88 $88 $106 Major Solvency Issues Including plausible management and regulatory action, the Combined Interest Rate, Equity Decline, and High Loss Ratio scenario results in projected retained earnings of less than zero by the 2016/17 fiscal year. Page 3

7 Review of Events since the Previous DCAT Report The results of the 2012 Amended Basic DCAT report (dated August 3, 2012) were presented to the PUB as part of the 2013/14 General Rate Application (GRA). The report recommended a Rate Stabilization Reserve (RSR) target of at least $200 million. The PUB did not approve the DCAT-based target at the 2013/14 GRA. However, the PUB did provide the following direction to the Corporation as part of Board Order 157/12: The Board believes that the DCAT methodology is an improved approach for determining the target for the RSR over the current methodology, however, further analysis and discussion is needed, particularly in relation to the adverse scenarios used in the DCAT and the methodology construct, before such an approach should be utilized for rate-setting purposes. Over the course of the GRA, it became apparent that all parties seem willing to enter into further discussions with a view to achieving a consensus regarding the appropriate adverse scenarios to be used within the DCAT process. Although it was MPI s position that these discussions could take place within the framework of next year s GRA proceeding, it is the Board s view that this discussion is better suited to the less formal process of a technical conference. The Board is pleased that the Corporation is willing to be more consensus based in preparing the DCAT, and that it is receptive to aspects of the adverse scenarios being discussed and revised. The Board directs MPI to hold a technical conference in early 2013 to discuss, as between the parties to the GRA, the adverse scenarios and methodology construct being utilized currently by the Corporation within the DCAT, with a view to refining the adverse scenarios and gaining a better understanding of the DCAT modeling process. Page 4

8 DCAT Technical Conference The PUB held a DCAT Technical Conference on April 18 and 19, Participants included MPI, the PUB Board advisors, and the Consumers Association of Canada. There were professionals from various fields including actuarial, accounting, and economics. The Corporation provided a list of areas of agreement based on the discussions at the technical conference. Listed below are these areas of agreement along with an explanation of how these items are incorporated into this report (in bold). Areas of Agreement from the DCAT Technical Conference 1. MPI is not required to prepare the DCAT as prescribed by law, but it is best to prepare it in accordance with the Actuarial Standards of Practice. MPI will continue to prepare the DCAT in accordance with the Actuarial Standards of Practice and will file this in the GRA. The PUB may order a variation therefrom for the purpose of setting the RSR target. Action: The 2013 DCAT report is prepared based on Canadian Institute of Actuaries Standards of Practice. 2. MPI will include a balance sheet forecast in future GRAs, likely commencing in the 2015 GRA. Action: Balance sheets will be included in the 2014 DCAT report. 3. MPI will add a section to the DCAT disclosing changes from the previous year to enhance transparency. Response: For each adverse scenario, the 2013 DCAT includes an explanation of the changes from the previous DCAT report. 4. MPI will run adverse scenarios and risk tolerance levels as requested by the PUB and interveners, subject to the requests being very limited in numbers, recognizing the extensive work required. The process and timing is yet to be established. Action: The 2013 DCAT report provides estimated impacts to retained earnings for each adverse scenario at three risk tolerance levels (1-in-100, 1-in-40, 1-in-20). Because of the significant number of scenarios, not all of these scenarios were run through the financial model. 5. MPI will provide more disclosure in the DCAT, including reconciliation. Action: The 2013 DCAT report will include more detailed exhibits for investments and claims incurred. Page 5

9 6. MPI will provide more disclosure explaining how investment income is derived. Action: The Corporation built a new financial model over the past fiscal year. The model provides a much more detailed and transparent calculation of investment income. The 2013 DCAT report provides more detailed investment exhibits for each adverse scenario. 7. MPI will, for purposes of calculating the actuarial liabilities, incorporate the projected interest rates from the investment model (rather than assuming no change). Action: The new financial model allows the Corporation to include the impact of projected interest rate changes on asset and liability values. The Corporation's base forecast and the 2013 DCAT adverse scenarios include the impact of projected interest rate changes. 8. The purpose here is to put the DCAT framework in place to allow the PUB to establish an appropriate risk tolerance level for the RSR. 9. The DCAT should be run in a pure form first without inclusion of either management or regulator action, since these are unknown. Then the DCAT should be run including both management and regulator action. Action: Each adverse scenario in the 2013 DCAT report includes results with and without management action. 10. The weighting of historical data (such as equity returns since 1919 or inflation returns) is permissible and is the judgment of the actuary in the DCAT. That judgment is yet to be determined. Action: The adverse scenarios in the 2013 DCAT report include a more detailed discussion of these assumptions. 11. DCAT will provide a description of terms and statistical methods utilized in the analysis. Action: This section was not included in the DCAT report. We believe that the current DCAT report (which is in excess of 100 pages) is written in a relatively easy to understand format and provides the reader with adequate explanations and details of the methodologies and assumptions utilized. We also believe that descriptions of statistical terms (e.g. percentile) are readily available from other sources. Page 6

10 New Financial Model The Corporation implemented a new financial modeling tool in the past year which has improved the Corporation s ability to forecast different scenarios more quickly and accurately. In particular the model can more accurately incorporate complex assumptions regarding the various types of investments held. For example, the model has the ability to assume different portfolio turnover frequencies for purposes of recognizing the gains on the sale of equities. The model also establishes the ability to forecast a rebalancing of the portfolio in line with the Corporation s Investment Policy Statement sector allocation. In addition, the new tool enables the Corporation to forecast the impact that changes in interest rates have on the value of the fixed income portfolio and claims liabilities. Modeling interest rate impacts was not possible with the Corporation's previous financial model. Given the Basic insurance program s sensitivity to interest rates, the Corporation believes these impacts must be considered going forward. The inclusion of interest rate impacts in the Corporation s forecast was also an area of agreement from the DCAT Technical Conference. DCAT Peer Review The 2013 DCAT report was peer reviewed by Joe S. Cheng, F.C.I.A. from J.S. Cheng & Partners. In Joe Cheng s report, dated October 16, 2012, he provided a list of Findings and Recommendations. This list is provided below along with the actions in response to each item (in bold). 1. In the Decline in Equity Markets scenario, selection of an adverse scenario is based on historical cumulative four year returns on the TSX from 1919 to present. However, MPI must review its future financial condition annually. In future DCAT reports the selection of Decline in Equity Markets adverse scenario should consider one year returns from the TSX. Action: The Corporation reviewed single and multiple year scenarios in previous DCAT reports, but did not include the results of the analysis in the DCAT report. In this year s DCAT report the Corporation will provide the analysis of equity returns for 1, 2, 3, and 4 year scenarios. Page 7

11 2. In the Decline in Equity Markets scenario, the 40% decline is based on the approximate 95th percentile of historical cumulative four year returns on the TSX from 1919 to present; the actual 95th percentile return was -43.2%. Normally, plausible adverse scenarios would be selected in the 95 th to 99 th percentile range. In future DCAT reports, the actuary should select plausible adverse scenarios at a minimum 95th percentile (i.e., more than 43.2% decline in this case) if he should decide a four-year testing period is more appropriate than a one-year testing period. Action: The selection of the 40% equity decline was the judgment of the Corporation s actuary based on the historical TSX return distribution. The most significant four-year equity declines occurred much farther back in the historical period (e.g s) and the actuary did not believe it was reasonable to give 100% weight to these results. In this year s DCAT report we will provide more details on the historical TSX data and a better explanation of why the given scenario was selected. 3. Investment risk may come from a variety of sources including significant change in the yield curve, increase in the default rate on debt securities, and a decrease in returns and/or value of equities, real estate or other major asset categories. The Corporation has all of the above investments in its portfolio. In future DCAT reports, the actuary should consider an integrated scenario involving a combination of these events; correlation among the various investments should also be considered. Action: Based on available historical institutional real estate and equity data, there were no combined equity and real estate scenarios that were determined to be a top three adverse scenario. Similar to last year s DCAT report, we have stress tested scenarios involving combined impacts to multiple asset categories. We will provide more details (relative to last year s DCAT) of the stress tests used in this report. 4. Most scenarios with major changes in expected claims should include a review of the Deferred Policy Acquisition Expenses (DPAE); such review often results in a write down of the DPAE or even a premium deficiency. These actions would increase expenses on the statement of operations and reduce retained earnings. In future DCAT reports, the actuary should consider the ripple effect of changes Page 8

12 in expected claims on DPAE and premium deficiencies. Action: We have included the impact of a DPAE write down and/or premium deficiency in this year s DCAT report. 5. Many items on the statement of operations that affect the net income are calculated using figures found on the Statement of Financial Position. Additional figures were requested and received from MPI in the course of my review. In future DCAT reports, Statement of Financial Position and other schedules of financial statements should be included as part of the supporting exhibits to assist the reviewer in validation of the model outputs. Action: The Corporation will have balance sheets available for the 2014 DCAT. We have estimated the unrealized equity gains/losses at each fiscal year end as part of this report. 6. As Basic Auto has long-term liabilities, it is always prudent to stress test a scenario in which its claims provision is understated by a reasonably high percent (e.g. 10%). Action: We will provide the results of such stress tests in this year s DCAT report. In previous DCAT reports, we performed such tests but did not identify the results as a top three adverse event. 7. The definition of satisfactory future financial condition for the Corporation states that if throughout the forecast period it is able to meet all its future obligations under the base scenario and all plausible adverse scenarios. I believe the threshold for failing this test should include monies available under the Accumulated Other Comprehensive Income section of Total Equity not just the Rate Stabilization Reserve ( RSR ). For the Corporation, this means any scenario involving changes in equity values should have the full impact accounted for in the first year either through realization of losses/gains or changes in AOCI account. Based on my modeling, the total equity remains greater than zero in all adverse scenarios tested. MPI and their Regulator should consider AOCI when determining satisfactory financial condition and when deciding whether to issue rebates and or surcharges, and MPI should include forecasts of AOCI as part of its DCAT output. Action: The Corporation will have balance sheets available for the 2014 DCAT report. In this year s DCAT report, the Corporation has provided Page 9

13 the estimated unrealized gains/losses from equities at each fiscal year end. We have recommended that the Corporation and the PUB consider AOCI when deciding on whether to issue rebates. Deterioration in Basic Retained Earnings in Fiscal 2012/13 The Corporation ended the 2012/13 year with a net loss of $72.2 million in the Basic Autopac program. This loss resulted from: Lower investment returns by $12 million mainly as a result of low interest rates and lower equity dividends Continued low interest rates negatively impacting both pension ($9 million over budget) and claim liabilities ($4 million over budget) Bad winter weather resulting in collision and property damage claims being $17 million over budget. Revised estimates for PIPP claim liabilities in the October 2012 and February 2013 Appointed Actuary s report that were $14 million over budget (excluding interest rate impacts). The combination of lower than expected interest rates, higher than expected collision and property damage costs, and the PUB ordered 8% rate decrease (compared to the 6.8% applied for rate decrease) resulted in 2012/13 unearned premiums that were not sufficient to cover all expected costs. Therefore, the Corporation had to write-down $15 million of deferred policy acquisition costs (i.e. commissions and premiums taxes). These actual results are $76.9 million lower than the 2012/13 forecast contained in the 2013 General Rate Application (GRA). The reason for this unfavourable variance from the forecast is reflected in earned premiums lower by $3.8 million, higher claim costs by $46.3 million, higher operating costs by $5.5 million and lower investment income by $12 million. The most significant difference compared to last year s forecast was with respect to higher physical damage claims incurred. The number of actual collision claims rose by 11,694 or 7.8 per cent, which contributed to an increase in the cost of these claims by $31.0 million compared to last year s forecast. The increased number of collisions was primarily due to the many storms that occurred in the winter of 2012/13. As stated earlier, low interest rates, lower returns on equities and fewer cash dividends contributed to investment income being $12 million less than last year s forecast. Page 10

14 Another contributing factor to the difference from forecasted results is that last year s GRA submission was based on the former Public Utilities Board directed cost allocation methodology whereas the actual results for 2012/13 are based on the new cost allocation methodology approved by the Public Utilities Board in December 3, 2012 Order No. 157/12. The new cost allocation methodology uses net claims incurred as the allocator for claims expenses to the insurance lines of business. Recommendation 1. Set the minimum Rate Stabilization Reserve (RSR) target at $172 million for Basic. This amount represents the most significant decline in retained earnings relative to the base forecast for the adverse scenarios tested in this report. 2. If the RSR falls below the minimum DCAT RSR target, Management should implement a plan to restore the RSR to the minimum level. 3. If there is a significant increase in projected claims costs, Management should be prepared to increase rates as quickly as possible. 4. Management should continue to monitor loss cost and premium trends to determine if there are any threats to the financial condition of Basic. 5. Management should continue to monitor its reinsurance coverage as the severity of the modeled adverse scenarios could increase substantially if this coverage is reduced. 6. Management should continue to monitor other important risk factors such as inflation, policy liability risk, and changes to international financial reporting standards. 7. The Regulator should consider the balance of funds in Accumulated Other Comprehensive Income before making decisions on future rebates. Page 11

15 2.0 Introduction Role of the Appointed Actuary As per Subsection 2520 of the Canadian Institute of Actuaries Standards of Practice: The appointed actuary should make an investigation at least once during each financial year of the insurer s recent and current financial position, and financial condition, as revealed by dynamic capital adequacy testing for selected scenarios. The appointed actuary should make a report of each investigation in writing to the insurer s board of directors (or to their audit committee if they so delegate) or its chief agent for Canada. The report should identify possible actions for dealing with any threats to satisfactory financial condition that the investigation reveals. The appointed actuary should also make an interim investigation if there is a material adverse change in the insurer s circumstances. The appointed actuary should ensure that the investigation is current. The investigation should take into consideration recent events and recent financial operating results of the insurer. The actuary s investigations would be done with a frequency sufficient to support timely corrective actions by management and the board of directors or chief agent for Canada. Purpose The purpose of DCAT is to identify plausible threats to satisfactory financial condition, actions that would lessen the likelihood of those threats, and actions that would mitigate a threat if it materialized. Page 12

16 Scope The DCAT report contains the key assumptions of the base scenario and the plausible adverse scenarios posing the greatest risk to the satisfactory financial condition of the Corporation. The report discloses each of the risk categories considered in undertaking the DCAT analysis, including those identified in the CIA Standards of Practice. The report contains the plausible adverse scenarios examined that cause the Corporation s retained earnings to fall below zero given the Corporation s current and projected financial position and the Regulator s maximum RSR (retained earnings) target as described in Section 3 of this report. The DCAT analysis was performed by Luke Johnston, FCIA, FCAS, PRM, Chief Actuary and Executive Director of Pricing and Economics. Mr. Johnston is available to answer any questions in regards to this report and can be reached at the following address: Manitoba Public Insurance Donald Street Box 6300 Winnipeg, MB R3C 4A4 Telephone: (204) ljohnston@mpi.mb.ca Use and Distribution The DCAT report was prepared for the internal use of Manitoba Public Insurance. A copy of this report may be provided to the Company s external auditors and to the Public Utilities Board. Page 13

17 Process DCAT has the following key elements: Development of a base scenario; Analysis of the impact of adverse scenarios; Identification and analysis of the effectiveness of various strategies to mitigate risks; A report on the results of the analysis and recommendations to the insurer s management and the Board of Directors; and An opinion signed by the actuary and included in the report on the financial condition of the insurer. Method The Corporation s internal financial model was used to perform the 2013 DCAT analysis. The Corporation s base scenario was generated through the combined effort of several departments and committees, including: Actuarial Services Department Investments Department Budgeting and Planning Services Claims Forecasting Committee Revenue Forecasting Committee Management Committee The assumptions and forecasts generated by the above departments and committees are the inputs for the Corporation s financial model. A summary of the base scenario assumptions are contained in Section 4 of this report. The modeling of plausible adverse scenarios involves reviewing all of the assumptions (or inputs) of the base scenario and determining how they are impacted by the event. A new set of assumptions and forecasts are then generated based on the assumed plausible adverse scenario. These assumptions are then input into the financial model and the results are compared to the base scenario. Page 14

18 Data Sources To perform this valuation, I have used information provided by: Wes Sprenger, Acting Manager, Investments Dean Dunstone, Assistant Manager, Budgeting and Forecasting Tyler Clearwater, Actuarial Analyst, Actuarial Services 3.0 Capital Adequacy Management Definition of the Minimum Regulatory Capital Requirement The Public Utilities Board (PUB) in Manitoba sets the Corporation s retained earnings levels under the Basic Compulsory program. Basic retained earnings, net of any special appropriations, are referred to as the Rate Stabilization Reserve (RSR). In 2014/15 the Regulator s projected minimum and maximum allowable RSR levels are $88 million and $176 million respectively, or 10% to 20% of net written premiums (total vehicle and driver premiums). These amounts may change at any time by a Board Order. The assumed minimum and maximum RSR levels in each year are shown in the table below. The calculations assume that the Corporation s applied for 2014/15 overall Rate Increase of 1.8% will be approved by the Public Utilities Board. Insurance Year Minimum RSR Maximum RSR 2013/14 $83M $165M 2014/15 $88M $176M 2015/16 $92M $184M 2016/17 $97M $193M 2017/18 $101M $200M Definition of Satisfactory Future Financial Condition The Corporation s financial condition is satisfactory if throughout the forecast period it is able to meet all its future obligations under the base scenario and all plausible adverse scenarios, and under the base scenario it meets the minimum regulatory capital requirement. Page 15

19 Expanding on the above definition for MPI Basic: Meet all its future obligations means that the Rate Stabilization Reserve will remain above zero at all times during the forecast period. Meets the minimum regulatory capital requirement means that the Rate Stabilization Reserve will remain above the Public Utilities Board minimum RSR targets (as shown in the previous section) at all times during the forecast period. Materiality As per Canadian actuarial standards of practice, an omission, understatement or overstatement is material if the actuary expects it materially to affect either the user s decision making or the user s reasonable expectations. We have judgmentally selected a materiality standard of $10 million, which is twice the materiality standard used in the Basic Appointed Actuaries Report. The higher standard reflects the much greater uncertainty associated with the DCAT projections relative to the uncertainty of the base forecast. The materiality standard is approximately equal to 1.3% of projected net earned revenues for Basic in 2013/14. Note: The materiality level is not intended to represent the range of reasonable values or the inherent uncertainty in an actuarial estimate. Page 16

20 4.0 Background Discussion Description of Basic MPI Basic is the Corporation s compulsory automobile insurance product. The Corporation has a monopoly on the sale of Basic products. The Basic coverages are as follows: All perils coverage with a $500 deductible No-fault accident benefits (Personal Injury Protection Plan) Third Party Liability with a $200,000 limit. Recent and Current Financial Position Historical Results From Statement of Operations (in millions) 2008/ / / / /13 Earned Revenues $715 $744 $768 $780 $775 Total Claims Costs $623 $623 $447 $733 $786 Expenses $104 $117 $121 $130 $129 Investment Income $4 $84 $84 $101 $68 Net Income ($8) $88 $284 $19 -$72 IIF Transfers $16 $2 $0 $0 $0 Rebates/Surcharges $0 $0 -$322 -$14 $0 IFRS Adjustments $0 $0 $19 $0 $0 IT Optimization Fund $0 $0 -$65 $65 $0 Retained Earnings* $137 $225 $206 $214 $141 Rate Stabilization Reserve $135 $154 $141 $156 $141 Excess Retained Earnings** $88 $71 $0 $58 $0 * Historical retained earnings include appropriations for the Immobilizer Incentive Fund and the IT Optimization Fund. ** Excess Retained Earnings are retained earnings amounts in excess of the maximum Rate Stabilization Reserve target as ordered by the Public Utilities Board. Page 17

21 Base Scenario The base scenario for MPI Basic is shown below and in Exhibits 1a through 1d: Base Scenario From Statement of Operations and Statement of Retained Earnings (in millions) 2013/ / / / /18 Earned Revenues $787 $835 $881 $922 $963 Total Claims Costs $770 $775 $791 $801 $831 Expenses $125 $131 $134 $139 $144 Investment Income $115 $63 $46 $38 $36 Net Income $5 ($7) $2 $20 $24 Retained Earnings $147 $139 $142 $162 $186 Rate Stabilization Reserve $147 $139 $142 $162 $186 Excess Retained Earnings $0 $0 $0 $0 $0 PUB RSR Range $83-$165 $88-$176 $92-$184 $97-$193 $101-$200 Description of Economic Assumptions in the Base Scenario Volume growth: The number of insured units (excluding trailers and ORVs) is assumed to increase 2.00% in 2013/14 and 1.75% per year thereafter, which is consistent with the historical averages. Trailers and ORVs have higher growth rates, but represent less than 1% of annual loss costs. Upgrade Factor: The average premium can increase or decrease without rate changes as customers change their vehicle preferences (e.g. SUV s versus cars), where they live (e.g. Winnipeg versus rural), or how they use their vehicle (e.g. all purpose versus pleasure). The upgrade factor (excluding trailers and ORVs) is assumed to be 2.50% per year over the entire forecast period. Inflation: Projected Manitoba and Canadian Consumer Price Inflation (CPI) are forecasted at 1.7% and 1.3% respectively in 2013/14. Thereafter, both CPI forecasts are projected at 2.0% per year. These rates are based on the consensus forecast from various banks and economic forecasting firms rounded to the nearest 25 basis points. Page 18

22 Interest rates and yields: The projected interest rates and yields are shown in the table below. The interest rate forecasts are based on the median forecast from various banks and economic forecasting firms. The returns for equities, real estate, and infrastructure are the Corporation s internal forecasts. Fiscal Year CDN 91 Day T-Bill Canadian 10 Year MUSH Rate CND/US Equities Real Estate Infra- Structure 2013/ % 2.00% 5.09% 6.20% 5.30% 6.30% 2014/ % 2.32% 4.97% 6.20% 6.00% 7.00% 2015/ % 2.67% 4.93% 6.20% 6.00% 7.00% 2016/ % 3.21% 4.95% 6.20% 6.00% 7.00% 2017/ % 3.86% 5.05% 6.20% 6.00% 7.00% *The interest rates and yields in the above table are for the fourth quarter of each fiscal year. The Corporation creates forecasts for each quarter (not shown). The discount rate used for claim liabilities is calculated directly from the current average yields on the Corporation s fixed income portfolio. The assumed claim liability discount rates are shown in the table below. Assumed Claims Liability Discount Rate Fiscal Year End Nominal Real 2013/ % 1.48% 2014/ % 1.68% 2015/ % 1.91% 2016/ % 2.26% 2017/ % 2.70% Rate changes Vehicle premiums: The base forecast includes a 0.0% rate decrease in 2013/14, which has been approved by the Public Utilities Board, and a 1.8% rate increase in 2014/15, which has not yet been approved by the Public Utilities Board (expected ruling in December 2013). There are no other rate changes assumed in the forecast period. Driver premiums: The base forecast includes PUB approved increases to driver premium rates for demerit level drivers in 2013/14. The Corporation is not proposing any changes to the driver rates in 2014/15. Page 19

23 Rebates The base forecast assumes that no rebates will be ordered by the Public Utilities Board over the forecast period. Reinsurance The Corporation s reinsurance structure is as follows: Catastrophe program in excess of $15 million with a limit of $300 million. MPI retains 1/3 of the $100 million excess of $200 million layer. Casualty program with retention of $5 million and a limit of $50 million. In 2013/14 the Corporation began transitioning to an annual, rather than a multiyear, Catastrophe reinsurance program. The transition does not affect the layers of coverage purchased by the Corporation. No changes in coverage are anticipated for the reinsurance program over the projection period. Discussion of Prior Year s DCAT Results, Recommendations, and Management Actions Last year s DCAT report identified two plausible adverse scenarios that resulted in a reduction to the Basic RSR in excess of the PUB s projected maximum RSR target of $162 million as of the end of the 2013/14 fiscal year. The two scenarios were the Equity Decline scenario and the Combined (high loss ratio and a decline in equities) scenario. The report indicated that the Corporation would require at least $200 million in the RSR as at February 29, 2012 to achieve a satisfactory financial condition. As discussed in the Review of Events since the Previous DCAT Report section, the PUB did not approve the Corporation s DCAT-based minimum RSR target of $200 million. Page 20

24 5.0 Adverse Scenarios Summary of Results A summary of the projected retained earnings for the selected plausible adverse scenarios (including management and regulatory action) are shown in the table below. The adverse scenarios listed below are considered to have the most significant financial impact to the Corporation. All other risk categories are discussed in the Analysis of All Property and Casualty Insurer Risk Categories section of this report. Retained Earnings (in millions) Adverse Scenarios including Management Action Scenario 2013/ / / / /18 Base $147 $139 $142 $162 $186 Combined Interest Rate, Equity Decline, High Loss Ratio $138 $54 $16 ($10) $35 High Loss Ratio $147 $80 $80 $68 $79 Sustained Low Interest Rates $138 $106 $88 $88 $106 Combined Equities and Loss Ratio $147 $100 $62 $37 $125 Equity Decline $147 $119 $102 $115 $152 A comparison of the changes in retained earnings relative to the base forecast are shown in the table below. Change in Retained Earnings from the Base Forecast (in millions) Adverse Scenario including Management Action Scenario 2013/ / / / /18 Combined Interest Rate, Equity Decline, High Loss Ratio ($9) ($85) ($126) ($172) ($151) High Loss Ratio $0 ($59) ($62) ($94) ($107) Sustained Low Interest Rates ($9) ($33) ($54) ($74) ($80) Combined Equities and Loss Ratio $0 ($39) ($80) ($125) ($61) Equity Decline $0 ($20) ($40) ($47) ($34) As shown in the above table, there is one adverse scenario (the Combined Interest Rate, Equity Decline, and High Loss Ratio scenario) that resulted in retained earnings of less than zero in the 2016/17 fiscal year. This scenario also resulted in a total reduction in retained earnings of $172 million relative to the base forecast. Page 21

25 Decline in Equity Markets Scenario Description The Corporation s equity assets experience a decline beginning in the 2014/15 fiscal year. Ripple Effects None identified other than those impacts already incorporated into the Corporation s financial model. Changes from Last Year s DCAT Report In addition to the changes already discussed in Review of Events Since the Previous DCAT Report, the Decline in Equity Markets Scenario includes the following modeling changes from last year s scenario: This year s scenario used the S&P/TSX Composite total return index using data from 1956 to March 31, Last year s scenario used the S&P/TSX Composite index from 1919 to present, which only measures capital return and excludes dividends. This year s scenario models 20% realization of losses each year for Canadian equities and 0% realization of losses for U.S. equities. Last year s scenario assumed that 67% of losses were realized in 2013/14 and 33% of remaining losses were realized in 2014/15. Scenario Justification Equity Returns A historical analysis was conducted of the cumulative 1, 2, 3, and 4 year returns of the S&P/TSX Composite index from 1919 to present and from 1956 to present. The table below shows the actual capital returns (i.e. excluding dividends) at the 1 st, 2.5 th, and 5 th percentiles over these two historical periods. Page 22

26 Historical Capital Returns on the S&P/TSX by Percentile and Return Period Return Period (Years) Time Period Percentile present 1st -40.7% -57.1% -67.9% -65.0% 1956-present 1st -34.1% -33.7% -28.3% -20.0% 1919-present 2.5th -34.2% -43.6% -43.4% -51.3% 1956-present 2.5th -29.3% -28.8% -21.1% -16.3% 1919-present 5th -26.4% -29.9% -27.4% -33.0% 1956-present 5th -20.4% -21.9% -15.7% -12.2% The 1919-to-present historical period over the 1 st, 2.5 th and 5 th percentile had significantly worse percentile returns than the 1956-to-present time period. These lower percentile returns were because of the stock market decline in the late 1920s and 1930s. For this year s equity decline scenario, the S&P/TSX Composite total return index (capital returns and dividends) will be used instead of the S&P/TSX Composite (capital returns only). Total return for the S&P/TSX Composite index is not available prior to The table below shows the actual total returns at the 1st, 2.5th, and 5th percentiles for the S&P/TSX Composite from 1956 to present. Historical Total Returns on the S&P/TSX by Percentile and Return Period (Cumulative) Return Period (Years) Time Period Percentile present 1st 32.5% 29.5% 24.6% 9.5% 1956 present 2.5th 27.1% 23.4% 13.3% 3.1% 1956 present 5th 18.0% 15.9% 6.6% 0.3% Based on the historical results above, the Corporation selected equity decline scenarios based on fitted distributions selected to best represent the historical data. The assumptions are shown as total return in the table below. Page 23

27 Selected Adverse Scenarios by Percentile and Return Period (Cumulative) Return Period (Years) Percentile st 32.0% 27.9% 22.8% 10.5% 2.5th 25.3% 21.7% 15.1% 5.9% 5th 19.6% 16.0% 8.3% 1.0% Dividend Yield The dividend yield used in the equity decline scenarios is 3.2% for Canadian equities and 2.4% for U.S. equities, which is the same dividend yield as the base forecast. The dividend yield is based on the 3 year Bloomberg forecasted average dividend yield for the S&P/TSX and S&P 500 index. Dividend income is calculated based on the market value of the portfolio times the dividend yield. When the market value of the equity portfolio declines in the scenario analysis, dividends received as investment income also declines on a proportionate basis. Realized Losses Canadian and U.S. equity unrealized losses are not recognized in net income for rate setting purposes. Last year s DCAT assumed that 67% of the equity loss was realized in the first year, and the remaining 33% of losses were in the second year for the Canadian and U.S. equity portfolio. For Canadian equities, it is assumed that 20% of the unrealized losses are realized each year, which is unchanged from the base scenario. Equity turnover indicates the rate at which gains or losses are realized in the equity portfolio on an annual basis. During the most recent market crisis, equity turnover in the portfolio was relatively low. In calendar year 2008 and 2009, the Canadian equity turnover ratio was 31% and 16% based on the current composition of the Canadian equity managers. The base Canadian equity turnover ratio was 20%, which was based on the 7 year average of the turnover ratio. Therefore, for DCAT modeling purposes, it is assumed that unrealized gains/losses are realized at 20% per year. The U.S. equity portfolio is passively managed and gains or losses are only realized when the manager is directed to sell units. Therefore, it is assumed that 0% of the U.S. equity gains or losses are realized, which is the same as the base forecast. Page 24

28 Rebalancing Assumptions In all of the equity decline scenarios that were run, the Canadian and U.S. equity portfolio were not rebalanced within the model since the declines did not cause either asset class to go outside of the tolerance range. For information, the Canadian minimum/target/maximum tolerance ranges are 12%/15%/18% of the total portfolio, and the U.S. equity tolerance ranges are 3%/5%/7%. Impairments Impairment in the DCAT scenarios is based on the Corporation s existing impairment rule where market value must be less than 80% of the book value at fiscal year-end before impairment can be considered. As of February 28, 2013, the market value to book value ratio of the Canadian equity portfolio was approximately 118%. Given this relatively high market value to book value ratio, impairment only occurs in the most adverse scenario: the 1 year DCAT decline of -32.0% (1 in a 100 scenario). For this scenario, it was assumed that there was an impairment of -$18.6 million, which was based on historical experience in 2008 and This $18.6 million is comparable to the $24.6 million that was written down as of February 28, 2009 when the Canadian equity portfolio declined by -37.8% that fiscal year. U.S. equities are assumed to be invested in exchange traded funds (ETFs) within the model. In 2009, U.S. equity ETFs were exempted from impairment even though the ETFs were below the 80% market value to book value threshold. Therefore, based on this experience, U.S. equities were not written down in any of the scenarios. Results before Management and Regulatory Action The tables below show (i) the projected investment income and (ii) the cumulative change in investment income from the base forecast for each of the equity decline scenarios described above. The results are shown without management or regulatory action. Also, the highlighted cells indicate where the base forecast was assumed. We've marked these cells because the historical data indicates that equity returns are not completely independent from year-to-year (especially after large declines), and therefore, these results may not be plausible beyond the return period tested. These Page 25

29 highlighted results are for information only and will not be used in the selection of the most adverse equity decline scenario. Decline in Equity Markets Scenario Investment Income (in millions) Probability Return Period 2014/ / / /18 1-in year + base $8 $24 $19 $21 1-in-40 1 year + base $32 $29 $24 $25 1-in-20 1 year + base $36 $33 $27 $28 1-in year + base $40 $22 $17 $19 1-in-40 2 year + base $43 $27 $21 $22 1-in-20 2 year + base $45 $31 $25 $26 1-in year + base $45 $31 $16 $17 1-in-40 3 year + base $48 $35 $21 $22 1-in-20 3 year + base $49 $38 $26 $26 1-in year $50 $39 $26 $20 1-in-40 4 year $51 $40 $28 $23 1-in-20 4 year $52 $42 $31 $26 Base $63 $46 $38 $36 Decline in Equity Markets Scenario Cumulative Difference from Base Forecast Investment Income (in millions) Probability Return Period 2014/ / / /18 1-in year + base ($55) ($77) ($95) ($111) 1-in-40 1 year + base ($31) ($48) ($62) ($74) 1-in-20 1 year + base ($27) ($40) ($50) ($58) 1-in year + base ($23) ($47) ($67) ($85) 1-in-40 2 year + base ($20) ($39) ($56) ($70) 1-in-20 2 year + base ($18) ($33) ($45) ($56) 1-in year + base ($18) ($33) ($54) ($74) 1-in-40 3 year + base ($15) ($26) ($43) ($58) 1-in-20 3 year + base ($14) ($21) ($33) ($44) 1-in year ($13) ($21) ($32) ($49) 1-in-40 4 year ($12) ($18) ($27) ($41) 1-in-20 4 year ($12) ($15) ($22) ($33) Page 26

30 Based on the above table, the most significant cumulative reductions in Basic investment income (excluding the highlighted cells) occur at: 1-in-100: 1 year scenario ($55M) 1-in-40: 3 year scenario ($43M) 1-in-20: 4 year scenario ($35M) For modeling purposes, we selected the three year scenario at the 1-in-40 probability level. The results are shown in the table below and in Exhibits 2a and 2b. Decline in Equity Markets Scenario (in millions) 2013/ / / / /18 Earned Revenues $787 $835 $881 $922 $963 Total Claims Costs $770 $775 $791 $801 $831 Expenses $125 $131 $134 $139 $144 Investment Income $115 $48 $35 $21 $22 Net Income $5 ($23) ($9) $4 $9 Retained Earnings $147 $124 $115 $119 $129 Unrealized Gains/(Losses) $52 $10 ($24) ($53) ($34) Decline in Equity Markets Scenario - Difference from Base Forecast (in millions) 2013/ / / / /18 Earned Revenues $0 $0 $0 $0 $0 Total Claims Costs $0 $0 $0 $0 $0 Expenses $0 $0 $0 $0 $0 Investment Income $0 ($15) ($11) ($17) ($15) Net Income $0 ($15) ($11) ($17) ($15) Retained Earnings $0 ($15) ($26) ($43) ($58) Unrealized Gains/(Losses) $0 ($37) ($76) ($110) ($99) Results with Management and Regulatory Action The table below shows the estimated retained earnings from the Equity Decline scenario before management and regulatory action. Page 27

31 Decline in Equity Markets Scenario Estimated Retained Earnings before Management and Regulatory Action (in millions) Probability Return Period 2014/ / / /18 1-in year + base $85 $65 $67 $75 1-in-40 1 year + base $108 $93 $100 $112 1-in-20 1 year + base $113 $102 $112 $128 1-in year + base $116 $95 $95 $102 1-in-40 2 year + base $119 $102 $106 $117 1-in-20 2 year + base $122 $109 $117 $130 1-in year + base $122 $109 $108 $113 1-in-40 3 year + base $124 $115 $119 $129 1-in-20 3 year + base $126 $121 $129 $143 1-in year $126 $121 $130 $137 1-in-40 4 year $127 $124 $135 $145 1-in-20 4 year $128 $126 $140 $154 For the Equity Decline scenario we used the following assumptions to determine management and regulatory actions: The occurrence of an equity decline would not result in a rate increase in future years as the projected net income would continue to remain above zero despite the decline in equity asset values. If projected retained earnings are less than $125 million at the end of 2014/15, we assumed that the PUB would approve a 2% rate surcharge in the 2016/17 rate application. If projected retained earnings are less than $125 million at the end of 2015/16, we assumed that the PUB would leave any existing surcharges in place and approve an additional surcharge of 2% in the 2017/18 rate application. The projected retained earnings and the difference from the base forecast after the assumed management and regulatory actions are shown in the tables below. Page 28

32 Decline in Equity Markets Scenario Retained Earnings After Management and Regulatory Action (in millions) Probability Return Period 2014/ / / /18 1-in year + base $85 $65 $75 $92 1-in-40 1 year + base $108 $93 $108 $128 1-in-20 1 year + base $113 $102 $120 $144 1-in year + base $116 $95 $103 $118 1-in-40 2 year + base $119 $102 $114 $133 1-in-20 2 year + base $122 $109 $125 $146 1-in year + base $122 $109 $116 $129 1-in-40 3 year + base $124 $115 $127 $145 1-in-20 3 year + base $126 $121 $129 $151 1-in year $126 $121 $130 $145 1-in-40 4 year $127 $124 $135 $154 1-in-20 4 year $128 $126 $140 $154 Decline in Equity Markets Scenario After Management and Regulatory Action Difference from Base Retained Earnings (in millions) Probability Return Period 2014/ / / /18 1-in year + base ($55) ($77) ($87) ($95) 1-in-40 1 year + base ($31) ($48) ($54) ($58) 1-in-20 1 year + base ($27) ($40) ($42) ($42) 1-in year + base ($23) ($47) ($59) ($69) 1-in-40 2 year + base ($20) ($39) ($48) ($54) 1-in-20 2 year + base ($18) ($33) ($38) ($40) 1-in year + base ($18) ($33) ($46) ($58) 1-in-40 3 year + base ($16) ($26) ($35) ($42) 1-in-20 3 year + base ($14) ($21) ($33) ($35) 1-in year ($13) ($21) ($32) ($41) 1-in-40 4 year ($13) ($18) ($27) ($33) 1-in-20 4 year ($12) ($15) ($22) ($33) Based on the above results, we selected the two-year, 1-in-40 probability level scenario for modeling purposes. This scenario assumes a 2.0% RSR rebuilding surcharge in 2016/17 and a 4% RSR rebuilding surcharge in 2017/18. The results for this scenario are shown below and in Exhibits 2e and 2f. Page 29