Description
Enterprise risk management (ERM) in business includes the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives.
RISK MANAGEMENT
eNteRPRise Risk MANAGeMeNt (eRM) FRAMeWoRk
CMHC is exposed to a variety of risks in its operating environment that could have an impact on the achievement of its objectives. The ability to respond adequately to expected and unanticipated change is critical to the organization’s success. Within this context, CMHC has an enterprise risk management framework which helps to guide the organization in its risk management activities. This framework establishes a governance structure, specifies our appetite for risk and defines, assesses and categorizes the risks that the organization is exposed to. The enterprise risk management framework and governance structure encourages a risk-aware culture where risk management is an integral part of our strategic and operational decision-making; ensures that we are identifying the main risks and opportunities to the Corporation; and facilitates the understanding, discussion, evaluation and management of risks at all levels of the organization. eRM Governance The Board of Directors is responsible for the overall corporate governance of CMHC which includes oversight of the Corporation’s ERM framework. The following diagram and accompanying details highlight the key stakeholders and their major responsibilities in our enterprise risk management framework:
CMHC Management and ALCO
The Board of Directors oversees the risk management activities at CMHC and establishes acceptable risk parameters through a risk appetite statement. The President and Chief Executive Officer (CEO) is accountable for ensuring that all significant risks are appropriately identified and managed within CMHC. The CEO provides the Board with assurance that these activities are being completed in an annual ERM Letter of Representation, included on page 70. All members of CMHC Management play an integral role in ERM activities through their responsibilities for identifying, assessing, monitoring and reporting potential risks that may put the organization outside the tolerances expressed in the risk appetite statement. The Chief Risk Officer (CRO) is accountable for developing and maintaining an effective risk management framework for the organization. The CRO assists the CEO in developing and communicating the organization’s risk management objectives, risk appetite and risk management framework. ALCO (Asset-Liability Management Committee) is a senior level committee chaired by the President and CEO which draws on internal and external specialized expertise in financial management. The ALCO committee is involved in reviewing Board and approving all ERM reports prior to their presentation to the Board.
President and CEO CRO
ERM Director Audit Senior and Middle Managers
ERM Commitee and Resource Group
Strategic Planning
Management’s Discussion and Analysis
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Management’s Discussion & Analysis
The CRO and CMHC Management are assisted in their risk management efforts by the ERM Committee and the Director, ERM. The ERM Committee is comprised of senior level managers and is chaired by the Director, ERM. The committee members represent the major business and risk management units and have a strong technical understanding of risks in their business units. The ERM Committee also obtains advice and support from additional subject matter experts. The ERM Committee is actively involved in the process of identifying and assessing risks. The other groups and individuals shown in the ERM governance diagram all play a role in ensuring that risks are identified and assessed in a consistent manner and are mitigated as appropriate. Processes are also in place to ensure that risk identification and mitigation strategies are an integral part of the corporate planning and regular performance reporting processes. Risk Appetite statement CMHC’s ERM framework includes a risk appetite statement which is designed to ensure a consistent understanding of risk exposures which are acceptable or unacceptable to the Corporation. The risk appetite statement begins with the following statement: “CMHC is exposed to a variety of risks as it strives to achieve the objectives set out in its corporate and business plans. This high-level risk appetite statement describes the level at which risks should be avoided and where strategies must be implemented to manage risk.”
The statement then indicates that during the Corporation’s five-year corporate planning horizon, it wants a very high level of confidence that:
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spending on government funded programs will not vary from approved funding by more than a specified percentage; exposures to financial risk expressed as a percentage of capital in the three primary business lines – mortgage insurance, securitization and lending – will not exceed specified risk levels; variances of operating expenses to budget will not exceed a specified maximum variance.
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The risk appetite statement also contains a subjective risk tolerance statement for the five-year planning horizon which states that: “It is considered unacceptable that CMHC would experience a significant negative impact to the reputation of CMHC or to its ability to achieve key objectives in the business and corporate plans.” The risk appetite statement concludes with a statement that a specified minimum percentage of the annual priority corporate objectives should also be achieved. eRM Framework CMHC Management continually assesses internal and external risks through the ERM framework, which groups risks under three broad categories: strategic, infrastructure and specific risks.
CREDIT MANDATE MARKET
STRATEGIC
Risks
BUSINESS ENVIRONMENT RELATIONAL ORGANIZATIONAL
INFRASTRUCTURE
PEOPLE PROCESS TECHNOLOGY
Risks
SPECIFIC
FINANCIAL LEGAL AND REGULATORY SECURITY CATASTROPHIC
Risks
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Canada Mortgage and Housing Corporation
Risk monitoring and reporting The Chief Risk Officer works closely with Management to assess changes in the environment that affect the level of risks associated with each of the risk categories and subcategories in the ERM framework. CMHC Management and the Board are kept informed of significant risks and mitigating strategies through a variety of reporting mechanisms. Quarterly financial risk reporting provides Management, the Audit Committee and Board with details on significant financial risks and on compliance with operational and financial risk policies. A semi-annual ERM report is also prepared which includes assessments of each of the entity-level risk tolerances expressed in the risk appetite statement and a risk register which identifies and assesses risks within each of the risk categories. This report also includes details on risk mitigation strategies and identifies new and emerging risks and opportunities. Other reports to the Board include details on actuarial valuations and stress testing results.
Lending Activity Under Objective 1: Help Canadians in need, CMHC provides loans to federally-subsidized social housing sponsors. These loans can be offered to social housing sponsors at lower interest rates because CMHC borrows funds through the Crown Borrowing Program. The main sources of risks to the Corporation in providing these loans are credit risk, prepayment risk and interest rate risk.
Credit risk Credit risk is defined as risk of loss due to the failure of counterparties to meet their contractual obligations. CMHC’s loan portfolio consists of loans in support of social housing that are either under the administration of provinces or territories, or administered by CMHC directly, including those on reserve. The majority of credit risk is mitigated by either CMHC mortgage loan insurance or through recoveries from the federal government.
In order to manage credit risk, project level annual reports, which include audited financial statements submitted by social housing sponsors, provide CMHC with a means to detect and to intervene, as appropriate, when a project faces financial difficulty and, therefore, poses a credit risk to CMHC. A feasibility analysis is performed to determine the value of the property and any other collateral. Work-outs or restructuring, which may involve additional financing or Enhanced Assistance, are determined on a case-by-case basis. CMHC is assured full collection of principal and accrued interest on the majority of the loans. The guarantee/insurance on these loans is provided by various sources as shown in the graph. Twenty per cent (20%) of assured loans are eligible for recovery from the Government of Canada through funds that CMHC receives through Parliamentary appropriations.
FiNANCiAL Risks
The nature of risks and risk mitigation strategies associated with CMHC Lending, Mortgage Loan Insurance and Securitization Activities are described in further detail below. For initiatives under Canada’s Economic Action Plan, a risk assessment framework was developed. The framework identifies the risks and associated mitigation activities related to the implementation of those initiatives delivered by provinces and territories as well as initiatives directly delivered by CMHC. Risk assessments and the status of mitigating activities are reviewed on a regular basis by CMHC Management and the Audit Committee of the Board.
Management’s Discussion and Analysis
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Management’s Discussion & Analysis
CMHC mortgage loan default insurance covers 21%, 38% is recoverable from provinces and territories, and 10% is recoverable from Indian and Northern Affairs Canada as these loans carry a Ministerial Loan Guarantee.
default Recovery Mitigation
10%
20%
21%
11% 38%
Reserve Fund for Lending Activity Contributed Capital by the Government of Canada is $25 million. Pursuant to the CMHC Act, a Reserve Fund is established to hold profits and losses from CMHC’s lending activities. CMHC is authorized to retain up to $240 million in the Reserve Fund. Included in this limit is an amount of $115 million designated specifically to absorb fluctuations in net income arising from unrealized gains and losses from financial instruments incurred by the Lending Activity, with the remaining $125 million to cover general options and prepayment/re-pricing losses. The current Reserve Fund stands at $134 million, of which $17 million results from unrealized gains and losses. interest rate risk The Corporation is exposed to interest rate risk when asset and liability principal and interest cash flows have different interest payments or maturity dates. The severity of this risk is largely dependent upon the size and direction of interest rate changes and on the size and maturity schedules of mismatched positions. Interest rate risk is mitigated through the matching of assets and liabilities and through the use of derivatives where mismatches exist. In the Direct Lending portfolio, 97.9% of the loans are hedged. Un-hedged interest rate risk is monitored and managed against internal risk tolerance limits set by ALCO. Interest rate sensitivity analyses are performed by calculating the magnitude of cash flow fluctuations caused by changes in interest rates. At a 95% confidence level, the negative change in the net interest margin for the next 12 months cannot exceed the limit of $1.5 million. This limit has never been exceeded.
Indian and Northern Affairs Canada CMHC mortgage loan insurance Municipal Infrastructure Loan Program Provinces and territories Government of Canada (through Parliamentary appropriations)
MILP loans represent 11% of the loans provided by CMHC and are assessed on a regular basis to determine if a provision for loss is necessary. As at 31 December 2010, no impaired loans have been identified and no provision for loss has been recorded.
Prepayment risk CMHC is subject to prepayment risk in some of its Lending Activities. For 2010, prepayments totalled $22.9 million. These prepayments were $4 million higher than experienced in 2009. Prepayments will result in a reduction in CMHC’s income if the proceeds of prepayments are invested at a reduced interest rate. CMHC monitors and reports these risks through quarterly scenario analyses modelled using average historical prepayment experience and on a worst case basis.
MoRtGAGe LoAN iNsuRANCe
The main risk of financial loss to the Corporation from its Mortgage Loan Insurance Activity is represented by the amount of future claims associated with insured mortgages relative to insurance premiums received. Economic conditions are the principal determinants that affect the incidence and magnitude of claim amounts. Changes in income, employment and, to a much lesser extent, changes in interest rates can impact a borrower’s
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ability to continue making mortgage payments. The probability and loss severity of claims are affected by housing prices at both national and local levels.
Homeowner Risks related to homeowner mortgage loan insurance are assessed through CMHC’s state-of-the-art automated underwriting system, emili. Incorporated within emili are borrower, market, property, and fraud risk assessment models. Together, these automated models provide CMHC underwriters, located in all regions of the country, with the tools to effectively assess applications for mortgage loan insurance. If necessary, underwriters can then take further steps to determine if risk-mitigating actions are required to effectively reduce the overall risk to a level that is acceptable and prudent. The most effective risk mitigating actions are continually researched and updated for underwriters. Management monitors and, if necessary, adjusts its risk assessment models based on actual claims experience and local market conditions. These automated models also provide the required information framework for the design of new or modified mortgage loan insurance products and their appropriate pricing. Large rental properties (in excess of four units) Risks associated with rental mortgage loan insurance are also assessed through detailed and thorough underwriting processes that include analysis and risk assessment of the borrower, market, property and loan characteristics. A standardized risk assessment tool is employed by underwriters to assign a risk rating to each of these major risk components. Based upon the risk rating and complexity of the application, the underwriters take risk mitigating actions that effectively ensure the risk being assumed is at a level that is acceptable and prudent. The risk ratings, along with the size of the loan and policy considerations, determine the appropriate approval authority. Portfolio Risk assessment for loans submitted for Portfolio insurance is analogous to that of homeowner insurance. Low ratio homeowner loans (loans with LTVs of less than 80%) are bundled into pools by lenders and assessed by CMHC through an automated
underwriting system similar to emili which is used for high ratio loans. The assessments include an analysis and risk assessment of the borrowers, markets and property characteristics of the mortgages. Individual pools are then priced accordingly.
quality assurance, capital management and stress testing of CMHC’s Mortgage Loan insurance Activity Through our Quality Assurance Framework, CMHC further manages insurance risks by assessing lenders’ insured loan portfolios and working with lenders on a regular basis to maintain quality standards in the underwriting and servicing of their mortgage portfolios.
Under its Capital Management Framework, CMHC follows prudential regulations as set out by the Office of the Superintendent of Financial Institutions. OSFI uses the Minimum Capital Test (MCT) to measure the capital adequacy of an insurer. CMHC has a capital holding target of 200% MCT and as such maintains twice the minimum capital required by OSFI. Key OSFI capital targets and the relative risk tolerances set by CMHC Management and Board of Directors are defined as follows:
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Minimum Regulatory Capital: 100% Minimum Capital Test (MCT). Below this level, an insurance company would no longer be allowed to write new business. A level below 0% MCT indicates insolvency. The acceptable level of risk has been set by CMHC at a 99% confidence level for not falling below the 100% MCT level and a 99.5% confidence level for the solvency test of 0% MCT. This means that the probability of falling below the minimum capital requirement must be less than 1% and the probability of insolvency must be less than 0.5%. Internal Capital Target: OSFI expects each insurer to establish an internal capital target in order to provide adequate time for management to resolve financial problems that may arise, while minimizing the need for regulatory intervention. CMHC has determined that an internal capital target level of 150% MCT is appropriate. The capital holding target of 200% MCT mentioned above reduces the likelihood of falling below this internal capital target.
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Management’s Discussion and Analysis
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Management’s Discussion & Analysis
CMHC conducts stress testing of its insurance business on an annual basis to evaluate how various economic scenarios could potentially affect its insurance financial performance, its capital levels, and its risk tolerance thresholds. A Dynamic Financial Analysis model is used to annually stress test the financial impact of 10,000 economic scenarios, coupled with plausible adverse business scenarios, on its Insurance Activity results. The results of the most recent stress testing exercise of the insurance business undertaken for the 2011-2015 Corporate Plan indicate that CMHC continues to be within the acceptable levels of risks set out in its Capital Management Framework and Risk Appetite Statement. For all economic and adverse business scenarios tested, the confidence level of capital not falling below 0% MCT is greater than 99.5%. The 50 worst scenarios of the 10,000 economic scenarios that are stress tested represent the “tail risk” beyond the 99.5% confidence level. These scenarios, while extremely unlikely, are also reviewed to ensure a complete understanding of the impacts of excessively negative financial conditions on CMHC’s insurance portfolio. These extreme scenarios reflect negative GDP growth, elevated unemployment and significant house price depreciation lasting for a number of years with assumption of no corrective action being taken by CMHC during the period. In summary, the Insurance Activity is well positioned to weather severe economic scenarios. The results from the annual stress testing are within the requirements of the Capital Management Framework.
mentioned above. An annual independent external actuarial valuation ensures that policy liabilities related to all policy holder obligations in force are appropriate and in accordance with accepted actuarial practice.
seCuRitiZAtioN
The major risk of financial loss to the Corporation arising from CMHC’s guarantee is making timely payments when an issuer is unable to honour its commitments and the assets backing the securities are insufficient. For NHA MBS, the risk associated with issuer default is mitigated by both quality assessment and monitoring of the issuers and by a minimum spread requirement between the security coupon and the lowest mortgage rate in the pool. In the event of issuer default, the minimum spread is made available to a third-party issuer for the continued servicing of both underlying mortgages and the NHA MBS payments. All securitized mortgages have full mortgage default insurance coverage. For Canada Mortgage Bonds and the Insured Mortgage Purchase Program, in addition to the NHA MBS mitigations above, the risk associated with swap counterparty default is mitigated through program requirements for collateralization and the ability to replace swap counterparties in the event that counterparty credit ratings are below specific ratings thresholds. All principal run-off investments must also be rated R-1 (High) or AAA within CHT (for CMB) and government-guaranteed for IMPP.
external actuarial valuation CMHC operates its insurance business on a commercial basis at no cost to Canadian taxpayers. CMHC Management ensures the financial viability of CMHC’s Insurance Activity by making provisions for insurance policy liabilities in accordance with prudent actuarial practices and by setting aside earnings consistent with capitalization guidelines developed by the Office of the Superintendent of Financial Institutions (OSFI). OSFI provides a risk-based capital adequacy framework which establishes regulatory capital requirements for Canadian property and casualty insurers, including mortgage insurers. CMHC follows OSFI’s guidelines as a best-in-class business practice and its capitalization rate is approximately twice the recommended level as
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iNsuRANCe ANd seCuRitiZAtioN iNvestMeNt PoRtFoLios
Premiums from Mortgage Loan Insurance Activity and fees from the Securitization Activity are invested in separate investment portfolios. The main sources of risk from our investment activities relate to credit and market risk. Credit risk in the portfolios arises from investments in fixed income securities. Market risk is generally defined as the risk of loss as a result of fluctuations in capital market conditions. Market risk includes changes in interest rates, foreign exchange values and equity prices. CMHC uses its insurance investment portfolio (insurance premiums are received when the mortgage is taken out and cover the life of the mortgage) to cover obligations associated with
its provision of insurance to lenders against borrower default on residential mortgages. The investment objective for the insurance and securitization portfolios is to prudently maximize investment returns while maintaining sufficient liquidity to meet projected business requirements, including potential future claims and other liabilities. The investment objective is subject to appropriate risk considerations and to the constraints outlined in CMHC’s funding, investment and risk management policies. The size of the insurance investment portfolio has grown over the last few years and this trend is expected to continue. In 2010, the portfolio grew by $1.69 billion, from $15.95 billion to $17.64 billion, due primarily to investment income and positive net cash inflows. Performance information, including absolute and relative risk-adjusted measures, is tracked and monitored in aggregate and at the individual asset class levels of the portfolio. As at December 31, 2010, the total return for the insurance portfolio was 7.44% which was 0.16% below the performance of the benchmark index.
The securitization investment portfolio is comprised of investments related to both the Mortgage-Backed Securities (MBS) program and the Canada Mortgage Bonds (CMB) program. As at December 31, 2010, the total return for the securitization portfolio was 7.37% which was 0.23% below the performance of the benchmark index. The investment management strategies for both portfolios are the same, as is the strategic asset allocation model which is outlined in the table below. Approximately 50% and 52.1% of the total assets supporting the Insurance and Securitization Activities, respectively, at year-end were invested in fixed income securities issued or guaranteed by the Government of Canada or Canadian provinces. As the majority of CMHC’s insurance and securitization investment assets are held within the fixed income portfolios, duration management is an important consideration in managing interest rate risk in the portfolios. The durations of the fixed income investment portfolios are managed within ranges relative to the duration of the DEX Universe Bond Index (DEXUBI) benchmark. As at December 31, 2010, the insurance and securitization fixed income portfolios had durations that were marginally shorter than the benchmark.
insurance and securitization investment Portfolios (%) Asset type Fixed Income Money Market Canadian Equity EAFE Equity U.S. Equity Real Estate Other Total strategic Allocation 78.0 3.9 10.0 4.0 4.0 0.1 0.0 100.0 insurance 77.7 3.2 10.4 4.2 4.0 0.2 0.3 100.0 securitization 78.0 3.3 10.5 4.1 4.0 0.1 0.0 100.0
Management’s Discussion and Analysis
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Management’s Discussion & Analysis
CMHC Management Enterprise Risk Management Letter of Representation
February 8, 2011 This Letter of Representation is provided to the Board of Directors in support of its responsibilities with respect to the identification of the main business risks outlined in the Board of Directors Mandate and By-Law 44 (relating generally to the conduct of the affairs of the Corporation). The intended purpose is to provide reasonable assurance that CMHC Management has identified and is managing the main business risks influencing CMHC’s operating environment. For and during 2010, CMHC Management through our enterprise risk management structure and process has: identified and assessed the main business risks to which CMHC is exposed and provided the Audit Committee of the Board of Directors and the Board of Directors with reports throughout the year intended to enable them to understand and be apprised of these risks; and n reviewed CMHC’s risk management policies to ensure that they continue to remain relevant and prudent under our current operating environment and, as required, recommended new policies and/or amendments to existing policies for the consideration by the Audit Committee and then approval by the Board of Directors.
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Based on the work undertaken by CMHC Management during this period and our knowledge of the Corporation’s affairs as of December 31, 2010, we represent that: 1. the risk management practices and policies currently in place to identify and manage the main business risks arising from these activities remain relevant and prudent, and that these practices and policies effectively support the Corporation’s broader enterprise risk management efforts; 2. the adequacy and integrity of the Corporation’s systems and management practices applied, in relation to the management of the main business risks of the Corporation, have been upheld; and 3. CMHC has an effective, corporate-wide, enterprise risk management structure and process in place. In making this representation, CMHC Management has ensured that a reasonable level of consideration has been given to the identification and management of the main business risks to the Corporation.
Karen Kinsley, FCA President and Chief Executive Officer
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Canada Mortgage and Housing Corporation
doc_653595149.pdf
Enterprise risk management (ERM) in business includes the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives.
RISK MANAGEMENT
eNteRPRise Risk MANAGeMeNt (eRM) FRAMeWoRk
CMHC is exposed to a variety of risks in its operating environment that could have an impact on the achievement of its objectives. The ability to respond adequately to expected and unanticipated change is critical to the organization’s success. Within this context, CMHC has an enterprise risk management framework which helps to guide the organization in its risk management activities. This framework establishes a governance structure, specifies our appetite for risk and defines, assesses and categorizes the risks that the organization is exposed to. The enterprise risk management framework and governance structure encourages a risk-aware culture where risk management is an integral part of our strategic and operational decision-making; ensures that we are identifying the main risks and opportunities to the Corporation; and facilitates the understanding, discussion, evaluation and management of risks at all levels of the organization. eRM Governance The Board of Directors is responsible for the overall corporate governance of CMHC which includes oversight of the Corporation’s ERM framework. The following diagram and accompanying details highlight the key stakeholders and their major responsibilities in our enterprise risk management framework:
CMHC Management and ALCO
The Board of Directors oversees the risk management activities at CMHC and establishes acceptable risk parameters through a risk appetite statement. The President and Chief Executive Officer (CEO) is accountable for ensuring that all significant risks are appropriately identified and managed within CMHC. The CEO provides the Board with assurance that these activities are being completed in an annual ERM Letter of Representation, included on page 70. All members of CMHC Management play an integral role in ERM activities through their responsibilities for identifying, assessing, monitoring and reporting potential risks that may put the organization outside the tolerances expressed in the risk appetite statement. The Chief Risk Officer (CRO) is accountable for developing and maintaining an effective risk management framework for the organization. The CRO assists the CEO in developing and communicating the organization’s risk management objectives, risk appetite and risk management framework. ALCO (Asset-Liability Management Committee) is a senior level committee chaired by the President and CEO which draws on internal and external specialized expertise in financial management. The ALCO committee is involved in reviewing Board and approving all ERM reports prior to their presentation to the Board.
President and CEO CRO
ERM Director Audit Senior and Middle Managers
ERM Commitee and Resource Group
Strategic Planning
Management’s Discussion and Analysis
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Management’s Discussion & Analysis
The CRO and CMHC Management are assisted in their risk management efforts by the ERM Committee and the Director, ERM. The ERM Committee is comprised of senior level managers and is chaired by the Director, ERM. The committee members represent the major business and risk management units and have a strong technical understanding of risks in their business units. The ERM Committee also obtains advice and support from additional subject matter experts. The ERM Committee is actively involved in the process of identifying and assessing risks. The other groups and individuals shown in the ERM governance diagram all play a role in ensuring that risks are identified and assessed in a consistent manner and are mitigated as appropriate. Processes are also in place to ensure that risk identification and mitigation strategies are an integral part of the corporate planning and regular performance reporting processes. Risk Appetite statement CMHC’s ERM framework includes a risk appetite statement which is designed to ensure a consistent understanding of risk exposures which are acceptable or unacceptable to the Corporation. The risk appetite statement begins with the following statement: “CMHC is exposed to a variety of risks as it strives to achieve the objectives set out in its corporate and business plans. This high-level risk appetite statement describes the level at which risks should be avoided and where strategies must be implemented to manage risk.”
The statement then indicates that during the Corporation’s five-year corporate planning horizon, it wants a very high level of confidence that:
n
spending on government funded programs will not vary from approved funding by more than a specified percentage; exposures to financial risk expressed as a percentage of capital in the three primary business lines – mortgage insurance, securitization and lending – will not exceed specified risk levels; variances of operating expenses to budget will not exceed a specified maximum variance.
n
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The risk appetite statement also contains a subjective risk tolerance statement for the five-year planning horizon which states that: “It is considered unacceptable that CMHC would experience a significant negative impact to the reputation of CMHC or to its ability to achieve key objectives in the business and corporate plans.” The risk appetite statement concludes with a statement that a specified minimum percentage of the annual priority corporate objectives should also be achieved. eRM Framework CMHC Management continually assesses internal and external risks through the ERM framework, which groups risks under three broad categories: strategic, infrastructure and specific risks.
CREDIT MANDATE MARKET
STRATEGIC
Risks
BUSINESS ENVIRONMENT RELATIONAL ORGANIZATIONAL
INFRASTRUCTURE
PEOPLE PROCESS TECHNOLOGY
Risks
SPECIFIC
FINANCIAL LEGAL AND REGULATORY SECURITY CATASTROPHIC
Risks
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Risk monitoring and reporting The Chief Risk Officer works closely with Management to assess changes in the environment that affect the level of risks associated with each of the risk categories and subcategories in the ERM framework. CMHC Management and the Board are kept informed of significant risks and mitigating strategies through a variety of reporting mechanisms. Quarterly financial risk reporting provides Management, the Audit Committee and Board with details on significant financial risks and on compliance with operational and financial risk policies. A semi-annual ERM report is also prepared which includes assessments of each of the entity-level risk tolerances expressed in the risk appetite statement and a risk register which identifies and assesses risks within each of the risk categories. This report also includes details on risk mitigation strategies and identifies new and emerging risks and opportunities. Other reports to the Board include details on actuarial valuations and stress testing results.
Lending Activity Under Objective 1: Help Canadians in need, CMHC provides loans to federally-subsidized social housing sponsors. These loans can be offered to social housing sponsors at lower interest rates because CMHC borrows funds through the Crown Borrowing Program. The main sources of risks to the Corporation in providing these loans are credit risk, prepayment risk and interest rate risk.
Credit risk Credit risk is defined as risk of loss due to the failure of counterparties to meet their contractual obligations. CMHC’s loan portfolio consists of loans in support of social housing that are either under the administration of provinces or territories, or administered by CMHC directly, including those on reserve. The majority of credit risk is mitigated by either CMHC mortgage loan insurance or through recoveries from the federal government.
In order to manage credit risk, project level annual reports, which include audited financial statements submitted by social housing sponsors, provide CMHC with a means to detect and to intervene, as appropriate, when a project faces financial difficulty and, therefore, poses a credit risk to CMHC. A feasibility analysis is performed to determine the value of the property and any other collateral. Work-outs or restructuring, which may involve additional financing or Enhanced Assistance, are determined on a case-by-case basis. CMHC is assured full collection of principal and accrued interest on the majority of the loans. The guarantee/insurance on these loans is provided by various sources as shown in the graph. Twenty per cent (20%) of assured loans are eligible for recovery from the Government of Canada through funds that CMHC receives through Parliamentary appropriations.
FiNANCiAL Risks
The nature of risks and risk mitigation strategies associated with CMHC Lending, Mortgage Loan Insurance and Securitization Activities are described in further detail below. For initiatives under Canada’s Economic Action Plan, a risk assessment framework was developed. The framework identifies the risks and associated mitigation activities related to the implementation of those initiatives delivered by provinces and territories as well as initiatives directly delivered by CMHC. Risk assessments and the status of mitigating activities are reviewed on a regular basis by CMHC Management and the Audit Committee of the Board.
Management’s Discussion and Analysis
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Management’s Discussion & Analysis
CMHC mortgage loan default insurance covers 21%, 38% is recoverable from provinces and territories, and 10% is recoverable from Indian and Northern Affairs Canada as these loans carry a Ministerial Loan Guarantee.
default Recovery Mitigation
10%
20%
21%
11% 38%
Reserve Fund for Lending Activity Contributed Capital by the Government of Canada is $25 million. Pursuant to the CMHC Act, a Reserve Fund is established to hold profits and losses from CMHC’s lending activities. CMHC is authorized to retain up to $240 million in the Reserve Fund. Included in this limit is an amount of $115 million designated specifically to absorb fluctuations in net income arising from unrealized gains and losses from financial instruments incurred by the Lending Activity, with the remaining $125 million to cover general options and prepayment/re-pricing losses. The current Reserve Fund stands at $134 million, of which $17 million results from unrealized gains and losses. interest rate risk The Corporation is exposed to interest rate risk when asset and liability principal and interest cash flows have different interest payments or maturity dates. The severity of this risk is largely dependent upon the size and direction of interest rate changes and on the size and maturity schedules of mismatched positions. Interest rate risk is mitigated through the matching of assets and liabilities and through the use of derivatives where mismatches exist. In the Direct Lending portfolio, 97.9% of the loans are hedged. Un-hedged interest rate risk is monitored and managed against internal risk tolerance limits set by ALCO. Interest rate sensitivity analyses are performed by calculating the magnitude of cash flow fluctuations caused by changes in interest rates. At a 95% confidence level, the negative change in the net interest margin for the next 12 months cannot exceed the limit of $1.5 million. This limit has never been exceeded.
Indian and Northern Affairs Canada CMHC mortgage loan insurance Municipal Infrastructure Loan Program Provinces and territories Government of Canada (through Parliamentary appropriations)
MILP loans represent 11% of the loans provided by CMHC and are assessed on a regular basis to determine if a provision for loss is necessary. As at 31 December 2010, no impaired loans have been identified and no provision for loss has been recorded.
Prepayment risk CMHC is subject to prepayment risk in some of its Lending Activities. For 2010, prepayments totalled $22.9 million. These prepayments were $4 million higher than experienced in 2009. Prepayments will result in a reduction in CMHC’s income if the proceeds of prepayments are invested at a reduced interest rate. CMHC monitors and reports these risks through quarterly scenario analyses modelled using average historical prepayment experience and on a worst case basis.
MoRtGAGe LoAN iNsuRANCe
The main risk of financial loss to the Corporation from its Mortgage Loan Insurance Activity is represented by the amount of future claims associated with insured mortgages relative to insurance premiums received. Economic conditions are the principal determinants that affect the incidence and magnitude of claim amounts. Changes in income, employment and, to a much lesser extent, changes in interest rates can impact a borrower’s
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ability to continue making mortgage payments. The probability and loss severity of claims are affected by housing prices at both national and local levels.
Homeowner Risks related to homeowner mortgage loan insurance are assessed through CMHC’s state-of-the-art automated underwriting system, emili. Incorporated within emili are borrower, market, property, and fraud risk assessment models. Together, these automated models provide CMHC underwriters, located in all regions of the country, with the tools to effectively assess applications for mortgage loan insurance. If necessary, underwriters can then take further steps to determine if risk-mitigating actions are required to effectively reduce the overall risk to a level that is acceptable and prudent. The most effective risk mitigating actions are continually researched and updated for underwriters. Management monitors and, if necessary, adjusts its risk assessment models based on actual claims experience and local market conditions. These automated models also provide the required information framework for the design of new or modified mortgage loan insurance products and their appropriate pricing. Large rental properties (in excess of four units) Risks associated with rental mortgage loan insurance are also assessed through detailed and thorough underwriting processes that include analysis and risk assessment of the borrower, market, property and loan characteristics. A standardized risk assessment tool is employed by underwriters to assign a risk rating to each of these major risk components. Based upon the risk rating and complexity of the application, the underwriters take risk mitigating actions that effectively ensure the risk being assumed is at a level that is acceptable and prudent. The risk ratings, along with the size of the loan and policy considerations, determine the appropriate approval authority. Portfolio Risk assessment for loans submitted for Portfolio insurance is analogous to that of homeowner insurance. Low ratio homeowner loans (loans with LTVs of less than 80%) are bundled into pools by lenders and assessed by CMHC through an automated
underwriting system similar to emili which is used for high ratio loans. The assessments include an analysis and risk assessment of the borrowers, markets and property characteristics of the mortgages. Individual pools are then priced accordingly.
quality assurance, capital management and stress testing of CMHC’s Mortgage Loan insurance Activity Through our Quality Assurance Framework, CMHC further manages insurance risks by assessing lenders’ insured loan portfolios and working with lenders on a regular basis to maintain quality standards in the underwriting and servicing of their mortgage portfolios.
Under its Capital Management Framework, CMHC follows prudential regulations as set out by the Office of the Superintendent of Financial Institutions. OSFI uses the Minimum Capital Test (MCT) to measure the capital adequacy of an insurer. CMHC has a capital holding target of 200% MCT and as such maintains twice the minimum capital required by OSFI. Key OSFI capital targets and the relative risk tolerances set by CMHC Management and Board of Directors are defined as follows:
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Minimum Regulatory Capital: 100% Minimum Capital Test (MCT). Below this level, an insurance company would no longer be allowed to write new business. A level below 0% MCT indicates insolvency. The acceptable level of risk has been set by CMHC at a 99% confidence level for not falling below the 100% MCT level and a 99.5% confidence level for the solvency test of 0% MCT. This means that the probability of falling below the minimum capital requirement must be less than 1% and the probability of insolvency must be less than 0.5%. Internal Capital Target: OSFI expects each insurer to establish an internal capital target in order to provide adequate time for management to resolve financial problems that may arise, while minimizing the need for regulatory intervention. CMHC has determined that an internal capital target level of 150% MCT is appropriate. The capital holding target of 200% MCT mentioned above reduces the likelihood of falling below this internal capital target.
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CMHC conducts stress testing of its insurance business on an annual basis to evaluate how various economic scenarios could potentially affect its insurance financial performance, its capital levels, and its risk tolerance thresholds. A Dynamic Financial Analysis model is used to annually stress test the financial impact of 10,000 economic scenarios, coupled with plausible adverse business scenarios, on its Insurance Activity results. The results of the most recent stress testing exercise of the insurance business undertaken for the 2011-2015 Corporate Plan indicate that CMHC continues to be within the acceptable levels of risks set out in its Capital Management Framework and Risk Appetite Statement. For all economic and adverse business scenarios tested, the confidence level of capital not falling below 0% MCT is greater than 99.5%. The 50 worst scenarios of the 10,000 economic scenarios that are stress tested represent the “tail risk” beyond the 99.5% confidence level. These scenarios, while extremely unlikely, are also reviewed to ensure a complete understanding of the impacts of excessively negative financial conditions on CMHC’s insurance portfolio. These extreme scenarios reflect negative GDP growth, elevated unemployment and significant house price depreciation lasting for a number of years with assumption of no corrective action being taken by CMHC during the period. In summary, the Insurance Activity is well positioned to weather severe economic scenarios. The results from the annual stress testing are within the requirements of the Capital Management Framework.
mentioned above. An annual independent external actuarial valuation ensures that policy liabilities related to all policy holder obligations in force are appropriate and in accordance with accepted actuarial practice.
seCuRitiZAtioN
The major risk of financial loss to the Corporation arising from CMHC’s guarantee is making timely payments when an issuer is unable to honour its commitments and the assets backing the securities are insufficient. For NHA MBS, the risk associated with issuer default is mitigated by both quality assessment and monitoring of the issuers and by a minimum spread requirement between the security coupon and the lowest mortgage rate in the pool. In the event of issuer default, the minimum spread is made available to a third-party issuer for the continued servicing of both underlying mortgages and the NHA MBS payments. All securitized mortgages have full mortgage default insurance coverage. For Canada Mortgage Bonds and the Insured Mortgage Purchase Program, in addition to the NHA MBS mitigations above, the risk associated with swap counterparty default is mitigated through program requirements for collateralization and the ability to replace swap counterparties in the event that counterparty credit ratings are below specific ratings thresholds. All principal run-off investments must also be rated R-1 (High) or AAA within CHT (for CMB) and government-guaranteed for IMPP.
external actuarial valuation CMHC operates its insurance business on a commercial basis at no cost to Canadian taxpayers. CMHC Management ensures the financial viability of CMHC’s Insurance Activity by making provisions for insurance policy liabilities in accordance with prudent actuarial practices and by setting aside earnings consistent with capitalization guidelines developed by the Office of the Superintendent of Financial Institutions (OSFI). OSFI provides a risk-based capital adequacy framework which establishes regulatory capital requirements for Canadian property and casualty insurers, including mortgage insurers. CMHC follows OSFI’s guidelines as a best-in-class business practice and its capitalization rate is approximately twice the recommended level as
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iNsuRANCe ANd seCuRitiZAtioN iNvestMeNt PoRtFoLios
Premiums from Mortgage Loan Insurance Activity and fees from the Securitization Activity are invested in separate investment portfolios. The main sources of risk from our investment activities relate to credit and market risk. Credit risk in the portfolios arises from investments in fixed income securities. Market risk is generally defined as the risk of loss as a result of fluctuations in capital market conditions. Market risk includes changes in interest rates, foreign exchange values and equity prices. CMHC uses its insurance investment portfolio (insurance premiums are received when the mortgage is taken out and cover the life of the mortgage) to cover obligations associated with
its provision of insurance to lenders against borrower default on residential mortgages. The investment objective for the insurance and securitization portfolios is to prudently maximize investment returns while maintaining sufficient liquidity to meet projected business requirements, including potential future claims and other liabilities. The investment objective is subject to appropriate risk considerations and to the constraints outlined in CMHC’s funding, investment and risk management policies. The size of the insurance investment portfolio has grown over the last few years and this trend is expected to continue. In 2010, the portfolio grew by $1.69 billion, from $15.95 billion to $17.64 billion, due primarily to investment income and positive net cash inflows. Performance information, including absolute and relative risk-adjusted measures, is tracked and monitored in aggregate and at the individual asset class levels of the portfolio. As at December 31, 2010, the total return for the insurance portfolio was 7.44% which was 0.16% below the performance of the benchmark index.
The securitization investment portfolio is comprised of investments related to both the Mortgage-Backed Securities (MBS) program and the Canada Mortgage Bonds (CMB) program. As at December 31, 2010, the total return for the securitization portfolio was 7.37% which was 0.23% below the performance of the benchmark index. The investment management strategies for both portfolios are the same, as is the strategic asset allocation model which is outlined in the table below. Approximately 50% and 52.1% of the total assets supporting the Insurance and Securitization Activities, respectively, at year-end were invested in fixed income securities issued or guaranteed by the Government of Canada or Canadian provinces. As the majority of CMHC’s insurance and securitization investment assets are held within the fixed income portfolios, duration management is an important consideration in managing interest rate risk in the portfolios. The durations of the fixed income investment portfolios are managed within ranges relative to the duration of the DEX Universe Bond Index (DEXUBI) benchmark. As at December 31, 2010, the insurance and securitization fixed income portfolios had durations that were marginally shorter than the benchmark.
insurance and securitization investment Portfolios (%) Asset type Fixed Income Money Market Canadian Equity EAFE Equity U.S. Equity Real Estate Other Total strategic Allocation 78.0 3.9 10.0 4.0 4.0 0.1 0.0 100.0 insurance 77.7 3.2 10.4 4.2 4.0 0.2 0.3 100.0 securitization 78.0 3.3 10.5 4.1 4.0 0.1 0.0 100.0
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CMHC Management Enterprise Risk Management Letter of Representation
February 8, 2011 This Letter of Representation is provided to the Board of Directors in support of its responsibilities with respect to the identification of the main business risks outlined in the Board of Directors Mandate and By-Law 44 (relating generally to the conduct of the affairs of the Corporation). The intended purpose is to provide reasonable assurance that CMHC Management has identified and is managing the main business risks influencing CMHC’s operating environment. For and during 2010, CMHC Management through our enterprise risk management structure and process has: identified and assessed the main business risks to which CMHC is exposed and provided the Audit Committee of the Board of Directors and the Board of Directors with reports throughout the year intended to enable them to understand and be apprised of these risks; and n reviewed CMHC’s risk management policies to ensure that they continue to remain relevant and prudent under our current operating environment and, as required, recommended new policies and/or amendments to existing policies for the consideration by the Audit Committee and then approval by the Board of Directors.
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Based on the work undertaken by CMHC Management during this period and our knowledge of the Corporation’s affairs as of December 31, 2010, we represent that: 1. the risk management practices and policies currently in place to identify and manage the main business risks arising from these activities remain relevant and prudent, and that these practices and policies effectively support the Corporation’s broader enterprise risk management efforts; 2. the adequacy and integrity of the Corporation’s systems and management practices applied, in relation to the management of the main business risks of the Corporation, have been upheld; and 3. CMHC has an effective, corporate-wide, enterprise risk management structure and process in place. In making this representation, CMHC Management has ensured that a reasonable level of consideration has been given to the identification and management of the main business risks to the Corporation.
Karen Kinsley, FCA President and Chief Executive Officer
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doc_653595149.pdf