Canada: OSFI releases draft guideline on insurance company internal capital targets

On May 21, 2010, the Office of the Superintendent of Financial Institutions (Canada) (OSFI), Canada's federal financial institutions regulator, released a draft Guideline on the development of internal capital targets by the insurance companies it regulates.  Noting that "recent volatile market conditions have put pressure on financial institutions' capital positions" and "emphasizing the need for appropriate and supportable capital targets", the draft Guideline, which applies to all domestic Canadian life and property & casualty companies and licensed foreign branches, is intended to foster a common view of how insurer-specific capital targets are to be set and address how assessment of capital adequacy fits within OSFI's supervisory framework.  The draft Guideline is open for comments until August 31, 2010.

The draft Guideline replaces guidance originally issued in the form of an Advisory in December 2003 to the property & casualty insurance industry.  The original guidance, OSFI noted, is also of importance to life insurers and may have been, in retrospect, insufficiently clear, resulting in some insurers selecting internal capital targets that were inappropriately too high or too low.  Upon the issuance of the final Guideline, OSFI expects that insurance companies will become compliant with the Guideline within one year.  OSFI indicated that it will be conducting a follow-up review of insurer capital targets after release of the final Guideline in order to determine whether the Guideline is resulting in the establishment of appropriate capital targets.

OSFI noted in the draft Guideline that regulatory capital levels are an important factor in OSFI's assessment of the institutions it regulates.  OSFI expects the level and quality of an insurer's capital to be appropriate to its circumstances, including its risk profile, tolerance for risk and operating environment.  Trends, and the outlook regarding capital and earnings, are also relevant in assessing the adequacy of an insurer's current capital position.  OSFI has established risk-based capital tests, which assess material risks to which insurers are exposed, as well as the general level of capital required to support those risks.  Those tests are the Minimum Continuing Capital and Surplus Requirements/Test of Adequacy of Assets in Canada and Margin Requirements (MCCSR/TAACM) for life insurance companies and the Minimum Capital Test/Branch Adequacy of Assets Test (MCT/BAAT) for property and casualty insurance companies.  OSFI has set minimum and supervisory capital targets under each, as indicated in the table below.

Minimum and Supervisory Capital Targets

However, the minimum supervisory targets are not tailored to an individual insurer's risk profile and, accordingly, OSFI expects each insurer to establish an internal target well above the supervisory target of 150% in order to provide adequate time for management to resolve financial problems that may arise, while minimizing the need for OSFI invention.  OSFI expects an insurer's internal capital target to be set considering the insurer's risk profile and appetite and the possible negative impact to its capital position from the material and relevant business risks to which it is exposed.  An adequate internal capital target provides additional capacity to absorb unexpected losses and provides the insurer with the continued ability to assess capital markets to address financial requirements as they may emerge.  The internal capital target should take into account the current and forecasted business environment and should, as a result of adequacy planning, be adjusted on a timely basis by senior management in consultation with the board (with advance notice to OSFI) to ensure adequacy under stress scenarios and through entire business cycles.

When setting an internal model, OSFI expects an insurer to examine future capital resources requirements under both "relatively likely" and "higher loss" scenarios.  The results of forward-looking stress testing should be considered when evaluating the adequacy of an insurer's capital level and internal capital target.  OSFI noted that parental guarantees or injections of capital, where applicable, and other management actions, should not be assumed in the setting of an internal capital target.

OSFI noted that it is the responsibility of the board and senior management to determine how the internal target ratio will be developed.  A process must be established to ensure that each material risk is identified, measured and taken into account appropriately when setting the internal target.  OSFI will review the process to ensure that the underlying principles are relevant and reflective of the insurer's risk profile and appetite.  When stress testing, an insurer should test the impact of various scenarios on its target capital instead of its actual capital level.  OSFI also noted that analysis supporting the setting and maintaining of an insurer's internal capital ratio should be clearly and formally documented, updated at least annually (or more frequently if conditions warrant), and should be discussed with the insurer's board and made available for OSFI review.  OSFI expects insurers will:

• maintain actual capital in excess of their internal capital target;
  
• fall below the internal capital infrequently; and
  
• notify OSFI immediately in the event capital is expected to fall, or has fallen below, the insurer's internal capital target.

In general, even under normal business conditions, insurers should establish internal capital targets and maintain levels adequate to provide a reasonable cushion above the supervisory level.

In the draft Guideline, OSFI also commented on key elements of an insurer's capital management policy.  OSFI expects each insurer to develop and maintain a capital management policy that includes, but is not limited to:

• an internal capital target;
  
• documented policies and procedures designed to ensure that the insurer identifies, measures and reports all material risks potentially requiring capital;
  
• clearly defined roles and responsibilities with respect to the design and execution of the relevant policies and procedures;
  
• a process to measure capital relative to current and anticipated future levels of risk;
  
• a policy that states capital adequacy goals with respect to risk, taking account of the insurer's strategic focus and business plan;
  
• a set of internal controls, reviews and audits to ensure the integrity of the overall risk management process;
  
• identification of corrective actions that management may take to improve its capital position if at any time the capital level falls, or is anticipated to fall, below the company's internal capital target or the supervisory capital target;and
  
• a requirement for the board to regularly review and approve the capital management policy.

If an insurer has fallen, or anticipates falling, below its internal target, it is required to inform OSFI immediately and provide plans on how it intends to expect to return to, or preferably above, its internal capital level within a reasonable and relatively short period of time.  Possible corrective management actions could include, but are not limited to:

• suspension of dividend payments, capital reductions and transfers to the parent or home office, where applicable;
  
• raising additional capital;
  
• strengthening risk management practices and mitigation of the risk causing the capital short-fall;
  
• a written description of a plan to increase, within a reasonable but short as possible timeframe, the capital ratio to a level no less than the internal capital target level; and
  
• an increased level of monitoring and reporting with respect to the insurer's capital position.

Consideration should also be given to the effectiveness of planned management actions in a volatile or stressed environment.

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