Canada: OSFI Opens The Door To MCT And BAAT Discussions

On May 24, 2013, following an in-depth review of the regulatory capital framework for federally regulated Property & Casualty (“P&C”) insurers, the Office of the Superintendent of Financial Institutions (“OSFI”) released a discussion paper communicating proposed changes to the Minimum Capital Test (“MCT”) for Canadian P&C insurers and the Branch Adequacy of Assets Test (“BAAT”) for branches of foreign P&C insurers. All P&C insurers, excepting mortgage insurers, are requested to participate in a quantitative impact study (“QIS”) to estimate the capital impact of the proposed changes on their individual companies. OSFI believes that the proposed changes will ensure that the capital framework continues to remain appropriate for federally regulated P&C insurers and the risks they manage. P&C insurers have been invited to provide comments on the proposed revisions to the regulatory capital tests, and the completed QIS files, to OSFI by July 31, 2013. OSFI will consider the industry’s comments and the QIS results in the preparation of the draft MCT Guideline, which is scheduled to be issued for public consultation before the end of the year. It is expected that OSFI will issue the final version of the MCT Guideline in the summer of 2014 after a period of public consultation, and that it will take effect on January 1, 2015.

Click here to access the OSFI MCT Discussion Paper.

KEY PROPOSED CHANGES

Definition of Capital

OSFI proposes to (i) revise the composition of regulatory capital, qualifying criteria for eligible capital instruments, and applicable limits; and (ii) clarify and amend regulatory adjustments to capital.

OSFI proposes to add to the MCT Guideline an explicit list of qualifying criteria for common shares and allowable capital instruments other than common shares. The proposed qualifying criteria are intended to clarify whether certain instruments are eligible for inclusion in capital. OSFI also proposes to include accumulated other comprehensive income (“AOCI”) as a component of capital available, subject to adjustments to remove the impact of certain AOCI items that are currently excluded from capital. This modification would change the current presentation of capital available, where the calculation of capital available in the MCT would begin with the IFRS definition of equity, subject to regulatory adjustments. Moreover, OSFI proposes to clarify and amend capital composition limits. Some of the proposed regulatory adjustments to capital available are meant to clarify the existing restrictions used in practice, while others present changes to the current regulatory adjustments in the MCT Guideline. The proposed changes are consistent with proposed changes in other financial sectors. OSFI has noted that it does not intend to change its proposed capital treatment of computer software (i.e., deduction of computer software intangibles from capital available) despite the industry concern that the proposed change may discourage the industry in general from maintaining and upgrading systems at a time when such investment is required to ensure efficient and effective operations.

Insurance Risk

OSFI proposes to (i) revise the risk factors for insurance premiums and claims liabilities, with the recognition of an implicit diversification credit within the insurance risk factors; (ii) apply risk factors to premium liabilities rather than unearned premiums; (iii) eliminate the risk factors on deferred policy acquisition expenses; and (iv) revise the calculation of the margin for reinsurance ceded to unregistered insurers.

A factor-based approach is currently used in the MCT and is the approach recommended for determining insurance risk requirements under the new capital framework. The factors will continue to be applied to the best estimate liability by line of business and be the same for all companies, (i.e., will not vary based on the volume of business of the company). OSFI is proposing to replace the 5%, 10% and 15% risk buckets applied to net unpaid claims at the minimum level to a four-risk buckets scheme of 10%, 15%, 20% and 25% at the target level.

Credit Risk

OSFI proposes to (i) review all credit risk factors for balance sheet assets and make adjustments where deemed necessary; and (ii) introduce effective maturity as an alternative approach in calculating capital requirements for instruments that are subject to a determined cash flow schedule.

The credit risk factors introduced effective January 1, 2012, will remain unchanged. In addition to the revised credit risk factors, OSFI is considering allowing P&C insurers to use effective maturity in order to determine risk factors for calculating capital required for instruments that are subject to a determined cash flow schedule.

Risks Associated with Off-Balance Sheet Exposures

OSFI proposes to (i) revise the risk factors for structured settlements, derivatives and other exposures with more granular risk factors based on a credit rating and term to maturity of an exposure; and (ii) replace the 0.5% risk factor for letters of credit with more granular risk-based factors.

The MCT currently applies a 0.5% risk factor on all letters of credit used for unregistered reinsurance and self-insured retention. OSFI proposes to change the current 0.5% risk charge to more granular risk-based factors based on the credit rating of the issuing or confirming bank, similar to the factors applied to investments in long-term obligations on the balance sheet. Similarly, for structured settlements, derivatives, and other off-balance sheet exposures, OSFI proposes changing the current risk factors to more granular factors based on credit ratings and term to maturity, similar to those applied to invested assets or long-term investments.

Market Risk

OSFI proposes to (i) calibrate the risk factors for investments in common equity and real estate; (ii) adjust the shock factor for the interest rate risk margin; and (iii) implement a more robust methodology for calculating foreign exchange risk requirements.

OSFI proposes amending the risk factor for investments in common shares from 15% at the minimum level to 30% at the target level of confidence. The new risk factor at target would better reflect the increased volatility experienced in global equity markets, would harmonize the risk factor that will be applied to equity investments for the life insurance sector, and is consistent with international trends. Consistent with the proposed increase in the risk factor for common shares from the 15% minimum factor to 30% at target, OSFI proposes increasing the risk factor on investments in joint ventures with less than or equal to 10% ownership to 30%. Moreover, OSFI proposes an interest shock factor of 1.25% for the revised framework, but will continue monitoring the Canadian economic and interest rate environment and will consider adjusting the interest rate shock factor in future revisions of the MCT, if deemed appropriate. Lastly, OSFI proposes to introduce a foreign exchange risk margin calculated for the portfolio of positions in different currencies, by applying a 10% risk factor. OSFI proposes a carve out of up to 25% of liabilities in a given foreign currency, which can be used by insurers holding a net open long position in the same currency to reduce the amount of the net exposure.

Operational Risk

OSFI proposes to introduce an explicit risk charge for operational risk.

The current requirement for operational risk is embedded in the supervisory target capital ratio, but as part of its proposed changes, OSFI has developed an explicit formula to calculate operational risk charge, and proposes to use the following definition of operational risk in the revised MCT Guideline: Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition includes legal risk but excludes strategic and reputation risks. The risk drivers that would be used to calculate the operational risk margin, subject to a cap are: (i) capital/margin required; (ii) premium level: direct, assumed and ceded; and (iii) increase in gross premiums beyond a given threshold.

Diversification Credit

OSFI proposes to recognize an aggregation benefit arising from the diversification between insurance risk and the sum of credit risk and market risk.

A diversification credit results when the method of aggregation of risks produces elements that are less than the sum of the total of the individual risk elements. Under the revised capital framework, OSFI is prepared to allow some diversification credit in the determination of P&C capital/margin requirements. OSFI has identified two suitable risk categories: (1) diversification within a risk category but across different lines of business, and (2) diversification across different risk categories. OSFI considers allowing a diversification credit within insurance risk and a diversification credit between insurance risk and a sum of credit and market risks.

COMMENTARY

Many of the proposed changes to the regulatory capital framework serve to ensure that P&C insurers are relying on a robust risk-based capital test. OSFI’s intention is that the revised test will assess all risk measures and better align with capital frameworks across financial sectors. The changes would allow stakeholders to better understand the relationship between equity and regulatory capital. Moreover, the revised framework would be more consistent with the concept of risk-based regulation, and therefore more aligned with international regulatory developments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Nilanka Maldeniya
Richard Da Costa
Miho Felicio
Gordon Goodman
 
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