Guideline Subject: Life Insurance Capital Adequacy Test No: A Issue Date: September 2016 Revision Date: November 2017 Effective Date: January 1, 2018 Subsection 515(1), 992(1) and 608(1) of the Insurance Companies Act (ICA) requires federally regulated life insurance companies and societies, holding companies and companies operating in Canada on a branch basis, respectively, to maintain adequate capital or to maintain an adequate margin of assets in Canada over liabilities in Canada. Guideline A: Life Insurance Capital Adequacy Test is not made pursuant to subsections 515(2), 992(2) and 608(3) of the ICA. However, the guideline along with Guideline A-4: Regulatory Capital and Internal Capital Targets provide the framework within which the Superintendent assesses whether a life insurer1 maintains adequate capital or an adequate margin pursuant to subsection 515(1), 992(1) and 608(1). Notwithstanding that a life insurer may meet these standards; the Superintendent may direct the life insurer to increase its capital under subsection 515(3), 992(3) or 608(4). This guideline establishes standards, using a risk-based approach, for measuring specific life insurer risks and for aggregating the results to calculate the amount of a life insurer’s regulatory required capital to support these risks. The guideline also defines and establishes criteria for determining the amount of qualifying regulatory available capital. The Life Insurance Capital Adequacy Test is only one component of the required assets that foreign life insurers must maintain in Canada. Foreign life insurers must also vest assets in Canada per the ICA. Life insurers are required to apply this guideline for reporting periods ending on or after January 1, 2018. Early application is not permitted. 1 For purposes of this guideline, “life insurers” or “insurers” refer to all federally regulated insurers, including Canadian branches of foreign life companies, fraternal benefit societies, regulated life insurance holding companies and non-operating life insurance companies. 255 Albert Street Ottawa, Canada K1A 0H2 www.osfi-bsif.gc.ca Contents Chapter 1 Overview and General Requirements ......................................5 1.1. Overview ...................................................................................................5 1.2. Minimum and Supervisory Target ratios ..................................................8 1.3. Accounting basis .......................................................................................8 1.4. General requirements ................................................................................9 1.5. Minimum amount of Available Capital ..................................................13 Chapter 2 Available Capital ......................................................................14 2.1. Tier 1 .......................................................................................................14 2.2. Tier 2 .......................................................................................................31 2.3. Capital Composition and Limitations .....................................................38 2.4. Transition ................................................................................................38 Appendix 2-A Information Requirements for Capital Confirmations ............40 Chapter 3 Credit Risk – On-Balance Sheet Items ...................................42 3.1. Credit Risk Required Capital for On-balance Sheet Assets ...................43 3.2. Collateral .................................................................................................52 3.3. Guarantees and credit derivatives ...........................................................59 3.4. Asset backed securities ...........................................................................64 3.5. Repurchase, reverse repurchase and securities lending agreements .......66 Appendix 3-A Rating Mappings .....................................................................68 Chapter 4 Credit Risk - Off-Balance Sheet Activities ............................69 4.1. Over-the-counter derivatives contracts ...................................................69 4.2. Netting of derivative contracts ................................................................72 4.3. Off-balance sheet instruments other than derivatives .............................76 4.4. Commitments ..........................................................................................78 Chapter 5 Market Risk ..............................................................................82 5.1 Interest rate risk ......................................................................................82 5.2 Equity risk .............................................................................................100 5.3 Real estate risk ......................................................................................107 5.4 Mutual funds .........................................................................................108 5.5 Index-linked products risk ....................................................................108 5.6 Currency risk.........................................................................................110 Appendix 5-A Rating Mappings ...................................................................117 Life A LICAT 2018 2 Chapter 6 Insurance Risk ........................................................................118 6.1. Projection of insurance liability cash flows ..........................................119 6.2. Mortality risk ........................................................................................120 6.3. Longevity risk .......................................................................................126 6.4. Morbidity risk .......................................................................................127 6.5. Lapse risk ..............................................................................................130 6.6. Expense risk ..........................................................................................132 6.7 Property and casualty risk .....................................................................133 6.8 Credit for reinsurance and special policyholder arrangements .............133 Chapter 7 Segregated Fund Guarantee Risk .........................................137 7.1. Products ................................................................................................137 7.2. Documentation and reporting ...............................................................138 7.3. Total gross calculated requirement .......................................................141 7.4. Classifying the asset exposure ..............................................................146 7.5. Determining the risk attributes .............................................................151 7.6. Retrieving the appropriate nodes ..........................................................156 7.7. Use of supplied functions to determine the requirement ......................157 7.8. Margin Offset Adjustment ....................................................................165 7.9. Credit for reinsurance ceded or capital markets hedging .....................165 7.10. Custom factors and internal models......................................................166 7.11. Analysis of results .................................................................................167 Chapter 8 Operational Risk ....................................................................168 8.1 Operational risk formula .......................................................................168 8.2 Operational risk exposures and factors .................................................168 Chapter 9 Participating and Adjustable Products ................................171 9.1. The participating product credit ............................................................171 9.2. The contractually adjustable product credit ..........................................175 9.3. Participating products that are contractually adjustable .......................178 Chapter 10 Credit for Reinsurance ..........................................................180 10.1. Definitions ............................................................................................180 10.2. Valuation basis for ceded liabilities ......................................................181 10.3. Deductions from Available Capital for unregistered reinsurance ........182 10.4. Collateral and letters of credit ...............................................................184 Life A LICAT 2018 3 10.5. Calculation of required capital/margin or eligible deposits ..................187 Chapter 11 Aggregation and Diversification of Risks ............................193 11.1. Within-risk diversification ....................................................................193 11.2 Between-risk diversification .................................................................196 11.3 Base Solvency Buffer ...........................................................................200 Chapter 12 Life Insurers Operating in Canada on a Branch Basis ......201 12.1. LIMAT Ratios.......................................................................................201 12.2. Available Margin ..................................................................................202 12.3. Surplus Allowance and Eligible Deposits ............................................205 12.4. Required Margin ...................................................................................205 Life A LICAT 2018 4 Chapter 1 Overview and General Requirements This chapter provides an overview of the Life Insurance Capital Adequacy Test (LICAT) guideline and sets out general requirements. Details on specific components of the LICAT are contained in subsequent chapters. 1.1. Overview 1.1.1. LICAT Ratios The LICAT measures the capital adequacy of an insurer and is one of several indicators used by OSFI to assess an insurer’s financial condition. The ratios should not be used in isolation for ranking and rating insurers. Capital considerations include elements that contribute to financial strength through periods when an insurer is under stress as well as elements that contribute to policyholder and creditor protection during wind-up. The Total Ratio focuses on policyholder and creditor protection. The formula used to calculate the Total Ratio is: Available Capital + Surplus Allowance + Eligible Deposits Base Solvency Buffer The Core Ratio focuses on financial strength. The formula used to calculate the Core Ratio is: Tier 1 Capital+70% of Surplus Allowance + 70% of Eligible Deposits Base Solvency Buffer 1.1.2. Available Capital Available Capital comprises Tier 1 and Tier 2 capital, and involves certain deductions, limits and restrictions. The definition encompasses Available Capital within all subsidiaries that are consolidated for the purpose of calculating the Base Solvency Buffer, which is described below. Available Capital is defined in Chapter 2. 1.1.3. Surplus Allowance The amount of the Surplus Allowance included in the numerator of the Total and Core Ratios is based on provisions for adverse deviations (PfADs) calculated under the Canadian Asset Liability Method (CALM), or any other method prescribed under the Standards of Practice of the Canadian Institute of Actuaries, that is used to determine insurance contract liabilities reported on the insurer’s financial statements.2 Any PfAD included in the Surplus Allowance to account for a specific risk must correspond to a PfAD included in the total liability reported in 2 If approximations are permitted by the CIA Standards of Practice and used to calculate the PfADs those approximations should continue to be used for LICAT purposes. Life A LICAT 2018 5 financial statements. The specific PfADs included in the Surplus Allowance used to calculate the LICAT ratios are: 1) PfADs relating to scenario assumptions for risk-free interest rates associated with insurance contracts other than segregated fund contracts, calculated net of all reinsurance; and 2) PfADs for the following non-economic assumptions associated with insurance contracts other than segregated fund contracts, calculated net of registered reinsurance only: insured life mortality, annuitant mortality, morbidity, withdrawal and partial withdrawal, anti-selective lapse, expense and policy owner options. 3 These PfADs are described in the Standards of Practice of the Canadian Institute of Actuaries. All other PfADs, including PfADs for economic assumptions other than those for risk-free interest rates (e.g. credit spreads, foreign currencies, and investment expenses), PfADs for non- economic assumptions other than those listed above (e.g. operational risk), and PfADs associated with segregated fund contracts, are excluded from the Surplus Allowance. 1.1.4. Eligible Deposits Subject to limits, excess deposits placed by unregistered reinsurers (qq.v. sections 6.8.1 and 10.5.4) and claims fluctuation reserves (q.v. section 6.8.4) may be recognized as Eligible Deposits in the calculation of the Total Ratio and Core Ratio. Recognition of these amounts is subject to the criteria for risk transfer described in section 10.5. 1.1.5. Base Solvency Buffer Insurers’ capital requirements are set at a supervisory target level that, based on expert judgment, aims to align with a conditional tail expectation (CTE) of 99% over a one-year time horizon including a terminal provision. The risk capital requirements in this guideline are used to compute capital requirements at the target level. An insurer's Base Solvency Buffer (q.v. section 11.3) is equal to the sum of the aggregate capital requirement net of credits, for each of six geographies, multiplied by a scalar of 1.05. An aggregate capital requirement is calculated for: 1) Canada 2) The United States 3) The United Kingdom 4) Europe other than the United Kingdom 5) Japan 6) Other locations 3 The PfADs in the Surplus Allowance include insurance risk PfADs for all business that an insurer has assumed under modified coinsurance arrangements, and exclude insurance risk PfADs for business that the insurer has ceded under registered modified coinsurance arrangements. Life A LICAT 2018 6 Liabilities and their associated risks are allocated to geographies based on where the original policy underlying the liability was written directly. Assets backing liabilities under CALM are allocated to the same geography as the liabilities that they back. Assets backing surplus are allocated to the geography in which the entity holding the assets is domiciled. The aggregate capital requirement within a geography comprises requirements for each of the following five risk components: 1) credit risk (Chapters 3 and 4); 2) market risk (Chapter 5); 3) insurance risk (Chapter 6); 4) segregated funds guarantee risk (Chapter 7); and 5) operational risk (Chapter 8). Aggregate requirements are reduced by credits for qualifying in-force participating and adjustable products (Chapter 9), and risk diversification (Chapter 11). Additionally, it is possible to obtain credit (via a reduction of specific risk components or an amount recognized in Eligible Deposits) for the following risk mitigation arrangements: 1. reinsurance (insurance risk components, and other components where reinsurance is explicitly recognized); 2. collateral, guarantees and credit derivatives (credit risk component for fixed-income and reinsurance assets); 3. other derivatives serving as hedges (market risk components); and 4. asset securitization (credit risk component). Any arrangement (including securitization) under which a third party assumes, or agrees to indemnify an insurer for losses arising from insurance risk is treated as reinsurance for capital purposes, and is subject to the requirements in Chapter 10. Collateral, guarantees and credit derivatives may be used to reduce the credit risk requirements for fixed-income financial assets and registered reinsurance assets. The conditions for their use and the capital treatment are described in sections 3.2, 3.3 and 10.5.3. Collateral and letters of credit may be used to reduce the deductions from available capital for unregistered reinsurance as described in section 10.3, subject to the conditions in section 10.4. Derivatives serving as equity hedges may be applied to reduce the market risk requirements for equities, as described in section 5.2.4, and derivatives serving as foreign exchange risk hedges may be applied to reduce the requirement as described in sections 5.6.2 and 5.6.4. Asset securitization may be used to reduce credit risk requirements as provided for in Guideline B-5: Asset Securitization; guarantees providing tranched protection are treated as synthetic securitizations, and fall within the scope of the securitization guideline. Reinsurance that is intended to mitigate credit or market risks associated with a ceding insurer’s on-balance sheet assets (e.g. equity risk, real estate risk), irrespective of whether it mitigates Life A LICAT 2018 7 other risks simultaneously, must meet the conditions and follow the capital treatment specified in sections 10.5.3 and 10.5.4 in order for an insurer to reduce the requirements for these risks. 1.1.6. Foreign life insurers4 The Life Insurance Margin Adequacy Test (LIMAT) Ratios are designed to measure the adequacy of assets in Canada of foreign insurers. These ratios and their components (Available Margin, Surplus Allowance and Required Margin) are described in Chapter 12, “Life insurers Operating in Canada on a Branch Basis”. The LIMAT is only one element in the determination of the required assets that foreign insurers must maintain in Canada. Foreign insurers must also vest assets in Canada pursuant to section 610 of the Insurance Companies Act. 1.2. Minimum and Supervisory Target ratios OSFI has established a Supervisory Target Total Ratio of 100% and a Supervisory Target Core Ratio of 70%. The Supervisory Targets provide cushions above the minimum requirements, provide a margin for other risks, and facilitate OSFI’s early intervention process.5 The Superintendent may, on a case by case basis, establish alternative targets in consultation with an insurer based on that insurer’s individual risk profile. Insurers are required, at minimum, to maintain a Total Ratio of 90% and a Core Ratio of 55%6. Insurers should refer to Guideline A4 - Regulatory Capital and Internal Capital Targets for OSFI’s definitions and expectations around the Minimum and Supervisory Target ratios and expectations regarding internal capital targets and capital management policies. 1.3. Accounting basis Unless indicated otherwise, the starting basis for the amounts used in calculating Available Capital, Available Margin, Surplus Allowance, Base Solvency Buffer, Required Margin and any of their components are those reported in, or used to calculate the amounts reported in, the insurer’s financial statements and other financial information contained in the Life Quarterly Return and Life Annual Supplement, all of which have been prepared in accordance with Canadian GAAP7 in conjunction with OSFI instructions and accounting guidelines. These financial statements and information are required to be adjusted as specified below to determine the carrying amounts that are subject to capital charges or are otherwise used in 4 Within this guideline, the term “foreign life insurer” has the same meaning as life insurance “foreign company” in section 2 of the Insurance Companies Act. 5 Industry-wide Supervisory Targets are not applicable to regulated insurance holding companies and non- operating insurance companies. 6 Regulated insurance holding companies and non-operating insurance companies are required to maintain a minimum Core Ratio of 50%. 7 The Canadian Accounting Standards Board has adopted International Financial Reporting Standards (IFRS) as Canadian GAAP for publicly accountable enterprises, including insurers. The primary source of Canadian GAAP is the Chartered Professional Accountants of Canada Handbook. Life A LICAT 2018 8 LICAT calculations. The Canadian GAAP financial statements and information should be restated for LICAT purposes and reported in accordance with the following specifications: 1) Only subsidiaries (whether held directly or indirectly) that carry on a business that an insurer could carry on directly (e.g., life insurance, real estate and ancillary business subsidiaries) are reported on a consolidated basis.8 2) Consolidated equity investments in non-life solvency regulated financial corporations9 that are controlled should be deconsolidated and reported using the equity method of accounting. 1.4. General requirements 1.4.1. Opinion of the Appointed Actuary The Appointed Actuary is required to sign, on the front page of the LICAT Quarterly Return10, an opinion in accordance with the Standards of Practice of the Canadian Institute of Actuaries. The text of the required opinion is: “I have reviewed the calculation of the LICAT Ratios of [Company name] as at [Date]. In my opinion, the calculations of the components of Available Capital, Surplus Allowance, Eligible Deposits and Base Solvency Buffer have been determined in accordance with the Life Insurance Capital Adequacy Test guideline and the components of the calculation requiring discretion were determined using methodologies and judgment appropriate to the circumstances of the company.” [Note: For a foreign insurer “LICAT Ratios”, “Available Capital” and “Base Solvency Buffer” are replaced by “LIMAT Ratios”, “Available Margin” and “Required Margin”.] The memorandum that the Appointed Actuary is required to prepare under the Standards of Practice (LICAT Memorandum) to support this certification must be available to OSFI upon request. 1.4.2. Authorized official signature Each life insurer is required to have an authorized Officer endorse the following statement on the LICAT Quarterly Return: “I confirm that I have read the Life Insurance Capital Adequacy Test guideline and related instructions issued by the Office of the Superintendent of Financial Institutions and that this form is completed in accordance with them.” 8 Composite insurance subsidiaries that write both life insurance and property and casualty insurance are included within the scope of consolidation. 9 Non-life solvency regulated financial corporations include entities engaged in the business of banking, trust and loan business, property and casualty insurance business, the business of cooperative credit societies or that are primarily engaged in the business of dealing in securities, including portfolio management and investment counselling. 10 The Appointed Actuary is only required to sign the front page of the LICAT Quarterly Return for submissions made at year end. Life A LICAT 2018 9 The Officer attesting to the validity of this statement on the LICAT Quarterly Return at year end must be different from the insurer’s Appointed Actuary. 1.4.3. Audit requirement Life insurers are required to retain an Auditor appointed pursuant to section 337 or 633 of the ICA to report on the year-end LICAT Quarterly Return in accordance with the relevant standards for such assurance engagements, as promulgated by the Canadian Auditing and Assurance Standards Board (AASB). 1.4.4. Best Estimate Assumptions Best Estimate Assumptions used to calculate the capital requirements for insurance and market risks are the assumptions used in the CALM base scenario, and consist of: 1) base scenario assumptions for interest rates as specified in the Standards of Practice of the Canadian Institute of Actuaries; and 2) best estimates for all other assumptions, where these assumptions are consistent with the base scenario for interest rates. 1.4.5 Use of Approximations Insurers should adhere to the Standards of Practice of the Canadian Institute of Actuaries on materiality and approximations with respect to approximations permitted within the LICAT. All approximations used, along with the vetting completed to measure the effectiveness of approximations, and the steps taken to refine and correct ineffective approximations, should be reported in the LICAT Memorandum. In addition, insurers should adhere to the following specifications: Approximations of LICAT calculations are not permitted if most of the data or information is available from other internal processes and this data or information is used to calculate liabilities for financial statement purposes. For example, if an insurer performs its CALM testing in real time, it should not use in-arrears asset and liability cash flows for LICAT purposes. In this case, approximations for LICAT should only be used if the actual calculation cannot be performed in real time (i.e. it is done in-arrears for valuation). Insurers should use approximations consistently from quarter to quarter, unless reviews of their effectiveness require a modification to improve accuracy, or an improvement in the insurer’s processes renders the approximation unnecessary. The following approximations may be used in the calculation of the relevant LICAT components:11 11 Only the approximations listed below may be used for LICAT components that affect the LICAT ratios materially. Other immaterial approximations may be used in the determination of the LICAT ratios. Life A LICAT 2018 10