Government of Canada
Symbol of the Government of Canada

Federally Regulated
Financial Institutions

Staff image Adri van Hilten
Supervision Sector

Pamela Hopkins
Managing Director,
Supervision Sector
Photo: Adri van Hilten, Director, Supervision, Supervision Sector; Pamela Hopkins, Managing Director, Supervision, Supervision Sector

Risk Assessment and Intervention

OSFI supervises federally regulated financial institutions (FRFIs), monitors the financial and economic environment to identify issues that may have a negative impact on these institutions, and intervenes in a timely manner to protect depositors and policyholders from loss. OSFI does this while recognizing that management and boards of directors are ultimately responsible and that financial institutions can fail.

Throughout 2012-2013, OSFI exercised a heightened level of monitoring of financial institutions and markets as the global outlook remained clouded by sovereign indebtedness and weak economic recovery. Domestically, the level of household indebtedness continued to be seen as a source of systemic vulnerability. OSFI took action to address the potential impact of these challenges and achieve its strategic priorities by: developing supporting guidance for the updated Supervisory Framework; strengthening the design and application of supervisory processes; conducting significant reviews in several areas, including stress testing, commercial real estate and residential mortgage credit risk; and communicating our expectations for risk management to FRFIs.

Review by Sector

Deposit-Taking Institutions

The Canadian banking industry performed satisfactorily in 2012, despite the challenging global environment. Strong and consistent revenue and earnings performance led to an improved average return on equity for the banking sector of 17.3% in 2012 compared to 15.5% in 2011.

The Canadian banking industry is comprised of six large domestic banks and many smaller deposit-taking institutions (DTIs). The six largest banks account for approximately 90% of total assets among Canada's federally regulated DTIs. Their diversified business lines extend beyond traditional deposit-taking and lending activities into trading, investment banking, wealth management and insurance. In addition to their primary domestic focus, these large banks have operations in the United States and other parts of the world.

The remaining 10% of Canadian banking assets are held by smaller institutions with niche focus and business strategies, such as mortgage lending, commercial real estate or credit cards.

Canadian deposit-taking institutions made significant progress in implementing Basel III capital requirements during 2012-2013. OSFI fully implemented the new Basel III capital rules as planned, with the publication of a new Capital Adequacy Guideline in December 2012, and Canadian institutions met OSFI’s 7% “all-in” common equity Tier 1 capital target on schedule in January 2013.

Also consistent with international standards, OSFI increased its supervisory activities and dedicated more resources to review and monitor the six large domestic banks, which were designated as “domestic systemically important banks” (D-SIBs) in March 2013. These banks will be expected to meet enhanced disclosure requirements and a 1% capital surcharge above the minimum Basel capital requirements. They are well positioned to meet this latter requirement by the target date (January 2016).

The banking industry benefited from the relatively stable Canadian economy in 2012-2013. While credit quality of retail lending (mortgages, auto loans, credit cards) remains acceptable, the continued growth in domestic household debt has led to significant work continuing in bank lending practices in this area. Persistent low interest rates have the potential to shift risk-taking behavior towards more exposure to higher-yielding, riskier assets. OSFI is closely reviewing banks’ risk appetite practices to understand how this is evolving and being managed. While growth in commercial lending including Commercial Real Estate has increased, credit quality and risk have been stable.

OSFI, in conjunction with the Bank of Canada, conducted another macroeconomic stress-testing exercise. This involved prescribing a common scenario to participating banks in order to better understand, and to increase awareness in financial institutions about, potential system-wide risks and vulnerabilities. OSFI shared the individual results with participating banks, and has used the findings to inform our assessment of bank risk exposures and their ability to withstand adverse events.

Life Insurance Companies

The capital position of the Canadian life insurance industry remained acceptable and stable in 2012 (see figure 1). OSFI’s supervisory target ratio is 150% for both the Minimum Continuing Capital and Surplus Requirement (MCCSR) for operating federally regulated Canadian life insurance companies, and the Test of Adequacy of Assets and Margin (TAAM), for branches of foreign companies operating in Canada. The aggregate capital ratio for Canadian life insurers in 2012 was 218% (216% in 2011), remaining significantly above OSFI’s target capital level.

Figure 1
Life Insurance Companies: Capital Ratios*

Figure 1: Life Insurance Companies: Capital Ratios*

*As at fiscal year-end of financial institution

[Text Version]

In 2012, the aggregate capital ratio for Canadian life insurers was 218%, up slightly from 2011 and significantly above OSFI’s target of 150%.

With a sound capital base and strong reserve levels, the life insurance industry was healthy going into 2013; however, several challenges remain.

Low interest rates continue to have a negative impact on the financial results of many life insurers, as do sensitivity to potential declines in equity values and market volatility. Recognizing that investment portfolios are generating lower earnings in the wake of low yields on fixed-income investments, life insurance companies have been exploring higher risk/return investments. OSFI will continue to monitor closely conformance to, and changes in, risk appetite policies among federally regulated companies.

Canadian life insurance industry net income for 2012 increased 75% over 2011 but remains volatile. Total net income of federally regulated life insurance companies and branches for the year was $7.4 billion (73% from the three large conglomerates). This compares with a 2011 performance of $4.3 billion in net income (50% from the three large conglomerates). Return on equity for the industry was 9.8% in 2012 compared to 5.9% in 2011.

Due to low interest rates and rising life insurance premiums over the past five years, policy surrenders have declined noticeably as policyholders’ ability to substitute more economical forms of insurance is reduced, and attractive alternative investments for policy cash values declined. The result is that a larger proportion of insurance policies remain in-force until they become claims. In response, life insurers have been increasing their reserves for future claims, increasing the downward pressure on earnings. This trend is expected to continue for the foreseeable future as global markets struggle to recover from the financial crisis that began in 2008.

Credit experience in life insurer investment portfolios was stable in 2012. In aggregate, no significant changes were recorded in the levels of credit provisions at the conglomerate companies. OSFI continues to monitor closely the credit environment and industry practices relating to credit risk management.

In 2012, OSFI asked a select number of life insurers and life reinsurers to complete a macroeconomic stress test. This involved prescribing a common scenario to participating insurers in order to better understand, and to increase awareness in financial institutions about, potential system-wide risks and vulnerabilities. OSFI shared the individual results with the participating companies, and will use the findings to inform our assessment of the companies’ risk exposures and their ability to withstand adverse events.

Property and Casualty Insurance Companies

The financial performance of the property and casualty (P&C) industry in Canada was positive in 2012. Net income improved to $4.4 billion and return on equity was 11.3%, up from the 9.6% reported in 2011.

A key measure of the industry’s core profitability is the ‘combined ratio’, which measures the revenue from premiums relative to the sum of claims plus expenses. A combined ratio under 100% indicates that premium income exceeds claims and expenses (before net investment returns) and that an underwriting profit has been earned. In 2012, the combined ratio was 96%, a modest improvement over recent years.

Investment income before realized gains of $2.9 billion, and realized gains of $852 million, in 2012 were similar to those reported in 2011 but on a larger investment base, and reflect lower yields from the low-interest-rate environment. This continuing decline highlights the importance of focusing on core underwriting to achieve and sustain financial results.

The Minimum Capital Test (MCT) is the capital metric for Canadian companies and the Branch Adequacy of Assets Test (BAAT) is used for foreign companies. Capital levels in the Canadian P&C industry in 2012 were stable relative to 2011, with an industry combined MCT/BAAT ratio of 250% — well above OSFI’s supervisory target of 150% (see figure 2).

Figure 2
P&C Insurance Companies: MCT/BAAT Ratios*

Figure 2: P&C Insurance Companies: MCT/BAAT Ratios*

*As at fiscal year-end of financial institution

[Text Version]

The 2012 combined MCT/BAAT ratio was 250% — a 0.8% increase from 2011 and well in excess of OSFI’s minimum supervisory target of 150%.

With nearly half of the Canadian P&C insurance industry (by premium volume) being foreign owned, market conditions in the home jurisdiction can occasionally affect Canadian operations. Sovereign debt concerns in Europe also continued to require enhanced monitoring of parent jurisdictions. Globally, with fewer high severity events, insured catastrophe claims for the P&C insurance industry improved in 2012 over 2011.

Domestically, personal auto insurance continued to be the major underwriting challenge. The largest auto insurance market, Ontario, had experienced deteriorating profitability for several years but improved in 2011, largely due to reforms introduced by the Government of Ontario that took effect in September 2010. However, in 2012, the overall improvement in results due to reduced accident benefits claims activity was offset by increased third-party liability claims, the other major component of auto insurance. It is unclear whether the recent improvement will continue, as post-reform claims currently in the dispute resolution process are expected to begin to reach the arbitration stage in 2013.

The property insurance segment continued to see catastrophe-related claims from severe weather events. In 2012, these severe-weather-related claims were estimated at $1.2 billion. In response to this increased exposure to severe weather events, insurers have been increasing premium rates in recent years. Overall profitability in mortgage insurance rose on improved underwriting results, along with recognition of one-time gains on the wind up of the guarantee fund following the enactment of the Protection of Residential Mortgage or Hypothecary Insurance Act in 2011. Commercial lines of business had favourable results during 2012.

Supervisory Tools

Managing Risk Effectively

In 2012-2013, OSFI began updating internal guidance to support its risk-based Supervisory Framework, which considers an institution’s inherent business risks, risk management practices (including corporate governance) and financial condition.

In 2012-2013, OSFI again held annual risk management seminars for the industries it regulates (DTIs, life insurance, and P&C insurance) to reinforce the need for strong risk management and to share lessons learned. The goal is to communicate OSFI’s expectations related to key risk management areas based on detailed work OSFI has undertaken during the year, and to share information on issues being discussed internationally by regulators. The seminars also provide participants with the opportunity to ask questions of OSFI’s senior supervisory and regulatory teams.

Continuing the practice of organizing Colleges of Supervisors, in 2012-2013, OSFI hosted a college for two of Canada’s largest banks, in line with Financial Stability Board recommendations, bringing together executives from each bank with supervisors from several jurisdictions where they do business. OSFI also hosted a supervisory college for a large life insurance company. In addition, OSFI hosted a series of Anti-Money Laundering themed colleges for each of Canada’s five biggest banks. Crisis management and industry information sessions were conducted again for deposit-taking institutions, in conjunction with the Canada Deposit Insurance Corporation.

Composite Risk Ratings

The Composite Risk Rating (CRR) represents OSFI’s overall assessment of an institution's safety and soundness. There are four ratings for Composite Risk: ‘low’, ‘moderate’, ‘above average’ and ‘high’. The CRR is reported to most institutions at least once a year (certain inactive or voluntary wind-up institutions may not be rated). Supervisory Information Regulations prohibit institutions from publicly disclosing their rating. As at the end of March 2013, OSFI had assigned a low or moderate CRR to 89% of all rated institutions and had rated 11% as either above average or high risk (compared to 92% and 8% as at March 31, 2012).

Intervention Ratings

Financial institutions are also assigned an intervention (stage) rating, as described in OSFI’s guides to intervention for FRFIs, which determines the degree of supervisory attention they receive. Broadly, these ratings are categorized as: normal (stage 0); early warning (stage 1); risk to financial viability or solvency (stage 2); future financial viability in serious doubt (stage 3); and non-viable/insolvency imminent (stage 4). As at March 31, 2013, there were 43 staged institutions. With a few exceptions, the majority of the staged institutions were in the early warning (stage 1) category.

Staff image Marc Toulouse
Montreal Regional Office,
Supervision Sector

Kenza Sentissi
Senior Supervisor,
Montreal Regional Office,
Supervision Sector
Photo: Marc Toulouse, Manager, Montreal Regional Office, Supervision Sector; Kenza Sentissi, Senior Translator, Montreal Regional Office, Supervision Sector