LICAT 2018 – Update

Document Properties

  • Type of Publication: Letter
  • Reference: Guideline for Federally Regulated Life Insurance Companies and Fraternal Benefit Societies
  • Date: November 24, 2017
  • To: Federally Regulated Life Insurance Companies & Fraternal Benefit Societies

Today, OSFI is issuing an updated version of Guideline A: Life Insurance Capital Adequacy Test (LICAT) initially published in September 2016. Effective January 1, 2018, this guideline will replace Guideline A: Minimum Continuing Capital and Surplus Requirements (MCCSR).

On September 12, 2016, OSFI published the LICAT guideline on its website. OSFI indicated it would launch a LICAT implementation exercise in late 2016 to, among other things, test the framework and finalize calibration. Our analysis of the results of the exercise and consideration of stakeholder feedback resulted in further refinements to the September 2016 version of the LICAT. These were reflected in a draft version of the guideline posted on June 23, 2017 for public consultation. The comment period ended on July 28, 2017. We thank everyone for their comments. All were considered and some resulted in changes to the draft guideline.

Appendix 1 provides a summary of consultation comments received, organized by theme, along with OSFI responses. Appendix 2 outlines changes made to the guideline since the version issued in September 2016, with those made as a result of the public consultation shown in italics.

As the focus is now to LICAT’s implementation, a number of measures were developed to facilitate the transition to the new framework:

  • Fifteen explicit approximations are available to ease the calculation of more complex and system intensive components (chapter 1).
  • Transition measures are available for specific capital instruments and for capital composition limits and requirements (chapter 2).
  • A series of pre-recorded topic-specific webcasts and general LICAT speaking engagements are planned in the upcoming months to raise awareness and promote good understanding.
  • New, more user-friendly, capital return templates with expanded instructions have been developed, along with validation rules.
  • Extensions were granted to insurers for filing the LICAT results of the first four quarters following its effective date:
Reporting
Period
Extension
(calendar days)
Q1 28
Q2 21
Q3 14
Q4/Annual 7

Consistent with its previous practice, OSFI will continue to revise its guidance in light of industry and economic developments and in consultation with industry. Notable future revisions are expected with the coming into force of IFRS 17 Insurance Contracts and the completion of OSFI’s review on the treatment of segregated fund guarantees.

The LICAT is a culmination of many years of work by OSFI in consultation with insurers and other industry stakeholders. I would like to personally thank insurers, their staff and experts in contributing to this guideline. In particular, I would like to thank l’Autorité des marchés financiers (AMF) and Assuris for their continued and meaningful contributions. The LICAT is more robust, advanced and risk sensitive than the MCCSR and will contribute to improved policyholder and creditor protection.

Should you have any questions, please contact Lisa Peterson, Director, Life Insurance Capital at lisa.peterson@osfi-bsif.gc.ca or at (613) 990-7282.

Sincerely,

Carolyn Rogers
Assistant Superintendent
Regulation Sector

Attachments

Appendix 1 – Summary of Public Consultation Comments and OSFI Responses

Comment OSFI Response

1) Sensitivity Testing

The sensitivity of the LICAT ratios to increases in interest rates is counter-intuitive for many industry participants; increases in interest rates are generally a positive outcome for the life insurance industry with extra-long liabilities. Ratio elements should be reviewed to avoid counter-intuitive outcomes.

OSFI’s review of sensitivity testing results, filed by insurers earlier this year, demonstrated that the impact of changes in interest rates on LICAT results appropriately reflected company-specific circumstances. Nonetheless, OSFI intends to monitor future results to assess the appropriateness of the interest rate risk methodology and that it is operating as intended.

2) Inappropriate Volatility

OSFI should consider future adjustments to address the inappropriate volatility of capital ratios, specifically with respect to the volatility of the Surplus Allowance.

OSFI will monitor future results and assess whether the LICAT test is operating as intended. If any issues become apparent, the framework may be modified, as necessary, at that time. That said, OSFI recognizes that the framework is more sensitive and, therefore, the scalar was maintained at its 1.05 level, notwithstanding that Test Run 1 results suggest that it could be set at a higher level.

3) Third Party Share Limit

The inclusion of Surplus Allowance in the denominator of the Third Party Share limit is flawed, as this amount would be shared with partners and other non-controlling interests.

Also, the calculation of the marginal capital requirement of a subsidiary should be simplified.

The Third Party Share limit represents the amount of risk arising from a subsidiary, covered by third party capital. By including the Surplus Allowance amount in the denominator of the Third Party Share limit, the limit appropriately recognizes that the subsidiary’s Base Solvency Buffer (BSB) will be covered by both its Available Capital and Surplus Allowance. If the Surplus Allowance was not included, then the Third Party Share limit would overstate the amount of a subsidiary’s BSB covered by third party capital; this excess amount then (inappropriately) included in consolidated Available Capital could result in undercapitalization.

To assist with the calculation of the Third Party Share limit, insurers are permitted to approximate marginal capital requirements.

4) Out-of-Canada Terminal Dividends

Unlike MCCSR, which permits the inclusion in Tier 2C capital of 50% of the terminal dividend reserve associated with out-of-Canada participating life insurance business, LICAT does not allow any such amount in Available Capital. It is suggested that OSFI maintain the current MCCSR approach.

Not allowing this reserve amount within LICAT Tier 2 capital largely stems from OSFI’s assessment of qualifying Tier 2 elements as well as the introduction of the new par credit allocation (i.e., these reserves are counted as available dividends in the par credit calculation). OSFI expects to further review the current par credit along with the adjustable credit methodology for a future version of the LICAT.

5) Capital Composition and Limitations

The reduction in capacity (to 25%) for Tier 1 Instruments other than Common Shares as a percentage of total Tier 1 capital from the current MCCSR level of 40% (for preferred shares and innovative instruments) is restrictive. OSFI is encouraged to maintain 40%, and to grandfather all existing securities to count as Tier 1 capital while they remain outstanding.

The LICAT Core Ratio and capital composition limits set out OSFI’s expectations that insurers have high-quality capital available to protect policyholders and creditors. OSFI expects common equity, the highest quality capital, to be the predominant form (i.e.: at least 75%) of an insurer’s Tier 1 capital, and limits Tier 1 Instruments other than Common Shares to 25% of Net Tier 1 capital. The 25% limit is appropriate considering that these instruments are of lesser quality than common shares.

The LICAT guideline has been updated whereby instruments subject to transition under sections 2.4.1 and 2.4.2 are no longer impacted by section 2.3 capital composition limits.

OSFI may further review capital composition requirements and limitations for a future version of the LICAT. If undertaken, this review would likely be done in conjunction with other initiatives (e.g., assessing the applicability of Non-Viability Contingent Capital (NVCC) to life insurers).

6) Internal Ratings

OSFI should reconsider its decision to discontinue the use of insurer-specific internal model credit ratings for unrated private and other investments due to the possible market distortions that it may create.

OSFI should also consider allowing the use of insurer-specific internal model credit ratings for unrated Asset-Backed Securities (ABS). Under the LICAT guideline, unrated ABSs are grouped with poor quality ABSs rated B or lower and receive a risk factor of 60%.

The LICAT 2018 framework only permits the use of a standard methodology, except for segregated fund guarantees. The approval and use of insurer-specific internal models may be permitted in a later version of the LICAT framework for other risks. At this time, it is OSFI’s view that the 6% charge for most unrated investments is appropriate. A post-implementation review will be conducted to identify and assess any unintended consequences from the new framework.

The factor for the most senior tranches of unrated securitizations will be reviewed concurrently with OSFI’s review of Guideline B-5 – Asset Securitization; work expected to extend to 2018. Changes, if any, would therefore only be made after January 1, 2018.

7) Interest Rate Risk Methodology

In situations where assets and liabilities are in a currency other than that of the country where the products were originally sold, scenario testing results should be measured using the appropriate exposure to interest rate risk (i.e., based on the currency in which the assets and liabilities are denominated).

The methodology specified in the LICAT was designed as such, in part, for practical reasons; cash flows for policies sold by an entity are more easily aggregated within the originating geography for calculating the Interest Rate Risk requirement. OSFI intends to review the methodology for a future version of the LICAT.

8) Limited Partnerships

Unlike the existing MCCSR framework, LICAT only allows look-through treatment under Section 5.4 Mutual Funds. Per LICAT Guideline Section 5.2.1, Limited Partnerships (LPs) are subject to Equity Risk charges. LPs can and do hold instruments other than equity, including real estate and un-rated/investment grade debt. This arrangement is at odds with the LICAT risk-based principle as the capital treatment is dependent on the legal structure chosen rather than the underlying asset risk of the investments held. LPs are more appropriately treated as mutual funds, where a look-through approach is more appropriate to reflect the underlying risks and capital requirements of the investment.

OSFI intends to review the treatment of limited partnerships and changes may be incorporated in a future version of the LICAT guideline.

9) Bond Investments in the Capital of Other Financial Institutions

These investments now get charged as a preferred equity risk. This is only appropriate for innovative hybrid bonds that are recognized as Tier 1 capital and not for other types of regulatory debt capital to which fixed-income risk charges should apply.

Not all of the debt investments in financial institutions that qualify as capital are hybrid in nature, especially when the capital is in other jurisdictions, some may be “plain vanilla” bonds. Also, these capital instruments are individually rated taking into account any hybrid optionality, so the risk charge based on the bond rating already covers this added risk. OSFI should exclude “plain vanilla” bonds from the application of a preferred equity risk charge and rated hybrids should use their corresponding LICAT risk charge.

In order to avoid the potential double-counting associated with using higher preferred share factors, at the same time as the more adverse (from the investor’s perspective) characteristics of a capital instrument which might be reflected in its rating, the LICAT has been amended whereby the factor assigned to capital instruments has been changed to generally be the higher of:

  1. the preferred share factor corresponding to the issuer’s senior unsecured debt rating; or
  2. the bond factor corresponding to the rating and maturity of the instrument.

10) Currency Risk Offsets

The LICAT expects insurers to use the Base Solvency Buffer (BSB) for assets and liabilities denominated in the currency under consideration to calculate currency risk offsets. Recalculating the BSB for each currency may result in an unrealistic and inappropriate BSB for the offset calculation, which would not tie to the actual BSB held by the company. Moreover, recalculating the BSB for each currency will introduce significant operational complexity. OSFI should review the current methodology.

In light of comments received, two approximations have been incorporated in the guideline.

11) Catastrophe Risk

For catastrophe risk, a calculation is required for contracts with long term obligations (e.g., group long-term disability). However, it is not clear why products with short term obligations (e.g., dental, travel) are excluded, as the risk is similar to individual medical products.

OSFI intends to review this issue for a future version of the guideline.

12) Morbidity Risk Shocks

For mortality, LICAT permits an adjustment to the level risk calculation, where the impact of year 1 claims is deducted in order to avoid double counting with the volatility risk. Morbidity incidence rates level risk should be measured consistently with the mortality risk to also avoid double counting with morbidity incidence volatility risk.

The actual first year shock for level risk is intended to be zero. However, a portion of the volatility shock is included within level risk in the first year equal to the level percentage shock for all future years so that a constant percentage shock could be applied for the entire projection period without having to make an adjustment as is done for mortality. Therefore, the shock for volatility risk on morbidity was calibrated using the sum of the shock for volatility risk and the component included as a first year shock within level risk. This was designed to avoid a double counting adjustment and is a practical simplification for morbidity risk as shocks vary by product type, which would create additional complexities in determining the double counting adjustment in addition to the complexity posed by using a non-constant level shock.

13) Claims Fluctuation Reserves

OSFI should provide further insight as to why the treatment afforded to policyholder deposits (i.e., a continuation from MCCSR of the deduction to required capital) cannot be extended to claims fluctuation reserves.

The principle followed in MCCSR that has been carried over to LICAT is that reinsurance claims fluctuation reserves (CFRs) are treated in the same manner as unregistered reinsurance deposits.

The new treatment for unregistered reinsurance deposits and reinsurance CFRs is appropriate because $1.00 of deposits or CFRs, which are both available to cover only specific risks on specific treaties, should not provide a greater total capital benefit than $1.00 of actual capital, which is available to cover any risk. If the $1.00 of CFR were to be deducted from the solvency buffer then, because of the operating target ratio, this would provide a total capital benefit of, for example, $1.30, which would be greater than the $1.00 benefit of holding $1.00 in actual capital.

14) Longevity Swaps

OSFI should provide clarity on the treatment of longevity swaps for the general requirement for operational risk. Specifically, are both payout annuities and longevity swaps/insurance excluded from the 2.5% direct premium charge?

The guideline was amended to clarify that direct and assumed premium charges do not apply to annuities or longevity swaps.

15) Measurement of large increases in business volume

An insurer could face an operational risk requirement for large increases in business volume if currency exchange rates fluctuate while the amount of business written, measured in a foreign currency, remains constant.

The measurement basis for business volume in foreign currencies has been modified to use the exchange rates in effect at the LICAT period-ending report date, irrespective of when premiums or liabilities accrued. This amended measure more accurately represents the growth due to increases in volume as measured in the original foreign currency, and excludes the impact of changes in exchange rates over the measurement period.

16) Participating Insurance

The current treatment of participating insurance does not appropriately reflect the annual dividend setting approach and the risk-sharing nature of this business. OSFI should lower the 10% interest rate risk credit floor for participating business.

OSFI continues to believe that the 10% floor is appropriate. That said we will monitor the results of the LICAT methodology for determining the interest rate risk charge for participating policies and review potential alternative measures for a future version of the LICAT.

17) Unregistered versus Registered Reinsurance

The design of the LICAT ratios disadvantages unregistered reinsurance compared to registered reinsurance for the ceding company unless the funding is at the operating level of the ceding company. Further, this could result in funding well above the operating level of a registered reinsurer and could never be matched if it exceeds the 150% limit outlined in section 6.8.1.

This is further exacerbated in the case of the Core Ratio given the 30% haircut of the eligible deposits for unregistered reinsurance. The quality, priority and permanence of the assets in the RSA are such that they are very similar to other eligible Tier 1 elements and a 30% haircut seems unjustified.

The unregistered reinsurance regime is designed so that, when an insurer’s reported ratio is the same as its ratio calculated net of all reinsurance, then all business ceded under unregistered reinsurance has been funded at the reported level. Else, the new ratio will be lower.

In terms of advantages and disadvantages between registered and unregistered, one has to look to other considerations. For example, an insurer ceding business to a registered reinsurer will be subject to the 2.5% counterparty risk charge to cover the risk of the reinsurer defaulting.

The 150% limit is intentionally designed so that reported ratios above 150% are backed by capital rather than deposits.

Eligible Deposits do not have the same quality characteristics in the areas of permanence, availability, and freedom from mandatory charges when compared to Tier 1 capital such as retained earnings or common stock.

18) Haircut Approach for Reinsurance

The LIMAT gives very little relief for registered reinsurance that is also fully collateralized and does not recognize overcollateralization. It is common in other jurisdictions to allow a reduction of the counterparty risk requirement to the ceding company if an equivalent amount is posted in trust by the reinsurer. For example, with the LIMAT counterparty risk charge of 2.5%, the ceding company would be permitted to reduce its counterparty risk component to zero if the reinsurer maintains assets in trust for 102.5% of the reinsurance asset. OSFI’s rules should permit such an offset.

The capital requirement can be reduced to zero if it is fully collateralized with assets that have a 0% capital charge (e.g. Canadian government bonds).

If a haircut approach were to be used (as it is in LICAT for derivatives and securities financing), the haircut will depend on the quality of the collateral and the frequency of re-margining, not the credit quality of the obligor. OSFI currently has no plans to introduce a haircut approach for secured lending and reinsurance.

19) Interest Rate Risk for Unregistered Reinsurance

The current treatment of interest rate risk for unregistered reinsurance makes pricing difficult, particularly in the case of large transactions.

The current design of the interest rate risk charge on other business is likely an indication of how the new charge will be developed for unregistered reinsurance business. OSFI intends to introduce the methodology for the 2019 version of the LICAT guideline and will consult with the industry on the proposed methodology beforehand.

20) Transfer of on-balance sheet asset risks under reinsurance arrangements

The guideline is not clear about whether and how a ceding insurer can take credit for asset credit and market risks transferred under funds withheld and modified coinsurance agreements.

Explicit guidance, consistent with the substitution approach used for guarantees and collateral, has been added to the guideline to cover the treatment of asset risks transferred under funds withheld coinsurance and modified coinsurance agreements. Illustrative examples have been added as well.    

21) Diversified PfADs

In line with the new approach promulgated by the CIA where diversification is allowed between mortality/longevity improvement PfADs, the concept that PfADs cannot be diversified could be reassessed.

In the current test, a PfAD equivalent of 50% of the insurance risk level and trend components is used as a proxy for the purpose of calculating the diversification credit. This is based on overall industry averages. The standardized nature of this proxy makes it too imprecise to calculate a valid diversification benefit between mortality and longevity improvement. This issue will next be reviewed in the context of the treatment of risk margins under IFRS 17.

22) Portfolio Volume Credit

In relation to section 11.1.3, the portfolio volume credit should be net of registered (i.e., not all) reinsurance. The cedant’s BSB includes insurance risk ceded under unregistered reinsurance. Hence for purposes of the LICAT methodology, this insurance risk ceded should be considered “retained” business. Accordingly, it should be part of the diversification credit.

The capital requirements for business ceded under unregistered reinsurance arrangements is usually covered by eligible deposits that can be used for the reinsured business only, and not for the insurer’s retained business. Since the capital covering this business is not available for retained business, the diversification benefit between the ceded business and the retained business is lost.

23) Miscellaneous

The guideline text could be made clearer or expanded upon in a number of places to improve clarity and ensure consistent interpretation. A number of corrections were suggested to references within the document.

OSFI has made a number of updates and clarifications throughout the guideline to assist with calculations and to promote a consistent interpretation of the methodology. These include, for example: encumbered assets, stress scenarios, fixed-coupon puttable bonds, interest rate swaps, projection of insurance liability cash flows and stop-loss arrangements. As well, in addition to having updated approximations, Chapter 1 now outlines more clearly how aggregate requirements are reduced by various credits outlined and defined in different guideline chapters throughout the guideline. A number of references were corrected.

Appendix 2 – Summary of LICAT Changes Since September 2016 (Since June 2017 in Italics)

TOPIC CHANGE
1) Overview and General Requirements
  • Added guidance on the types of liability margins that may be included in the Surplus Allowance
  • Added guidance on the use of approximations
    • Approximation of the marginal capital requirements used in the calculation of the Third Party Share limit and for calculating the deduction for encumbered assets
    • Approximation of currency risk offset using allocation approaches based on liabilities and on standardized factors applied to business volume measures (e.g.: liabilities, net amounts at risk)
  • Clarified how aggregate requirements are reduced by various credits
  • Removed Section 2.4.3, a placeholder for other transitional arrangements
  • Added guidance on the treatment of composite subsidiaries writing both life and P&C business
  • Added various supporting examples / illustrations throughout the guideline (identified by a box insert)
2) Ratios
  • Reduced the minimum core ratio from 60% to 55% for operating companies, and from 60% to 50% for regulated insurance holding companies and non-operating insurance companies
3) Available Capital
  • Removed deduction from Tier 1 and add-back to Tier 2 of fair value gains after transition to IFRS on investment properties that do not back policy liabilities under CALM; the risk is appropriately captured within real estate risk solvency buffer for investment properties
  • Allowed instruments subject to transition to be excluded from the capital composition limit calculations, and clarified the limits applicable to Tier 1 Capital Instruments Other than Common Shares
4) Credit Risk
  • Specified conditions that must be met by commitments not subject to capital requirements
5) Market Risk
  • Added information related to the determination of the initial scenario discount rates and market spreads
  • Simplified the methodology for projecting cash flows on interest rate swaps
  • Clarified the treatment of interest rate risk on participating non-pass through cash flows in the determination of the most adverse scenario and participating policy credit
  • Corrected an error in the treatment of interest rate swaps and also expanded the treatment to also apply to any legs of a currency swap that makes or receives fixed payments
  • Changed the factor assigned to capital instruments in order to account for the potential lower quality (from the investor’s perspective) already reflected in their rating
  • Specified the cash flow treatment for all investment contracts, not just deposit-type contracts
6) Insurance Risk
  • Reduced AD&D mortality catastrophe factor from 60% to 20%
7) Operational Risk
  • Expanded the application of the 5.75% factor net of credit to special policyholder and reinsurance arrangements
  • Clarified the specific treatment for coinsurance arrangements
  • Clarified that the volume and large increases in volume charges do not apply to direct and assumed premiums in the case of annuities or longevity swaps
  • Prescribed a specific calculation to limit the impact of currency exchange fluctuations on the risk charge for large increases in business volume
  • Clarified the methodology to calculate general required capital for ceded annuity business and for longevity swaps
8) Reinsurance
  • Narrowed the scope of Chapter 10 to cover reinsurance only; other risk transfer arrangements are now covered in Chapter 1
  • Added examples and clarifications in Chapter 10 on the treatment of credit and market risk associated with on-balance sheet assets transferred under registered reinsurance arrangements