Life Insurance Capital Adequacy Test - 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:

The Core Ratio focuses on financial strength. The formula used to calculate the Core Ratio is:

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.^{Footnote 1} 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 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.^{Footnote 2} 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 geographic regions, 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

Liabilities and their associated risks are allocated to geographic regions based on where the original policy underlying the liability was written directly. Assets backing liabilities are allocated to the same region as the liabilities that they back. Assets backing surplus, if held in a branch, are allocated to the region in which the branch is registered, otherwise they are allocated to the region in which the legal entity holding the assets is incorporated.

The aggregate capital requirement within a geographic region 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 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 insurers^{Footnote 3}

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^{Footnote 4}. 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%^{Footnote 5}. 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 GAAP^{Footnote 6} 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 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.^{Footnote 7}
2. Consolidated equity investments in non-life solvency regulated financial corporations^{Footnote 8} 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 Return^{Footnote 9}, 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."

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:^{Footnote 10}

1. Sections 2.1.1.5, 2.1.2.6 and 2.2.1.4: Insurers may approximate marginal capital requirements by using quarter-in-arrears data to determine the ratio of the marginal solvency buffer to the standalone solvency buffer, and then multiplying this ratio by the current standalone solvency buffer. Additionally, the marginal requirements in sections 2.1.1.5 and 2.2.1.4 may be approximated using quarter-in-arrears data if the amount of capital held by third-party investors or attributable to non-controlling interests remains well below the applicable limit.

2. Section 2.1.2.9.2: An insurer may use quarter-in-arrears data to determine the individual and total policy requirements rc_vol,rc_cat,RC_vol, and RC_cat.

3. Section 3.1.2: Quarter-in-arrears cash flows may be used to approximate the effective maturities of credit exposures subject to this section. If this approximation is used, an insurer should make appropriate adjustments for significant changes in asset inventory, disposals, maturities, etc. that have occurred since the last quarter-end.
   
   In low-interest rate environments where an insurer is using the weighted average approach to calculate the effective maturity of exposures to a connected group, an insurer may apply weights based on market value instead of undiscounted cash flows to the individual exposures.

4. Sections 3.1.7 and 3.1.8: An insurer may estimate the proportions of reinsurance receivables and premium receivables that have been outstanding less than 60 days and more than 60 days using quarter-in-arrears data.

5. Section 3.1.7: An insurer may approximate reinsurance assets by reinsurer for the purpose of applying the zero floor by using quarter-in-arrears data to determine the percentage of reserves ceded to each reinsurer, and multiplying these percentages by total current ceded liabilities.

6. Sections 5.1.2 and 5.1.3: Quarter-in-arrears cash flows, in combination with roll-forwards and true-ups that an insurer uses for its in-arrears CALM cash flow testing, may be used to determine the most adverse scenario and project all cash flows.

7. Section 5.1.3.3: Second-order impacts of restating dividends on paid-up additions may be ignored.

8. Sections 5.1.3.17 and 6.1: Investment income taxes and tax timing differences may be projected under the CALM worst interest rate scenario instead of the base scenario.

9. Section 5.6.1: The maximum amount of the offsetting short position for a currency within a geographic region may be approximated as:

    

   where:

   • BCR_currency is the basic capital requirement for business denominated in the currency under consideration, defined below;
   • ∑BCR is the sum of all basic capital requirements for all currencies within the region;
   • BSB is the Base Solvency Buffer for the region, with all requirements for currency risk excluded, the requirement for insurance risk calculated net of all reinsurance, and all credits for within-risk diversification, between-risk diversification, and participating and adjustable products applicable to the aggregated requirements taken into account.

   The basic capital requirement BCR_currency is the sum of the following amounts that are denominated in the currency under consideration:

   1. 2.8% of all liabilities;
   2. 0.24% of the net amount at risk for term products and other life products that do not have significant cash values;
   3. 2.4% of liabilities for:
      1. life products that have significant cash values;
      2. participating contracts; and
      3. accident, health and disability coverage;
   4. 4.8% of annuity liabilities;
   5. 4.4% of liabilities for GICs, or of notional value for synthetic GICs (e.g. wraps); and
   6. 4.8% of guaranteed value for segregated funds.

   Insurance liabilities, net amounts at risk, and segregated fund guarantee values in the above sum should be based on Best Estimate Assumptions, and should be measured net of all reinsurance. The guaranteed value of segregated funds is defined to be the actuarial present value of all benefits due to policyholders assuming that all account values are zero, and remain at zero for the life of the policies.

   Up to and including year-end 2020, the maximum amount of the offsetting short position for a currency within a geography may also be approximated as:

    

   where L_currency is the amount of liabilities in the currency under consideration, and ∑L is the total amount of liabilities in all currencies in the geography.

10. Sections 6.2.1 and 6.5.1: Insurers may use cash flows with a lag of up to one year when conducting the tests used to determine which products are life supported and death supported, or lapse supported and lapse sensitive.

11. Sections 6.2.2.1: Insurers may use a lag of up to one year when calculating the ratio of the individual life volatility risk component to the following year's expected claims.

12. Sections 6.4.3, 6.4.4, 6.5.3, 6.5.4, 6.6.1: For the volatility and catastrophe components of morbidity and lapse risks, the shocks applied to best estimate assumptions are for the first year only, and zero thereafter. If an insurer, for example due to software limitations, is unable to apply shocks for partial calendar years, it may instead apply the LICAT insurance risk shock for the remaining portion of the calendar year, and a different shock for the entirety of the following calendar year. The second shock should be equal to the LICAT shock multiplied by the proportion of the current calendar year that has elapsed. For example, if the insurer is preparing a LICAT filing for the end of Q1 20x1, and LICAT specifies an insurance risk shock of 30%, then the insurer may use a shock of 30% for the remainder of 20x1, and a 7.5% shock for all of 20x2.

    If this approximation is used for expense risk, the second shock representing the carryover from the first year should be added to the 10% shock in the second year.

13. Section 6.5.3: An insurer may approximate the requirement for lapse volatility by determining the present value of cash flows for a shock of +/- 30% in the first year, and subtracting the present value of best estimate cash flows.

14. Sections 6.8.1, 6.8.4, and 9.2: In order to determine a marginal insurance risk solvency buffer, insurers may use quarter-in-arrears data to determine the ratio of the marginal insurance risk solvency buffer to the standalone insurance risk solvency buffer, and then apply this ratio to the current standalone insurance risk solvency buffer. An insurer may use this approximation if changes from the previous quarter (e.g. diversification credit or the relative weights of different risks) do not have a material impact on the results.

1.5. Minimum amount of Available Capital

Notwithstanding the minimum and target Total and Core Ratios described in the Guideline, Canadian life insurance companies are required to maintain a minimum amount of Available Capital, as calculated in this Guideline, of $5 million or such amount as specified by the Superintendent.