Office of the Superintendent of Financial Institutions
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal riskFootnote 1 but excludes strategic and reputational risk.
Required capital for operational risk is the sum of:
This section outlines exposures and factors used to calculate required capital for operational risk.
Business volume required capital is determined by applying the following factors to direct premiums and assumed reinsurance premiums written in the past 12 months, and to account values/liabilities for deposit-type products:
Liabilities for annuities in payout period, and annuity liability equivalents for longevity risk transfer arrangements
Account values of mutual funds, GICs, other investment-type products and segregated funds without guarantees, and liabilities for annuities in accumulation period
Direct written premiums for individual and group life policies include universal life premiums, but exclude annuity and longevity risk transfer premiums, mutual fund deposits, GICs, segregated fund deposits and premium equivalents for administrative service only/investment management services.
In determining the premiums to which the 1.75% risk factor for assumed reinsurance is applied, coinsurance premiums may be calculated net of expense allowances, such as ceding commissions that comprise agent commissions, premium taxes and administrative expenses. For funds withheld coinsurance and modified coinsurance arrangements, the 1.75% factor applies to the portion of the gross accruing receivable or gross modified coinsurance receivable corresponding to premiums net of expense allowances (i.e. the premium amount should be the same as for regular coinsurance).
The account and liability values to which the factors for investment-type products and annuities are applied are calculated gross of reinsurance (where applicable), and include PfADs. The liability value for business assumed under modified coinsurance arrangements is the pro forma liability for the business had it been assumed under regular coinsurance.
Longevity risk transfer arrangements that assume longevity risk have the same requirement as the underlying annuity business. The annuity liability equivalent for a swap is the current gross value of the floating leg of the swap, without deductions or offsets.
Business volume operational risk charges do not apply to business in controlled non-life financial corporations that are deducted from Available Capital.
Large increase in business volume required capital is calculated by geographic region. The factors in section 8.2.1 are applied to the amounts by which the year-over-year increases in direct written premiums, assumed reinsurance premiums, and account values/liabilities for investment-type products and annuities exceed a threshold of 20%.
The year-over-year increase for direct written premiums is defined to be the total amount of direct premiums written in the past 12 months that exceed 120% of the direct premiums written for the same period in the previous year. It is calculated separately for each of:
Example: Increase in Direct Written Premiums
If, as a result of rapid business growth, direct written premiums increase by 50% from 100 in Y1 to 150 in Y2, the premiums in Y2 in excess of 120% of the premiums in Y1 (30) is subject to an additional capital requirement of 0.75 (30 x 2.50%).
The year-over-year increase for assumed reinsurance premiums is defined to be the total amount of reinsurance premiums assumed in the past 12 months that exceed 120% of the premiums assumed for the same period in the previous year, for all products combined.
For investment-type products and annuities, the year-over-year increase is calculated separately for each of:
To adjust for the effect of exchange rate fluctuations over the measurement period, current and prior period premiums, account values and liabilities denominated in foreign currencies should be converted to Canadian dollars at the exchange rates in effect at the LICAT report ending date. Accordingly, the amounts used to measure large increases in business volume may not correspond to the amounts reported in prior period financial statements, and in the case of premiums, may not correspond to amounts reported in the current period financial statements.
In the case of an acquisition of another entity or an acquisition of a block of business (e.g. through assumption reinsurance), the premiums, account values, or liabilities and equivalents for any prior reporting period (before the acquisition) is the sum of the premiums, account values, or liabilities and equivalents of the two separate entities/blocks of business, i.e., the sum of the acquiring company's and the acquired company's/blocks of business' premiums, account values, or liabilities and equivalents. Following an acquisition, the acquiring insurer should re-classify premiums based on the merged company's categorization, using approximations, as necessary, in order to follow categories used in the LIFE Return.
Example: Business Acquisition
Assume that company A has direct written premiums of 100 for the 12-month period ending December 31, Y1. In Y2 it acquires company B that wrote direct premiums of 50 during Y1. The merged company reports a total of 225 in direct written premiums for the 12-month period ending December 31, Y2. The operational risk requirement for large increase in business volume is calculated as:
2.50% x [225 – ((100 + 50) x 1.20)] = 2.50% x 45 = 1.13
General required capital has two components. The first component is calculated as follows:
The second component is calculated as a 2.5% factor applied to ceded reinsurance premiums, and compensates for the understatement of the first component arising from its calculation net of reinsurance. For ceded annuity business, the amount that should be used as the ceded reinsurance premium equivalent is the annual amount of annuity payments ceded to the reinsurer. For risks ceded under longevity risk transfer arrangements, the amount that should be used as the ceded reinsurance premium equivalent is the gross amount of annuity payments ceded (for swaps, this amount is the gross annual payment under the floating leg of the swap without deductions or offsets). For coinsurance arrangements, the 2.5% risk factor applies to ceded premiums net of expense allowances, such as ceding commissions that include agent commissions, premium taxes and administrative expenses.
Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.
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