Life Insurance Capital Adequacy Test - Chapter 9 Participating and Adjustable Products

Required capital components for participating and adjustable products are calculated in the prior chapters as if the products were non-participating and non-adjustable. However, participating and adjustable policies allow insurers to share risk with policyholders through discretionary benefits. Therefore, insurers may include credits for participating products (par credit) and for contractually adjustable policies (adjustable credit) in the calculation of the Base Solvency Buffer provided certain conditions are met.

An insurer should calculate the credit for participating products by geographic region. However, if not all participating products within a region are homogeneous with respect to the risks that are passed through to policyholders via reductions in dividends, it will be necessary for the insurer to partition its participating business within the region into separate blocks that are homogeneous with respect to the risks passed through to policyholders.Footnote 1 A partitioned block may contain assets and liabilities (e.g. surplus, PfADs, and ancillary funds, and/or the assets backing them) whose risks are not passed through to policyholders. A standalone capital requirement net of par credit is calculated for each participating block.

The adjustable credit is calculated for each adjustable product within a geographic region.

A non-trivial reduction in dividends or significant adjustments made to adjustable features may result in other adverse impacts (second-order effects) due to lapses, anti-selection, unit expense increases or legal action undertaken by policyholders. Such second-order effects should not be reflected in cash flows when calculating the credit for participating and adjustable products.

9.1. The participating product credit

9.1.1. Conditions for the par credit

A par credit may be used to reduce the required capital for a block of participating policies provided that the experience with respect to specified risk elements is incorporated into the annual dividend adjustment process in a consistent manner from year to year. A par credit may be taken for the block only if the following three criteria are met:

  1. The insurer's participating dividend policy must be publicly disclosed and must make clear that policyholder dividends are not guaranteed and will be adjusted to reflect actual experience. The insurer should publicly disclose the elements of actual experience that are incorporated in the annual dividend adjustment process. Insurers should disclose all material elements and indicate whether and how the risks are passed through to the policyholders (e.g., investment income, asset defaults, mortality, lapses and expenses).
  2. The insurer should regularly (at least once a year) review the policyholder dividend scale in relation to the actual experience of the participating account (i.e., including all blocks of business). The insurer should be able to demonstrate to the satisfaction of OSFI which individual elements of actual experience, to the extent that they were not anticipated in the current dividend scale, have been passed through in the annual dividend adjustment. Furthermore, the insurer should be able to demonstrate that shortfalls in actual overall experience, to the extent that they are not fully absorbed in any additional reserves or other similar experience levelling mechanisms, are recoveredFootnote 2 on a present value basis through level or declining reductions in the dividend scaleFootnote 3. The dividend scale reductions required to effect recovery must be made within two years from when the shortfall occurs.
  3. The insurer should be able to demonstrate to OSFI that it follows the dividend policy and practices referred to above.

9.1.2. Calculation of the par credit for a block

The par credit for a qualifying block of par business takes into account the present value of restated dividend cash flows. The par credit CPi for the block that is used to calculate the Base Solvency Buffer (q.v. section 11.3) is given by:

Math formula  

where:

  • Ci initial is 75% of the present value of restated dividend cash flows for the block used in the interest rate risk calculation (q.v. section 5.1.3.3), discounted using the Initial Scenario Discount Rates in section 5.1.1

  • Ci adverse is 75% of the present value of restated dividend cash flows for the block used in the interest rate risk calculation, discounted using the rates under the most adverse scenario that determines the requirement for interest rate risk

  • IRRi par is the interest rate risk requirement (q.v. section 5.1.2.3) for the block under the most adverse scenario that determines the requirement for interest rate risk

  • Ki is the adjusted diversified requirement K for the block (q.v. section 11.2)

  • Ki reduced interest is the adjusted diversified requirement K for all risks in the block, with the interest rate risk component reduced. This quantity is calculated by setting the interest rate risk component of the block to max(IRRi parCiadverse,0), and leaving all other risk components unchanged.

  • Ki floor is the minimum adjusted diversified requirement for the block. This quantity is calculated by aggregating, within the calculation of KFootnote 4:

    1. 100% of the requirements for all risks in the block, that cannot be passed through to policyholders by making adjustments to the dividend scaleFootnote 5

    2. 10% of the interest rate risk requirement for the block, if interest rate risk can be passed through to policyholders by making adjustments to the dividend scale

    1. 30% of all other risk components that can be passed through to policyholders by making adjustments to the dividend scale.

For a block that has assets and liabilities for which interest rate risk is passed through to policyholders, and other assets and liabilities for which interest rate risk is not passed through to policyholders, the combined amount for i) and ii) above that should be used for the interest rate risk requirement in calculating Ki floor is:

100% x IRRi par npt + 10% x max( IRRi par - IRRi par npt'0)

where IRRi par npt is as defined in section 5.1.2.3.

Example: Par Credit

Suppose that a participating block of business has the following risk components:

Life insurance risk Gross component (IRi) Level and trend components (LTi) IRi − 0.5 × LTi
Mortality750,000300,000600,000
Longevity000
Morbidity incidence000
Morbidity termination000
Lapse sensitive500,000200,000400,000
Lapse supported000
Expense50,000050,000
Totals1,300,000500,000
Other risks Component
Credit risk300,000
Interest rate risk (IRR)400,000
Other market risks250,000
Property and casualty risk0

Suppose further that the present value of restated dividends for the block under the initial scenario is 800,000, and that this present value moves to 1,200,000 under the adverse scenario that determines the requirement for interest rate risk. The quantity Cinitial for the block is therefore (75% x 800,000 =) 600,000, and Cadverse is (75% x 1,200,000 =) 900,000. Finally, suppose that all risks associated with the block except mortality risk are passed through to policyholders through dividend adjustments.

The requirement K for this block is equal to 1,913,534 (the intermediate quantities in the calculation are I = 832,166, D = 1,544,525, and U = 2,250,000; refer to section 11.2.4 for an example that shows the steps in the calculation of K). Since IRR < Cadverse for the block, the requirement Kreduced interest is the requirement K for the block recalculated using an interest rate risk requirement of 0, and is equal to 1,565,932 (I = 832,166, D = 1,205,277, U = 1,850,000). The potential credit as a function of the dividend absorption capacity is therefore:

Math formula  

Since all risks except for mortality risk are passed through to policyholders, the requirement Kfloor for the block is calculated using 100% of the requirement for mortality risk, 10% of the requirement for interest rate risk, and 30% of the requirements for all other risks:

Life insurance risk Gross component (IRi) Level and trend components (LTi) IRi − 0.5 × LTi
Mortality750,000300,000600,000
Longevity000
Morbidity incidence000
Morbidity termination000
Lapse sensitive150,00060,000120,000
Lapse supported000
Expense15,000015,000
Totals915,000360,000
Other risks Component
Credit risk90,000
Interest rate risk (IRR) 40,000
Other market risks75,000
Property and casualty risk0

The value of Kfloor is therefore 987,966 (I = 649,173, D = 772,354, U = 1,120,000), and the maximum credit as a function of the requirements above the LICAT floors is:

1,913,524 − 987,966 = 925,568

The par credit CP for the block is equal to the lower of the two amounts, which is 680,935.

9.2. The contractually adjustable product credit

9.2.1. Conditions for the adjustable credit

Products that are contractually adjustable qualify for a credit if all of the following conditions are met:

  1. Contractual adjustability is at the sole discretion of the insurer.
  2. All adjustable features associated with the products (e.g. premiums, fees and benefits) have been explicitly disclosed in the contract.
  3. The insurer should regularly (at least once a year) review the product's experience and consider its potential impact on adjustments. Although the review and resulting adjustments may be for the most part forward-looking, the insurer should be able to demonstrate to the satisfaction of OSFI which individual elements of actual experience are considered in the review process.
  4. The adjustability is reasonably flexible, and the insurer has tested the reasonable flexibility of the adjustable features in pricing the policy or subsequent to pricing the product. The test should demonstrate that the insurer is able to recuperate at least half of any unexpected insurance risk losses (defined as the product's marginal capital requirement for insurance risks minus its Surplus Allowance related to insurance risks) by comparing the price with and without future adjustments. Tests of adjustability may not take into consideration amounts recoverable through arrangements that are accorded a separate credit in the insurance risk components, such as hold harmless agreements, deposits made by policyholders or claims fluctuation reserves. The tests should be documented and available for review by OSFI on request, and should demonstrate, to the satisfaction of OSFI, that these conditions are met.
  5. If an insurer takes credit for an adjustable feature, the insurer should have a documented internal policy on how it makes adjustments and the key considerations in making adjustments, including the consideration given to losses or shortfalls in actual overall experience. Any credit taken must be calculated consistently with the manner stated in the internal policy, and must reflect policies that, if followed, would reduce or restrict the adjustability otherwise permitted in the contract.
  6. The insurer should be able to demonstrate to OSFI that it follows the adjustment policy and practices referred to above.

A product that is only adjustable up to a certain age or has a one-time adjustment may be considered adjustable provided that it meets all other conditions. A credit may not be taken for an adjustment that is no longer available (e.g., used up or expired), or that the insurer would not exercise, according to its policy or past practices , in the event of adverse experience or loss.

A product that is adjustable at the discretion of the insurer but that is also subject to third-party (e.g. regulatory) approval will be considered a qualifying adjustable product; however, such a product will receive a lower credit than other qualifying adjustable products that do not require third-party approval.

A product with a solvency maintenance clause (e.g. certain non-participating products issued by fraternal benefit societies) may be considered a qualifying adjustable product provided that it meets all other conditions.

A product with adjustable features that are not at the discretion of the insurer (such as formula or index based adjustments) is treated as non-adjustable businessFootnote 6.

9.2.2. Calculation of the adjustable credit

The gross adjustable credit Cj is calculated for two categories of qualifying products where there are contractually adjustable liability cash flows:

  1. Products adjustable at the sole discretion of the insurer and that do not require third-party approval, and
  2. Products adjustable at the sole discretion of the insurer and that do require third-party approval.

The gross adjustable credit is equal to the difference between non-adjusted cash flows and adjusted cash flows discounted using the Initial Scenario Discount Rates specified in section 5.1.1. The adjusted cash flows are based on the maximum possible adjustment for the contracts, up to a limit, for each adjustable feature. The limit for each adjustable feature is set depending on whether adjustments to the feature require third-party approval or not.

For products with adjustable features that do not require third-party approval, the increases or decreases for each feature recognized in adjusted cash flows are capped at 50% of the feature's current level, phased-in on a straight line basis over a period of five years (i.e. 10% per year)Footnote 7. For products with adjustable features that do require third-party approval, the increases or decreases for each feature recognized in adjusted cash flows are capped at 30% of the current level, phased-in on a straight line basis over a period of five years after a delay period of two years (i.e. adjustments of 6% per year occur after a waiting period of two years)Footnote 8.

Once the gross adjustable credit Cj for a product has been calculated, the adjustable credit CAj for the product used to calculate the Base Solvency Buffer (q.v. section 11.3) is given by:

Math formula  

where:

  • Knon-par is the requirement K (q.v. section 11.2) calculated for the non-participating block, and
  • Knon-par excluding ajustable product j is the requirementFootnote 9K for the non-participating block recalculated excluding the requirements for all of the qualifying adjustable product's insurance risks.

Example: Adjustable Credit

This example builds on the example presented at the end of section 11.2.4, where the requirement Knon-par for a non-participating block of business within a geographic region is determined to be 1,517,987. If this block contains an adjustable product, in order to determine the adjustable credit for the product it is necessary to calculate the gross adjustable credit C, and to recalculate the block's insurance components with insurance risks related to the adjustable product excluded. Suppose that the gross adjustable credit is equal to 250,000, and that when the adjustable product's insurance risks are removed from the non-participating block, the block's recalculated insurance risk components are as follows:

Life insurance risk Gross component (IRi) excluding adjustable product Level and trend components (LTi) excluding adjustable product IRi − 0.5 × LTi
Mortality800,000500,000550,000
Longevity3,0003,0001,500
Morbidity incidence50,00010,00045,000
Morbidity termination2,5001,0002,000
Lapse sensitive200,00090,000155,000
Lapse supported100,00040,00080,000
Expense7,50007,500
Totals1,163,000644,000

The recalculation of the components I, D, U and K for the block then proceed as follows:

Math formula  

The adjustable credit for the product is then:

CA = min[250,000,0.7×(1,517,987-1,247,823)] = 189,115

9.3. Participating products that are contractually adjustable

Where a product is both participating and has an adjustable feature that is able to pass through losses or reflect adverse experience arising from all risks, an insurer may take a simultaneous credit for participating and adjustable features as specified below. In order for an insurer to take credit for participating and adjustable features simultaneously, the product must meet all of the conditions for participating products specified in section 9.1.1 and all of the conditions for adjustable products specified in section 9.2.1, and the insurer should have sole discretion to exercise the adjustable feature without third-party approval to recover losses or reflect adverse experience that occurs for any reason (i.e. adjustability must not be confined to specific risks). If the participating product has an adjustable feature that is not able to pass through losses or reflect adverse experience for all risks, the credit in this section is not available. For such a product, the insurer has the option to apply either the par credit or the adjustable credit, but not both.

If a product is eligible for both credits, the adjustable credit for the product should be recalculated using the methodology for participating products in section 9.1. The revised adjustable credit is:

Math formula  

where:

  • K, Kreduced interest, and IRR have the same definitions as in section 9.1.2
  • Cinitial is the gross adjustable credit defined in section 9.2.2
  • Cadverse is the gross adjustable credit modified so that it is discounted using the rates under the most adverse scenario that determines the requirement for interest rate risk, instead of the initial scenario
  • Kfloor adj is calculated by aggregating, within the calculation of K:
    • 30% of all insurance risk components for the block, and
    • 100% of all other risk components for the block

The aggregate credit for the product is then equal to:

min(CP + CA, KKfloor global)

where:

  • CP is the participating credit for the product
  • CA is the recalculated adjustable credit for the product
  • K is the adjusted diversified requirement for the block
  • Kfloor global is calculated by aggregating, within the calculation of K:
    • 10% of the interest rate risk component for the block, and
    • 30% of all other risk components for the block

Footnotes

Footnote 1

Assets and liabilities whose risks are not passed through to policyholders that are commingled and support multiple participating blocks within a geographic region should be allocated proportionally to particular participating blocks.

Return to footnote 1

Footnote 2

The recovery of shortfalls must be demonstrated based on reductions in the dividend scale compared to what would have been paid taking into account all of the elements, and only those elements, that are passed through to policyholders.

Return to footnote 2

Footnote 3

Reductions in the dividend scale must be level or must represent front-loaded or accelerated experience recovery.  Reductions in terminal dividends, where there are no periodic dividends, are considered to be level reductions in the dividend scale.

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Footnote 4

For insurance risks, the percentage factors below are applied to the intermediate quantities IRi and LTi used to calculate K.

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Footnote 5

These include requirements for credit and market risks related to assets backing surplus, PfADs and/or ancillary funds if returns on these assets are not passed through to policyholders. If the block contains assets/liabilities whose risks are not passed through to policyholders, and these assets/liabilities are commingled with assets/liabilities whose risks are passed through to policyholders, then the requirements for credit and market risks, other than interest rate risk, for the non-pass through assets/liabilities should be determined using proportional allocation.

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Footnote 6

It is possible, for example, that a product with a formula or an index based adjustment to have other contractually adjustable features that are at the sole discretion of management such as cost of insurance (COI) charges. In such a case, only the contractually adjustable features that are at the sole discretion of management are treated as adjustable for the calculation of the credit.

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Footnote 7

An insurer may instead cap the adjustments at 25% of the feature's current level starting after one year.

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Footnote 8

An insurer may instead cap the adjustments at 10% of the feature's current level starting after one year.

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Footnote 9

An approximation may be used under section 1.4.5.

Return to footnote 9

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