Office of the Superintendent of Financial Institutions
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.
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:
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:
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 188.8.131.52), 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
par is the interest rate risk requirement (q.v. section 184.108.40.206) 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
Ciadverse,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:
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
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
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 220.127.116.11.
Example: Par Credit
Suppose that a participating block of business has the following risk components:
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.
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
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:
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:
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.
Products that are contractually adjustable qualify for a credit if all of the following conditions are met:
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.
The gross adjustable credit
Cj is calculated for two categories of qualifying products where there are contractually adjustable liability cash flows:
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:
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:
The recalculation of the components
K for the block then proceed as follows:
The adjustable credit for the product is then:
CA = min[250,000,0.7×(1,517,987-1,247,823)] = 189,115
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:
The aggregate credit for the product is then equal to:
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
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
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.
Return to footnote 3
For insurance risks, the percentage factors below are applied to the intermediate quantities
LTi used to calculate
Return to footnote 4
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.
Return to footnote 5
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.
Return to footnote 6
An insurer may instead cap the adjustments at 25% of the feature's current level starting after one year.
Return to footnote 7
An insurer may instead cap the adjustments at 10% of the feature's current level starting after one year.
Return to footnote 8
An approximation may be used under section 1.4.5.
Return to footnote 9