Minimum Continuing Capital and Surplus Requirements

Document Properties

  • Type of Publication: Guideline
  • Issue Date: November 2015
  • Effective Date: January 1, 2016
  • No: A
  • Audiences: Life

Subsection 515(1), 992(1) and 608(1) of the Insurance Companies Act (ICA) requires federally regulated life insurance companies and societies, holding companies and companies operating in Canada on a branch basis, respectively, to maintain adequate capital or to maintain an adequate margin of assets in Canada over liabilities in Canada. Guideline A: Minimum Continuing Capital and Surplus Requirements (MCCSR) is not made pursuant to subsections 515(2), 992(2) and 608(3) of the ICA. However, the guideline along with Guideline A-4: Regulatory Capital and Internal Capital Targets provides the framework within which the Superintendent assesses whether a life insurerFootnote 1 maintains adequate capital or an adequate margin pursuant to subsection 515(1), 992(1) and 608(1). Notwithstanding that a life insurer may meet these standards, the Superintendent may direct the life insurer to increase its capital under subsection 515(3), 992(3) or 608(4).

This guideline establishes standards, using a risk-based approach, for measuring specific life insurer risks and for aggregating the results to calculate the amount of a life insurer's regulatory required capital to support these risks. The guideline also defines and establishes criteria for determining the amount of qualifying regulatory available capital.

The MCCSR is only one component of the required assets that foreign life insurers must maintain in Canada. Foreign life insurers must also vest assets in Canada as prescribed under the Assets (Foreign Companies) Regulations of the ICA.

Life insurers are required to apply this version of the guideline for reporting periods ending on or after January 1, 2016. Early application of this version of the guideline is not permitted.

Table of Contents

Chapter 1. Overview and General Requirements

This chapter provides an overview of the guideline, and sets out general requirements. More detailed information on specific components of the calculation is contained in subsequent chapters. The requirements in this guideline are updated regularly by the Superintendent as experience with the MCCSR formula develops, as the risk profiles of life insurers change, and so that risks may be better considered.

1.1. Overview

1.1.1. Qualifying Regulatory Available Capital

The determination of qualifying regulatory available capital (Available Capital) is detailed in chapter 2. It comprises two tiers, tier 1 (core capital) and tier 2 (supplementary capital), and involves certain deductions, limits and restrictions.

The determination of Available Capital includes all subsidiaries that are consolidated for the purpose of calculating the Base Required Capital.

1.1.2. Base Required Capital

A life insurer's Base Required Capital is determined as the sum of the capital requirements for each of five risk components. The component capital requirements are determined using factor-based or other methods that are applied to specific on- and off-balance sheet assets or liabilities.

The five risk components are:

  • asset default (C-1) risk (risk of loss resulting from on-balance sheet asset default and from contingencies in respect of off-balance sheet exposure and related loss of income; and the loss of market value of equities and related reduction of income) (reference chapters 3 and 7);

  • mortality/morbidity/lapse risks (risk that assumptions about mortality, morbidity and lapse will be wrong) (reference chapter 4);

  • changes in interest rate environment (C-3) risk (risk of loss resulting from changes in the interest rate environment) (reference chapter 5);

  • segregated funds risk (risk of loss arising from guarantees embedded in segregated funds) (reference chapter 8); and

  • foreign exchange risk (risk of loss resulting from fluctuations in currency exchange rates) (reference chapter 9).

Chapter 10 describes all of the methods by which the above component requirements may be reduced through risk mitigation or risk transfer arrangements.

The Base Required Capital is determined on a consolidated basis. The consolidated entity includes all subsidiaries (whether held directly or indirectly) that carry on a business that a company could carry on directly (e.g., life insurance, real estate, ancillary business subsidiaries, etc.).

1.1.3. Foreign companiesFootnote 2

The margin requirement for companies operating in Canada on a branch basis (Required Margin) is set forth under the Test of Adequacy of Assets in Canada and Margin Requirements (TAAM) in chapter 6. The TAAM covers each of the five risk components, and is determined using factor-based or other methods that are applied to vested assets, to specific assets under the control of the Chief Agent, and to liabilities, obligations and other commitments in Canada. The Required Margin is then used in calculating part of the vesting requirements for foreign insurers.

The TAAM is only one component of the required assets that foreign insurers must maintain in Canada. Foreign life insurers must also vest assets in Canada as prescribed in the Assets (Foreign Companies) Regulations made section 610 of the ICA.

1.1.4. Interpretation of results

The MCCSR has been designed to measure the capital adequacy of a company and is one of several indicators that OSFI uses to assess financial condition. The MCCSR should not be used in isolation for ranking and rating companies. Please refer to Guideline A-4: Regulatory Capital and Internal Capital Targets for more information about OSFI's minimum and supervisory targets expectations in the assessment of insurers' capital adequacy within the context of OSFI's Supervisory FrameworkFootnote 3 and OSFI's expectations with respect to the setting of insurer-specific internal capital targets and capital management policies for federally regulated insurance companies.

1.2. General requirements

1.2.1. MCCSR/TAAM minimum and supervisory target capital ratiosFootnote 4

The MCCSR compares the total Available Capital to the Base Required Capital (Total Ratio) and compares the adjusted net tier 1 capital to the Base Required Capital (Tier 1 Ratio). The TAAM compares the Available Margin to the Required Margin (Total Ratio) and compares the Available Margin excluding Other Admitted Assets to the Required Margin (Core Ratio). The MCCSR and TAAM ratios are generally expressed as a percentage of the Base Required Capital or the Required Margin.

With respect to the Total Ratio, if considering only the risks where calculations are specified, a minimum Total Ratio of 100% may be considered acceptable. However, life insurers are exposed to more risks than those for which calculations are specified. Consequently, the minimum Total Ratio for life insurers is set at 120% rather than 100% to cover operational risks that are not explicitly measured, but which form part of the minimum requirement under MCCSR/TAAM.

In addition, OSFI has established a supervisory target Total Ratio of 150% that is intended to cover the risks specified in the MCCSR/TAAM and other risks that are not included in the calculation. Other risks may include strategic and reputational risk, as well as risks not explicitly addressed by the actuary when determining policy liabilities.

Tier 1 capital is the primary element of capital that allows institutions to absorb losses during ongoing operations. Therefore, OSFI has established corresponding regulatory requirements for adjusted net tier 1 capital. Parallel requirements are also applicable with respect to branches.

The minimum Tier 1/Core Ratio is 60%. However, OSFI expects each institution to maintain its Tier 1/Core Ratio at no less than the supervisory target of 105%. This represents 70% of the 150% supervisory target Total Ratio.

Not all of a company's risks can be mitigated through reinsurance. Therefore, OSFI expects each institution to maintain Tier 1 Available Capital/Available Margin excluding Other Admitted Assets at or above 25% of the gross MCCSR/TAAM Base Required Capital/Required Margin, i.e. the requirement calculated without any reduction for reinsurance ceded. The requirement to calculate a Tier 1/Core Ratio gross of reinsurance is waived for companies that cede less than 60% of their business, as measured by both ceded reserves and the ceded MCCSR/TAAM Base Required Capital/Required Margin.

Companies are expected to maintain their Total and Tier 1/Core Ratios at or above the established minimum and supervisory target levels on a continuous basis. Questions about an individual company's/branch's minimum and supervisory target capital levels should be addressed to the Relationship Manager at OSFI.

1.2.2. Opinion of the Appointed Actuary

The Appointed Actuary is required to sign, on the front page of the annual MCCSR-TAAM return, an opinion as to the accuracy of the return in accordance with subsection 2480 of the CIA Practice-Specific Standards for Insurers. The text of the required opinion is:

"I have reviewed the calculation of the Minimum Continuing Capital and Surplus Requirement ratios of [Company name] as at [Date]. In my opinion, the calculations of the components of the Base Required Capital and Available Capital have been determined in accordance with the regulatory guidelines, and the components of the calculations requiring discretion were determined using methodologies and judgment appropriate to the circumstances of the company."
[Note: For TAAM form filings "Minimum Continuing Capital and Surplus Requirement ratios", and "Base Required Capital and Available Capital" are replaced by "Test of adequacy of assets in Canada and margin requirements ratios", and "Base Required Margin and Available Margin".]

The memorandum supporting this certification that the Appointed Actuary is required to prepare under the Standard must be available to OSFI upon request.

1.2.3. Authorized official signature

Each life insurer is required to have an authorized Officer endorse the following statement on the annual and quarterly MCCSR/TAAM returns:

"I confirm that I have read the relevant guideline and annual return reporting instructions issued by the Office of the Superintendent of Financial Institutions and that this form is completed in accordance with them."

The Officer endorsing this statement on the annual return must be different from the insurer's Appointed Actuary.

1.2.4. Audit requirement

Life insurers are required to engage the auditor appointed pursuant to section 337 or 633 of the Insurance Companies Act to report on the MCCSR and TAAM returns in accordance with the relevant standards for such assurance engagements, as promulgated by the Canadian Auditing and Assurance Standards Board (AASB).

1.2.5. Policy liabilities

For MCCSR purposes the policy liabilities used in calculating the mortality, morbidity, lapse and changes in interest rate environment components should include deferred income taxes under valuation assumptions as required by the Canadian Institute of Actuaries (CIA) Standards, prior to any accounting adjustment for balance sheet presentation. In addition, the policy liabilities used should exclude fifty percent of the future morbidity improvement if any portion of the impact of such improvement has been reversed from retained earnings in the determination of gross tier 1 capital under section 2.1.1.1 and should exclude future mortality improvement under CIA standard 2350.06 and additional future mortality improvementFootnote 5 under CIA standard 2350.11 if the combined impact of such improvement has been reversed from retained earnings in the determination of gross tier 1 capital under section 2.1.1.1.

1.2.6. Criteria for qualifying participating policies

In light of the risk pass-through nature of participating policies, some of the risk components associated with participating policy liabilities and the assets backing them may be reduced if certain conditions are met. A risk component for a block of policies may only be reduced if experience with respect to the risk component is explicitly incorporated into the annual dividend adjustment process for the policies in a consistent manner from year to year . Specifically, participating policy liabilities and the assets backing them may be treated as qualifying participating policies (i.e. qualifying for a reduced risk component only) if the following four criteria are metFootnote 6:

  1. The policies must pay meaningful dividends. To be considered meaningful, the present value of projected dividends calculated using valuation assumptions must be greater than the reduction in required capital that would result from using reduced risk factors.
  2. The company's participating dividend policy must be publicly disclosed and must make it clear that policyholder dividends are not guaranteed and will be adjusted to reflect actual experience. The company must publicly disclose the elements of actual experience that are incorporated into the annual dividend adjustment process. Such elements may include investment income, asset defaults, mortality, lapses and expenses.
  3. The company must regularly (at least once a year) review the policyholder dividend scale in relation to the actual experience of the participating account. It must be able to demonstrate to OSFI which individual elements of actual experience, to the extent they were not anticipated in the current dividend scale, have been passed through in the annual dividend adjustment. Furthermore, it must be able to demonstrate that shortfalls in actual overall experience, to the extent that they are not fully absorbed by any dividend stabilization reserves (DSRs)Footnote 7 or other similar experience levelling mechanisms, are recoveredFootnote 8 on a present value basis through (level or declining) reductions in the dividend scaleFootnote 9. The dividend scale reductions required to effect recovery must be made within two years from when the shortfall occurs.
  4. The company must be able to demonstrate to OSFI that it follows the dividend policy and practices referred to above.

Chapter 2. Qualifying Regulatory Available Capital

2.1. Summary of capital components

The three primary considerations for defining the Available Capital of a company for purposes of measuring capital adequacy are:

  • its permanence;
  • its being free of mandatory fixed charges against earnings; and
  • its subordinated legal position to the rights of policyholders and other creditors of the institution.

Total Available Capital comprises two tiers. Tier 1 (core capital) comprises the highest quality capital elements. Tier 2 (supplementary capital) elements fall short in meeting either of the first two capital properties listed above, but contribute to the overall strength of a company as a going concern. If there can be some doubt as to the availability of capital (i.e., retraction privileges, uncertainty as to realizable values), it is classified as tier 2. Deferred tax liabilities do not qualify as Available Capital/Margin. Unless explicitly stated otherwise in this Guideline, deferred tax liabilities may not be used to increase any component of Available Capital /Margin, and the carrying amount of any item required to be deducted from Available Capital /Margin may not be reduced by any portion of the associated deferred tax liabilities.

All capital instruments must be issued and fully paid for in money or, with the approval of the Superintendent, in property.

Given the potential impact of the disqualification of a capital instrument, insurers are encouraged to seek confirmations of capital quality from OSFI prior to issuing instruments. In conjunction with such requests, the institution is expected to provide specific information (reference Appendix 2-A).

No asset default factor will be applied to items that are deducted from capital. If changes in the balance sheet value of a deducted item have not been recognized in MCCSR Available Capital or TAAM Available Margin, the amount deducted for the item should be its amortized cost rather than the value reported on the balance sheet.

For capital adequacy purposes, the reported values of liabilities and capital instruments (including preferred shares, innovative instruments and subordinated debt) should not reflect the effects of changes in an institution's own creditworthiness that have occurred subsequent to issuance. Consistent with the treatment of liabilities and capital instruments, the amount of retained earnings reported for capital adequacy purposes should exclude accumulated after-tax fair value gains or losses arising from changes to an institution's own credit risk under the Fair Value Option.

Debt obligations, as defined in the Insurance Companies Act, made by life insurers that do not qualify as Available Capital by virtue of their characteristics are subject to a capital charge (reference section 5.3).

The capital elements comprising tiers 1 and 2, as well as the various limits, restrictions and deductions to which they are subject, are described next.

2.1.1. Tier 1

Tier 1 capital instruments are required to meet the qualifying criteria in section 2.1.1.2 (Common Shares) or sections 2.1.1.3 to 2.1.1.5 (Tier 1 Capital Instruments other than Common Shares). Tier 1 capital instruments issued prior to August 7, 2014 that do not meet the qualifying criteria for Tier 1 Available Capital in section 2.1.1.2 or sections 2.1.1.3 to 2.1.1.5, are required to meet the qualifying criteria specified in Appendix 2-B; these will be subject to transitional measures in due course.

2.1.1.1. Gross tier 1 capital

Tier 1 capital elements are restricted to the following, subject to requirements established by the Superintendent, such that gross tier 1 capital is the sum of the following:

  • Common shareholders' equity, defined to include common shares, contributed surplus,Footnote 10 and retained earningsFootnote 11, Footnote 12;
  • Participating account;
  • Qualifying non-controlling interests in subsidiaries arising on consolidation from tier 1 capital instruments;
  • Qualifying Tier 1 instruments other than common shares (reference sections 2.1.1.3, 2.1.1.4, 2.1.1.5 and Appendix 2-C)
    • Qualifying non-cumulative perpetual preferred shares
    • Other
  • Non-participating account (mutual companies);
  • Accumulated foreign currency translation adjustments reported in Other Comprehensive Income (OCI)Footnote 13;
  • Accumulated net unrealized loss on available-for-sale equity securities reported in OCIFootnote 14;
  • Accumulated changes in liabilities reported in OCI under shadow accounting;
  • Accumulated defined benefit pension plan remeasurements reported in OCI.

Companies may elect to phase-in, in gross tier 1:

  • the impact on gross tier 1 of including the accumulated defined benefit pension plan OCI remeasurements, if any, that existed on December 31, 2012 (i.e.: the amounts, if any, that existed immediately prior to the effective date of the requirement in this guideline to include in gross tier 1 accumulated defined pension plan remeasurements in OCI)

    and

  • the impact on gross tier 1 related to net defined benefit pension plan liabilities (assets) upon the initial adoption of the revisions to IAS 19 Employee Benefits, effective for fiscal years beginning on or after January 1, 2013 (i.e.: the impact on gross tier 1 of the net restatement of retained earnings and AOCI together).

The amount subject to phase-in in gross tier 1 is the sum of a) and b) above. The phase-in will be made on a straight-line basis over the phase-in period. The phase-in period begins on January 1, 2013 for item a) and on the effective date of the revisions to IAS 19 Employee Benefits for item b) and must be completed by the earliest quarter-end occurring on or after December 31, 2014. If a company elects the phase-in, it will be irrevocable, the adjustment amount will be reflected in gross tier 1 capital and the company will have to phase-in the net defined benefit pension plan impacts on net tier 1 and on tier 2C capital, as outlined in sections 2.1.1.6 and 2.1.2.4.

For MCCSR purposes, the following items are reversed from reported retained earnings:

  • Accumulated after-tax gains or losses on fair-valued liabilities that arise from changes to an institution's own credit risk;
  • Items related to real estateFootnote 15:
    • After-tax fair value gains or losses on owner-occupied property upon conversion to IFRS (cost model)Footnote 16;
    • Accumulated after-tax revaluation loss on owner-occupied property (revaluation model);
    • The accumulated net after-tax fair value gains after transition to IFRS on investment properties that do not back policy liabilities under CALMFootnote 17;
    • Accumulated net after-tax gains or losses up to the transfer date on owner-occupied property that was previously classified as investment property;Footnote 18
  • Fifty percent of the net decrease in policy liabilities, net of reinsurance, resulting from the recognition of morbidity improvement.
  • The net decrease in policy liabilities (for insurance and annuity business combinedFootnote 19, net of all reinsurance) resulting from the recognition of future mortality improvement under CIA standard 2350.06 and additional future mortality improvement3 under CIA standard 2350.11;
  • Discretionary participation features reported in a component of equity that is included in MCCSR Available Capital.

The following item is added to reported retained earnings for MCCSR purposes:

  • Accumulated gains reported in OCI up to the transfer date on investment property that was previously classified as owner-occupied property.

The amount of morbidity improvement by product subject to reversal may be offset by the amount of mortality improvement within the same product, provided that it is not applied in the calculation of the net decrease in policy liabilities resulting from the recognition of future mortality improvement described above. Companies may elect to phase in the impact on retained earnings of reversing the future morbidity improvement assumption in policy liabilities. The phase-in will be made on a straight-line basis over the phase-in period. The phase-in period, which will be twelve quarters, begins on January 1, 2015 and must be completed by the earliest quarter-end occurring on or after December 31, 2017.

2.1.1.2 Qualifying Criteria for Common Shares

Common shares qualify as Tier 1 capital if all of the following criteria are met:

  1. Represents the most subordinated claim in liquidation of the insurer.
  2. The investor is entitled to a claim on the residual assets that is proportional with its share of issued capital, after all senior claims have been paid in liquidation (i.e., has an unlimited and variable claim, not a fixed or capped claim).
  3. The principal is perpetual and never repaid outside of liquidation (setting aside discretionary repurchases or other means of effectively reducing capital in a discretionary manner that is allowable under relevant law and subject to the prior approval of the Superintendent).
  4. The insurer does not, in the sale or marketing of the instrument, create an expectation at issuance that the instrument will be bought back, redeemed or cancelled, nor do the statutory or contractual terms provide any feature which might give rise to such expectation.
  5. Distributions are paid out of distributable items (retained earnings included). The level of distributions is not in any way tied or linked to the amount paid in at issuance and is not subject to a contractual cap (except to the extent that an insurer is unable to pay distributions that exceed the level of distributable items or to the extent that distributions on senior ranking capital must be paid first).
  6. There are no circumstances under which the distributions are obligatory. Non-payment is, therefore, not an event of default.
  7. Distributions are paid only after all legal and contractual obligations have been met and payments on more senior capital instruments have been made. This means that there are no preferential distributions, including in respect of other elements classified as the highest quality issued capital.
  8. It is in the form of issued capital that takes the first and proportionately greatest share of any losses as they occur. Within the highest quality capital, each instrument absorbs losses on a going-concern basis proportionately and pari passu with all the others.
  9. The paid-in amount is recognised as equity capital (i.e., not recognised as a liability) for determining balance sheet solvency.
  10. It is directly issued and paid-inFootnote 20 and the insurer cannot directly or indirectly have funded the purchase of the instrument. Where the consideration for the share is other than cash, the issuance of the common share is subject to the prior approval of the Superintendent.
  11. The paid-in amount is neither secured nor covered by a guarantee of the issuer or related entityFootnote 21 or subject to any other arrangement that legally or economically enhances the seniority of the claim.
  12. It is only issued with the approval of the owners of the issuing insurer, either given directly by the owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorised by the owners.
  13. It is clearly and separately disclosed as equity on the insurer's balance sheet, prepared in accordance with relevant accounting standards.

The criteria for common shares also apply to non-joint stock companies, such as mutual insurance companies and fraternal benefit societies, taking into account their specific constitutions and legal structures. The application of the criteria should preserve the quality of the instruments by requiring that they are deemed fully equivalent to common shares in terms of their capital quality, including their loss absorption capacity, and do not possess features which could cause the condition of the insurer to be weakened as a going concern during periods when the insurer is under stress.

2.1.1.3 Qualifying Criteria for Tier 1 Capital Instruments Other than Common SharesFootnote 22

Instruments, other than common shares, qualify as Tier 1 capital if all of the following criteria are met:

  1. Issued and paid-in in cash or, subject to the prior approval of the Superintendent, in property.
  2. Subordinated to policyholders, general creditors, and subordinated debt holders of the insurer.
  3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis the insurer's policyholders and creditorsFootnote 23.
  4. Is perpetual, i.e. there is no maturity date and there are no step-upsFootnote 24 or other incentives to redeemFootnote 25.
  5. May be callable at the initiative of the issuer only after a minimum of five years:
    • To exercise a call option an insurer must receive prior approval of the Superintendent; and
    • An insurer's actions and the terms of the instrument must not create an expectation that the call will be exercised; and
    • An insurer must not exercise the call unless:
      • It replaces the called instrument with capital of the same or better quality, including through an increase in retained earnings, and the replacement of this capital is done at conditions which are sustainable for the income capacity of the insurerFootnote 26; or
      • The insurer demonstrates that its capital position is well above the supervisory target capital requirements after the call option is exercisedFootnote 27.
  6. Any repayment of principal (e.g., through repurchase or redemption) requires Superintendent approval and insurers should not assume or create market expectations that such approval will be given.
  7. Dividend / coupon discretion:
    • The insurer must have full discretion at all times to cancel distributions/paymentsFootnote 28.
    • Cancellation of discretionary payments must not be an event of default or credit event.
    • Insurers must have full access to cancelled payments to meet obligations as they fall due.
    • Cancellation of distributions/payments must not impose restrictions on the insurer except in relation to distributions to common shareholders.
  8. Dividends/coupons must be paid out of distributable items.
  9. The instrument cannot have a credit sensitive dividend feature, i.e. a dividend/coupon that is reset periodically based in whole or in part on the insurer's credit standingFootnote 29.
  10. The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of insolvency law.
  11. Other than preferred shares, instruments included in Tier 1 Capital must be classified as equity per relevant accounting standards.
  12. Neither the insurer nor a related party over which the insurer exercises control or significant influence can have purchased the instrument, nor can the insurer directly or indirectly have funded the purchase of the instrument.
  13. The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified timeframe.
  14. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g., a special purpose vehicle – "SPV"), proceeds must be immediately available without limitation to an operating entityFootnote 30 or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 1 capitalFootnote 31.

Purchase for cancellation of Tier 1 capital instruments is permitted at any time with the prior approval of the Superintendent. For further clarity, a purchase for cancellation does not constitute a call option as described in the above qualifying criteria.

Tax and regulatory event calls are permitted during an instrument's life subject to the prior approval of the Superintendent and provided the insurer was not in a position to anticipate such an event at the time of issuance. Where an insurer elects to include a regulatory event call in a Tier 1 capital instrument, the regulatory event should be defined as "the date specified in a letter from the Superintendent to the Company on which the instrument will no longer be recognized in full as eligible Tier 1 capital of the insurer on a consolidated basis".

Dividend stopper arrangements that stop payments on common shares or Tier 1 capital instruments are permissible provided the stopper does not impede the full discretion the insurer must have at all times to cancel distributions or dividends on the Tier 1 capital instrument, nor must it act in a way that could hinder the recapitalization of the insurer pursuant to criterion # 13 above. For example, it would not be permitted for a stopper on a Tier 1 instrument to:

  • attempt to stop payment on another instrument where the payments on the other instrument were not also fully discretionary;
  • prevent distributions to shareholders for a period that extends beyond the point in time that dividends or distributions on the Tier 1 instrument are resumed;
  • impede the normal operation of the insurer or any restructuring activity, including acquisitions or disposals.

A dividend stopper may also act to prohibit actions that are equivalent to the payment of a dividend, such as the insurer undertaking discretionary share buybacks.

Where an amendment or variance of a Tier 1 instrument's terms and conditions affects its recognition as Available Capital, such amendment or variance will only be permitted with the prior approval of the SuperintendentFootnote 32.

Insurers are permitted to "re-open" offerings of capital instruments to increase the principal amount of the original issuance provided that call options will only be exercised, with the prior approval of the Superintendent, on or after the fifth anniversary of the closing date of the latest re-opened tranche of securities.

Defeasance options may only be exercised on or after the fifth anniversary of the closing date with the prior approval of the Superintendent.

2.1.1.4 Tier 1 Capital Instruments Other than Common Shares issued to a Parent

In addition to the qualifying criteria and minimum requirements specified in this Guideline, Tier 1 capital instruments other than common shares issued by an insurer to a parent, either directly or indirectly, can be included in Available Capital subject to the insurer providing prior written notification of the intercompany issuance to OSFI's Capital Division together with the following:

  • a copy of the instrument's terms and conditions;
  • the intended classification of the instrument for Available Capital purposes;
  • the rationale for not issuing common shares in lieu of the subject capital instrument;
  • confirmation that the rate and terms of the instrument are at least as favourable to the insurer as market terms and conditions;
  • confirmation that the failure to make dividend or interest payments, as applicable, on the subject instrument would not result in the parent, now or in the future, being unable to meet its own debt servicing obligations nor would it trigger cross-default clauses or credit events under the terms of any agreements or contracts of either the insurer or the parent.
2.1.1.5 Tier 1 Capital Instruments Other than Common Shares issued out of Branches and Subsidiaries outside Canada

In addition to any other requirements prescribed in this Guideline, where an insurer wishes to include, in its consolidated Available Capital, a capital instrument issued out of a branch or subsidiary of the insurer outside Canada, it must provide OSFI's Capital Division with the following documentation:

  • a copy of the instrument's terms and conditions;
  • certification from a senior executive of the insurer, together with the insurer's supporting analysis, that confirms that the instrument meets the qualifying criteria for the tier of Available Capital in which the insurer intends to include the instrument on a consolidated basis; and
  • an undertaking whereby both the insurer and the subsidiary confirm that the instrument will not be redeemed, purchased for cancellation, or amended without the prior approval of the Superintendent. Such undertaking will not be required where the prior approval of the Superintendent is incorporated into the terms and conditions of the instrument.
2.1.1.6. Deductions from tier 1

Certain items are deducted from gross tier 1 capital to arrive at net tier 1 capital and adjusted net tier 1 capital. Net tier 1 capital is used for the purpose of determining limitations on elements of capital (reference section 2.1.5), while adjusted net tier 1 capital is used for the purpose of calculating the MCCSR Tier 1 and Total Ratios (reference section 2.1.6).

Net tier 1 capital is defined as gross tier 1 capital less the following deductions:

  • Goodwill (reference section 2.3);
  • Intangible assets in excess of 5% of gross tier 1 capital (reference section 2.3);
  • Adjusted negative reserves calculated policy by policy (reference section 2.4) and negative reserves ceded to unregistered reinsurers (reference sections 10.4.2, 10.4.3, and 10.5);
  • Cash surrender value deficiencies calculated on a grouped aggregate basis (reference section 2.4);
  • Back-to-back placements of new tier 1 capital, arranged either directly or indirectly, between financial institutions;
  • Each net defined benefit pension plan recognized as an asset on the insurer's balance sheet (inclusive of the impact of any asset ceiling limitation) net of any associated deferred tax liabilityFootnote 33. Insurers can reduce this deduction by the amount of available refunds of defined benefit pension plan surplus assets to which the insurer has unrestricted and unfettered access if they obtain prior written OSFI supervisory approvalFootnote 34. (The amount hereby deducted is referred to as the Pension Asset Deduction)

Companies that elect to phase-in the impact on gross tier 1 capital of changes related to the net defined benefit pension plan liability (asset) must also phase-in, in net tier 1, the impact on net tier 1 of the Pension Asset Deduction:

  • on account of each net defined benefit pension plan recognized as an asset on the insurer's balance sheet (inclusive of the impact of any asset ceiling limitation) net of any associated deferred tax liabilityFootnote 30, if any, that existed on December 31, 2012 (i.e.: the amount of the Pension Asset Deduction, if any, immediately prior to the effective date of the Pension Asset Deduction requirement in this guideline.)

    and

  • restatement upon the initial adoption of the revisions to IAS 19 Employee Benefits, effective for fiscal years beginning on or after January 1, 2013 (i.e.: the impact of the restatement on the Pension Asset Deduction).

The amount subject to phase-in in net tier 1 is the sum of a) and b) above. The phase-in will be made on a straight-line basis over the phase-in period. The phase-in period begins on January 1, 2013 for item a) and on the effective date of the revisions to IAS 19 Employee Benefits for item b) and must be completed by the earliest quarter-end occurring on or after December 31, 2014. The phase-in will be irrevocable and the adjustment amount will be reflected in net tier 1 capital.

Adjusted net tier 1 capital is defined as net tier 1 capital less the following additional deductions:

  • 50% of deductions/adjustments as defined in section 2.1.4; and
  • Deductions from tier 2 capital in excess of total tier 2 capital available (reference section 2.1.2.5).

2.1.2. Tier 2

Tier 2 capital instruments are required to meet the qualifying criteria specified in sections 2.1.2.1 to 2.1.2.3. Tier 2 capital instruments issued prior to August 7, 2014 that do not meet the qualifying criteria in sections 2.1.2.1 to 2.1.2.3, are required to meet the qualifying criteria specified in Appendix 2-B; these will be subject to transitional measures in due course.

When reporting Tier 2 instruments, insurers should first confirm that the instrument meets the Tier 2 qualifying criteria specified in sections 2.1.2.1 to 2.1.2.3. The insurer should then further classify the Tier 2 instrument into either Tier 2A or Tier 2B per the criteria applicable to capital instruments issued prior to August 7, 2014 (reference Appendix 2-B).

Tier 2 capital elements are restricted to the following, subject to requirements established by the Superintendent:

  • Tier 2A: Hybrid (debt/equity) capital instruments
  • Tier 2B: Limited life instruments
  • Tier 2C: Other Capital Items (reference section 2.1.2.4)

Tier 2A capital also includes:

  • the accumulated net after-tax unrealized gain on available-for-sale equity securities reported in OCI, and
  • the accumulated net after-tax fair value gain after transition to IFRS on investment properties that do not back policy liabilities under CALM.
2.1.2.1. Qualifying Criteria for Tier 2 Capital InstrumentsFootnote 35

Instruments qualify as Tier 2 capital if all of the following criteria are met:

  1. Issued and paid-in in cash or, with the prior approval of the Superintendent, in property.
  2. Subordinated to policyholders and general creditors of the insurer.
  3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis the insurer's policyholders and/or general creditors.
  4. Maturity:
    • Minimum original maturity of at least five years;
    • Recognition in Available Capital in the remaining five years before maturity will be amortised on a straight line basis;
    • There are no step-upsFootnote 36 or other incentives to redeem.
  5. May be callable at the initiative of the issuer only after a minimum of five years:
    • To exercise a call option an insurer must receive the prior approval of the Superintendent; and
    • An insurer must not do anything that creates an expectation that the call will be exercisedFootnote 37; and
    • An insurer must not exercise the call unless;
      • It replaces the called instrument with capital of the same or better quality, including through an increase in retained earnings, and the replacement of this capital is done at conditions which are sustainable for the income capacity of the insurerFootnote 38; or
      • The insurer demonstrates that its capital position is well above the supervisory target capital requirements after the call option is exercisedFootnote 39.
  6. The investor must have no rights to accelerate the repayment of future scheduled principal or interest payments, except in bankruptcy, insolvency, wind-up or liquidation.
  7. The instrument cannot have a credit sensitive dividend feature; that is, a dividend or coupon that is reset periodically based in whole or in part on the insurer's credit standingFootnote 40.
  8. Neither the insurer nor a related party over which the insurer exercises control or significant influence can have purchased the instrument, nor can the insurer directly or indirectly have funded the purchase of the instrument.
  9. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g., a special purpose vehicle – "SPV"), proceeds must be immediately available without limitation to an operating entityFootnote 41 or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 capitalFootnote 42.

Tier 2 capital instruments must not contain restrictive covenants or default clauses that would allow the holder to trigger acceleration of repayment in circumstances other than the liquidation, insolvency, bankruptcy or winding-up of the issuer.

Purchase for cancellation of Tier 2 instruments is permitted at any time with the prior approval of the Superintendent. For further clarity, a purchase for cancellation does not constitute a call option as described in the above Tier 2 qualifying criteria.

Tax and regulatory event calls are permitted during an instrument's life subject to the prior approval of the Superintendent and provided the insurer was not in a position to anticipate such an event at the time of issuance. Where an insurer elects to include a regulatory event call in a Tier 2 capital instrument, the regulatory event should be defined as "the date specified in a letter from the Superintendent to the Company on which the instrument will no longer be recognized in full as eligible Tier 2 capital of the insurer or included as risk-based Total Available Capital on a consolidated basis".

Where an amendment or variance of a Tier 2 instrument's terms and conditions affects its recognition as Available Capital, such amendment or variance will only be permitted with the prior approval of the SuperintendentFootnote 43.

Insurers are permitted to "re-open" offerings of capital instruments to increase the principal amount of the original issuance provided that call options will only be exercised, with the prior approval of the Superintendent, on or after the fifth anniversary of the closing date of the latest re-opened tranche of securities.

Defeasance options may only be exercised on or after the fifth anniversary of the closing date with the prior approval of the Superintendent.

2.1.2.2. Tier 2 Capital Instruments Issued to a Parent

In addition to the qualifying criteria and minimum requirements specified in this Guideline, Tier 2 capital instruments issued by an insurer to a parent either directly or indirectly, can be included in Available Capital subject to the insurer providing prior written notification of the intercompany issuance to OSFI's Capital Division together with the following:

  • a copy of the instrument's term and conditions;
  • the intended classification of the instrument for Available Capital purposes;
  • the rationale for not issuing common shares in lieu of the subject capital instrument;
  • confirmation that the rate and terms of the instrument are at least as favourable to the insurer as market terms and conditions;
  • confirmation that the failure to make dividend or interest payments, as applicable, on the subject instrument would not result in the parent, now or in the future, being unable to meet its own debt servicing obligations nor would it trigger cross-default clauses or credit events under the terms of any agreements or contracts of either the insurer or the parent.
2.1.2.3. Tier 2 Capital Instruments Issued out of Branches and Subsidiaries Outside Canada

Debt instruments issued out of an insurer's branches or subsidiaries outside Canada must be governed by Canadian law. The Superintendent may, however, waive this requirement where the insurer can demonstrate that an equivalent degree of subordination can be achieved as under Canadian law. Instruments issued prior to year-end 1994 are not subject to this requirement.
In addition to any other requirements prescribed in this Guideline, where an insurer wishes to consolidate a capital instrument issued by a foreign subsidiary, it must provide OSFI's Capital Division with the following documentation:

  • a copy of the instrument's term and conditions;
  • certification from a senior executive of the insurer, together with the insurer's supporting analysis, that confirms that the instrument meets the qualifying criteria for the tier of Available Capital in which the insurer intends to include the instrument on a consolidated basis; and
  • an undertaking whereby both the insurer and the subsidiary confirm that the instrument will not be redeemed, purchased for cancellation, or amended without the prior approval of the Superintendent. Such undertaking will not be required where the prior approval of the Superintendent is incorporated into the terms and conditions of the instrument.
2.1.2.4. Tier 2C: Other capital items:

The following items qualify as tier 2C:

  • 75% of amounts deducted from tier 1 on account of cash surrender value deficiencies;
  • all amounts deducted from tier 1 on account of negative reserves;
  • 50% of the terminal dividend reserve associated with out-of-Canada participating life insurance business meeting the conditions set out in section 2.9;
  • 50% of the amount deducted from gross tier 1 (per section 2.1.1.6) on account of each net defined benefit pension plan recognized as an asset on the insurer's balance sheet. (The amount that hereby qualifies as tier 2C is referred to as the Pension Asset Add-back.); and
  • adjustment amount to amortize the impact in the current period on Available Capital on account of the net defined benefit pension plan liability (asset).

Companies that elect to phase-in the impact on gross tier 1 capital of changes related to the net defined benefit pension plan liability (asset) must also phase-in, in tier 2C the impact on tier 2C capital of the Pension Asset Add-back:

  • on account of each net defined benefit pension plan recognized as an asset on the insurer's balance sheet that existed on December 31, 2012 (i.e.: the amount of the Pension Asset Add-back, if any, immediately prior to the effective date of the requirement in this guideline to add-back in tier 2C 50% of the Pension Asset Deduction)

    and

  • restatement upon the initial adoption of the revisions to IAS 19 Employee Benefits, effective for fiscal years beginning on or after January 1, 2013 (i.e.: the impact of the restatement on the Pension Asset Add-back).

The amount subject to phase-in in tier 2C is the sum of a) and b) above. The phase-in will be made on a straight-line basis over the phase-in period. The phase-in period begins on January 1, 2013 for item a) and on the effective date of the revisions to IAS 19 Employee Benefits for item b) and must be completed by the earliest quarter-end occurring on or after December 31, 2014. The phase-in will be irrevocable and the adjustment amount will be reflected in tier 2C capital.

Companies may make a one-time election to amortize the impact on Available Capital on account of the net defined benefit pension plan liability (asset). The amounts subject to amortization in each period include the change, in each period, of the:

  • accumulated net defined benefit pension plan OCI remeasurements included in gross tier 1;
  • amount of the Pension Asset Deduction from gross tier 1 (per section 2.1.1.6); and
  • Pension Asset Add-back in tier 2C.

The amount subject to amortization in each period is the sum of a), b) and c) above. The amortization will be made on a straight-line basis over the amortization period. The amortization period will be twelve quarters and will begin in the current quarter. The election will be irrevocable and the company will continue, in each quarter, to amortize the new impact on Available Capital in subsequent periods. The adjustment amount will be reflected in tier 2C capital.

2.1.2.5. Deductions from tier 2

Net tier 2 capital is defined to be total tier 2 capital available less the following two deductions:

  • 50% of deductions/adjustments as defined in section 2.1.4;
  • back-to-back placements of new tier 2 capital arranged either directly or indirectly between financial institutions.

However, net tier 2 capital may not be lower than zero. If the total of all tier 2 deductions exceeds total tier 2 capital available, the excess must be deducted from tier 1.

2.1.3. Qualifying non-controlling interests

Non-controlling interests, including capital instruments issued by subsidiaries to third party investors, arising on consolidation will be included in the respective categories, provided:

  • the instruments meet the criteria applicable to that category; and
  • they do not effectively rank equally or ahead of the claims of policyholders and other senior creditors of the insurer due to a parent guarantee or by any other contractual means.

Companies will generally be permitted to include in Available Capital minority and other non-controlling interests in operating subsidiaries that are fully consolidated for MCCSR purposes, provided that the capital in the subsidiary is not excessive in relation to the amount necessary to carry on the subsidiary's business, and the level of capitalization of the subsidiary is comparable to that of the insurance company as a wholeFootnote 44.

If a subsidiary issues capital instruments for the funding of the company, or that are substantially in excess of its own requirements, the terms and conditions of the issue, as well as the intercompany transfer, must ensure that investors are placed in the same position as if the instrument were issued by the company in order for it to qualify as capital on consolidation. This can only be achieved by the subsidiary using the proceeds of the issue to purchase a similar instrument from the parent. Since subsidiaries cannot buy shares in the parent life company, it is likely that this treatment will only be applicable to the subordinated debt. In addition, to qualify as Available Capital for the consolidated entity, the debt held by third parties cannot effectively be secured by other assets, such as cash, held by the subsidiary.

2.1.4. Deductions/adjustments

Fifty percent of the following amounts is deducted from tier 1, and an additional fifty percent is deducted from tier 2 after application of the net tier 1 limit:

  • unrealized unamortized other than temporaryFootnote 45 declines in value ("impairment") of real estate investments that have not been taken into account in the valuation of policy liabilities less, 45% on the portion of gains/losses on which recoverable income taxes are not accounted for, or the deferred income tax amount. The amount deducted should also include expected disposition costs. This is calculated on a property-by-property basis;
  • investments in non-life financial corporations that are controlled by the company, net of goodwill and identified intangibles that have been deducted from tier 1 capital (reference section 2.6);
  • substantial investments in entities including joint ventures (reference section 2.7);
  • other facilities that are treated as capital by unconsolidated subsidiaries and by unconsolidated corporations in which the company has a substantial interest;
  • first loss facilities as required under Guideline B-5:Asset Securitization;
  • aggregate positive policy liabilities ceded under arrangements defined to be unregistered reinsurance, less the amount of collateral and letters of credit applied toward these liabilities (reference chapter 10); and
  • purchased options for which the company elects deduction under section 3.7.4.

Companies may elect to phase-in the initial impact of adopting IFRS 11 Joint Arrangements, effective for fiscal years beginning on or after January 1, 2013, related to investments classified as joint ventures previously accounted for using proportionate consolidation. The amount subject to phase-in will be the amount of the substantial investments in joint ventures, determined using the equity method of accounting, that were previously accounted for using the proportionate consolidation method of accounting. The phase-in will be made on a straight-line basis over the phase-in period. The phase-in period begins on the effective date of the accounting standard and must be completed by the earliest quarter-end occurring on or after December 31, 2014.

2.1.5. Limitations

Common shareholders' equity (i.e., common shares, contributed surplus, retained earnings and participating account surplus) and policyholders' equity (mutual companies) should be the predominant form of a company's tier 1 capital.

The following limitations will apply to capital elements after the specified deductions and adjustments:

  • A strongly capitalized company should not have Tier 1 capital instruments other than common sharesFootnote 46that, in aggregate, exceed 40% of net tier 1 capital. Tier 1 capital instruments other than common and preferred shares shall not, at the time of issuance, comprise more than 15% of net tier 1 capital. If at any time either limit is breached, the company must immediately notify OSFI and provide an acceptable plan showing how the insurer proposes to quickly eliminate the excess.
  • The amount of capital elements, net of amortization, included in tier 2 shall not exceed 100% of net tier 1 capital.
  • Limited life instruments, net of amortization, included in tier 2BFootnote 47 shall not exceed 50% of net tier 1 capital.

Any capital instruments and limited life instruments issued in excess of these limitations will not be counted as Available Capital for the purpose of the risk-based capital adequacy test unless the FRFI has obtained the agreement of its Relationship Manager in advance ; however, they will be taken into account when reviewing the overall strength of the companyFootnote 48.

2.1.6. MCCSR Available Capital

For the purpose of calculating the MCCSR Tier 1 Ratio, the measure of Available Capital used is adjusted net tier 1 capital, after the application of all limitations. For the purpose of calculating the MCCSR Total Ratio, the measure of Available Capital used is adjusted net tier 1 capital plus net tier 2 capital, after the application of all limitations to both components.

2.2. Hedging of subordinated debentures

When a company issues subordinated debentures and fully hedges (both in terms of duration and amount) these debentures against movements in another currency and the hedge is subordinate to the interest of the policyholders, the company should report the Canadian dollar value of the instrument, net of the accrued receivable or payable on the hedge. For limited life subordinated debentures (tier 2B), a hedge to a date less than three years before maturity will qualify as a full hedge; hedges to a call date or to a date more than three years before maturity will not.

In addition, the company should disclose information on the hedging arrangement, the amount of the translation gain/losses and the accounting treatment accorded the translation gains/losses in a note to the MCCSR/TAAM return.

Subordinated debentures denominated in a foreign currency that are not fully hedged, or where the hedge is not subordinated, should be translated into Canadian dollars at the value at the time of reporting.

2.3. Goodwill and intangible assets

Unamortized goodwill will be deducted in the determination of net tier 1 capital. This deduction comprises goodwill related to consolidated subsidiaries and goodwill related to subsidiaries deconsolidated for MCCSR purposes. Goodwill related to substantial investments in unconsolidated entities that is not otherwise deducted for MCCSR purposes represents a diminution in the quality of tier 1 capital and will be subject to supervisory scrutiny in the assessment of the strength of capital against the supervisory target ratio. Companies will not be required to report goodwill related to substantial investments on a regular basis, but must be able to produce this information if requested by OSFI.

Additionally, the carrying value, net of amortization, of identified intangible assetsFootnote 49 that is in excess of 5% of gross tier 1 capital will be deducted in the determination of net tier 1 capital. The deduction for intangible assets applies to identified intangible assets purchased directly, or acquired in conjunction with or arising from the acquisition of a business. Such intangibles may include, but are not limited to, trade names, customer relationships, and policy and other distribution channels. Identified intangible assets include those related to consolidated subsidiaries and subsidiaries deconsolidated for MCCSR purposes.

Computer software classified as intangible assets per IAS 38 are not included in the definition of identified intangible assets for determining the excess of 5% of gross tier 1 deduction.

2.4. Negative reserves and cash surrender value deficiencies

Companies are required to calculate negative reserves on a policy-by-policy basis and cash surrender value (CSV) deficiencies on an aggregate basis by group. Policy-by-policy negative reserves are adjusted for income taxes, amounts that may be recovered on surrender, and the capital that a company is holding in respect of each policy's insurance components. The adjusted amount of policy-by-policy negative reserves and the amount of aggregate CSV deficiencies must be deducted from tier 1 capital or included in Assets Required. All of the adjusted negative reserve amount and 75% of the aggregate CSV deficiency amount may be included in tier 2c capital or Other Assets. The details of both calculations are described below.

For MCCSR purposes, the policy liabilities used in calculating negative reserves and CSV deficiencies should include deferred income taxes under valuation assumptions as required by the Canadian Institute of Actuaries Standards prior to any accounting adjustment for balance sheet presentation, and should exclude cashflows resulting from any future morbidity improvement if the impact of such improvement has been reversed from retained earnings in the determination of gross tier 1 capital under section 2.1.1.1 and should exclude cashflows resulting from future mortality improvement under CIA standard 2350.06 if the impact of such improvement has been reversed from retained earnings in the determination of gross tier 1 capital under section 2.1.1.1.

2.4.1. Negative reserves

Policy-by-policy negative reserves should be calculated for all products and lines of business, including group and accident and sickness business. The calculation should include:

  • The negative reserve for each certificate under group policies for which premiums or reserves are based on individual insured characteristics, such as group association or creditor insurance;
  • The excess, if positive, of the deferred acquisition costs for any policy over its termination or surrender charges; and
  • Negative group refund provisions where recovery is not completely assured, calculated policy by policy.

The negative reserve for a policy may be multiplied by a factor of 70%, in order to account for the effect of income taxes, if it arises from either of the following:

  • Active life reserves for Canadian individual health business, or
  • Canadian individual life business.

No tax reduction is allowed for negative reserves relating to any other type of business. The negative reserve for the policy, after adjustment (if any) for taxes, may then be further reduced to a minimum of zero by the sum of the following five policy components:

  • The net commission chargeback for the policy;
  • The lapse component for the policy;
  • The policy's marginal mortality component;
  • The policy's marginal morbidity component; and
  • An adjustment if the policy is part of a YRT reinsurance treaty.

However, the maximum total amount by which the deduction from tier 1 of tax-adjusted policy-by-policy negative reserves for a Canadian company may be reduced is limited to 25% of:

  • Gross tier 1 capital available; less
  • All deductions from tier 1 used to determine adjusted net tier 1 capital as specified in section 2.1.1.6, excluding negative reserves; less
  • Total tax-adjusted policy-by-policy negative reserves, calculated without any reduction for the policy components listed above.

For a foreign company, the maximum reduction in tax-adjusted policy-by-policy negative reserves included in Assets Required is limited to 25% of:

  • Admitted assets vested in trust; plus
  • Investment income due and accrued on admitted vested assets; less
  • The portion of Deductions/Adjustments (reference section 6.6) that is subtracted directly in the determination of Assets Available (reference section 6.3); less
  • Assets Required excluding negative reserves; less
  • Total tax-adjusted policy-by-policy negative reserves, calculated without any reduction for the policy components listed above.

In order to use any of the components to offset the policy's negative reserve, the component must be calculated for that policy alone. The following provides additional detail on the calculation of each of the policy components.

2.4.1.1. Commission chargebacks

The net commission chargeback for a policy is defined as:

0.85 × T × C

where T is the factor used to adjust the policy negative reserve for taxes (either 70% or 100%) and C is the policy's commission chargeback that the company could reasonably expect to recover in the event the policy were to lapse. The chargeback amount used should be based on the policy's chargeback schedule, and should be calculated net of all ceded reinsurance allowances and commissions.

2.4.1.2. Lapse component

For the purpose of determining the negative reserve reduction for the policy on account of the lapse component (reference section 4.5), this component should be calculated net of both registered and unregistered reinsurance.

2.4.1.3. Marginal mortality component

In order to use the mortality component (reference section 4.1) as an offset to the negative reserve deduction for a particular policy, the partition of the company's book of business used for the mortality component must contain a set consisting of this policy alone. For basic death policies, the marginal mortality volatility component should be calculated as:

Not yet defined

and for AD&D policies it should be calculated as:

Not yet defined

where:

  • s is the volatility component, net of all reinsurance (registered and unregistered), calculated for the set consisting of the policy,
  • k is the catastrophe component, net of all reinsurance, calculated for the set consisting of the policy,
  • The sum is taken over all sets of basic death or AD&D policies, including the set consisting of the policy for which a deposit has been made, and S is the volatility component for the set net of all reinsurance, and
  • d is the amount of any reduction in the mortality component that has been taken on account of a deposit placed by the policyholder.

A company may not use the mortality component for the policy to reduce the negative reserve if it has reduced its mortality requirement on account of a reinsurance claims fluctuation reserve covering the policy.

2.4.1.4. Marginal morbidity component

The marginal morbidity component (reference section 4.4) for a policy should be calculated as:

M0 M1 D

where M0 is the morbidity requirement for the company's entire book of business (net of both registered and unregistered reinsurance and after adjustment for statistical fluctuation), M1 is the morbidity requirement (taking account of the increased statistical fluctuation factor) for the company's book of business excluding the policy, and D is the amount of any reduction in the morbidity component that has been taken on account of a deposit placed by the policyholder. A company may not use the morbidity component for the policy to reduce the negative reserve if it has reduced its morbidity requirement on account of a reinsurance claims fluctuation reserve covering the policy.

2.4.1.5. Adjustment for policies assumed under YRT treaties

If a policy has been assumed under an eligible YRT reinsurance treaty (defined as a treaty that has fully guaranteed premiums and does not provide for profit sharing), the adjustment that may be used to reduce the policy's negative reserve is:

Not yet defined

where:

  • NR is the policy's tax-adjusted negative reserve,
  • A is the total of tax-adjusted negative reserves for all policies within the company's eligible YRT reinsurance treaties calculated policy by policy, and
  • B is the total of tax-adjusted negative reserves for all of the company's eligible YRT reinsurance treaties, calculated treaty by treaty.

2.4.2. Cash surrender value deficiencies

Cash surrender value deficiencies may be calculated on an aggregate basis within groupings by product type. The deduction from tier 1 or amount included in Assets Required is then the sum of the aggregate deficiencies (if positive) for each grouping of policies. All of the policies in an aggregated group must be within the same line of business (as defined in the LIFE-1 or LIFE-2), must be contractually similar, and must eventually offer a meaningful cash surrender value. Policies that never pay cash surrender cash values may not be used to offset deficiencies in policies that do. The cash surrender values used in the calculation of deficiencies should be net of all surrender charges, market value adjustments and other deductions that a company could reasonably expect to apply in the event the policy were to be surrendered.

2.5. Amortization of Tier 2 Capital Instruments

Tier 2 capital instruments are subject to straight-line amortization in the final five years prior to maturity. Hence, as these instruments approach maturity, such outstanding balances are to be amortized based on the following schedule:

Years to Maturity Included in Capital
5 years or more 100%
4 years and less than 5 years 80%
3 years and less than 4 years 60%
2 years and less than 3 years 40%
1 year and less than 2 years 20%
Less than 1 year 0%

Amortization should be computed at the end of each fiscal quarter based on the "years to maturity" schedule (above). Thus amortization would begin during the first quarter that ends within five calendar years of maturity. For example, if an instrument matures on October 31, 2000, 20% amortization of the issue would occur on November 1, 1995, and be reflected in the December 31, 1995 MCCSR return. An additional 20% amortization would be reflected in each subsequent December 31 return.

2.6. Non-life financial corporation controlled by the company

Equity investments in non-life solvency regulated financial corporationsFootnote 50 that are controlled (as defined in the Act) by the company will be deductedFootnote 51, Footnote 52 from Available Capital. Non-life solvency regulated financial corporations include those entities that are engaged in the business of banking, trust and loan business, property and casualty insurance business, the business of co-operative credit societies or that are primarily engaged in the business of dealing in securities, including portfolio management and investment counselling. Fifty percent of the net equity investment will be deducted from tier 1 capital, and an additional fifty percent will be deducted from tier 2 capital. The deduction should be net of both:

  • goodwill and identified intangibles related to the investment that have been deducted from tier 1 capital per section 2.3, and
  • all amounts related to the investment representing components of accumulated other comprehensive income that are ineligible for inclusion in MCCSR Available Capital.

Where the company has investments in preferred shares or debt instruments of the corporation, the amount invested in these instruments will also be deducted from Available Capital if they qualify as capital by the regulator in that corporation's home jurisdiction. Further, where a facility such as a letter of credit or guarantee is provided by the company, is treated as capital by the non-life financial corporation controlled by the company, being available for drawdown in the event of impairment of the corporation's capital and is subordinated to the corporation's customer obligations, the full amount of the facility will also be deducted from Available Capital. Although the facility has not been called upon, if it were drawn, the resources would not be available to cover capital requirements in the life company.

No asset default factor will be applied to equity investments, letters of credit and guarantees or other facilities provided to controlled non-life financial corporations where these have been deducted from Available Capital.

Investment in preferred shares or debt instruments of, or letters of credit provided to, controlled non-life financial corporations that are not deducted from Available Capital will be treated like any other asset in accordance with this guideline (reference chapter 3).

If a company guarantees the obligations of a controlled non-life financial corporation, an off-balance sheet capital requirement will also be imposed (reference chapter 7).

2.7. Substantial investments without control

Ownership interests in an entityFootnote 53 including a joint venture, other than an eligible mutual fund entity as described below, in which the company has made a substantial investment (as defined in Section 10 of the Act) but does not control will be deducted from Available Capital. Fifty percent of the investments will be deducted from tier 1 capital, and an additional fifty percent will be deducted from tier 2 capital. Canadian companies should calculate the deduction net of all amounts related to the investment representing components of accumulated other comprehensive income that are ineligible for inclusion in MCCSR Available Capital.

Portfolio investments, defined as investments of between 10% and 30% in the common shares of a corporation, that are subject to section 513 of the Insurance Companies Act, will be grandfathered. However, the grandfathering provision will not apply to equity investments in which the company, together with any of its subsidiaries and/or other financial institutions affiliated with the company, hold more than 30% of the common shares of another corporation.

Where a company has not been permitted to have a controlling interest in a foreign life entity due to restrictions imposed in the foreign jurisdiction, the company will be permitted to consolidate based on its proportionate equity interest of that entity. However, excess capital in the foreign life entity can only be counted by the company if confirmation that the excess capital is repatriable to the parent is provided by the regulator in that jurisdiction. Further, excess capital that is counted must reflect any income tax effect upon repatriation.

Where the company has investments in preferred shares or debt instruments of a foreign life entity, the amount invested in these instruments will also be deducted from Available Capital if the instruments qualify as capital by the regulator in the home jurisdiction of the entity. Further, where a facility such as a letter of credit or guarantee is provided by the company and is treated as capital by the entity being available for drawdown in the event of impairment of the entity's capital and is subordinated to the entity's customer obligations, the full amount of the facility will be deducted from Available Capital. Although the facility has not been called upon, if it were drawn, these resources would not be available to cover capital requirements in the life company.

No asset default factor will be applied to facilities that are deducted from Available Capital. Investments in preferred shares, debt instruments, and facilities that are not deducted from Available Capital will be treated like any other asset in accordance with this guideline (reference chapter 3).

If a company guarantees the obligations of an entity it does not control, but in which it has a substantial investment and has deducted it from Available Capital, an off-balance sheet capital requirement will also be imposed (reference chapter 7).

Companies are not required to deduct from Available Capital substantial investments in mutual fund entities that do not leverage their equity by borrowing in debt markets, and that do not otherwise leverage their investments. Instead, a capital charge on the assets of the mutual fund entity will apply based on the requirements of section 3.1.9. For example, no deduction need be made from Available Capital where the company makes a substantial investment in a mutual fund as part of a structured transaction that passes through the unaltered returns (i.e., no guarantee of performance) on the substantial investment to the mutual fund holder.

2.8. Minimum amount of capital and surplus

Notwithstanding the capital requirement described in the guideline, Canadian life insurance companies will be required to maintain a minimum amount of Available Capital, as calculated in this guideline, of $5 million or such amount as specified by the Minister.

2.9. Out-of-Canada terminal dividend reserves (tier 2C)

Fifty per cent of the terminal dividend reserve associated with out-of-Canada participating life insurance business qualifies as Tier 2C capital where:

  • The terminal dividend reserve can be shown to be uniquely associated with a block of out-of-Canada (e.g. United Kingdom) lives, terminal dividends constitute a high proportion of the total benefit paid to the policyholder, and the foreign jurisdiction either does not require actuarial liabilities to be set up for these dividends, or allows the reserves established for such dividends to be considered as available to offset risk in determining the required capital for the company;
  • The terminal dividend reserve is calculated in accordance with the CIA's Consolidated Standards of Practice;
  • Policyholder material discloses the true variability of terminal dividend payments and that the returns will vary with the returns on equity or other assets supporting the policies. The disclosure must indicate that ultimate terminal dividends are tied to the financial condition of the company or of the subsidiary issuing these policies and that the payments are at the discretion of the company or of the subsidiary issuing these policies;
  • The board of directors of the company or subsidiary issuing these policies has passed a resolution that it will act to adjust the terminal dividends to take account of the advice of the Appointed Actuary or with-profits actuary and any other factors they consider relevant regarding the appropriateness of the terminal dividend scale, consistent with policyholder expectations and the financial condition of the company or subsidiary.
  • The participating fund associated with out-of-Canada participating life insurance business is sufficient to cover extreme scenarios at a 99.5% confidence level based on stochastic or other appropriate stress testing, acceptable to the company's or subsidiary's regulator, of all of the relevant risks. The stress tests must be undertaken assuming one of the following:
    • Neither the Canadian GAAP provisions for adverse deviation in liabilities nor the MCCSR capital held for the participating business are available to cover losses, but terminal dividends are fully adjusted (consistent with policyholder expectations) to reflect adverse experience; or
    • Provisions for adverse deviation and MCCSR capital are used to cover losses, but a maximum of 50% of the terminal dividend reserve is released to reflect adverse experience.
  • The country in which the out-of-Canada participating life insurance business is issued is considered by OSFI to have a strong regulation and supervision system.

Appendix 2-A Information Requirements for Capital Confirmations

Given the potential impact of the disqualification of a capital instrument, insurers are encouraged to seek confirmations of capital quality from OSFI prior to issuing instrumentsFootnote 54. In conjunction with such requests, the institution is expected to provide the following information to the Capital Division.

  1. An indicative term sheet specifying indicative dates, rates and amounts and summarizing key provisions should be provided in respect of all proposed instruments.
  2. The draft and final terms and conditions of the proposed instrument supported by relevant documents (i.e. Prospectus, Offering Memorandum, Debt Agreement, Share Terms, etc.).
  3. A copy of the institution's current by-laws or other constating documents relevant to the capital to be issued as well as any material agreements, including shareholders' agreements, which may affect the capital quality of the instrument.
  4. Where applicable, for all debt instruments only:
    • the draft and final Trust Indenture and supplemental indentures; and
    • the terms of any guarantee relating to the instrument.
  5. Where the terms of the instrument include a redemption option or similar feature upon a tax event, an external tax opinion confirming the availability of such deduction in respect of interest or distributions payable on the instrument for income tax purposesFootnote 55.
  6. An accounting opinion describing the proposed treatment and disclosure of the Tier 1 capital instrument (other than common shares) or the Tier 2 capital instrument on the institution's financial statementsFootnote 56.
  7. Where the initial interest or coupon rate payable on the instrument resets periodically or the basis of the interest rate changes from fixed to floating (or vice versa) at a pre-determined future date, calculations demonstrating that no incentive to redeem, or step-up, will arise upon the change in the initial rate. Where applicable, a step-up calculation should be provided according to the swap-spread methodology which confirms there is no step-up upon the change in interest rate and supported by screenshots of the applicable reference index rate(s).
  8. Capital projections that demonstrate that the insurer will be in compliance with its supervisory target capital ratios as well as the capital composition requirements specified in section 2.1.5 at the end of the quarter in which the instrument is expected to be issued.
  9. An assessment of the features of the proposed capital instrument against the minimum criteria for inclusion in Other Tier 1 capital or Tier 2 capital, as applicable, specified in this Guideline. For greater certainty, this assessment would only be required for an initial issuance or precedent and is not required for subsequent issuances provided the terms of the instrument are not materially altered.
  10. A written attestation from a senior officer of the insurer confirming that the insurer has not provided financing to any person for the express purpose of investing in the proposed capital instrument.

Appendix 2-B Qualifying Criteria for Capital Instruments Issued Prior to August 7, 2014

Capital instruments issued prior to August 7, 2014 that do not meet the relevant criteria specified in sections 2.1.1.2 to 2.1.1.5 or 2.1.2.1 to 2.1.2.3 are assessed against the relevant criteria specified in this Appendix for inclusion in Available Capital. Capital instruments that meet the relevant criteria in this Appendix, but do not meet the relevant criteria specified in sections 2.1.1.2 to 2.1.1.5 or 2.1.2.1 to 2.1.2.3 will be subject to transitional measures in due course.

A. Tier 1

1. Preferred shares (Tier 1)

Tier 1 capital instruments are intended to be permanent. Where tier 1 preferred shares provide for redemption by the issuer after five years, with supervisory approval, the Office would not normally prevent such redemptions by healthy and viable companies when the instrument is or has been replaced by equal or higher quality capital including an increase in retained earnings, or if the company is downsizing. The redemption or purchase for cancellation of tier 1 instruments requires the prior approval of the Superintendent.

Preferred shares will be judged to qualify as tier 1 instruments based on whether they are, in form and in substance:

  • subordinated;
  • permanent; and
  • free of mandatory fixed charges.
1.1. Subordination

Preferred shares must be subordinated to policyholders and unsecured creditors of the company. If preferred shares are issued by a subsidiary or intermediate holding company for the funding of the company and are to qualify for capital at the consolidated entity (non-controlling interest), the terms and conditions of the issue, as well as the intercompany transfer, must ensure that investors are placed in the same position as if the instrument were issued by the company.

1.2. Permanence

To ensure that preferred shares are permanent in nature, the following features are not permitted:

  • retraction by the holder;
  • obligation for the issuer to redeem shares;
  • redemption within the first five years of issuance; and
  • any step-upFootnote 57 representing a pre-set increase at a future date in the dividend (or distribution) rate based in whole or in part on the issuer's credit rating or financial conditionFootnote 58.

Any conversion, other than to common shares of the issuerFootnote 59, or redemption is subject to supervisory approval and:

  • redemption can only be for cash or the equivalent; and
  • conversion privileges cannot be structured to effectively provide either a redemption of or return on the original investment.

For example, an issue would not be considered non-cumulative if it had a conversion feature that compensates for undeclared dividends or provides a return of capital.

Preferred shares with dividends that are fixed for a period of time and then shift to a floating rate ("Fixed-Floaters") may contain embedded step-ups. OSFI must be satisfied that dividend reset features do not impair the permanence of the shares, and that these features do not create an incentive to redeem. A dividend reset feature that results in a step-up from the initial rate signals intent to redeem. Accordingly, step-ups, at any level and any time, are not acceptable in a tier 1 preferred share instrument. To qualify for inclusion as Available Capital, applicants must demonstrate that a dividend reset feature does not give rise to a step-up of any amount, given the company's credit quality at the original date of issue.

Fixed-Floaters that are determined to contain a step-up will be subject to the specific treatment that is established by OSFI with the issuing FRFI.Footnote 60

For purposes of determining the existence of a step-up, international standards employ the "swap spread" methodology outlined in Appendix 2-C. In situations where the index that is the basis for the reset rate differs from that of the initial rate, this methodology uses the public swap markets to enable a comparison of the two rates. FRFIs wishing to include a dividend reset mechanism in a preferred share instrument must demonstrate, using the swap spread methodology, that no embedded step-up exists. However, for this analysis to be conclusive, a public swap market should exist between the two reference rates. Without such a market, it will be difficult for a FRFI to demonstrate objectively to demonstrate to OSFI's satisfaction that no step-up exists. In these circumstances, OSFI believes that only a public swap market between the two reference rates contained in the instrument provides certainty as to the intent of the dividend reset mechanism.

The only capital instruments that could qualify as tier 1 capital and contain a step-up feature are instruments that meet the requirements of rules for innovative instruments outlined in Appendix 2-C. In those limited circumstances, the instrument may have a moderate step-up only after 10 years.

1.3. Free of mandatory fixed charges

Preferred shares included in tier 1 capital are not permitted to offer the following features:

  • cumulative dividends;
  • dividends influenced by the credit standing of the institution;
  • compensation to preferred shareholders other than a dividend; or
  • sinking or purchase funds.

In addition, the non-declaration of a dividend shall not trigger restrictions on the issuer other than the need to seek approval of the holders of the preferred shares before paying dividends on other shares or before retiring other shares. Non-declaration of a dividend would not preclude the issuer from making the preferred shares voting or, with the prior approval of the Superintendent, making payment in common shares.

To conform with accepted practice, in the event of non-declaration of a dividend, approval of the holders of preferred shares may be sought before:

  • paying dividends on any shares ranking junior to the preferred shares (other than stock dividends in any shares ranking junior to the preferred shares); or
  • redeeming, purchasing or otherwise retiring any share ranking junior to the preferred shares (except out of the net cash proceeds of a substantially concurrent issue of shares ranking junior to the preferred shares); or
  • redeeming, purchasing or otherwise retiring less than all such preferred shares; or
  • except pursuant to any purchase obligation, sinking fund, retraction privilege or mandatory redemption provisions attached to any series of preferred shares, redeeming, purchasing or otherwise retiring any shares ranking on a parity with such preferred shares.
1.4. Examples of acceptable features

Outlined below are examples of certain preferred share features that may be acceptable in tier 1 capital instruments:

  • a simple call feature that allows the issuer to call the instrument provided the issue cannot be redeemed in the first five years and, after that, only with prior supervisory approval;
  • a dividend that floats at some fixed relationship to an index or the highest of several indices as long as the index or indices are linked to general market rates and not to the financial condition of the borrower;
  • a dividend rate that is fixed for a period of years and then shifts to a rate that floats over an index plus an additional amount tied to the increase in common share dividends if the index is not based on the institution's financial condition and the increase is not automatic, not a step-up, nor of an exploding rate nature; and
  • conversion of preferred shares to common shares where the minimum conversion value or the way it is to be calculated is established at the date of issue. Examples of conversion prices are: a specific dollar price; a ratio of common to preferred share prices; and a value related to the common share price at time of conversion.
1.5. Examples of unacceptable features

Examples of preferred share features that will not be acceptable in tier 1 capital are:

  • an exploding rate preferred share, where the dividend rate is fixed or floating for a period and then sharply increases to an uneconomically high level;
  • an auction rate preferred share or other dividend reset mechanism in which the dividend is reset periodically based, in whole or part, on the issuer's credit rating or financial condition; and
  • a dividend-reset mechanism that does not specify a cap, consistent with the institution's credit quality at the original date of issue.

B. Tier 2

Tier 2 capital instruments must not contain restrictive covenants or default clauses that would allow the holder to trigger acceleration of repayment in circumstances other than the insolvency, bankruptcy or winding-up of the issuer. Further, the debt agreement must normally be subject to Canadian law. However, OSFI may waive this requirement, in whole or in part, provided the company can show that an equivalent degree of subordination can be achieved as under Canadian law. In all cases, the prior consent of OSFI must be obtained where law other than Canadian law will apply. Instruments issued prior to year-end 1994 are grandfathered. Tier 2 capital instruments with a purchase for cancellation clause will be deemed to mature on the date this clause becomes effective unless the purchase requires the prior approval of the Superintendent.

Tier 2 capital components are subject to straight-line amortization in the final five years prior to maturity or the effective dates governing holders' retraction rights.

1. Hybrid capital instruments (Tier 2A)

Hybrid capital includes instruments that are essentially permanent in nature and that have certain characteristics of both equity and debt. Hybrid capital instruments must, at a minimum, meet the following criteria:

  • are unsecured, subordinated to policyholder and creditor obligations and fully paid;
  • are not redeemable at the initiative of the holder;
  • may be redeemable by the issuer after an initial term of five years with the prior consent of the Superintendent of Financial Institutions;
  • are available to participate in losses without triggering a cessation of ongoing operations or the start of insolvency proceedings; and
  • allow service obligations to be deferred (as with cumulative preferred shares) where the profitability of the company would not support payment.

These instruments include:

  • cumulative perpetual preferred shares;
  • qualifying 99-year debentures; and
  • qualifying non-controlling interest arising on consolidation from tier 2 hybrid capital instruments.

To qualify as tier 2A capital, preferred shares should have characteristics similar to those required for tier 1 capital with the exception that tier 2A preferred shares may be cumulative.Footnote 61

Hybrid capital instruments issued in conjunction with a repackaging arrangement that are deemed by the Superintendent to be an effective amortization are to be treated as limited life instruments subject to their conforming with the criteria for tier 2B instruments. Repackaging arrangements vary but normally involve above-market coupons and a step down in interest rates after a specified period. Economically, therefore, they may be regarded as involving disguised capital repayment. To qualify for tier 2A, capital should not have a limited life.

PerpetualFootnote 62 debentures meeting the criteria for hybrid capital instruments specified above will be eligible for inclusion in tier 2A capital if they also:

  • are available to participate in losses while the issuer is still a going concern. Therefore, if the retained earnings (both par and non-par) of the issuer are negative, then the principal amount of the debt and unpaid interest must automatically convert to common or perpetual preferred sharesFootnote 63;
  • must allow the issuer to defer principal and interest payments if the issuer does not report a net profit for the most recent combined four quarters and the issuer eliminates cash dividends on its common and preferred stock. Under no circumstances will the deferral of interest be allowed to compound;
  • must not contain provisions for any form of compensation in respect of any unpaid payments, except subject to prior approval of the Superintendent; and
  • are free from special restrictive covenants or default clauses that would allow the holder to trigger acceleration of repayment in circumstances other than insolvency.

Where hybrid instruments provide for redemption by the issuer after five years, with supervisory approval, the Office would not normally prevent such redemptions by healthy and viable companies when the instrument is or has been replaced by equal or higher quality capital including an increase in retained earnings, or if the company is downsizing.

Preferred shares or perpetual subordinated debentures with moderate step-ups may be included in tier 2A capital, provided these instruments meet all of the other conditions for tier 2A treatment and subject to the following additional requirementsFootnote 64:

  • step-up cannot result in an increase of more than 100 basis points over the initial rate;
  • step-up must be calculated using the "swap spread" methodology outlined in Appendix 2-C;
  • step-up cannot occur before 10 years from the date on which the capital is issued;
  • terms of the instrument must not provide for more than one step-up over the life of the instrument; and
  • the step-up cannot be combined with any other feature that causes an economic incentive to redeem.
2. Limited life instruments (tier 2B)

Limited life instruments must, at a minimum, meet the following criteria:

  • subordination to policyholders and other senior creditors;
  • an initial minimum term greater than five years; and
  • may be redeemable by the issuer in the first five years only with the prior consent of the Superintendent of Financial InstitutionsFootnote 65.

In contrast to hybrid instruments, limited life instruments are not permanent and include:

  • limited life redeemable preferred shares;
  • qualifying capital instruments issued in conjunction with a repackaging arrangement;
  • other debentures and subordinated debt; and
  • qualifying non-controlling interests arising on consolidation from tier 2 limited life instruments.

Preferred shares with dividends that are fixed for a period of time and then shift to a floating rate ("Fixed-Floaters") may contain embedded step-ups.

Subordinated debt or term preferred shares with embedded step-ups may be included in tier 2B capital, provided these instruments meet all of the other conditions for tier 2B treatment and subject to the following requirements:

  • step-up must be calculated using the "swap spread" methodology outlined in Appendix 2-C;
  • step-up cannot be combined with any other feature that causes an economic incentive to redeem;
  • terms of the instrument must not provide for more than one step-up over the life of the instrument;
  • instrument must not have a step-up of any amount in the first five years; and
  • capital instruments with step-ups greater than 100 basis points will be treated for amortization purposes as term debt that matures at the date the step-up comes into effect.

Limited life debt instruments issued to a parent company either directly or indirectly will be included in tier 2B capital only with the prior approval of the Superintendent. Before granting approval, the Superintendent will consider the rationale provided by the parent for not providing equity capital or not raising tier 2B capital from external sources. The Superintendent will also want to be assured that the interest rate is reasonable and that failure to meet debt servicing obligations on the tier 2B debt provided by the parent would not, either now or in the future, be likely to result in the parent company being unable to meet its own debt servicing obligations, and would not trigger cross-default clauses under the covenants of other borrowing agreements of either the institution or the parent.

Limitations apply to the amount of limited life instruments that may be included in tier 2B (see section 2.1.5).

Capital instruments issued in conjunction with a repackaging arrangement that are deemed by the Superintendent to be an effective amortization are to be treated as limited life instruments subject to their conforming with the criteria for tier 2B instruments.

3. Amortization of Tier 2 Capital Instruments

Tier 2 capital instruments are subject to straight-line amortization in the final five years prior to maturity or the effective dates governing holders' retraction rights. Hence, as redeemable preferred shares and subordinated debentures of the company or non-controlling interest preferred shares and qualifying subsidiary debt instruments approach maturity, redemption or retraction, such outstanding balances are to be amortized based on the following criteria:

Years to Maturity Included in Capital
5 years or more 100%
4 years and less than 5 years 80%
3 years and less than 4 years 60%
2 years and less than 3 years 40%
1 year and less than 2 years 20%
Less than 1 year 0%

Similarly for capital instruments that have sinking funds, amortization of the amount paid into the sinking fund should begin five years before it is made. This is required because the amount in the sinking fund is not subordinated to the rights of policyholders.

Amortization should begin five years before the date at which the debenture or share may be redeemed at the company's option. For example, for a 20-year debenture or share that can be redeemed at the company's option any time after the first ten years, amortization should begin after the fifth year. This rule does not apply when redemption requires the Superintendent's approval.

Where there is an option for the issuer to redeem an instrument subject to the Superintendent's approval, the instrument would be subject to straight-line amortization in the final five years to maturity.

Tier 2B capital instruments with step-ups greater than 100 basis points will be treated for amortization purposes as term debt that matures at the date the step-up comes into effect.

Amortization should be computed at the end of each fiscal quarter based on the "years to maturity" schedule (above). Thus amortization would begin during the first quarter that ends within five calendar years of maturity. For example, if an instrument matures on October 31, 2000, 20% amortization of the issue would occur on November 1, 1995, and be reflected in the December 31, 1995 MCCSR return. An additional 20% amortization would be reflected in each subsequent December 31 return.

C. Early Redemption of Capital Instruments

Redemption of a tier 1 preferred share or tier 2A hybrid instrument at the option of the issuer is not permitted within the first five years of issuance. There are however, certain circumstances under which OSFI would consider redemption during this period. These circumstances are limited to:

  • Tax laws change, adversely affecting the tax advantage of the preferred shares/hybrid instrument;
  • OSFI's capital adequacy requirements change, such that the preferred shares/hybrid instrument could no longer be included in calculating the Available Capital of the company on a consolidated basis; or
  • A restructuring resulting from a major acquisition or merger where the instrument is immediately exchanged for a capital qualifying instrument of the continuing company with identical terms and conditions and capital attributes.

Superintendent approval is required for redemption at any time.

D. Related Guidance Notes and Advisories

Refer to the following OSFI additional guidance on the definition of capital.

Guidance Date
Ruling 2005-01: Conversion of subordinated debt 2005
Advisory: Innovative Tier 1 and Other Capital Clarifications – Revised Version December 2008

Appendix 2-C Principles Governing Inclusion of Innovative Instruments in Tier 1 Capital

A. Application

The principles in this Appendix take effect immediately. Given the nature of the subject matter covered in this Appendix, OSFI will continue to review the principles in light of any issues arising from their application to specific transactions. We plan to revisit the Appendix as our experience develops. Subsequent amendments to the principles, if any, will not disqualify approvals granted under this Appendix.

For the purposes of this Appendix, "innovative instrument" means an instrument issued by a Special Purpose Vehicle (SPV), which is a consolidated non-operating entity whose primary purpose is to raise capitalFootnote 66. A non-operating entity cannot have depositors or policyholders.

This Appendix applies to indirect issues done through a SPV. To qualify as capital, direct issues must meet the conditions set out in OSFI Guidelines Minimum Continuing Capital and Surplus Requirements or Capital Adequacy Requirements (CAR), as applicable. Note that step-ups are not permitted in directly issued Tier 1 instruments.

In this Appendix, FRFI means:

  • the operating federally regulated life insurance company that has policyholders (Life Company); or
  • the operating bank or the operating federally regulated trust or loan company that has depositors (DTI) and with whom the SPV is consolidated.

In this Appendix, an Asset-Based Structure is one where the assets of the SPV do not include an instrument issued by the FRFI. A Loan-Based Structure is one where the SPV's primary asset is an instrument issued by the FRFI.

B. Limits on Innovative Instruments in Tier 1 Capital

Principle #1: OSFI expects FRFIs to meet capital requirements without undue reliance on innovative instruments.
Common shareholders' equity (i.e., common shares, contributed surplus, retained earnings and participating account surplus, as applicable) should be the predominant form of a FRFI's Tier 1 capital.

1(a): Innovative instruments must not, at the time of issuance, make up more than 15 per cent of a FRFI's net Tier 1 capital. Any excess cannot be included in Available Capital.Footnote 67

If, at any time after issuance, a FRFI's ratio of innovative instruments to net Tier 1 capital exceeds 15 per cent, the FRFI must immediately notify OSFI. The FRFI must also provide a plan, acceptable to OSFI, showing how the FRFI proposes to eliminate the excess quickly. A FRFI will generally be permitted to include such excesses in its Tier 1 capital until such time as the excess is eliminated in accordance with its plan.

1(b): Tier 1-qualifying preferred shares (combined with innovative instruments) must not, at the time of issuance, make up more than 40 per cent of a FRFI's net Tier 1 capital. Any excess cannot be included in Available Capital.Footnote 64

Tier 1-qualifying preferred shares that were previously included in Tier 1 capital (i.e., they were within the 40% aggregate limit for Tier 1 instruments other than common shares as at issuance) but which subsequently exceed the 40% aggregate limit due to operating losses and/or the payment of normal dividends will be considered eligible for continued inclusion in Tier 1 capital.

A FRFI that wishes to include such excess preferred share amounts in Tier 1 capital must obtain OSFI's prior confirmation that this treatment is acceptable. To obtain confirmation, the FRFI must demonstrate that operating losses and/or the payment of normal dividends created the excess amount. The FRFI must also provide a clear and supportable plan, acceptable to OSFI, outlining how it proposes to eliminate the excess quickly. This approach to the treatment of excess Tier 1-qualifying preferred share amounts is effective as at March 31, 2003.

1(c): A strongly capitalized FRFI should not have innovative instruments and perpetual non-cumulative preferred shares that, in aggregate, exceed 40% of its net Tier 1 capital. Tier 1-qualifying preferred shares issued in excess of this limit can be included in Tier 2 capital.

1(d): For the purposes of this principle, "net Tier 1 capital" means Tier 1 capital after deductions for goodwill etc., as set out in OSFI's MCCSR or CARGuideline, as applicable.

C. General Principles for Innovative Instruments

Innovative instruments may be included in Tier 1 capital (subject to the limits set out in Principle #1), provided they meet certain requirements. The following principles will govern their inclusion:

Principle #2: The nature of inter-company instruments issued by the FRFI in connection with the raising of Tier 1 capital by way of innovative instruments must not compromise the Tier 1 qualities of the innovative instrument.

2 (a): An SPV should not, at any time, hold assets that materially exceed the amount of the innovative instrument. For Asset-Based Structures, OSFI will consider the excess to be material if it exceeds 25 per cent of the innovative instrument(s) and, for Loan-Based Structures, the excess will be considered to be material if it exceeds 3 per cent of the innovative instrument(s). Amounts in excess of these thresholds require the Superintendent's approval.

2 (b): The following minimum standards apply to inter-company instruments issued by the FRFI when raising Tier 1 capital by way of an innovative instrument:.

  1. Inter-company instruments must be permanent; they may contain a maturity date provided the term to maturity is at least 99 years.Footnote 68 If, at maturity, the proceeds are not used to repay the innovative instrument, the SPV must reinvest the proceeds in assets acquired from the FRFI
  2. Failure to make payments or to meet covenants must not cause acceleration of repayment of the inter-company instrument.
  3. The inter-company instrument must not be secured or covered by a guarantee or other arrangement that legally or economically results in a priority ahead of the claims of policyholders/depositors.

2 (c): Life Companies wishing to include an Asset-Based Structure in Tier 1 capital pursuant to this Appendix must satisfy OSFI that, after the assets have been transferred to the SPV, there will be sufficient cash flows available to support actuarial liabilities within the FRFI and the valuation of the FRFI's actuarial liabilities will not be materially affected.

Principle #3: Innovative instruments must allow FRFIs to absorb losses within the FRFIs on an ongoing basis.

3 (a): Innovative instruments must enable the FRFIs to absorb losses without triggering the cessation of ongoing operations or the start of insolvency proceedings. The ability to absorb losses must be present well before there is any serious deterioration in the FRFI's financial position.

3 (b): The method used to achieve loss absorption within the FRFI must be transparent and must not raise any uncertainty about the availability of capital for this purpose. Any of the following mechanisms would be acceptable, provided OSFI receives a high degree of assurance that they will function appropriately:

  1. Mandatory write-down of the innovative instrument.
  2. Automatic conversion into Tier 1-qualifying preferred shares of the FRFI. Automatic conversion must occur, at a minimum, upon the occurrence of any of the following events (Loss Absorption Events):
    • an application for a winding-up order in respect of the FRFI pursuant to the Winding-up and Restructuring Act (Canada) is filed by the Attorney General of Canada or a winding-up order in respect of the FRFI pursuant to that Act is granted by a court; or
    • the Superintendent advises the FRFI in writing that the Superintendent has taken control of the FRFI or its assets pursuant to the Insurance Companies Act, Bank Act or Trust & Loan Companies Act, as applicable; or
    • the Superintendent advises the FRFI in writing that the Superintendent is of the opinion that, in the case of a Life Company, it has a net Tier 1 Ratio of less than 75 per cent or a MCCSR Total Ratio of less than 120 per cent; or
    • in the case of a DTI, it has a Tier 1 capital ratio of less than 5.0 per cent or a Total Capital ratio of less than 8.0 per cent; or
    • the FRFI's Board of Directors advises the Superintendent in writing that, in the case of a Life Company, the FRFI has a Tier 1 Ratio of less than 75 per cent or a MCCSR Total Ratio of less than 120 per centFootnote 69, or, in the case of a DTI, the FRFI has a Tier 1 capital ratio of less than 5.0 per cent or a Total Capital ratio of less than 8.0 per cent; or
    • the Superintendent directs the FRFI, pursuant to the Insurance Companies Act, Bank Act or Trust & Loan Companies Act, as applicable, to increase its capital or provide additional liquidity and the FRFI elects to cause the exchange as a consequence of the issuance of such direction or the FRFI does not comply with such direction to the satisfaction of the Superintendent within the time specified.

    If the Tier 1-qualifying preferred shares issued pursuant to an automatic conversion contain a feature allowing the holder to convert into common shares at future market values, such a feature must be structured to ensure that the investors would absorb losses. Accordingly, the right to convert must be structured to ensure that the holder cannot exercise the conversion right while a Loss Absorption Event is continuing.

    The risk premium (over the risk-free rate) reflected in the dividend rate on the Tier 1-qualifying preferred shares issued pursuant to the automatic conversion must be established at the time the innovative instrument is issued and must not exceed the risk premium (over the risk-free rate) reflected in the dividend rate of comparable shares as at that date (i.e. upon the original issuance of the innovative instrument).Footnote 70

  3. Another method that is consistent with Principle #4 and approved by the Superintendent.

Principle #4: Innovative instruments must absorb losses in liquidation.

4 (a): Innovative instruments must achieve, through conversion or other means (for example, a mechanism that ensures investors will receive distributions consistent with preferred shareholders of the FRFI), a priority after the claims of policyholders/depositors, other creditors and subordinated debt holders of the FRFI in a liquidation.

4 (b): Innovative instruments must not be secured or covered by a guarantee or other arrangement that legally or economically results in a claim ranking equal to or prior to the claims of policyholders/depositors, other creditors and subordinated debt holders of the FRFI in a liquidation.

Principle #5: Innovative instruments must not contain any feature that may impair the permanence of the instrument.

5 (a): For the purposes of this principle, a step-up is defined as a pre-set increase at a future date in the dividend (or distribution) rate to be paid on an innovative instrument. Moderate step-ups in innovative instruments are permitted only if the moderate step-up occurs at least 10 years after the issue date and if it results in an increase over the initial rate not exceeding the greater of:

  • 100 basis points, less the swap spread between the initial index basis and the stepped-up index basis; and
  • 50 per cent of the initial credit spread, less the swap spread between the initial index basis and the stepped-up basis.

The terms of the innovative instrument should provide for no more than one rate step-up over the life of the instrument. The swap spread should be fixed as of the pricing date and should reflect the differential in pricing on that date between the initial reference security or rate and the stepped-up reference security or rate.

5 (b): A step-up feature cannot be combined with any other feature that creates an economic incentive to redeem.

5 (c): A redemption feature after an initial five-year period is acceptable in an innovative instrument on the condition that the redemption requires both the prior approval of the Superintendent and the replacement of the innovative instrument with capital of the same or better quality, unless the Superintendent determines that the FRFI has capital that is more than adequate to cover its risks.

An innovative instrument may be redeemed during the initial five-year period, with the Superintendent's approval, upon the occurrence of tax or regulatory (including legislative) changes affecting one or more components of the transaction. It is highly unlikely that the Superintendent would approve redemption of an innovative instrument in the initial five-year period due to a tax reassessment.

The purchase for cancellation of an innovative instrument requires the prior approval of the Superintendent.

5 (d): Innovative instruments issued after December 2008 can include securities that mature in at least 99 years. However, these will be subject to straight-line amortization for regulatory capital purposes beginning 10 years prior to maturity.Footnote 71 The instrument may contain the right of holders, at their option, to exchange their innovative instrument for Tier 1-qualifying preferred shares of the FRFI provided the dividend rate is established at the time the innovative instrument is issued and it does not exceed the market rate for such shares as at that date.

5 (e): An innovative instrument must not contain a feature allowing the holder to convert the innovative instrument directly into common shares of the FRFI or of other entities. Conversions into common shares are permitted only if the conversion occurs first into Tier 1-qualifying preferred shares of the FRFI which are then convertible into common shares of the FRFI or its OSFI-regulated holding company, and provided OSFI is satisfied that the innovative instrument is issued in a market where the conversion feature is widely accepted.Footnote 72

Structures permitting the indirect conversion of an innovative Tier 1 instrument into the common shares of an unregulated holding company may be submitted to OSFI for review and approval, provided the following conditions are met:

  1. unregulated holding company has a material public common float and the FRFI does not;
  2. unregulated holding company is the direct parent and controlling shareholder of the FRFI; and
  3. unregulated holding company is a non-operating holding company.

OSFI reserves the right to require additional conditions or restrictions, consistent with the proposed regulatory capital treatment of an instrument, to address the particular nature of proposals presented for its consideration.Footnote 73

Principle #6: Innovative instruments must be free from mandatory fixed charges.Footnote 74

6 (a): The FRFI, through the SPV, must have discretion over the amount and timing of distributions. Rights to receive distributions must clearly be non-cumulative and must not provide for compensation in lieu of undeclared distributions. The FRFI must have full access to undeclared payments.

6 (b): Distributions may be paid only in cash.

6 (c): Distributions may not be reset based on the future credit standing of the FRFI.

Principle #7: Innovative instruments must be issued and fully paid-for in money, or, with the approval of the Superintendent, in property.

Principle #8: Innovative instruments, even if not issued as shares, may be included in Tier 1 capital.

Principle #9: The main features of an innovative instrument must be easily understood and publicly disclosed.

9 (a): For the purposes of this principle, OSFI will consider the main features of an innovative instrument to be easily understood where:

  1. the legal (including tax) and regulatory risks arising out of the innovative instrument have been minimized to the satisfaction of the Superintendent. The likelihood of failing this test increases as the number of entities placed between the investors and the ultimate recipient of the proceeds increases, as the number of jurisdictions involved increases, and/or if the assets of the FRFI are transferred to an entity outside Canada; and
  2. the manner by which the innovative instrument meets the Tier 1 capital requirements and the main features of the instrument are, in the opinion of the Superintendent, transparent to a reasonably sophisticated investor.

9 (b): The main features of innovative instruments, including those features designed to achieve Tier 1 capital status (for example, the triggers and mechanisms used to achieve loss absorption), must be publicly disclosed in the FRFI's annual report to shareholders.

OSFI expects that FRFIs will, particularly for innovative instruments issued after July 1, 2008, provide prospectus-level disclosure at issuance to ensure the main features of the innovative instruments and the structure of the issue are transparent and easily understood by investors, including all relevant risk factors. Further, in the case of material changes, OSFI expects the FRFI will provide additional disclosure on a timely basis. In particular, the following information should be disclosed to investors in innovative instruments and to the shareholders of the FRFI issuing, directly or indirectly, the innovative instruments:

  1. Tier 1 treatment: It should be explicitly stated that innovative instruments are structured with the intent of achieving Tier 1 regulatory capital treatment and, as such, have features of equity capital. It should be clearly stated that dividends on the innovative instruments will not be paid if dividends are not paid by the FRFI on its common and preferred shares. In addition, it should be disclosed that the innovative instruments contain certain features that will convert these instruments into preferred shares of the FRFI and thus, in the event of liquidation of the FRFI, holders of the innovative instruments issued by the SPV will rank as preferred shareholders of the FRFI.
  2. Trust assets (asset-based only): FRFIs should, at issuance and on at least a quarterly basis thereafter, provide prospectus-level disclosure of any material information that will assist investors in understanding the risks of the underlying trust assets, including, to the extent relevant: a breakdown of the assets by type (i.e., residential mortgage, mortgage backed security, etc.), the geographic distribution of the assets, information on the creditworthiness of obligors and guarantors, a description of collateral and a description of the average maturities of the assets.

D. Grandfathering

Principle #10: For purposes of Principle #1, FRFIs exceeding the "25 per cent limit" as of the date of the release of this Appendix can continue to include the excess in Tier 1 capital if the excess also existed at July 30, 1999, but may only do so until July 30, 2004 unless otherwise permitted in writing by the Superintendent. Excesses created subsequent to July 30, 1999 are not grandfathered for purposes of Principle #1 unless otherwise permitted in writing by the Superintendent. All existing innovative instruments and Tier 1-qualifying preferred shares must continue to be included in the computation of a FRFI's position relative to the 15 per cent and 25 per cent limits going forward.

Chapter 3. Asset Default (C-1) Risk

3.1. Asset default factors

Asset default risk covers losses resulting from asset defaults, loss of market value of equities, and related reductions in incomeFootnote 75. It encompasses both on- and off-balance sheet risks of life insurers. To compute the component requirement for on-balance sheet risks, factors are applied to the values of the company's assets. To compute the component requirement for off-balance sheet instruments, factors are applied to the exposure amount determined according to chapter 7. The resulting charges are summed to arrive at the asset default risk component requirement.

For the purpose of calculating the C-1 risk component, on-balance sheet assets should be valued at their balance sheet carrying amounts, with the following exceptions:

  • loans carried at fair value under the fair value option, fair value hedge accounting, or available-for-sale accounting, which should be valued at amortized cost;
  • debt securities carried at fair value under available-for-sale accounting, which should also be valued at amortized cost; and
  • owner-occupied property, which should be valued in accordance with section 3.1.11.

Additionally, the C-1 component relating to certain types of asset risks is calculated using techniques that are different from applying the regular factors:

  • The on- and off-balance sheet risks relating to qualifying participating policies should be tracked separately from those relating to non-par policies and surplus, as the asset default factors differ (see below).
  • The capital requirement for securitizations is described in section 3.4.
  • The capital requirement for securities that have been lent is described in section 3.5.
  • Assets backing index-linked products receive capital factors based on correlation calculations, as described in section 3.6.
  • Assets held in segregated funds by a company's policyholders are not subject to the requirements of this chapterFootnote 76.
  • Reinsurance assets are not subject to the requirements of this chapter, and instead receive the capital treatment described in sections 10.4 and 10.5.

For assets backing qualifying participating policies that meet the criteria in section 1.2.6, the asset default factors are 50% of the regular factors. Regular factors apply to assets backing non-participating products, ancillary funds, and surplus. If the assets backing qualifying participating policies are commingled within an asset segment that also backs other products, the assets to which the reduced C-1 requirements for qualifying participating are applied must be the same assets used to back these qualifying participating policies in the calculation of the policy liabilities under the CALM methodology.

3.1.1. Use of ratings

Many of the factors in this chapter depend on the rating assigned to an asset or an obligor. In order to use a factor that is based on a rating, a company must meet all of the conditions specified in this section.

Companies may recognize credit ratings from the following rating agencies for MCCSR purposes:

  • DBRS
  • Moody's Investors Service
  • Standard and Poor's (S&P)
  • Fitch Rating Services

A company must choose the rating agencies it intends to rely on and then use their ratings for MCCSR purposes consistently for each type of claim. Companies may not "cherry pick" the assessments provided by different rating agencies.

Any rating used to determine a factor must be publicly available, i.e. the rating must be published in an accessible form and included in the rating agency's transition matrix. Ratings that are made available only to the parties to a transaction do not satisfy this requirement.

If a company is relying on multiple rating agencies and there is only one assessment for a particular claim, that assessment should be used to determine the capital charge for the claim. If there are two assessments from the rating agencies used by a company and these assessments differ, the company should apply the capital charge corresponding to the lower of the two ratings. If there are three or more assessments for a claim from a company's chosen rating agencies, the company should exclude one of the ratings that corresponds to the lowest capital charge, and then use the rating that corresponds to the lowest capital charge of those that remain (i.e. the company should use the second-highest rating from those available, allowing for multiple occurrences of the highest rating).

Where a company holds a particular securities issue that carries one or more issue-specific assessments, the capital charge for the claim will be based on these assessments. Where a company's claim is not an investment in a specifically rated security, the following principles apply:

  • In circumstances where the borrower has a specific rating for an issued debt security, but the company's claim is not an investment in this particular security, a rating of BBB- or better on the rated security may only be applied to the company's unrated claim if this claim ranks pari passu or senior to the rated claim in all respects. If not, the credit rating cannot be used and the company's claim must be treated as an unrated obligation.
  • In circumstances where the borrower has an issuer rating, this assessment typically applies to senior unsecured claims on that issuer. Consequently, only senior claims on that issuer will benefit from an investment-grade (BBB- or better) issuer assessment; other unassessed claims on the issuer will be treated as unrated. If either the issuer or one of its issues has a rating of BB+ or lower, this rating should be used to determine the capital charge for an unrated claim on the issuer.
  • Short-term assessments are deemed to be issue specific. They can only be used to derive capital charges for claims arising from the rated facility. They cannot be generalized to other short-term claims, and in no event can a short-term rating be used to support a capital charge for an unrated long-term claim.
  • Where the capital charge for an unrated exposure is based on the rating of an equivalent exposure to the borrower, foreign currency ratings should be used for exposures in foreign currency. Canadian currency ratings, if separate, should only be used to determine the capital charge for claims denominated in Canadian currency.

The following additional conditions apply to the use of ratings:

  • External assessments for one entity within a corporate group may not be used to determine the capital charge for other entities within the same group.
  • No rating may be inferred for an unrated entity based on assets that the entity possesses.
  • In order to avoid the double counting of credit enhancement factors, companies may not recognize credit risk mitigation under sections 3.2 and 3.3 if the credit enhancement has already been reflected in the issue-specific rating.
  • A company may not recognize a rating if the rating is at least partly based on unfunded support (e.g. guarantees, credit enhancement or liquidity facilities) provided by the company itself or one of its affiliates.
  • Any assessment used must take into account and reflect the entire amount of credit risk exposure a company has with regard to all payments owed to it. In particular, if a company is owed both principal and interest, the assessment must fully take into account and reflect the credit risk associated with repayment of both principal and interest.

Companies may not rely on unsolicited ratings in determining the capital charge for an asset, except where the asset is a sovereign exposure and a solicited rating is not available.

3.1.2. Basic component requirement

Factor Basic Components
Regular Qualifying Participating
0% 0%

Currency held on the company's own premises

0% 0%

Unrealized gains and accrued receivables on forwards, swaps, purchased options and similar derivative contracts where they have been included in the off-balance sheet calculation

0% 0%

Receivables from federally regulated insurers and approved provincial reinsurers

0% 0%

Any deductions from capital, including goodwill, intangible assets and substantial investments (including facilities)

Demand deposits, certificates of deposit, drafts, checks, acceptances and similar obligations that have an original maturity of less than three months, and that are drawn on regulated deposit-taking institutions subject to the solvency requirements of the Basel Framework, receive a factor of 0.25% (0.125% for qualifying participating).

3.1.3. Miscellaneous items

Factor Miscellaneous Items
Regular Qualifying Participating

8%

4%

Book value of miscellaneous items (e.g., outstanding premiums, agent's debit balancesFootnote 77, receivables, furniture and fixtures, prepaid expenses, deferred tax assets, intangible assets not deducted from capital)

8%

4%

Receivables from insurers that are not federally regulated or not approved provincial reinsurers

8%

N/A

The amount of available refunds from defined benefit pension plan surplus assets included in Tier 1

8%

4%

Instruments or investments that are not specifically identified in this guideline

16%

8%

AssetsFootnote 78 classified as held for sale (HFS)Footnote 79

3.1.4. Entities eligible for a 0% factor

Bonds, notes and other obligations of the following entities are eligible for a 0% C-1 factor:

  • The Government of Canada
  • Sovereigns rated AA- or better and their central banks, provided such rating applies to the currency in which an obligation is issuedFootnote 80
  • Unrated sovereigns with a country risk classification of 0 or 1, as assigned by Export Credit Agencies participating in the "Arrangement on Officially Supported Export Credits"Footnote 81, for obligations denominated in the sovereign's domestic currency
  • Canadian provincial and territorial governments
  • Agents of the Canadian Government or a Canadian provincial or territorial government whose debts are, by virtue of their enabling legislation, direct obligations of the Crown in right of such federal or provincial government
  • The Bank for International Settlements
  • The International Monetary Fund
  • The European Community and the European Central Bank
  • The following multilateral development banks:
    • International Bank for Reconstruction and Development (IBRD)
    • International Finance Corporation (IFC)
    • Asian Development Bank (ADB)
    • African Development Bank (AfDB)
    • European Bank for Reconstruction and Development (EBRD)
    • Inter-American Development Bank (IADB)
    • European Investment Bank (EIB)
    • European Investment Fund (EIF)
    • Nordic Investment Bank (NIB)
    • Caribbean Development Bank (CDB)
    • Islamic Development Bank (IDB)
    • Council of Europe Development Bank (CEDB)
    • Council of Europe Development Bank (CEDB)
    • Multilateral Investment Guarantee Agency (MIGA)
  • Public sector entities in jurisdictions outside Canada where:
    1. The jurisdiction's sovereign rating is AA- or better, and
    2. The national bank supervisor in the jurisdiction of origin permits banks under its supervision to use a risk weight of 0% for the public sector entity under the Basel Framework
  • Recognized exchanges and clearing housesFootnote 82 that serve as central counterpartiesFootnote 83 to derivatives and securities financing transactions.

3.1.5. Factors based on external ratings

Companies may use the following factors for all credit exposures (including guaranteed and off-balance sheet exposures), with the exception of asset backed securities and reinsurance assets, that are eligible to receive a factor based on an external rating under section 3.1.1. The treatment of rated asset backed securities is described in section 3.4.

Factor

Rating

Regular

Qualifying Participating

Short Term:

0.25%

0.125%

Rated A-1, P-1, F1, R-1 or equivalent

0.50%

0.25%

Rated A-2, P-2, F2, R-2 or equivalent

2%

1%

Rated A-3, P-3, F3, R-3 or equivalent

8%

4%

All other ratings, including non-prime and B or C ratings

Long Term:

0.25%

0.125%

AAA, Aaa or equivalent

0.5%

0.25%

AA, Aa or equivalent

1%

0.5%

A or equivalent

2%

1%

BBB, Baa or equivalent

4%

2%

BB, Ba or equivalent

8%

4%

B or equivalent

16%

8%

Lower than B or equivalent

3.1.6. Unrated claims

Unrated commercial paper and similar short-term facilities having an original maturity of less than one year should receive the factor corresponding to a rating of A-3, P-3 or equivalent, unless an issuer has a short-term facility with an assessment that warrants a capital charge of 8% (4% for qualifying participating). If an issuer has such a short-term facility outstanding, all unrated debt claims on the issuer, whether long term or short term, also receive a capital charge of 8% (4% for qualifying participating) unless the company uses recognized credit risk mitigation techniques (reference sections 3.2 and 3.3) for such claims.

Where a rating is not available for a long-term bond or private placement, the factor used should be based on the insurer's internal rating. These internal ratings must be reviewed at least annually. The minimum factor that may be used is 2% (1% for qualifying participating). If OSFI believes that the factor used is inappropriate, a higher factor will be required.

Internal ratings may not be used for mortgages, asset backed securities or loans. The treatment of unrated asset backed securities is described in section 3.4.3. In the case of loans, a factor of 8% (4% for qualifying participating) should normally be used.

The C-1 factor for derivatives contracts or other capital markets transactions for which a rating cannot be inferred is 8% (4% for qualifying participating).

3.1.7. MortgagesFootnote 84

Factor

Mortgages

Regular

Qualifying Participating

2%

1%

Qualifying residential mortgages, as defined below

4%

2%

Commercial mortgages

8%

4%

Mortgages secured by undeveloped land (i.e., construction financing), other than land used for agricultural purposes or the production of minerals. A property recently constructed or renovated will be considered as under construction until it is completed and 80% leased.

8%

4%

That part of the mortgage that is based on an increase in value occasioned by a different future use.

Qualifying residential mortgages include:

  • loans secured by first mortgages on individual condominium residences and one- to four-unit residential dwellings made to a person(s) or guaranteed by a person(s), provided that such loans are not more than 90 days past due and do not exceed a loan-to-value ratio of 80%, and
  • collateral mortgages (first and junior) on individual condominium residences or one- to four-unit residential dwellings, provided that such loans are made to a person(s) or guaranteed by a person(s), where no other party holds a senior or intervening lien on the property to which the collateral mortgage applies and such loans are not more than 90 days past due and do not, collectively, exceed a loan-to-value ratio of 80%.

Investments in hotel properties and time-shares are excluded from the definition of qualifying residential mortgages.

The factor for residential mortgages insured under the NHA or equivalent provincial mortgage insurance programs is 0%. Where a mortgage is comprehensively insured by a private sector mortgage insurer that has a backstop guarantee provided by the Government of Canada (for example, a guarantee made pursuant to the Protection of Residential Mortgage or Hypothecary Insurance Act), companies may recognize the risk-mitigating effect of the counter-guarantee by reporting the portion of the exposure that is covered by the Government of Canada backstop as if this portion were directly guaranteed by the Government of Canada. The remainder of the exposure should be treated as an exposure to the mortgage guarantor in accordance with the rules set out in section 3.3.

The factor for commercial mortgages applies to mortgages that do not meet all of the criteria for qualifying residential mortgages.

3.1.8. Investments in equities and innovative instruments

Factor

Stocks*

Regular

Qualifying Participating

Preferred stocks:

1%

0.5%

AAA, AA, Pfd-1, P-1 or equivalent

2%

1%

A, Pfd-2, P-2 or equivalent

4%

2%

BBB, Pfd-3, P-3 or equivalent

6%

3%

BB, Pfd-4, P-4 or equivalent

15%

7.5%

B or lower, Pfd-5, P-5 or equivalent or unrated

15%

7.5%

Common stocks, income trusts, and other similar investments, and interests in joint ventures

* Other than investments in corporations controlled by the company, or in entities or joint ventures in which the company has a substantial investment.

Investments in innovative or other non-common capital instruments issued by domestic or international financial institutions must be treated as equity investments based upon the underlying economic risk of the instruments.

Substantial investments in an entity including a joint venture will be deducted from the Available Capital of the company (reference section 2.7).

3.1.9. Mutual funds

The factor for investments in unleveraged mutual funds, exchange traded funds, segregated funds and real estate investment trusts is a weighted average of factors for assets that the fund is permitted to invest in. The weights and factors are calculated assuming that the fund first invests in the asset class attracting the highest capital requirement, to the maximum extent permitted in its prospectus or Annual Information Form (where more current). It is then assumed that the fund continues allocating investments to asset classes in declining order of capital charge, to the maximum extent permitted, until a total allocation of 100% is reached. The factor for the mutual fund is then the sum of the products of the weights and risk factors for the assumed investment allocation.

In the absence of specific limits to asset classes or if the fund is in violation of the limits stated in the prospectus, the entire fund is subject to the highest risk charge applicable to any security that the fund holds or is permitted to invest in.

The factor for any fund that employs leverageFootnote 85 is 15% (7.5% for qualifying participating).

3.1.10. Corporations controlled by the company

An accounting consolidation equivalent will be used for controlling investments in corporations carrying on a business that the company could carry on directly (e.g., life insurance, real estate and ancillary business subsidiaries). For those situations, the MCCSR rules will be applied to the controlled corporation. The same consolidation principle applies to subsidiaries of the company whether held directly or indirectly. The corporation's MCCSR will then be added to the parent life company's own MCCSR. The tier limitations (i.e., term tier 2 may not exceed 50% of tier 1) will be applied on a consolidated basis.

Corporations controlled by the company

Treatment

Life insurance corporation

accounting consolidation equivalent

Non-life financial corporation
(reference section 2.6)

deduct investment in corporation from tier 1 and tier 2 capital (reference section 2.6)

Commercial corporation (i.e., ancillary business corporations)

accounting consolidation equivalent

Real estate corporation

accounting consolidation equivalent

3.1.11. Real estateFootnote 86

Factor

Real Estate

Regular

Qualifying Participating

4%

2%

Used by the company or a consolidated subsidiary

7%

3.5%

Income-producing rental properties (see below)

15%

7.5%

Other

35%Footnote 87

17.5%

Oil and gas properties

Factors are applied to real estate book values, with the exception of owner-occupied property. Reported exposures for owner-occupied property should be based on :

  • original acquisition cost net of subsequent depreciation, for properties acquired after December 31, 2010, or
  • moving-average market value on December 31, 2010 (i.e. book value prior to conversion to IFRS) net of subsequent depreciation, for properties acquired before 2011.

All real estate exposures should be reported gross of any associated mortgages or other debt.

Companies may only use the factor for income-producing rental properties for residential and commercial properties that earn an income yield of at least 4% of their carrying values. For properties acquired after December 31, 1991, the carrying value in the 4% test should be calculated net of encumbrances, if any, and income should be calculated net of all real-estate expenses (including interest on encumbrances) and taxes (including property and other taxes, but excluding income taxes). For real estate assets acquired prior to December 31, 1991, encumbrances should not be deducted from the carrying value of the property in the 4% test, and interest expenses should not be deducted from income. The income amount used in the 4% test includes cash income only, and does not include amortization of the value of the property. The factor for income-producing rental properties may not be used for properties currently under development and for which imputed interest is capitalized for financial reporting purposes.

3.1.12. Limited partnerships

Investments in limited partnerships are treated as direct investments by the life company. The approach is to "look through" the partnership.

3.1.13. Leases

3.1.13.1. Lessee

Where a life company is the lessee under an operating lease, no capital is required. However, under a capital lease, the capital requirement for the asset held on the balance sheet is based on the underlying property leased per section 3.1.11.

3.1.13.2. Lessor

Companies may use a 0% factor for any lease that is a direct obligation of an entity listed in section 3.1.4 that is eligible for a 0% C-1 factor. A 0% factor may also be used for a lease that is guaranteed by such an entity if the guarantee meets the criteria for recognition under section 3.3. The 0% factor may not be used for leases where a company does not have direct recourse to an entity eligible for a 0% factor under the terms of the obligation, even if such an entity is the underlying lessee.

For financial leases and sales type leases, if the lease is secured only by equipment the 4% factor applies (2% for qualifying participating). If the lease is also secured by the general credit of the lessee and the lease is rated or a rating for the lease can be inferred under section 3.1.1, the factor is based on this rating. Any rating used must be applicable to the direct obligor of the instrument held by the company (or the direct guarantor, if recognition is permitted under section 3.3), which may be different from the underlying lessee. If no rating can be inferred, the factor is 2% (1% for qualifying participating) or a higher factor, if the company's internal rating would result in a higher capital charge.

3.1.14. Impaired and restructured obligations

The charges for impaired and restructured obligations in this section replace the charges that would otherwise apply to a performing asset. They are to be applied instead of (not in addition to) the charge that was required for the asset before it became impaired or was restructured.

The factor for the unsecured portion of any asset for which there is reasonable doubt about the timely collection of the full amount of principal or interest (including any asset that is contractually more than 90 days in arrears), and that does not carry an external rating from an agency listed in section 3.1.1, is 16% (8% for qualifying participating). This factor is applied to the net carrying amount of the asset on the balance sheet, defined as the principal balance of the obligation net of write-downs and individual allowances. For the purpose of defining the secured portion of a past due obligation, eligible collateral and guarantees are the same as in sections 3.2 and 3.3.

This capital treatment also applies to restructured obligations. An asset is considered to have been restructured when the company, for economic or legal reasons related to the obligor's financial difficulties, grants a concession that it would not otherwise consider. The 16% factor (8% for qualifying participating) will continue to apply to restructured obligations until cash flows have been collected for a period of at least one year in accordance with the amended terms and conditions.

3.1.15. Investment income due and accrued

Investment income due and accrued should be reported with, and receive the same factor as the assets to which it relates.

3.2. Collateral

A collateralized transaction is one in which:

  • a company has a credit exposure or potential credit exposure; and
  • that credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterpartyFootnote 88 or by a third party on behalf of the counterparty.

The following standards must be met before capital relief will be granted in respect of any form of collateral:

  • The effects of collateral may not be double counted. Therefore, companies may not recognize collateral on claims for which an issue-specific rating is used that already reflects that collateral. All criteria in section 3.1.1 around the use of ratings remain applicable to collateral.
  • All documentation used in collateralized transactions must be binding on all parties and legally enforceable in all relevant jurisdictions. Companies must have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.
  • The legal mechanism by which collateral is pledged or transferred must ensure that the company has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore, companies must take all steps necessary to fulfil those requirements under the law applicable to the company's interest in the collateral for obtaining and maintaining an enforceable security interest, e.g. by registering it with a registrar, or for exercising a right to net or set off in relation to title transfer collateral.
  • The credit quality of the counterparty and the value of the collateral must not have a material positive correlation. For example, securities issued by the counterparty – or by any related group entity – provide little protection and are therefore ineligible.
  • Companies must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.
  • Where collateral is held by a custodian, companies must take reasonable steps to ensure that the custodian segregates the collateral from its own assets.

Collateralized transactions are classified according to whether they are policy loans, capital markets transactions, or other secured lending arrangements. The category of capital markets transactions includes repo-style transactions (e.g. repos and reverse repos, and securities lending and borrowing) and other capital-markets driven transactions (e.g. OTC derivatives and margin lending).

3.2.1. Policy loans

Loans for which insurance policies are provided as collateral will receive a 0% factor if the following conditions are met:

  • Both the loan and the policy provided as collateral are issued by and remain held by the company
  • The term of the loan does not exceed the term of the policy provided as collateral
  • The company has the legal right and intention of offset in the event the loan goes into default or the policy is cancelled
  • Amounts owing under the loan, including any unpaid interest, are never greater than the proceeds available under the collateral
  • The aggregate amount outstanding under the loan agreement, including accrued interest, will not at any time in the future exceed the cash surrender value of the policy

If any of these conditions are not met, an asset default factor of 8% (4% for qualifying participating) should be applied to the loan.

3.2.2. Eligible financial collateral

The following collateral instruments may be recognized for secured lending and capital markets transactions:

  • Debt securities rated by a recognized rating agency (reference section 3.1.1) where these securities are:
    • rated BB- or better and issued by an entity eligible for a 0% bond factor; or
    • rated BBB- or better and issued by other entities (including banks, insurance companies, and securities firms); or
    • short-term and rated A-3/P-3 or better.
  • Debt securities not rated by a recognized rating agency where:
    • the securities are issued by a Canadian bank whose equity is listed on a recognized exchange; and
    • the original maturity of the securities is less than one year; and
    • the securities are classified as senior debt; and
    • all debt issues by the issuing bank having the same seniority as the securities and that have been rated by a recognized rating agency are rated at least BBB- or A-3/P-3.
  • Equities and convertible bonds that are included in a main index.
  • Gold.
  • Mutual funds where:
    • a price for the units is publicly quoted daily; and
    • the mutual fund is limited to investing in the instruments listed aboveFootnote 89.

Additionally, the following collateral instruments may be recognized for capital markets transactions:

  • Equities and convertible bonds that are not included in a main index but that are listed on a recognized exchange, and mutual funds that include such equities and bonds.

For collateral to be recognized in a secured lending transaction, it must be pledged for at least the life of the loan. For collateral to be recognized in a capital markets transaction, it must be secured in a manner that would preclude release of the collateral unless warranted by market movements, the transaction is settled, or the collateral is replaced by new collateral of equal or greater value.

3.2.3. Secured lending

Collateral received in secured lending must be revalued on a mark-to-market basis at least every six months. The market value of collateral that is denominated in a currency different from that of the loan must be reduced by 20%. The portion of a loan that is collateralized by the market value of eligible financial collateral receives the capital charge applicable to the collateral instrument, subject to a minimum of 0.25% (0.125% for qualifying participating) with the exception noted below. The remainder of the loan is assigned the capital charge appropriate to the counterparty.

A charge of 0% may be used for a secured lending transaction if:

  • the loan and the collateral are denominated in the same currency; and
  • the collateral consists entirely of securities eligible for a 0% capital charge; and
  • the market value of the collateral is at least 25% greater than the carrying value of the loan.

3.2.4. Capital markets transactions

3.2.4.1. Introduction

When taking collateral for a capital markets transaction, companies must calculate an adjusted exposure amount to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Using haircuts, companies are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of the counterparty's obligations to take account of possible future fluctuations in the value of eitherFootnote 90 occasioned by market movements. This will produce volatility-adjusted amounts for both the exposure and the collateral. Unless either side of the transaction is in cash, the volatility-adjusted amount for the exposure will be higher than the exposure itself, and for the collateral it will be lower. Additionally, where the exposure and collateral are held in different currencies, an additional downwards adjustment must be made to the volatility-adjusted collateral amount to take account of possible future fluctuations in exchange rates.

Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), the capital charge is calculated as the difference between the two multiplied by the C-1 factor appropriate to the counterparty.

Section 3.2.4.2 describes the size of the individual haircuts used. These haircuts depend on the type of instrument and the type of transaction. The haircut amounts are then scaled using a square root of time formula depending on the frequency of remargining. Section 3.2.4.3 sets out conditions under which companies may use zero haircuts for certain types of repo-style transactions involving government bonds. Finally, section 3.2.4.4 describes the treatment of master netting agreements.

3.2.4.2. Calculation of the capital requirement

For a collateralized capital markets transaction, the exposure amount after risk mitigation is calculated as follows:

E* = max (0, [E × (1 + He) − C × (1 − HcHfx)])

where:

E*
is the exposure value after risk mitigation
E
is the current value of the exposure
He
is the haircut appropriate to the exposure
C
is the current value of the collateral received
Hc
is the haircut appropriate to the collateral
Hfx
is the haircut appropriate for currency mismatch between the collateral and the exposure

The exposure amount after risk mitigation is multiplied by the C-1 factor appropriate to the counterparty to obtain the charge for the collateralized transaction.

When the collateral consists of a basket of assets, the haircut to be used on the basket is the average of the haircuts applicable to the assets in the basket, where the average is weighted according to the market values of the assets in the basket.

The following are the standard haircuts, expressed as percentages:

Issue rating for debt securities Residual Maturity Securities eligible for a 0% C-1 factor Other securities
AAA to AA-/A-1 ≤ 1 year 0.5 1
>1 year, ≤ 5 years 2 4
> 5 years 4 8

A+ to BBB-

A-2/A-3/P-3

Unrated bank debt securities

≤ 1 year 1 2
>1 year, ≤ 5 years 3 6
> 5 years 6 12
BB+ to BB- All 15
Main index equities and convertible bonds, and gold 15
Other equities and convertible bonds listed on a recognized exchange 25
Mutual funds Highest haircut applicable to any security in which the fund can invest

The standard haircut for currency risk where the exposure and collateral are denominated in different currencies is 8%.

For transactions in which a company lends cash, the haircut to be applied to the exposure is zeroFootnote 91. For transactions in which a company lends non-eligible instruments (e.g. non-investment grade corporate debt securities), the haircut to be applied to the exposure should be the same as that applied to an equity that is traded on a recognized exchange but not part of a main index.

For collateralized OTC derivatives transactions, the E* component term , representing the volatility-adjusted exposure amount before risk mitigation, is replaced by the exposure amount for the derivatives transaction calculated using the current exposure method as described in chapter 7. This is either the positive replacement cost of the transaction plus the add-on for potential future exposure, or, for a series of contracts eligible for netting, the net replacement cost of the contracts plus ANet. The haircut for currency risk should be applied when there is a mismatch between the collateral currency and the settlement currency, but no additional adjustments beyond a single haircut for currency risk are required if there are more than two currencies involved in collateral, settlement and exposure measurement.

All of the standard haircuts listed above must be scaled by a square root of time factor according to the following formula:

Not yet defined

where:

H
represents any of the haircuts used in calculating the exposure amount after risk mitigation;
S
is the standard haircut specified above for the exposure or collateral;
N
is the actual number of business days between remargining under the transaction; and
T
is equal to 5 for repo-style transactions, and 10 for all other capital markets transactions.
3.2.4.3. Conditions for using zero haircuts

For repo-style transactions that satisfy the following conditions, and for which the counterparty is a core market participant as defined below, companies may apply haircuts of zero to both the exposure and collateral:

  • Both the exposure and the collateral are cash or securities issued by the Government of Canada or a provincial or territorial government in Canada.
  • Both the exposure and the collateral are denominated in the same currency.
  • Either the transaction is overnight or both the exposure and the collateral are marked to market daily and are subject to daily remargining.
  • Following a counterparty's failure to remargin, the time that is required between the last mark to market before the failure to remargin and the liquidationFootnote 92 of the collateral is considered to be no more than four business days.
  • The transaction is settled across a settlement system proven for that type of transaction.
  • The documentation covering the agreement is standard market documentation for repo-style transactions in the securities concerned.
  • The transaction is governed by documentation specifying that if the counterparty fails to satisfy an obligation to deliver cash or securities or to deliver margin or otherwise defaults, then the transaction is immediately terminable.
  • Upon any default event, regardless of whether the counterparty is insolvent or bankrupt, the company has the unfettered, legally enforceable right to immediately seize and liquidate the collateral for its benefit.

Core market participants include the following entities:

  • Sovereigns, central banks and public sector entities
  • Banks and securities firms
  • Other financial companies (including insurance companies) rated AA- or better
  • Regulated mutual funds that are subject to capital or leverage requirements
  • Regulated pension funds
  • Recognized clearing organizations
3.2.4.4. Treatment of repo-style transactions covered under master netting agreements

The effects of bilateral netting agreements covering repo-style transactions will be recognized on a counterparty-by-counterparty basis if the agreements are legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of whether the counterparty is insolvent or bankrupt. In addition, netting agreements must:

  • provide the non-defaulting party the right to terminate and close out in a timely manner all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty;
  • provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under it so that a single net amount is owed by one party to the other;
  • allow for the prompt liquidation or setoff of collateral upon the event of default; and
  • be, together with the rights arising from the provisions required above, legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of the counterparty's insolvency or bankruptcy.

For repo-style transactions included within a master netting agreement, the exposure amount after risk mitigation is calculated as follows:

E* = max (0, [∑E − ∑C + ∑(Ex × Hs) + ∑(Efx × Hfx)])

where:

E*
is the exposure value after risk mitigation
E
is the current value of the exposure
C
is the current value of the collateral received
Es
is the absolute value of the net position in each security covered under the agreement
Hs
is the haircut appropriate to Es
Efx
is the absolute value of the net position in each currency under the agreement that is different from the settlement currency
Hfx
is the haircut appropriate for currency mismatch

All other rules regarding the calculation of haircuts in section 3.2.4.2 equivalently apply for companies using bilateral netting agreements for repo-style transactions.

3.3. Guarantees and credit derivatives

Where guaranteesFootnote 93 or credit derivatives are direct, explicit, irrevocable and unconditional, and companies fulfil certain minimum operational conditions relating to risk management processes, they will be allowed to take account of such credit protection in calculating capital requirements. The capital treatment is founded on the substitution approach, whereby the protected portion of a counterparty exposure is assigned the capital charge of the guarantor or protection provider, while the uncovered portion retains capital charge of the underlying counterparty. Thus only guarantees issued by or protection provided by entities with a lower capital charge than the underlying counterparty will lead to reduced capital requirements. A range of guarantors and protection providers is recognized.

3.3.1. Operational requirements common to guarantees and credit derivatives

The effects of credit protection may not be double counted. Therefore, no capital recognition is given to credit protection on claims for which an issue-specific rating is used that already reflects that protection. All criteria in section 3.1.1 around the use of ratings remain applicable to guarantees and credit derivatives.

A guarantee (counter-guarantee) or credit derivative must represent a direct claim on the protection provider and must be explicitly referenced to a specific exposure or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible. Other than non-payment by a protection purchaser of money due in respect of the credit protection contract it must be irrevocable; there must be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposureFootnote 94. It must also be unconditional; there should be no clause in the protection contract outside the direct control of the insurer that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due.

All documentation used for documenting guarantees and credit derivatives must be binding on all parties and legally enforceable in all relevant jurisdictions. Insurers must have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.

3.3.2. Additional operational requirements for guarantees

The following conditions must be satisfied in order for a guarantee to be recognized:

  • On the qualifying default/non-payment of the counterparty, the insurer may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the insurer, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The insurer must have the right to receive any such payments from the guarantor without first having to take legal action in order to pursue the counterparty for payment.
  • The guarantee is an explicitly documented obligation assumed by the guarantor.
  • Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. Where a guarantee covers payment of principal only, interest and other uncovered payments should be treated as an unsecured amount in accordance with section 3.3.5.

3.3.3. Additional operational requirements for credit derivatives

The following conditions must be satisfied in order for a credit derivative contract to be recognized:

  • The credit events specified by the contracting parties must at a minimum cover:
    • failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation);
    • bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and
    • restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account). Refer to the exception below when restructuring is not specified as a credit event.
  • If the credit derivative covers obligations that do not include the underlying obligation, section g) below governs whether the asset mismatch is permissible.
  • The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay.
  • Credit derivatives allowing for cash settlement are recognized for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must be a clearly specified period for obtaining post-credit event valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different than the underlying obligation, section g) below governs whether the asset mismatch is permissible.
  • If the protection purchaser's right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation must provide that any required consent to such transfer may not be unreasonably withheld.
  • The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event.
  • A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (1) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.
  • A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (1) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.

When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements above are met, partial recognition of the credit derivative will be allowed. If the amount of the credit derivative is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognized as covered. If the amount of the credit derivative is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation.

Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition. Where a company buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by increasing provisions), the credit protection will not be recognized.

Other types of credit derivatives are not eligible for recognition.

3.3.4. Eligible guarantors and protection providers

Insurers may recognize credit protection given by the following entities:

  • entities eligible for a 0% C-1 factor under section 3.1.4;
  • externally rated public sector entities, banks and securities firms with a lower C-1 factor than that of the counterparty; and
  • other entities rated A- or better. This includes credit protection provided by parent, subsidiary and affiliate companies of an obligor when they have a lower C-1 factor than that of the obligor.

However, an insurer may not recognize a guarantee or credit protection on an exposure to a third party when the guarantee or credit protection is provided by a related party (parent, subsidiary or affiliate) of the insurer. This treatment follows the principle that guarantees within a corporate group are not a substitute for capital.

3.3.5. Capital treatment

The protected portion of a counterparty exposure is assigned the capital factor of the protection provider. The uncovered portion of the exposure is assigned the factor of the underlying counterparty.

Where the amount guaranteed, or against which credit protection is held, is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority (i.e. the company and the guarantor share losses on a pro-rata basis), capital relief will be afforded on a proportional basis, so that the protected portion of the exposure will be receive the treatment applicable to eligible guarantees and credit derivatives, and the remainder will be treated as unsecured. Where a company transfers a portion of the risk of an exposure in one or more tranches to a protection seller or sellers and retains some level of risk, and the risk transferred and the risk retained are of different seniority, companies may obtain credit protection for the senior tranches (e.g. second-loss position) or the junior tranches (e.g. first-loss position). In this case, the rules as set out in Guideline B-5:Asset Securitization will apply.

Materiality thresholds on payments below which no payment is made in the event of loss are equivalent to retained first-loss positions, and must be deducted from Available Capital as a first loss position under section 2.1.4.

3.3.6. Currency mismatches

Where the credit protection is denominated in a currency different from that in which the exposure is denominated, the amount of the exposure deemed to be protected will be 80% of the nominal amount of the credit protection, converted at current exchange rates.

3.3.7. Maturity mismatches

A maturity mismatch occurs when the residual maturity of the credit protection is less than that of the underlying exposure. If there is a maturity mismatch and the credit protection has an original maturity lower than one year, the protection may not be recognized. As a result, the maturity of protection for exposures with original maturities less than one year must be matched to be recognized. Additionally, credit protection with a residual maturity of three months or less may not be recognized if there is a maturity mismatch. Credit protection will be partially recognized in other cases where there is a maturity mismatch.

The maturity of the underlying exposure and the maturity of the credit protection should both be measured conservatively. The effective maturity of the underlying should be gauged as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period. For the credit protection, embedded options that may reduce the term of the protection should be taken into account so that the shortest possible effective maturity is used. Where a call is at the discretion of the protection seller, the maturity will always be at the first call date. If the call is at the discretion of the company buying protection but the terms of the arrangement at origination contain a positive incentive for the company to call the transaction before contractual maturity, the remaining time to the first call date will be deemed to be the effective maturity. For example, where there is a step-up cost in conjunction with a call feature or where the effective cost of cover increases over time even if credit quality remains the same or improves, the effective maturity will be the remaining time to the first call.

When there is a maturity mismatch, the following adjustment will be applied:

Not yet defined

where:

Pa
is the value of the credit protection adjusted for maturity mismatch
P
is the nominal amount of the credit protection, adjusted for currency mismatch if applicable
T
is the lower of 5 or the residual maturity of the exposure expressed in years
t
is the lower of T or the residual maturity of the credit protection arrangement expressed in years

3.3.8. Sovereign counter-guarantees

Some claims may be covered by a guarantee that is indirectly counter-guaranteed by a sovereign. Such claims may be treated as covered by a sovereign guarantee provided that:

  • the sovereign providing the counter-guarantee is eligible for a 0% C-1 factor;
  • the sovereign counter-guarantee covers all credit risk elements of the claim;
  • both the original guarantee and the counter-guarantee meet all the operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original claim; and
  • the cover is robust, and there is no historical evidence suggesting that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee.

3.3.9. Public sector entities in competition

Companies may not recognize guarantees made by public sector entities, including provincial and territorial governments in Canada, that would disadvantage private sector competition. Companies should look to the host (sovereign) government to confirm whether a public sector entity is in competition with the private sector.

3.3.10. Other items related to the treatment of credit risk mitigation

In the case where a company has multiple types of mitigators covering a single exposure (e.g. both collateral and a guarantee partially cover an exposure), the company will be required to subdivide the exposure into portions covered by each type of mitigator (e.g. portion covered by collateral, portion covered by guarantee) and the capital charge for each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, these must be subdivided into separate protection as well.

There are cases where a company obtains credit protection for a basket of reference names and where the first default among the reference names triggers the credit protection and the credit event also terminates the contract. In this case, the company may recognize credit protection for the asset within the basket having the lowest capital charge, but only if the notional amount of the asset is less than or equal to the notional amount of the credit derivative. In the case where the second default among the assets within the basket triggers the credit protection, the company obtaining credit protection through such a product will only be able to recognize credit protection on the asset in the basket having the lowest capital charge if first-to-default protection has also been obtained, or if one of the assets within the basket has already defaulted.

3.4. Asset backed securities

The category of asset backed securities encompasses all securitizations, including collateralized mortgage obligations and mortgage backed securities. Companies are requested to closely review the documentation supporting these types of investments, paying particular attention to the investment's financial structure. For investments that arise as a result of asset securitization transactions, companies should refer to Guideline B-5: Asset Securitizationz Footnote 95 to determine whether there are functions provided (i.e., credit support, enhancement or liquidity facilities) that would require a deduction from Available Capital or a charge for C-1 risk and should ensure that there is an adequate reporting system for monitoring the creditworthiness of the borrower as required under IAS 39.

3.4.1. NHA mortgage-backed securities

NHA mortgage-backed securities that are guaranteed by the Canada Mortgage and Housing Corporation carry a factor of 0% to recognize the fact that obligations incurred by CMHC are legal obligations of the Government of Canada.

3.4.2. Rated asset backed securities

The credit risk factors applicable to asset backed securities that have been rated are contained in Annex 1 of Guideline B-5:Asset SecuritizationFootnote 94. In order for ratings of asset backed securities to be recognized, the ratings must meet all of the requirements in section 3.1.1.

3.4.3. Unrated asset backed securities

The asset default factor is 8% (4% for qualifying participating) for unrated asset backed securities unless they are of the pass-through type and effectively a direct holding of the underlying assets, and the following conditions are met:

  • the underlying asset pool may contain only assets that are fully performing when the asset-backed security is created;
  • the securities must absorb their pro rata share of any losses incurred;
  • a special-purpose vehicle should be established for securitization and administration of the pooled assets;
  • the underlying assets are assigned to an independent third party for the benefit of the investors in the securities who will then own the underlying assets;
  • the arrangements for the special-purpose vehicle and trustee must provide that these obligations are observed:
    • if an administrator or a servicer is employed to carry out administration functions, the vehicle and trustee must monitor the performance of the administrator or servicer;
    • the vehicle and/or trustee must provide detailed and regular information on structure and performance of the pooled assets;
    • the vehicle and trustee must be legally separate from the originator of the pooled assets;
    • the vehicle and trustee must be responsible for any damage or loss to investors created by their own or their servicer's mismanagement of the pooled assets;
    • the trustee must have a first priority charge on underlying assets on behalf of the holders of the securities;
    • the agreement must provide for the trustee to take clearly specified steps in cases when an asset goes into default;
    • the holder of the security must have a pro rata share in the underlying assets or the vehicle that issues the security must have only liabilities related to the issuing of the asset-backed security;
    • the cash flows of the underlying assets must meet the cash flow requirements of the security without undue reliance on any reinvestment income; and
    • the vehicle or trustee may invest cash flows pending distribution to investors only in short-term money market instruments (without any material reinvestment risk) or in new assets that meet the terms and conditions of the security.

Stripped mortgage-backed securities or different classes of securities (senior/junior debt, residual tranches) that bear more than their pro-rata share of losses will automatically receive an 8% factor (4% for qualifying participating).

Where the underlying pool of assets is comprised of assets having different capital charges, the charge for the security will be the highest charge associated with the pool of assets. Where the underlying pool contains assets that have become impaired, that portion of the instrument should be treated as a past due investment in accordance with section 3.1.14.

3.5. Repurchase, reverse repurchase and securities lending agreements

A securities repurchase (repo) is an agreement whereby a transferor agrees to sell securities at a specified price and repurchase the securities on a specified date and at a specified price. Since the transaction is regarded as a financing for accounting purposes, the securities remain on the balance sheet. Given that these securities are temporarily assigned to another party, the capital charge associated with this exposure should be the higher of:

  • the capital charge for the securities to be repurchased, or
  • the capital charge for an exposure to the counterparty to the transaction, recognizing any eligible collateral (see section 3.2).

A reverse repurchase agreement is the opposite of a repurchase agreement, and involves the purchase and subsequent resale of a security. Reverse repos are treated as collateralised loans, reflecting the economic reality of the transaction. The risk is therefore to be measured as an exposure to the counterparty. If the asset temporarily acquired is a security that qualifies as eligible collateral per section 3.2, the exposure amount may be reduced accordingly.

In securities lending, companies can act as a principal to the transaction by lending their own securities, or as an agent by lending securities on behalf of their clients. When a company lends its own securities, the capital charge is the higher of:

  • the capital charge for the instruments lent, or
  • the capital charge for an exposure to the borrower of the securities. The exposure to the borrower may be reduced if the company holds eligible collateral (refer to section 3.2). Where the company lends securities through an agent and receives an explicit guarantee of the return of the securities, the company may treat the agent as the borrower, subject to the conditions in section 3.3.

When a company, acting as agent, lends securities on behalf of a client and guarantees that the securities lent will be returned or the company will reimburse the client for the current market value, the company should calculate the capital requirement as if it were the principal to the transaction. The capital charge is that for an exposure to the borrower of the securities, where the exposure amount may be reduced if the company holds eligible collateral (see section 3.2).

The methodologies described above do not apply to repurchases or loans of securities backing a company's index-linked products, as defined in section 3.6. If a company enters into a repurchase or loan agreement involving such assets, the capital charge is equal to the charge for the exposure to the counterparty or borrower (taking account of eligible collateral), plus the charge applicable under section 3.6.

3.6. Index-linked products

3.6.1. Scope of application

The C-1 asset default factors in section 3.1 do not apply to assets backing index-linked products. All assets backing index-linked products must be segmented and included in the index-linked reporting form, and will attract capital factors based on the correlation factor calculation in section 3.6.2.

The correlation factor calculation may be used for products, such as universal life policies, having the following characteristics:

  • Both assets and liabilities for these contracts are held in the general fund of the life insurance company;
  • The policyholder is promised a particular return in the contract, based on an index, possibly subject to a floor. The following are examples of such returns:
    1. The same return as a specified public index. This includes, but is not limited to a public stock index, a bond index, an index maintained by a financial institution, etc.
    2. The same return as is earned by one of the company's segregated funds.
    3. The same return as is earned by one of the company's mutual funds.
    4. The same return as is earned by another company's mutual funds; and
  • The company may invest in assets that are not the same as those that constitute the indices.

The following conditions must be adhered to.

  • All supporting assets must be segmented into asset subgroups;
  • A separate asset subgroup must be maintained for each index referred to in the products;
  • The returns (on a market basis) of each asset subgroup must be tracked; and
  • Any transfers into or out of the asset subgroup must be at market.

3.6.2. Capital requirements

To determine the capital factor applicable to a particular subgroup of assets, a correlation factor (CF) must be calculated. This factor is given by:

CF = A*(B/C)

where: A represents the historical correlation between the returns credited to the policyholder funds and the returns on the subgroup's assets
B represents the minimum of [standard deviation of asset returns, standard deviation of returns credited to policyholder funds]
C represents the maximum of [standard deviation of asset returns, standard deviation of returns credited to policyholder funds]

Note that the CF must be calculated for each asset subgroup.

The historical correlations and standard deviations must be calculated on a weekly basis, covering the previous 52-week period. The returns on asset subgroups must be measured as the increase in their market values net of policyholder cash flows.

The CF for the previous 52 weeks is required to be calculated each quarter. The MCCSR required capital factor is then equal to 100% minus the lowest of the four correlation factors calculated over the previous four quarters. This required capital factor is applied to the market value at quarter-end of the assets in the asset subgroup.

Instead of using policyholder funds in the calculations, a company may use cash surrender values or policy liabilities to measure the correlation. The basis used must be consistently applied in all periods.

For assets backing index-linked products that are not segmented into asset subgroups, or for which the CF cannot be calculated, the MCCSR required capital factor is 15% (i.e. CF = 85%).

Newly formed funds will have a 15% MCCSR required capital factor (i.e. CF = 85%) for the first three quarters. Combined with the requirement to use the highest capital factor of the last four quarters' calculations, this implies that the MCCSR required capital factor will be 15% (i.e. CF = 85%) for the first 18 months of newly formed funds.

When a synthetic index investment strategy is used, there is some C-1 risk that is not borne directly by policyholders. This may include credit risk associated with fixed income securities and counterparty risk associated with derivatives that are purchased under the synthetic strategy. Companies must hold the C-1 capital requirements for these risks in addition to the index-linked requirements of this section.

For those index-linked insurance policies that have a minimum death benefit guarantee, the appropriate MCCSR factor for segregated fund mortality guarantees should be applied. These factors may be obtained using the GetCost function as described in section 8.7.1. The required amounts may be reduced by reinsurance credits and by any policyholder liabilities covering this risk.

3.7. Assets replicated synthetically and derivatives transactions

This section describes the capital charge for transactions that increase a company's exposure to C-1 risk and for which the full notional amount of the transaction may not be reported on the balance sheet, such as transactions undertaken through derivatives. Companies are required to report the entire exposure amount in the OSFI 86/87 and to hold capital for the full underlying risk assumed for these transactions irrespective of how they are reported on the balance sheet.

No additional capital is required under this section for hedges of index-linked liabilities that have been taken into account in the correlation factor calculation under section 3.6, nor for purchased put options that clearly serve to hedge a company's segregated fund guarantee risk. For hedges of segregated fund guarantees undertaken as part of an OSFI-approved hedging program, OSFI will determine at the time of approval the extent to which the hedges may be exempted from the requirements of this section.

Where a company has entered into transactions (including short equity positions) that:

  • are intended to hedge the company's segregated fund guarantee risk;
  • are not applied as offsets or hedges against other positions within the company to reduce required capital; and
  • have not been undertaken as part of an OSFI-approved hedging program,

the capital charge for the hedges may be reduced to a minimum of zero if the company is able to demonstrate that losses on the hedges under particular scenarios would be offset by decreases in its segregated fund guarantee liabilities. Companies should contact OSFI for details on the calculation for determining the capital requirement for hedges in this situation.

The requirements in this section are distinct from the requirements for counterparty credit risk arising from off-balance sheet transactions. Transactions referenced in this section remain subject to the charges for potential replacement cost as described in section 3.1 and chapter 7.

3.7.1. Credit protection provided

Where an insurer has guaranteed a debt security (for example through the sale of a credit derivative) it should hold the same amount of capital as if it held the security directly. Such exposures should be reported as off-balance sheet instruments in the OSFI 86/87.

Where an insurer provides credit protection on a securitisation tranche rated BBB- or higher via a first-to-default credit derivative on a basket of assets, the capital charge may be determined as the notional amount of the derivative times the C-1 factor corresponding to the tranche's rating, provided that this rating represents an assessment of the underlying tranche that does not take account of any credit protection provided by the insurer. If the underlying product does not have an external rating, the insurer may either deduct the full notional amount of the derivative from Available Capital as a first loss position, or it may calculate the capital charge as the notional amount times the sum of the C-1 factors for each asset in the basket. In the case of a second-to-default credit derivative, the insurer may exclude the asset in the basket having the lowest C-1 factor if using the summation approach.

3.7.2. Short positions in equities

The charge for a short position in any equity security or index that does not wholly or partially offset a long equity position elsewhere within the company is the same as that for a long position of the same magnitude. Positions eligible for offset recognition and the corresponding capital treatments are described in section 3.8.

3.7.3. Futures, forwards and swaps

The capital treatment for a futures or forward position in any security or index is the same as that for the equivalent spot position, and should be reported in the OSFI 86/87 as if the position were current. The charge for a swap is the same as that for the series of future or forward transactions that replicates the swap.

Example: A company has entered into a futures contract to purchase equity securities on a future date. The company should report an equity exposure in an amount equal to the total current market value of the equities underlying the futures contract.

Example: A company has entered into a one-year swap during which it will pay the total return (coupons and capital gains) on a 10-year Government bond, and receive the return on a notional index of equities that was worth $100M at the time of inception. The index of equities is currently worth $110M. The company should report an equity exposure of $110M for the long position in the index, but no exposure for the short position in the bond because such a position is not subject to a capital charge.

3.7.4. Options on equities

The following describes the methodology used to determine the capital charge for both equity options that have been purchased and options that have been sold. This methodology may not be applied to equity options embedded in products sold to policyholders. The market risk capital charge for policies containing an equity option component should be calculated using the methodologies for index-linked products (section 3.6) or segregated fund guarantees (chapter 8) as appropriate.

The capital charge for an option (or a combination of options in exactly the same underlying equity) is determined by constructing a two-dimensional matrix of changes in the value of the option position under various market scenarios, using the same valuation model that is used for financial reporting purposes. The first dimension of the matrix requires a company to evaluate the price of the option position over a range of 15% above and below the current value of the underlying stock or index, with at least seven observations (including the current observation) used to divide the range into equally spaced intervals. The second dimension of the matrix entails a change in the volatility of the underlying stock or index equal to ±25% of its current volatility. The capital charge for the option position is then equal to the largest decline in value (or 50% of this amount for options backing qualifying participating policies) calculated in the matrix. As an alternative to constructing a scenario matrix for a purchased option, a company may deduct 50% of the carrying amount of the option from its reported tier 1 capital available, and an additional 50% from tier 2.

The application of this method and the precise manner in which the analysis is undertaken will be subject to review by OSFI. Companies must understand the details of the valuation model used to construct the scenario matrix, and must independently review and test the model on an ongoing basis. Market prices, volatilities and other inputs to the valuation model must be subject to verification by a unit independent of the immediate parties to the transactions.

Example: A company has sold a call option on a stock, with the stock currently having a market value of $100 and volatility of 20%. The first dimension of the matrix should range from $85 to $115, divided into six intervals of $5.00 each, and the second dimension should assume that volatility stays at 20%, increases to 25% (= 20% + 25% of 20%) or decreases to 15% (=20% - 25% of 20%). If the change in the value of the company's option position under the various market scenarios is as below, then the capital charge for the option is $8.16 ($4.08 for qualifying participating).

Gain (loss) due to change in option value

Stock Price

$85.00

$90.00

$95.00

(current)

$100.00

$105.00

$110.00

$115.00

Volatility 15%

$3.71

$2.96

$2.22

$1.14

($0.61)

($2.12)

($5.60)

(current)
20%

$2.68

$1.84

$1.04

0

($1.72)

($4.47)

($6.69)

25%

$1.32

$0.70

($0.65)

($1.93)

($3.58)

($5.80)

($8.16)

3.7.5. Equity-linked notes

The balance sheet carrying amount of an equity- or index-linked note should be decomposed into the sum of a fixed-income amount, equivalent to the present value of the minimum guaranteed payments under the note, and an amount representing the value of the option embedded within the note. The fixed-income portion of the note should be classified as a debt exposure, with the capital charge based on the rating of the note, and the residual amount should be treated as an equity option.

Example: A company purchases an A-rated equity-linked note from a Canadian bank for $10,000. The note promises to pay, in two years, the $10,000 purchase price of the note plus the purchase price times 65.7% of the percentage appreciation (if positive) of a stock index over the term of the note. The company uses the Black-Scholes option valuation model for financial reporting purposes. The volatility of the stock index is 25%, the yield curve is flat, the annual risk-free rate is 5%, and the issuing bank's annual borrowing rate is 6.5%. The total charge for this note is $861.41, which is the sum of the following three separate charges:

  1. Bond component: The value of the fixed-income component of the note is $10,000/(1.065)2 = $8,816.59. The capital charge, based on the note's A rating, is 1% of this amount, or $88.17.
  2. Option component: The value of the call option embedded within the note, taking into account the credit risk of the issuer, is the residual amount, namely $1,183.41. In the option scenario table, the greatest loss will occur if the value of the index declines by 15% at the same time as the index volatility declines to 18.75%, in which case the value of the option will decline by $756.15; this is the capital charge for the option.
  3. Counterparty credit risk (per chapter 7): The exposure amount for the option is calculated under the current exposure method as:

    Positive mark-to-market + Factor x Notional
    = $1,183.41 + 8% x $6,570
    = $1,709.01

Since the note has an A rating, the capital charge is 1% of the current exposure amount, or $17.09.

3.7.6. Convertible bonds

The capital charge for a convertible bond is equal to the charge for the bond's fixed-income component, plus the equity option charge for the bond's embedded warrant. The charge for the fixed-income component is equal to the bond's C-1 factor (based on its rating) multiplied by the present value of the minimum guaranteed payments under the bond. The charge for the embedded warrant should be calculated using the scenario table method for options on equities, where the gains and losses are based on either the change in value of the bond's warrant component (if the valuation methodology assigns an explicit value to this component) or the change in value of the whole bond.

As an alternative to the above methodology, a company may classify the full carrying amount of the convertible bond as an equity exposure.

3.7.7. Other instruments

If a company has entered into a transaction not described in this section that increases its exposure to C-1 risk, it should contact the Capital Division at OSFI with the details of the transaction in order to determine the appropriate treatment for MCCSR purposes.

3.8. Recognition of equity hedges

3.8.1. Offsetting long and short positions in equities

Equity positions backing indexed-linked policyholder liabilities for which a required capital factor is calculated under section 3.6 may not be recognized as an offset to any other positions. However, 50% of any net equity position backing a company's participating business may be offset against positions that do not support the participating block. Offsetting hedges of an equity position may only be recognized if the party providing the hedge is an eligible guarantor as defined in section 3.3.4.

3.8.1.1. Identical reference assets

Long and short positions in exactly the same underlying equity security or index may be considered to be offsetting so that a company is required to hold capital only for the net position.

3.8.1.2. Closely correlated reference assets

Where the underlying securities or indices in a long and short position are not exactly the same but are closely correlated (e.g. a broad stock index and a large capitalization sub-index), companies should calculate the required capital factor for the combined position using the correlation factor methodology described in section 3.6.2. If a company has not held a short position over the entire period covered in the correlation factor calculation, but the security or index underlying the short position has quotations that have been published at least weekly for at least the past two years, the company may perform the calculation as if it had held the short position over the entire period. However, returns for actively managed short positions may not be inferred for periods in which the positions were not actually held, and mutual funds that are actively managed externally may not be recognized as an offsetting short position in an inexact hedging relationship.

3.8.2. Recognition of equity option hedges

Option hedges of an equity holding may only be recognized if the party providing the hedge is an eligible guarantor as defined in section 3.3.4. Option hedges of segregated fund guarantee risk may not be recognized in the segregated fund guarantee capital calculation without explicit approval from OSFI. The form and amount of any such recognition will be specified by OSFI at the time of approval. Option hedges of segregated fund guarantee risk that receive recognition in the segregated fund guarantee capital calculation cannot be applied towards other equity risks .

3.8.2.1. Identical reference assets

If an option's reference asset is exactly the same as that underlying an equity position held, a company may exclude the equity holding in calculating the charge for its equity exposures and instead consider the combined change in value of the equity position with the option in constructing the scenario table (reference section 3.7.4).

3.8.2.2. Closely correlated reference assets

If an option's reference asset is not exactly the same as that underlying an equity position, but is closely correlated with the equity, then the required capital factor for offsetting long and short positions in the option's reference asset and the asset underlying the equity position should be calculated as described in section 3.8.1.2. A company may then exclude the equity holding from its requirement for equity exposures and instead calculate the combined change in value of the equity position with the option in a scenario table (reference section 3.7.4). However, the movement in the option's reference asset under each scenario must be assumed to be higher or lower (whichever produces a lower value for the option position) than the movement of the equity, by an amount equal to the capital requirement for directly offsetting positions. No additional adjustments need be made to the assumed changes in asset volatilities under the scenarios to account for asset mismatch.

Example: A company has a long position in a main equity index, and also owns a call option and a put option on different indices that are closely correlated with the main index. The lowest correlation factor over the previous four quarters between the reference index of the call option and the main index, calculated per section 3.6.2, is 97%, and the lowest correlation factor calculated over the previous four quarters between the reference index of the put option and the main index is 99%. The company would therefore construct a scenario table in which the price of the main index ranged from 15% below to 15% above its current value, while the index underlying the call option ranged from 18% below to 12% above its current value, and the index underlying the put option ranged from 14% below to 16% above its current value. In the scenarios in the center column of the table, the main index would remain at its current value, while the index underlying the call option would be 3% lower than currently and the index underlying the put option would be 1% higher than currently.

Chapter 4. Mortality, Morbidity and Lapse Risk

4.1. Mortality risk

The methodology described below is based on the February 2005 CIA Researc