- Type of Publication: Guideline
- Category: Sound Business and Financial Practices
- Date: June 2000
- Revised: July 2010
- No: E-12
- Audiences: Life
This guideline establishes OSFI’s expectations for the operation
of inter-segment note (Note) programs by federally regulated life
insurance companies and fraternal benefit societies. OSFI believes
it essential for any Note program to incorporate the elements outlined
in this guideline.
The revised Guideline is effective for fiscal years beginning
on or after January 1, 2011.
OSFI recognizes the potential benefits of Notes; however, their
use may expose companies to increased levels of operational risk.
Given that notes are internal to a company, they do not have the
formal structure and market discipline of publicly traded bonds.
The integrity of the valuation of policy liabilities under the Canadian
Asset Liability Method (CALM) valuation methodology is highly dependent
on the asset and liability cash flows, including those from any
Notes. It is expected that if a Note program is used, it will be
formally incorporated into a company’s investment policy framework.
Rationale for the Use of Inter-Segment Notes
Life Insurance companies generally segment their assets in order
to match them with particular blocks of liabilities. This reflects
the need for asset/liability management, risk measurement, internal
management reporting, and the need to meet regulatory reporting
requirements and regulatory and professional standards that require
the use of the CALM.
However, there are circumstances under which combining some of
the asset or liability cash flows of two distinct blocks of business
could result in either:
- a better matching of cash flows in aggregate, resulting in
a reduction in interest mismatch risk under the CALM valuation
method that would be reflected in lower total policy liabilities,
- a source of immediate cash funding from one block of business
to another, using future product cash flows to repay the borrowing.
Notes are a means of reducing interest rate mismatch risk through
the sale of future asset or product cash flows of currently in-force
policies from one product segment to another product segment.
some of this management of interest rate mismatching could be done
using interest rate swaps with banks. However, this would result
in additional transaction costs and would introduce a counterparty
A segment is created when a block of assets is
separately earmarked and tracked, on a real or allocated basis,
to back a particular block of liabilities and/or surplus.
An asset or liability cash flow is any future
cash flow used in the valuation of policy liabilities under the
CALM valuation methodology. Such future cash flows could originate
from assets, loans, policy premiums, fees, expenses or payments
An Inter-Segment Note is created when one product
segment of a life insurance company buys/sells asset or liability
cash flows used in the valuation of policy liabilities under the
CALM valuation method from/to another product segment in the form
of a note promising specific future payments. Notes are internal
equivalents to bonds or loans entered into with external parties.
The selling product segment is the one that sells
a Note representing future cash flows to another product segment.
In return, it receives cash or other assets immediately.
The buying product segment is the one that buys
a Note and, in exchange, pays cash or other assets to the selling
The International Financial Reporting Standard (IFRS) for insurance
contracts, IFRS 4, includes definitions and guidance for classifying
contracts as insurance or non insurance contracts (i.e.
investment or service contracts). Companies should apply
this Guideline consistent with the contract classification determinations
made under IFRS 4.
Restrictions on Inter-Segment Loan Activities
The CALM valuation methodology, which is the Canadian Institute
of Actuaries’ standard for the valuation of insurance contract liabilities,
requires the use of asset and liability cash flows. If the valuation
of a product segment uses any cash flows from another product segment
that has a separate valuation, OSFI considers these cash flows to
be Notes and, therefore, subject to this Guideline.
The integrity of the valuation of insurance contract liabilities
under the CALM valuation methodology is highly dependent on the
asset and liability cash flows, including those from any Notes.
Given that notes are internal to a life insurance company, they
do not have the formal structure and market discipline inherent
to publicly traded bonds or loans. This can result in higher levels
of operational risk.
In order to address operational risk issues, a company is expected
to formally adopt a policy on Notes before implementing a Note program.
A Note policy would include the implementation of an appropriate
infrastructure of procedures and controls to properly administer
the Notes and to be compliant with the expectations outlined in
Where Notes are used, all future cash flows resulting
from the Notes should be recognized in the valuation of the insurance
contract liabilities by both the selling product segment and the
buying product segment.
OSFI expects that Notes will only be based on the future cash
flows related to existing in-force policies. They should not
include expected future cash flows related to future sales.
Notes are expected to be used only as an interest rate risk mitigation
tool or as a cash funding arrangement, and not for
speculative purposes. Further, Notes should not be
used for short-term cash flow management.
OSFI will review Note activity as part of its supervisory responsibilities
and through the Appointed Actuary's Report.
Structure, Documentation and Operational
Life insurance companies are expected to clearly document the
structure of a Note program and to clearly document the protocols
that will be used to manage the Notes. It is expected that a Note
program will be formally incorporated into the company’s investment
policy framework. The Note program is expected to be subject to
the same levels of controls as the company applies to external bond
It is expected that the documentation will:
- describe the intended purpose of the Notes and how they fit
into the company's overall asset/liability matching strategy;
- specify any limitations on the size, number, structure or term
of the Notes;
- describe the protocol and procedures for creating a Note, who
can initiate it, who must approve it, and who has oversight responsibilities.
Such procedures should be consistent with the framework governing
external bond assets; and,
- describe the rights and obligations of the buying and selling
product segments with respect to each Note, including the process
to follow should either the buying or selling segment need to
unwind a Note.
It is expected that Notes will be subject to the same level of
scrutiny by the company’s internal and external auditors as is followed
in auditing externally sourced bonds.
Limitations and Restrictions
OSFI expects that the following rules will apply to the use of
- Notes sold by a surplus segment to any product segment are
prohibited. This is to prevent the possibility of not recognizing
a mismatch risk with the surplus. However, Notes sold by a product
segment to surplus for immediate cash in exchange for future cash
flows is acceptable.
- Notes between general fund product segments and segregated
funds are prohibited. However, it is allowable to have Notes involving the general fund
insurance contract liabilities associated with segregated fund products.
- Notes to or from non-insurance contract (i.e. investment contract
or service contract) segments are prohibited. The liabilities
for these contract types are not valued using CALM, so there are
no requirements to recognize mismatch risks within the liabilities.
- Notes between product segments and holding companies, parent
companies, subsidiaries or affiliates of the insurer are prohibited,
except where permitted by other OSFI Guidelines or Regulations.
For example, refer to Guideline E-6 Materiality Criteria for
Related Party Transactions and Part XI of the Insurance
Companies Act for further details. Notes between foreign
subsidiaries are permitted to the extent that such Notes do not
cross national jurisdictions, that such subsidiaries are subject
to the rules of the same local regulator and where the use of
such Notes does not contravene local regulations.
- Notes between insurance segments that are domiciled in separate
national jurisdictions are prohibited. For example, Notes are
not permitted between a product segment backing Canadian liabilities
and a product segment in a U.S. branch. Similarly, Notes are not
permitted between two foreign branches of a Canadian company.
- If a product segment contains both assets backing the insurance
contract liabilities and assets that represent surplus or are
backing non-insurance contracts, all the cash flows, in their
entirety, represented by the Notes must be cash flows that are
used in the valuation of the insurance contract liabilities under
the CALM valuation method. This should be the case in both the
selling and the buying product segments.
- Notes are expected to be in the form of bonds; either periodic
coupon payment or zero- coupon. Similar to bonds, the Notes must
have a fixed maturity date. The maturity date may not be longer
than what is commonly and readily available externally in the
market place, but in any case, no longer than 30 years.
- The size of each Note is expected to be consistent with the
company’s investment policy on the size of external bonds purchased.
- The total value of the Notes bought by a product segment must
not exceed 25% of the total assets in the segment. Notes are to
represent a fine-tuning of the asset/liability matching, and not
a predominant asset category in its own right.
- For Canadian life insurance companies and fraternal benefit
societies, the aggregate of all Notes in effect at any time is
limited to 100% of the company’s consolidated total capital available,
as defined for the purpose of calculating the Minimum Continuing
Capital and Surplus Requirements (MCCSR).
- For Canadian branches of foreign life insurance companies and
foreign fraternal benefit societies, the aggregate of all Notes
in effect at any time is limited to 20% of net assets available,
as defined for the purposes of calculating the Test of Adequacy
of Assets in Canada and Margin Requirements (TAAM).
Pricing of Inter-Segment Notes
Notes should be used to improve asset/liability matching by sharing
cash flows between product segments or to provide a cash funding
mechanism between product segments. Notes should not be used as
a way for one segment to subsidize another through transfer pricing
arrangements. Each product segment should be self-supporting and
the Note should not put either segment at a disadvantage.
Notes should be fairly priced at currently prevailing market rates,
with the price being fair to both the buying and selling segment
to avoid any transfer pricing concerns.
The conditions and the pricing of the Notes should be consistent
with the investment policy of the buying segment.
Since Notes cannot default, the best estimate expected default
assumption used in the actuarial valuation should be deducted to
give a default-free pricing rate for a Note. Appropriate asset default
assumptions are needed in the product segment that uses proceeds
from selling a Note to invest in external assets.
The selling product segment is expected to invest the cash or
other assets received from the sale of the Notes in accordance with
its own investment policy.
It is expected that any Note program will include a requirement
to inform the Appointed Actuary in advance of any new Note being
initiated. This notice is expected to include the terms of the new
Note. The Appointed Actuary, and at least one of the Chief Financial
Officer or the Chief Risk Officer, are expected to give approval
in writing before the Note is implemented.
Although no specific guidance is given here on how to determine
the price, the Note program documentation is expected to detail
the pricing methodology that will be consistently applied to all
the company’s Notes.
Unwinding of Inter-Segment Notes
Since circumstances change over time, it may be necessary, or
advisable, to unwind an existing Note. The circumstances under which
a Note can be unwound should be documented in the protocols that
govern the Note program.
Any unwinding of Notes is expected to be done based on the then
current market values of the notes.
It is expected that any Note program will include a requirement
to notify the Appointed Actuary, and at least one of the Chief Financial
Officer or the Chief Risk Officer, in advance of any unwinding of
an existing Note and that this notice must include the terms of
the unwinding. The Appointed Actuary, and at least one of the Chief
Financial Officer or the Chief Risk Officer, are expected to give
approval in writing before the Note is terminated.
Oversight, Record Keeping and Reporting
It is expected that Notes will be tracked and reported separately
in each asset segment. The buying product segment should show them
as positive assets and the selling product segment should show them
as negative assets. The accounting function in the company should
ensure that all Notes are netted and eliminated when preparing the
financial statements of the company.
Ongoing management of Notes and their reporting to appropriate
levels of management is expected to be at least as rigorous and
frequent as the reporting for other asset classes.
The accounting of Notes should include the calculation and reporting
of accrued interest to the same standards as is used for external
A current inventory of all Notes should be maintained at all times
and be available to the appropriate investment managers, external
auditors, the Appointed Actuary, the Chief Financial Officer, the
Chief Risk Officer and OSFI. This should include the segments involved,
the structure of the notes, the maturity values, maturity dates,
issue prices (and yield rates), issue dates, current values (and
yield rates), and current date.
For actuarial valuation purposes, the Notes are assets of the
buying product segment and negative assets of the selling product
The appropriate cash flows from the Notes should be fully included
in the CALM cash flow assumptions of both the buying product segment
and the selling product segment.
The company is therefore expected to maintain a CALM valuation
system that incorporates all the cash flows from all Notes. This
system should be sensitive to the impact of interest-rate changes,
death, and lapse on the cash flows.
Given that Notes are default-free to the buyer, this feature should
be reflected in the CALM valuation of the insurance contract liabilities
of the buying product segment.
Since the Notes are internal transactions of the company, there
is no direct impact on MCCSR or TAAM.
Where Notes affect any participating accounts, the Appointed Actuary
is expected to opine that the fair treatment of participating policyholders
The stress testing and scenario testing performed during the DCAT
process should consider the impact of adverse experience on cash
flows supporting the Notes in a manner consistent with the testing
of the sensitivities of other cash flows.
As part of the data verification process, the Appointed Actuary
should ensure that the cash flows of each Note are correct, that
each is accounted for and included in the valuation, and that each
is counted only once.
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