Office of the Superintendent of Financial Institutions
OSFI is releasing a revised Minimum Capital Test (MCT) Guideline for federally regulated property and casualty (P&C) insurers. The MCT 2019 guideline incorporates changes to reflect OSFI’s review of the framework for reinsurance, International Financial Reporting Standard (IFRS) 16, and the amendments to Guideline B-5 – Asset Securitization.
We would like to thank the stakeholders who provided comments during the public consultation period in June-August 2018. OSFI appreciates the collaboration, time and support of everyone in helping to refine the regulatory capital framework. Appendix A summarizes comments received and includes OSFI responses.
Key changes to the MCT guideline, compared to the June 2018 draft version, include:
Please address any comments or enquiries regarding the MCT to Judith Roberge, Director, Property and Casualty Insurance Capital, at 613-990-4412 or firstname.lastname@example.org
Summary of Comments and OSFI Responses
Draft Minimum Capital Test 2019 Guideline
Consultation period ended August 16, 2018
1. General Comments
OSFI should review all reinsurance changes proposed in the discussion paper together to assess impacts and implement any changes in the MCT effective for 2020 rather than 2019.
As part of its review of the reinsurance framework, OSFI identified measures that address concerns related to specific reinsurance practices. OSFI plans to implement changes in three phases. The changes to the MCT guideline fall under the first and the third phases of implementation. The first phase will be effective in 2019 and 2020. We will consider third phase changes for future updates to the MCT.
Risk charge of 10% on owner-occupied premises
Option to extend the lease
Including the option to extend the property lease in the calculation of the risk charge is not a reasonable approach from a risk and capital management perspective because an option to extend (or terminate) a lease is not a legal commitment and it does not represent an obligation on the part of the company, financial or otherwise.
The accounting standard states that the lessee must be reasonably certain to exercise the option to extend the property lease to include it in the carrying value of the right-of-use asset. It is our understanding that once the lessee has determined that renewing the lease is economically and financially better than terminating the lease and it becomes “reasonably certain” that it will exercise the option to renew, only then must the insurer reflect that term of the lease in the right-of-use asset. It is our opinion that the value of the lease term included in the right-of-use asset is equally relevant for capital purposes.
3. Credit Risk
OSFI intends to publish an updated B-5 guideline “Asset Securitization” at a later date in 2018. It would have been useful to publish a draft concurrent with the draft MCT to review for consistency and therefore provide comments that may be applicable to both.
OSFI released the Draft Guideline B-5 Asset Securitization for public consultation on September 14th, 2018.
As part of the amendments, we updated the capital requirements, i.e. transferred the credit risk factors for securitized assets from Guideline B-5 to the MCT 2019 guideline. The remaining amendments were to update the general expectations with respect to asset securitization transactions, which reflect events that have occurred since the last update in 2004
External Credit Rating
Unsolicited credit ratings are of equal quality to solicited credit ratings. To the extent OSFI continues to use external credit ratings for regulatory purposes, including in the MCT Guideline, the use of unsolicited ratings should not be restricted.
OSFI conducted a review of the treatment of unsolicited ratings in 2013. This review led to changes permitting a limited use of unsolicited ratings for sovereign exposures when a solicited rating is not available. OSFI believes this position remains appropriate.
4. Insurance Risk
The restriction is acceptable. However, we suggest revising the condition to allow for return of excess funds withheld other than those funds that are in excess of the amount required for the ceding insurer to obtain credit for reinsurance in accordance with the terms of the arrangement, which is industry practice.
OSFI has revised the condition to allow the payment of funds withheld that are in excess of the ceded policy liabilities and margin required.
Counterparty Credit Risk
Unregistered Reinsurance Margin Required
OSFI should provide the rationale for the increase of the margin required from 15% to 20%. Further increases to collateral requirements will affect reinsurance capacity and increase costs. It also affects global programs. If OSFI proceeds with the change, the change should be applied prospectively as contracts for existing reinsurance arrangements were negotiated with a 15% collateral requirement.
As detailed in the Discussion Paper on OSFI’s Reinsurance Framework, OSFI does not regulate unregistered reinsurers; these are not subject to the same legislative requirements, supervision or capital requirements as federally regulated insurers. Given that regulated insurers operate at a higher target capital ratio than the current 150% margin required for cessions to unregistered reinsurers, we increased the margin required to better align with the capital levels maintained by federally regulated insurers.
To determine the 20% rate of the margin required, OSFI reviewed the operating capital ratios and internal capital targets of insurers over a number of periods and applied supervisory judgement. OSFI finds that the revised margin requirement better aligns the collateral needed to support insurance risk with the capital requirements of regulated insurers.
The margin-required increase is subject to a transition period.
30% Limit on the Use of Letters of Credit as Collateral for Unregistered Reinsurance
The MCT limits the use of LOCs to obtain capital credit for unregistered reinsurance to 30% of ceded liabilities. OSFI has indicated that the limit is based, in part, on legal advice provided to OSFI concerning the security of LOCs. However, some Canadian insurers have received legal advice to the contrary. In addition, regulators in many jurisdictions do not impose a limit on the use of LOCs.
Additional actions are required to convert an LOC to liquid assets available to pay claims. OSFI reviewed the limit in the past and, based on the information presented at the time, decided to maintain the 30% limit. Comments provided did not include any new or compelling information: OSFI does not intend to review this matter further.
Unregistered Reinsurance Margin Calculation
If insurers hold excess collateral, they could be penalized with a capital charge in the MCT calculation depending on the type of collateral held as excess collateral. OSFI should require insurers to use assets that attract the lowest capital charge up to the margin requirements and any excess collateral would be excluded from the calculation.
An alternative approach is to calculate the margin requirements using the credit rating of the reinsurer similar to the methodology used for credit risk charges for investments. A sliding scale could be implemented with 120% applied to the lowest credit rating of a reinsurer.
OSFI will review the proposals for a future update of the MCT guideline.
OSFI should reconsider two of the requirements governing foreign insurers’ ability to include amounts due from federally regulated insurers and reinsurers in net assets available. The two requirements of an executed, written, bilateral netting contract or agreement and written and reasoned legal opinions are unnecessary and burdensome.
Foreign insurers cannot vest amounts due from federally regulated insurers. Therefore, OSFI believes that both the netting agreement and the legal opinions are necessary to provide contractual and legal certainty to minimize disputes over how the amounts owed or due are determined in, for example, a period when the insurer is under stress or in liquidation.