Mortgage Insurer Capital Adequacy Test - Guideline (2023)

where T* represents the remaining amortization for the mortgage loan as of the reporting date and is measured in years^{Footnote 28}.

Otherwise,

2. Formula for B

$B=\left\{C_1\times \exp \left({\displaystyle \frac{-{\left({\displaystyle \frac{1}{\mathit{LTV}}}-{\mu }_1\right)}^2}{2\times {{\sigma }_1}^2}}\right)+C_2\times \exp \left({\displaystyle \frac{-{\left({\displaystyle \frac{1}{\mathit{LTV}}}-{\mu }_2\right)}^2}{2\times {{\sigma }_2}^2}}\right)\right\}$

where LTV represents the loan-to-value ratio for the mortgage loan as defined in subsection 3.1.1.5 and in this case, μ₁ , μ₂ , σ₁ , σ₂ , C₁ , C₂ are defined as follows:

If the remaining term of insurance for the mortgage loan as of the reporting date is five years or less then

where T* represents remaining amortization for the mortgage loan as of the reporting date and is measured in years.

Otherwise,

3.1.1.3. Supplementary capital requirement for an individual mortgage loan

If a mortgage loan originated after December 31, 2016 corresponds to a property that is located in one of the 11 metropolitan areas listed in Appendix 3-A and if the value of the supplementary capital requirement indicator (SCRI) for this metropolitan area is greater than the threshold value for this metropolitan area then a supplementary capital requirement must be determined for this mortgage loan and added to the base total requirement for this mortgage loan to determine the total amount for this loan.

The calculation of the SCRI is described in Appendix 3-A.

If a supplementary capital requirement must be determined for a particular mortgage loan, it is calculated using the following formula:

$S=r\times T_B$

where T_B is as defined in subsection 3.1.1.2 and where the quantity r is defined as follows.

$r=a+b\times \exp (-0.1\times T^{*})$

where a and b are defined as follows:

If the remaining term of insurance for the mortgage loan as of the reporting date is five years or less then

$a=\min \left\{c+0.1\times \left({\displaystyle \frac{1}{\mathit{LTV}}}-1\right),1.15\right\},$

$b=\left\{\begin{array}{cc}0.3& \mathrm{for}{T}^{*}\le 10\\ 0& \mathrm{for}{T}^{*}>10\end{array}\right.$

$c=\left\{\begin{array}{cc}0.08& \mathrm{for}{T}^{*}\le 10\\ -0.013\times T^{*}+0.32& \mathrm{for}10<T^{*}\le 13\\ 0.19& \mathrm{for}{T}^{*}>13\end{array}\right.$

where:

• LTV represents the loan-to-value ratio for the mortgage loan as defined in subsection 3.1.1.5, and
• T* represents remaining amortization as of the reporting date and is measured in years.

Otherwise,

$a=\min \left\{0.08+0.1\times \left({\displaystyle \frac{1}{\mathit{LTV}}}-1\right),1.15\right\},$

$b=0.3$

Note that for a given mortgage loan, LTV and T^* have the same values as in the calculation of the base total requirement in subsection 3.1.1.2.

3.1.1.4. Adjustment factor for credit quality of an individual mortgage loan

The adjustment factor for credit quality, m, used in the formulas for α_B and β_B to determine the base total requirement for an individual mortgage loan depends on the credit score(s) of the borrower(s) associated with the mortgage loan as of origination.

The credit score used to determine the value of m for a particular mortgage loan should come from a reputable credit bureau and should also be used as part of the insurer’s business and risk management processes. It should not be acquired for the sole purpose of determining regulatory capital requirements.

In cases where an insurer obtains credit scores from more than one credit bureau, the insurer should select the bureau whose scores the insurer primarily uses in the management of its business, and use the scores of this credit bureau consistently for all mortgage loans and from one reporting period to the next. The only exception is if there is no credit score available for a particular mortgage loan from the credit bureau whose scores the insurer primarily uses to manage its business; in this situation, the insurer may use the credit score from another reputable credit bureau until such time that a credit score becomes available from the bureau whose scores the insurer primarily uses.

For mortgage loans with more than one borrower, the credit score used to determine the value of m is the maximum of the credit scores of the individual borrowers. In cases where the credit scores of the individual borrowers are from different credit bureaus, the maximum is calculated using only the credit scores from the bureau whose scores the insurer primarily uses to manage its business. In cases where none of the credit scores of the individual borrowers is from the credit bureau whose scores the insurer primarily uses to manage its business, the maximum is calculated using the available scores.

The value assigned to the adjustment factor for credit quality, m, of a mortgage loan with no credit score is 1.3 unless more than 5% of an insurer’s mortgage loans considered residential exposures have no credit score, in which case the value assigned to the adjustment factor for credit quality, m, of a mortgage loan with no credit score is 3.0.

3.1.1.5. Loan-to-value ratio for an individual mortgage loan

This subsection describes the calculation of the LTV input for the formulas given in subsections 3.1.1.2 and 3.1.1.3. Note that if the value of LTV determined in this subsection is greater than 100% then an LTV input of 100% should be used in the formulas in subsections 3.1.1.2 and 3.1.1.3.

The value of the LTV input for the formulas in subsections 3.1.1.2 and 3.1.1.3 depends on the origination date of the mortgage, and whether it is a First-Time Home Buyer Incentive (FTHBI) mortgage or not.

i) Mortgages originated after December 31, 2015 that are not FTHBI mortgages

For mortgages originated after December 31, 2015, the LTV input is calculated by dividing the outstanding loan balance on the reporting date by the property value on the origination date or the date of the most recent appraisal, provided that the appraisal was commissioned by an independent third party entity other than an insurer.

ii) FTHBI Mortgages

For FTHBI mortgages, the reciprocal of the LTV input is determined by taking a weighted average of the following two quantities:

1. the reciprocal of loan-to-value if the mortgage were not a FTBHI mortgage, and
2. the reciprocal of loan-to-value calculated using:
   • for the loan amount, the sum of the outstanding loan balance as of the reporting date and the shared equity amount,
   • for the property value, the value as of the origination date or the date of the most recent appraisal, if the appraisal was commissioned by an independent third party entity other than an insurer, and
   • the shared equity amount as of the origination date, unless the property value is updated to the most recent appraisal, in which case the shared equity amount should be updated as well.

The reciprocal of the LTV input for FTHBI mortgages is represented formulaically below:

${\displaystyle \frac{1}{\mathit{LTV}}}=w\times {\displaystyle \frac{1}{{\mathit{LTV}}^{\mathit{SE}}}}+(1-w)\times {\displaystyle \frac{1}{{\mathit{LTV}}^M}}$

Where

${\mathit{LTV}}^{\mathit{SE}}={\displaystyle \frac{\mathit{outstanding\; loan\; balance}+\mathit{shared\; equity\; amount}}{\mathit{property\; value}}}$

and

${\mathit{LTV}}^M={\displaystyle \frac{\mathit{outstanding\; loan\; balance}}{\mathit{property\; value}}}$

and

$w=\max \left[35\%,\min (95\%,200\%\times {\displaystyle \frac{1}{{\mathit{LTV}}^M}}-205\%)\right]$

iii) Mortgages originated after December 31, 2004 but on or before December 31, 2015

For mortgages originated after December 31, 2004 but on or before December 31, 2015, the LTV input is calculated by dividing the outstanding loan balance on the reporting date by the property value that is determined as follows.

1. If the property is located in one of the 11 Census Metropolitan Areas specified in Appendix 3-A and defined by Statistics Canada then the property value used to calculate the LTV input is

   $\mathit{Property\; Value\; at\; Origination}\times {\displaystyle \frac{\mathit{Teranet\; index\; value\; as\; of\; December\; 2015}}{\mathit{Teranet\; index\; value\; as\; of\; origination\; month\; and\; year}}}$

   where “Teranet index value” refers to the value of the Teranet-National Bank House Price Index for the particular metropolitan area as of the end of the indicated month. If the property is located in one of these metropolitan areas but the mortgage was originated in December 2015 or later then the property value used to calculate the LTV input is the property value on the origination date.

2. If the property is not located in one of these metropolitan areas then the property value used to calculate the LTV input is

   $\mathit{Property\; Value\; at\; Origination}\times {\displaystyle \frac{\mathit{Teranet\; composite\; index\; value\; as\; of\; December\; 2015}}{\mathit{Teranet\; composite\; index\; value\; as\; of\; origination\; month\; and\; year}}}$

   where “Teranet composite index value” refers to the value of the Teranet-National Bank National Composite House Price Index as of the end of the indicated month.

iv) Mortgages originated prior to 2005

For mortgages originated prior to 2005, the LTV input is calculated by dividing the outstanding loan balance on the reporting date by the property value that is determined as follows.

1. If the property is located in one of the 11 Census Metropolitan Areas specified in Appendix 3-A and defined by Statistics Canada then the property value used to calculate the LTV input is

   $\mathit{Property\; Value\; at\; Origination}\times {\displaystyle \frac{\mathit{Teranet\; index\; value\; as\; of\; December\; 2015}}{\mathit{Teranet\; index\; value\; as\; of\; December\; 2004}}}$

   where “Teranet index value” refers to the value of the Teranet-National Bank House Price Index for the particular metropolitan area as of the end of the indicated month.

2. If the property is not located in one of these metropolitan areas then the property value used to calculate the LTV input is

   $\mathit{Property\; Value\; at\; Origination}\times {\displaystyle \frac{\mathit{Teranet\; composite\; index\; value\; as\; of\; December\; 2015}}{\mathit{Teranet\; composite\; index\; value\; as\; of\; December\; 2004}}}$

   where “Teranet composite index value” refers to the value of the Teranet-National Bank National Composite House Price Index as of the end of the indicated month.

3.1.2. Capital required for liabilities for incurred claims

Liabilities for incurred claims are the liabilities that an insurer holds to cover losses that have already occurred and for which settlement is not yet complete. This includes mortgage loans that are currently delinquent or in arrears. The capital required for liabilities for incurred claims associated with residential exposures is calculated by multiplying the liabilities for incurred claims associated with residential exposures by 20%.

3.1.3. Capital required for the loss components of liabilities for remaining coverage

The capital required for loss components of liabilities for remaining coverage associated with residential exposures is calculated by multiplying the loss component amounts associated with residential exposures by 40%.

3.2 Commercial exposures

3.2.1. Capital required for liabilities for remaining coverage

The capital required for liabilities for remaining coverage associated with commercial exposures is the sum of the capital requirements for individual commercial exposures, where the sum is calculated over all commercial mortgage loans that were expected to be in-force on the reporting date based on the mortgage’s amortization schedule at the time of mortgage origination. Unlike the situation for residential exposures, an amount must be calculated and held for all commercial mortgages that were expected to be in-force on the reporting date based on the mortgage’s original amortization schedule, regardless of whether the mortgage is still in-force on the reporting date.

The capital required for an individual mortgage loan is determined by the formula

$F_1\times F_2\times F_3\times A$

where:

• F₁ is a factor that depends on the age of the loan and is defined in subsection 3.2.1.1,
• F₂ is a factor that depends on whether the mortgage’s loan-to-value ratio at origination is greater or less than 80% and whether the underlying mortgage is a first or second mortgage and is defined in subsection 3.2.1.2,
• F₃ is a factor that depends on the settlement option stated in the master policy and the mortgage’s loan-to-value ratio at origination and is defined in subsection 3.2.1.3, and
• A is the mortgage balance, including any mortgage insurance premium amounts added to the balance, as of origination, measured in units of $100.^{Footnote 29}

3.2.1.1. Calculation of F₁

The value of F₁ for an individual mortgage loan depends on the number of years that have elapsed since the mortgage loan was issued and is defined by the following table.

The values for fractional ages can be determined by interpolation.

3.2.1.2. Calculation of F₂

The value of F₂ for an individual mortgage loan depends on whether the mortgage’s loan-to-value ratio at origination is greater or less than 80% and whether the underlying mortgage is a first or second mortgage, and is defined by the following table.

3.2.1.3. Calculation of F₃

The value of F₃ for an individual mortgage loan depends on the settlement option stated in the master policy and the mortgage’s loan-to-value ratio at origination.

If the maximum amount payable on an individual mortgage loan after all recoveries is 100% or more of the mortgage balance at origination, then the value of F₃ is as defined in the following table.

If the maximum amount payable on an individual mortgage loan after all recoveries is less than 100% of the mortgage balance at origination, then the value of F₃ is as defined in the following table.

If the amount payable on an individual mortgage loan is a fixed percentage of the lender’s loss net of recoveries, then the value of F₃ is determined by multiplying this fixed percentage by the value of F₃ in the case where the maximum amount payable is 100% of the mortgage balance at origination. For example, if the master policy provides coverage for 50% of the lender’s loss net of recoveries, and the loan-to-value ratio at origination is 85%, then the value of F₃ would be 55% (= 50% × 110%).

3.2.2. Capital required for liabilities for incurred claims

The capital required for liabilities for incurred claims associated with commercial exposures is calculated by multiplying the liabilities for incurred claims associated with commercial exposures by 20%.

3.2.3. Capital required for the loss components of liabilities for remaining coverage

The capital required for the loss components of liabilities for remaining coverage associated with commercial exposures is calculated by multiplying the loss component amounts associated with commercial exposures by 40%.

3.3 Additional policy provisions

This section describes the calculation of the additional policy provision for residential and commercial exposures.

An additional policy provision must be determined for every mortgage that was expected to be in-force on the reporting date based on the mortgage’s original amortization schedule, regardless of whether the mortgage is still in-force on the reporting date.

When calculating the capital required at the supervisory target, the total of the additional policy provisions for residential mortgages is to be deducted from the capital required for liabilities for remaining coverage that is determined in section 3.1.1 and then added to the capital required for catastrophes. The total of the additional policy provisions for commercial exposures is to be multiplied by 1.25 and simply added to the capital required for catastrophes.

Appendix 3-A. Determining supplementary capital requirement indicators

This appendix describes how insurers are to calculate the supplementary capital requirement indicators (SCRIs) for the purpose of determining whether a supplementary capital requirement is applied to a given residential mortgage loan.

The data sources necessary to calculate the SCRIs are outlined in Section 1 of this appendix. The Teranet – National Bank National Composite House Price Index (“Teranet index”) is used to measure house prices and Statistics Canada household disposable income and population data are used to measure per capita income.

An SCRI is to be determined for 11 metropolitan areas in the Teranet index. For each metropolitan area, an SCRI is calculated on a quarterly basis and is determined as follows:

${\displaystyle \frac{H}{I}}\times s$

where:

• H is the smoothed value of the Teranet index for a metropolitan area as determined in Section 2;
• I is the per capita income value as determined in Section 3; and
• s is the scaling factor for the particular metropolitan area as indicated in Section 4.

The SCRI for a metropolitan area is compared to a threshold value for that particular area as defined in Section 5. If the SCRI exceeds the threshold value for that metropolitan area, then supplementary capital requirements will apply at the beginning of an insurer’s next quarterly fiscal reporting period, according to the schedule presented in Section 6, for the life of the loan for newly originated mortgages in that metropolitan area^{Footnote 30}.

An example illustrating how to calculate SCRIs is provided in Section 7.

1. Data sources

Insurers need to access the following data sources to calculate the SCRIs:

1. Teranet index data source: Teranet index, monthly (June 2005 = 100, Monthly to present)
2. Per capita income data sources:
   1. Statistics Canada Current and Capital Accounts – Households, quarterly – table 36-10-0112-01 (formerly CANSIM table 380-0072)
   2. Statistics Canada Labour force characteristics monthly, seasonally adjusted and trend cycle – table 14-10-0287-01 (formerly CANSIM table 282-0087)

The SCRIs are to be determined using as of dates of March 31, June 30, September 30 and December 31. As the income data in table 36-10-0112-01 is the last item to be released, approximately two months after the calendar quarter ends, its release date determines when the SCRIs can be calculated.

2. Metropolitan area house price indices

The Teranet index values are available on a monthly basis for the following 11 metropolitan areas: Calgary, Edmonton, Halifax, Hamilton, Montréal, Ottawa-Gatineau, Québec, Toronto, Vancouver, Victoria, and Winnipeg.

The Teranet indices for the metropolitan areas as published are not seasonally adjusted. Given the seasonal nature of the housing market, the indices need to be smoothed to ensure the stability of the SCRIs. Without smoothing, there is a risk that an index could exhibit short-term fluctuations above and below its threshold, which would not be a desirable outcome. Therefore, a simplified approach is used to determine the smoothed Teranet indices for use in the SCRIs; an average of the last 12 months of each Teranet Index’s monthly metropolitan area values must be calculated.

3. Calculation of per capita income

The per capita income for use in the SCRI is determined as:

$\mathrm{Per\; capita\; income}={\displaystyle \frac{\mathrm{1,000}\times \mathrm{Household\; disposable\; income}}{\mathrm{Population}}}$

where:

1. The “Household disposable income” is a quarterly data series from the table 36-10-0112-01. The data characteristics for this table necessary to calculate the per capita income are:
   • Estimates = Household disposable income (× 1,000,000)
   • Geography = Canada
   • Seasonal adjustment = Seasonally adjusted at annual rates
2. The “Population” is a monthly data series and is part of the table 14-10-0287-01. The data characteristics for this table necessary to calculate the per capita income are:
   • Labour force characteristics = Population (× 1,000)
   • Geography = Canada
   • Sex = Both sexes
   • Age group = 15 years and over
   • Data type = Seasonally adjusted

To determine the “Per capita income” on a quarterly basis, the “Population” data series must be converted from a monthly basis to a quarterly basis by calculating a three month average of the data series.

4. Calculation of metropolitan area SCRIs

The quarterly SCRI before scaling for each metropolitan area is determined as:

$\mathrm{SCRI\; before\; scaling}={\displaystyle \frac{\mathrm{Smoothed\; quarter-end\; Teranet\; house\; price\; index\; for\; a\; metropolitan\; area}}{\mathrm{Per\; capita\; income}}}$

The SCRI for a metropolitan area needs to be scaled before being compared to the threshold values to determine whether the mortgages originated in that area are subject to a supplementary capital requirement. The SCRIs are determined by multiplying the ratio of the smoothed Teranet index for a metropolitan area over the per capita income by the scaling factors in the following table.

5. Threshold values

Each metropolitan area has its own threshold value that has been determined by OSFI using an algorithm that ensured consistency across metropolitan areas. Threshold values will remain stable over time, but are subject to periodic review.

The following table shows the threshold values for each metropolitan area used to determine whether a newly originated mortgage in a given area is subject to a supplementary capital requirement. For each metropolitan area, if the calculated SCRI has breached its threshold value, then effective the beginning of the next quarterly fiscal reporting period, any mortgage loan originated in that area is subject to the supplementary capital requirement for the life of the loan.

Exposures in those areas remain subject to the supplementary capital requirements until the SCRI for a metropolitan area falls below the threshold value. In this case, the supplementary capital requirement would no longer be required for mortgage loans originated in the next quarterly fiscal reporting period.

6. Timing of the calculation

The following table provides a summary of the timing for performing the SCRI calculation and determining when the supplementary capital requirement applies.

7. Example

This example illustrates how to calculate the SCRIs for Q4 2015 for the 11 metropolitan areas in the Teranet index.

Step 1: Calculation of metropolitan area smoothed Teranet indices

The following table provides the monthly Teranet values for the 11 metropolitan areas for 2015 as well as the December 2015 smoothed values (determined as the 12-month average of the January through December 2015 values).

Step 2: Calculation of per capita income

Given the following values for the data series “Household disposable income” (table 36-10-0112-01) and “Population” data series (table 14-10-0287-01), the per capita income for Q4 2015 is determined as follows. The average population has to be rounded to the first decimal.

Then the per capita income for Q4 2015 is:

${\displaystyle \frac{\mathrm{1,000}\times \mathrm{1,131,400}}{\mathrm{29,399.2}}}=\mathrm{38,484.0}$

The per capita income value has to be rounded to the first decimal.

Step 3: Calculation of metropolitan area SCRIs

Using the December 2015 smoothed Teranet values for the 11 metropolitan areas and the per capita income for Q4 2015, the SCRIs before and after scaling as at Q4 2015 are included in the table below. The SCRI before scaling has to be rounded to the fifth decimal, while the final SCRI has to be rounded to the second decimal.

Where for example the Calgary Q4 2015 SCRI before scaling $\left({\displaystyle \frac{H}{I}}\right)$ is determined as:

${\displaystyle \frac{183.87}{\mathrm{38,484.0}}}=0.00478$

And the SCRI would be calculated as:

$0.00478\times \mathrm{2,500}=11.95$

As the threshold value is set at 10.0 for Calgary, had this Guideline been in effect in Q2-2016, the supplementary capital requirements would therefore have applied for the life of a mortgage loan originated in the Calgary metropolitan area during that reporting quarter.

Chapter 4. Credit Risk

In the context of this guideline, credit risk refers to any default risk as defined in this chapter other than the borrower default risk associated with mortgage insurance which is covered in chapter 3, Insurance Risk.

Credit risk is the risk of loss arising from a counterparty's potential inability or unwillingness to fully meet its contractual obligations due to an insurer. Exposure to this risk occurs any time funds are extended, committed, or invested through actual or implied contractual agreements. Components of credit risk include loan loss/principal risk, pre-settlement/replacement risk and settlement risk. Counterparties include issuers, debtors, borrowers, brokers, policyholders, and guarantors.

All on- and off-balance sheet exposures are subject to a specific risk factor that either: 1) corresponds to the external credit rating of the counterparty or issuer or 2) represents a prescribed factor determined by OSFI. To determine the capital requirements for balance sheet assets, factors are applied to the balance sheet values or other specified values of these assets. To determine the capital requirements for off-balance sheet exposures, factors are applied to the exposure amounts determined according to the section 4.2. Collateral and other forms of credit risk mitigators may be used to reduce the exposure. No risk factors are applied to assets deducted from capital available (reference section 2.3). The resulting amounts are summed to arrive at the credit risk capital requirements.

In respect of invested assets, insurers must comply with OSFI’s Guideline B-2 Property and Casualty Large Insurance Exposures and Investment Concentration.

4.1. Capital Requirements for Balance Sheet Assets

For the purpose of calculating the capital requirements for credit risk, balance sheet assets should be valued at their balance sheet carrying amounts, with the following exceptions:

• loans measured at fair value through profit and loss, fair value hedge accounting, or fair valued through other comprehensive income, should be measured at amortized cost;
• financial assets measured at amortized cost should be valued gross of IFRS 9 Stage 1 and Stage 2 expected credit loss provisions; and
• off-balance sheet exposures should be valued in accordance with section 4.2.

4.1.1. Use of ratings

Many of the risk factors in this chapter depend on the external credit rating assigned to an asset or an obligor. In order to use a factor that is based on a rating, an insurer must meet all of the conditions specified in this section. For MICAT purposes, insurers may recognize credit ratings from the following rating agencies:

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

An insurer must choose the rating agencies it intends to rely on and then use their ratings for MICAT purposes consistently for each type of asset or obligation. Companies should not select the assessments provided by different rating agencies with the sole intent to reduce their capital requirements (i.e. "cherry picking" is not permitted).

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

Where an insurer holds a particular securities issue that carries one or more issue-specific assessments, the capital requirements for the asset or obligor will be based on these assessments. Where an insurer's asset 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 insurer's asset is not an investment in this particular security, a rating of BBB- or better on the rated security may only be applied to the insurer's unrated asset if this asset ranks pari passu or senior to the rated security in all respects. If not, the credit rating cannot be used and the insurer's asset must be treated as an unrated obligation.

• In circumstances where the borrower has an issuer rating, this assessment typically applies to senior unsecured assets or obligations on that issuer. Consequently, only senior assets or obligations on that issuer will benefit from a BBB- or better issuer assessment; other unassessed assets or obligations 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 requirements for an unrated asset or obligation on the issuer.

• Short-term assessments are deemed to be issue specific. They can only be used to derive capital requirements for assets or obligations arising from the rated facility. They cannot be generalized to other short-term assets or obligations, and in no event can a short-term rating be used to support a risk factor for an unrated long-term asset or obligation.

• Where the risk factor 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 requirements for assets or obligations 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 risk factors 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 if the credit enhancement has already been reflected in the issue-specific rating.

• An insurer 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 insurer itself or one of its associates.

• Any assessment used must take into account and reflect the entire amount of credit risk exposure an insurer has with regard to all payments owed to it. In particular, if an insurer 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.

• Insurers may not rely on unsolicited ratings in determining the risk factors for an asset, except where the asset is a sovereign exposure and a solicited rating is not available.

4.1.2 Credit risk factors

Various risk factors are applied to invested assets depending on the external credit rating and the remaining term to maturity as outlined below.

Investments in mutual funds or other similar assets must be broken down by type of investment (bonds, preferred shares, etc.) and assigned the appropriate risk factor relating to the investment. If these investments are not reported on a prorated basis, then the factor of the riskiest asset held in the fund, is assigned to the entire investment.

4.1.2.1 Long-term obligations

Long-term obligations, including term deposits, bonds, debentures, and loans that are not eligible for a 0% risk factor attract risk factors according to the following table. Long-term obligations generally have an original term to maturity at issue of 1 year or more.

• Remaining term to maturity denotes the number of years from the reporting date until the maturity date.

• Insurers may use effective maturity as an option for determining risk factors for investments in long-term obligations subject to a determined cash flow schedule. The following formula may be used to calculate effective maturity:

  $\mathit{Effective\; Maturity}\left(M\right)={\displaystyle \frac{\sum _{t}t\times {\mathit{CF}}_t}{\sum _t{\mathit{CF}}_t}}$ ,

  where CF_t denotes the cash flows (principal, interest payments and fees) contractually payable by the borrower in period t.

• In cases where an insurer elects not to calculate an effective maturity or if it is not feasible to do so using the above formula, the insurer is required to use the maximum remaining time (in years) that the borrower is permitted to fully discharge its contractual obligation (principal, interest, and fees) under the terms of the loan agreement. Normally, this would correspond to the nominal maturity or term to maturity of the instrument.

• Where information is not available to determine the redemption/maturity of an asset, insurers must use the "greater than 5 years" category for that asset.

4.1.2.2 Short-term obligations

Short-term obligations, including commercial paper, that are not eligible for a 0% risk factor have risk factors assigned according to the following table. Short-term obligations generally have an original term to maturity at issue of no more than 365 days.

4.1.2.3 Asset-backed securities

The category of asset-backed securities encompasses all securitizations, including collateralized mortgage obligations and mortgage-backed securities, as well as other exposures that result from stratifying or tranching an underlying credit exposure. For exposures that arise as a result of asset securitization transactions, insurers should refer to Guideline B-5: Asset Securitization to determine whether there are functions provided (e.g., credit enhancement and liquidity facilities) that require capital for credit risk.

National Housing Act (NHA) mortgage-backed securities

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

Other asset-backed securities

The capital requirements for all other asset-backed securities are based on their external ratings. In order for an insurer to use external ratings to determine a capital requirement, the insurer must comply with all of the operational requirements for the use of ratings in Guideline B-5: Asset Securitization.

For asset-backed securities (other than resecuritizations) rated BBB or higher, the capital requirement is the same as the requirement specified in subsection 4.1.2.1 for a long-term obligation having the same rating and maturity as the asset-backed security. If an asset-backed security is rated BB, an insurer may recognize the rating only if it is a third-party investor in the security. The credit risk factor for an asset-backed security (other than a resecuritization) rated BB in which a company is a third-party investor is 300% of the requirement for a long-term obligation rated BB having the same rating and maturity as the security.

The credit risk factors for short-term asset-backed securities (other than resecuritizations) rated A-3 or higher are the same as those in subsection 4.1.2.2 for short-term obligations having the same rating.

The credit risk factor for any resecuritization rated BBB or higher is 200% of the risk factor applicable to an asset-backed security having the same rating and maturity as the resecuritization.

The credit risk factor for securitization exposures classified within the highest risk category of securitization exposures in Guideline B-5: Asset Securitization, is 60%.

The credit risk factor for any asset-backed security that is not mentioned above (including unrated securities and any asset-backed security that is rated lower than BB) is 60%.

4.1.2.4 Preferred shares

4.1.2.5 Other balance sheet assets

4.2. Capital Requirements for Off-Balance Sheet Exposures

The capital required for off-balance sheet exposures such as structured settlements, letters of credit or non-owned deposits, derivatives and other exposures is calculated in a manner similar to on-balance sheet assets in that the credit risk exposure is multiplied by a counterparty risk factor to arrive at the capital required. However, unlike most assets, the face amount of an off-balance sheet exposure does not necessarily reflect the true credit risk exposure. To approximate this exposure, a credit equivalent amount is calculated for each exposure. This amount, net of any collateral or guarantees, is then multiplied by a credit conversion factor. For letters of credit and non-owned deposits, the credit equivalent amount is the face value. The determination of the counterparty credit risk categories and the approach for determining the eligibility of collateral and guarantees is the same as it is for other assets.

Insurers should also refer to OSFI's Guideline B-5: Asset Securitization, which outlines the regulatory framework for asset securitization transactions, including transactions that give rise to off-balance sheet exposures.

The risk to an insurer associated with structured settlements, letters of credit, non-owned deposits, derivatives and other exposures and the amount of capital required to be held against this risk is:

1. The credit equivalent amount of the instrument at the reporting date;
2. Less: the value of eligible collateral securities or guarantees (reference section 4.3);
3. Multiplied by: a factor reflecting the nature and maturity of the instrument (credit conversion factor); and
4. Multiplied by: a factor reflecting the risk of default of the counterparty to a transaction (counterparty credit risk).

4.2.1 Credit equivalent amount

The credit equivalent amount related to off-balance sheet exposures varies according to the type of instrument.

4.2.1.1 Derivatives

The credit equivalent amount for derivatives is the positive replacement cost (obtained by "marking to market") plus an amount for potential future credit exposure (an "add-on" factor).

Derivatives include forwards, futures, swaps, purchased options, and other similar contracts. Insurers are not exposed to credit risk for the full face value of these contracts (notional principal amount); only to the potential cost of replacing the cash flow (on contracts showing a positive value) if the counterparty defaults. The credit equivalent amounts are assigned the risk factor appropriate to the counterparty in order to calculate the capital requirement.

The credit equivalent amount depends on the maturity of the contract and the volatility of the underlying instrument. It is calculated by adding:

1. the total replacement cost (obtained by "marking to market") of all contracts with positive value; and
2. an amount for potential future credit exposure (or "add-on"). This is calculated by multiplying the notional principal amount by the following factors:

Notes:

1. Instruments traded on exchanges do not require capital for counterparty credit risk where they are subject to daily margining requirements.

2. For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining payments in the contract.

3. For contracts that are structured to settle outstanding exposures following specified payment dates, and where the terms are reset so that the market value of the contract is zero on these specified dates, the residual maturity is considered to be the time until the next reset date. In the case of interest rate contracts with remaining maturities of more than one year and that also meet the above criteria, the add-on factor is subject to a floor of 0.5%.

4. Contracts not covered by columns (02) to (05) in the above table are to be treated as "other instruments" for the purpose of determining the add-on factor.

5. No potential credit exposure would be calculated for single currency floating/floating interest rate swaps; the credit exposure on these contracts would be evaluated solely on the basis of their mark-to-market value.

6. The add-ons are based on effective rather than stated notional amounts. In the event that the stated notional amount is leveraged or enhanced by the structure of the transaction, companies must use the actual or effective notional amount when determining potential future exposure. For example, a stated notional amount of $1 million with payments calculated at two times LIBOR would have an effective notional amount of $2 million.

7. Potential credit exposure is to be calculated for all over-the-counter (OTC) contracts (with the exception of single currency floating/floating interest rate swaps), regardless of whether the replacement cost is positive or negative.

No add-on for potential future exposure is required for credit derivatives. The credit equivalent amount for a credit derivative is equal to the greater of its replacement cost or zero.

4.2.1.2 Other exposures

Commitments

A commitment involves an obligation (with or without a material adverse change or similar clause) of the insurer to fund its customer in the normal course of business should the customer seek to draw down the commitment. This includes:

1. extending credit in the form of loans or participations in loans, lease financing receivables, mortgages or loan substitutes; or
2. purchasing loans, securities, or other assets.

Normally, commitments involve a written contract or agreement and a commitment fee or some other form of consideration.

The maturity of a commitment should be measured from the date when the commitment was accepted by the customer, regardless of whether the commitment is revocable or irrevocable, conditional or unconditional, until the earliest date on which:

1. the commitment is scheduled to expire, or
2. the insurer can, at its option, unconditionally cancel the commitment.

Repurchase and reverse repurchase 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 transaction for accounting purposes, the securities remain on the balance sheet. Given that these securities are temporarily assigned to another party, the factor accorded to the asset should be the higher of the factor of the security and the factor of the counterparty to the transaction (net of any eligible collateral).

A reverse repo agreement is the opposite of a repo agreement, and involves the purchase and subsequent sale of a security. Reverse repos are treated as collateralized loans, reflecting the economic reality of the transaction. The risk is therefore to be measured as an exposure to the counterparty. Where the asset temporarily acquired is a security that attracts a preferential factor, this would be recognized as collateral and the factor would be reduced accordingly.

Guarantees provided in securities lending

In securities lending, insurers can act as principal to the transaction by lending their own securities or as agent by lending securities on behalf of clients. When the insurer lends its own securities, the risk factor is the higher of:

• the risk factor related to the instruments lent, or

• the risk factor for an exposure to the borrower of the securities. The exposure to the borrower may be reduced if the insurer holds eligible collateral (reference section 4.3). Where the insurer lends securities through an agent and receives an explicit guarantee of the return of the securities, the insurer may treat the agent as the borrower subject to the conditions in section 4.3.2.

When the insurer, acting as an agent, lends securities on behalf of a client and guarantees that the securities lent will be returned, or the insurer will reimburse the client for the current market value, the insurer should calculate the capital requirement as if it were the principal to the transaction. The capital requirements are those for an exposure to the borrower of the securities, where the exposure amount may be reduced if the insurer holds eligible collateral (reference section 4.3).

4.2.2 Credit conversion factors

Separate credit conversion factors exist for structured settlements, letters of credit, non-owned deposits, derivatives and other exposures.

For other exposures, the weighted average of the credit conversion factors, described below, for all of these instruments held by the insurer, should be used.

4.2.3 Risk factors

Risk factors for off-balance sheet exposures are assigned a risk factor consistent with section 4.1. All criteria in section 4.1 around the use of ratings are applicable to off-balance sheet exposures.

Risk factors for structured settlements, which are considered long-term exposures, are based on the credit rating of the counterparty from which the annuity is purchased. The risk factors are as follows:

If the structured settlement is not rated by one of the four rating agencies listed in section 4.1.1, an insurer may use a credit rating from another reputable rating agency. The use of an alternative rating agency must comply with all the criteria around the use of ratings specified in section 4.1.1, including a consistent use of the same rating agency in order to assign a risk factor based on the credit rating of the annuity underwriter.

4.3. Capital Treatment of Collateral and Guarantees

4.3.1 Collateral

A collateralized transaction is one in which:

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

Recognition of collateral in reducing the capital requirement is limited to cash or securities rated A- or higher. Any collateral must be held throughout the period for which the exposure exists. Only that portion of an exposure that is covered by eligible collateral will be assigned the risk factor given to the collateral, while the uncovered portion retains the risk factor of the underlying counterparty. Only collateral securities with a lower risk factor than the underlying exposure will lead to reduced capital requirements. All criteria in section 4.1 around the use of ratings are applicable to collateral. Where a rating is not available for the collateral asset, exposure, or counterparty where applicable, no reduction in capital required is permitted.

The effects of collateral may not be double counted. Therefore, insurers may not recognize collateral on claims for which an issue-specific rating is used that already reflects that collateral.

Collateral securities used to reduce capital requirements must materially reduce the risk arising from the credit quality of the underlying exposure. In particular, collateral used may not be related party obligations of the issuer of the underlying exposure (i.e. obligations of the underlying counterparty itself, its parent, or one of its subsidiaries or associates).

4.3.2 Guarantees

Investments (principal and interest) or exposures that have been explicitly, directly, irrevocably and unconditionally guaranteed by a guarantor whose long-term issuer credit rating is A- and higher, may attract the risk factor allocated to a direct claim on the guarantor where the desired effect is to reduce the risk exposure. Thus only guarantees^{Footnote 35} issued by entities with a lower risk factor than the underlying counterparty will lead to reduced capital requirements. To be eligible, guarantees must be legally enforceable.

Where the recovery of losses on a loan, financial lease agreement, security or exposure is partially guaranteed, only the part that is guaranteed is to be weighted according to the risk factor of the guarantor (see examples below). The uncovered portion retains the risk factor of the underlying counterparty.

All criteria in section 4.1 around the use of ratings remain applicable to guarantees. Where a rating is not available for the investment, exposure, or guarantor where applicable, no reduction in capital required is permitted.

An insurer may not recognize a guarantee provided by a related party (parent, subsidiary or associate) of the insurer. This treatment follows the principle that guarantees within a corporate group are not a substitute for capital.

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.

To be eligible, a guarantee must cover the full term of the exposure, i.e. no recognition will be given to a guarantee if there is a maturity mismatch^{Footnote 36}.

4.3.2.1 Additional requirements for guarantees

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

1. 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.

2. The guarantee is an explicitly documented obligation assumed by the guarantor.

3. 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 4.1.2.

Example 4-1: Credit risk exposure

To record a $100,000 bond rated AAA due in 10 years that has a government guarantee of 90%, the insurer would report a balance sheet value of $90,000 ($100,000 x 90%) in the 0% risk weighted category and a balance value of $10,000 ($100,000 - $90,000) in the AAA category under bonds expiring or redeemable in more than five years. The capital required in the 0% risk weighted category is $0 ($90,000 x 0.0%). The capital required in the AAA category is $125 ($10,000 x 1.25%) for a total capital requirement of $125. An example of the calculation, assuming no other assets, is provided in the chart below.

Example 4-2: Type 1 structured settlement

To record a $300,000 Type 1 structured settlement rated BBB+ to B-, backed by collateral or a guarantee of $200,000 from a counterparty rated A- or higher, the insurer would report a credit equivalent amount of $300,000 and collateral and guarantees of negative $200,000 in the BBB+ to B- category, and collateral and guarantees of $200,000 in the A- and higher category.

The capital required in the BBB+ to B- category is $4,000 (($300,000 - $200,000) x 50% x 8%). The capital required in the A- and higher category is $500 ($200,000 x 50% x 0.5%) for a total capital requirement of $4,500. An example of the calculation, assuming no other exposures, is provided in the table below.

Chapter 5. Market Risk

Market risk arises from potential changes in rates or prices in various markets such as for interest rates, foreign exchange rates, equities, real estate, and other market risk exposures. Exposure to this risk results from trading, investing, and other business activities, which create on- and off-balance sheet positions.

Investments in mutual funds or other similar assets must be broken down by type of investment (bonds, preferred shares, common shares, etc.) and assigned the appropriate risk factor relating to the investment. If these investments are not reported on a prorated basis, then the factor of the riskiest asset held in the fund is assigned to the entire investment.

5.1. Interest Rate Risk

Interest rate risk represents the risk of economic loss resulting from market changes in interest rates and the impact on interest rate sensitive assets and liabilities. Interest rate risk arises due to the volatility and uncertainty of future interest rates.

Assets and liabilities whose value depends on interest rates are affected. Interest rate sensitive assets include fixed income assets. Interest rate sensitive liabilities include those for which the values are determined using a discount rate.

To compute the interest rate risk margin, a duration and an interest rate shock factor are applied to the fair value of interest rate sensitive assets and liabilities. The interest rate risk margin is the difference between the change in the value of interest rate sensitive assets and the change in the value of interest rate sensitive liabilities, taking into account the change in the value of recognized interest rate derivative contracts, as appropriate.

5.1.1. General requirements

The components used to calculate the interest rate risk margin are as follows.

5.1.1.1. Interest rate sensitive assets

The interest rate sensitive assets to be included in the calculation of the interest rate margin are those for which their fair value will change with movements in interest rates. Although certain assets, for example loans and bonds held to maturity, may be reported on the balance sheet on an amortized cost basis, their economic value, and changes in that value, are to be considered for interest rate risk margin purposes. Interest rate sensitive assets include:

• term deposits and other similar short-term securities (excluding cash),
• bonds and debentures,
• commercial paper,
• loans,
• mortgages (residential and commercial),
• mortgage-backed and asset-backed securities (MBS and ABS),
• preferred shares,
• interest rate derivatives held for other than hedging purposes, and
• insurance contracts assets

Investments in mutual funds and other similar assets should be broken down by type of investment (bond, preferred share, common shares, etc.). The assets in the fund that are interest rate sensitive are to be included in the determination of the fair value of the insurer’s total interest rate sensitive assets.

Other assets, such as cash, investment income due and accrued, common shares and investment properties, are not to be included in the determination of the value of interest rate sensitive assets. Such assets are assumed for interest rate risk margin determination purposes to be insensitive to movements in interest rates.

5.1.1.2. Interest rate sensitive liabilities

The interest rate sensitive liabilities to be included in the calculation of the interest rate risk margin are those for which their fair value will change with movements in interest rates. The following liabilities are considered sensitive to interest rates and are to be included:

• insurance contract liabilities for incurred claims, and
• insurance contract liabilities for remaining coverage^{Footnote 37}.

Insurers must obtain OSFI’s supervisory approval in order to be able to consider other liabilities in the calculation of interest rate risk margin.

5.1.1.3. Allowable interest rate derivatives

Interest rate derivatives are those for which the cash flows are dependent on future interest rates. They may be used to hedge an insurer’s interest rate risk and as such may be recognized in the determination of the margin required for interest rate risk, subject to the conditions below.

Only plain-vanilla interest rate derivatives that clearly serve to offset fair value changes in a company’s capital position due to changes in interest rates may be included in the interest rate risk calculation. Plain-vanilla interest rate derivative instruments are limited to the following:

• interest rate and bond futures,
• interest rate and bond forwards, and
• single-currency interest rate swaps.

Other interest rate derivatives, including interest rate options, caps and floors are not considered plain-vanilla and may not be recognized in the determination of the interest rate risk margin.

Insurers must understand the interest rate hedging strategies that they have in place and be able to demonstrate to OSFI, upon request, that the underlying hedges decrease interest rate risk exposure and that the addition of such derivatives does not result in overall increased risk. For example, insurers are expected to be able to demonstrate that they have defined the hedging objectives, the class of risk being hedged, the nature of the risk being hedged, the hedge horizon, and have considered other factors, such as the cost and liquidity of the hedging instruments. In addition, the ability to demonstrate an assessment, retrospectively or prospectively, of the performance of the hedge would be appropriate. If the insurer cannot demonstrate that the derivatives result in decreased overall risk, then additional capital may be required, and companies in this situation should contact OSFI for details.

Derivatives used for hedging an insurer’s interest rate risk are subject to credit risk requirements. Refer to section 4.2 for further details.

5.1.1.4. Duration of interest rate sensitive assets and liabilities

Insurers are required to calculate the duration of the interest rate sensitive assets and liabilities for the purpose of the interest rate risk requirement calculation. The duration of an asset or a liability is a measure of the sensitivity of the value of the asset or liability to changes in interest rates^{Footnote 38}. More precisely, it is the percentage change in an asset or liability value given a change in interest rates.

The calculation of duration for an asset or liability will depend on the duration measure chosen and whether the cash flows of the asset or liability are themselves dependent on interest rates. Modified duration is a duration measure in which it is assumed that interest rate changes do not change the expected cash flows. Effective duration is a duration measure in which recognition is given to the fact that interest rate changes may change the expected cash flows.

An insurer may use either modified duration or effective duration to calculate the duration of its assets and liabilities. However, the duration methodology chosen should apply to all interest rate sensitive assets and liabilities under consideration and the same methodology must be used consistently from year to year (i.e. “cherry-picking” is not permitted).

The cash flows associated with interest rate derivatives are sensitive to changes in interest rates and therefore the duration of an interest rate derivative must be determined using effective duration. In particular, if a company has interest rate derivatives on its balance sheet that lie within the scope of section 5.1.1.3, then it must use effective duration for all of its interest rate sensitive assets and liabilities.

The portfolio duration (modified or effective) can be obtained by calculating the weighted average of the duration of the assets or the liabilities in the portfolio.

The dollar duration of an asset or liability is the change in dollar value of an asset or liability for a given change in interest rates.

5.1.1.5. Modified duration

Modified duration is defined as the approximate percentage change in the present value of cash flows for a 100 basis point change in the annually compounded yield rate, assuming that expected cash flows do not change when interest rates change.

Modified duration can be written as:

where,

Yield = the annually compounded yield to maturity of the cash flows,
PVCF_t = the present value of the cash flow at time t discounted at the yield rate,
and the sum in the numerator is taken over all times t at which a cash flow occurs.

5.1.1.6. Effective duration

Effective duration is a duration measure in which recognition is given to the fact that interest rate changes may change the expected cash flows. Although modified duration will give the same estimate of the percentage fair value change for an option-free series of cash flows, the more appropriate measure for any series of cash flows with an embedded option is effective duration.

Effective duration is determined as follows:

where,

Δy = change in yield in decimal
V₀ = initial fair value
V_- = fair value if yields decline by Δy
V₊ = fair value if yields increase by Δy,

then effective duration is as follows:

5.1.1.7. Portfolio duration

The duration of a portfolio of interest rate sensitive assets or liabilities is to be determined by calculating the weighted average of the duration of the assets or liabilities in the portfolio. The weight is the proportion of the portfolio that a security comprises. Mathematically, a portfolio’s duration is calculated as follows:

where,

w_i = fair value of security i/fair value of the portfolio
D_i = duration of security i
K = number of securities in the portfolio.

5.1.1.8. Dollar fair value change

Modified and effective duration are related to percentage fair value changes. The interest rate risk requirements depend on determining the adjustment to the fair value of interest rate sensitive assets and liabilities for dollar fair value changes. The dollar fair value change can be measured by multiplying duration by the dollar fair value and the number of basis points (in decimal form). In other words,

Dollar fair value change = duration × dollar fair value × interest rate change (in decimal)

5.1.1.9. Duration of allowable interest rate derivatives

Effective duration is the appropriate measure that should be used when assets or liabilities have embedded options. For portfolios with eligible plain-vanilla interest rate derivatives, insurers should be using effective dollar duration because the insurer is hedging the dollar interest rate risk exposure.

Example 5-1: Effective dollar duration of a swap

Assuming an insurer has a longer duration for its interest rate sensitive assets and a shorter duration for its interest rate sensitive liabilities, the current dollar duration position of the insurer, prior to taking into consideration any interest rate derivatives, is effectively as follows:

The insurer enters into a single-currency interest rate swap in which it pays fixed-rate and receives floating-rate. The dollar duration of a swap for a fixed-rate payer can be broken down as follows:

Assuming the dollar duration of the floating-rate bond is near zero, then

The dollar duration of the swap position is negative; therefore, adding the swap position reduces the company’s dollar duration of assets and moves the insurer’s overall dollar duration position closer to zero.

5.1.2. Interest rate risk margin

The interest rate risk margin is determined by measuring the economic impact on the insurer of a Δy change in interest rates. The Δy interest rate shock factor is 1.25% (Δy = 0.0125).

1. The estimated change in the interest rate sensitive asset portfolio for an interest rate shock factor increase of Δy is determined as follows:

2. The change in the interest rate sensitive liabilities for an interest rate shock factor increase of Δy is determined as follows:

3. The change in the allowable interest rate derivatives for the interest rate shock factor increase of Δy is determined as follows:

4. The capital requirement for an interest rate shock factor increase of Δy is determined as the greater of zero and A - B + C.
5. Steps A through C are repeated for an interest rate shock factor decrease of Δy (i.e. -Δy) and the capital requirement for an interest rate decrease of Δy is the greater of zero and A - B + C.
6. The interest rate risk margin is then determined as the maximum of D or E.

5.2. Foreign Exchange Risk

The foreign exchange risk margin is intended to cover the risk of loss resulting from fluctuations in currency exchange rates and is applied to the entire business activity of the insurer.

5.2.1. General requirements

Two steps are necessary to calculate the foreign exchange risk margin. The first is to measure the exposure in each currency position. The second is to calculate the capital requirement for the portfolio of positions in different currencies.

The foreign exchange risk margin is 10% of the greater of:

• the aggregate net long positions in each currency, adjusted by effective allowable foreign exchange rate hedges if any are used, and
• the aggregate net short positions in each currency, adjusted by effective allowable foreign exchange rate hedges if any are used,

where effective allowable foreign exchange rate hedges are limited to plain-vanilla foreign currency derivatives such as futures and forward foreign currency contracts and currency swaps.

Investments in mutual funds and other similar assets should be broken down by type of investment (bonds, preferred shares, common shares, etc.) for calculating foreign exchange risk margin. The assets in the fund that are denominated in a foreign currency are to be included in the calculation to determine the capital requirement for each currency position. In cases where a claim liability is recorded in Canadian dollars but the settlement of the claim will be made in a foreign currency, the liability must be included in the calculation of the foreign exchange risk margin.

5.2.2. Foreign exchange risk margin

Step 1: Measuring the exposure in a single currency

The net open position for each currency is calculated by summing

• the net spot position, defined as all asset items less all liability items denominated in the currency under consideration, including accrued interest and accrued expenses if they are subject to exchange rate fluctuations;
• the net forward position (i.e. all net amounts under forward foreign exchange transactions, including currency futures and the principal on currency swaps), valued at current spot market exchange rates or discounted using current interest rates and translated at current spot rates;
• guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable;
• net future income/expenses not yet accrued but already fully hedged (at the discretion of the reporting institution); and
• any other item representing a profit or loss in foreign currencies.

Adjustments

For insurers with foreign operations, those items that are currently deducted from capital available in calculating the MICAT ratio and are denominated in the corresponding currency may be excluded from the calculation of net open currency positions, to a maximum of zero. For example:

• Goodwill and other intangibles;
• Interests in non-qualifying subsidiaries, associates and joint ventures; and
• Non-allowable foreign exchange rate hedges that are not considered in capital available.

Carve-out

An insurer with a net open long position in a given currency may reduce the amount of the net exposure, to a maximum of zero, by the amount of a carve-out, which is equivalent to a short position of up to 25% of the liabilities denominated in the corresponding currency.

Step 2: Calculating the capital requirement for the portfolio

The nominal amount (or net present value) of the net open position in each foreign currency calculated in step 1 is converted at a spot rate into Canadian dollars. The gross capital requirement is 10% of the overall net open position, calculated as the greater of:

• the sum of the net open long positions; and
• the absolute value of the sum of the net open short positions.

Example

An insurer has $100 of U.S. assets and $50 of U.S. liabilities.

• The net spot position, defined as assets less liabilities, is a long position of $50.
• The carve-out, using 25% of liabilities, is:

= 25% * 50
= 12.5

• Therefore, the foreign exchange risk margin is:

= 10% * MAX^{Footnote 39} ((net spot position - carve-out), 0)

= 10% * MAX ((50 - 12.5), 0)

= 10% * 37.5
= 3.75

5.2.2.1. Allowable foreign currency hedges

Foreign currency derivatives are those for which the cash flows are dependent on future foreign exchange rates. They may be used to hedge an insurer’s foreign exchange risk and as such, may be recognized in the determination of the capital requirement for foreign exchange risk, subject to the following requirements.

Only effective hedges that offset the changes in fair value of the hedged item may be included in the foreign exchange risk calculation. The company must be able to demonstrate to OSFI the effectiveness of its foreign exchange hedges.

Companies with foreign currency derivatives on their balance sheet must be able to demonstrate that the addition of such derivatives does not result in increased risk. If the insurer cannot demonstrate that the derivatives do not result in increased risk, then OSFI may require additional capital.

Only plain-vanilla foreign currency derivatives may be recognized in the calculation of the foreign exchange capital requirement. Plain-vanilla foreign currency derivative instruments are limited to the following:

• futures foreign currency contracts,
• forward foreign currency contracts, and
• currency swaps.

Other foreign currency derivatives, including options on foreign currencies, are not considered plain-vanilla and are not to be recognized in the determination of the foreign exchange risk margin.

Derivatives used for hedging an insurer’s foreign exchange risk are subject to credit risk requirements. Refer to section 4.2 for further details.

5.2.2.2. Measurement of forward currency positions

Forward currency positions should be valued at current spot market exchange rates. It would not be appropriate to use forward exchange rates since they partly reflect current interest rate differentials. Companies that base their normal management accounting on net present values are expected to use the net present values of each position, discounted using current interest rates and translated at current spot rates, for measuring their forward currency positions.

5.2.2.3. Accrued and unearned interest income and expenses

Accrued interest, accrued income and accrued expenses should be treated as a position if they are subject to exchange rate fluctuations. Unearned but expected future interest, income or expenses may be included, provided the amounts are certain and have been fully hedged by allowable forward foreign exchange contracts. Companies must be consistent in their treatment of unearned interest, income and expenses and must have written policies covering the treatment. The selection of positions that are only beneficial to reducing the overall position will not be permitted for capital purposes.

5.3. Equity Risk

Equity risk is the risk of economic loss due to fluctuations in the value of common shares and other equity securities.

5.3.1. Common shares and joint ventures

A 30% risk factor applies to investments in common shares and joint ventures in which a company holds less than or equal to 10% ownership interest.

5.3.2. Futures, forwards, and swaps

Equity futures, forwards, and swaps attract a 30% risk factor, which is applied to the market value of the underlying equity security or index. Where a swap exchanges a return on an equity security or index for a return on a different equity security or index, a 30% risk factor applies to the market value of both equity securities or indices for which the returns are being exchanged.

Example

An insurer has entered into a one-year swap during which it will pay the 3-month Canadian Dollar Offered Rate (CDOR) plus fees, and receive the total return on a notional index of equities that was worth 100 at the time of inception. The index of equities is currently worth 110. A 30% equity risk charge will apply to 110 for the long position in the index, but no capital charge will be required on the short position in the bond because such a position is not subject to an equity risk charge.

In addition to the capital requirements set out in this section, futures, forwards, and swaps are subject to credit risk requirements. Refer to section 4.2 for further details.

5.3.3. Short positions

The capital requirements for short positions in common shares, equity futures, forwards, and swaps that do not wholly or partially offset a long equity position are determined by assuming the instrument is held long and then applying the corresponding risk factor. Common shares, futures, forwards, and swaps eligible for offset recognition and the corresponding capital treatment are described in section 5.3.4.

5.3.4. Recognition of equity hedges

Equity futures, forwards, and swaps, as well as common shares can be used to wholly or partially hedge an equity exposure. Insurers may recognize qualifying equity hedges in the calculation of the capital requirements in accordance with section 5.3.4.1 and 5.3.4.2.

Insurers must document the equity hedging strategies employed and demonstrate that the hedging strategies decrease the overall risk. The documentation must be available for review, upon request. If the insurer cannot demonstrate, to the satisfaction of the Superintendent, that the hedging strategies result in decreased overall risk, then additional capital above that calculated as per sections 5.3.4.1 and 5.3.4.2 may be required, at the discretion of the Superintendent.^{Footnote 40}

For hedges to qualify, they must be issued by an entity that:

• issues obligations which attract a 0% factor under section 4.1.2; or
• is rated A- or better (including clearing houses rated A- or better).

5.3.4.1. Identical equity securities or indices

Long and short positions in exactly the same underlying equity security or index may be considered to be offsetting so that the capital requirements are calculated for the net exposure only. Individual instruments of portfolios that qualify for the capital treatment under section 5.3.4.2 cannot be carved out of the portfolios to receive the capital treatment of section 5.3.4.1.

Only common shares and plain-vanilla equity futures, forwards, and swaps can obtain the capital treatment under this section. Exotic equity derivatives^{Footnote 41} do not qualify for this treatment.

5.3.4.2. Closely linked equity securities or indices

A portfolio of common shares and equity futures, forwards, and swaps can be used to partially hedge the equity exposure of another portfolio of similar instruments. When the instruments contained in both portfolios are closely linked, instead of following the capital requirements set out in sections 5.3.1, 5.3.2, and 5.3.3, insurers may calculate the capital requirements for the combined portfolios in the following manner:

The capital requirements set out above are capped at 60% of the minimum market value of both portfolios.

The difference between the market value of the two portfolios is not considered a hedged position and is subject to a 30% risk factor.

The Correlation Factor is derived by using:

where:

• A represents the historical correlation between the returns on the portfolio of instruments being hedged and the returns on the portfolio of hedging instruments

• B represents the minimum of [standard deviation of returns on the portfolio of instruments being hedged, standard deviation of returns on the portfolio of hedging instruments]

• C represents the maximum of [standard deviation of returns on the portfolio of instruments being hedged, standard deviation of returns on the portfolio of hedging instruments]

The historical correlations and standard deviations must be calculated on a weekly basis, covering the previous 52-week period. The returns on each portfolio of hedging instruments used to calculate the components of the CF must be determined by assuming that the portfolio is held long. The returns on each portfolio must be measured net of additional capital injections, and must include the returns on each component of the portfolio. For example, the returns on both the long and short legs of a total return swap included in a portfolio must be reflected in the calculation of the CF.

The CF for the previous 52 weeks is required to be calculated for each of the past four quarters. The Correlation Factor is the lowest of the four CFs calculated and is used to calculate capital requirements.

In order for the portfolios to obtain the capital treatment set out in this section, the following conditions must be met:

• The instruments in both portfolios are limited to exchange-traded common shares, and plain-vanilla equity futures, forwards, and swaps where the underlying asset is an exchange-traded common share or an equity index. Portfolios that contain instruments other than those specified in this section will be subject to the capital treatment under sections 5.3.1, 5.3.2, and 5.3.3.
• The CF is determined at the portfolio level. Individual instruments cannot be carved-out of the portfolios and receive the capital treatment as per section 5.3.4.1.
• The portfolios that are part of a hedging strategy must have been established at least two years prior to the reporting date. In addition, the hedging strategy and the active management strategy on which both portfolios are based must not have changed in the past two years prior to the reporting date.^{Footnote 42} Portfolios that have been established for at least two years but have undergone a change in the hedging strategy or active management strategy will attract a 30% risk factor.

Example

Suppose a portfolio of instruments is valued at $200 and is paired with another portfolio of instruments as part of a qualifying equity hedge. Assuming that the second portfolio is worth $190 and that the Correlation Factor between the two portfolios is 0.95, the total capital charge for both portfolios will be 190 × 5% × 1.5 + $10 × 30% = $17.25.

Portfolios that were established less than two years prior to the reporting date attract the following capital treatment:

• No recognition of the equity hedge in the first year following the establishment of the portfolios (i.e. a 30% factor is applied to both portfolios); and
• in the second year, the sum of:

  • T × capital requirements for the combined portfolios using the correlation factor approach described in this section^{Footnote 43}; and

  • (1-T) × capital requirements set out in 1 above.

    T equals 20%, 40%, 60%, and 80% in the first, second, third, and fourth quarter, respectively, of the second year following the establishment of the portfolios.

Example

Two portfolios (as part of an equity hedge), each equal to 100, are established on April 1, 2016. On March 31, 2017, the capital charge for both portfolios will be 30% × 100 + 30% × 100 = 60. On June 30, 2017, assuming that the Correlation Factor is 0.90, the combined portfolios will be subject to a capital charge of 20% × 10% × 1.5 × 100 + 80% × 60% × 100 = 51.

5.4. Real Estate Risk

Real estate risk is the risk of economic loss due to changes in the value of a property or in the amount and timing of cash flows from investments in real estate.

For owner-occupied properties, the risk factor is applied to the value using the cost model, excluding any unrealized fair value gains (losses) arising at the conversion to IFRS, or subsequent unrealized fair value gains (losses) due to revaluation.

5.5. Other Market Risk Exposures

Other market risk exposures include assets that fall in the category “other assets,” for example, equipment, that are exposed to asset value fluctuations that may result in the value realized upon disposal being less than the balance sheet carrying value. A 10% risk factor applies to other assets as part of the total capital requirements for market risk.

Chapter 6. Operational Risk

Operational risk is the risk of loss due to inadequate or failed internal processes, people and systems, or external events. It includes legal risk but does not include strategic or reputational risk.

The capital required for an insurer’s operational risk is calculated using the following formula:

where:

• TC is the insurer’s total capital required, before the calculation of the requirement for operational risk.

• SC is, if applicable, the supplementary capital required for insurance risk (reference subsection 3.1.1.3).