Key Principles for the Future Direction of the Canadian Regulatory Capital Framework on Insurance

Document Properties

  • Type of Publication: Memorandum
  • Date: May 5, 2006
  • To: Canadian Life Insurance Industry
  • From: MCCSR Advisory Committee, Capital Division

Since the MCCSR was first put into place, Canada has been recognized internationally as a leader in the development of risk-based capital adequacy tests for insurance companies. There is a great deal of interest both in Canada and abroad in developing new capital requirements to encourage financial institutions to develop better risk management procedures and to collect the data necessary to use company-specific risk components whenever possible.

OSFI and the Canadian life insurance industry are working together through the MCCSR Advisory Committee to develop more advanced risk measurement techniques to incorporate into the MCCSR. These techniques will include the development of criteria for risk-sensitive methodologies for use by companies that have the commitment and resources to implement them.

The MCCSR Advisory Committee is co-chaired by Simon Curtis, Chair of the CIA’s Risk & Capital Committee and Robert Hanna, Senior Director of OSFI’s Capital, Accounting and Research Division. Its members are senior representatives from the CLHIA, the CIA, Assuris, the Autorité des marchés financiers (AMF) and OSFI.

The MCCSR Advisory Committee’s mandate is to:

  • build consensus on the direction of the new framework

  • establish high-level principles for the development of the new framework

  • provide strategic guidance on technical direction

  • assess recommendations on modifications to the capital framework made by the technical groups involved in the process.

This note is the first in a series of regular updates on the Committee’s progress in developing a new framework for assessing life insurance capital adequacy.

The Committee plans to develop and recommend to OSFI and the AMF changes to the current capital framework in stages. Its first priorities are to revise the Asset/Liability Mismatch and Interest Rate (C-1 and the Asset Default (C-1) risk components.

OSFI will follow its normal public consultation process before any changes are made to the framework. An important collateral benefit of this work will be stronger conceptual and analytical bases for considering modifications to the standardized MCCSR. This will ensure that the current approach based on factors and formulas remains appropriately risk-related for that majority of companies that will not be using their own models.

The Changes in Interest Rate risk component was chosen because:

  • the risk sensitivity of the current method could be improved where large mismatches exist;

  • the IASB’s proposals on insurance accounting (IFRS 4- Phase II) are expected to call for the use of a risk-free discount rate for the actuarial liabilities; and

  • the CALM method is not compatible with using a risk-free rate, and ALM considerations will be absent from insurance liabilities once the IASB proposals are implemented. Thus we will have to provide for this risk through capital.

The Asset Default risk component was chosen because:

  • this risk is the largest component of the MCCSR for the industry as a whole; and

  • more risk-sensitive measures of capital requirements for default risk have been developed for other sectors that may provide a roadmap or indication of areas for improvement.

While a definitive timetable has yet to be developed, the Changes in Interest Rate and Asset Default risks initiatives are expected to be completed over the next three years.

The Committee developed and adopted a set of high-level principles to guide the development of a new capital framework. These are set out in the appendix to this note.

For questions, please contact Bernard Dupont at OSFI, 613-990-7797 or via e-mail bernard.dupont@osfi-bsif.gc.ca. For comments please contact Jim Witol at CLHIA, 416-359-2017 or via e-mail jwitol@clhia.ca .

ANNEX 1 - Key Principles for the Future Direction of the Canadian Regulatory Capital Framework on Insurance

The New Capital Framework should:

On risk measurement

  1. Consider all risks

    • The solvency framework should consider all risks for the consolidated group:

    • Including Concentration, Liquidity, Operational, Business, Insurance, Market and Credit risks

    • The methodology and process for inclusion may vary depending upon the precision with which a risk can be measured

    • Capital requirements should reflect risk mitigants, reinsurance, interrelationship and diversification taking account of effectiveness under normal and stress scenarios

    • An appropriate approach should be developed for aggregation of risks

  2. Determine assets, liabilities and the requirement on a consistent basis for risk measurement purposes

    • Off balance sheet items have to be considered

  3. Be practical, yet technically sound

    • There should be a standard approach to every risk

    • Capital requirements can be based on either a standard approach or a sophisticated approach

    • The more sophisticated approach should be developed subject to insurers meeting minimum standards

    • Standardized approach may need to be recalibrated based on testing from sophisticated approaches

    • Capital requirements for immaterial risks could be based on a standardized approach

  4. Reflect existing risks on going concern basis and consider winding-up and re-structuring

    • Risks should be measured on a going concern basis

    • Regulatory capital available has two key functions: it allows institutions to absorb losses during ongoing operations and it protects policyholders from loss in the event of liquidation.

    • In defining available capital and required capital risks should not be double counted.

    • Existing risks include all current commitments

    • Future new business is to be stress tested or considered in other supplements to capital and should be considered in target levels but not in minimum levels

  5. Use measures (e.g. CTE) that are comparable across risks and products.

    • The current capital level and the reserve margins should be considered on a global basis

    • Consistency of measurement between risks should be maintained if possible

    • The risk measure should be based on statistically credible data

    • The risk measure should establish a time horizon (combined with an appropriate measure of terminal liabilities) that is common to institutions

    • The Framework (minimum capital) should be based on a risk measure level (e.g., CTE 99) that is common to institutions

    • Companies may hold capital above the minimum because of economic cycles, desired ratings and differences in risk management

On risk management

  1. Ensure that capital is prudent

    • For market discipline, the meaning and methodology for regulatory capital and capital requirements should be transparent

    • Regulatory capital covers unexpected losses on both sides of the balance sheet in stress conditions; unexpected losses will include those coming from volatility (statistical fluctuations) as well as from catastrophes or epidemics.

    • The measurement process should be comprehensive (e.g. using a total balance sheet approach) as well as ensuring that capital is independently at a prudent level. Expected losses under the total balance sheet approach will include margins for misestimation and deterioration

  2. Encourage good risk management

    • Sophisticated approaches should reward companies that manage their risks to prudent levels

    • The models and techniques that are used for capital purposes should be used internally for managing risks

    • Standards for the use of models will be established

    • When an advanced approach is used for one risk it should apply to all parts of the risk for the whole group (cherry picking not allowed), except when a risk is immaterial.

  3. Adapt international principles and best practices

    • The insurance market is global

    • International principles and best practices should be adapted to reflect the market, risks and products of Canadian companies

    • Capital requirements should be risk-based

On risk monitoring

  1. Allow comparison of similar risks across financial institutions

    • Banks, Life insurers and P&C companies should hold comparable levels of capital for similar products and risks, taking into account the level of conservatism in the balance sheet

    • We need to recognize differences in the nature of business and operating environments across the sectors

  2. Be transparent, validated and based on credible data

    • Minimum standards for data and inputs to models are necessary

    • Credible data can be audited

    • The CIA standards may help to develop these criteria but are not yet sufficient

    • The data should reflect the company’s own experience and practices

  3. Use reliable processes with assumptions sustainable in times of stress

    • Rules for using models should be clear

    • A process should be in place to make sure model applications are appropriate

    • A review process should be implemented

    • The results of models should be replicable

    • Material changes to models will be subject to approval

  4. Be part of intervention levels for supervisory action

    • The test should be part of the supervision rating and staging process as a tool among series of control levels, that define possible supervisory interventions when, among others, the available capital falls below a predetermined level

    • The capital ratio level for intervention should be sufficiently high to allow supervisory action at an early stage