Office of the Superintendent of Financial Institutions
The purpose of this study is to gather information to evaluate a number of potential methods for determining the capital requirements related to credit risk. Appendix I summarizes how the credit risk solvency buffer has been determined.
QIS#5 for credit risk is similar to QIS#4 completed by insurers in 2012, except for the following changes:
The basic information required for this study is to be entered in the attached Excel workbook. In addition to supplying the requested information, we would appreciate receiving your written comments on the results of the QIS. A worksheet is included titled “Questions and Comments” for insurers to provide supplementary information and any questions or comments.
The instructions set out below provide explanations to assist insurers in completing the calculations and the Excel worksheets. While the calculations may use different factors or more detailed calculations than that required in the existing Minimum Continuing Capital and Surplus Requirements (MCCSR) Guideline, much of the guidance reflected in Chapter 3 of the MCCSR Guideline issued in December 2012 is still applicable and should be referred to.
All information is to be calculated as at December 31, 2012, using year end 2012 data. For insurers with a fiscal year end other than December 31, the insurer will use their fiscal year-end data. All amounts are in thousands of dollars. When it is not possible to use 2012 year-end data, the insurer may use more recent data and make approximations to determine the December 31, 2012 values. This should only be considered for some limited values and specified in the “Questions and Comments” worksheet.
The market risk solvency buffer for index linked risk pass through (RPT) products replaces the credit risk solvency buffer on the assets backing those products. If the index linked RPT product risk component is not used in the QIS (including new asset funds), credit risk components will apply to those assets.
Fill in only the un-shaded areas of the spreadsheet. Asset categories are the same as those used in the Life 1/2 and existing MCCSR annual returns.
Asset balances should reconcile to the Life 1/2 (including due and accrued) except for assets not included in the MCCSR calculation such as non-life subsidiaries, securities lent, reverse repurchase agreements and those backing index linked RPT products that have been included in the related market risk solvency buffer. The insurer should describe the reason assets were excluded in the “Questions and Comments” worksheet, if applicable.
The existing MCCSR guidance on ratings should be used including consideration in certain cases, of issuer ratings when issue level ratings are not available.
The methodology for assets with optionality (e.g. callable) should be consistent with the Canadian Asset Liability Method (CALM) valuation. Embedded options should be examined in light of the current date and market price and the duration corresponding to the worst case scenario for the investor should be used. If such a method is not used in CALM, the earliest call date is an acceptable approximation. Approximations should be described in the “Questions and Comments” worksheet.
The solvency buffer is calculated separately for non-participating and participating business. Surplus segments should be included with their respective product grouping.
The same factors are applied to assets, whether backing capital, non-participating, or qualifying participating, as the credit for participating and adjustable products is calculated in aggregate for all risks.
Information is requested for Canada, United States, United Kingdom, Europe, Japan and other geographies (Other) based on where the business and capital are located.
The “Summary Page” contains information on the solvency buffers for each of the components of credit risk. These are automatically sourced from each of the worksheets. Information on how to calculate these amounts is provided below.
The existing MCCSR and total credit risk Provisions for Adverse Deviations (PfADs), split by non-participating and participating business are included in the “Summary Page” of the general summary form. The components should equal the amounts reported in your December 31, 2012 MCCSRFootnote 1 return and the Report of the Appointed Actuary (i.e. credit risk PfADs in the actuarial reserves).
The credit for diversification is included in the “Summary Page” of the general summary form as it is calculated by geography in aggregate for all risks. The potential credit is described in the general instructions.
The credit for participating and adjustable products will be included in the “Summary Page” of the general summary form as it will apply to all risks (market, credit, insurance and operational) in aggregate. The potential credit is described in the general instructions.
Companies are also reminded to enter their company name at the top of the “Summary Page”.
The calculation of the solvency buffer for short term investments uses the same categories as the existing MCCSR and adopts the approach for collateral/guarantees that is to be used in the 2012 MCCSR forms (refer to sections 3.2 and 3.3 of the MCCSR Guideline dated December 2012). Please note that the “Collateral/Guarantees” column must net to zero. Totals are automatically carried to the “Summary Page”.
The calculation of the solvency buffer for public bonds is more detailed than that used in the existing MCCSR guideline. Insurers must group their public bonds based on the effective maturity (“maturity”) of the bond at the date of calculation (December 31, 2012) as set out below:
The insurer should include the average duration for each maturity group. If this is not feasible, the insurer may use the higher factor for the maturity group (as in QIS#4) and disclose this assumption in the “Questions and Comments” worksheet.
For guidance on calculating the maturity for bonds and other instruments, please refer to Appendix II for a description of the calculation. An alternate measure of maturity may be used as an approximation if the result is more conservative than effective maturity. The methodology for assets with no fixed maturity (e.g. mortality bonds linked to mortality experience) permits the use of a more conservative measure such as the maximum remaining time (in years) that the borrower is permitted to take to fully discharge its contractual obligation (principal, interest, and fees) under the terms the loan agreement. Normally, this will correspond to the nominal maturity of the instrument. Approximations should be described in the “Questions and Comments” worksheet.
All publicly traded bonds (except for certain instruments separately accounted for as set out below) are to be included in the calculation of the solvency buffer. Provincial bonds and provincially guaranteed municipal bonds should be treated in accordance with the existing MCCSR guideline. Impaired bonds are included in the “lower than B” section.
In most cases where an issuer has a rated public bond issue, it will be possible to infer a rating for the unrated bonds using the rules in section 3.1.1 of the MCCSR Guideline. In those cases where this is not possible, the factor to be used is 6%.
Adjustments for redistribution related to collateral/guarantees are to be inputted for total public bonds. Insurers should refer to Section 3.2 and 3.3 of the December 2012 MCCSR Guideline for adjustments related to collateral/guarantees. For this QIS, the 0.25% floor is replaced by the minimum use of AAA factors. The redistribution for collateral/guarantees should net to zero.
The solvency buffer for bonds and other loans that are not publicly traded is to be separately calculated from the solvency buffer for publicly traded bonds. Debt instruments to be included in this calculation are not only “Bonds and Debentures” that are not publicly traded but also leases and any loan/debt instruments included in “Other Loans and Invested Assets” (separate line item in Life 1/2).
Non-public bonds, leases and other loans are to be grouped according to the maturity and rating of the issue on the same basis as previously set out for public bonds. In most cases where an issuer has a rated public bond issue, it will be possible to infer a rating for the unrated bonds using the rules in section 3.1.1 of the MCCSR Guideline. In those cases where this is not possible, the factor to be used is 6%.
All bonds, leases and loans where no rating can be inferred are to be included in the line titled “All other private placement bonds”.
Adjustments for redistribution related to collateral/guarantees are to be inputted for total private bonds. Insurers should refer to Section 3.2 and 3.3 of the December 2012 MCCSR Guideline for adjustments related to collateral/guarantees. For this QIS, the 0.25% floor is replaced by the minimum use of AAA factors. The redistribution for collateral/guarantees should net to zero.
Current MCCSR guideline is used for policy loans. Qualifying policy loans receive a 0% factor and non-qualifying loans are treated as bonds rated B with a 0-1 year maturity.
As is the case under the existing MCCSR Guideline, the solvency buffer for asset backed securities is calculated separately since asset backed securities are treated as a separate category of assets. For specific rules concerning the categorization of asset backed securities preparers are referred to Section 3.4 of the MCCSR Guideline (issued December 2012), Guideline B-5 and the Advisory issued in October 2008.
Asset backed securities are to be grouped according to the maturity and rating of the issue, on a similar basis as previously set out for public and private bonds. Public bond factors are used for rated issues. The treatment of unrated asset backed securities is being reviewed in available capitalFootnote 2.
The categorization of mortgages is based on the existing MCCSR Guideline but with additional categories of mortgages. Mortgages are to be grouped according to the remaining term of the mortgage.
Where not specifically addressed, the categorization should be consistent with current MCCSR guideline and reporting. Mortgages backed by CMHC carry a guarantee provided by the Government of Canada and therefore are eligible for a 0% factor. Qualifying HELOCs should use the residential mortgage factors and non-qualifying HELOCs should use the commercial mortgage loans – other factor.
The adjustment for collateral/guarantees is applied as a redistribution from mortgages to categories based on the external rating of the relevant counterparties, in a manner similar to public and private bonds. Section 3.2 and 3.3 of the December 2012 MCCSR Guideline should be referred to. For this QIS, the 0.25% floor is replaced by the minimum use of AAA factors. The total of the redistribution should net to zero.
For the line item “Impaired and restructured obligations” in the “Mortgages” worksheet, the calculated buffer replaces the amount that would otherwise apply to a performing asset. They are to be applied instead of, not in addition to, the amount that is required for the asset before it became impaired or restructured.
The categorization of preferred shares is the same as the existing MCCSR Guideline, which includes Tier 1 financial instruments (trust securities eligible for innovative Tier 1 capital status in the company that issued the instrument).
The calculation of the solvency buffer for other assets and miscellaneous items is based on the existing MCCSR Guideline with some minor changes. Receivables must be reported according to the amount of time they have been outstanding (i.e. less than 60 days and 60 days or more). Use an estimate if the split between less than 60 days and 60 days or more is not readily available. Approximations should be described in the “Questions and Comments” worksheet. In addition, recoverables due under arrangements deemed to constitute registered reinsurance (i.e. policy liabilities ceded) has been added as a new item. More details on this item can be found in Appendix I.
The amounts from the 2012 MCCSR are entered into the “Off Balance Sheet” worksheet to calculate the solvency buffer for these items. The insurer should enter 100% of the capital requirements in the applicable worksheet and the worksheet will adjust to target level (125%). For the solvency buffer calculation, report the amount of capital required under the current MCCSR for qualifying participating business as if it were non-participating business by doubling the factors.
Space is provided for comments covering a number of topics. Insurers are required to respond to the specific questions and are encouraged to provide additional comments in the “Questions and Comments” worksheet.
This appendix summarizes how the solvency buffer for credit risk should be determined.
The approach (described below) used for public bonds did not produce factors significantly different for short durations from the existing MCCSR factors and therefore the existing factors have been retained.
The solvency buffer for public bonds uses the factors set out below by rating and maturity:
For effective maturities between 1 and 10 years, the factor should be determined using linear interpolation between the nearest effective maturities in the above table. For effective maturities greater than 10 years, the factors for 10-year maturity should be used. For effective maturities less than 1 year, the factors for 1-year maturity should be used.
Established Using a Modified Basel Foundation Approach
These factors have been established using the Basel Foundation IRB approach as a starting point. The Basel formula for a one-year obligation is:
Capital requirement (K) = LGD * N [(1 - R)^-0.5 * N-1 (PD) + (R / (1 - R))^0.5 * N-1 (0.999)]- PD * LGD
An amount is then added to the basic requirement if the maturity of the obligation extends beyond one year.
Global historical bond default data supplied by the rating agencies has been used to establish the probabilities of default (PD). Losses given default (LGD) were set at a constant 45%, consistent with the Basel Foundation approach.
To be consistent with the Canadian life insurance companies’ solvency buffer approach, a 99.5% confidence interval has been used, instead of the 99.9% used in the Basel Foundation IRB formula. This is approximately equivalent to the 99% conditional tail expectation, CTE(99), over the one year time horizon used for other risks.
The maturity adjustment in the Basel Foundation approach is limited to maturities of less than five years. A modified maturity adjustment appropriate for the longer duration of bonds held by Canadian life companies has been used since Canadian life companies hold a large portion of their bond portfolios in bonds with maturities between five and thirty years. The Basel maturity adjustment uses regression lines that were fit to output from KMVTM Portfolio Manager based on S&P default data from 1981 to 2000. However, the results of the KMVTM valuation formulas have been used directly, and with updated S&P default data from 1981 to 2008.
The factors are higher for longer duration bonds since they are more vulnerable to deterioration in credit quality over time. The new factor appropriately captures the time dimension as an important element of credit risk and reflects historical experience.
The same correlation factor (R) has been used, as in the Basel II approach. The correlations may be reviewed further in a future QIS.
The results were checked for reasonableness using an alternate approach
The results were checked for reasonableness using an alternate approach. This method used Canadian empirical data for bond defaults, downgrades, loss given default and loss given downgrade. Over a one year time horizon, the possible losses on downgrade and the losses on default for each category of bond rating and maturity range were calculated with a high degree of confidence. This alternate approach gave similar results to the modified Basel II approach.
Solvency II approach was not taken
An alternative approach is the European Solvency II approach, which provides for a change in market spread due to widening spread or downgrade over a one year time horizon. This may work well for publicly traded bonds but would not be consistent with the approach taken for other loans with no liquid market.
There is little empirical evidence on the probability of loss and on the loss given default of Canadian private placement bonds. The Society of Actuaries studies on the North American private placement bonds suggest that their loss experience is similar to public bonds with the same credit rating.
The approach taken for private bonds has also been applied to asset backed securities. The solvency buffer for asset-backed securities rated BB- or higher may be determined using the bond factors. The solvency buffer for asset-backed securities rated B+ or lower, short-term asset-backed securities rated below A-3/R-3/P-3, and unrated asset-backed securities is 100%, similar to Basel II.
The importance of harmonizing the capital requirements for credit and other risks of Canadian life companies with those for banks is recognized. It is also recognized that the loans made by Canadian life companies are subject to different underwriting standards and tend to be of longer duration than those issued by banks.
The preferred method for commercial mortgages is the same as that used for public bonds, which is a development of the Basel foundation approach. However, there is a lack credible historical data to be able to adopt that approach.
The evidence that was available, although not statistically valid, suggests that commercial mortgages go through long periods (up to 10 years) with virtually no defaults. However, during a recession and a real estate downturn they suffer significant defaults and loss given default over a three to four year period. Based on evidence from the 1990 real estate downturn, a quantum of loss may be in the order of 6% of the value of the portfolio. Therefore, a factor of 6% for all commercial mortgages has been used. This is also in line with historical data and a shock based on CTE(99) for one year.
This new requirement would be higher than the current MCCSR factor of 4% but lower than the standard Basel II factor of 8%.
Factors that vary by loan to value ratios were considered, as this may be the best predictor of loss given default for commercial mortgages. However, credible data was lacking to use this approach.
Single family residential mortgages are a relatively small asset class for life insurance companies and therefore the current MCCSR factors have been retained. Also, some historical data from the industry and a shock based on CTE(99) for one year seems to show numbers in line with the current factors.
The approach taken for preferred shares was to ensure consistency between the factors for bonds, common stock and preferred shares.
In considering the total provision for asset default set up by Canadian life insurance companies, it is important to consider the provision for defaults contained in the actuarial liabilities - the provision for C1 risk. This is a provision for expected losses and is expressed as a basis point reduction to the effective discount rate used to value the liabilities.
C1 provisions are generally reflected in the best estimate liability by the use of a lower effective discount rate. C1 PfADs are for unexpected losses and are held in addition to the C1 provision. For the QIS, the C1 provision is included in the total asset requirements implicitly by using a discount rate based on corporate A bonds for the best estimate liability. For example if a company is holding corporate B bonds, using a discount rate based on corporate A bonds implicitly reflects the charge for default risk.
A factor of 0.7% is applied to receivables from federally regulated insurers and approved provincial reinsurers to reflect that there is a risk of non-collectability of receivables.
A factor of 5% is applied to receivables, other than from federally regulated insurers and approved provincial reinsurers, outstanding less than 60 days, while the 10% factor will be maintained for receivables outstanding 60 days or more. This better reflects that collectability is more difficult over time.
Registered Reinsurance Recoverable: A factor of 2.5% is applied to recoverables due under arrangements deemed to constitute registered reinsurance (i.e. reinsurance asset) to reflect that there is a risk of non-collectability. OSFI will recognize collateral posted by the reinsurer subject to sections 3.2 Collateral and 3.3 Guarantees and credit derivatives of the MCCSR guideline. Thus, the substitution method will apply such that the reinsurance counterparty charge (based on 2.5%) will be replaced by a credit charge based on the rating of the posted collateral. The charge should not increase if the requirement on the collateral is greater. The uncollateralized portion of the reinsurance asset is subject to the 2.5% capital charge. Modified coinsurance and funds withheld coinsurance arrangements are collateralized by the assets due to the reinsurer and the funds withheld, respectively. Thus, the ceding company can net amounts due to the reinsurer or any funds withheld against its exposure. The counterparty charge of 2.5% will be applied to the ceding company’s net exposure. The ceding company must satisfy the MCCSR guideline conditions for recognition of netting in section 6.2 Assets RequiredFootnote 3. The ceding company’s exposure is equal to the reinsurance asset. The substitution method will still apply as the ceding company is subject to a C-1 charge on the collateral it is holding (i.e. the modified coinsurance assets or funds withheld assets). In the MCCSR guideline, exposures under arrangements deemed to constitute registered reinsurance are not currently subject to a capital charge.
The factors for other miscellaneous items (outstanding premiums, agent’s debit balances, furniture and fixtures, prepaid expenses, deferred tax assets and intangible assets not deducted from capital) have been grossed up to 10% to reflect that we are calculating the solvency buffers at the target level rather than the minimum level.
For an instrument subject to a determined cash flow schedule, effective maturity is defined as:
Where CFt denotes the cash flows (principal, interest payments and fees) contractually payable by the borrower in period t.
If an insurer is not in a position to calculate the effective maturity of the contracted payments as noted above, it is allowed to use a more conservative measure such as the maximum remaining time (in years) that the borrower is permitted to take to fully discharge its contractual obligation (principal, interest, and fees) under the terms of the loan agreement. Normally, this will correspond to the nominal maturity of the instrument.
For derivatives subject to a master netting agreement, the weighted average maturity of the transactions should be used when applying the explicit maturity adjustment. Further, the notional amount of each transaction should be used for weighting the maturity.
Insurers should aggregate all exposures to a connected group (as defined in guideline B-2) within each rating grade before calculating the maturity for the exposures.
For Branches of foreign companies, refer to the equivalent lines on the TAAM return, where applicable. For provincial insurance companies, refer to the equivalent lines on the provincial return.
Return to footnote 1 referrer
The potential treatment in available capital stems from global regulatory concerns about harsh recent default experience of ABSs.
Return to footnote 2 referrer
The conditions of Section 6.2 are now the conditions for netting all cedants, not just branches.
Return to footnote 3 referrer