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 market risk.
QIS#5 for market risk is similar to QIS#4 completed by insurers in the fall of 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 comments or questions.
The calculation of the solvency buffer for each component is intended to be largely consistent with the Standardized Approach for Calculating the Solvency Buffer for Market Risk (Market Risk Paper) published in November 2008. The instructions set out below contain extracts from the Market Risk Paper as well as additional explanations to assist insurers in completing the calculations and the Excel worksheets.
All information is to be calculated as of 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) product risk replaces the market risk solvency buffer on the assets backing those products. If the index linked RPT product risk components are not used including new asset funds (e.g. equity funds), market risk components will apply to these assets. Index linked RPT products and supporting investments should be included in the interest rate risk solvency buffer regardless of the treatment of the index linked RPT product risk component.
Under IFRS, certain liabilities used to be included under the Canadian Asset Liability Method (CALM) methodology have been reclassified as investment contract liabilities since they do not meet the definition of insurance products under IFRS 4. Deposit type contracts accounted for as investment contracts under IFRS are subject to the interest rate risk solvency buffer and certain information is requested related to these liabilities. However, any cash flows from segregated funds and service contracts are excluded from the interest rate risk solvency buffer.
Fill in only the non-shaded areas of the spreadsheet. Asset categories are the same as those used in the Life 1/2 and the existing Minimum Continuing Capital and Surplus Requirements (MCCSR) guideline.
Asset balances should reconcile to the Life 1/2 (including due and accrued) except for assets not included in the MCCSR guideline 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 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.
For the new solvency buffer, use the same approach and methodology as the current MCCSR guideline for the following:
Where the current MCCSR guideline approach is used, the insurer should enter 100% of the capital requirements in the applicable worksheet and the worksheet will adjust to target level (125%).
Information is requested for Canada, United States, United Kingdom, Europe, Japan and other geographies (Other) based on where the business and capital are located. Discount rates by geography are used in the present value calculations in the worksheets. For this QIS, any geography not specified (i.e. the “Other” category) will use United States discount rates. Likewise, business sold in a geography will use the discount rates of that geography even if the business is denominated in another currency. Discount rates used in the calculation are those described in these instructions. Insurers wishing to discuss the discount rates should contact their regulator.
The “Summary Page” contains information on the solvency buffers for each of the components of market 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 market 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 2
return or Report of the Appointed Actuary.
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”.
Interest rate risk is the risk of economic loss resulting from market changes in interest rates. The most significant part of this risk is the risk of economic loss due to the effect of the volatility and uncertainty of future interest rates on the mismatch of cash flows from interest sensitive assets with liability cash flows. This includes the risk of increasing interest rates for assets backing surplus or similarly negative reserves.
The asset and liability cash flows are to be projected separately using annual cash flows. For each year presented, deduct the liability cash flows from the asset cash flows to arrive at the net cash flows.
The asset, liability and net cash flows are to be separately disclosed for each of the following liability categories (for the whole product):
The asset, liability and net cash flows are to be projected separately for Canada, United States, United Kingdom, Europe, Japan and Other for each of the categories above.
Except for products where a credit is calculated separately such as participating, adjustable and index linked RPT products, interest sensitive asset and liability cash flows should change in relation to the interest rate scenario, unless it is not material. The insurer should disclose any approximations in the “Questions and Comments” worksheet. Participating, adjustable, index linked RPT and non-interest sensitive products should use the same cash flows for all interest scenarios. A summary of the cash flows by product for interest rate risk is in Appendix I.
When IFRS 4/II for insurance contracts is introduced it is possible the liability cash flows for capital purposes will be projected using assumptions that are consistent with IFRS.
Cash flows should be calculated using the assumptions that are consistent with those used in preparing the CALM actuarial liabilities except with no reinvestment assumptions. The cash flows are to be included in the worksheet titled “Asset and Liability Cash Flows”.
Provisions for Adverse Deviation
The cash flows will be determined as at December 31, 2012 using best estimate cash flows including PfADs except for PfADs for interest rate risk (C3 provisions). Provisions for asset default risk (C1 provisions including PfADs) should be included in the cash flows (whether deducted from asset cash flows or included in the liability cash flows which ever is the insurer’s practice). This includes C1 on lease asset cash flows. Liability cash flows should include PfADs for insurance risk (mortality, longevity, morbidity, lapse and expense).
PfADs are required for CALM purposes and are often used by insurers for Asset Liability Management (ALM). When risk margins are determined under IFRS 4/II, we will review the appropriateness of including the risk margins in cash flows.
Insurers should indicate in the “Questions and Comments” worksheet whether the insurer uses best estimate cash flows or best estimate cash flows with PfADs for ALM purposes.
Future Income Taxes
Future income tax cash flows resulting from timing differences in an IFRS environment will be excluded from the cash flows as deferred income tax balances are not expected to vary with interest rates in an IFRS environment. Future income tax cash flows should be included in the cash flows as they are generally included by insurers in their ALM.
Asset Cash Flows
For assets with fixed cash flows that are matched with policy liabilities, insurers should use the same cash flows as used in preparing the CALM valuation. These cash flows are net of investment expenses and expected default provisions (including C1 PfADs). No reinvestment of asset cash flows should be assumed. Only contractual asset cash flows should be projected.
For assets with fixed cash flows matched with surplus, insurers should use the cash flows net of investment expenses and any expected default provisions (including C1 PfADs). A fixed cash flow is a cash flow with contract guaranteed amount and whose value is not contingent on future market prices or future interest rates.
NFI asset cash flows including equities and real estate, insurers should use their balance sheet value at time zero less the present value of those assets’ fixed cash flows. Common share dividends are to be excluded from the cash flows.
For real estate, insurers should include the fixed cash flows in the applicable period they are contractually expected to be received (i.e. leases in force – no renewals to be assumed). Insurers should then include, at time zero, the balance sheet value less the present value of fixed cash flows using QIS discount rates. Where the fixed cash flows are not included in the applicable period, insurers should use the real estate’s full market value at time zero. The adjusted amount at time zero should be the same for all interest rate scenarios. This amount should be calculated using the base discount rates.
For preferred shares (excluding substantial investments), the fixed cash flows should be recognized to the first call or redemption date and the redemption proceeds should be recognized on the redemption date. Insurers should then include, at time zero, the balance sheet value less the present value of fixed cash flows using QIS discount rates or the market value. For preferred shares that are currently redeemable, insurers should use the market value at time zero. The adjusted amount at time zero should be the same for all interest rate scenarios. This amount should be calculated using the base discount rates.
Innovative Tier 1
For innovative Tier 1 instruments, the fixed cash flows should be recognized to the first call or redemption date and the redemption proceeds should be recognized on the redemption date. Insurers should then include, at time zero, the market value less the present value of fixed cash flows using QIS discount rates or the market value. The adjusted amount at time zero should be the same for all interest rate scenarios. This amount should be calculated using the base discount rates.
Pooled Funds – Index Linked RPT Products
Where the account value of a policy varies directly with a pooled fund and the pooled fund is held by the insurer, cash flows should be projected in the “Asset and Liability Cash Flows” worksheet. The pooled funds including mutual and segregated funds may contain bonds, equities or other assets.
If the index linked RPT product risk component is used, the liability cash flows should be equal to the asset cash flows in each scenario, except amounts for minimum interest guarantees should be used if higher. If the index linked RPT product risk component is not used, the liability cash flows should be related to the asset cash flows in each scenario according to the same rules as used for the CALM valuation. If minimum interest guarantees do not apply, time zero cash flows may be used.
Pooled Funds – Non-Index Linked RPT Products
Where the account value of a policy does not directly vary with a bond fund, cash flows should be included so that the value of the bond fund changes appropriately with the change in interest rates in each scenario.
For mutual and pooled funds that hold assets with non-fixed cash flows (e.g. equities, real estate), insurers should use their market value at time zero.
For securitized fixed income assets, such as bonds and mortgages, insurers should include the underlying fixed cash flows in the projected asset cash flows.
For securitized assets that are held in non-fixed cash flows, insurers should use their balance sheet value at time zero.
Interest Rate Swaps
For an interest rate swap, an amount of nominal cash flow should be added to the asset or liability cash flows at the term of the fixed rate portion of the swap. An offsetting amount should be added to the time zero cash flows. The reported offset may be positive or negative, and an asset or a liability. However, any reported nominal cash flows should be such that when the interest rate scenarios are applied, the change in the net present value amount of the nominal cash flows equals the change in market value of the swaps. If a swap is tied to a specific investment, the swap may be netted with the investment’s reported interest cash flows.
The shocked risk-free curve should be used to determine the floating rate swap asset or liability cash flows. The contractual rate should be used to determine the fixed rate swap asset or liability cash flows. All cash flows should be discounted at the same QIS discount rates. As an option for this QIS, if the model can project the floating portion of the swap appropriately, then the asset cash flows may be updated for each stressed interest rate scenario.
QIS discount rates and stressed interest rate scenarios apply to the swap rate rather than the swap spread.
Reverse Mortgages and Collateral Loans
For reverse mortgages and collateral loans with fixed interest rates, cash flows should be projected using reasonable assumptions including mortality. If the assets have variable interest rates, the assets should be shown as time zero cash flows. As an option for this QIS, if the model can project the variable interest assets appropriately, then the asset cash flows may be updated for each stressed interest rate scenario.
For policy loans with interest rates that are fixed or subject to guaranteed minimums, the cash flows should be projected using insurance risk PfADs (e.g. mortality and lapse rates).
For variable rate policy loans that are not subject to guaranteed minimums, policy loan amounts should be shown as time zero cash flows.
For deposit taking type business which has been reclassified out of actuarial liabilities under IFRS 4 in 2011 and classified as investment contracts, the related liability cash flows, PfADs, asset cash flows and the account value should be placed in their separate column in the worksheet. The account value is the amount the insurer expects to carry the liability at under IFRS accounting if they carry these liabilities using the effective interest methodFootnote 3
. Insurers that cannot split the investment contract cash flows from the insurance contract cash flows should describe the investment contract cash flows included elsewhere in the “Questions and Comments” worksheet.
Assets Backing Surplus and Other Liability Cash Flows
Cash flows from assets backing capital and surplus and any other liability cash flows not related to products should be included in the respective “Capital and Surplus” columns by geography in the “Asset and Liability Cash Flows” worksheet, and should be included in all calculations of market risk. See Appendix IV for an explanation of why surplus assets are included in the interest rate risk solvency buffer calculation.
One of the basic assumptions used is that only contractual cash flows should be projected. No reinvestments should be assumed. However with universal life, the contract continues after the end of any interest guaranteed period in the inside investment account. Therefore, a reinvestment assumption is required to generate the credited rate which is used to project realistic liability cash flows for premiums, policy charges and benefits and expenses.
After IFRS 4/II is introduced, the reinvestment assumption used should be consistent with the reinvestment assumption used in the IFRS valuation. It is not yet clear what that will be.
In the interim, insurers should use assumptions that are consistent with their CALM valuation. Ensure these reinvestment assumptions and credited rates vary appropriately with the scenario that is being tested, including the base scenario. Interest sensitive liability cash flows should use cash flows consistent with CALM but using QIS forward rates as investment return assumptions If this is not material, use CALM cash flows as an approximation. Approximations should be disclosed in the “Questions and Comments” worksheet. Asset cash flows should be consistent with the instructions above.
Where the universal life contract has minimum interest guarantees, the effect of these guarantees should be reflected in the scenario that is being tested. The method used to reflect the effect of these guarantees should be described in the “Questions and Comments” worksheet.
Where the performance of a universal life contract inside account benefit is tied to the performance of specific assets and these assets are held by the insurer (i.e. matching assets are held, as per the current MCCSR section 3.6), then the cash flows on these assets and liabilities should be included in the index linked RPT product worksheet.
If the matching assets are not held (i.e. the credited rate is supported by the general account assets), then the cash flows should be projected using assumptions that are consistent with their CALM valuation and then adjusted appropriately for the stress scenario being tested.
No adjustments will be made to the universal life cash flows due to anticipated changes in lapse rates and expense charges with the change in interest rates in each scenario. A solvency buffer for these changes will be considered under insurance risk.
It would be preferable if the discount rates used for the interest rate shocks were consistent with IFRS 4/II for insurance contracts. The determination of an appropriate discount rate is still under discussion. For the base scenario, assume the discount rates are the risk free interest rates plus a spread based on corporate A rated bonds as set out in the attached worksheet. Corporate A rated bond spread is used as a proxy for the illiquidity of the liability cash flows.
The risk free interest rates for Canada are the spot rates for Government of Canada bonds. The rates for the United States are the spot rates for applicable United States treasuries. The rates for United Kingdom are spot rates for UK sovereign benchmark bonds. For Europe the spot rates are the Government of Germany bonds. For Japan the spot rates are Government of Japan bonds.
The annualized discount rates are calculated based on the methodology set out below.
The ultimate forward rate (UFR) for all geographies other than Japan is defined as a forward reinvestment rate of 3.85% based on CTE(50) average from 1919Footnote 4
to 2012 (3.84%) rounded to the nearest 5 basis points. Since the UFR is a forward rate, a forward curve is necessary to determine spot rates after year 20. An additional component is the linear reduction of the corporate spread from 100% of the year 20 corporate spreadFootnote 5
at year 20 to 80% of what is viewed as a geography-specific long-term corporate spread at year 30. For example, a long-term spread of 80% x 1.25% = 1% is used for Canada. Based on data since 1989, the UFR for Japan is defined as 2% plus a long-term spread of 0.4% (corporate spread of 0.5% is also linearly reduced from 100% at year 20 to 80% at year 30.
To develop the forward curve, corporate spot rates up to year 20 are converted to forward rates. This allows forward rates for the years between 20 and 30 to be developed by linearly interpolating between the converted corporate spot rate at year 20 and the UFR with 80% of the long term corporate spread at year 30. The forward rates between year 30 and year 50 are held at constant at the year 30 forward rate (i.e. UFR with 80% of the long term corporate spread).
The forward rate curve is converted to a spot rate curve.
The discount rates to be used in the base scenario are:
The spread in the first 20 years is not modified by the conversion to forward rates. The spread after year 20 follows the first 20 years curve but is influenced by the UFR and ultimate spread. Beyond 30 years the spread is 80% of the long term corporate spread and converted to spot rates.
All interest rates are as at December 31, 2012. For insurers with a fiscal year end other than December 31, the insurer will use the discount rates as at December 31, 2012.
The rates for Canada, United States, United Kingdom, Europe and Japan are included the attached worksheet. Insurers are instructed to use the United States discount rates for other geographies.
The standardized approach will use a projected that measures the economic impact of a sudden change in interest rates at time zero. The procedure to calculate the solvency buffer is to project the contractual cash flows from all assets and liabilities (best estimate liability cash flows, PfADs excluding C3 and participating dividends) held on the reporting date unless otherwise instructed below. The discount rates to be used for the base scenario and the stressed discount rates for each significant geography are included in the worksheets. The present value calculations will be done automatically in the worksheets.
Stressed Discount Rates
For each test scenario, the annualized stressed discount rates are calculated as follows:
I) Base Scenario
II) Test Scenarios
The test scenarios are as follows:
Definition of Interest Rate Shocks
The interest rate shocks (T1, T2, S1, S2, B1, B2, C1 and C2) to be used are the following linear functions of the square roots of the current risk free rates r, where r is expressed as a decimal (for example five percent will be expressed as 0.05). This function is based on a simplified Cox-Ingersoll-Ross model fitted to the historic data. See Appendix II for a more detailed description of the method used for the shocks.
If the current 90-day risk free rate is r0.25 , then:
If the current 20-year risk free rate is r20 , then:
If the risk free rate for term t is equal to rt , where t is between 90 days and 20 years, then the changes interpolated for the time t rate under the four test scenarios, which in all cases are added to the base rates, are:
When adjusting the UFR:
When interest rates are stressed the liability cash flows should be adjusted to account for any interest rate guarantees.
Cash flows from participating products are those used in the calculation of best estimate policyholder obligations adjusted for PfADs, including dividends. The dividend cash flows used in the base scenario should be consistent with CALM base scenario but use QIS forward rates as investment return assumptions “QIS base scenario dividends”. If this is not material, use CALM base scenario dividends as an approximation. Approximations should be disclosed in the “Questions and Comments” worksheet. No adjustment to cash flows are made for anticipated reductions or increases in dividends that may result from increases or decreases in interest rates in each scenario. A reduction in the solvency buffer for potential reductions in dividends is calculated separately for the participating products.
Insurers are requested to calculate two other values of the interest rate risk buffer for participating products using:
In both cases, only the adverse scenario for each geography will change in the calculation of participating interest rate risk solvency buffer, not the base scenario. Also, assume the worst scenario for each geography from the participating interest rate risk solvency buffer calculation as the adverse scenario. For example, if scenario (i) is the worst scenario for participating interest rate risk, use scenario (i) to calculate the participating interest rate risk with the two versions of dividend cash flows above (a) and b)). Only the dividend cash flows will change in the two versions. The adjustment is done to the dividend cash flows, not the dividend scales. Impacts on other cash flows such as adverse impacts on lapse should not be reflected. Dividend cash flows should include dividends used to pay dividends or purchase paid-up additions. If this is not the case, changes in premium, cash surrender value and death benefit cash flows will need to be reflected.
The interest rate risk solvency buffer based in the dividend cash flows in a) is used in the calculation of the credit for participating products. The results of this test should be included in the “50%D Test” workbook. The interest rate risk solvency buffer based on the dividend cash flows in b) is included for test purposes as the “worst scenario dividend test” in the “WSD Test” workbook.
Details of the credit for participating products are included in the general instructions.
III) Resulting Solvency Buffer
For insurers operating only in Canada, the solvency buffer is the difference between the total net present value of the base scenario and the lowest total net present value of the test scenarios.
For insurers operating in Canada and the United States, the solvency buffer should be based on the scenario which produces the highest buffer on a combined basis for the two currency/interest environments. This recognizes that interest rates in the two countries tend to move in similar directions. The test scenario to be used is the scenario which produces the greatest difference between the total net present value of the base scenarios and the lowest total net present value of the test scenarios (in total for Canada and the United States), but if a scenario results in a negative buffer for a geography, that geography’s buffer will be set to zero for purposes of calculating the combined buffer for that scenario. The resulting solvency buffer for each geography, therefore, cannot be lower than zero. See example in Appendix III. We may also use the QIS data to test the impact of using the worst scenario in each geography to determine the solvency buffer.
The solvency buffer for other geographies (United Kingdom, Europe, Japan and Other) is the difference between the total net present value of the base scenario and the lowest total net present value of the test scenarios for each geography, respectively.
There is a concern that if an insurer has long term assets backing the solvency buffer, the insurer is disadvantaged since the current interest rate risk calculation does not recognize the solvency buffer cash flows.
As a voluntary test, insurers are requested to calculate the interest rate risk solvency buffer including the solvency buffer cash flows as a “liability cash flow”. These would include insurance risk level and trend solvency buffer cash flows (i.e. the difference between the shocked and best estimate cash flows, not discounted) and the bond cash flows reflecting the credit risk shocks (i.e. the projected impact on the bond cash flows). The solvency buffer cash flows should be reduced to reflect overall credits for diversification and participating and adjustable products.
The approach and results of the test including a description of how the credits for diversification and participating and adjustable products were reflected should be detailed in the “Questions and Comments” worksheet in the “SBCF Test” workbook.
This component may be tested at a later time.
Equity market risk is the risk of economic loss due to changes in the prices of common shares this includes both the systematic and specific components common share price fluctuation.
The solvency buffer for all investments classified as equities (including equity index securities, managed equity portfolios and investment trusts) excluding preferred shares should be calculated using a simple immediate (time zero) deterministic downward shock of 30% to the market value of the equities. The shock is applied to the net positions of identical equities. Where the underlying securities or indices in a long and short position are not exactly the same but are closely correlated (e.g. a broad stock index and a large capitalization sub-index), companies should calculate the solvency buffer factor for the combined position using the correlation factor methodology as defined in the index linked RPT products section below.
Substantial (as defined in Section 10 of the ICA) equity investments (including preferred shares) in an entity, including in a joint venture but where the company but does not have control (as defined in Section 3 of the ICA) should be calculated using a time zero deterministic shock of 40%.
The current MCCSR requirement using the scenario table charge for options (section 3.7.4 of the current MCCSR guideline) should be used with the +/-15% change in the value of the underlying security changed to +/-30%.
The charge for hedges of segregated fund guarantee risk according to the current MCCSR requirement (section 3.7 of the current MCCSR guideline) should be used.
Real estate market risk is the risk of economic loss due to changes in the amount and timing of cash flows from investments in real estate.
For income producing real estate, the solvency buffer should be calculated in two parts, a credit risk part and a market risk part.
The first part, a credit risk calculation, should be based on the present value of the fixed lease cash flows that are contractually expected to be received (i.e. leases in force – no renewals to be assumed). These are the same cash flows as was used in the calculation of interest rate risk solvency buffer. The categoriesFootnote 7 and the related factors are consistent with those used in the credit risk. The present value of the lease cash flows should be allocated to the categories listed in the QIS worksheets based on rating agency issuer ratings of the specific lessees.
Prepaid rent should be excluded from the present value of lease cash flows. A lease agreement with a rent-free period and a rent-paying period thereafter (within the terms of the lease agreement) should be included in the present value of lease cash flows. The present value related to lessees without external ratings may use internal ratings subject to a minimum factor of a 5-year BBB bond (4%) if the ratings are reviewed annually by qualified resources using appropriate standards. The methodology for credit ratings in geographies outside of Canada should be described in the “Questions and Comments” worksheet.
The second part, a market risk calculation, should be an immediate (time zero) deterministic downward shock to the residual market value of the real estate. The residual value is the market value at year-end 2012 net of the present value of the fixed cash flows that are contractually expected to be received as determined above except including prepaid rent cash flows. The calculation of this part will be a 30% immediate decline in the residual market value of real estate. The total real estate carrying value, total market value and total solvency buffer should be included by geography in the “Real Estate Risk” worksheet.
For non-income producing real estate; own use real estate; oil and gas properties; and timberland and agriculture properties, the solvency buffer will be calculated using a 30% downward shock to the market value of the real estate. The solvency buffer is the difference, if positive between the carrying value on the balance sheet at year-end 2012, and 70% of the market value at year-end 2012. The solvency buffer must be determined on a property by property basis. The total real estate carrying value, total market value and total solvency buffer are to be included by geography in the “Real Estate Risk” worksheet.
We recognize that carrying value may differ from the market value. The total carrying value and the total market value of real estate should be disclosed in order that this differential may be appropriately incorporated into our analysis.
Equity investments in real estate that are considered substantial (as defined in Section 10 of the ICA), but where the company but does not have control (as defined in Section 3 of the ICA) should be calculated using a time zero deterministic shock of 40%.
The solvency buffer for investments in mutual funds should be calculated using the market value shocks in this QIS. The factor for investment in mutual funds, segregated funds and real estate investment trusts is a weighted average of factors for assets that the fund is permitted to invest in. The weights and factors are calculated assuming that the fund first invests in the asset class attracting the highest factor, to the maximum extent permitted in its prospectus or annual information form (where more current). It is then assumed that the fund continues allocating investments to asset classes in declining order of capital charge, to the maximum extent permitted, until a total allocation of 100% is reached. The factor for the mutual fund is then the sum of the products of the weights and risk factors for the assumed investment allocation.
In the absence of specific limits to asset classes or if the fund is in violation of the limits stated in the prospectus, the entire fund is subject to the highest risk charge applicable to any security that the fund holds or is permitted to invest in. However, the determination of the factor may exclude fund holdings that meet both of the following conditions:
The solvency buffer for mutual funds is included in the “Equity Risk” worksheet. Insurers are requested to include details of the calculation in the “Questions and Comments” worksheet.
The MCCSR guideline includes a calculation of capital required for index linked pass through products. The amounts included on the existing MCCSR return page 35.010 should be included on this worksheet up to and including Line 19 of 35.010 (except as modified to include a new threshold of CF<70% and the change in factor from 15% to 30%), which responds to the market risk related to such products. For products with a 30% factor including products with new asset funds, insurers could alternatively use for those products (and their matched assets) the requirements for credit risk and other categories of market risk, including the interest rate risk and equity risk.
Currency market risk is the risk of economic loss due to changes in the amount and timing of cash flows arising from changes in currency rates of exchange.
The MCCSR guideline includes a calculation of capital required for currency risk based on the accounting treatment (i.e. exemption through the currency translation account (CTA)). For the purposes of this QIS, the current MCCSR approach should be used, with the following risk-based modifications:
The total currency risk solvency buffer should be calculated in aggregate and allocated by geography based on the contribution of the geography to the net exposure in the “Currency Risk” worksheet. Assume all currency risk solvency buffer is non-participating if not material else estimate and describe in the “Questions and Comments” worksheet.
An example of the currency risk solvency buffer is included in Appendix V.
Liability market options risk is the risk of economic loss due to changes in the amount and timing of cash flows related to all market related options and guarantees in the liabilities. These include minimum interest rate guarantees in and accumulation annuities and guarantees of segregated fund performance. In calculating cash flows under each interest rate scenario, interest rate guarantees should be taken into account with future cash flows changed as appropriate.
QIS requirements with respect to the standard approach for segregated fund guarantee risk, or liability market options risk, are included in separate instructions titled “Quantitative Impact Study No. 5: Instructions for Segregated Fund Guarantee Products”. The target level requirements should be based on current approved internal model results. The insurer should include on the “Liability Market Options Risk” the calculated amounts at the target level reported on Page 90.010 Line 230 Column 8 of the insurer’s MCCSR 2012 year end filing. The insurer should enter 100% of the capital requirements in the applicable worksheet and the worksheet will adjust to target level (125%).
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 contains a summary of the cash flows to be used for interest rate risk testing.
CALM with PfADs (excluding C3) and no reinvestment
CALM with PfADs (excluding C3) and no reinvestment
Dividends use QIS forward rates as investment returns (CALM base scenario dividends if not material)
CALM with PfADs (excluding C3) and use QIS forward rates as investment returns (CALM base scenario if not material)
This appendix contains a few types of interest rate models that were considered for use to determine the magnitude of the interest rate shocks in the market risk component. The potential method retained, based on a simplified Cox-Ingersoll-Ross model, is to use interest rate shocks for the 90-day and 30-year rates that are linear functions of the square roots of the current rates.
dr = f(r,t)dt+σdW
A simple model for observed rates is:
dr = σdW
dr = a(b−r)dt+plus;σ√r dW
Under this model, the rate becomes more volatile as it gets higher, but it also reverts to a
long-run value b.
However, the shocks for when the two rates move in opposite directions (i.e. twist scenarios) are much milder (no correlation is assumed between the short- and long-term rates):
In the twist scenarios, the 20-year rate is as follows:
The approach used is based on historical data and CTE(99) for a one year shock of the rates. The shocks are applied at the supervisory target level and not the minimum. The UFR is based on a long term average and the shock is the difference between a CTE(80) and CTE(50) average rates and rounded to the nearest 5 basis points. This approach results in a higher shock when average rates are higher. This approach also creates a more stable UFR. A fixed shock is more stable and this UFR is more stable than the current 10 year moving average used in CALM.
For the Canadian UFR, the approach used historical data from 1919. The period of historical data to use is still under review. For other countries, it is difficult to find appropriate data on historical long term interest rates before the 1980s. Therefore, the approach compared the Canadian 20 year interest rates to other countries’ rates for the longest period possible and then used a proportion of the Canadian UFR.
For Japan, the approach used the 20 year bond rates from 1989 (this is the oldest and longest continuous period where data was found). On average comparing those rates with Canadian 20 year bond rates, Japan rates are roughly 50% lower (the range is from about 35% to 65%). Since shocks appear to be proportionally equivalent between Japan rates and Canadian rates, the same % of the shock was assumed.
For the other countries, a similar approach was used for the UFR and shocks. But since the results were very close to Canadian UFR and shocks, the same UFR and shocks for all countries other than Japan.
Recognizing non-fixed income (NFI) assets such as equities and real estate may be appropriate for the CALM valuation, but not for capital purposes. NFI assets returns are not interest rate sensitive and the cash flows should not be included in the calculation of the interest rate solvency buffer. For capital purposes, it may not be prudent to rely on past NFI returns to produce stable cash flows.
Interest rate risk is intended to capture the impact of changes in interest rates, NFI assets are not directly interest rate sensitive. Therefore, to keep the present value the same for each interest rate scenario, allowing NFI asset cash flows would require that the NFI asset cash flows increase (decrease) with the same return as assumed by the interest rate scenarios. This would be in accordance with the assumption that the NFI assets are not interest rate sensitive and when interest rates change there is no direct change to the value of the NFI assets. A return equal to the QIS discount rate is implicitly assumed for the NFI assets.
Surplus assets are included in the calculation of the interest rate risk solvency buffer. It is difficult to estimate the solvency buffer cash flows that the surplus assets are supporting, however the interest rate risk solvency buffer is measuring interest rate risk, not mismatch risk. Surplus assets invested in cash does not bear the same risk as surplus assets invested in long bonds which are susceptible to rising interest rates. Surplus assets count as available capital and therefore the associated risks need to be accounted for.
Where an insurer operates in Canada and the United States, the solvency buffer for interest rate risk is determined using the same test scenario for both countries as interest rates are highly correlated. The following illustrates how to calculate the buffers for interest rate risk for these two geographies.
* Determining Worst Scenario:
1 As the difference is (4,925) it is set to zero
The QIS calculates a solvency buffer for interest rate risk on surplus assets. The following example illustrates why this requirement exists at the target level of surplus assets.
The first example below includes a liability duration that is shorter than the duration of the asset:
Required buffer: applied only to the assets supporting the liabilities = (100 − 100) − (90 − 95) = 5
Required buffer: applied to all the assets = (100 + 5 − 100) − (90 + 4.5 − 95) = 5.5
If the requirement only applies to the assets supporting the liabilities, then:
However, when all assets are subject to the interest rate risk, and it materializes as calibrated in the buffer requirement, the result would be:
If the requirement applies to all assets, then:
Then, when all assets are subject to the interest rate risk, and it materializes as calibrated in the buffer requirement, the result would be:
To reduce its required buffer for interest rate risk, an insurer could invest its assets supporting the surplus in non-interest sensitive assets such as cash or equity. Then it could be demonstrated that a surplus of 5 would be adequate.
For perfectly matched assets and liabilities, the requirement for interest rate risk applied to the assets supporting the surplus may seem unnecessary. It is not because the buffer is necessary when an increase in interest rate decreases the value of these assets at the same time as these assets are required to cover the exposure to another risk. The diversification credit considers the simultaneous occurrence of two different risks.
Also, in some cases, the inclusion of surplus assets may improve the cash flow match.
In the next example the duration of the liability is longer than the duration of the asset:
Required buffer: applied only to the assets supporting the liabilities = (100 − 100) − (110 − 115) = 5
Required buffer: applied to all the assets = (100 + 5 − 100) − (110 + 5.5 − 115) = 4.5
Then, when all assets are subject to the interest rate risk, and it materializes as calibrated in the buffer requirement, the result would be:
This demonstrates that an insurer can reduce its required buffer for interest rate risk when the duration of the liability is longer than the duration of the asset by investing its assets supporting the surplus in interest-sensitive assets as bonds.
A life insurer has the following asset and liability positions:
The offset is defined as a short position of up to 15% of the liabilities in each currency. In this example, U.S. dollar liabilities are $500, so the maximum permitted offset is 15% x $500 = $75 for the U.S exposure. A $10 offset for the Euro position is used (5% of $200 liabilities) to reduce the net Euro exposure to zero. The U.K. pound exposure is negative (short position), so no offset is calculated as any offset would increase the U.K. pound short position. Any percentage, up to 15%, may be used by the insurer to produce the lowest net exposure in each currency:
The net exposure, defined as the higher of the absolute value of (1) the net long open position (net of the offset) and (2) the net open short position, is $595 (max of $595 and $100):
The total currency risk solvency buffer is calculated as 10% of the net exposure ($595 x 10% = $59). U.S. dollar exposure contributes 425/595 of the $59 buffer ($42.14) and other currencies contribute 170/595 ($16.86). U.K. pound exposure (net short position) and Euro exposure (net zero position) do not contribute to the net exposure and therefore do not receive any allocation of the currency risk buffer.
Current approved internal models should be used to calculate the target level of solvency buffer. The standard approach for segregated fund guarantee risk is being separately tested.
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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.
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QIS participants are asked to refer to the accounting standard related to financial instruments (IAS 39) issued by International Accounting Standards Board.
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Using data from 1936-2012 is still under review. CTE(50) from 1936-2012 is 3.71%.
Return to footnote 4 referrer
The long-term spread was reviewed based on recent data.
Return to footnote 5 referrer
This is the level % of reduced dividends that reproduce the same result as using the worst scenario dividends. For example, if the worst scenario dividends are the QIS base dividends gradually reduced by duration, the flat % is the level % of dividends that gives the same PV of the worst scenario based on the worst scenario dividends.
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QIS participants should refer to Chapter 3 of the MCCSR Guideline for additional guidance regarding selection of appropriate credit ratings.
Return to footnote 7 referrer