Required capital components for participating and adjustable products are calculated in the prior chapters as if
the products were non-participating and non-adjustable. However, participating and adjustable policies allow
insurers to share risk with policyholders through discretionary benefits. Therefore, insurers may include
credits for participating products (par credit) and for contractually adjustable policies (adjustable credit) in
the calculation of the Base Solvency Buffer provided certain conditions are met.
An insurer should calculate the credit for participating products by geographic region. However, if not all
participating products within a region are homogeneous with respect to the risks that are passed through to
policyholders via reductions in dividends, it will be necessary for the insurer to partition its participating
business within the region into separate blocks that are homogeneous with respect to the risks passed through to
policyholders. A partitioned block may contain assets and liabilities whose risks are not passed
through to policyholders (e.g. risk adjustments, policy loans, amounts on deposit). A standalone capital
requirement net of par credit is calculated for each participating block.
The adjustable credit is calculated for each adjustable product within a geographic region.
A non-trivial reduction in dividends or significant adjustments made to adjustable features may result in other
adverse impacts (second-order effects) due to lapses, anti-selection, unit expense increases or legal action
undertaken by policyholders. Such second-order effects should not be reflected in cash flows when calculating
the credit for participating and adjustable products.
9.1. The participating product credit
9.1.1. Conditions for the par credit
A par credit may be used to reduce the required capital for a block of participating policies provided that the
experience with respect to specified risk elements is incorporated into the annual dividend adjustment process
in a consistent manner from year to year. A par credit may be taken for the block only if the following three
criteria are met:
- The insurer’s participating dividend policy must be publicly disclosed and must make clear that
policyholder dividends are not guaranteed and will be adjusted to reflect actual experience. The insurer
should publicly disclose the elements of actual experience that are incorporated in the annual dividend
adjustment process. Insurers should disclose all material elements and indicate whether and how the risks
are passed through to the policyholders (e.g., investment income, asset defaults, mortality, lapses and
expenses).
- The insurer should regularly (at least once a year) review the policyholder dividend scale in relation to
the actual experience of the participating account (i.e., including all blocks of business). The insurer
should be able to demonstrate to the satisfaction of OSFI which individual elements of actual experience, to
the extent that they were not anticipated in the current dividend scale, have been passed through in the
annual dividend adjustment. Furthermore, the insurer should be able to demonstrate that shortfalls in actual
overall experience, to the extent that they are not fully absorbed by any additional positive reserves or
other similar experience levelling mechanisms, are recovered on a
present value basis through level or declining reductions in the dividend scale. The
dividend scale reductions required to effect recovery must be made within two years from when the shortfall
occurs.
- The insurer should be able to demonstrate to OSFI that it follows the dividend policy and practices referred
to above.
9.1.2. Calculation of the par credit for a block
The par credit for a qualifying block of par business takes into account the present value of restated dividend
cash flows. The par credit CPi for the block that is used to
calculate the Base Solvency Buffer
(q.v. section 11.3) is given by:
where:
-
is 75% of the present value of restated dividend cash flows for the block used in the interest rate risk
calculation (q.v. section 5.1.3.3), discounted using the Initial Scenario Discount Rates in section 5.1.1
-
is defined by:
which represents the six-quarter rolling average of
taken over the current quarter and the previous five quarters. For each quarter, the quantity
is equal to 75% of the present value of restated dividend cash flows for the block used in the interest rate
risk calculation, discounted using the rates under the most adverse scenario that determines the requirement for
interest rate risk in that quarter
-
is the interest rate risk requirement (q.v. section 5.1.2.3) for the block
- Ki is the adjusted diversified requirement K for the block (q.v. section 11.2)
-
is the adjusted diversified requirement K for all risks in the block, with the interest rate risk
component reduced. This quantity is calculated by setting the interest rate risk component of the block to
), and leaving all other risk components unchanged.
-
is the minimum adjusted diversified requirement for the block. This quantity is calculated by aggregating,
within the calculation of
:
- 100% of the requirements for all risks in the block that cannot be passed through to policyholders by
making adjustments to the dividend scale
- 10% of the interest rate risk requirement for the block, if interest rate risk can be passed through to
policyholders by making adjustments to the dividend scale
- 30% of all other risk components that can be passed through to policyholders by making adjustments to
the dividend scale.
For a block that has assets and liabilities for which interest rate risk is passed through to policyholders, and
other assets and liabilities for which interest rate risk is not passed through to policyholders, the combined
amount for i) and ii) above that should be used for the interest rate risk requirement in calculating
is:
where
is as defined in section 5.1.2.3.
Example: Par Credit
Suppose that a participating block of business has the following risk components, and that the interest
rate risk component has remained level over the previous five quarters:
Life insurance risk |
Gross component (
) |
Level and trend components (
) |
|
Mortality |
750,000 |
300,000 |
600,000 |
Longevity |
0 |
0 |
0 |
Morbidity incidence |
0 |
0 |
0 |
Morbidity termination |
0 |
0 |
0 |
Lapse sensitive |
500,000 |
200,000 |
400,000 |
Lapse supported |
0 |
0 |
0 |
Expense |
50,000 |
0 |
50,000 |
Totals |
1,300,000 |
500,000 |
|
Other risks |
Component |
Credit risk |
300,000 |
Interest rate risk (IRR) |
400,000 |
Other market risks |
250,000 |
Property and casualty risk |
0 |
Suppose further that, in the current quarter and previous five quarters, the present value of
restated dividends for the block under the initial scenario is 800,000, and that this present value
moves to 1,200,000 under the adverse scenario that determines the requirement for interest rate
risk. The quantity
for the block is therefore 75% x 800,000 = 600,000, and
is 75% x 1,200,000 = 900,000. Finally, suppose that all risks associated with the block except
mortality risk are passed through to policyholders through dividend adjustments.
The requirement K for this block is equal to 1,913,436 (the intermediate quantities in the
calculation are I = 832,166, D = 1,544,525, and U = 2,250,000; refer to
section 11.2.4 for an example that shows the steps in the calculation of K). Since
for the block, the requirement
is the requirement K for the block recalculated using an interest rate risk requirement of
0, and is equal to 1,565,813 (I = 832,166, D = 1,205,277, U = 1,850,000).
The potential credit as a function of the dividend absorption capacity is therefore:
Since all risks except for mortality risk are passed through to policyholders, the requirement
for the block is calculated using 100% of the requirement for mortality risk, 10% of the requirement
for interest rate risk, and 30% of the requirements for all other risks:
Life insurance risk |
Gross component (
) |
Level and trend components (
) |
|
Mortality |
750,000 |
300,000 |
600,000 |
Longevity |
0 |
0 |
0 |
Morbidity incidence |
0 |
0 |
0 |
Morbidity termination |
0 |
0 |
0 |
Lapse sensitive |
150,000 |
60,000 |
120,000 |
Lapse supported |
0 |
0 |
0 |
Expense |
15,000 |
0 |
15,000 |
Totals |
915,000 |
360,000 |
|
Other risks |
Component |
Credit risk |
90,000 |
Interest rate risk (
) |
40,000 |
Other market risks |
75,000 |
Property and casualty risk |
0 |
The value of
is therefore 987,841 (I = 649,173, D = 772,354, U = 1,120,000), and the
maximum credit as a function of the requirements above the LICAT floors is:
The par credit CP for the block is equal to the lower of the two amounts, which is 680,956.
9.2. The contractually adjustable product credit
9.2.1. Conditions for the adjustable credit
Products that are contractually adjustable qualify for a credit if all of the following conditions are met:
- Contractual adjustability is at the sole discretion of the insurer.
- All adjustable features associated with the products (e.g. premiums, fees and benefits) have been explicitly
disclosed in the contract.
- The insurer should regularly (at least once a year) review the product’s experience and consider its
potential impact on adjustments. Although the review and resulting adjustments may be for the most part
forward-looking, the insurer should be able to demonstrate to the satisfaction of OSFI which individual
elements of actual experience are considered in the review process.
- The adjustability is reasonably flexible, and the insurer has tested the reasonable flexibility of the
adjustable features in pricing the policy or subsequent to pricing the product. The test should demonstrate
that the insurer is able to recuperate at least half of any unexpected insurance risk losses (defined as the
product's marginal capital requirement for insurance risks minus its Surplus Allowance related to insurance
risks) by comparing the price with and without future adjustments. Tests of adjustability may not take into
consideration amounts recoverable through arrangements that are accorded a separate credit in the insurance
risk components, such as hold harmless agreements, deposits made by policyholders or claims fluctuation
reserves. The tests should be documented and available for review by OSFI on request, and should
demonstrate, to the satisfaction of OSFI, that these conditions are met.
- If an insurer takes credit for an adjustable feature, the insurer should have a documented internal policy
on how it makes adjustments and the key considerations in making adjustments, including the consideration
given to losses or shortfalls in actual overall experience. Any credit taken must be calculated consistently
with the manner stated in the internal policy, and must reflect policies that, if followed, would reduce or
restrict the adjustability otherwise permitted in the contract.
- The insurer should be able to demonstrate to OSFI that it follows the adjustment policy and practices
referred to above.
A product that is only adjustable up to a certain age or has a one-time adjustment may be considered adjustable
provided that it meets all other conditions. A credit may not be taken for an adjustment that is no longer
available (e.g., used up or expired), or that the insurer would not exercise, according to its policy or past
practices, in the event of adverse experience or loss.
A product that is adjustable at the discretion of the insurer but that is also subject to third-party (e.g.
regulatory) approval will be considered a qualifying adjustable product; however, such a product will receive a
lower credit than other qualifying adjustable products that do not require third-party approval.
A product with a solvency maintenance clause (e.g. certain non-participating products issued by fraternal benefit
societies) may be considered a qualifying adjustable product provided that it meets all other conditions.
A product with adjustable features that are not at the discretion of the insurer (such as formula or index based
adjustments) is treated as non-adjustable business.
9.2.2. Calculation of the adjustable credit
The gross adjustable credit Cj is calculated for two categories of qualifying products where there are
contractually adjustable liability cash flows:
- Products adjustable at the sole discretion of the insurer and that do not require third-party approval, and
- Products adjustable at the sole discretion of the insurer and that do require third-party approval.
The gross adjustable credit is equal to the difference between non-adjusted cash flows and adjusted cash flows
discounted using the Initial Scenario Discount Rates specified in section 5.1.1. For each adjustable feature
within a contract, adjusted cash flows are based on the maximum possible adjustment for the contract within the
contract boundary, up to a limit. The limit for each adjustable feature is set depending on whether adjustments
to the feature require third-party approval or not.
For products with adjustable features that do not require third-party approval, the increases or decreases for
each feature recognized in adjusted cash flows are capped at 50% of the feature’s current level, phased-in
on a straight line basis over a period of five years (i.e. 10% per year). For products
with adjustable features that do require third-party approval, the increases or decreases for each feature
recognized in adjusted cash flows are capped at 30% of the current level, phased-in on a straight line basis
over a period of five years after a delay period of two years (i.e. adjustments of 6% per year occur after a
waiting period of two years).
Once the gross adjustable credit Cj for a product has been calculated, the adjustable credit CAj for the product used to calculate the Base Solvency Buffer (q.v. section 11.3) is given by:
where:
-
is the requirement K (q.v. section 11.2) calculated for the non-participating block, and
-
is the requirement K for the non-participating block
recalculated excluding the requirements for all of the qualifying adjustable product’s insurance
risks.
Example: Adjustable Credit
This example builds on the example presented at the end of section 11.2.4, where the requirement
for a non-participating block of business within a geographic region is determined to be 1,517,987. If
this block contains an adjustable product, in order to determine the adjustable credit for the product
it is necessary to calculate the gross adjustable credit C, and to recalculate the
block’s insurance components with insurance risks related to the adjustable product excluded.
Suppose that the gross adjustable credit is equal to 250,000, and that when the adjustable
product’s insurance risks are removed from the non-participating block, the block’s
recalculated insurance risk components are as follows:
Life insurance risk |
Gross component (
) excluding adjustable product |
Level and trend components (
) excluding adjustable product |
|
Mortality |
800,000 |
500,000 |
550,000 |
Longevity |
3,000 |
3,000 |
1,500 |
Morbidity incidence |
50,000 |
10,000 |
45,000 |
Morbidity termination |
2,500 |
1,000 |
2,000 |
Lapse sensitive |
200,000 |
90,000 |
155,000 |
Lapse supported |
100,000 |
40,000 |
80,000 |
Expense |
7,500 |
0 |
7,500 |
Totals |
1,163,000 |
644,000 |
|
The recalculation of the components I, D, U and K for the block
then proceed as follows:
(unchanged)
The adjustable credit for the product is then:
9.3. Participating products that are contractually adjustable
Where a product is both participating and has an adjustable feature that is able to pass through losses or
reflect adverse experience arising from all risks, an insurer may take a simultaneous credit for participating
and adjustable features as specified below. In order for an insurer to take credit for participating and
adjustable features simultaneously, the product must meet all of the conditions for participating products
specified in section 9.1.1 and all of the conditions for adjustable products specified in section 9.2.1, and the
insurer should have sole discretion to exercise the adjustable feature without third-party approval to recover
losses or reflect adverse experience that occurs for any reason (i.e. adjustability must not be confined to
specific risks). If the participating product has an adjustable feature that is not able to pass through losses
or reflect adverse experience for all risks, the credit in this section is not available. For such a product,
the insurer has the option to apply either the par credit or the adjustable credit, but not both.
If a product is eligible for both credits, the adjustable credit for the product should be recalculated using the
methodology for participating products in section 9.1. The revised adjustable credit is:
where:
-
,
, and
have the same definitions as in section 9.1.2
-
is the gross adjustable credit defined in section 9.2.2
-
is the six-month rolling average, taken over the current quarter and previous five quarters, of the gross
adjustable credit modified so that in each quarter it is discounted using the rates under the most adverse
scenario that determines the requirement for interest rate risk in that quarter, instead of the initial
scenario
-
is calculated by aggregating, within the calculation of
:
- 30% of all insurance risk components for the block, and
- 100% of all other risk components for the block
The aggregate credit for the product is then equal to:
where:
-
is the participating credit for the product
-
is the recalculated adjustable credit for the product
-
is the adjusted diversified requirement for the block
-
is calculated by aggregating, within the calculation of
:
- 10% of the interest rate risk component for the block, and
- 30% of all other risk components for the block