Office of the Superintendent of Financial Institutions
Today, OSFI is releasing the final Minimum Capital Test (MCT) 2023 guideline, reporting forms and instructions that will come into force on January 1, 2023. This final version of the MCT 2023 guideline is the result of extensive engagement with stakeholders to define regulatory capital requirements under the new International Financial Reporting Standard 17
– Insurance Contracts (IFRS 17). This marks the final milestone announced in the September 30, 2020,
Letter to Federally Regulated Insurers.
While a great deal of effort has gone towards a robust implementation, IFRS 17 is a new standard, and we expect insurers to act conservatively when making decisions that would result in changes to their levels of capital.
Key revisions to the MCT 2023 guideline include:
Also, given IFRS 17 requirements for reinsurance, the MCT 2023 sets out OSFI’s expectation for insurers to obtain a supervisory approval for any new or existing intra-group reinsurance pooling arrangements.
Appendix 1 provides a summary of consultation comments received since the June 2021 public consultation, organized by theme, along with OSFI responses. MCT reporting forms and instructions have been updated to reflect changes to the MCT guideline.
The completion of this work is a significant milestone towards insurers implementing a new global accounting standard. We would like to acknowledge the extensive engagement with the insurance industry throughout this multi-year project to update the MCT framework for IFRS 17.
Should you have any questions related to regulatory capital requirements, please contact Tara-Lea Herkert, Director, Capital Division (firstname.lastname@example.org).
Amar Munipalle Executive Director, Risk Advisory Hub
What is the impact of the new capital guideline on insurers? For a change as significant as IFRS 17, a transition period is appropriate.
The MCT 2023 will not include a transition adjustment. Based on our analysis, it is not needed. The MCT 2023 is expected to result in a capital neutral outcome at the industry level, and while there will be some variance in results across federally regulated insurers, this variance is generally not material and will be managed according to our principles-based supervisory approach.
Are the allocation principles to be used only for the classes of insurance when determining margins required for insurance risks or can the principles be used to determine other capital requirements?
The MCT 2023 provides guidance for any allocation exercise undertaken by the institution to determine capital. The allocation guidance is presented in Chapter 1 and is a general requirement applicable to all sections of the MCT, where appropriate. The guidance is not exclusive to Chapter 4 and the classes of insurance when determining margins required for insurance risks, although this is a likely area of the MCT where the allocation guidance may be applicable.
The QIS used year-end 2020 as the underlying basis for the exercise, which may not be representative of the upcoming years, and therefore not an appropriate basis upon which to make capital calibration decisions. Moreover, insurers had not finalized all their accounting policy decisions.
We have considered this in our analysis and are comfortable that the final adjustments made to the MCT 2023 are appropriate. Furthermore, OSFI will undertake post-implementation monitoring to ensure the MCT remains fit-for-purpose and appropriate.
The insurance acquisition cash flows (IACF) deduction is not consistent with the IFRS 4 capital policy, which allows for the deferral of policy acquisition expenses other than taxes and commissions.
While some insurers defer other expenses under IFRS 4, premium taxes and commissions represent the vast majority of deferred policy acquisition expenses today. The new deduction for IACF other than premium taxes and commissions is therefore largely aligned with current capital policy, and will result in greater consistency and comparability across the industry.
There is currently no capital deduction for unamortized insurance acquisition cash flows, i.e., those that are deferred and amortized as part of Liability for Remaining Coverage (LRC), except for what already exists for accident and sickness business. Can OSFI provide clarification about which type of expenses would be deducted from capital available, such as, directly attributable prepaid acquisition expenses not yet recognized in the liability for remaining coverage?
The type of expenses deducted from capital available would be all other insurance acquisition cash flows paid, other than premium taxes and commissions. The deduction applies to all classes of insurance except title.
Is OSFI intending to allow the deduction to be net of any associated deferred tax liabilities?
No. This deduction is intended to be reflected gross of any potential tax implications.
If premium cash flows are excluded from (re)insurance contracts issued, the reinsurance commission cash flow should also be excluded. For the premium allocation approach only future claims costs are considered (via expected loss ratio) to determine the margin requirements.
The formula in section 184.108.40.206 of the MCT 2023 was modified to exclude acquisition expenses cash flows.
Liability for remaining coverage under IFRS 17 should only include the amount of acquisition cash flows paid that are yet to be amortized/expensed. This is one of the significant changes from IFRS 4, which required the presentation of all acquisition cash flows to be amortized/expensed in deferred acquisition costs.
We added footnote 23 to the MCT 2023 to explain that unamortized insurance acquisition cash flows are insurance acquisition costs paid and deferred that are embedded in the liability or asset for remaining coverage and are yet to be amortized/expensed.
OSFI should provide capital relief if an insurer elects the policy option available under the IFRS 17 Premium Allocation Approach to expense acquisition costs as incurred expenses rather than to defer them.
We understand the capital framework has implications for insurers who elect the accounting policy option to expense acquisition costs relative to those who opt for defer them, and we may consider this matter during a future review MCT.
Accounting for retrospective reinsurance contracts under IFRS 17 results in the reinsurance recoverable from retrospective reinsurance contracts being recognized as an Asset for Remaining Coverage instead of Asset for Incurred Claims. This results in a mismatch and increases capital.
We have amended the final MCT 2023 to include the reinsurance recoverable from certain retrospective reinsurance contracts held in the determination of the margin for liability for incurred claims, rather than in the determination of the margin for unexpired coverage.
The calculation of the unexpired coverage for insurance contracts issued as well as the unexpired coverage for reinsurance contracts held is not consistent with the results using the premium liabilities calculation under IFRS 4. Including extra costs and premiums within the liability for remaining coverage/asset for remaining coverage will provide a margin that is different than the calculation today.
Our analysis of QIS results concluded that the capital requirements for the margin for unexpired coverage were comparable to those obtained under the margin for premium liabilities, at the industry level.
In formula 1 (general measurement method or GMM) of section 220.127.116.11, future cash flows for (re)insurance contracts issued will include cash flows for policies issued after the balance sheet date. This will create margin requirements for these cash flows since unexpired coverage excludes premiums. How is underlying future business treated in calculating the unexpired coverage for reinsurance contracts issued?
The unexpired coverage for reinsurance contracts issued using GMM under IFRS 17 is determined using all cash flows related to all underlying contracts expected to attach within the contract boundary under these treaties, including underlying contracts that have not yet been issued (i.e., future business). OSFI’s commitment was for industry-wide neutrality and it is not possible or practical for every element of the MCT 2023 guideline to be neutral.
The unexpired coverage for reinsurance contract held (premium allocation approach) formula does not define future reinsurance premiums. Could OSFI clarify?
We have amended the formula to distinguish between in-force and future reinsurance contracts held.
For reinsurance contracts held, using the premium allocation approach, the asset for remaining coverage includes other deferred acquisition costs. Therefore, OSFI should modify the definition of “premiums associated with unexpired coverage” in section 18.104.22.168 to include these additional items i.e., unamortized reinsurance commission deferred acquisition costs, premiums payable to the assuming insurer, ceded written commissions, premium taxes and expenses receivable from assuming reinsurer.
The premiums associated with unexpired coverage is an MCT 2023 concept defined in section 22.214.171.124. The definition uses asset for remaining coverage as one component (along with adding back unamortized reinsurance commission and adding premiums to be paid to assuming insurer). As the asset for remaining coverage is an IFRS 17 term, the MCT does not itemize what is included therein.
For the insurance risk calculation, can OSFI clarify the capital treatment for funds withheld reinsurance arrangements given the change to the accounting treatment under IFRS 17 to a net basis?
Funds withheld amounts are added back to the formula in section 4.2.1 of the MCT 2023 to determine the asset/liability for incurred claims for both the cedent and the assuming company to gross-up the asset/liability for incurred claims.
For the calculation of the margin for unregistered reinsurance, the asset for incurred claims will include receivables, and the 20% margin will therefore be applied to a higher amount. Will OSFI make an adjustment to exclude receivables?
No adjustment will be made. While the asset for incurred claims will include receivables, it will also include offsetting payable amounts. We have concluded that adjusting the formula for receivables and payables would add unnecessary complexity; that is, we do not anticipate a material change to the margin required for unregistered reinsurance under the MCT 2023 relative to today. This was further validated with the QIS results.
Including payables and receivables in the liability for incurred claims increases capital required for liability for incurred claims as well as volatility due to timing compared to the capital required for unpaid claims under the current guideline.
In addition, the additional payables represent timing risk and not insurance risk. We recommend the draft guideline be adjusted to ensure capital neutrality with the current guideline.
We opted to use the liability/asset for incurred claims as defined in the IFRS 17 standard (which includes some payables and receivables), with only the risk adjustment for non-financial risk carved out of the liability/asset for incurred claims for MCT purposes because this keeps the test relatively simple and because QIS results did not indicate a material impact. We note that the inclusion of payables in the liability for incurred claims may be partially offset by the inclusion of receivables in the asset for incurred claims.
The “premiums associated with unexpired coverage” is intended to duplicate “unearned premium reserves” under IFRS 4. By excluding premiums payable to the assuming reinsurer in determining collateral adequacy, collateral requirements will increase.
We have amended the formula to calculate the margin for unregistered reinsurance to include premiums payable in determining margin requirements.
In section 4.2.2, could OSFI clarify whether net premiums received should be net of commissions and premium taxes?
“Net premiums received” in section 4.2.2 of the MCT 2023 guideline does not mean net of commissions and premium taxes. The “net” refers to reinsurance (i.e., premiums received less any associated reinsurance premiums paid).
In section 126.96.36.199, should component A (premiums associated with unexpired coverage on reinsurance contracts held) of the formula exclude the loss recovery component?
In addition, the asset for remaining coverage may include a loss recovery component associated with bound but not incepted business. Should any adjustments be made for this?
Component A should include any loss recovery component. We have redefined component A in the formula as "amount of premiums associated with unexpired coverage,
including any loss-recovery component, on reinsurance contracts held."
The loss recovery component associated with bound but not incepted business should be included in the asset for remaining coverage. We added this clarification to the PC4 instructions.
What is OSFI's expectation for recognizing reinsurance loss recovery from future reinsurance contracts held not yet signed?
The MCT 2023 will continue to recognize, for capital purposes, future reinsurance contracts for the unexpired portion of underlying insurance contracts issued in the calculation of the unexpired coverage for reinsurance contracts held.
For accident and sickness business, is the annual insurance revenue a net amount?
Yes, we have clarified in section 4.6 of the MCT 2023 that the annual insurance revenue is net of reinsurance, and it is annualized (i.e., net insurance revenue in the past 12 months).
The fair value of net premium liabilities is greater than the fair value of liabilities for remaining coverage. In addition, if the duration of the liability for remaining coverage is zero years whereas the duration for net premium liabilities is greater than zero years, there is a capital impact. OSFI should adjust the 2023 MCT to ensure capital neutrality with the current guideline.
Liability for remaining coverage is used since the intent of the interest rate risk test is to measure the risk of economic loss resulting from the impact of changes in interest rates on interest rate sensitive assets and liabilities on the balance sheet. OSFI’s commitment was for industry-wide neutrality, and it is not possible or practical for every element of the MCT 2023 guideline to be neutral.
To have the same capital required as under IFRS 4, the MCT 2023 guideline should include an adjustment to the interest rate risk calculation to reflect that yield changes on assets and liabilities may not be perfectly correlated.
OSFI recognizes that the discount rate for calculating the present value of future cash flows of insurance contract liabilities has changed under IFRS 17. OSFI’s commitment was for industry-wide neutrality, and it is not possible or practical for every element of the MCT 2023 guideline to be neutral.
Payables and receivables are subject to interest rate risk as they are assumed to be paid/received within a year. For consistency across schedules, the total liability for incurred claims/asset for incurred claims balance (including risk adjustment) was used to calculate the margin required for interest rate risk, with the duration being adjusted for the proportion of payables not deemed to be interest rate sensitive. Can OSFI clarify that this is the correct approach or if it is expected that only items that are interest rate sensitive should be included in the liability for incurred claims/asset for incurred claims to be used for schedule 50.00 calculations.
The total liability for incurred claims/asset for incurred claims balance (including risk adjustment) should be used to calculate the margin required for interest rate risk, with the duration adjusted accordingly for the proportion of payables/receivables and other components of liability for incurred claims/asset for incurred claims that are not interest rate sensitive.
Setting the duration of contractual service margin to zero is not consistent with the definition of duration, which measures the sensitivity of changes in interest rates. For insurers using the IFRS 17 General Measurement Method, the contractual service margin is sensitive to interest rate changes.
The basis for the zero duration of the contractual service margin is the IFRS 17 standard, which outlines that contractual service margin is not affected by changes in the time value of money.
In calculating the capital required for credit risk, could OSFI clarify if the amounts to be reported in the PC4 are the receivables that are included in insurance contract liabilities or whether it is only receivables outside the scope of IFRS 17?
All receivables, whether they are included in liability for remaining coverage or not, are to be reported in the PC4. The receivables are identified by type in the return with the applicable risk factors.
The Provincial Risk Sharing Pools (RSP) administered by the Facility Association (FA), as well as the Groupement des assureurs automobiles (GAA), are now subject to credit risk charges. Could OSFI provide the rationale for the 2.5% capital charge on recoverable amounts and is OSFI considering excluding the RSP from credit risk charges similar to intra-group pooling arrangements?
The 2.5% risk charge is used to capture the credit risk for third party reinsurance. The provincial risk sharing pools are treated similarly to third party reinsurance, with the same risk charge applied.
With Risk Sharing Pools now considered registered reinsurance, there are credit risk charges on the recoverable of 2.5% and operational risk charges that are not currently applicable. OSFI should adjust the 2023 MCT to ensure capital neutrality with the current guideline.
We are not considering changes to the credit and operational risk factors.
We understand that there will be capital implications on some components of capital required due to accounting differences under IFRS 17 compared to IFRS 4. OSFI’s commitment was for industry-wide neutrality, and it is not possible or practical for every element of the MCT 2023 guideline to be neutral.
Should the “premiums received and paid” be the actual cash flows resulting in premiums received and paid during the past 12 months, and are these intended to capture insurance acquisition expenses paid and received as well?
“Premiums received and paid” are meant to be the actual cash flows resulting in premiums received and paid during the past 12 months. Acquisition expenses paid and received are excluded.
Using premiums received may result in more volatility due to the timing of payment settlement. It may also result in significantly higher operational risk charge when there is a significant premium receivable in one year. Will OSFI consider using premiums written instead?
Our analysis has concluded that premiums received are a good proxy for premiums written to determine capital (margin) required for operational risk.