Guideline Subject:

Internal Target Capital Ratio for Insurance Companies

Category: Capital Management No:

A-4

Date: June 2011

This guideline describes the regulatory capital ratios considered in the assessment of insurers’ capital adequacy within the context of OSFI’s Supervisory Framework 1 and sets out OSFI’s expectations with respect to the setting of an internal target capital ratio and capital management 2 policies for Federally Regulated Insurance Companies .

Table of Contents Page I. The Role of Capital in OSFI’s Risk Assessment Process..............................................2 II. Regulatory Capital Ratios ..............................................................................................3 III. Establishing an Internal Target Capital Ratio................................................................4 IV. Capital Management Policy...........................................................................................6 V. Corrective Management Actions ...................................................................................7 Appendix I: Determining an Internal Target Capital Ratio .................................................8

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More detail regarding OSFI’s Supervisory Framework, including assessment criteria, can be found at OSFI’s website: www.osfi-bsif.gc.ca. This guideline applies to Canadian incorporated Life and P&C companies and to the Canadian operations of foreign companies operating in Canada on a branch basis (excluding Regulated Insurance Holding Companies and Non-Operating Insurance Companies). The guideline replaces an earlier OSFI Advisory “MCT and BAAT Supervisory Targets,” dated December 2003.

255 Albert Street Ottawa, Canada K1A 0H2 www.osfi-bsif.gc.ca

I.

The Role of Capital in OSFI’s Risk Assessment Process

OSFI’s risk assessment process begins with an evaluation of the inherent risk within each significant activity of a Federally Regulated Insurer (FRI) and the quality of risk management applied to mitigate these risks. After considering this information, OSFI determines the level and direction (i.e., whether it is decreasing, stable, or increasing) of the net risk of each significant activity. The net risks of the significant activities are combined, by considering their relative importance, to arrive at the Overall Net Risk of the FRI. The Overall Net Risk is a consolidated rating or assessment of the potential adverse impact that the significant activities collectively could have on the FRI’s earnings performance and adequacy of capital. OSFI then develops a composite risk rating (and its direction) for the FRI, taking into account both the assessment of the overall net risk and its assessment of capital, earnings and liquidity. While regulatory capital test results 3 are important factors in OSFI’s capital and earnings assessment, they are not the only factors considered. Other assessment criteria include, for example:       

the quality of capital; the adequacy of capital to support the insurer’s risk profile and business plan; the sustainability of earnings; the ability to access capital at reasonable rates to meet projected needs; Senior Management’s and the Board of Directors’ 4 roles and effectiveness with respect to the insurer’s capital management processes; the quality or strength of the insurer’s capital management policy, including its capital management processes; and consideration of risks that may not be fully captured in the regulatory capital tests.

OSFI expects the level and quality of an insurer’s capital and its capital management to be appropriate to its circumstances, including its risk profile, tolerance for risk and operating environment. Past and emerging trends, including the outlook for capital, earnings and liquidity, as well as the insurer’s preparedness to deal with potential capital deficiencies, are also relevant in assessing the adequacy of an insurer’s current capital position.

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Life Capital Tests - Minimum Continuing Capital and Surplus Requirements (MCCSR) /Test of Adequacy of Assets in Canada and Margin Requirements (TAAM) and P&C Capital Tests - Minimum Capital Test (MCT) /Branch Adequacy of Assets Test (BAAT). For foreign company branch operations in Canada, OSFI looks to the Chief Agent to oversee the management of the branch, including matters of corporate governance. Therefore, in this document, a reference to a Board of Directors’ role and function is meant to refer to a Chief Agent’s role and function with respect to foreign company branch operations in Canada. Life/P&C A-4 June 2011

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II.

Regulatory Capital Ratios

OSFI’s risk-based capital tests assess specific risks to which insurers are exposed, as well as the general level of capital required to support these risks. Using these tests, OSFI has determined general risk-based industry standard minimum capital requirement levels 5 . These serve as a gauge of a financial institution’s capital adequacy and can trigger certain intervention 6 actions. OSFI has set the following levels of capital requirements:

Minimum Capital Ratio The MCCSR/TAAM and MCT/ BAAT address specified risks of insurers and determine a general minimum level of capital required to support these risks. If an insurer’s capital ratio approached, or was to fall below, the Minimum Capital Ratio (Minimum), OSFI would be very concerned about the ongoing viability of the insurer.

Minimum: The minimum level of capital necessary for an insurer to cover the risks specified in the capital tests.

Supervisory Target Capital Ratio OSFI’s mandate provides for an early intervention approach. This is partly addressed by establishing a Supervisory Target Capital Ratio (Supervisory Target) above the Minimum that will provide an early signal to assure that intervention will be timely and for there to be a reasonable expectation that action can successfully address difficulties.

Supervisory Target: The level of capital necessary for an insurer to cover the risks specified in the capital tests as well as to provide a margin for other types of risks not included in the tests.

From a Supervisory perspective, an insurer’s failure to maintain its capital level above the Supervisory Target is indicative of material safety and soundness concerns and a vulnerability to adverse business and economic conditions that require immediate attention. An insurer whose 5

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The Insurance Companies Act requires federally regulated insurance companies to maintain adequate capital and companies operating in Canada on a branch basis to maintain an adequate margin of assets in Canada over liabilities in Canada. The MCCSR/TAAM and MCT/BAAT Guidelines provide the framework within which the Superintendent assesses whether each company maintains adequate capital or margin, as the case may be. Guide to Intervention for Federally Regulated Life Insurance Companies and Supervisory Guide Applicable to Federally Regulated Insurance Companies can be found at OSFI’s website: www.osfi-bsif.gc.ca. Life/P&C A-4 June 2011

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capital level approaches or falls below the Supervisory Target will attract increased supervisory attention, generally including an early warning intervention status (stage 1). The amount of supervisory attention will depend on the circumstances of the particular insurer. The following table provides the required regulatory capital ratios which are calculated pursuant to capital test returns:

Regulatory Capital Ratios MCCSR/TAAM

III.

MCT/BAAT

Net Tier 1

Total

Total

Minimum

60%

120%

100%

Supervisory Target

105%

150%

150%

Establishing an Internal Target Capital Ratio

It is recognized that not all risks specific to an individual institution can be addressed explicitly by industry-wide tests alone. The minimum risk-based capital requirements specified in the industry-wide tests are based upon simplifying assumptions and are not tailored to individual insurers’ risk profiles. Accordingly, an insurer must not unduly rely on compliance with regulatory capital ratios when conducting its own risk and solvency assessment. Therefore, each FRI is expected to establish an Internal Target Capital Ratio (Internal Target) by considering its own risk appetite and risk profile, including the possible negative impacts to its capital position due to material and relevant business and other risks to which it is exposed. The Internal Target should be above the Supervisory Target in order to absorb unexpected losses beyond those covered by the Supervisory Target and to provide adequate time for management to resolve financial problems that arise, while minimizing the need for OSFI’s intervention. It is expected that an insurer’s own risk identification, measurement and solvency assessment processes will have a sufficiently high level of confidence or should otherwise be calibrated such that its determination of the Internal Target will be above the Supervisory Target. OSFI should be notified when a FRI changes its Internal Target.

Internal Target: The level of capital, based on the company’s own risk and capital adequacy assessment process, necessary to cover the risks specified in the capital tests as well as all other risks of the insurer. The Internal Target must be set above the Supervisory Target. Normally, insurers are expected to operate at a level of capital above the Internal Target.

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The Internal Target should take into account the current and forecasted business environments and should, as a result of capital adequacy planning, be adjusted when appropriate to ensure capital adequacy under stress scenarios and through entire business cycles. An insurer’s capital planning process should be forward-looking and incorporate rigorous stress testing and scenarios that identify possible events or changes in market conditions that could adversely impact the insurer. Stress testing is a risk management technique used to evaluate the potential effects of a set of specified changes in risk factors, corresponding to exceptional but plausible events. When setting an Internal Target, an insurer should examine future capital resources and capital requirements for various scenarios at an appropriate level of confidence. The results of Dynamic Capital Adequacy Test (DCAT) scenarios, other forward-looking scenarios and reverse-engineered scenarios should be considered when evaluating the adequacy of an insurer’s operating capital level and its Internal Target. When analyzing the results of stress tests for setting an Internal Target, an insurer should consider the probability of falling below each of the three levels of capital requirements using various measures. For further guidance on stress testing, insurers should refer to Guideline E-18 Stress Testing. Parent / head office guarantees, 7 potential future injections of capital or other management actions should not be assumed in the setting of an Internal Target but could be considered when determining the level at which the insurer will operate above the Internal Target. An insurer should operate at a level of capital that provides it with the continued ability to access capital (e.g. through capital markets) to address financial requirements as they emerge. The Board of Directors has ultimate responsibility for the insurer’s overall risk management program. Given that capital adequacy is an essential component of insurer solvency, it is the responsibility of the Board to establish the Internal Target. In doing so, the Board is expected to oversee Senior Management’s design and implementation of the process for determining the Internal Target as well as conduct a review/approval of the appropriateness of the Internal Target. The process for determining the Internal Target should identify, measure and appropriately consider all material risks 8 . Analysis supporting the determination and review of an insurer’s Internal Target should be clearly and formally documented in a report to the Board. The report should contain sufficient information about the process, underlying principles, methodologies, key assumptions and overall results relative to the risk appetite, strategic and operational plans and capital management framework of the company. The report should enable members of the Board to make an assessment of the overall result and appropriateness of the Internal Target. The report should be updated at least annually (more frequently if conditions warrant), and should be made available for review by OSFI upon request. OSFI may review the report and assess whether the process and its results are appropriate and congruent with its own assessment of the insurer’s risk

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Parent / head office guarantees should also not be considered in the calculation of the Minimum and the Supervisory Ratio. While setting the Internal Target is the responsibility of the FRI, Senior Management is encouraged to engage in discussions with its OSFI Relationship Manager with respect to the identification and measurement of risks or any other aspects of the process. Life/P&C A-4 June 2011

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appetite and risk profile. Additional considerations with respect to the process for setting an Internal Target are included in Appendix I. Insurers are expected to maintain actual capital in excess of their Internal Target, although it may fall below on rare and unforeseen occasions. If the capital level of an insurer falls, or is anticipated to fall within two years 9 , below its Internal Target, it is required to inform OSFI immediately and provide plans on how it expects to manage the risks and/or restore its capital level to its Internal Target within a reasonable and relatively short period of time. Increased supervisory attention may be warranted based on OSFI’s assessment of the timeliness and appropriateness of remedial actions.

IV.

Capital Management Policy

Capital management is the on-going process of determining and maintaining the quantity and quality of capital appropriate for a FRI to support planned operations. This process should be integrated with both an insurer’s enterprise risk management program and its regular planning cycle. Capital should be managed to withstand adverse economic conditions, maintain financial strength, allow for growth opportunities and meet other risk management and business objectives. OSFI expects each FRI to develop and maintain a capital management policy that includes but is not limited to:       

An Internal Target; Documented policies and procedures designed to ensure that the insurer identifies, measures and reports all material risks potentially requiring capital; Clearly defined roles and responsibilities with respect to the design and execution of the relevant policies and procedures; A process to measure capital needs relative to current and anticipated future levels of risk; A policy that states capital adequacy goals relative to risk, taking into account the insurer’s strategic focus and business plan; A set of internal controls, reviews and audits to ensure the integrity of the overall risk management and capital adequacy assessment processes; Identification of corrective actions that management may take to improve its capital position if at any time the capital level falls or is anticipated to fall below the company’s Internal Target or the Supervisory Target; and

 A requirement for the Board of Directors to regularly 10 review and approve the capital management policy.

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As may be contained in financial forecasts or other reports (e.g. projections of very likely scenarios) prepared for Senior Management, the Board or the public. The review should be at least annually or more frequently if conditions warrant. Life/P&C A-4 June 2011

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V.

Corrective Management Actions

As discussed above, an insurer’s capital management policy should include possible corrective actions management may take if at any time the capital ratio falls, or is anticipated to fall below its Internal Target. Such corrective management actions should identify, amongst other things, the levels of capital where preventative corrective actions may be appropriate (i.e. to avoid falling below the Internal Target), the expected effectiveness of potential actions, or alternatives, and the circumstances under which they could apply. Consideration should be given to the effectiveness of planned management actions in a volatile or stressed environment. If a plan is submitted in response to, or in anticipation of, the capital ratio falling below the Internal Target, insurers should provide a clear analysis of the reasons behind the decline of the capital ratio and their plans to mitigate the impact of similar and other potential future events. The plan should include sufficient details about the proposed corrective management actions, milestones and their anticipated results against which the plan’s effectiveness can be measured and monitored. The plan should include specific timeframes within which the capital ratio is expected to return to the Internal Target.

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Appendix I: Determining an Internal Target Capital Ratio The purpose of this Appendix is to share a few examples of scenarios; it is not to provide guidance with respect to the setting of an internal target capital ratio and not to prescribe a uniform method for the determination of the Internal Target. OSFI may issue additional guidance in the future with respect to the process for determining the Internal Target, the risks an insurer should assess and considerations for quantifying those risks. It is OSFI’s view that insurers should be the most qualified and capable of assessing and quantifying their own risks and determining an appropriate level for their Internal Target based on their risk profile and risk appetite. However, it may be useful to provide a few examples of scenarios for consideration. As each insurer has its own unique risk profile, the two examples below do not constitute an exhaustive list and should not be interpreted as OSFI’s minimum criteria. In fact, if an insurer were to set its Internal Target based solely on the examples provided in this appendix, OSFI would consider the process insufficient and incomplete and would request further testing and scenarios specific to the insurer’s risk profile and risk concentration. The following are some possible starting points an insurer could use when determining its Internal Target. The Internal Target could be set at a level such that: 

the impact of any relatively likely scenario, as determined by the insurer’s risk appetite, based on single or multiple risk factors would not be projected to result in the capital ratio falling below the Supervisory Target of 150% at any time over at least a one-year time horizon; and

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the impact of any higher loss scenario, as determined by the insurer’s risk appetite, based on single or multiple risk factors would be projected to result in the capital ratio remaining above an insurer-determined threshold (e.g. 50%) at all times over at least a one-year time horizon.

The terms relatively likely and higher loss scenarios in the above examples are arbitrary as OSFI believes that insurers should determine their own level of confidence (e.g. 95th, 99th, or 99.5th percentile) and definitions of relatively likely or higher loss scenarios. Each insurer is expected to demonstrate how their selected scenarios are linked to their own risk profile and risk appetite as defined in their Capital Management Policy.

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