Guideline - Life Insurance Capital Adequacy Test

1 Guideline Subject: life Insurance Capital Adequacy Test No: A Issue Date: October 2018 Effective Date: January 1, 2019 Subsection 515(1), 992(1) and 608(1) of the Insurance Companies Act (ICA) requires federally regulated life Insurance companies and societies, holding companies and companies operating in Canada on a branch basis, respectively, to maintain adequate Capital or to maintain an adequate margin of assets in Canada over liabilities in Canada. Guideline A: life Insurance Capital Adequacy Test is not made pursuant to subsections 515(2), 992(2) and 608(3) of the ICA. However, the Guideline along with Guideline A-4: Regulatory Capital and Internal Capital Targets provide the framework within which the Superintendent assesses whether a life insurer1 maintains adequate Capital or an adequate margin pursuant to subsection 515(1), 992(1) and 608(1). Notwithstanding that a life insurer may meet these standards; the Superintendent may direct the life insurer to increase its Capital under subsection 515(3), 992(3) or 608(4).

2 This Guideline establishes standards, using a risk-based approach, for measuring specific life insurer risks and for aggregating the results to calculate the amount of a life insurer s regulatory required Capital to support these risks. The Guideline also defines and establishes criteria for determining the amount of qualifying regulatory available Capital . The life Insurance Capital Adequacy Test is only one component of the required assets that foreign life insurers must maintain in Canada. Foreign life insurers must also vest assets in Canada per the ICA. life insurers are required to apply this Guideline for reporting periods ending on or after January 1, 2019. Early application is not permitted. 1 For purposes of this Guideline , life insurers or insurers refer to all federally regulated insurers, including Canadian branches of foreign life companies, fraternal benefit societies, regulated life Insurance holding companies and non-operating life Insurance companies.

3 255 Albert Street Ottawa, Canada K1A 0H2 life A October 2018 LICAT 2 Contents Chapter 1 Overview and General Requirements ..5 Overview ..5 Minimum and Supervisory Target ratios ..8 Accounting basis ..8 General requirements ..9 Minimum amount of Available Capital ..13 Chapter 2 Available Capital ..14 Tier 1 ..14 Tier 2 ..31 Capital Composition and Limitations ..38 Transition ..38 Appendix 2-A Information Requirements for Capital Confirmations ..40 Chapter 3 Credit Risk On-Balance Sheet Items ..42 Credit Risk Required Capital for On-balance Sheet Assets ..43 Collateral ..52 Guarantees and credit derivatives ..59 Asset backed securities ..64 Repurchase, reverse repurchase and securities lending agreements ..66 Appendix 3-A Rating Mappings ..68 Chapter 4 Credit Risk - Off-Balance Sheet Activities ..69 Over-the-counter derivatives contracts ..69 Netting of derivative contracts.

4 72 Off-balance sheet instruments other than derivatives ..76 Commitments ..78 Chapter 5 Market Risk ..82 Interest rate risk ..82 Equity risk ..102 Real estate risk ..109 Mutual funds ..110 Index-linked products risk ..110 Currency risk ..112 Appendix 5-A Rating Mappings ..119 life A October 2018 LICAT 3 Chapter 6 Insurance Risk ..120 Projection of Insurance liability cash flows ..121 Mortality risk ..122 Longevity risk ..128 Morbidity risk ..129 Lapse risk ..132 Expense risk ..134 Property and casualty risk ..135 Credit for reinsurance and special policyholder arrangements ..135 Chapter 7 Segregated Fund Guarantee Risk ..139 Products ..139 Documentation and reporting ..140 Total gross calculated requirement ..143 Classifying the asset exposure ..148 Determining the risk attributes ..153 Retrieving the appropriate nodes ..158 Use of supplied functions to determine the requirement.

5 159 Margin Offset Adjustment ..167 Credit for reinsurance ceded or Capital markets hedging ..167 Custom factors and internal models ..168 Analysis of results ..169 Chapter 8 Operational Risk ..170 Operational risk formula ..170 Operational risk exposures and factors ..170 Chapter 9 Participating and Adjustable Products ..174 The participating product credit ..174 The contractually adjustable product credit ..178 Participating products that are contractually adjustable ..181 Chapter 10 Credit for Reinsurance ..183 Definitions ..183 Valuation basis for ceded liabilities ..185 Deductions from Available Capital for unregistered reinsurance ..185 Collateral and letters of credit ..187 life A October 2018 LICAT 4 Calculation of required Capital /margin or eligible deposits ..191 Chapter 11 Aggregation and Diversification of Risks ..197 Within-risk diversification ..197 Between-risk diversification.

6 200 Base Solvency Buffer ..204 Chapter 12 life Insurers Operating in Canada on a Branch Basis ..205 LIMAT Ratios ..205 Available Margin ..206 Surplus Allowance and Eligible Deposits ..209 Required Margin ..209 life A October 2018 LICAT 5 Chapter 1 Overview and General Requirements This chapter provides an overview of the life Insurance Capital Adequacy Test (LICAT) Guideline and sets out general requirements. Details on specific components of the LICAT are contained in subsequent chapters. Overview LICAT Ratios The LICAT measures the Capital Adequacy of an insurer and is one of several indicators used by OSFI to assess an insurer s financial condition. The ratios should not be used in isolation for ranking and rating insurers. Capital considerations include elements that contribute to financial strength through periods when an insurer is under stress as well as elements that contribute to policyholder and creditor protection during wind-up.

7 The Total Ratio focuses on policyholder and creditor protection. The formula used to calculate the Total Ratio is: Available Capital + Surplus Allowance + Eligible Deposits Base Solvency Buffer The Core Ratio focuses on financial strength. The formula used to calculate the Core Ratio is: Tier 1 Capital + 70% of Surplus Allowance + 70% of Eligible Deposits Base Solvency Buffer Available Capital Available Capital comprises Tier 1 and Tier 2 Capital , and involves certain deductions, limits and restrictions. The definition encompasses Available Capital within all subsidiaries that are consolidated for the purpose of calculating the Base Solvency Buffer, which is described below. Available Capital is defined in Chapter 2. Surplus Allowance The amount of the Surplus Allowance included in the numerator of the Total and Core Ratios is based on provisions for adverse deviations (PfADs) calculated under the Canadian Asset Liability Method (CALM), or any other method prescribed under the Standards of Practice of the Canadian Institute of Actuaries, that is used to determine Insurance contract liabilities reported on the insurer s financial Any PfAD included in the Surplus Allowance to account for a specific risk must correspond to a PfAD included in the total liability reported in 2 If approximations are permitted by the CIA Standards of Practice and used to calculate the PfADs those approximations should continue to be used for LICAT purposes.

8 life A October 2018 LICAT 6 financial statements. The specific PfADs included in the Surplus Allowance used to calculate the LICAT ratios are: 1) PfADs relating to scenario assumptions for risk-free interest rates associated with Insurance contracts other than segregated fund contracts, calculated net of all reinsurance; and 2) PfADs for the following non-economic assumptions associated with Insurance contracts other than segregated fund contracts, calculated net of registered reinsurance only: insured life mortality, annuitant mortality, morbidity, withdrawal and partial withdrawal, anti-selective lapse, expense and policy owner options. 3 These PfADs are described in the Standards of Practice of the Canadian Institute of Actuaries. All other PfADs, including PfADs for economic assumptions other than those for risk-free interest rates ( credit spreads, foreign currencies, and investment expenses), PfADs for non- economic assumptions other than those listed above ( operational risk), and PfADs associated with segregated fund contracts, are excluded from the Surplus Allowance.

9 Eligible Deposits Subject to limits, excess deposits placed by unregistered reinsurers ( sections and ) and claims fluctuation reserves ( section ) may be recognized as Eligible Deposits in the calculation of the Total Ratio and Core Ratio. Recognition of these amounts is subject to the criteria for risk transfer described in section Base Solvency Buffer Insurers Capital requirements are set at a supervisory target level that, based on expert judgment, aims to align with a conditional tail expectation (CTE) of 99% over a one-year time horizon including a terminal provision. The risk Capital requirements in this Guideline are used to compute Capital requirements at the target level. An insurer's Base Solvency Buffer ( section ) is equal to the sum of the aggregate Capital requirement net of credits, for each of six geographic regions, multiplied by a scalar of An aggregate Capital requirement is calculated for: 1) Canada 2) The United States 3) The United Kingdom 4) Europe other than the United Kingdom 5) Japan 6) Other locations 3 The PfADs in the Surplus Allowance include Insurance risk PfADs for all business that an insurer has assumed under modified coinsurance arrangements, and exclude Insurance risk PfADs for business that the insurer has ceded under registered modified coinsurance arrangements.

10 life A October 2018 LICAT 7 Liabilities and their associated risks are allocated to geographic regions based on where the original policy underlying the liability was written directly. Assets backing liabilities are allocated to the same region as the liabilities that they back. Assets backing surplus, if held in a branch, are allocated to the region in which the branch is registered, otherwise they are allocated to the region in which the legal entity holding the assets is incorporated. The aggregate Capital requirement within a geographic region comprises requirements for each of the following five risk components: 1) credit risk (Chapters 3 and 4); 2) market risk (Chapter 5); 3) Insurance risk (Chapter 6); 4) segregated funds guarantee risk (Chapter 7); and 5) operational risk (Chapter 8). Aggregate requirements are reduced by credits for qualifying in-force participating and adjustable products (Chapter 9), and risk diversification (Chapter 11).