On July 21, 2022, the Office of the Superintendent of Financial Institutions Canada (OSFI) issued the final insurance capital guidelines, which were updated to reflect the implementation of International Financial Reporting Standards 17 (IFRS 17). This marks the final milestone announced in the September 30, 2020, letter to Federally Regulated Insurers (FRIs). In particular, OSFI has made changes to the following guidelines (the Guidelines): Life Insurance Capital Adequacy Test (LICAT), Minimum Capital Test (MCT), and Mortgage Insurer Capital Adequacy Test (MICAT). According to OSFI, these Guidelines recognize the improvements in the new international accounting standards of increased transparency and comparability of risks across the global insurance industry. When releasing these revised Guidelines, OSFI advised that it remains committed to working with the industry and key stakeholders to support the robust implementation of IFRS 17.
The final Guidelines result from extensive, iterative, and collaborative consultation with insurance industry stakeholders and other provincial regulators. They are considered to be the most significant change to insurance accounting requirements in over 20 years. Following the first publication of the standards in 2017, OSFI embarked on a multi-year exercise to update its capital tests, guidance, reporting requirements, and supervisory expectations to support a robust implementation by insurers of IFRS 17. Following repeated delays, IFRS 17 will come into effect on January 1, 2023. In addition to adapting the capital Guidelines and accompanying forms for IFRS 17, OSFI has also made consequential changes to update references and streamline guidelines, as well as confirming expectations across all other relevant guidelines to address the new accounting rules. OSFI notes that the new guidance released results from the concentrated efforts to adapt its guidance to IFRS 17 while ensuring that the requirements are appropriate for the Canadian context.
When releasing the final Guidelines, OSFI issued a cover letter for each guideline that explained the specific changes. A summary of the explanation for each cover letter is set out below.
I. Changes to the LICAT
Key revisions to the LICAT include:
- Adapting it for IFRS Insurance Contracts, including the use of concepts and measurements of insurance liabilities, and also:
- Recalibrating certain elements of the test to minimise industry-wide capital impacts, including reducing the Base Solvency Buffer (BSB) scalar from 1.05 to 1.0; and
- Introducing a two-year optional volatility measure to dampen the volatility introduced by the market consistent valuation on the Cost of Guarantees (CoGs) under IFRS 17.
- Incorporating the OSFI Advisory Supplementary Guidance for the Treatment of Participating Insurance issued in November 2020; and
- Specifying credit risk requirements in a manner consistent with IFRS 9 – Financial Instruments terminology.
In the LICAT cover letter, OSFI published a summary of the consultation comments received during the June 2021 public consultation, along with OSFI’s responses. The comments and responses were divided into general and specific categories. General comments focused on capital neutrality, capital volatility, references to liabilities, and clarifications and corrections. Specific comments focused on several matters, including, but not limited to, adjustment to surplus allowance and tax credit for unregistered reinsurance. A summary of some of these comments is set out below.
OSFI communicated its intention to minimize industry-wide capital impacts on implementing IFRS 17 while maintaining the integrity of the test. To that end, OSFI has adopted the following levers to mitigate the impact of IFRS 17:
- Reduce the BSB scalar from 1.05 to 1.00.
- Made adjustments to the Interest Rate Risk (IRR) calculation for the par credit and the requirements for non-participating, non-segregated fund products as follows: (a) Exclude the incremental market consistent value of CoGs in the IRR buffer calculation for non-participating products (non-segregated fund); (b) Reduce the factor applied in the IRR buffer for the participating credit floor calculation from 10% to 5%.
- Increase the limit to 130% of the sum of items one through six in Section 188.8.131.52 of the LICAT guideline.
OSFI noted that it considered other adjustments but did not believe they were necessary to achieve its goal. OSFI also noted that the LICAT 2023 will not include a transition adjustment as it is not needed. OSFI advised that the LICAT is expected to result in a capital-neutral outcome at the industry level. While there will be some variance in results across FRIs, this variance is generally not material and will be managed according to its principles-based supervisory approach.
OSFI advised that it reviewed the LICAT sensitivity under different economic scenarios to understand the change in capital volatility from IFRS 4 to IFRS 17. At an industry level, OSFI did not observe material increases in volatility. OSFI noted one exception, which is volatility introduced through the market consistent CoGs under IFRS 17. Generally and where possible, OSFI expects insurers to take measures to address volatility introduced with IFRS 17. However, in the short-term, modelling of CoGs may not be fully developed for some insurers. Because of this, OSFI confirmed that it introduced a temporary volatility mitigation measure to the test, which will be in place for two years. Insurers will have a one-time option to decide whether or not to implement this measure.
Adjustment to surplus allowance – risk of non-performance by reinsurer
OSFI confirmed that the 2.5% charge for registered reinsurance contracts held, along with all of the other risk charges in Section 3.1, reflects the risk of unexpected credit losses. OSFI noted that it does not cover the risk of expected credit losses, which are covered by balance sheet credit risk provisions. OSFI confirmed that the balance sheet provision and the 2.5% capital charge provide for potential credit risk losses arising from reinsurance.
Tax credit for unregistered reinsurance
Industry stakeholders advised that the 10.2.5 tax credit for unregistered reinsurance should be based on all negative reserves ceded to an unregistered reinsurer. Industry stakeholders advised that this approach would ensure consistent and fair capital treatment between retaining or ceding the business to an unregistered reinsurer. OSFI disagreed and noted that parity is maintained because the ceding company will report a taxable loss and therefore receive a tax refund when it cedes a business having an aggregate negative reserve. OSFI further noted that the reason for setting the tax credit based on the offsetting liabilities is that if all negative reserve policies lapse after the business is ceded, the only additional taxable loss will be that arising from offsetting liabilities ceded.
In addition, minor consequential updates were made to the following forms, instructions, guidelines, and advisories as a result of the changes to the LICAT 2023 guideline: the Own Risk and Solvency Assessment; Key Metrics Report, Guideline A-4: Regulatory Capital and Internal Capital Targets; and the Revised Guidance for Companies that Determine Segregated Fund Guarantee Capital Requirements Using an Approved Model.
II. Changes to the MCT
Key revisions to the MCT include:
- Adapting it for IFRS Insurance Contracts, including the use of concepts and measurements of insurance liabilities;
- Adjusting requirements in respect of claims liabilities to maintain the overall level of required resources to protect policyholders;
- Specifying credit risk requirements in a manner consistent with IFRS 9 Financial Instruments terminology; and
- Establishing principles for allocation methods used for capital purposes.
The 2023 MCT sets out OSFI’s expectation that insurers obtain supervisory approval for any new or existing intra-group reinsurance pooling arrangements. Whereas the 2019 MCT did not explicitly state that insurers must obtain supervisory approval of any intra-group pooling arrangements, the updated 2023 MCT is clearer in that supervisory approval must be obtained prior to applying the intra-group pooling capital treatment. Given the impacts of IFRS 17, a new supervisory approval is required. Effective January 1, 2023, legacy arrangements and approvals obtained before May 1, 2022, will not be recognized.
In the MCT cover letter, OSFI also published a summary of the consultation comments received during the June 2021 public consultation, along with OSFI’s responses. The comments and responses were divided into several categories, including miscellaneous, insurance risk, market risk, credit risk, and operational risk. The comments focused on a number of matters including, but not limited to, impact and transition period, insurance acquisition cash flows, unregistered reinsurance, and funds withheld. A summary of some of these comments is set out below.
Impact and transition
OSFI confirmed that the 2023 MCT will not include a transition adjustment as it is not needed. The 2023 MCT is expected to result in a capital-neutral outcome at the industry level. While there will be some variance in results across FRIs, this variance is generally not material and will be managed according to OSFI’s principles-based supervisory approach.
Insurance acquisition cash flows
OSFI confirmed that the type of expenses deducted from the capital available would be all other insurance acquisition cash flows paid, other than premium taxes and commissions. OSFI noted that the deduction applies to all classes of insurance except title insurance and is intended to be reflected gross of any potential tax implications.
Industry stakeholders advised that when using the premium allocation approach for reinsurance contracts held, the asset for remaining coverage includes other deferred acquisition costs. Therefore, industry stakeholders advised that OSFI should modify the definition of “premium associated with unexpired coverage” in Section 184.108.40.206 to include these additional items. OSFI noted that the premiums associated with unexpired coverage are a 2023 MCT concept defined in Section 220.127.116.11. The definition uses the asset for remaining coverage as one component. OSFI further noted that the asset for remaining coverage is an IFRS 17 term; the MCT does not itemize what is included therein.
OSFI clarified that funds withheld amounts are added back to the formula in Section 4.2.1 of the 2023 MCT to determine the asset/liabilities for incurred claims for both the cedent and the assuming company to gross-up the asset/liabilities for incurred claims.
III. Changes to the MICAT
Key changes to the MICAT include:
- Adapting it for IFRS Insurance Contracts, including the use of concepts and measurements of insurance liabilities;
- Introducing a capital requirement on the loss components of liabilities for remaining coverage. This amendment was done so that the MICAT ratios better reflect the changes in the level of insurance risk during periods when mortgage insurers are under stress; and
- Specifying credit risk requirements in a manner consistent with IFRS 9 Financial Instruments terminology.
The MICAT 2023 guideline also directly incorporates the calculation for First-Time Homebuyer Incentive mortgages (FTHBI) specified in the advisory MICAT Total Requirements for FTHBI Mortgages. MICAT reporting forms and instructions have been updated to reflect changes to the MICAT guideline.
The implementation of IFRS 17 will impact FRIs by fundamentally changing accounting, actuarial, and reporting practices, and by significantly impacting supporting systems and practices. OSFI notes that Canada’s insurance industry is well-capitalized under current accounting rules and will remain well-capitalized after insurers implement IFRS 17. OSFI has reiterated its expectation that insurers act conservatively when making decisions resulting in changes to their capital levels.
According to OSFI’s progress reports in May 2021, a total of 98% of insurers self-assessed as being on track for robust implementation of IFRS 17. Although this may signal that many FRIs will be on track to implement IFRS 17 by January 1, 2023, self-assessments are not objective standards. Consistent with existing principles and practice, OSFI will continue to monitor the effectiveness of the Guidelines to ensure they remain fit for purpose and appropriate in light of industry and economic developments. Any changes will be introduced in a transparent manner and in consultation with external stakeholders.
As a reminder, FRIs must be prepared to provide data in IFRS format for the 2022 financial year. In particular, FRIs with a December year-end must use the updated forms beginning January 1, 2023, and FRIs with an October year-end must use the updated forms beginning November 1, 2023.
Please do not hesitate to contact any member of the Insurance group should you have any questions.