History in Canada
Prior to January 1, 2018, the solvency capital ratio for federally regulated life insurers in Canada was calculated using the Minimum Continuing Capital and Solvency Requirements ("MCCSR") framework. The MCCSR was developed by the federal regulator, The Office of the Superintendent of Financial Institutions ("OSFI").
MCCSR was put in place in Canada in 1992, and was largely a factor-based approach (with the major exception being for variable annuity products). The MCCSR framework was fairly comprehensive, although some risks were quantified implicitly such as reinsurance counterparty risk and operational risk. For life insurance companies registered in the province of Quebec, the rules were essentially the same, with only some minor differences.
The Life Insurance Capital Adequacy Test ("LICAT"), came into force on January 1, 2018. It was jointly developed by the Canadian and the Quebec insurance regulators. It is a principles-based framework.
While LICAT was being developed, the International Association of Insurance Supervisors ("IAIS") was developing a capital framework for internationally active insurance groups ("IAIGs"), ComFrame, which is intended to be a framework by which insurance supervisors globally can supervise the activities of, and share information about, IAIGs at a group-wide level and between group-wide and host supervisors. This capital framework is expected to apply to IAIGs as well as global systemically important insurers ("G-SIIs"). The similarities in the measurement of risks, and diversification credits available, between ComFrame and LICAT, are significant. This should not come as a surprise, as OSFI was a major contributor to the various IAIS working groups supporting the development of ComFrame.
LICAT vs MCCSR
The development of the LICAT capital standard kicked off in 2006 when OSFI published its Key Principles for the Future Direction of the Canadian Capital Framework on Insurance. This was followed by several draft guidelines, and six Quantitative Impact Studies ("QISs").
The LICAT was released in final form on November 24, 2017. The LICAT calculations are more complex and time consuming, relative to MCCSR, as described below. Because of this additional complexity and time effort involved, OSFI has provided some relief by permitting the use of certain approximations, including the latitude to perform some of the calculations off-cycle or even one quarter in arrears.
The key differences between LICAT and MCCSR can be highlighted as follows:
|Risk based; quantification of many of the insurance and economic risks is based on projected results of stress testing
||Based for the most part on static calculations, applying factors to balance sheet items
|Total balance sheet requirements are generally measured as best estimate reserves plus required capital. Required capital includes most provisions for adverse deviations in reserves and certain eligible deposits
||Total balance sheet requirements are measured as reserves plus required capital
|Explicit credit given for diversification within and across most risks
||Very limited diversification credit available
|More comprehensive calculation of mortality, lapse and morbidity risks, including level risk, trend risk, volatility risk and catastrophe risk
||Only volatility and catastrophe risks captured explicitly
|Explicit calculation of market risk, taking into account degree of asset and liability mismatch, including surplus assets
||Market (interest rate) risk calculated as a factor applied to policy liabilities
|Operational risk explicitly captured
||No explicit consideration for operational risk
|Required capital credits for participating products and products with adjustable features based on ability of insurer to pass adverse experience to policyholders
||Required capital credits permitted, based on crude test of amount of adverse experience insurer is able to pass through
|More refined consideration for embedded guarantees contained in the insurance products
||Limited recognition of embedded guarantees
OSFI has calibrated the LICAT formula such that the overall capital requirements for the industry remains largely unchanged relative to the previous regime. The impact is however quite different by risk category and therefore by company. Significant drivers of differences include product mix (long-duration vs. short duration), amount of diversification, par or adjustable credit, and exposure to longevity and foreign exchange risks. Companies cannot use internal models other than for variable annuity business. The variable annuity models continue to be pre-approved by OSFI.
LICAT Implementation Challenges
When compared to the MCCSR framework, LICAT is significantly more complex and time consuming to prepare. As a result, many companies have already concluded that model and process enhancements are required to support the LICAT implementation.
Since LICAT is still new (and more changes are coming in 2019), the drivers of quarter by quarter movements in capital ratios are not fully understood yet. In the short term, a significant amount of time will be spent analyzing and explaining the quarterly movements in LICAT ratios. It will take time to establish "rules of thumb" to be able to anticipate the (amount of) impact of changes in the various components of LICAT, and we expect companies to devote significant efforts in the testing of sensitivities.
While calculations of the regulatory required capital ("Base Solvency Buffer", or "BSB") are themselves onerous to calculate at a given point in time, projecting these values into the future is even more challenging. New tools and techniques are required in order to project the various components of the BSB in an efficient manner.
This risk based regulatory approach has had an impact on how companies think about risks and capital management. The following are examples of how the LICAT framework has impacted the industry:
- With a significant change in the regulatory capital framework, companies have had to reassess their internal target capital ratios, in the context of their Own Risk and Solvency Assessment ("ORSA") exercise. While one option has been to set the LICAT target based on an equivalent basis to the MCCSR target, many companies have chosen to re-think the appropriateness of their target capital level in light of their risk appetite and risk exposures.
- Credit risk is now measured on a more granular basis as it is tied to bond duration. Given that many insurers' fixed income portfolios are long in order to match the duration of liabilities, companies are evaluating optimal levels of asset mix in terms of quality and term on a net of cost of capital basis.
- Companies have begun to redesign or reprice their insurance products in light of the new required capital rules, reviewing the cost of long-term guarantees and the advantages of adjustable and participating products.
- Since the LICAT framework measures regulatory capital in excess of best estimate reserves, companies are paying more attention to the determination of best estimate assumptions relative to margins for adverse deviations. Under the MCCSR framework, required capital was set in excess of reserves, with margins, and the distinction between best estimate assumptions and margins did not have a significant impact on capital ratios. Under the LICAT framework, explicit valuation margins (to the extent permitted) are added to capital available against required capital. Companies are starting to take a closer look at how their valuation assumptions are split between best estimate and margins.
- Companies that have significant business ceded to reinsurers have observed, in some cases, material differences in capital ratios under LICAT. All risk mitigation strategies must be reassessed in this context to determine if desired efficiencies (cost to value analysis) are maintained.
What are some next steps?
Companies have now filed their 2017 year-end and Q1 2018 LICAT ratios with the Canadian regulators. A lot of good effort went into that work, but the focus has generally been on the production of the results on a timely basis. With this short time frame coupled with the significant work effort required to produce the results, companies may have necessarily adopted prudence in their approach.
Companies are now asking themselves a number of questions in order to refine their capital measurement and capital management strategies. Here are some questions they are considering:
- Did we interpret the regulatory guideline appropriately?
- Did we use reasonable approximations?
- Did we produce the LICAT ratios in the most efficient manner?
- Did we produce good documentation on our LICAT calculations?
- Did we try to maximize our LICAT ratios? If not, how can we do that?
- Did we set our new internal target LICAT ratios? If so, are we revisiting our decision this year?
- Do we know and understand how the new LICAT Guideline has affected the profitability of our current product offering?
We have already begun working with clients to assist them in optimizing their LICAT ratios.
For more information on the LICAT and how it will affect Canadian insurers please contact Ralph Ovsec or Hélène Pouliot