QUANTITATIVE IMPACT STUDY NO. 4 GENERAL INSTRUCTIONS

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1 QUANTITATIVE IMPACT STUDY NO. 4 GENERAL INSTRUCTIONS The purpose of this study is to gather information to evaluate a number of potential methods for determining the capital requirements related to market, credit, insurance and operational risk. The basic information required for this study is to be entered in the attached Excel workbook. In addition to supplying the requested information, we would appreciate receiving your written comments on the results of QIS#4. A worksheet is included titled Questions and Comments for insurers to provide supplemental information and any questions or comments you might have. The instructions set out below provide explanations to assist insurers in completing the calculations and the Excel worksheets. All information is to be calculated as of December 31, 2011, using year end 2011 data. For insurers with a fiscal year end other than December 31, the insurer will use their fiscal year-end data. All amounts are in thousands of dollars. When it is not possible to use 2011 year-end data, the insurer may use more recent data and make approximations to determine the December 31, 2011 values. This should only be considered for some limited values and specified in the Questions and Comments worksheet. Any item not explicitly mentioned in the instructions (market, credit, insurance and general) should follow current Minimum Continuing Capital and Surplus Requirements (MCCSR) rules for the QIS. Approximations are allowed where appropriate. Please provide a detailed explanation of the approximations in the Questions and Comments worksheet. Information is broken down for Canada, United States, United Kingdom, Europe, Japan and Other based on where the business and capital are located. Discount rates by geography are used in the present value calculations in the worksheets. For this QIS, any country not specified (i.e. the Other category) will use United States discount rates. Likewise, business sold in a country will use the discount rates of that country even if the business is denominated in another currency. Discount rates used in the calculation are those described in the market risk instructions. Insurers wishing to discuss the discount rates should contact their regulator. Summary Page The Summary Page contains five separate sets of information. The first set is the solvency buffers for each of the components of market, credit, insurance and operational risk. These are sourced from each Summary Page of the QIS Excel workbooks for market, credit and insurance risk. Operational risk is sourced from the Operational Risk workbook provided separately.

2 Quantitative Impact Study No. 4: General Instructions The second set is the existing MCCSR and Provisions for Adverse Deviations (PfADs). The components should equal the amounts reported in your December 31, 2011 MCCSR return 1 or Report of the Appointed Actuary, as applicable. The third set of information is used to calculate the potential credit for diversification as described below. The fourth set of information is used to calculate the potential credit for participating and adjustable products under the new capital standards as described below. The fifth set of information is a comparison between the total asset requirements under the potential new solvency framework and the existing capital and accounting frameworks. The components of this comparison are sourced from the completed QIS Excel files. A high level summary and example of how the solvency buffer is calculated is included in Appendices I and II respectively. An example of the application of the credits for participating and adjustable products is included in Appendix III. Insurers are requested to provide detailed MCCSR capital requirements, PfADs and statement value of asset information by product line and geography in the MCCSR, PfADs and Assets worksheets respectively. The components should equal the amount reported in the December 31, 2011 MCCSR return and the December 31, 2011 Report of the Appointed Actuary. Approximations should be described in the Questions and Comments worksheet. Insurers are requested to provide information on unregistered reinsurance, as considered in the MCCSR, in the Questions and Comments worksheet. The solvency buffer should be calculated for the reinsurance ceded to unregistered reinsurers in order to calculate the assets in trust (collateral) and to compare to the current MCCSR requirements. Since the solvency buffer is at the target level, there is no need to multiply by 150%, but rather by 125% to take into consideration operational risk (150/120=125%). Companies are also reminded to enter their company name at the top of the Summary Page. Aggregation Approach and Credit for Diversification This QIS reflects the aggregation of risk and provides a credit for diversification. The aggregation of risks is based on the sum of the risks components reduced by a risk diversification factor determined from a correlation matrix for diversification across risks. Four levels of diversification were considered. The within risk diversification is included in the insurance risk instructions, as it applies directly to each risk. The risk components should be aggregated as the sum of level and trend plus the square root of the sum of the squares for volatility and catastrophe risk. 1 For Branches of foreign companies, refer to the equivalent lines on the TAAM return, where applicable. For provincial insurance companies, refer to the equivalent lines on the provincial return. Page 2

3 Quantitative Impact Study No. 4: General Instructions The across risk diversification is included in the worksheet titled Diversification Credit. The correlation matrix calculation is sourced from the solvency buffer for each of the components of market, credit and insurance risk. These are sourced from the summary pages of the completed components of the QIS Excel files. The correlation matrix is applied using the following formula: Where SB aggregate = aggregate solvency buffer for all risks SB i = solvency buffer for risk i, before credit for participating and adjustable products Corr i,j = the correlation between risks i and j, as specified by the correlation matrix The diversification credit percentage is calculated as the difference between the sum of the individual solvency buffers for each risk before diversification and the solvency buffer calculated on an aggregated basis after diversification. For clarity, the diversification credit percentage equals 1 (aggregate solvency buffer after diversification divided by aggregate solvency buffer before diversification). A gradual haircut will be applied for credits in excess of 5% such that the maximum diversification credit is 15%. The following formula depicts the calculation of the adjusted diversification credit: where UDC = unadjusted diversification credit { ( ) ( ) The diversification credit percentage is applied to the capital requirements, before credit for participating and adjustable products. The capital requirements are defined as the solvency buffer minus an estimate of the insurance risk margin for the liability. For this QIS, the risk margin is defined as 50% of the level and trend insurance risk solvency buffers 2. As an additional test, the diversification credit will also be calculated based on the diversification credit percentage applied to the solvency buffer only. The across risk credit for diversification also includes a test to ensure that the total solvency buffer is not reduced below the highest single risk solvency buffer. The across entities diversification is included in the relevant QIS instructions. Each risk will be aggregated across entities within the same geography using the consolidated approach. Risks from different entities in the same geography should be treated as one consolidated entity. The across geographies diversification will not be considered at this time. The solvency buffer across geographies will be the sum of the solvency buffers for each geography. 2 Include the total expense risk solvency buffer. Page 3

4 Quantitative Impact Study No. 4: General Instructions Credit for Participating and Adjustable Products The potential credit for participating and adjustable products is calculated in aggregate for all risks - market, credit, insurance and operational. Business that is contractually adjustable at the sole discretion of management meets the definition of adjustable products. Adjustable products include universal life (UL) policies and others products, e.g. T-100 with adjustable premiums, that are contractually adjustable. UL is treated as adjustable only if the cost of insurance (COI), expense charges and/or the credited interest or fees are adjustable. Products with adjustable features not at the discretion of management, such as formula or index based adjustments, should be treated like non-adjustable business. It is possible for a product with formula or index based adjustments to have other contractually adjustable features at the sole discretion of management such as COI charges. Only the contractually adjustable features at the sole discretion of management may be treated as adjustable for the calculation of the credit. Adjustability should not take into consideration amounts recovered through special policyholder arrangements that have been accounted for separately (hold harmless agreements, amounts on deposit, claims fluctuation reserves). Insurers should calculate the credit for participating and adjustable products by major blocks of business and separately by geography. For example, the credit for participating products will apply by participating fund. Geographies with more than one participating fund should add together the separate participating credits to apply the overall limit by geography. This approach to multiple participating funds will be used for this QIS and will be reviewed further for the next QIS. In this QIS, the credit for participating and adjustable products is based on the value of the discretionary benefits, i.e. the level of dividends and contractual adjustability in the best estimate scenario. This results in a total asset requirement (before the credit for participating and adjustable products) that is comparable with the total asset requirements on a non-participating, non-adjustable basis since the best estimate dividends and contractual adjustability are included in the best estimate liability. As a minimum, the participating and adjustable total asset requirements should be comparable to the equivalent non-participating, non-adjustable total asset requirements assuming no future discretionary benefit cash flows and assuming similar product design, risk profile and investment strategy. The total credit will be limited based on the solvency buffer for participating products and the present value of best estimate cash flows for adjustable products before contractual adjustments, i.e. current best estimate. The limit will be applied by geography and after credit for diversification. See Appendix III for an example of this calculation. The credit for discretionary features is calculated as follows. Par A credit for participating products is calculated if there are projected dividend cash flows. The credit is calculated as 80% of the present value of the dividends using the best estimate cash flows. The cash flows are discounted using base scenario interest rates described in the market risk instructions. The CALM best estimate dividends can be used as an approximation to QIS Page 4

5 Quantitative Impact Study No. 4: General Instructions best estimate dividends. The percentage is based on the amount of adjustment to participating dividends that could reasonably be made to offset significant adverse experience considering anti-selective lapsation, market pressures and other factors influencing the ability to adjust participating dividends. The percentage also reflects that the credit is based on best estimate dividends and does not reflect the impact of the shocked environment. The dividend cash flows are to be included in the worksheet titled Par Dividends. The amount of the credit is limited to 80% of the participating solvency buffer after credit for diversification. The limit by geography ensures a minimum level of solvency buffer for participating products. The final credit is calculated in the worksheet titled Summary - Credit Par & Adj Prod. Adjustable A credit for adjustable products is calculated if there are contractually adjustable liability cash flows at the sole discretion of management. The credit is calculated as 75% of the present value of the best estimate liability cash flows before contractual adjustments, i.e. current best estimate, less the present value of the best estimate liability cash flows after contractual adjustments, i.e. 75% x (before adjustments - after adjustments). An illustrative example is as follows: Benefits and expenses = 90 Premiums = 100 Net liability cash flow = -10 After adjustment (premium increase example) Benefits and expenses = 90 Premiums = 110 Net liability cash flow = -20 Credit is 75% x 10 = 7.5 = 75% of premium increase before any limit is applied For products with contractually adjustable liability cash flows at the discretion of management but that require regulatory approval, the credit is calculated as 50% of the present value of the best estimate liability cash flows before contractual adjustments, i.e. current best estimate, less the present value of the best estimate liability cash flows after contractual adjustments, i.e. 50% x (before adjustments - after adjustments). The cash flows are discounted using base scenario interest rates described in the market risk instructions. The percentage is based on the amount of adjustment that could reasonably be made to offset significant adverse experience considering anti-selective lapsation, market pressures and other factors influencing the contractual adjustability. The percentage also reflects that the credit is based on best estimate liability cash flows and does not reflect the impact of the shocked environment. The adjustable liability cash flows are to be included in the worksheet titled Contractual Adjustability. Page 5

6 Quantitative Impact Study No. 4: General Instructions Although this may not be permitted in a future capital test, insurers could use, as an approximation, the expected management actions which would be taken rather than the maximum contractual adjustability if the latter is not available for this QIS and if management actions would result in a higher solvency buffer than that calculated using maximum contractual adjustability. Approximations should be described in the Questions and Comments worksheet. The amount of the credit is limited to 10% of the present value of best estimate adjustable liability cash flows (current best estimate) and is calculated in aggregate for adjustable products that require regulatory approval and for those that do not require regulatory approval. The limit by geography ensures a minimum level of solvency buffer for adjustable products. The percentage credit for adjustable products is less than that for participating products. Adjustable products are different in their nature and adjustability and therefore less credit will be given compared to products with discretionary liability cash flows such as participating dividends. The final credit is calculated in the worksheet titled Summary - Credit Par & Adj Prod. The calculation of the credit on adjustable products is needed to evaluate the level of discretionary liability cash flows. We are aware that this may require significant work for some insurers. If this information is not available or insufficiently complete/reliable from our analysis of QIS#4 results, the level of the credit may be reduced to reflect the uncertainty or the implementation of the credit may be delayed to provide insurers with the time to gather and provide the required information. Operational Risk The instructions for the calculation of the operational risk solvency buffer will be provided separately. Discount Rate Test As a test of the sensitivity arising from changes in the QIS discount rates, insurers are requested to provide the results of QIS#4 using an adjusted discount rate. The solvency buffer should be recalculated for each risk (insurance risk and interest rate risk) assuming the 2011 interest rates +100 bps (only the yield curve, not the UFR). The worksheets for this test will be provided separately. Interest sensitive cash flows and participating dividends should be recalculated for the revised interest rates. If this is not feasible, the insurer should describe whether the cash flows were unchanged for the interest rate tests. The impact on credit risk and other market risks may be estimated based on the overall change in asset values as described below. This test of the impact of interest rate changes also requires the recalculation of the 2011 total assets using the test interest rates. As an approximation, insurers may calculate the impact of the discount rate sensitivity on the present value of the asset cash flows used for the interest rate risk calculation. This change in asset value may be added to the 2011 statement value of assets to approximate the change in the 2011 assets. Any other reasonable methodology may be applied. The insurer should describe the methodology used for the calculation of the asset impact. Page 6

7 Appendix I CALCULATION OF SOLVENCY BUFFER: SUMMARY Definition Mt: Lo: Mcl: Mte: Lse: Lsu: Ex: Ar: Op: Mortality risk Longevity risk Morbidity claim risk Morbidity termination risk Lapse sensitive risk Lapse supported risk Expense risk Asset risk Operational risk V: Volatility C: Catastrophe L: Level T: Trend Dc: AdjC: Diversification credit Adjustable product credit Pv AdjCF: Present value of adjusted cash flows minus present value of best estimate cash flows for adjustable products Pv BE ADjCFs: Present value of best estimate cash flows for adjustable products RM: Risk margin equal to 50% x (level + trend insurance (mortality, longevity, morbidity and lapse) risk + expense risk solvency buffers before adjustments) Buf All- Dc: Buffer for all policies after diversification credit and before participating and adjustable credit Buf NPar- Dc: Buffer for non-participating policies after diversification credit Par Test: Marginal buffer for participating policies for participating credit test Pv Dvd: Par Crt: Buffer: Present value of participating dividends Participating credit Solvency buffer for all policies and all risks after diversification credit and participating and adjustable credit CR: Capital requirement, i.e. net buffer which is the buffer minus the risk margin Page 7

8 Formulas 1. Risk calculation Mt All = ( ) ( ) + ( )+ ( ) Lo All = (Death supported + Annuities) + (Death supported + Annuities) Mcl All = ( ) ( ) + Mte All = ( ) ( ) + Lse All = ( ) ( ) + Lsu All = + 2. Diversification credit calculation Unadjusted diversification credit (UDC) = 1 (Matrix [Mt All ;Lo All ;Mcl All ; Mte All ;Lse All ;Lsu All ;Ex All ;Ar All ] / Sum[Mt All ;Lo All ;Mcl All ; Mte All ;Lse All ;Lsu All ;Ex All ;Ar All ]) Adjusted diversification credit (ADC) { ( ) ( ) 3. Par credit calculation Buf NPar- Dc = Matrix[Mt NPar ;Lo NPar ;Mcl NPar ; Mte NPar ;Lse NPar ;Lsu NPar ;Ex NPar ;Ar NPar ] Par Test = Buf All- Dc - Buf NPar- Dc Par Crt = min [0.8 Pv Dvd; 0.8 Par Test] 4. Adjustable product credit calculation AdjC = min [0.75 Pv AdjCF; 0.10 Pv BE ADjCFs] where 0.75 is replaced by 0.5 for products where adjustment is subject to regulatory approval 5. Buffer calculation CR= Sum [Mt All ;Lo All ;Mcl All ; Mte All ;Lse All ;Lsu All ;Ex All ;Ar All ] - RM Buf All- Dc = Sum [Mt All ;Lo All ;Mcl All ; Mte All ;Lse All ;Lsu All ;Ex All ;Ar All ] ADC x CR Buffer = Buf All- Dc + Op All Par Crt AdjC Page 8

9 Appendix II CALCULATION OF SOLVENCY BUFFER: EXAMPLE Solvency Buffer before Adjustments for Diversification, Discretionary Features and Operational Risk All Non-Par Credit Risk Market Risk Insurance Risk Solvency Buffer before Adjustments and Operational Risk (A) 1,500 1,200 Solvency Buffer after Diversification Matrix (B) 1, Unadjusted Diversification % (C) = 1- (B)/(A) 18% 23% Adjusted Diversification % (D) (using haircut formula) 3 12% 14% Risk Margins Solvency Buffer before Adjustments less Risk Margins (E) 1,300 1,050 Diversification Credit (F) = (D) x (E) Solvency Buffer after Adjustment for Diversification and before Adjustment for Discretionary Features and Operational Risk (G) = (A) (F) 1,344 1,053 Operational Risk (H) 100 Participating Credit (I) (see Appendix III) 233 Adjustable Credit (J) (see Appendix III) 163 Solvency Buffer after Adjustments for Diversification, Discretionary Features and Operational Risk Solvency Buffer all Risks after Adjustments = (G) + (H) (I) - (J) = 1,048 3 Using round numbers for simplified example. Page 9

10 Appendix III CREDIT FOR PARTICIPATING AND ADJUSTABLE: EXAMPLE Solvency Buffer after Diversification for Participating Funds Solvency Buffer after Diversification for all Funds 1,344 Solvency Buffer after Diversification for Non-Participating Funds 1,053 Difference: Solvency Buffer after Diversification for Participating Funds (A) 291 Participating Credit Present value of Participating Dividends in the Best Estimate Scenario (B) 500 Participating Credit [min(80% A, 80% B)] (I) 233 Adjustable Credit Calculate PV of Best Estimate Cash Flows (no regulatory approval): No Contractual Adjustability (C) 1,900 With Contractual Adjustability 1,750 Difference Calculate PV of Best Estimate Cash Flows (regulatory approval): No Contractual Adjustability (D) 1,500 With Contractual Adjustability 1,400 Difference Adjustable Credit before Limit (E) 163 Adjustable Credit [min(10% (C+D), E] (J) 163 Page 10