A New Chapter in Life Insurance Capital Requirements

A New Chapter in Life Insurance Capital Requirements Remarks by Mark Zelmer Deputy Superintendent Office of the Superintendent of Financial Institutions Canada (OSFI) to the CFA Society Toronto Toronto, Ontario April 21, 2016 Please check against delivery For additional information contact: Kaitlin Sabourin Communications and Consultations kaitlin.sabourin@osfi-bsif.gc.ca www.osfi-bsif.gc.ca

Remarks by Deputy Superintendent Mark Zelmer Office of the Superintendent of Financial Institutions Canada (OSFI) to the CFA Society Toronto Toronto, Ontario April 21, 2016 Introduction Thank you for inviting me to speak with you today. Financial professionals like you are very important stakeholders for Canadian financial institutions and those of us who supervise them. We, at OSFI, believe it is important that you understand our prudential regulatory framework and how it can help you in assessing the financial condition of the institutions we supervise. On March 31, OSFI released for public comment an all-new, draft regulatory capital guideline for federally regulated life insurance companies. We are calling this new guideline the Life Insurance Capital Adequacy Test, or LICAT guideline, to distinguish it from our current Minimum Continuing Capital Surplus Requirement, or MCCSR guideline. The draft LICAT guideline has been developed in close collaboration with the Quebec financial services regulator, the Autorité des marchés financiers (AMF), Assuris 1 and representatives of the life insurance industry. I would like to thank them for their many hours of hard work in developing it. Their active engagement and constructive feedback on this project has helped to deliver a draft capital guideline that is consistent with OSFI s mandate to protect policyholders and other creditors, while allowing life insurers to compete and take reasonable risks. The comment period closes on May 9, and discussions with our partners will continue during the public consultation period. We also look forward to hearing what you and other stakeholders have to say. Comments received during the consultation period and results of some test runs will help us finalize the calibration of the LICAT guideline. Let me stress that the LICAT is not expected to impact the overall level of capital in the system. Moreover, the LICAT guideline is very different from the MCCSR guideline. A simple comparison of the two sets of ratios will not allow for any reasonable conclusions about the financial condition of a life insurer. As such, this afternoon I would like to spend some time outlining the key features of the LICAT, and how they differ from those of its MCCSR predecessor. I will then briefly explain how the draft LICAT guideline compares at a high level with the Solvency II insurance capital framework recently introduced in Europe, and the new 1 The AMF supervises life insurance companies with a license to conduct business in Quebec while Assuris is responsible for protecting policyholders if a federally incorporated life insurance company fails. 1

international capital standard that is currently under construction by the International Association of Insurance Supervisors (IAIS). I will also highlight how our new draft guideline has been designed to measure capital requirements in different interest rate environments, including today s very low interest rate environment and interest rate volatility more generally, an issue that is very important in assessing the solvency of life insurers given the long-term nature of their liabilities. Not surprisingly, this is a lively topic in the ongoing discussions internationally on the new international capital standard. I will conclude my remarks today by providing the next steps and a timetable for finalizing and implementing the LICAT guideline. Capital requirements protect policyholders and promote confidence in life insurers Before delving into the details of the LICAT, let me take a minute to remind you why OSFI sets regulatory capital requirements. At their core, regulatory capital requirements protect policyholders and creditors and promote confidence in the financial condition of life insurers. A life insurer s policyholders and creditors need to have confidence from the outset that they will receive their benefits and have their claims honoured when they fall due, even if that is many years down the road. Capital requirements set by OSFI help protect policyholders and creditors in the event their life insurer encounters stress in the interim. Life insurers are less dependent on financial markets for funding than deposit-taking institutions, and less exposed to runs due to the long-term nature of most of their insurance liabilities. However, the long-term nature of their contracts exposes them to other asset/liability management risks. For example, life insurers make assumptions regarding the long-term yield when pricing a product, but may not be able to back that assumption with assets of equal duration. This exposes them to reinvestment risk years into the future. Not only does capital protect existing policyholders and creditors, it also serves as an important signal of a life insurer s financial condition to prospective policyholders and other stakeholders. It gives comfort to prospective policyholders, creditors, sales distribution networks, and regulators that a life insurer is sound, enabling it to attract new business, and continue to grow. LICAT is not your parents MCCSR The MCCSR guideline was an effective early pioneer in setting risk-based capital requirements for Canadian life insurers when it was first introduced in 1992, and it has served policyholders and creditors well since then. However, increasingly we have had to rely on additional Pillar II capital adjustments tailored to individual life insurers to 2

compensate for the fact that some risks might not be adequately captured in the current MCCSR guideline. It became apparent that OSFI needed to undertake a fundamental review of the MCCSR guideline for it to remain comprehensive and risk-based, and to enable a closer alignment between specific risks and their probability of occurrence. Forthcoming changes to insurance accounting standards, lessons from evolving capital frameworks in other jurisdictions, and the global financial crisis have also added to our desire to evolve the MCCSR guideline. 2 In keeping with OSFI s principles-based approach to regulation and supervision, the draft LICAT guideline has been guided by five core principles. In essence, the new guideline will: Include a standardised capital approach with risk measurement methods that can be objectively and consistently applied by all life insurers. Consider all relevant cash flows from on-balance sheet assets and liabilities, as well as off-balance sheet activities such as derivatives transactions. Include individual measures of required capital for insurance, credit, market and operational risks, measured at similar confidence levels over a defined time horizon. Appropriately account for reinsurance, hedging and other risk mitigation strategies used by life insurers. Include a methodology for aggregating the required capital associated with each type of risk while considering the dependencies and interactions within and across risks. A new concept introduced in the draft LICAT guideline is the Base Solvency Buffer. It is the amount of assets a life insurer needs to hold to meet its regulatory requirements over and beyond the assets required to back its actuarially determined best estimate policyholder liabilities. The Base Solvency Buffer will cover credit, market, insurance and operational risks. It starts by computing and summing the amount of assets required for each individual risk. It then encourages risk mitigation by subtracting from that sum: limited credits for diversification (within and across risks); for risk mitigation arising from reinsurance and for hedging transactions that are on the books at the valuation date; as well as some credits for the ability to adjust over time the discretionary features contained in participating and adjustable products. The net requirement gets multiplied by a scalar that is not expected to change often but will allow for adjustments to the overall level of capital in the system. 2 See: OSFI, Life Insurance Regulatory Framework, September 2012. Available at http://www.osfi-bsif.gc.ca 3

If you look under the hood of the LICAT, you will see that it contains a mix of factorbased approaches, OSFI-prescribed shock assumptions, and reliance on computed capital requirements derived from life insurance companies own risk models in the case of exposures related to segregated fund products. This hybrid approach allows for greater risk sensitivity and better measurement of certain risks, such as insurance risks, which will now be measured using, for the most part, shock-based approaches. The LICAT relies on more advanced and risk-based techniques and more current and granular data to measure credit, market and insurance risks. There is also, for the first time, an explicit methodology for operational risk. OSFI has endeavoured to measure all of the risks at a consistent level of confidence; more specifically CTE 99% over a oneyear horizon including a terminal provision. Or to put it more simply, the draft LICAT guideline has been calibrated so a life insurer can withstand a 1 in 200 year stress event with enough assets to sell or run-off the business after the stress event. Refinements have also been introduced for the risk mitigation components of the framework. For example, a more sophisticated approach will be used to measure risk mitigation benefits associated with participating and adjustable products. Some diversification credits are also allowed, such as between insurance and investment risks, using prudent factors. However, like the MCCSR, the draft LICAT guideline makes no allowance for diversification between credit and market risks, given those benefits can evaporate in times of stress. In the wake of the global financial crisis OSFI has reviewed and tightened up the definition of regulatory capital for banks and insurers. Thus, the draft LICAT guideline also includes some changes to the definition of regulatory capital for life insurers or what is called Available Capital in the guideline. Deductions and adjustments to Available Capital will now be made at the same level where the losses occur. So, for example, losses and write-downs that directly reduce retained earnings will now be deducted from Tier 1 capital. And of note, for instruments to qualify as Available Capital, OSFI needs to be comfortable that they will absorb losses in times of stress. Hence, the changes we made to the definition of qualifying regulatory capital instruments back in 2014 in anticipation of this new life insurance capital guideline. Items subject to write-downs in periods of stress have also been re-evaluated and their regulatory capital treatment adjusted accordingly for the draft LICAT guideline. Intangible assets are a good case in point. In the MCCSR they are only deducted from Available Capital if they exceed 5% of a life insurer s gross Tier 1. In the new guideline, all intangible assets (including computer software intangibles) will be fully deducted in computing Tier 1 capital. By now you may be wondering what all this means for the amount of capital that life insurers need to carry. Back in 2012 OSFI indicated that it believed that the life insurance industry had adequate financial resources, in aggregate, for its risks at that 4

time, but that the allocation of capital to various risks or business lines may change with the new capital guideline. 3 Our view has not changed. We continue to be broadly satisfied with the amount of capital available in the life insurance industry as a whole. Of course what holds for the industry may not hold for individual companies. Much will depend on what businesses they are engaged in and the risks they are assuming. This may require life insurers to evaluate their overall capital plans and requirements, particularly for those businesses that may require more capital under the new framework. Let me also note that initially OSFI developed the draft LICAT guideline to be compatible with the International Accounting Standards Board (IASB) proposals regarding accounting for insurance contracts. The IASB is still working on that accounting project, thus, we are moving forward with our new capital guideline using the Canadian Asset Liability Method, more commonly known as CALM. This way the capital guideline can be implemented as planned in 2018 without the life insurance industry being in limbo while waiting for the finalization of the accounting standards. Like the MCCSR, we plan on reviewing the LICAT guideline on an annual basis to ensure it keeps pace with industry developments and evolving risk management practices. We will thus leverage this review cycle to amend it again after the IASB has issued its new insurance accounting standard in its final form. OSFI has also committed to review the volatility of the new capital framework at that time to ensure that capital requirements for life insurers are not too volatile. A final note on this point, you may have noticed I have not said anything about how the LICAT guideline will handle segregated fund guarantees. Work on a new methodology to determine regulatory capital requirements for these exposures is underway on a separate parallel track. OSFI plans to implement a new standardised methodology for these guarantees effective for financial years beginning in January 2020. Taken together, this all means that ratios under the LICAT guideline are going to be different and behave differently than the MCCSR ratios that life insurer stakeholders like you have become used to. Apples and oranges, if you will. That is why OSFI has decided to underscore this point by resetting the measurement basis so that LICAT ratios will look very different from their MCCSR predecessors. LICAT is largely consistent with Solvency II and emerging international standards Let me now turn to how the LICAT guideline compares to regulatory capital frameworks in place in other jurisdictions. OSFI and its partners first developed the MCCSR and subsequently the LICAT guideline without the benefit of a uniform international capital standard. This partly reflects the fact that insurance markets and insurer investment strategies can vary significantly from jurisdiction to jurisdiction. For example, major life insurers in Canada and the United States stand out from many of their overseas 3 ibid, page 4. 5

counterparts by offering longer-term insurance products whose pricing is often fixed at the outset and contain embedded guarantees (such as minimum interest rate guarantees) in savings and annuity products. Plus, major North American life insurers are often more active managers of the investment assets backing their insurance obligations. These differences need to be kept in mind in the design of regulatory capital frameworks. When the MCCSR was first introduced it was an international pioneer in many respects in applying a risk-based solvency framework to life insurers. Newer frameworks like Solvency II in Europe have gone further in this respect, and our development of the draft LICAT guideline has certainly benefitted from lessons learned in the construction of those frameworks. Indeed, newer insurance capital frameworks around the world are generally converging towards more sophisticated risk-based frameworks. Thus, it is no surprise that the LICAT is largely consistent with Solvency II and the proposed new Insurance Capital Standard (ICS) currently being developed by the IAIS. Important differences remain. Nowhere is that more apparent than in how different capital frameworks handle the current environment of exceptionally low interest rates and interest rate volatility more generally. One notable approach is the US capital framework, where Pillar 1 regulatory capital requirements and available capital only adjust to interest rate movements when insurance liabilities and their supporting assets mature and are replaced with new assets and liabilities. Another important point of reference is Solvency II, where initial versions of that regulatory capital framework were very sensitive to interest rates due to their heavier reliance on fair-valuation of cash flows on both sides of the balance sheet. However, more recent versions now include several measures that serve to mitigate excessive volatility in regulatory capital positions. OSFI and its partners in Canada have opted for a practical middle ground. On the one hand we agree that life insurer regulatory capital ratios need to respond to market forces if they are to convey credible signals of the financial condition of life insurers to you and other stakeholders. But, we want those signals to be clear and not clouded by noise generated by transitory fluctuations in market prices for long-term insurance contract liabilities. Let s face it, at any point in time prevailing prices are highly unlikely to offer much information as to how many assets are required today to cover a long-term liability cash flow that is unlikely to materialize for several decades. But, if the price movements persist, life insurers should be incented to respond accordingly so their liabilities are supported by adequate assets well before liabilities come due. For example, in the draft LICAT guideline, an Ultimate Interest Rate or UIR is introduced to reduce excessive volatility when discounting long term cash flows. The UIR is essentially a long-term view of interest rates based on the average of the preceding 20 years of long-term GDP growth and inflation. It is therefore not expected to vary materially from year to year and will be used to measure interest rate risk associated 6

with longer-term insurance contract liabilities when there are no directly observable market prices. Meanwhile, the draft LICAT guideline relies on observable market prices for valuing the asset side of the balance sheet and liabilities that are within the range of observable market prices. This approach helps to address any excessive volatility in regulatory capital requirements, while ensuring that policyholder obligations are adequately covered by assets well before they crystalize. Conclusion You have been a patient audience, but it is time I wrap up. So let me end by reiterating my main points: 1. OSFI is broadly satisfied with the amount of capital in the life insurance industry as a whole and this is reflected in the calibration of the new framework. OSFI believes that the new framework provides the appropriate balance of policyholder/creditor protection and the ability of life insurers to compete. 2. The draft LICAT guideline represents an evolution in OSFI s solvency expectations. It takes into account changes in life insurer business practices and advances in risk management techniques over the past 25 years. As a result, LICAT solvency ratios will not be directly comparable with their MCCSR predecessors. 3. While consistent with international developments towards an insurance capital standard, the draft LICAT guideline has been tailored to the Canadian life insurance marketplace where many insurers offer long-term insurance liabilities whose pricing is fixed from the outset, and who actively manage their investment assets to help to minimize the cost of insurance products while achieving their profit targets. The feedback received from the public consultation process, ongoing discussions with our partners as well as results from some test runs will help us calibrate our final approach and ensure there are no anomalous effects to introducing the LICAT guideline in 2018. As has been the case with the MCCSR, OSFI will regularly review the new LICAT guideline and update it as needed to keep abreast of developments in the life insurance industry and evolving risk management practices. This will most certainly include adapting it after the IASB completes its project on insurance contracts and the results of it are implemented in Canada. Thank you again for the opportunity to speak with you today. I would be pleased to respond to your questions. 7