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Article

OSFI Issues Revised Capital Requirements for Property and Casualty Insurers

Date

October 7, 2014

AUTHOR(s)

Ana Badour
Nancy J. Carroll
Frédéric Cotnoir
Barry J. Ryan


On September 24, 2014, the Office of the Superintendent of Financial Institutions (OSFI) issued the revised Minimum Capital Test Guideline (Guideline) setting forth more robust risk-based capital requirements applicable to federally regulated property and casualty insurance companies (P&C Insurers) beginning January 1, 2015, on a phased-in basis. The Guideline applies to Canadian P&C Insurers and foreign P&C Insurers operating in Canada on a branch basis. It is part of OSFI’s broader initiative to better align capital frameworks across financial sectors.

In 2013, OSFI identified the need to update the Guideline, originally issued in 2003, to move toward a more risk-based approach addressing changing risks affecting the property and casualty insurance industry. As a result, OSFI issued in May 2013 the Discussion Paper on OSFI’s Proposed Changes to the Regulatory Framework for Federally Regulated Property and Casualty Insurance Companies, outlining proposed changes to the Guideline. OSFI’s review and update of insurance company capital requirements occurred in the context of evolving international capital standards under the Basel III and Solvency II (the European Union insurance capital model) initiatives.

The Guideline outlines the capital requirements that will apply to P&C Insurers beginning in 2015 and provides as follows:

  • Minimum Capital Test – P&C Insurers continue to be required to maintain a Minimum Capital Test (MCT) of 100%, with a supervisory target of 150%. OSFI expects P&C Insurers to establish an internal target above the supervisory target.

  • Impact of updated capital test – The revised Guideline will result in the following changes on average across the industry to P&C Insurers’ capital ratios from the ratios as at December 31, 2012: the MCT will increase from 246.4% to 250%; the Branch Adequacy of Assets Test (BAAT) will decrease from 311.1% to 283.7%; and the combined MCT/ BAAT will decrease from 261.2% to 258.4%, a decrease of 2.8 percentage points. The dollar impact of the Guideline will be a decrease of $53 million of required capital on average across the industry. However, the impact of the revised Guideline on individual P&C Insurers will vary depending on their current capital policy and risk profile.

  • Changes to definition of capital – The Guideline sets out an explicit list of qualifying criteria for common shares (Category A Capital) and allowable capital instruments other than common shares (Category B Capital and Category C Capital), and requires that Category B and Category C capital be limited to 40% of total capital (with Category C capital limited to 7%). The Guideline adds availability to absorb losses as a primary consideration for defining the capital of P&C Insurers for the purpose of measuring their capital adequacy. In addition, the Guideline provides for certain regulatory adjustments to capital, consistent with changes imposed by OSFI in capital requirement calculations in other financial sectors. The revised definition of capital brings the P&C industry (with respect to the terms of instruments) generally in line with the banking industry (aside from the non-viable contingent capital requirement applicable to banks).

  • Updated insurance risk factors, market risk factors and credit risk factors – The Guideline specifies updated risk factors applicable to insurance risk, market risk and credit risk, based on updated data and detailed review by OSFI.

  • New risk charge for operational risk – The Guideline explicitly requires an operational risk charge to be included in the calculation of capital required and sets out the required formula. The Guideline defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. The definition includes legal risk but excludes strategic and reputation risk.” In addition to the operational risk charge applicable to all P&C Insurers, those P&C Insurers that are experiencing rapid growth (more than 20% growth in gross premiums over the last 12 months) are subject to an additional 2.50% risk factor on their year-over-year premium growth beyond the 20% growth threshold. There is a 30% cap on operational risk margin applicable under the Guideline.

  • Diversification credit – The Guideline permits P&C Insurers to benefit from a diversification credit based on a specified formula which lowers the total capital otherwise required for insurance, market and credit risk factors.

  • Changes from draft guideline – The draft Minimum Capital Test Guideline issued by OSFI in December 2013 was revised to respond to comments received. As a result, the operational risk factor was reduced by 15%; the time for filing the audit opinion on MCT and BAAT was extended from 60 to 90 days; the phase-in period of the capital impacts of the Guideline was extended from two to three years; and the calculation date for the phase-in impacts was changed to October 31, 2014, for P&C Insurers with an October 31 fiscal year-end.

  • Transitional period – For the fiscal year ended October 31 or December 31, 2014, P&C Insurers will be required to calculate their capital ratios using both the old framework (applicable on October 31 or December 31, 2014) and the new framework (applicable January 1, 2015). However, only the ratios calculated under the old framework will be required to be filed with OSFI as at October 31 or December 31, 2014, depending on the insurer’s year-end. Going forward, P&C Insurers are required to phase in the capital impact of the Guideline over a three-year period beginning January 1, 2015. They are required to determine the net capital impact (the difference between capital available and minimum capital required under the old versus the new framework) and amortize the capital impact over that three-year period, reporting the amortization of capital available and capital required amounts each quarter until October 31 or December 31, 2017, depending on their fiscal year-end.

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