Reference: Guideline for Banks/T&L
July 30, 1999
Our File: P2215-2-1

TO: All CEOs of Banks and Federally Regulated Trust & Loan Companies

Subject: Capital Treatment of Insured Mortgages

Further to our letter of January 29, 1999 on the capital treatment of insured mortgages, I am writing to clarify the proposed treatment of reinsured mortgages that originated within a federally regulated deposit-taking institution (DTI). We also wish to outline the proposed treatment of a DTI's equity investments in insurance and reinsurance subsidiaries for capital adequacy purposes.

My previous letter stated that "if a DTI's Government-Guaranteed Mortgages are subsequently reinsured with another party that is not itself government guaranteed, it is questionable whether the government guarantee can continue to be considered explicit, unconditional and irrevocable." This statement related to the capital treatment of such mortgages where the originating bank through its subsidiary assumed the risk of loss via reinsurance. The statement did not relate to the underlying legal enforceability of the Government guarantee. OSFI continues to recognize such guarantees for capital risk-weighting purposes under the conditions set out in OSFI's Capital Adequacy Requirements (CAR) guideline. Where a DTI is exposed to risk through reinsurance, however, OSFI wants to ensure that the DTI maintains adequate capital for that risk.

Some applications of the capital rules outlined in Guideline A, Capital Adequacy Requirements appear to result in inappropriate capital charges because certain risks are not recognized. The intent of the guideline was to consolidate, for capital purposes, all insurance subsidiaries except those that are solvency regulated. Consolidation of unregulated insurance subsidiaries was intended to ensure their activities were subject to capital requirements. However, the current CAR rules are not designed to capture or measure insurance or reinsurance risks.

To address this issue, OSFI is proposing to deduct, for capital adequacy purposes, investments in insurance and reinsurance subsidiaries not regulated for solvency purposes rather than consolidating those operations. The investment to be deducted from capital of the federally regulated DTI parent would be the greater of: 

1. the investment in a subsidiary that is of a capital nature (using the equity method of accounting for common share investments); or
2. the amount of capital that would result from the application of OSFI's capital requirements for that type of institution.

It would be the responsibility of the Canadian parent financial institution to have records that prove to the satisfaction of OSFI that the amount of the deduction complies with the above policy.

With respect to insurance and reinsurance subsidiaries that are regulated for solvency, it is proposed that the amount of the deduction from the DTI parent's capital would be the greater of:

1. the investment in the subsidiary that is of a capital nature (using the equity method of accounting for common share investments); or
2. the amount of capital that results from the application of the foreign supervisory rules for capital where such subsidiary is based.

OSFI would expect that the latter amount should not differ significantly from OSFI's capital requirement for that type of institution (using Canadian actuarial and accounting standards to ensure adequate reserves or provisions). Once the policy is finalized, the Canadian parent DTI should contact its Relationship Manager to discuss whether the foreigncapital rules satisfy this requirement.

The above policy would be subject to an override clause to address the insurance orreinsurance of financial obligations, including mortgages, originating within the Canadian DTI industry and reinsured by a subsidiary of a Canadian DTI. To the extent that the financial risk rests with a Canadian DTI or unconsolidated subsidiary of a Canadian DTI, OSFI would not be prepared to recognize a reduced risk weight for such financial obligations. For example, a risk weight of 50 per cent would apply with respect to Government-Guaranteed residential mortgages remaining on the books of a Canadian DTI if those mortgages were reinsured with a subsidiary of a Canadian DTI.

If such situations exist, the DTI would be required under this proposed policy tocontact its Relationship Manager to discuss the calculation of the capital deduction for the reinsurance subsidiary. Where the reinsurance was provided by the Canadian DTI's own subsidiary, the DTI would be required to hold the capital, and the deduction for there insurance subsidiary would be reduced. Where the DTI's subsidiary was reinsuring another Canadian DTI's portfolio, the investment in the reinsurance subsidiary to be deducted from capital would be increased to reflect the DTI capital requirement for that type of activity.

OSFI's capital rules are under review in the context of the government's proposals toallow greater use of holding company structures by financial institutions. The regulatory treatment for capital purposes of insurance subsidiaries within a holding company whose regulated activities predominantly relate to DTIs is expected to be similar to that proposed above.

Comments should be directed before August 31, 1999 toDenis Sicotte, Manager, Capital Division, Office of the Superintendent of FinancialInstitutions, 255 Albert Street, Ottawa, Ontario, K1A 0H2, telephone: (613) 990-7196, fax:(613) 998-8466.

The proposal is available in English and French on OSFI's Internet site (http://www.osfi-bsif.gc.ca)under the Publications section or may be obtained by contacting Stephane Dupel by Email atextcomm@osfi-bsif.gc.ca or by facsimile at (613)952-8219.

John R.Thompson
Deputy Superintendent

c.c. CBA, TCA, CLHIA, IBC, GECMIC and CMHC