July 21, 1997

Reference: Guideline for Life Insurance Companies and Fraternal Benefit Societies

Subject : Guideline on Minimum Continuing Capital and Surplus Requirements (MCCSR)

Attached is a newsletter outlining changes to MCCSR for 1997. Revised pages of the guideline and returns for MCCSR and the Test of Adequacy of Assets in Canada and Margin Requirements (TAAM) will be sent in September.

MCCSR was introduced in 1992, and since then, has been modified annually. Effective December 31, 1997, OSFI will place a moratorium on changes to the formula except in the circumstances set out below. OSFI is taking this step for several reasons:

• the requirements are becoming less independent of actuarial reserves and it is time to reconsider the fundamentals underlying the formula and ensure that it is still theoretically sound. Studies are underway to determine what should be appropriately covered in actuarial reserves and what should be covered in the capital requirements;
• although MCCSR is a regulatory tool, public pressure for disclosure of insurers' capital adequacy positions is increasing. The formula needs to be relatively stable to allow for meaningful comparisons between years; and
• the formula is now quite complex, in part as a result of the piecemeal approach taken to changes; and the revision process has been time-consuming for both OSFI and the industry. It is not clear that the annual refinements justify the cost.

The moratorium will remain in place until December 31, 1999. However, OSFI recognizes that the current formula is driven by actuarial reserves and accounting practices, and will revise the formula for any substantive changes to generally accepted accounting principles and actuarial practices.

In the meantime, OSFI will continue to assess the appropriateness of the formula in the context of emerging risks, international initiatives and work in other financial sectors. OSFI will liaise as necessary with The Canadian Life and Health Insurance Association (CLHIA) and the Canadian Institute of Actuaries task forces studying aspects of the MCCSR formula such as C-3 risk and the split between reserves and capital requirements. This may lead to fundamental changes. Prior to the end of the moratorium, OSFI will invite industry associations and provincial regulators of financial institutions to discuss the need to revisit the formula. At that time, a timetable and action plan can be established.

Questions concerning the newsletter should be directed to Philippe Morisset at (613)990-4412 or Aina Liepins at (613) 990-6943 or by fax at (613)990-8466.

The attached newsletter is available in English and French on the OSFI internet site, www.osfi-bsif.gc.ca. Copies may be obtained by contacting Stéphane Dupel at (613) 990-7655 or by fax at (613) 990-8219.

Nicholas Le Pan
Deputy Superintendent
Policy

MCCSR Newsletter
1997 MCCSR/TAAM Changes

This newsletter outlines changes to MCCSR for 1997. These include:

Lapse Risk Component

Negative Reserves and CSV Deficiency Reserves as Tier 2C Capital

C-1 and C-3 Components for CMOs, MBSs and Other Asset Backed Securities

Other than Temporary Declines in the Value of Real Estate

Out-of-Canada Terminal Dividend Reserves

Transitional Solvency Provision

C-3 Component for Type C Accumulation Funds

Other Changes

The following abbreviations are used in this newsletter:

1. Lapse Risk Component

This is a new component for required capital. It recognizes the risk that assumptions about lapse rates will be wrong. The lapse risk component is calculated for all individual life business by:

1. dividing individual life business into two broad groupings:

• Group A - policy series for which lower lapses at duration 6 and on will produce higher net reserves;
• Group B - policy series for which higher lapses at duration 6 and on will produce higher net reserves.

  1) determining total net reserves for Group A and Group B, following the method used for statement liability purposes.

  2) recalculating total net reserves for:

• Group A - reducing the assumed lapse rate by 10% (e.g., 3% to 2.7%) for the sixth and all subsequent durations;
• Group B - increasing the assumed lapse rate by 1 percentage point (e.g., from 7% to 8%).

  All other assumptions are unchanged from Step 2.

  For participating business with meaningful dividends and adjustable premium products the factors are cut in half, unless dividend and premium adjustability is not reasonably flexible:

• Group A - the lapse rate is reduced by 5% (e.g., from 3% to 2.85%);
• Group B - the lapse rate is increased by half a percentage point (e.g., from 7% to 7.5%).

  3) subtracting the reserve calculated in step 2 from the reserve calculated in step 3.

Although it is preferable to calculate the lapse risk component based on year end reserves, companies may calculate the component based on a quarter end selected during the year. In this case, the increase in net reserves for each of groups A and B is expressed as a percentage and used for all MCCSR/TAAM calculations for the following 12 months.

It should be noted that the intent is not to permanently set a given policy series' classification at issue. Instead, once each year, a company must run its valuation file two additional times, once based on 90% of the regular lapse rate and the other with lapses at 1% higher than the regular rate. For each policy series, the result of exactly one of these two calculations would be higher than the balance sheet reserves. That determines into which group that policy series falls, and the difference between the recalculated reserves and the balance sheet reserves is the component.

OSFI recognizes that mortality is a function of lapse assumptions and, depending on how sophisticated a company's system is, this may mean implicit changes in mortality. To simplify the process, companies should not make VTP-2 adjustments nor should they undo what mortality adjustments their systems automatically do.

Transitional Provision

The lapse risk component must be phased in equally over three years, at year-end i.e., 1/3 in 1997; 2/3 in 1998 and 3/3 in 1999.

2. Negative Reserves and CSV Deficiency Reserves as Tier 2C Capital

With the introduction of the lapse risk component, changes have been made to the definition of available capital. 75% of the regular amounts of negative reserves and cash surrender value deficiencies, i.e. not as recalculated for the lapse component, may now be counted as tier 2C capital. The calculation continues to be on a policy by policy basis for negative reserves and on an aggregate basis for CSV deficiencies. In addition, the limit on negative reserves included in tier 2C has increased to 33 1/3% of tier 1 capital.

Transitional Provision

The changes to the definition of capital available must be phased in equally over three years, at year-end:

3. C-1& C-3 Components for CMOs, MBSs, and Other Asset Backed Securities

The asset default (C-1) and change in interest rate (C-3) components for required capital have been amended to cover fixed income assets with cash flow uncertainty.These instruments include CMOs, MBSs and other asset backed securities. The asset default (C-1) factor applied to ABSs has been changed to cover only the credit risk associated with these instruments. The revised C-1 and C-3 factors are set out below.

1) Revised Asset Default (C-1) Factors:

Rated Asset Backed Securities:

An asset backed security rated by a recognized, widely followed credit rating service will attract the credit risk factor that applies to a bond with the same rating.

Unrated ABSs that satisfy the conditions on Special Purpose Vehicles and Third Party Assignments set out on pages 3-4-1 and 3-4-2 of the MCCSR guideline:

Where the investor bears less than pro rata share of credit risk, the C-1 factor is the highest factor associated with the underlying assets. Where the underlying pool contains assets that have become impaired, that portion of the instrument requires an additional factor calculated in accordance with the treatment accorded to impaired investments as set on page 3-1-8 of the MCCSR guideline.

Where the investor bears more than a pro rata share of credit risk, the C-1 factor for the instrument is 8%. Where the underlying pool contains assets that have become impaired, that portion of the instrument requires an additional factor calculated in accordance with the treatment accorded to impaired investments as set on page 3-1-8 of the MCCSR guideline.

Other Unrated ABSs:

The asset default factor is 8%.

2) Change in Interest Risk (C-3) Component

C-3 component is not required for:

• traditional fixed income investments including non-callable, callable and extendible bonds;
• residential mortgages and commercial mortgages with prepayment penalties or prepayment conditions;
• commercial mortgage backed securities supported by pools of commercial mortgages with prepayment penalties or prepayment conditions;
• Canadian pass-through MBSs and Canadian CMOs supported by pools of NHA insured mortgages with prepayment penalties or prepayment conditions;
• assets backed by a pool of automobile and light truck loans, credit card receivables and trade receivables;
• asset backed securities with floating rate coupons; and
• franchise loans with treasury make whole clauses.

A C-3 factor of 1% applies to:

• residential mortgages and commercial mortgages that have no prepayment penalties or conditions;
• Canadian CMOs supported by a pool of mortgages that have no prepayment penalties or clauses; and
• pass-through asset backed securities collateralized by home improvement loans and manufactured housing loans.

U.S. Pass-through MBSs and CMOs

The Flow Uncertainty Index (FLUX) was developed for the National Association of Insurance Commissioners as a measure of the relative cash flow variability of CMO bands. Bloomberg makes available FLUX scores of U.S. MBSs and CMOs.

FLUX scores of U.S. MBSs and CMOs determine the C-3 factor that applies to these investments:

Other Fixed Income Assets

If the appointed actuary has conducted tests on a fixed income investment not covered above under an appropriate range of interest rate scenarios, has completed and documented the work, and has concluded that:

• the investment has a degree of cash flow uncertainty risk no greater than that of a U.S. CMO with a FLUX score of less than 5, or no more than two times greater than that of a non callable bond with the same maturity, C-3 factor is 0.5% for the investment;
• the degree of cash flow uncertainty is equivalent to that of a U.S. CMO with a FLUX score of between 5 and 10, or five times that of a non callable bond of the same maturity, the C-3 factor is 1%;
• the degree of cash flow uncertainty is greater than that of a U.S. CMO with a FLUX score of 10, the C-3 factor is 8%.

The 8% factor also applies to untested investments as well as to leveraged derivatives and leveraged structured notes.

C-3 factors for cash flow uncertainty may be reduced by 50% for assets backing cash flow tested reserves.

4. Other than Temporary Declines in the Value of Real Estate

AcG 9, a CICA accounting guideline issued in March 1997, clarifies when an other than temporary decline in the value of a life insurer's real estate portfolio has occurred. When the market value of the entire portfolio has remained below book value for three or four years, the carrying value of the portfolio should be written down to recognize the loss. The write-down should be taken into income immediately.

Although this accounting guidance requires other than temporary declines in value to be calculated on a portfolio basis for accounting purposes, OSFI continues to require companies to make these calculations on a property by property basis for MCCSR (see MCCSR Bulletin-1). As a result, the calculation must be adjusted to ensure that capital available for MCCSR is not reduced twice, once in the accounting provision and again for capital adequacy purposes.

OSFI no longer requires companies to reduce the total of tier 1 and tier 2 capital for other than temporary declines in the value of properties held in respect of policy liabilities. A deterioration in the value of these properties should be reflected promptly in the actuarial reserves.

The table below illustrates how the reduction of capital for an other than temporary decline in the value of a real estate portfolio is calculated. In this example, an other than temporary decline in the value of the real estate portfolio is recognized for accounting purposes in year 4.

5. Out-of-Canada Terminal Dividend Reserves - Tier 2C Capital

Fifty per cent of the terminal dividend reserve associated with out-of-Canada participating life insurance business now qualifies as Tier 2C capital where:

• the terminal dividend reserve can be shown to be uniquely associated with a block of out-of-Canada (e.g. United Kingdom) lives, terminal dividends constitute a high proportion of the total benefit paid to the policyholder, and the foreign jurisdiction does not require actuarial liabilities to be set up for these dividends;
• the terminal dividend reserve is calculated according to the standard of practice for the valuation of participating business set out in the CIA's Valuation Technique Paper #10 (VTP 10);
• policyholder material discloses the true variability of terminal dividend payments and that the returns will vary with the returns on equity assets supporting the policies. The disclosure must indicate that the ultimate terminal dividends are tied to the financial condition of the company and the payments are at the discretion of the company; and
• the company's board of directors has passed a resolution that it will act to adjust the terminal dividends to take account of the advice of the appointed actuary and any other factors they consider relevant regarding the appropriateness of the terminal dividend scale, consistent with policyholder expectations, and the financial condition of the company.

6. Transitional Solvency Provision (TSP) No Longer Required

Life insurance companies began calculating their policy liabilities using the policy premium method (PPM) in 1992. In the absence of specific PPM valuation standards for participating insurance, OSFI required companies to establish a TSP pending further guidance on the calculation of reserves for participating products. The TSP represented the difference between the reserve calculation under the policy premium method and the method used previously. Guidance has been provided in VTP 10, that was approved for implementation for the 1997 year end. Accordingly, the need for an additional requirement for the TSP has been eliminated.

7. C-3 Component for Accumulation Funds

The table on page 6-1-3 of the MCCSR guideline setting out C-3 capital requirements will be amended to clarify that the factor of 0.005 applies to accumulation funds with interest rate guaranteed periods remaining of 6 months or less.

A factor of 0.02 (2%) now applies to Type C accumulation funds, where the guarantee period remaining is greater than 6 months but less than 18 months. This will smooth the grading on these funds.

8. Other Changes

Asset Default (C-1)Requirements Clarified

The Asset Default requirements will be amended to clarify that:

• a C-1 risk weight of 0% applies to residential mortgages insured under the NHA or equivalent provincial mortgage insurance programs;
• a factor of 0% applies to short term securities and bonds issued by OECD central governments and claims against OECD central banks. The words "where the company does business" will be removed from pages 3-1-2 and 3-1-3; and
• for mortgages, amounts that are explicitly, unconditionally and irrevocably insured by OECD central governments, OECD central banks and organizations with the guarantee of OECD central governments may be deducted from the outstanding balance. Such insurance should be legally enforceable. The words "where the company does business" will be removed from pages 3-1-4.

Morbidity Risk Table, page 60.020 of the MCCSR Return modified

A line for Other Adjustments will be inserted between lines 069 and 070 on page 60.020. The additional adjustments described on page 4-1-3, net of the credits for reinsurance described on page 4-4-3, are to be shown on this line.

MCCSR Tax Adjustments

The CLHIA has requested that OSFI review the treatment of taxes on deferred gains and other adjustments to available capital for MCCSR. OSFI is studying a report from the CLHIA Working Group on MCCSR Tax Rate Adjustments and will communicate its position in the fall.