Actuarial Notes

Minimum Capital Test

By Office of the Superintendent of Financial Institutions · 2024 · A

Study guide: Exam 6C

OSFI's Minimum Capital Test (MCT) guideline sets out the capital framework for federally regulated P&C insurers that are not mortgage insurers. It outlines a risk-based formula for target and minimum capital required, defines the capital available to meet the minimum standard, and sets the Branch Adequacy of Assets Test (BAAT) for foreign companies operating in Canada on a branch basis. Its standards are the framework within which the Superintendent assesses whether an insurer maintains adequate capital under the Insurance Companies Act. This is the 2024 guideline (Guideline A), effective January 1, 2024.

On the syllabus

  • Exam 6C — objectives C2–C4; candidates are not responsible for sections 1.2.2, 2.1.1.1, 2.1.2, 2.1.3, App. 2-A, 3, 4.6, 5.2.2, 5.3.4.1, 5.3.4.2, 6.1.1, 6.2.1, 6.2.2, 6.2.3 and 6.3, nor for risk factors relating to insurance, market, or credit risk; candidates will not be penalized if their answers are based on the final version of the paper.

1 Overview and General Requirements

  • 1.1 Overview
    • 1.1.1 Minimum and target capital requirements under the MCT
      • Capital requirements are set directly at a target confidence level of 99% of the expected shortfall (CTE 99%) over a one-year horizon, including a terminal provision; the requirements are then divided by 1.5 to derive the minimum capital required, and the MCT ratio is capital available over minimum capital required.

      \text{MCT ratio} = \frac{\text{Capital available}}{\text{Minimum capital required}}

    • 1.1.2 Risk-based capital adequacy
    • 1.1.3 Scope of consolidation
    • 1.1.4 Foreign companies
    • 1.1.5 Interpretation of results
      • The MCT is a standardized measure of capital adequacy, one of several indicators OSFI uses to assess an insurer's financial condition, and should not be used in isolation for ranking and rating insurers.
  • 1.2 General Requirements
    • 1.2.1 MCT supervisory capital ratio for federally regulated insurers
      • Insurers must maintain an MCT ratio of at least 100%; OSFI's industry-wide supervisory target of 150% provides a cushion above the minimum and facilitates early intervention.
      • Each insurer sets an internal target under Guideline A-4 and maintains capital above it, informing OSFI immediately if it anticipates falling below; the Superintendent may set an alternative supervisory target for an individual insurer.
    • 1.2.2 Audit requirement
    • 1.2.3 Allocation Methodology
    • 1.2.4 Intra-Group Pooling Arrangements
  • 1.3 Transitional Arrangements
    • 1.3.1 Business combinations and portfolio transfers entered into and effective on or prior to June 30, 2019

2 Definition of Capital Available

  • 2.1 Summary of Capital Components
    • The four primary considerations for defining capital available are availability, permanence, absence of encumbrances and mandatory servicing costs, and subordination; capital available is the sum of category A (common equity), category B and category C capital.
    • 2.1.1 Category A capital (i.e. common equity)
      • Includes qualifying common shares and contributed surplus, retained earnings, earthquake, nuclear and general contingency reserves, accumulated other comprehensive income, and the residual interest of owner-policyholders of mutual entities.
    • 2.1.2 Category B capital
    • 2.1.3 Category C capital
    • 2.1.4 Non-controlling interests
  • 2.2 Capital Composition Limits
    • Category B and C instruments together may not exceed 40% of total capital available, and category C 7%, both excluding accumulated other comprehensive income; excess amounts are excluded from capital available.
  • 2.3 Regulatory Adjustments to Capital Available
    • 2.3.1 Deductions
      • Deductions include interests in, and loans reported as equity to, non-qualifying subsidiaries, associates and joint ventures in which the company holds more than 10%; unregistered reinsurance receivables and recoverables not covered by payables or acceptable collateral; uncollateralized self-insured retentions where OSFI requires collateral; the earthquake premium reserve not used as a financial resource; and assets for insurance acquisition cash flows.
    • 2.3.2 Additions
    • 2.3.3 Adjustments
  • 2.4 Capital Treatment of Interests in and Loans to Subsidiaries, Associates and Joint Ventures
    • 2.4.1 Consolidated subsidiaries (e.g. property and casualty insurance and ancillary businesses such as agencies, brokerages and mutual funds)
    • 2.4.2 Non-qualifying subsidiaries
    • 2.4.3 Associates
    • 2.4.4 Joint ventures in which a company holds less than or equal to 10% ownership interest
    • 2.4.5 Joint ventures in which a company holds more than a 10% ownership interest
    • 2.4.6 Ownership interests in an intra-group investment arrangement
    • 2.4.7 Summary of exposures
  • Appendix 2-A: Information Requirements for Capital Confirmations

3 Foreign Companies Operating in Canada on a Branch Basis

  • 3.1 Branch Adequacy of Assets Test
    • 3.1.1 Net assets available
    • 3.1.2 Regulatory adjustments to net assets available
    • 3.1.3 Margin required

4 Insurance Risk

  • Insurance risk is divided into four parts: the liability for incurred claims (reserving risk), unexpired coverage (underwriting risk, including catastrophe risk other than earthquakes and nuclear), unregistered reinsurance, and earthquake and nuclear catastrophes.
  • 4.1 Diversification Credit within Insurance Risk
    • The risk factors for each class of insurance contain an implicit diversification credit, assuming a well-diversified portfolio.
  • 4.2 Margins for Liability for Incurred Claims and Unexpired Coverage
    • 4.2.1 Margin for liability for incurred claims
      • Calculated by class of insurance from the liability for incurred claims on insurance contracts issued less the asset for incurred claims on reinsurance contracts held, both excluding the risk adjustment for non-financial risk.
    • 4.2.2 Margin for unexpired coverage
      • Calculated by class of insurance by applying the risk factors to the greater of net unexpired coverage and 30% of net premiums received in the past 12 months; unexpired coverage for insurance contracts issued is determined by one of two methods, for groups measured under the general measurement model or the premium allocation approach.
    • 4.2.3 Risk factors for warranty business
  • 4.3 Risk Mitigation and Risk Transfer - Reinsurance
    • 4.3.1 General
      • Credit for reinsurance with a registered or unregistered reinsurer requires the arrangement to comply with Guideline B-3 Sound Reinsurance Practices and Procedures.
    • 4.3.2 Registered reinsurers
    • 4.3.3 Unregistered reinsurers
      • Amounts receivable and recoverable from an unregistered reinsurer are deducted from capital available to the extent they are not covered by premiums payable to it or acceptable collateral (non-owned deposits under a reinsurance security agreement, other acceptable non-owned deposits, funds held and letters of credit), and a margin is required for the reinsurance ceded.
  • 4.4 Self-Insured Retention
    • OSFI must be satisfied that self-insured retentions are collectable before they are admitted, and may require collateral.
  • 4.5 Earthquake and Nuclear Catastrophes
    • 4.5.1 Earthquake risk exposure
      • Earthquake reserves, the earthquake premium reserve (EPR) plus the earthquake reserve component (ERC), are added to total capital required; OSFI expects a test of financial preparedness for a 500-year return period country-wide event, measured by the PML.

      \text{Earthquake reserves} = (\text{EPR} + \text{ERC}) \times 1.25 \text{ERC} = \text{Country-wide PML}_{500} - \text{capital and surplus} - \text{reinsurance coverage} - \text{capital market financing} - \text{EPR} \geq 0 \text{Country-wide PML}_{500} = \left(\text{East Canada PML}_{500}^{\,1.5} + \text{West Canada PML}_{500}^{\,1.5}\right)^{1/1.5}

      • The financial resources are capital and surplus (up to 10%), the earthquake premium reserve, reinsurance coverage and capital market financing (with OSFI's prior approval); Guideline B-9 sets the expectations for earthquake exposure risk management.
    • 4.5.2 Nuclear reserve
      • Insurers issuing nuclear risk policies hold an additional provision of premiums received less premiums paid, net of commissions, multiplied by 1.25, for twenty years.
  • 4.6 Accident and Sickness Business

5 Market Risk

  • Market risk arises from potential changes in interest rates, foreign exchange rates, equity prices, real estate and other market exposures, through on- and off-balance sheet positions.
  • 5.1 Interest Rate Risk
    • The interest rate risk margin is the change in value of interest rate sensitive assets less that of interest rate sensitive liabilities under an interest rate shock applied with their durations, allowing for recognized interest rate derivatives.
    • 5.1.1 General requirements
    • 5.1.2 Interest rate risk margin
  • 5.2 Foreign Exchange Risk
    • 5.2.1 General requirements
    • 5.2.2 Foreign exchange risk margin
  • 5.3 Equity Risk
    • 5.3.1 Common shares and joint ventures
    • 5.3.2 Futures, forwards, and swaps
    • 5.3.3 Short positions
    • 5.3.4 Recognition of equity hedges
  • 5.4 Real Estate Risk
  • 5.5 Right-of-Use Assets
  • 5.6 Other Market Risk Exposures

6 Credit Risk

  • Credit risk is the risk of loss from a counterparty's potential inability or unwillingness to meet its contractual obligations; every on- and off-balance sheet exposure carries a risk factor that corresponds to the counterparty's external credit rating or is prescribed by OSFI.
  • 6.1 Capital Requirements for Balance Sheet Assets
    • 6.1.1 Use of ratings
    • 6.1.2 Credit risk factors
  • 6.2 Capital Requirements for Off-Balance Sheet Exposures
    • The capital required is the credit equivalent amount, less eligible collateral or guarantees, multiplied by a credit conversion factor and by a counterparty credit risk factor.
    • 6.2.1 Credit equivalent amount
    • 6.2.2 Credit conversion factors
    • 6.2.3 Risk factors
  • 6.3 Capital Treatment of Collateral and Guarantees
    • 6.3.1 Collateral
    • 6.3.2 Guarantees

7 Operational Risk

  • Operational risk is the risk of loss from inadequate or failed internal processes, people and systems or from external events; it includes legal risk but excludes strategic and reputation risk.
  • 7.1 Operational Risk Formula
    • The two risk drivers are capital required and premiums, subject to a cap; CR_0 is total capital required before the operational risk margin and diversification credit, and P_\Delta is premium growth above a 20% threshold.

    \text{Operational risk margin} = \min\left\{30\%\,CR_0,\ \left(8.50\%\,CR_0 + 2.50\%\,P_d + 1.75\%\,P_a + 2.50\%\,P_r + 2.50\%\,P_\Delta\right) + \max\left(0.75\%\,P_{aig},\ 0.75\%\,P_{rig}\right)\right\}

  • 7.2 Components of Operational Risk Margin
    • 7.2.1 Capital required
    • 7.2.2 Premium volume
    • 7.2.3 Year-over-year premium growth beyond a threshold
    • 7.2.4 Cap on operational risk margin

8 Diversification Credit

  • Because losses across risk categories are not perfectly correlated, an explicit credit for diversification is allowed between the sum of the credit and market risk requirements (A) and the insurance risk requirement (I), with a correlation factor R of 50%.
  • 8.1 Risk Aggregation and Diversification Credit

    \text{Diversification credit} = A + I - \sqrt{A^2 + I^2 + 2 \times R \times A \times I}

Related readings

  • OSFI Target Capital — Guideline A-4, under which §1.2.1 has each insurer set its internal target
  • OSFI Reinsurance — Guideline B-3, with which a reinsurance arrangement must comply for credit to be taken (§4.3.1)
  • OSFI Earthquake — Guideline B-9, to which §4.5.1 refers for earthquake exposure risk management and the PML adjustments
  • OSFI Concentration — Guideline B-2, which Chapter 6 requires insurers to comply with for invested assets
  • OSFI Minimum Capital — the MCT/BAAT quarterly return (PC4), whose 2024 instructions accompany the guideline and in whose unregistered reinsurance exhibit §4.3.3.3 has the margin calculated

Sources