On June 17, 2011, the Office of the Superintendent of Financial Institutions (“OSFI”) released Guideline A-4 Internal Target Capital Ratio for Insurance Companies (“Guideline A4”). Guideline A4 may be accessed by CLICKING HERE. Guideline A4 replaces an earlier OSFI advisory “MCT and BAAT Supervisory Targets,” dated December 2003. Guideline A4 sets-out OSFI’s expectations for the setting of an internal target capital ratio (“Internal Target”) by Federally Regulated Life Insurance Companies (Canadian, Foreign & Fraternal Benefit Societies) and Federally Regulated Property and Casualty Insurance Companies (“FRIs”). Guideline A4 also deals with certain related elements of FRIs’ capital management policies.
According to OSFI, Guideline A4 was released in response to recent volatile conditions that are putting pressure on some financial institutions’ capital positions – OSFI believes that there is a need for an appropriate and supportable Internal Target.
Guideline A4 is effective immediately and OSFI expects FRIs to be in compliance with it before June 30, 2012.
ESTABLISHING AN INTERNAL TARGET
Guideline A4 stipulates that each FRI is required to establish an Internal Target. It is the responsibility of the FRI’s Board of Directors to establish the Internal Target. An Internal Target is defined as the level of capital, based on the FRI’s own risk and capital adequacy assessment process, necessary to cover the risks specified in the capital tests as well as all other risks of the FRI. As such, the Internal Target must be established by considering the FRI’s own risk appetite and risk profile, including possible negative impacts to its capital position due to material and relevant business and other risks to which it is exposed. In addition, the Internal Target should take into account the current and forecasted business environments and should, as a result of capital adequacy planning, be adjusted when appropriate to ensure capital adequacy under stress scenarios and through entire business cycles. For further guidance on stress testing, FRIs should refer to Guideline E-18 Stress Testing.
The Internal Target should be set above OSFI’s Supervisory Target Capital Ratio (“Supervisory Target”) in order to absorb unexpected losses beyond those covered by the Supervisory Target. The Supervisory Target is the level of capital necessary for an insurer to cover the risks specified in the capital tests as well as to provide a margin for other types of risks not included in the tests. 150% is the current Supervisory Target. FRIs must operate at a level of capital above the Internal Target. If a FRI operates below the Internal Target, it will attract unwanted OSFI regulatory intervention. OSFI should be notified when a FRI changes its Internal Target.
CAPITAL MANAGEMENT POLICY
Capital management is the ongoing process of determining and maintaining the quantity and quality of capital appropriate for a FRI to support planned operations. Under Guideline A4, OSFI expects each FRI to develop and maintain a capital management policy that includes but is not limited to:
- an Internal Target;
- documented policies and procedures designed to ensure that the insurer identifies, measures and reports all material risks potentially requiring capital;
- clearly defined roles and responsibilities with respect to the design and execution of the relevant policies and procedures;
- a process to measure capital needs relative to current and anticipated future risk levels;
- a policy that states capital adequacy goals relative to risk, taking into account the insurer’s strategic focus and business plan;
- a set of internal controls, reviews and audits to ensure the integrity of the overall risk management and capital adequacy assessment processes;
- identification of corrective actions that management may take to improve its capital position if at any time the capital level falls or is anticipated to fall below the company’s Internal Target or the Supervisory Target;
- a requirement for the Board of Directors to review and approve the capital management policy annually or more frequently where conditions warrant; and
- possible corrective actions that the FRI’s management may take if at any time the capital ratio falls, or is anticipated to fall below its Internal Target.
OSFI has indicated it will conduct a follow-up review of internal capital ratios after the release of Guideline A4 in order to ensure Guideline A4 is leading to the establishment of appropriate Internal Targets.
Guideline A4 initially appears to impose a requirement for insurers to develop a new internal policy as well as be subject to additional rules. However, in practical terms, it simply codifies what OSFI has been requiring most insurers to do on an informal basis over the last couple of years. OSFI already requires all insurers to have a Capital Management Policy which includes a target capital ratio (MCCSR, TAAM, MCT or BAAT). Many of our clients have already received calls from their Relationship Managers at OSFI immediately after filing Interim or Annual Returns where their capital ratios had dropped below their target ratios.
It is our view that Guideline A4 is useful since it provides a clear statement of OSFI’s expectations with respect to minimum capital levels. Insurers will be required to set their own Internal Targets based largely on the DCAT as well as other forms of stress testing.
OSFI was previously much more concerned that insurers maintained their capital ratios above 150%. It is clear that the Target Capital Ratio is becoming an equally important (and much higher) number. Guideline A4 reflects OSFI’s desire that all insurers maintain higher levels of capital than was previously necessary in order to deal with what OSFI perceives is an environment of significantly increased volatility and risk.
We will be preparing a draft version of a Capital Management Policy that will comply with the requirements of Guideline A4 for use by our clients. Please contact us if you would like to receive a copy once it becomes available.