Analyzing Canada’s Prudential Solvency Regime

Episode Summary

Canada has one of the world’s most sophisticated and internationally integrated insurance markets, marked by robust capital requirements and an increasing orientation towards ESG- and climate-related considerations. Continuing Skadden’s global tour of prudential solvency regimes, host Rob Chaplin and colleague Chiara Iorizzo examine Canada’s insurance regulation structure, valuation approach, capital quality standards and modernization efforts.

Key Points

• Division of Oversight: Canada’s federal Office of the Superintendent of Financial Institutions (OSFI) is responsible for prudential regulation of most insurers. Provincial regulators also play a role, with market conduct and licensing insurers and intermediaries falling under provincial jurisdiction.
• Life Insurance Capital Adequacy Test (LICAT): LICAT is Canada’s risk-based capital framework for life insurers, which establishing rigorous standards set minimum target ratios for core capital at 55% and total capital at 90%, as well as supervisory target ratios for core capital at 70% and total capital at 100%.
• International Financial Reporting Standard 17 (IFRS 17): Canadian insurers prepare their financial statements in accordance with Canadian GAAP and life insurance liabilities are valued using the new IFRS 17 valuation approach (often referred to in Canada as an Asset Liability Method, or ALM). This phased out the previously used Canadian Asset Liability Method, or CALM, which was used under IFRS 4 when IFRS 17 came into effect at the start of 2023. IFRS 17 represents a transformative shift in accounting for insurance contracts in Canada, introducing a comprehensive framework that enhances transparency, consistency and comparability.
• The Future of Canadian Involvency Regulation: Canada is actively modernising its solvency framework. Despite rejecting the International Association of Insurance Supervisors’ Insurance Capital Standard, with the adoption of IFRS OSFI is moving toward a total balance sheet approach for capital adequacy, which will bring Canadian standards closer to Solvency II and other international regimes. The new framework will emphasize economic valuation principles, greater transparency, and more risk-sensitive capital requirements. The goal is to maintain the competitiveness and resilience of the Canadian insurance sector in a global market.

Voiceover (00:01):
From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner, Robert Chaplin, leads conversations with industry practitioners and explores Solvency II developments that matter to you.

Robert Chaplin (00:18):
Welcome back to the Standard Formula Podcast. Today we are continuing our global tour of insurance regulatory capital regimes, and our focus is on Canada, one of the world’s most sophisticated and internationally integrated insurance markets worldwide. I’m Rob Chaplin, and joining me today is my colleague, Chiara Iorizzo. Chiara, great to have you with us.

Chiara Iorizzo (00:42):
Thanks, Rob. It’s great to be here with you to discuss Canada’s prevention solvency regime. We’re enormously grateful to our good friends as Stikeman Elliott in Canada for their review for this podcast.

Robert Chaplin (00:54):
Okay. Let’s start with the basics. Chiara, can you please provide our listeners with a brief overview of the Canadian insurance market?

Chiara Iorizzo (01:02):
Of course. The Canadian insurance market is marked by robust capital requirements, a strong focus on customer protection, and an increasing orientation towards ESG and climate-related considerations. There is a lot of variation between their life insurance and non-life insurance sectors: the life sector is heavily consolidated with three large groups controlling the majority of the market while non-life is highly fragmented, featuring a mix of domestic firms, subsidiaries and branches of major international groups and government monopolies for private passenger auto insurance in three provinces.

Robert Chaplin (01:38):
This makes for an interesting landscape for our discussion today. Now, Chiara, how is insurance regulated in Canada? And who are the key players?

Chiara Iorizzo (01:48):
Canada is known for having a mature, sophisticated regulatory framework and a distinctive division of oversight between federal and provincial authorities. Prudential regulation of most insurers, including all branches of foreign companies, is managed federally by the Office of the Superintendent of Financial Institutions, or OSFI, which employs a predominantly principles-based approach and is recognized for its conservative, globally respected supervision. OSFI is an integrated regulator overseeing not just insurers but also banks, private pension plans and certain other financial institutions. This integrated approach allows for enhanced coordination and consistency in solvency regulation across the financial sector. Provincial regulators also play a role, with market conduct and the licensing of insurers and intermediaries falling under provincial jurisdiction. A few provincially incorporated insurers are also prudentially regulated at the provincial level. There are notable regional variations, particularly in Quebec, which operates under a unique civil law system and imposes French language requirements. But for our purposes today, we’ll focus on OSFI and the federal regime.

Robert Chaplin (02:58):
Thanks, Chiara, that’s helpful context. Now let’s talk about the core of the Canadian solvency regime, the Life Insurance Capital Adequacy Test, or LICAT. Chiara, can you explain how the LICAT works and what it’s designed to achieve?

Chiara Iorizzo (03:15):
Absolutely. The LICAT is Canada’s risk-based capital framework for life insurers and is a cornerstone of Canada’s approach for assessing the capital strength of life insurers. Introduced by OSFI, LICAT establishes rigorous standards to ensure that insurers maintain sufficient capital to support the unique risks inherent in the life insurance sector. The framework emphasizes transparency and market discipline by mandating annual public disclosures of both qualitative and quantitative information, enabling stakeholders to evaluate insurers’ solvency and risk positions with greater clarity. LICAT’s standardized disclosure templates promote comparability across the industry. Notably, the framework sets minimum target ratios for core capital at 55% and total capital at 90%, as well as supervisory target ratios for core capital at 70% and total capital at 100%. This approach not only protects policyholders, but also enhances confidence among investors and other market participants, reflecting a broader trend towards robust risk management and regulatory oversight in the Canadian financial services landscape.

Robert Chaplin (04:31):
Great. Well, how are assets and liabilities valued under the Canadian regime?

Chiara Iorizzo (04:37):
Canadian insurers prepare their financial statements in accordance with Canadian GAAP and life insurance liabilities are valued using the new IFRS 17 valuation approach, often referred to in Canada as an asset liability method, or ALM. This phased out the previously used Canadian asset liability method, CALM, which was used under IFRS 4 when IFRS 17 came into effect at the start of 2023. IFRS 17 represents a transformative shift in accounting for insurance contracts, introducing a comprehensive framework that enhances transparency, consistency and comparability across the insurance sector. The standard requires insurers to recognize and measure insurance contracts based on a current risk-adjusted estimate of future cash flows combined with the recognition of profit over the period services are provided.

(05:33):
This approach ensures that financial statements more accurately reflect the economic realities of insurance activities, particularly the long-term and variable nature of insurance cash flows. IFRS 17 mandates the separation of insurance services results from insurance finance income or expenses, and introduces rigorous disclosure requirements to enable stakeholders to assess the impact of insurance contracts on an entity’s financial position and performance. In the Canadian context, the adoption of IFRS 17 is particularly significant given the market concentration of large, diversified insurers and its robust regulatory environment, which emphasizes prudential oversight and consumer protection. The standard’s implementation is expected to drive greater alignment between Canadian insurers and their global peers, foster enhanced comparability for investors and support ongoing industry trends towards digitalization and innovation in product offerings.

Robert Chaplin (06:39):
And what about the valuation of assets?

Chiara Iorizzo (06:42):
Asset valuation under Canadian GAAP depends on classification. Most reserve assets are held for trading and market-to-market, while surplus assets are often classified as available for sale and carried at amortized cost for regulatory capital purposes. OSFI’s approach is to focus on the fair value of assets, but with some adjustments to reflect the long-term nature of insurance liabilities and the likelihood that certain assets will not be sold.

Robert Chaplin (07:11):
Let’s dig into the LICAT formula itself. Chiara, what are the main principles?

Chiara Iorizzo (07:17):
LICAT is underpinned by five key principles that shape its disclosure requirements and reinforce the integrity of Canada’s life insurance regulatory regime. Principle one: disclosures should be clear, ensuring that information is presented in an accessible and understandable manner for key stakeholders. Principle two: disclosures should be meaningful to users, focusing on significant current and emerging risks and their management, and providing information that adds genuine value to users’ understanding of an insurer’s risk and capital position. Principle three: disclosures should be consistent over time, enabling stakeholders to track trends and changes in an insurer’s risk profile across reporting periods.

(08:02):
Principle four: disclosures should be comparable across life insurers, with standardized formats and levels of detail that facilitate meaningful benchmarking of solvency and capital adequacy within the Canadian market. Principle five: disclosures should be accompanied by qualitative narratives, offering context and explanations for material changes and other issues of interest, thereby enhancing transparency and supporting informed decision-making by policyholders, investors and other market participants. Canadian branches of foreign life insurers are subject to minimum margin tests within the LICAT, called the Life Insurance Margin Adequacy Test, or LIMAT. These principles collectively promote high-quality, transparent and comparable disclosures, strengthening market discipline and confidence in the Canadian life insurance sector. Rob, can you tell us what are the equivalent provisions for the general insurance sector?

Robert Chaplin (09:01):
With pleasure. Thanks, Chiara. Subsection 515(1) of the Insurance Companies Act, or ICA, requires federally regulated life and P&C companies and their branches to maintain adequate capital. Similarly, Subsection 608(1) requires foreign life and P&C companies operating in Canada to maintain an adequate margin of assets in Canada over their Canadian liabilities. The Minimum Capital Test, or MCT, guideline, while not issued under specific subsections of the ICA, provides the framework for assessing whether these companies meet the capital or margin requirements. The MCT sets out minimum and supervisory target capital standards using a risk-based formula to determine the required capital or margin and to define what qualifies as available capital or assets. Even if a company meets the MCT tests, OSFI has the authority to require higher capital or margin levels, if deemed necessary. Under subsections 515(3) and 608(4) of the ICA, foreign P&C branches must comply with the branch adequacy of assets test within the MCT. Chiara, please tell us a bit more about the MCT.

Chiara Iorizzo (10:23):
Sure, Rob. The MCT sets regulatory capital requirements for different risks at specific confidence levels, chosen by OSFI to be the 99% conditional tail expectation (CTE 99%) over a one year including a terminal provision. This means the capital requirements are designed to cover losses up to a very high level of certainty. Risk factors outlined in OSFI’s guidelines are applied to calculate the capital needed at target level. Insurers must maintain the required MCT capital at all times, using the definition of available capital. That includes qualifying capital instruments, composition limits and regulatory adjustments. This definition also covers capital within or consolidated subsidiaries. The minimum capital requirement is calculated on a consolidated basis. It is determined by summoning the capital required at the target level for each risk component: insurance risk, market risk, credit risk and operational risk; then subtracting the diversification credit. The result is divided by 1.5 to arrive at the final minimum capital requirement. Rob, can you tell us about the significance of the MCT ratio?

Robert Chaplin (11:39):
Certainly, Chiara. The MCT ratio, which is a key measure of capital adequacy, is calculated as the amount of available capital divided by the minimum capital requirement. Federally regulated insurers must maintain an MCT ratio of at least 100%. In addition, OSFI has set a supervisory target capital ratio of 150%. This higher target acts as a buffer above the minimum, helping insurers absorb unexpected losses and supporting early regulatory intervention, if needed. Each insurer is also expected to set its own internal target capital ratio following OSFI’s guidelines and to keep its capital above its internal target at all times. OSFI may set a different supervisory target for an insurer based on its own unique risk profile after consultation. Internal targets will often be in the 175 to 225% range.

(12:38):
If an insurer expects its MCT ratio to fall below its internal target, it must notify OSFI immediately and submit a plan for returning to compliance, subject to OSFI’s approval. OSFI will take into account any unusual market conditions when assessing an insurer’s performance relative to its internal target. Insurers are required to continuously maintain their MCT ratios at or above internal targets. Any questions about a specific insurer’s target ratio should be directed to their OSFI lead supervisor. Chiara, what about availability of capital?

Chiara Iorizzo (13:15):
Thanks, Rob. OSFI sets standards for ensuring that insurers have sufficient and appropriate capital resources to meet regulatory capital requirements. Capital must be able to fulfill obligations to policyholders and creditors and absorb losses during times of financial stress. OSFI sets out criteria for evaluating the quality of different capital components and specifies that the composition of regulatory capital should be dominated by the highest-quality capital.

(13:44):
There are four primary considerations for determining the capital available of a company for the purpose of measuring capital adequacy, which are: availability, to the extent that the capital element is fully paid in and available to absorb losses; permanence, the period for, and extent to which, the capital element is available; absence of encumbrances and mandatory servicing costs, the extent to which the capital element is free from mandatory payments or encumbrances; and subordination, the extent to which, and circumstances under, the capital element is subordinated to the rights of policyholders and creditors of an insurer and in insolvency or winding-up.

(14:27):
Regulatory capital available will consist of the sum of the following components: common equity, or category A capital; category B capital; and category C capital. There is a detailed description of each type of capital in the guidelines reflecting that A is the highest quality and C, the lowest quality of capital. The sum of capital instruments meeting qualifying criteria under category B and category C must not exceed 40% of the total capital available. Further capital instruments meeting the qualifying criteria under category C must not exceed 7% of total capital available. Rob, can you tell us about diversification under the MCT?

Robert Chaplin (15:11):
Of course, Chiara. OSFI recognizes that because losses arising across some risk categories are not perfectly correlated with each other, a company is not likely to incur the maximum possible loss as a given level of confidence from each type of risk simultaneously. Consequently, OSFI allows for an explicit credit for diversification between the sum of credit and market risk requirements and the insurance risk requirement, so that the total capital required for these risks is lower than the sum of the individual requirements for these risks. The diversification credit is calculated using a formula that is expressed in terms of the asset risk margin - that is the capital required for credit and market risks and insurance risk margin, and a correlation factor between these two risk margins of 50%. Chiara, can you talk us through how the Canadian approach compares to other regimes like the U.S. RBC or Solvency II in Europe?

Chiara Iorizzo (16:11):
The Canadian MCT and LICAT share similarities with the U.S. RBC system in that both are risk-based and use factor-based formulas. However, there are important differences. For example, the Canadian approach is more principle-based, especially in its use of the new IFRS 17 valuation approach (i.e., the ALM) for liability valuation, which allows for more realistic modeling of asset-liability interactions. The Canadian regime also places a strong emphasis on explicit margins for adverse deviation and dynamic testing. Compared to Solvency II, the Canadian system is less explicitly calibrated to a specific confidence level like Solvency II’s 99.5% over one year, and it does not use a full economic balance sheet approach. However, Canada is moving in that direction, especially with the adoption of IFRS and ongoing reforms to align with international best practices.

Robert Chaplin (17:13):
Are there any unique challenges in the Canadian system that our listeners should be aware of?

Chiara Iorizzo (17:18):
One unique challenge is the subjectivity in setting margins for adverse deviation, which can lead to variability in reported liabilities and capital across companies. OSFI addresses this through rigorous review and guidance, but it remains an area of focus as the regime evolves.

Robert Chaplin (17:36):
Chiara, before we wrap up, how is Canada preparing for the future of insurance solvency regulation?

Chiara Iorizzo (17:42):
Canada is actively modernizing its solvency framework. Despite rejecting the International Association of Insurance Supervisors’ insurance capital standard, with the adoption of IFRS OSFI is moving toward a global balance sheet approach for capital adequacy, which will bring Canadian standards closer to Solvency II and other international regimes. The new framework will emphasize economic valuation principles, greater transparency and more risk-sensitive capital requirements. The goal is to maintain competitiveness and resilience of the Canadian insurance sector in a global market. Looking forward, the Canadian insurance market presents a range of compelling opportunities, driven by its mature and sophisticated regulatory environment, high capital requirements and a strong focus on innovation and consumer protection.

(18:34):
Notably, the market is seeking significant growth in embedded digital insurance products; new specialty lines, such as cyber and cannabis coverage; and representations and warranties insurance. Alberta’s recent introduction of a captive insurance regime further diversifies the market, aiming to address capacity shortages in sectors like energy and to foster economic development. These opportunities are underpinned by a regulatory framework that is increasingly principles-based, with federal and provincial regulators emphasizing fair treatment of customers, climate resilience and robust governance. This dynamic environment, combined with ongoing consolidation and the active participation of large pension funds and private equity, positions Canada as an attractive and innovative jurisdiction for insurance sector growth.

Robert Chaplin (19:26):
That’s a really great overview. Thank you, Chiara. Thank you for joining us today to discuss the Canadian prudential solvency regime. For our listeners, stay tuned for our next episode where we’ll be exploring the prudential regime in another major insurance market. As always, if you have any questions or comments, we’d love to hear from you. Thanks for listening.

Voiceover (19:48):
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