Weighing in MCT

The minimum capital test (MCT) is the new regulatory capital test for Canadian insurers. MCT comes into effect from the beginning of 2003. One harmonized capital test will replace the various federal and provincial asset tests.

As the new test is being introduced, work has begun on future reform ideas, which the industry is pressing for Canadian regulatory capital requirements to come in line with other major insurance markets like the U.S. and Europe. Below is an analysis of the new test and a sense of reforms that will likely follow.

WHY NOW?

Changes in regulatory practices are difficult for insurers in the best of times, and are particularly challenging in hard markets like that which is currently evident across Canada. Several years of work led to the introduction of the minimum capital test (MCT). This involved the Insurance Bureau of Canada (IBC), the Canadian Council of Insurance Regulators (CCIR), The Office of the Superintendent of Financial Institutions (OSFI), among a host of stakeholders.

During 2002, a consensus emerged around the proposed MCT that it would improve supervision relative to the various asset tests current in place, and this change would be implemented at the start of 2003. Discussion continues about further reforms, but no additional changes are expected over the next couple of years.

WHY HARMONIZATION?

There are material differences in the asset tests of OSFI and the various provincial regulators. It is not right that otherwise identical insurance companies may pass or fail regulatory tests of asset adequacy based upon where they are based in Canada. Several years ago agreement was reached between the industry and regulators that these tests should be harmonized. Everyone wanted to establish a single test, the challenge has been to find the test that would be acceptable to all parties.

THE BRANCH DIFFERENCE

Canadian insurers have traditionally been subject to the various MATs established by OSFI and the provincial regulators. Branch insurers operating in Canada have been subject to “Deposit Adequacy Tests”. The MCT reforms apply to both Canadian insurers and branch operations.

The initial focus of the reform project was on adjustments to the MAT for Canadian insurers, there was a clear commitment by all involved that the test for branches would also be reformed, but this would be best accomplished when a consensus emerged over the MAT. We did succeed in changing the tests for both Canadian insurers and branches at the same time.

RISK-BASED

OSFI has been an international leader in redirecting their solvency supervision to focus on risky industry practices and reduce supervision of less risky practices. Reforms in this direction are encouraged by both insurers and regulators. Indeed, the best bank and insurance supervisors around the world are shifting away from recording compliance toward supervision of risky practices that could have a material adverse impact on the institution.

MCT introduces several risk elements into the previous asset tests. For example, Government of Canada bonds are more likely to avoid loss in value than equity investments, so MCT includes investment risk adjustment factors. The new test also introduces adjustments to reflect differences in capital risk across the various major lines of p&c insurance. There was broad consensus about areas where asset and liability risk is lower or higher, but it was challenging for the parties to determine the specific adjustment factors.

SIMPLIFIED

Risk-based capital tests have been in place for several years for Canadian life insurers and U.S. p&c insurers. Following the introduction of the U.S. p&c test, there was considerable pressure to introduce a similar test for Canadian insurers. A specific objective of the IBC was to ensure that Canada did not adopt the current U.S. test.

The U.S. test has been criticized by insurers and regulators. It is remarkably complex. Efforts to adjust asset and liability measures to reflect risk are so complicated that the meaning of the final test scores is unclear. The IBC’s objective was to largely maintain the current test when establishing one unified test, while introducing a few of the more significant risk factors.

NEUTRAL GAIN

OSFI and the provincial regulators were seeking to establish a unified test, and not to increase or reduce the overall impact of the test. The new test increases demands on some insurers, but this is offset by some reduction in the requirements for others. From the industry’s perspective it was important that the capital requirements for the industry should not exceed the demands of the previous tests, and we argued that the overall minimum capital requirements should be relaxed somewhat.

The first discussion paper about the MCT released by the Canadian Council of Insurance Regulators achieved most of the goals set out by the various regulators and the insurance industry. However, when company filings information for 2000 was used to examine the test it became clear that the proposal would have significantly increased minimum regulatory requirements. The regulators worked with the IBC to identify adjustments to ensure that the new test would not increase capital requirements. Testing of the final MCT using 2000 and 2001 filings did confirm that the new test was successful in achieving a neutral overall impact.

WHAT NEXT?

Minimum regulatory capital demands in Canada are much higher than other countries. Insurance leaders have asserted this for many years. Currently IBC and OSFI are jointly managing a study to quantify regulatory capital requirements for property and casualty insurers in Canada, the U.S., the European Union, the U.K., Japan and some other major insurance markets.

The study will also assess accounting and actuarial practices. This report will provide a basis for further discussion about the capital test. Minimum regulatory capital demands should be similar in the major insurance markets, and the study will provide a shared information base to support the discussion.

The International Association of Insurance Supervisors (IAIS) is involved in two related projects. They are looking at solvency tests around the world for insurers, and at the supervision of reinsurers. OSFI and several provincial regulators participate in the activities of this organization. These projects will provide additional information that will be available as IBC and industry leaders press to bring the Canadian capital test in line with international demands.

UNIFIED CONCLUSION

The new capital test comes into effect at the beginning of 2003. This is a difficult time for insurers to adapt to regulatory changes, but there was a consensus that the new test is a step toward an improved system of monitoring solvency risk so it will be introduced now. The new test adds some key risk elements in the measure of regulatory capital, while avoiding the complexity found in the U.S. The new test will increase the minimum requirements for some insurers and reduce it for others, while the overall impact is neutral. Most importantly, the various asset tests now in place will be replaced by a unified capital test.

With these reforms in place, the IBC is working with OSFI and the CCIR to compare the minimum regulatory capital requirements in Canada with those found in the other major insurance markets. We argue that regulatory capital demands in Canada are too high and they should be brought in line with those found in other major jurisdictions. This will take time to complete in terms of research and discussion, but the work has begun.