Reports on Observance of Standards and
1. This report provides an assessment of Canada's observance of and consistency with relevant international standards and core principles in the financial sector, as part of a broader assessment of the stability of the financial system. This assessment work by the IMF was undertaken under the auspices of the IMF-World Bank Financial Sector Assessment Program (FSAP) based on information up to October 1999. This has helped to place the standards assessments in a broader institutional and macroprudential context, and identify the extent to which the supervisory and regulatory framework has been adequate to address the potential risks in the financial system. The assessment has also provided a source of good practices in financial regulation and supervision in various areas.
2. The assessment covered (i) the Basel Core Principles for Effective Banking Supervision; (ii) the International Organization of Securities Commissions' (IOSCO) Objectives and Principles of Securities Regulation; (iii) the International Association of Insurance Supervisors' (IAIS) Supervisory Principles; (iv) the Committee on Payment and Settlement Systems' (CPSS) Core Principles for Systemically Important Payment Systems; and (v) the IMF's Code of Good Practices on Transparency in Monetary and Financial Policies. Such a comprehensive coverage of standards was needed as part of the financial system stability assessment for Canada in view of the increasing convergence in the activities of banking, insurance, and securities firms, and the integrated nature of the markets in which they operate. It should be noted that some of the standards are still in draft form, and some do not yet have a complete methodology to systematically assess compliance or consistency.2 This module was prepared in consultation with the Canadian authorities in the context of the IMF FSAP mission that visited Canada in October 1999, and constitutes a summary of the detailed assessments prepared by the mission. The summary was part of the Financial System Stability Assessments (FSSA) report that was considered by the IMF Executive Board on February 2, 2000, in the context of the IMF's Article IV consultation discussions with Canada.
3. The assessment of standards and codes draws on the self-assessments of the Canadian authorities, and on the field work undertaken October 11-22, 1999, based on a peer review process by Kai Barvll (Payment Systems, Sveriges Riksbank), Karl Driessen and Charles Siegman (Transparency Code, IMF), Alvir Hoffmann (Banking Supervision, Banco Central do Brasil), Rodney Lester (Insurance, World Bank), Michael Martinson (Banking Supervision, Board of Governors of the Federal Reserve System), Stefan Spamer (Banking Supervision, Deutsche Bundesbank), and Shane Tregillis (Securities, Australian Securities and Investments Commission). The expert team was coordinated by the IMF FSAP mission, led by V. Sundararajan, and comprised R. Barry Johnston, Karl Driessen, Haizhou Huang and Martin Cerisola. The assessment has been communicated to the authorities.
4. Overall, the assessment found a high degree of compliance that had contributed to a stable financial system. Minor deviations from Basel Core Principles of Effective Supervision were detected, which are addressed by proposals contained in the Policy paper.3 Full compliance with the Core Principles for Systemically Important Payment Systems was noted for the Large Value Transfer System. Canada is broadly compliant with all principles of insurance regulation, and is broadly consistent with IOSCO Objectives and Principles of Securities Regulation. The complexity of federal/provincial regulatory arrangements, oversight of mutual funds, and resource limitations on the enforcement capacity of some securities commissions are areas of concern that are being addressed. There is a high degree of consistency with the Code of Good Practices on Transparency in Monetary and Financial Policies. The more specific findings in the area of insurance supervision are discussed below.
A. Background and Overview
5. The Canadian insurance sector is mature, competitive and several Canadian life insurers have achieved a high market penetration overseas. The insurance sector has four main markets: life, property and casualty (P&C), health, and mortgage lenders. Approximately 22 million Canadians have some form of life insurance. Total worldwide investment assets under management amounted to $267 billion in capital guaranteed products and $153 billion in investment-linked products as at the end of the last fiscal year. Total domestic capital guaranteed net policyholder liabilities amounted to $149 billion or 25 percent of the amount of domestic bank deposits. Even though the domestic insurance market is composed of 150 players, it is still relatively concentrated.
6. Life insurers are aggressively moving into the domestic wealth management business by developing and marketing a variant of mutual funds like products. The guarantees associated with these new products pose additional risks. A process of demutualization of major life insurance companies is also underway.
7. The IAIS has developed two sets of principles to date: (i) Insurance Supervisory Principles; and (ii) Principles Applicable to the Supervision of International Insurers and Insurance Groups and their Cross-Border Establishments. Standards based on these principles so far cover only a small fraction of these principles, and deal with licensing, on-site inspection, and derivatives. In addition, insurance has a wider range of risk factors than banking, including a number of liability related risks which make supervision more a function of environment and country development than is the case with banking, where more specific and universal core principles have been possible. The principles do not capture the prudential requirements arising from product innovation and the associated buildup of contingent liabilities, including guarantees and exposures to increasingly complex derivative instruments.
8. Canada fully complies with most of the IAIS prudential regulation principles, and broadly complies with the remainder (Table 1). Variations generally reflect its unique legal history; for example the coexistence of common law and a civil code within one federation. The major explicit deviations include the following: (i) marine insurance does not require the insurer to be licensed if the insurer only writes this class of business; (ii) the Minister of Finance, rather than the Superintendent, grants new licenses; however, in practice the Minister acts on the recommendation of the Supervisor, who places primary emphasis on the suitability of the new owners; (iii) the Supervisor does not have primary responsibility for setting corporate governance standards; (iv) ultimate responsibility for asset selection lies with directors; however, an overriding "prudent person" rule applies, augmented by a guidance note issued by OSFI; (v) dealings with non-Canadian licensed foreign reinsurers are controlled indirectly through non-allowance in capital adequacy/solvency tests; and (vi) OSFI is not automatically advised of findings regarding criminal activity affecting the insurance sector where the investigation was carried out by another government entity.
B. Assessment of IAIS PrinciplesPrinciple 1.A: Licensing
9. A company wishing to incorporate under the Insurance Companies Act must apply for letters patent according to a defined process. The authority to incorporate a federally registered insurance company rests with the Minister of Finance, however, in practice this is on a recommendation by the Superintendent of OSFI. Criteria are established including minimum capital, a sound business plan, owner track record in the financial services sector, and management skills. A foreign company must also have at least a five-year successful track record in its home country, proven expertise and an acceptable corporate name. In addition, the provinces must sign off on the marketing plan and the proposed product range; and a chief agent and an actuary, both Canadian residents, and a Fellow of the Canadian Institute of Actuaries (FCIA) in the latter case, must be appointed.
10. Assessment: The principle is met.
2/ BC: Broadly compliant
3/ NC: Non-compliant
4/ Mat. NC: Materially non-compliant
Principle 1.B: Changes in Control
11. No person shall acquire control of a company or acquire or increase a significant interest in a class of shares without ministerial approval (the Superintendent can approve the acquisition of up to 10 percent of non-voting shares and increases in capital). If control of a company is changing, the requirements are broadly similar to those for a new license. Canada also has a number of rules requiring companies to be widely held once they get to a certain size, defined in terms of equity. Additional rules apply if the acquirer is a financial institution (and a Bank in particular), and if it is a related company.
Assessment: The principle is met.
Principle 2: Corporate Governance and Internal Controls
12. The Insurance Companies Act (ICA) has a large and comprehensive section on the roles and responsibilities of Directors and Officers. Insurance companies must have a minimum of seven directors and at least half (for a foreign subsidiary) or three quarters (for a domestic insurer) must be resident Canadians. Certain people are disqualified by virtue of their responsibilities or personal history from being a director. Normally, no more than two-thirds of the directors may be affiliated with the company and up to 50 percent of directors may be employees. Comprehensive law exists to cover the election of directors and further requires directors to meet at least 4 times a year. OSFI has reinforced this by issuing a letter on "Compliance with the Insurance Companies Act" reminding directors, officers and chief agents of their governance responsibilities and specifying a deadline of December 31, 2000 for implementation.
13. In the case of life insurers, the above procedures are supplemented by a "Program for Assessment of Regulatory Compliance with the Standards of Sound Business and Financial Practices for Life Insurance Companies (PARC)", which from 1999 must be reviewed by the Board Audit Committee. OSFI reviews all compliance documentation and auditors are required to report noncompliance under the "well being reporting requirements." When auditors, actuaries and directors sever connections with a company, the reasons should be communicated to the Supervisor. In addition, OSFI has the ability to veto the appointment of directors for problem companies.
14. OSFI has issued a detailed guideline on internal controls for life insurers and a guideline is in course of preparation for P & C companies. OSFI also meets with the external auditors after the annual audit and has periodic meetings with the auditing profession. In addition, the Standards of Sound Business and Financial Practices are very comprehensive, covering capital, credit risk, foreign exchange risk, securities portfolio management, real estate appraisals, product design and pricing, underwriting and liability management, interest rate risk management, liquidity management and internal controls.
15. Assessment: The principle is met.Principle 3.A: Prudential Rules-Assets
16. The Insurance Companies Act specifies that the directors of a company "will establish policies relating to investment and lending and policies that a reasonable and prudent person would apply with respect to a portfolio of investments and loans and the company must adhere to that policy." OSFI has issued guidelines on the Prudent Person Approach. In addition, there are clear limits on the types of subsidiary in which an insurer may hold a substantial interest. Further legislated guidelines limit a company's aggregate investments in real estate and equities. Certain asset-related matters are also covered in the life insurance standards of business and financial practices, including capital, asset, and liability quality (product design and pricing, and underwriting). Similar standards are being developed for non-life companies. The "well being reporting requirement" for auditors also requires the auditor to report on any inappropriate or overly risky investments. Related-party transactions are explicitly covered in the legislation and the Conduct Review Committee of the board has specific responsibilities in the area. Foreign companies are required to maintain certain liquidity facilities in Canada. Asset valuation methods are specified under Canadian GAAP as modified by OSFI, and are designed to be consistent with liability valuation methods.
17. Assessment: The principle is met.Principle 3.B: Prudential Rules-Liabilities
18. The Insurance Companies Act specifies that "the actuary shall value actuarial and policy liabilities of the company and any other matter specified by the Superintendent." The Act goes on to say that "the actuary's valuation shall be in accordance with the generally accepted actuarial practice with such changes and additional directions as the Superintendent may determine." Standards of practice are set by the Canadian Institute of Actuaries (in consultation with the regulator, the industry and the Canadian Institute of Chartered Accountants). However, these are not prescriptive and specify no minimum valuation basis: considerable discretion remains with the appointed actuary. In the case of P&C companies the board may set a reserve higher than that established by the appointed actuary. In special circumstances the Superintendent can ask for a report from an independent external actuary. The Superintendent also has the power to override Canadian GAAP; however, this authority is used sparingly. A guideline exists for the treatment of reinsurance. Net reinsurance assets in respect of non-registered life insurance reinsurers are not admitted for solvency purposes.
19. Assessment: The principle is met.Principle 3.C: Capital Adequacy and Solvency
20. The current legislative minimum capital requirement for the incorporation of domestic life insurance companies and domestic P&C insurers is $10 million. The Federal Canadian approach to life insurance solvency parallels the Basel Committee approach for banks, and is outlined in "Guideline A - Minimum Continuing Capital and Surplus Requirements for Life Insurers in Canada (MCCSR)" under which risk-based required capital is compared with capital available. The broad risk factors considered include asset default risk, mortality/morbidity/lapse risk, and interest margin pricing risk. Capital is allocated to two tiers according to the nature of the asset and insurers are expected to maintain a cushion over the minimum. Foreign life insurers must vest additional assets in accordance with an "Adequacy of Assets in Canada" test. P&C companies are also subject to a solvency test based on the excess of admitted assets over liabilities. Under the Insurance Companies Act, the Superintendent can require a life company to increase capital and liquidity, as well as require a P&C Company to increase assets. In addition to static solvency testing Canada has introduced Dynamic Capital Adequacy Testing (DCAT) in which future cash flows are stress tested against assumed adverse developments. P&C companies will be brought into this framework over the next two years (including the introduction of a minimum capital test).
21. Assessment: The principle is met. However, provincial regulators continue to use more traditional approaches to solvency testing.Principle 3.D: Derivatives and `Off Balance Sheet' Items
22. No explicit limitations on derivative trading apply, however the prudent person investment guidelines states that limits on currency and interest rate exposure should be established to contain risk, and that there should be policies detailing the circumstances under which the use of derivatives is permitted, as well as limits on type of instrument and counterparty.
23. In addition, an explicit OSFI guideline exists for derivatives, which requires senior management to specify which instruments may be purchased or written, and for which purposes and who has the relevant authorities. There is also a requirement that adequate capital is maintained to support the risks arising from derivatives. In particular if a derivative instrument results in an off-balance sheet exposure for a life insurer, then the potential credit exposure is determined by assigning a default factor appropriate to the counter party (similar treatment does not currently apply to P&C companies). The board is required to periodically review all significant policies pertaining to the institutions use of derivatives. Risks to be considered include market, credit, liquidity, and operations and systems, as well as legal issues.
24. Assessment: The principle is met.Principle 3.E: Reinsurance
25. Domestic reinsurers are subject to the same regulatory regime as direct insurers. The Governor-in-Council has the power to make regulations regarding reinsurance and has done so in the case of P&C insurance. This requires at least 25 percent premium retention and limits the amount reinsured with non-approved reinsurers to 25 percent of risks: OSFI assumes that the words "non-approved" are analogous to "not licensed in Canada", and places no reliance on the supervisor of a reinsurance company that is not so licensed. Reinsurance arrangements are reviewed by OSFI at the time of on-site inspections, and insurers are expected to consider the security of their reinsurers.
26. Assessment: The principle is met.Principle 4.A: Financial Reporting
27. Statutory reports required for life insurers include quarterly financial and MCCSR returns, annual returns, an annual appointed actuary's report, a dynamic solvency testing report, disclosures of dividend policy, activities for the year of the Conduct Review Committee, details of any changes in Board membership, and an annual return of Directors and Auditors. All reports are subject to deadlines and OSFI can impose fines for late lodgment. P&C statutory returns are similar although not as onerous. The Insurance Companies Act specifies that directors have to place an annual statement before shareholders and policyholders and that this will be prepared in accordance with the Handbook of the Canadian Institute of Chartered Accountants unless otherwise specified by the Superintendent.4 Typically auditors and the appointed actuary sign letters stating that they will rely on each other's findings. OSFI relies on the work of the external auditor as to the fairness of the accounts. It also advises the external auditor of any information that may be relevant to the formation of an opinion on the fairness of the financial statements.
28. Assessment: The principle is met.Principle 4.B: On-site Inspection and Access to Information
29. The Superintendent can examine and inquire into the business and affairs of any insurer operating in Canada to ensure compliance with the Act and that the insurer is in sound financial condition. The Superintendent is required to report to the Minister after each such examination. The Superintendent has full right of access to all records, cash, assets and securities and can request information from the chief agent, actuary, directors, officers and auditor (provided this is reasonable) regarding the condition and affairs of the enterprise. The Superintendent also has the powers of a commissioner to obtain evidence under oath and can delegate this authority. OSFI routinely examines the following items: internal auditors reports, external auditor's working papers, board and board committee minutes, loan assets and provisions for non-performing loans (using outside credit consultants), the institutions risk management processes, and financial performance trends, both against itself and peer insurers and the actuaries' working documents. In addition, routine interviews are held with the senior offices of the insurer to review operations.
30. Assessment: The principle is met.Principle 5: Sanctions
31. The Superintendent has extensive powers to impose temporary cease and desist instructions and to require remedial action if unsafe or unsound practices are in use or are contemplated by an insurer. A temporary order can be extended if the insurer does not make satisfactory representations. The Superintendent can apply to a court for an order. The Superintendent can also require that directors not be appointed if a company is under orders to maintain or improve its safety and soundness, subject to representations by that person. OSFI, however, cannot appoint directors. The Superintendent also has extensive powers to take possession of a company, if the company is seriously compromised, for up to 16 days and for longer periods if the Minister does not intervene. A company has ten days to make representations in such circumstances. The Superintendent can also apply to the Attorney General to wind up a company of which he has taken possession.
32. Penalties for breaches of the Act can be up to Can$5 million for a corporation that is convicted on indictment. Administrative penalties are not available but are planned for inclusion under the 1999 Policy paper. The Policy paper also proposes that the Superintendent will have the power to remove directors and officers of insurers in certain circumstances.
33. Assessment: The principle is met.Principles 6.A and 6.B: Cooperation and Confidentiality
34. OSFI does not have any formal relationships with any foreign insurance supervisors. While OSFI reviews the worldwide position of foreign branches and subsidiaries in Canada, the focus remains on the ability of the branch or subsidiary to stand on its own assets vested in Canada. Where OSFI has concerns that deteriorating results worldwide could create problems in Canada, it seeks regular contact with the foreign home supervisor. Where OSFI is the home supervisor, it does not have a standing protocol with foreign supervisors to share information at any particular level or to alert a foreign supervisor to a problem. Only in very rare cases, where a branch or subsidiary materially contributes to a company's overall results, would OSFI examiners leave Canada to perform an on-site examination.
35. All information obtained by OSFI as a result of administering or enforcing an act of Parliament is confidential. Legislation does not restrict the information that OSFI as supervisor may provide to other supervisors, whether domestic or foreign, other than that the information must be used solely for prudential purposes and be treated as confidential. OSFI does not have any legal responsibility to pass information on criminal activities onto a host supervisor as this responsibility rests with the Royal Canadian Mounted Police (RCMP). If a home supervisor uncovered criminal activities while carrying out an examination in Canada, it would not be obliged to inform OSFI of these activities.
36. Assessment: Partial compliance with Principle 6.A; Principle 6.B is met.
2 The Basel Core Principles were issued in September 1997; a Core Principles Methodology was released in October 1999 by the Basel Committee on Banking Supervision. The Code of Good Practices on Transparency was adopted by the Interim Committee in September 1999; work on a supporting document is in progress. The IOSCO Objectives and Principles were issued in September 1998, and a detailed self-assessment methodology is being developed. A draft of the Core Principles for Systemically Important Payment Systems was issued for public comment in December 1999. The IAIS Insurance Supervisory Principles were issued in September 1997; a self-assessment program has been developed to assist member countries in evaluating compliance.
4 Canada has, uniquely, reconciled actuarial and accounting concepts in its financial reporting system. Fair value assets and liabilities are determined and a separate explicit allowance is made for possible adverse deviations.