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### Executive summary — low interest rates: exposure and mechanisms
- Prolonged low interest rates since 2008 are a source of vulnerability for the insurance sector worldwide.
- Life companies are exposed because:
  - Low rates reduce returns on new investments, including reinvestment of maturing assets.
  - Low rates increase the current value to policyholders of guaranteed returns.
  - Policyholder behavior may change: surrendering fewer policies, increasing contributions into current policies where permitted, and buying fewer new policies.
- Non-life (P&C) business is generally less sensitive to interest rate changes because it is short term with regular renewals.

### Impact in Canada — structural features and market response
- Structural features accentuating low-rate exposure:
  - Prevalence of permanent life insurance policies with cash values supported by guaranteed rates.
  - Certain annuities, long term care and segregated fund products create both equity and interest-rate exposure.
  - Some groups accumulated exposures via U.S. operations selling similar products.
  - Matching long-term liabilities is often not possible, creating reinvestment risk.
- Accounting and regulatory recognition of low rates:
  - Actuarial standards require assumed reinvestment rates to take increasing account of current market rates, leading to higher liabilities as low rates persisted.
  - OSFI’s capital requirements are sensitive to asset and liability values; regulatory capital ratios have tended to decline as rates fell.
  - For one group, lower interest rates contributed to significant overall losses and a need to raise new capital.
- Industry responses (aimed at reducing product and pricing sensitivity rather than increasing portfolio risk):
  - New business repriced and premiums raised on existing policies where possible.
  - Fewer products with sensitivity to interest rates and equities are being sold; shift toward low-risk products including mutual funds.
  - Significant retrenchment in U.S. operations.
  - Portfolios remain overwhelmingly focused on investment-grade fixed-interest bonds; limited switching into higher yield or alternative investments.
  - Hedging has reduced sensitivities to future interest rate trends.
- Business-model and market implications:
  - Most revaluation losses from past interest rate reductions have been recognized; further liability increases must be recognized in the short term due to accounting and actuarial standards, irrespective of direction of rates.
  - Demand for life insurance and annuities in Canada remains high; insurers benefit from well-established brands and distribution.
  - Over the medium term, insurers shifting more risk to policyholders and selling more non-insurance products will face greater competition from other financial institutions, including banks.

### Market structure, product types, and guarantees
- Market segments and sales channels:
  - Individual life insurance sold through tied agents and independent brokers.
  - Group life insurance for corporate customers.
  - Annuity products including accumulation and payout annuities.
- Product distinctions and prevalence:
  - Participating versus non-participating policies; general fund versus segregated fund products.
  - Universal life (UL) policies: policyholders make regular (usually fixed) premium payments; excess accumulates into a fund, sometimes attracting a guaranteed rate of return.
  - Universal life products have accounted for as much as 40 percent of new product sales.
  - Only 18 percent of outstanding individual life insurance is participating, compared with nearly 30 percent ten years ago.
- Regulation of guarantees and dividend distribution:
  - Few product design regulations and no requirements for pre-approval of new products or premiums.
  - No restrictions in Canada on the level of guarantees that may be offered.
  - By law, segregated funds must be offered with a guarantee set at 75 percent of the principal.
  - Under s461 of the Insurance Companies Act, for the largest books of participating policies only 2.5 percent of profits may be transferred to shareholders.

### Accounting and regulatory framework (CALM and standards)
- Accounting alignment and standards:
  - Canada adopted IFRS with effect from 2011; pending a revised IFRS 4, existing national standards (Standards of Practice of the Actuarial Standards Board) provide the basis for Canadian GAAP.
  - Insurers use IFRS for regulatory reporting purposes unless OSFI requires variations (in practice it has required none).
- Canadian Asset Liability Method (CALM) key features:
  - Based on prospective future cash flows of liabilities and supporting assets; liabilities segmented and assets assigned to segments.
  - Use of scenarios and margins for adverse deviation; deterministic approaches generally act as a floor.
  - Base scenario includes current risk-free yield curve out to 20 years and from 40 years; Ultimate Reinvestment Rate equals the sum of half of the 60-month and the 120-month moving averages of historic long-term Canadian risk-free bond yields.
  - Nine additional scenarios must be tested, including reinvestment rates tracking current rates into the future; the least favorable outcome determines the provision for adverse deviation.
  - Standards apply group-wide, including for companies with international operations.

### Market exposures, asset availability, and investment strategy
- Asset/liability mismatch drivers:
  - Long-term policies are not matched by long-duration available assets: Government of Canada bonds limited to 30 years; some provincial issues exceed 30 years but in limited amounts. Corporate debt instruments do not extend to 30 years.
- Non-fixed income investment supply:
  - Good supply of non-fixed interest, non-equity investments such as direct real estate investment and infrastructure.
  - Investment in these assets requires skills and expertise which many insurers lack; only a small number of companies have specialist expertise.
- Hedging and portfolio composition:
  - Limited ability to lengthen duration via government bonds; some insurers have increased hedging where equity exposure on segregated fund business was significant.
  - Portfolios remain overwhelmingly focused on investment-grade fixed-interest bonds; some shift in quality (e.g., from AA to A) but no significant increase in below investment grade holdings.

### Sector performance and key statistics (aggregate, In Can$ millions unless otherwise indicated)
- Gross premiums by year:
  - 2008: 84,271
  - 2009: 78,420
  - 2010: 73,115
  - 2011: 72,458
  - 2012: 73,728
- Net premiums by year:
  - 2008: 76,527
  - 2009: 67,947
  - 2010: 61,646
  - 2011: 56,389
  - 2012: 48,890
- Investment income by year:
  - 2008: 3,881
  - 2009: 32,443
  - 2010: 33,742
  - 2011: 50,232
  - 2012: 29,107
- Net claims incurred by year:
  - 2008: 49,991
  - 2009: 46,662
  - 2010: 44,193
  - 2011: 38,740
  - 2012: 36,412
- Expenses by year:
  - 2008: 19,546
  - 2009: 19,850
  - 2010: 22,270
  - 2011: 21,630
  - 2012: 21,732
- ROE (after tax) by year:
  - 2008: 4.9%
  - 2009: 6.7%
  - 2010: 5.1%
  - 2011: 3.5%
  - 2012: 9.4%
- Observations:
  - Canadian interest rates have fallen since 2008.
  - Aggregate data point to declining premium income, volatile investment income and low returns on equity since 2008; aggregate RoE recovered to 9.4 percent for the sector in 2012.

### Industry concentration, foreign exposures, and group performance
- Major groups and concentration:
  - Manulife Financial Corporation, Sun Life Financial Inc. and The Great West Life Assurance Company together held just under 76 percent of total life insurance assets in Canada in 2012.
- Foreign operations and exposures:
  - U.S. was the largest foreign market for the top 3 groups, accounting for 37 percent of assets and 17 percent of premiums in 2012 (before recent divestments).
  - Europe accounted for 11 percent of assets and 12 percent of premiums.
  - Asian operations accounted for 9 percent of total assets.
  - 48 percent of the consolidated assets of the top-10 insurance groups and 69 percent of gross premium are attributable to domestic business.
- Performance variation:
  - One group maintained a healthy RoE in each year of the financial crisis; another experienced considerable volatility, including a significant loss in 2010 driven by U.S. variable annuities and equity exposures.

### Capital adequacy and regulatory impacts
- OSFI capital framework characteristics:
  - Factor based approach with limited scope for internal models (except for financial guarantees embedded in segregated funds for companies with approved models).
  - No credits for diversification across risk categories.
- Capital outcomes:
  - As assets and liabilities grew due to the fall in interest rates and significant mismatches, capital ratios tended to decline, although from high levels.
  - All major companies have maintained MCCSR ratios well above the minimum of 120 percent and the supervisory target ratio of 150 percent.

### Stress testing, scenarios, and sensitivities
- Reporting and stress testing:
  - Publicly reporting companies must disclose exposures to changes in key variables, including a 100 basis point reduction in interest rates along the yield curve.
  - Disclosures for the largest three groups suggest sensitivities to lower rates have fallen off since 2009 and sensitivities to assumptions on returns on non-fixed income (NFI) investments are relatively high.
  - Tests are broadly consistent with OSFI and FSAP exercises, including a market-wide exercise conducted with the IMF for the 2013 FSAP.
- Scenario outcomes:
  - Gradually rising rates:
    - Insurers would experience a strengthening of balance sheets because much of the impact of past rate changes has already been recognized.
    - The 2013 FSAP stress testing suggests MCCSR ratios could move up from around 215 percent (aggregate of the three major groups) to close to 300 percent over the period to 2017, based on a scenario of gradually rising rates.
  - Sharp increase in rates:
    - Could expose insurers to increased lapses as policyholders move funds to products likely to respond more swiftly to the new environment.
  - Further prolonged low rates:
    - Would likely create increased strain because large legacy books would have to be fully revalued at low rates while new business volumes would be affected by continuing low returns insurers could offer.
    - Current prices on some longer term products reflect an expectation that interest rates will recover well within the lifetime of the products; a long low-rate period would challenge those assumptions.

### Industry responses and strategic adjustments
- Repricing and product redesign:
  - New business repriced, sometimes many times and with total increases of up to 40 percent, based on lower guarantees and revised lapse assumptions; premiums raised on existing policies where possible.
  - UL and LTC policies redesigned with explicit provisions for adjustment of premiums or pass-through of changes in investment returns.
- Product mix and distribution strategy:
  - Fewer products with sensitivity to interest rates and equities; shift toward mutual funds and retirement-related business with limited or no guarantees.
  - Strategy to grow wealth management and assets under management rather than guarantee-rich insurance products.
- Retrenchment and hedging:
  - Significant retrenchment in foreign operations, including closures or divestments of U.S. variable annuity business.
  - Increased hedging where equity exposure on segregated fund business was significant.
- Limitations:
  - Adjusting premiums or benefits on existing business is difficult due to policy terms and reputational risk.
  - Legacy business constrains cost reductions.
  - Regulatory restrictions on dividend distribution and requirement to recognize present value of expected future dividends on participating policies partly explain reluctance to reintroduce participating products.

### Regulatory and supervisory priorities and recommended actions
- Observed stance:
  - Canadian accounting and regulatory standards have increased balance sheet sensitivity to rate changes compared with some other jurisdictions.
  - Standard-setters and supervisors have resisted pressure to dampen regime sensitivity while addressing crisis-exposed anomalies.
- Ongoing and recommended supervisory actions:
  - Timely revision of key actuarial standards, including on non-fixed income investments, to reflect recent experience and strengthen valuation requirements.
  - OSFI should review its data collection to improve oversight of trends in NFI investments (including information on duration and returns).
  - OSFI should continue to closely monitor foreign operations, particularly product design and implications for group-wide interest rate risk sensitivities.
  - Anticipation of the revised IFRS4 and its relatively market-consistent approach to valuation is influencing OSFI’s current redesign of its capital regime.
- Consideration of additional microprudential tools:
  - Market-wide stress tests based on economic scenarios tailored for insurance as a key input.
  - Limits on higher-risk types of business.
  - Additional buffers such as countercyclical regulatory capital requirements.
  - Strengthen the Prudent Person Approach Guideline to require Federally Regulated Insurers (FRI) invest only in assets whose risks they can properly assess and manage; add requirements on investments in complex or less transparent instruments.
  - Review exemptions for larger companies in the Investment Limit Regulations.
  - Prepare the life insurance capital regime for IFRS4; buffer capital framework against increased volatility in net income and capital adequacy ratios.
  - Consider use of capital buffers and continued market-wide stress tests; OSFI’s Guideline A-4 on Setting Internal Capital Targets is noted as a positive step.

_Italicized source: IMF staff summary of chapter content in the provided PDF._

### EXECUTIVE SUMMARY ___________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Low interest rates — what is at stake for insurers
- The prolonged low interest rate environment since 2008 has been a source of vulnerability for the insurance sector worldwide.
- Life companies are exposed because:
  - Low rates reduce returns on new investments, including reinvestment of maturing assets.
  - Low rates increase the current value to policyholders of guaranteed returns.
  - Policyholder behavior may change: surrendering fewer policies, increasing contributions into current policies where permitted, and buying fewer new policies.
- Non-life (P&C) business is generally less sensitive to interest rate changes because it is short term with regular renewals.

### The impact in Canada — structural features and market response
- Canadian life insurance features that accentuate low-rate exposure:
  - Prevalence of permanent life insurance policies with cash values supported by guaranteed rates.
  - Certain annuities, long term care and segregated fund products create both equity and interest-rate exposure.
  - Some groups accumulated exposures via U.S. operations selling similar products.
  - Matching long-term liabilities is often not possible, creating reinvestment risk.
- Accounting and regulatory recognition of low rates:
  - Canadian actuarial standards on valuation of liabilities require assumed reinvestment rates to take increasing account of current market rates, leading to higher liabilities as low rates persisted.
  - OSFI’s capital requirements are sensitive to asset and liability values; regulatory capital ratios have tended to decline as rates fell.
  - For one group, lower interest rates contributed to significant overall losses and a need to raise new capital.
- Industry responses (emphasis on reducing product and pricing sensitivity rather than increasing portfolio risk):
  - New business repriced and premiums raised on existing policies where possible.
  - Fewer products with sensitivity to interest rates and equities are being sold; shift toward low-risk products including mutual funds.
  - Significant retrenchment in U.S. operations.
  - Portfolios remain overwhelmingly focused on investment-grade fixed-interest bonds; limited switching into higher yield or alternative investments.
  - Hedging has reduced sensitivities to future interest rate trends.
- Business-model and market implications:
  - Most revaluation losses from past interest rate reductions have been recognized; further liability increases must be recognized in the short term due to accounting and actuarial standards, irrespective of direction of rates.
  - Demand for life insurance and annuities in Canada remains high; insurers benefit from well-established brands and distribution.
  - Over the medium term, insurers shifting more risk to policyholders and selling more non-insurance products will face greater competition from other financial institutions, including banks.

### Regulatory and supervisory response
- Canadian accounting and regulatory standards have increased balance sheet sensitivity to rate changes compared with some other jurisdictions (including the U.S. and EU).
- Standard-setters and supervisors in Canada have resisted pressure to dampen regime sensitivity to rate changes while addressing crisis-exposed anomalies.
- Ongoing and recommended supervisory actions:
  - Timely revision of key actuarial standards, including on non-fixed income investments, to reflect recent experience and strengthen valuation requirements.
  - OSFI should review its data collection to improve oversight of trends in non-fixed income investments (including information on duration and returns) against the possibility insurers increase such investments.
  - OSFI should continue to closely monitor foreign operations, particularly product design and implications for group-wide interest rate risk sensitivities.
  - Anticipation of the revised IFRS4 and its relatively market-consistent approach to valuation is influencing OSFI’s current redesign of its capital regime.
- Consideration of additional microprudential policy tools:
  - OSFI could consider tools to moderate insurance-sector risks analogous to actions taken in the banking sector, for example:
    - Market-wide stress tests based on economic scenarios tailored for insurance as a key input.
    - Limits on higher-risk types of business.
    - Additional buffers such as countercyclical regulatory capital requirements.

### Key contextual and technical notes (selected)
- References and program context:
  - This note forms part of the 2013 Financial Sector Assessment Program (FSAP) for Canada; staff visited Ottawa and Toronto in September 2013 and drew on a Detailed Assessment of Observance of the Insurance Core Principles prepared during an earlier mission in June 2013.
- International standard-setting and supervisory projects mentioned:
  - Insurance Contracts project of the IASB — latest proposals published on 20 June for consultation until 25 October 2013.
  - The Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame) — IAIS scheduled to formally adopt ComFrame in 2018.
  - EU Solvency II project and other moves toward greater market consistency in accounting and solvency standards could influence insurer behavior and product offerings.

*Prepared by Ian Tower, IMF Expert, with inputs from Timo Broszeit (MCM), as part of the 2014 FSAP Update of Canada.*

### 13. The Canadian life insurance market comprises three key segments (See Table 1), but

### 13. The Canadian life insurance market comprises three key segments (See Table 1), but

### Market structure and product types
- Three main sales channels and product groupings:
  - Individual life insurance sold through tied agents and independent brokers, generally offering advice.
  - Group life insurance where corporate customers buy coverage on behalf of all or groups of employees.
  - Annuity products comprising a variety of retirement savings (accumulation) products and payout annuities.
- Product distinctions:
  - Participating policies (policyholder participates in returns on the invested assets; return is variable) versus non-participating policies.
  - General fund products versus segregated fund products; segregated funds share characteristics with mutual funds but insurers provide guarantees to limit policyholders’ exposure to investment risk.
- Key long-term life products:
  - Term insurance (coverage for a fixed period).
  - Permanent insurance (lifetime coverage) such as whole of life and universal life (UL).
  - UL policies: policyholders make regular (usually fixed) premium payments; amounts exceeding cost of insurance accumulate into a fund, sometimes attracting a guaranteed rate of return.
- Market shares and product prevalence:
  - Universal life products have accounted for as much as 40 percent of new product sales.
  - Only 18 percent of outstanding individual life insurance is participating, compared with nearly 30 percent ten years ago.

### Product design, regulation, and guarantees
- Product design regulation and restrictions:
  - The market is mostly unregulated in relation to product design in Canada: few product design regulations and no requirements for pre-approval of new products or premiums.
  - No restrictions in Canada on the level of guarantees that may be offered (including no maximum guarantees).
  - By law, segregated funds have to be offered with a guarantee set at 75 percent of the principal.
  - Distribution of dividends to shareholders in relation to participating policies is restricted (relatively restrictive in Canada). Under s461 of the Insurance Companies Act, a sliding scale applies related to the size of the company’s book of such policies; for the largest books, only 2.5 percent of profits may be transferred to shareholders.
  - Insurance sales are subject in most countries to market conduct requirements including point of sale disclosure (where Canadian companies are active, such restrictions may apply).
- Practical implications:
  - Design and pricing are highly sensitive to market demand, reflecting close relationship between insurers and distributors and prevalence of advisor sales channels.
  - Surrender penalties: generally yes, sometimes penal (no cash value on surrender) resulting in low lapse experience.

### Interest rate sensitivity and key risk drivers (Box 1 summary points)
- Rate sensitive features and Canadian experience:
  - High life insurance penetration: In line with other major economies (>3 percent of GDP).
  - Long term policies: Prevalence of permanent insurance products (e.g. Universal life), long term care, annuities as part of diversified businesses.
  - Guaranteed rates of return: Common to longer term policies – with limited or no provision for premium adjustment in case of lower rates.
  - Sales-driven distribution: Mix of tied agents and independent, often commission-driven but most selling on an advisor basis.
  - Availability of long maturity assets: Government of Canada bonds limited to 30 years; good supply of non-fixed income investments including infrastructure assets, with large pension fund sector driving demand.
  - Regulation of policy terms and pricing: None except for minimum 75 percent of principal guarantee applying to segregated funds. Legislation also sets limits on dividend distribution to shareholders on participating policies.
  - Policyholder options: Universal life are often sold with policyholder options to increase premiums etc.
  - Surrender penalties: Generally yes, sometimes penal (no cash value on surrender) resulting in low lapse experience.
  - Accounting framework: Not market consistent, but prescribed assumptions on reinvestment rates require revaluation to reflect impact of rate changes over time.

### Accounting and regulatory framework (CALM and standards)
- Accounting and regulatory alignment:
  - Canada adopted IFRS with effect from 2011. Pending a revised IFRS 4 on the valuation of insurance contracts, existing national standards apply—the Standards of Practice of the Actuarial Standards Board provide the basis for Canadian GAAP.
  - Insurers must also use IFRS for regulatory reporting purposes, including capital adequacy, unless OSFI requires any variations (in practice it has required none). Accounting and regulatory standards are therefore well-aligned in Canada.
- Canadian Asset Liability Method (CALM):
  - CALM is based on the prospective future cash flows of liabilities and their supporting assets. Insurers must segment liabilities of similar classes, assign assets to each segment and derive best estimates of the value of the liabilities, using scenarios to apply margins for adverse deviation that reflect the risks and uncertainties of future cash flows.
  - For interest rates (fixed income investments), insurers may calculate provisions for adverse deviation using stochastic or deterministic approaches (the latter are generally used as they act as a floor).
  - Insurers must apply a base scenario to their current reinvestment strategy, which includes use of the current risk-free yield curve out to 20 years and from 40 years, use of risk-free rates equal to the sum of half of the 60-month and the 120-month moving averages of historic long-term Canadian risk-free bond yields (this rate is known as the Ultimate Reinvestment Rate).
  - Nine additional scenarios must also be tested, including reinvestment rates tracking current rates into the future, and any additional scenarios that the company considers appropriate. The least favorable outcome is then used to determine the provision for adverse deviation.
  - The effect of CALM in relation to interest rate risk depends on liability nature, pricing, matching, reinvestment strategy and scenario application. In a prolonged low interest rate environment, companies are required to converge their valuation bases with current risk free rates.
- Scope:
  - Standards apply, for both accounting and regulatory purposes, to group wide business such that companies with international operations are subject to financial and regulatory reporting on both Canadian and offshore bases.

### Market exposures, asset availability, and investment strategy
- Asset/liability mismatch drivers:
  - Long term nature of policies is not matched by longer term available assets. Longest duration instruments issued by the Government of Canada are 30 year bonds; some provincial issues exceed 30 years but in limited amounts. Corporate debt instruments do not extend to 30 years.
- Non-fixed income investment supply:
  - Good supply of non-fixed interest, non-equity investments in Canada such as direct real estate investment and infrastructure.
  - Investment in these assets requires skills and expertise which insurers’ investment units—focused mainly on traded securities—may not have; only a small number of companies have developed specialist expertise.
- Hedging and alternative investments:
  - Insurers have limited ability to lengthen duration via government bonds; some have increased hedging where equity exposure on segregated fund business was significant.

### Sector performance and financials (aggregate metrics, Table 2)
- Aggregate life insurance sector performance (In Can$ millions, unless otherwise indicated):
  - Gross premiums:
    - 2008: 84,271
    - 2009: 78,420
    - 2010: 73,115
    - 2011: 72,458
    - 2012: 73,728
  - Net premiums:
    - 2008: 76,527
    - 2009: 67,947
    - 2010: 61,646
    - 2011: 56,389
    - 2012: 48,890
  - Investment income:
    - 2008: 3,881
    - 2009: 32,443
    - 2010: 33,742
    - 2011: 50,232
    - 2012: 29,107
  - Net claims incurred:
    - 2008: 49,991
    - 2009: 46,662
    - 2010: 44,193
    - 2011: 38,740
    - 2012: 36,412
  - Expenses:
    - 2008: 19,546
    - 2009: 19,850
    - 2010: 22,270
    - 2011: 21,630
    - 2012: 21,732
  - ROE (after tax):
    - 2008: 4.9%
    - 2009: 6.7%
    - 2010: 5.1%
    - 2011: 3.5%
    - 2012: 9.4%
- Observations:
  - Canadian interest rates have fallen since 2008 in line with other major economies.
  - Aggregate data points to declining premium income, volatile investment income and low returns on equity since 2008; aggregate RoE recovered to 9.4 percent for the sector in 2012.

### Industry concentration, foreign exposures, and group performance
- Major life groups and concentration:
  - The three major groups are Manulife Financial Corporation, Sun Life Financial Inc. and The Great West Life Assurance Company.
  - Together, they held just under 76 percent of total life insurance assets in Canada in 2012.
- Foreign operations and exposures:
  - Canadian insurers are geographically diversified; largest exposures to low interest rates in some groups arose in non-Canadian operations, with sharp retrenchment.
  - The US is the largest foreign market for the top 3 insurance groups, accounting for 37 percent of assets and 17 percent of premiums in 2012 (i.e. before recent divestments), followed by Europe (11 percent of assets and 12 percent of premiums). Assets of Asian operations are low at 9 percent of total assets.
  - 48 percent of the consolidated assets of the top-10 insurance groups and 69 percent of gross premium are attributable to domestic business.
- Performance variation across groups:
  - One group with both Canadian and U.S. businesses maintained a healthy RoE in each year of the financial crisis.
  - Another experienced considerable volatility, including a significant loss in 2010; U.S. variable annuities and equity exposures were major drivers of poor performance.

### Capital adequacy and regulatory capital impacts
- OSFI capital framework and impacts:
  - OSFI uses a factor based approach to capital requirements, with limited scope for internal models (except for financial guarantees embedded in segregated funds for companies with approved models) and no credits for diversification across risk categories.
  - As assets and liabilities grew due to the fall in interest rates and significant mismatches, capital ratios tended to decline, although from high levels.
  - All major companies have maintained Minimum and Continuing Capital and Surplus Requirement (MCCSR) ratios that are well above the minimum of 120 percent and the supervisory target ratio of 150 percent.

### Industry responses and strategic adjustments (Box 3 and paragraph summaries)
- Key firm responses to low interest rates and market pressures:
  - New business repricing:
    - New business has been repriced (sometimes many times and with total increases of up to 40 percent) on the basis of lower guarantees and revised lapse assumptions; premiums raised on existing policies where possible.
  - Product mix shifts:
    - Companies are selling fewer products with sensitivity to interest rates and equities, switching to low risk products including mutual funds.
    - Companies have redesigned and relaunched UL and LTC policies with explicit provisions for adjustment of premiums in defined circumstances, or with provision to pass through changes in investment returns.
  - Retrenchment in foreign operations:
    - Significant retrenchment in foreign operations; the two major groups most exposed to the U.S. market have closed or divested significant lines of U.S. business, including variable annuities.
  - Strategy to grow wealth management:
    - Major companies focus on growing assets under management via wealth management rather than insurance, moving away from segregated fund/variable annuity business to mutual funds and retirement-related business (with limited or no guarantees).
  - Hedging and cost measures:
    - Companies with significant equity exposure on segregated fund business have increased hedging significantly, reflected in reduced sensitivities.
    - Companies are seeking to reduce costs, but high costs of extensive legacy business constrain reductions.
- Limitations and market realities:
  - Adjusting premiums or benefits on existing business is difficult: many policies do not make provision for adjustment and raising premiums presents reputational risks.
  - Despite repricing and product redesign, the range of available insurance products remains largely unchanged and there has not been a revival of participating policies; companies which ceased selling participating policies in the past have not re-entered the market.
  - Regulatory restrictions, including limitations on the share of investment returns distributable to shareholders, and the requirement to recognize present value of all expected future dividends on participating policies, partly explain reluctance to reintroduce participating products.

*Source: IMF staff summary of chapter content in the provided PDF.*

### 29. Life companies are not generally seeking higher risk in investment portfolios. With

### _cr1468 - 29. Life companies are not generally seeking higher risk in investment portfolios. With

### Investment strategies and portfolio composition
- Portfolios remain overwhelmingly focused on investment-grade fixed-interest bonds.
- With limited exceptions, companies have not been switching into higher yield or alternative investments.
- The major companies disclose the ratings of their portfolios in financial statements.
- There has been some shift in quality (for example, from AA to A), which may reflect migration of ratings on existing portfolios, but no significant increase in below investment grade holdings.
- Constraints cited:
  - Lack of available investments at longer duration (increased matching would offer the greatest cushioning against future changes in the investment environment).
  - Need for specialist investment expertise (and scale) associated with some alternative investment strategies.

### Interest rate sensitivities and stress testing
- Canadian accounting and actuarial standards cause further increases in liabilities to be recognized in the short term, whatever the direction of rates.
- Most revaluation losses resulting from past interest rate reductions have been recognized and sensitivities to future trends reduced through hedging.
- Publicly reporting insurance companies are required to disclose exposures to changes in key variables, including a 100 basis point reduction in interest rates along the yield curve.
- Reported disclosures (summary for the largest three insurance groups) suggest:
  - sensitivities to lower rates have fallen off since 2009 reflecting the recognition of reductions in interest rates already experienced; and
  - sensitivities to changes in assumptions on their returns on non-fixed income (NFI) investments are relatively high, which may reflect companies' expectations that they will invest in a higher proportion of such investments in the future.
- These tests are broadly consistent with recent stress test exercises by OSFI and for the FSAP, including a market-wide exercise conducted in conjunction with the IMF for the 2013 FSAP.
- Stress testing results point to continuing exposure to reduced rates, especially if rates stay low for an extended period; they also highlight the high sensitivity of net income and capital adequacy to equity risk and lapse experience.

### Scenarios: rising rates, sharp increases, and prolonged low rates
- Gradually rising rates:
  - Insurers would experience a strengthening of balance sheets because much of the impact of past rate changes has already been recognized in higher liabilities and reduced net income.
  - The 2013 FSAP stress testing suggests MCCSR ratios could move up from around 215 percent (aggregate of the three major groups) to close to 300 percent over the period to 2017, based on a scenario of gradually rising rates.
- Sharp increase in rates:
  - Could expose insurers to increased lapses as policyholders move funds to products likely to respond more swiftly (and transparently) to the new environment.
- Further prolonged low rates:
  - Would likely create increased strain because large legacy books of business would have to be fully revalued at low rates while new business volumes would be affected by continuing low returns insurers could offer.
  - Current prices on some longer term products reflect an expectation that interest rates will recover well within the lifetime of the products; a long low-rate period would challenge those assumptions.

### Business model and market-structure implications
- Insurers are shifting risk to policyholders and developing business through growing sales of mutual funds, including expansion in Asia.
- Greater competition from other financial institutions, including banks, is likely as insurers shift to products with less insurance value for policyholders, making differentiation harder.
- Legacy books of insurance policies remain a key driver of costs and a potential barrier to effective competition.
- P&C insurance:
  - Impact has been more limited than for life companies; benefits of rising rates are less clear.
  - Companies have adjusted pricing to reflect lower investment income and made marginal changes in investment risk and securities lending.
  - OSFI has introduced increased capital charges for interest rate risk in recent revisions to P&C capital standards (the Minimum Capital Test, MCT).

### Regulatory and supervisory response
- The Canadian regulatory regime has not changed its basis in response to pressure to dampen sensitivity to rate changes; authorities have maintained existing accounting and actuarial approaches.
- Actions taken and planned:
  - Early actions to develop actuarial and capital standards for options and guarantees attached to segregated fund products.
  - OSFI revised capital standards for lapse risk where pre-crisis requirements were judged too high relative to underlying risks.
  - Supervisory priority on how insurers have addressed risks in the low interest rate environment, especially for the large three groups.
- Key actuarial standards are undergoing revisions with aims to:
  - better align reinvestment assumptions where companies use the deterministic approach with the calibration of the stochastic approach (CTE 60 to 80), addressing current deterministic approaches that result in higher liabilities; and
  - develop a more appropriate standard on anticipated investment returns in excess of risk-free interest rates for non-fixed income (NFI) investments, addressing limited prescription and scope for overly optimistic assumed reinvestment rates.
- OSFI actions recommended:
  - Review data collection to improve oversight of trends in NFI investments, including collecting more information on the duration of investments and on actual returns, and monitor product design by foreign subsidiaries/branches and its implications for group-wide risk sensitivities.
  - Strengthen investment regulations and the Prudent Person Approach Guideline to add explicit requirements that Federally Regulated Insurers (FRI) invest only in assets whose risks they can properly assess and manage, and add requirements on investments in complex or less transparent instruments.
  - Review exemptions for larger companies in the Investment Limit Regulations (portfolio limits on commercial lending, real property, and equities).
  - Prepare the life insurance capital regime for IFRS4, recognizing that IFRS4 will likely introduce a relatively market consistent approach to valuation and may increase volatility of net income and/or equity numbers. The capital framework will need to bear more of the burden of providing a cushion against adverse events, and buffering against volatility in capital adequacy ratios is desirable.
  - Consider developing further policy tools to assist in micro-prudential insurance supervision to moderate risks from buildup of long-term commitments that can be met only in broadly benign economic conditions.
  - Continue market-wide stress tests based on economic scenarios tailored for insurance as a key input to decisions on policy tools; such scenarios should be appropriately severe and insurance risk-specific.
  - Consider use of capital buffers to enable companies to absorb some impact of changes in economic conditions and prevent sharp adjustments to pricing and product availability; OSFI’s Guideline A-4 on Setting Internal Capital Targets is noted as a positive step.

*Source: IMF staff analysis from the provided PDF content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr1468.pdf_