From the Office of the Superintendent of Financial Institutions

The OSFIPILLARFebruary 2019

PILLAR | February 2019 OSFI 1

Climate change and its impacts are affecting us now more than ever

before.

From wildfires, heatwaves and floods to other extreme

weather-related disasters, the breadth of change presents a growing

and complex challenge for insurance risk managers and financial

sector regulators as they assess the prudential implications of climate

change risk.

For property and casualty insurance, the growth in underwriting

risk is obvious as climate change is increasing the frequency and

magnitude of catastrophic claims.

For life insurers, as different approaches are developed to address

climate change, investment decisions must be made with an eye to

fluctuations in carbon-linked asset prices.

Ultimately, all of us, including insurance companies, will have to

adjust to a new reality. From increasing catastrophic events and

the resulting claims, to the transition to a future economy where

investment portfolios move away from carbon-based assets.

In this issue

Climate Change

Sound Mortgage Underwriting

OSFI Departmental Results

The Prudential Implications of Climate Change for Insurance Companies

Managing the Risk

There are generally three main categories of risk linked to climate

change: physical risks, investment risks and liability risks.

The Fort McMurray fires are an example of a physical risk. Physical

risks result in direct losses from weather-related events such as

storms, floods and forest fires, as well as the follow-on effects

including supply chain disruptions or resource scarcity.

The insurance industry is well positioned to manage physical risks

in the medium-term; however, there is growing concern about the

potential longer-term impact. A continued increase in the frequency

and magnitude of weather-related claims, coupled with changes in

the correlation between events, can create price-setting issues for

insurance products.

Increased catastrophic risk will lead to increased reliance on

reinsurance, to diversify the weather-related risk. Quantifying and

managing the counterparty risk associated with reinsurance will

continue to be a focus, and will be addressed in a future OSFI paper

on reinsurance.

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Investment risks are financial risks that could arise from downward

pressure on the value of carbon-linked assets during the transition to

an economy that seeks to reduce carbon emissions, and the speed

with which that transition takes place.

The risk of changing asset values caused by the movement toward

a greener environment with lower green house gas emissions is

referred to as transition risk, and it is the most difficult risk to quantify.

There are two classes of financial assets that will be most affected by

the transition to policies aimed at reducing carbon emissions. There

are investments that would be directly impacted by measures that

discourage carbon use, e.g. oil and gas, utilities, etc. Then there are

investments where changes could be influenced by the higher cost of

using fossil fuels,

e.g. transportation, industrial production, etc.

OSFI has noted that risk managers and many Canadian investors

are tracking these developments, and are moving to green assets as

circumstances justify.

A third type of risk, liability risk, could also arise from climate change

as parties seek to recover the loss from other parties they hold

responsible. The industry is very familiar with this type of long-term

risk exposure from asbestos-related liabilities.

Though asbestos may not be a perfect match, the most recent

estimate of the costs to the property and casualty industry is in

the $100 billion range, little of which was priced for in the original

contract. Companies need to be very careful in their contract wording

and provisions as well as policy limits in order to contain this risk.

Additionally, investors are increasingly seeking additional information

disclosure to quantify their exposure to carbon-linked assets.

Companies that fail to do so could face class-action lawsuits over

misrepresentation, in the event of significant decline in asset values

due to climate change.

OSFI approach and expectations

Insurance companies are enhancing their approaches to managing

physical risk related to climate change, but OSFI wants all insurers

to quantify their exposure and develop strategic approaches for

making the transition to fewer carbon-linked assets.

Appropriate oversight of these risks is key to managing the transition

and minimizing possible future financial disruptions. In the immediate

term, OSFI will be promoting an increased understanding and

monitoring insurer progress in estimating their potential risk. In the

longer term, we expect companies to include stress analyses and

their responses to it in their Own Risk and Solvency Assessment

(ORSA) and other reports to senior management and the board.

Insurance companies also need to diversify their risk, which can be

accomplished through reinsurance. While reinsurance is an important

tool, the insurer will retain the liability for any claim. Therefore, when

using reinsurance they must understand counterparty risks, including

concentration with a single reinsurer, the reinsurer’s capital availability

and the reinsurer’s exposure to geographies where major weather

catastrophes are prevalent.

Life insurers and pension plans are major holders of long-term

assets to back long-term liabilities. In order to address

investment risk, some insurers are stress testing their existing

asset portfolios to quantify the potential impact of changes in

carbon-based asset prices, and then using this information to

guide their reinvestment decisions.

OSFI will be looking to companies to analyze their exposure to

carbon-based asset repricing and develop policies to reflect possible

future changes.

Similarly, liability risks must also be top of mind. The health issues

associated with asbestos were often unknown until they started

showing up years later.

Property and casualty insurers are in a position to manage these

risks. However, they will need to begin adapting their catastrophic

risk models to ensure that the contractual obligations of their

insurance policies contain appropriate provisions to limit their liability

against the financial impacts of climate change.

Future Direction

No one knows the full extent of climate change risks and no single

country or regulator will have all the answers. That is why climate

change and global warming are the subject of frequent discussion at

international regulatory meetings.

OSFI has joined 22 other countries as a member of the Sustainable

Insurance Forum (SIF). The SIF is a network of leading insurance

supervisors and regulators seeking to strengthen their understanding

of and responses to sustainability issues for the business of

insurance. It is a global platform for knowledge sharing, research and

collective action.

As the knowledge in this area increases, companies will be expected

to analyze the potential impact of climate change on their financial

health and further develop a strategy for managing the risks.

Regulators and the industry need to continue to keep abreast of

global developments, ask questions, and determine appropriate

responses that will support overall financial stability. We look forward

to working with all parties in this area of ever-increasing interest.

PILLAR | February 2019 OSFI 3

The stress test is, quite simply, a safety buffer that ensures a borrower doesn’t stretch their borrowing capacity to its maximum, leaving no room to absorb unforeseen events. This is simply prudent. It’s prudent for the bank and it’s prudent for the borrower too.

B-20 was designed to target mortgage underwritingstandards. And sound underwritings look the same nomatter what city or province you live in. Ensuring a borroweris not over-leveraged and can withstand a change incircumstances, including a change in interest rates, issensible regardless of what city you’re in.

And when interest rates rise, they will go up in Calgary, and Winnipeg, at the same time and by the same amount that they will go up in Vancouver and Toronto.

There are sound options available for some borrowers in the private or unregulated lending space.

On February 5, Carolyn Rogers, Assistant Superin-tendent, Regulation Sector spoke at the Economic Club of Canada about sound mortgage underwriting. Following are some key excerpts:

But we understand the concerns raised by real estate agents, mortgage brokers and other financial advisors that some more vulnerable borrowers such as first time home buyers, risk making bad decisions or being taken advantage of by less scrupulous lenders. The mortgage broker and the real estate industry are well placed to help manage this risk. If you see risks, if you think these options put your borrower in a vulnerable position, you can steer them away. That would be the right thing to do.

The escalating cost of homeownership in Canada, and its knock-on effects to the economy and to society, is a problem. And it’s a problem that is proving very challenging to address.

But the answer to this important problem, cannot be more debt. Particularly, it cannot be more consumer debt, fuelled by lower underwriting standards.

Recent history has shown that relaxing bank underwriting standards can lead to extreme and persistent levels of financial instability that more than undo any economic gains they were intended to support.

We will continue to remain vigilant and proactive – we will regulate by looking through the windshield, not the rear view mirror. And we will continue to welcome the public engagement on mortgage underwriting standards. We appreciate that mortgage rules have a broad and direct impact on many people’s lives and we understand that they have become part of a broader, important public dialogue on how to address the rising cost of owning a home in Canada.

View the remarks.

Stressing the Stress Test: The Importance of Strong Mortgage UnderwritingRemarks by Assistant Superintendent Carolyn Rogers

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Financial institutions are lifting their business capabilities through a powerful combination of new technology and rapid digitization. These developments are fundamentally altering their operating environment and the expectations for effective risk management.

Technological advancements point toward a promising future. For financial institutions, fulfilling promises is how they build and maintain their reputations. From a prudential perspective, OSFI is interested in how financial institutions adapt and respond to technological changes.

Critically, our shared interest lies in how these risks may affect trust and confidence – or “reputation” – in financial institutions because without it, financial institutions will struggle.

We expect institutions to assure themselves of the quality

Non-financial Risk and Operational Resilience: The Rise of Machines

of risk management practices within the third party and the implications that this may have for their operational resilience.

While we need to maintain our focus on financial resilience, we also need to shift thinking toward the risk management of other non-financial risks because more capital will not improve resilience against a cyber attack or the service interruption of a third party.

New tools for newer risks will be required for risk management at financial institutions. OSFI is working hard in building out these new tools and laying the groundwork for collaboration with other experts, both domestically and internationally.

Machines are making the business more productive and capable; however, human judgement will continue to define the overall effectiveness of risk management for the foreseeable future.

What is different now than in the past is how far we can see into the future. It is shortening given the pace of technological developments and digitization.

View the remarks.

On November 13, 2018, Ben Gully spoke to senior risk professionals at the 6th Annual Canadian Risk Forum for PRMIA (Professional Risk Managers’ International Association). He discussed the evolving risk environment in the financial sector, and provided insight into the possible impacts of non-financial risks on financial institutions and some of the organizational changes OSFI is making to address these risks.

View a summary of the remarks.

Remarks by Assistant Superintendent Ben Gully

On February 7, Ben Gully, Assistant Superintendent, Risk Support Sector, spoke at the CD Howe Institute in Toronto about trends in technology and digitization (non-financial risks). Following are some key excerpts:

PILLAR | February 2019 OSFI 5

During the last global financial crisis we learned about the appropriate level of capital and that a lot of global banks fell below that level. We learned about the quality of capital, and in a number of situations, we learned that capital instruments did not have the loss absorbing capabilities that we previously thought that they did.

And globally, as regulators, we acted on those learnings. We improved the quality and quantity of capital held by our institutions, particularly our systemic institutions, through a combination of regulatory capital and even private capital buffer requirements.

It is true that banks hold capital to preserve the confidence of depositors, creditors and markets. However, the real test of a capital regime is whether and how that capital is used in times of stress to support stability. OSFI believes that an adjustable capital buffer, well communicated and understood, and responsive to conditions in the financial system is the way to achieve this objective.

And, that is why, in June of 2018, OSFI publicly disclosed the Domestic Stability Buffer for Canada’s six largest banks, known as our domestic systemically important banks, or D-SIBs.

Canada’s Domestic Stability Buffer: Swimming Against the Tide

What that means is that we build up the Domestic Stability Buffer when vulnerabilities are high but conditions are more stable, and we release the buffer when needed so that banks can use that capital cushion in order to continue to provide loans and services to Canadians. As a result, the primary feature of the Domestic Stability Buffer is that it may very well increase during stable economic times and, specifically before the risks actually materialize. While the intent of the buffer was well understood in the financial analyst community, and many noted the prudent nature of the change given healthy economic conditions, some analysts were more pessimistic.

To paraphrase their assessment, “nice idea but it won’t work when times get tough”. Essentially, the concern raised was that even if OSFI decreases the buffer in a downturn, the market is unlikely to accept declining capital ratios when loan losses are rising.

So let me be clear: in the event that systemic risks begin to materialize, OSFI will promptly and proportionately lower the Domestic Stability Buffer. This is part and parcel of the counter-cyclical design of the buffer: banks will be able to use the capital they have built up in “good times” when it is most needed in “bad times”.

View the remarks.

Domestic Stability Buffer Level Set

In December, OSFI announced that it had set the level of the Domestic Stability Buffer at 1.75%. The Domestic Stability Buffer contributes to domestic systemically important banks’ (D-SIBs) resilience to key vulnerabilities and system-wide risks, thereby contributing to financial stability.

Visit this webpage to see the current level of the Domestic Stability Buffer on the OSFI website.

Further information: Domestic Stability Buffer Information Sheet

Remarks by Assistant Superintendent Jamey Hubbs

On January 23, Jamey Hubbs, Assistant Superintendent, Deposit-Taking Supervision Sector spoke at the C.D. Howe Institute in Toronto about OSFI’s Domestic Stability Buffer. Following are some key excerpts:

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Large Exposure Limits In mid-December, OSFI released proposed revisions to Guideline B-2: Large Exposure Limits. The guideline will apply to domestic systemically important banks beginning in fiscal Q1 2020. The draft guideline incorporates the Basel Committee on Banking Supervision standard on large exposures to reflect current risk management sound practices and provides additional guidance on methods OSFI expects institutions to use for identifying, measuring, managing and monitoring large exposures.

Net Stable Funding RatioOn December 19, OSFI issued for consultation Chapter 3 Net Stable Funding Ratio (NSFR) and proposed revisions to Chapter 1 Overview of the Liquidity Adequacy Requirements guideline. Chapter 3 incorporates the Basel Committee on Banking Supervision’s NSFR rules issued in October 2014 into the Liquidity Adequacy Requirements guideline. OSFI is targeting implementation of the NSFR for January 1, 2020 for domestic systemically important banks. The application of NSFR to small- and medium-sized institutions will be addressed at a later date.

Leverage Ratio Disclosure RequirementsOn November 20, OSFI released the final version of the Leverage Ratio Disclosure Requirements guideline for implementation in Q1 2019. The revisions will align the guideline with the changes made to the Leverage Requirements and Capital Adequacy Requirements guidelines.

Capital Adequacy Requirements (CAR) GuidelineIn late October, OSFI released the final version of the CAR guideline for implementation in Q1 2019. The main revisions relate to the domestic implementation of the standardized approach to counterparty credit risk, capital requirements for bank exposures to central counterparties and the securitization framework. On the same day, OSFI released the final version of its Leverage Requirements guideline for implementation in Q1 2019. The revisions will align the Leverage Requirements guideline with modifications made to Chapter 4 (Settlement and Counterparty Risk) and Chapter 7 (Securitization) of the CAR guideline.

ICAAP Submission in 2019In October, OSFI announced that DTIs using the standardized approach to Pillar 1 capital levels will not be required to submit a formal ICAAP for 2019. However, they should continue implementing and updating their ICAAP programs as part of their annual capital planning process. Regarding internal audit review of the 2019 BCAR return, DTIs must submit their audit reports by February 29, 2020.

Interest Rate Risk ManagementOn October 5, OSFI issued proposed revisions to guideline B-12 Interest Rate Risk Management. The draft guideline incorporates most of the Basel Committee on Banking Supervision’s 2016 guidance on Interest Rate Risk in the Banking Book (IRRBB), including the methods expected to be used by institutions for measuring, managing and monitoring IRRBB, as well as updates related to supervisory practices. OSFI is targeting implementation of the revised guideline for January 1, 2020.

Deposit-Taking Institutions

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Insurance PensionsFireside Chat and KeynotesOn December 6, Superintendent Jeremy Rudin had a fireside chat at the KPMG Annual Insurance Conference in Toronto. Discussion topics ranged from climate change and innovation to corporate governance. View a summary of the remarks.

Also on December 6, Neville Henderson, Assistant Superintendent, Insurance Supervision Sector, spoke before a select group of senior insurance industry executives at Northwind’s 25th Annual Life Insurance Invitational Forum in Cambridge, Ontario. In his remarks, Mr. Henderson discussed innovation and other changes in the insurance sector. View a summary of his remarks.

Guideline UpdatesIn late November, OSFI published the final version of its 2019 Minimum Capital Test for Federally Regulated Property and Casualty Insurance Companies (MCT) guideline. The guideline includes amendments related to IFRS 16 – Leases, reinsurance, securitized assets and recognizes three additional rating agencies for regulatory capital purposes.

Also in late November, OSFI issued the final version of Guideline B-5: Asset Securitization, which sets out general expectations for asset securitization transactions undertaken by federally regulated insurance companies. Changes reflect events that have affected securitizations since 2004, including the financial crisis and changes to the Basel framework. The guideline also incorporates relevant content from OSFI’s 2008 advisory Securitization – Expected Practices.

In October, OSFI issued the final version of the 2019 LICAT guideline. Key changes include consequential amendments to reflect the adoption by insurers of IFRS 16 – Leases, the application of mortality risk components to group life insurance products and updates to ensure consistency with revised Guideline B-5: Asset Securitization.

InfoPensions NewsletterIn November, OSFI issued the latest edition of its pension newsletter, InfoPensions, which includes announcements and reminders on matters relevant to federally regulated private pension plans and pooled registered pension plans. View the newsletter.

New Pension Plan Assessment Remittance Form

On October 31, OSFI issued an updated pension plan assessment remittance form, for plans registered or plans filed for registration under the Pension Benefits Standards Act, 1985 (PBSA), to assist plan administrators in the calculation and remittance of their annual pension assessment that is due to be paid between April 1, 2019 and March 31, 2020.

Pension Plan RegulationsOSFI is moving ahead with proposed amendments to the Assessment of Pension Plans Regulations. At this time, the proposed amendments are not in effect and therefore there are no changes. OSFI will keep plan administrators informed of any process-related changes.

Maximum Income from LIF, RLIF and VBAOSFI has revised the table Maximum Annual Amount of Income that May be Paid in 2019 from a Life Income Fund, a Restricted Life Income Fund and a Variable Benefit Account to include the factors which will be applicable in 2019. Questions should be addressed to information@osfi.bsif.gc.ca.

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Office of the Chief Actuary (OCA)

Jean-Claude Ménard

On February 8, Acting Director Assia Billig participated in a discussion “Across the pond: Comparing the pension systems of Canada, Denmark and Sweden” during the Benefits Canada DC Plan Summit in Banff, Alberta.

On November 2, Ms. Billig spoke at the International Seminar on Public Pension 2018, in Seoul, South Korea. A few days later (November 6-8), she and Chief Actuary Jean-Claude Ménard attended the 19th ISSA International Conference of Social Security Actuaries, Statisticians and Investment Specialists that took place in Kuwait City, Kuwait at the invitation of The Public Institution for Social Security of Kuwait.

Upcoming Speaking Engagements

• On February 13, Chief Actuary Jean-Claude Menard and Acting Director Assia Billig will be speaking to the C.D. HoweInstitute at Pension Policy Council meeting on the recent OCA technical paper on the Additional Canada Pension PlanRegulation (Actuarial Study No. 20), Toronto. On the same day, Mr. Ménard will speak on the same topic to the Board ofDirectors of the Canada Pension Plan Investment Board.

• On February 14, Chief Actuary Jean-Claude Ménard and Director Laurence Frappier will discuss funding risks of thefederal public sector pension plans at the Public Sector Pension Investment Board in Montreal.

The OSFI Pillar is published by the Communications and Consultations Division of the Office of the Superintendent of Financial Institutions. For more information on the articles in this issue, or to provide feedback, please e-mail OSFI Communications at: communications@osfi-bsif.gc.ca.

To subscribe to The OSFI Pillar, visit the OSFI website.

On November 2, the Actuarial Report on the Pension Plan for the Public Service of Canada as at 31 March 2017, was tabled in Parliament. Tabled the same day was the Public Service Death Benefit Account as at 31 March 2017.

In October, the OCA released a Technical Paper on the Additional Canada Pension Plan Regulations: Actuarial Study No. 20.

In early October, a Presentation by Jean-Claude Ménard was made at the Canadian Association of Pension Supervisory Authorities in Vancouver, entitled Living to 100 – Would Canada Pension Plan be Sustainable?

In late September, in preparation for the triennial actuarial report on the Canada Pension Plan, the OCA hosted a Seminar on Demographic, Economic and Investment Perspectives for Canada Years 2018 to 2050.

In October, the Office of the Chief Actuary released a new fact sheet on Registered Pension Plans (RPPs) and Other Types of Savings Plans Coverage in Canada.

Technology and Cyber Security Incident Reporting

In late January, OSFI issued the advisory Technology and Cyber Security Incident Reporting, which sets out OSFI’s expectations for federally regulated financial institutions for reporting technology and cyber security incidents affecting their operations.

OSFI Departmental Results

OSFI’s 2017-18 Departmental Results Report (DRR) was tabled in the House of Commons on November 20, 2018.Departmental Results Reports are accounts of actual performance for the most recently completed fiscal year, against the plans, priorities and expected results set out in Departmental Plans. The report informs parliamen-tarians and Canadians of the results achieved by government organizations for Canadians.