OSFI.MCT-IFRS

STATUS: Chapters 1, 2, 8 are available in the wiki article below. The remaining chapters will be published here as they are completed. This article is listed in the syllabus as having "updates" for 2022-Fall but we are rewriting this article completely. The old version of the wiki article is available at OSFI.MCT, but many of the calculations are longer be relevant for the 2022-Fall exam.

Reading: “Minimum Capital Test (MCT) for Federally Regulated Property and Casualty Insurance Companies,” Draft Guideline A, Effective January 1, 2023,” June 2021.

Author: Office of the Superintendent of Financial Institutions Canada

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Challenge Task! This is one of several new long and complex readings for the 2022-Fall syllabus, and we are actively working on completing the content. Here is your challenge: → Please let us know if you find a typo. We will give you a shout-out. → If you find a calculation error, we will send you a BattleActs coffee mug, if you want one! We will also give you a shout-out. Email us at info@battleacts.ca with "MCT" in the subject line. There will likely be edits to this content over the next few weeks as we complete each section and receive feedback.

This is the most important reading on the syllabus and accounts for roughly 10% of the points on each exam. OSFI considers the MCT ratio (Minimum Capital Test ratio) to be a prime indicator of an insurer's health. This ratio compares capital available (CapAv) to capital required (CapReq). The benchmark MCT ratio is 150%. If an insurer's ratio falls below this benchmark, it may be in danger of having insufficient assets to cover its liabilities, and may come under increased regulatory scrutiny.

You must first understand how to calculate the MCT ratio. You must also have a conceptual understanding of how items in the financial statements affect the final ratio. The MCT ratio is the first of several financial health ratios listed in the paper MSA.Ratios.

Here are a few suggestions for how to study this reading:

Get an Overview:

• Spend a few minutes looking at table of contents of the source text and read the first paragraph of each of the 8 chapters, excluding chapter 3. (Everything you need for the exam is in the wiki article but since this is the most important reading on the syllabus, you should keep the source text handy anyway.)

Practice the Basic Calculations:

• BattleActs has numerous randomized web-based problems that cover basic components of the MCT calculation. You can access them through the mini BattleQuizzes within the wiki article, or by using the Calculation Problems link. Once there, click the button at the top of the page that says:

Daily Practice:

• This goes without saying! When you're first learning the MCT material, you should practice the web-based problems daily. Once you're able to solve them consistently, you can reduce the frequency but when it gets close to the exam, go back to daily practice. Of the 60-plus readings on the syllabus, the MCT material has historically accounted for over 10% of the points on the exam.

Conceptual Understanding:

• As you get better and better at the calculations, you'll start to understand how the various components of the MCT calculation relate to each other. See example 2 in the section Introduction and 2 Easy Examples.

Previous Exam Questions: (mostly not relevant anymore)

• As of 2022-Fall, the old exam problems covering MCT are no longer relevant. Many of them covered multiple readings, most of which have either been removed or significantly updated. Still, it might be helpful to glance at how these old questions are laid out but for the most part you will not be able to solve them. You can find them through the BattleTable from the prior outdated MCT article or BattleCards - Prior Exams.

Estimated study time: 2 weeks (not including subsequent review time)

BattleTable

No past exam questions are available for this reading.

reference	part (a)	part (b)	part (c)	part (d)

In Plain English!

Chapter 1: Overview and General Requirements

• Sections excluded from the source text:

→ 1.2.2 Audit requirement

Introduction and 2 Easy Examples

MCT stands for Minimum Capital Test. It is a standardized measure of capital adequacy for insurers. The OSFI.MCT-IFRS reading is about calculating & understanding the MCT ratio in the context of IFRS-17 (International Financial Reporting Standards). The mechanics of the calculation are covered in the web-based problems in the mini BattleQuizzes within this wiki article. (If you page down you'll see the big blue quiz buttons.) You can also access the quizzes and calculation problems for all readings using these links:

• Quiz Scores  ← to access quizzes for all wiki articles
• Calculation Problems  ← to access just the calculation problems

All insurers have assets available to them such as cash, investments, and real estate. These are listed in the insurer's financial statements on page 20.10, Statement of Financial Position - Assets. Financial statements are covered in a separate wiki article, CCIR.Instructions, but we'll cover what you need to know for MCT below. The MCT concept of capital available is a little different however. Capital available is roughly the same thing as equity and is listed in the insurer's financial statements on page 20.11 Statement of Financial Position - Liabilities and Equity. If you've taken an accounting class, you'll know the following formula, also called the Fundamental Accounting Equation:

• Assets   =   Liabilities   +   Equity

The MCT reading also details a procedure for calculating capital required. This is an estimated amount the insurer requires to support its particular risk profile, above and beyond normal reserves for unpaid claims. Obviously we want capital available to be greater than capital required. Otherwise, the insurer is at risk for insolvency.

Example 1: Calculate the MCT Ratio. Super-easy!

Suppose we have:

• CapAv (Capital Available)   =   62,400
• CapReq (Capital Required)   =   50,355  ← This is also called the Target Capital Required.

We'll assume that the diversification credit has already been taken. This credit is discussed later in this article. Let's also define the following:

• minCapReq   =   CapReq / 1.5  ← This is the Minimum Capital Required.

Then the most important formula you have to know is the formula for the final MCT Ratio:

MCT Ratio   =   CapAv / minCapReq

For our simple example, we have:

MCT   =   62,400 / (50,355/1.5)   =   185.9%

This is comfortably above OSFI's supervisory target of 150%, so this insurer is probably doing ok. In practice, we would need much more info than just a single year's MCT ratio to be able to draw meaningful conclusions about an insurer's overall health. The MSA ratios are a great supplement. Note that all federally regulated insurers are required to maintain an MCT ratio of 100%, so OSFI's supervisory target of 150% is a more strict requirement.

The source text discusses very briefly the basis for the target capital required:

• CapReq (or target CapReq) corresponds to a CTE of 99% over a one-year time horizon (Conditional Tail Expectation).
• This essentially means that the target capital required will be adequate 99% of the time.

Example 2: Does the MCT Ratio go up or down in the following situation?

Situation: Suppose there's a shift in the type of business an insurer writes from auto physical damage to auto liability. Without doing any calculations, can you tell whether the MCT Ratio will go up or down?

• The MCT Ratio will go down, because auto liability has a longer tail than physical damage. In other words auto liability is riskier, and increased risk causes an increase in capital required. Since capital required is in the denominator, the MCT Ratio will go down.

That type of conceptual question sometimes shows up on the exam but it's pretty easy if you understand the concept that MCT capital required is proportional to risk. The higher the risk, the more capital is required. Simple!

Allocation Methodology

Warning! This short section seems totally pointless but Alice-the-Actuary can't be certain it won't appear on the exam. 😟

According to the source text:

• Insurers may need to undertake an allocation exercise to determine capital requirements.

Other than to list 5 principles of allocation, the above statement is not explained any further. If I were taking the exam again, I would memorize these 5 allocation principles because this type of bullet point list often appears on the exam: [Hint: FACCS]

• allocation methods should be Free from bias
• allocation methods should be Accurate when allocating revenue & costs
• allocation methods should be Consistent with allocation methods used by the insurer for other business decision-making purposes
• allocation methods should be Consistent over time
• allocation methods should be Systematic & reasonable

Note that I rearranged the order that was given in the text to make the memory hint spell a word. It sounds like the word "facts" and in my mind, I pretend I'm a police detective interviewing a witness: "Just the FACCS, sir, the allocation facts." Anyway, it's a dumb memory hint but that what makes me remember it! 😜 And as always, if anyone can think of a better memory trick, just post it in the forum and I will link to it from the wiki!

Transitional Arrangements

WARNING! This section is even more pointless than the previous section on allocation methods. 😧

This very short section isn't going to fully make sense until you've covered the IFRS 17 material. I have traditionally put the MCT article in the #1 spot in the Ranking Table because it had always been the most heavily tested topic. Unfortunately it now relies somewhat on IFRS, which isn't covered until a little later, but we'll tell you what you need to know. Anyway, the transitional arrangement explains how to deal with the following:

• Business combinations and portfolio transfers entered into and effective on or prior to June 30, 2019

I think it's unlikely this section will be asked on the exam because it isn't part of the core MCT calculation, but I didn't want to leave it out completely. So after you've learned everything else, and if you're still looking for more things to memorize (ha ha!), the statement regarding transitional arrangements you would need to memorize is:

• The contractual service margin (CSM) arising from favorable development... (from business combinations and portfolio transfers entered into on or prior to June 30, 2019)

...can be included in capital available.

In plain English, it's giving the insurer a way to increase capital available. This arrangement is valid for 3 years starting January 1, 2023. You can click the link in the above bullet point to go to the part of the wiki where the CSM concept is explained.

A Full MCT Example

Alice's Pro Tip! Calculating the MCT Ratio will DEFINITELY appear on the exam. Learn it! 😁

In this section, we'll cover a full example of calculating the MCT ratio. It's relatively easy because you're directly given the main components of the MCT formula - you just have to know what to do with them. Later on in this article, we'll look at more complicated examples where you have to calculate each component yourself from the raw financial statement data.

When I say you're directly given the main components, here's an example of what I mean. If you glance down at the example, you'll see that total value for insurance risk is given as 34,600. Insurance risk however, has 3 separate components:

• liability for incurred claims and unexpired coverage
• reinsurance held with unregistered insurers
• earthquake and nuclear catastrophe reserves

In practice, you would have to calculate these 3 components separately then sum to get the total value of insurance risk. The same general comment also holds for market risk, credit risk, and operational risk. Together, these risk charges comprise capital required (as shown the example) and the detailed calculations are covered in chapters 4-7. The detailed calculations for the components of capital available are covered in chapter 2. It might be an idea to take a quick glance at the chapter 8 on the diversification credit. Just click the link. It's very short.

Another Pro Tip from Alice! Mini BattleQuiz #1 has a randomized web-based version of this MCT problem. It's scored by the computer and contributes to you BRQ score. 🤓

Here's the given information...

Here's the solution...

Now that you've gone through this full example, you should memorize the 4 main components of capital required. If you know that IMHO stands for "In My Humble Opinion", then the memory trick below should be easy to remember because it's very similar.

Question: identify the 4 components of MCT capital required [Hint: IMCO - In My Crummy Opinion!]

Insurance risk - risk of loss FROM the potential for claims (from policyholders & beneficiaries)

Market risk - risk of loss FROM changes in prices in various markets

Credit risk - risk of loss FROM counterparty's potential INABILITY or UNWILLINGNESS to fully meet contractual obligations due to the insurer

Operational risk - risk of loss FROM inadequate or failed internal processes, people, systems or from external events

And here are 2 more examples of calculating the MCT ratio in Excel format. Answers are included but you can try solving them yourself before looking. The mini BattleQuiz also has a randomized web-based version of this problem and here's another pro-tip from Alice.

Alice's Pro-Tip for web-based problems: All the web-based problems can be copied into Excel. Just highlight the given information and paste into a blank Excel worksheet. You can then solve the problem in Excel and type your final answer back into the web page to be scored and incorporated into your BRQ. 😉

Excel Practice: MCT Ratio

mini BattleQuiz 1

Chapter 2: Definition of Capital Available

• Sections excluded from the source text: (About 10 of the 17 pages in chapter 2 are excluded.)

→ (2.1.1.1) Qualifying criteria for inclusion of capital instruments in category A for regulatory capital purposes

→ (2.1.2) Category B capital

→ (2.1.3) Category C capital

→ (App. 2-A) Information Requirements for Capital Confirmations

(2.1) Summary of Capital Components

Chapter 2 explains how to calculate capital available, which is the numerator in the MCT ratio. The very first item in this section is the following list:

Question: identify qualitative considerations regarding MCT capital available [Hint: APAS]

Availability - is the capital element fully paid & available to absorb losses?

Permanence: - until when is the capital element available?

Absence - does the capital element have an absence of encumbrances & mandatory servicing costs?

Subordination - is the capital element subordinated to the rights of policyholders & creditors in an insolvency or winding-up?

These qualitative considerations are not referred to again and play no role in the MCT calculations as presented in the text. It was however asked in this old exam question so just memorize it:

E (2015.Fall #19)

The much more important information is how to calculate the regulatory capital available.

Question: identify the main components of regulatory capital available.

• category A capital (common equity)
• category B capital
• category C capital
• non-controlling interests  ← inclusion in capital available is subject to certain conditions

That doesn't seem too hard! But an exam problem isn't just going to give you these quantities directly. Each of these categories of capital have subcomponents that are generally available from financial statements. Details of the new IFRS 17 financial statements are covered in a different wiki article, CCIR.Instructions, but we'll cover here what you need to know.

Category A capital consists of these items:

• Common shares issued by the insurer that meet the category A qualifying criteria
• Surplus (share premium) resulting from the issuance of instruments included in common equity capital and other contributed surplus
• Retained earnings
• Earthquake, nuclear and general contingency reserves
• AOCI (Accumulated other comprehensive income)
• Residual interest, reported either as equity or as a liability, of owner-policyholders of mutual entities

Unfortunately, the MCT source text doesn't tell you where in the IFRS 17 financial statements you can find these quantities but they appear to be the following lines from page 20.11 - Statement of Financial Position - Liabilities & Equity:

Under Policyholders' Equity:

Line 420: Residual Interest (Non-Stock)

Under Shareholders' Equity: (include everything except Preferred Shares on Line 520)

Line 510: Common Shares

Line 530: Contributed Surplus

Line 540: Other Capital

Line 550: Retained Earnings

Line 560: Nuclear and Other Reserves

Line 570: AOCI

Side note: The source text mentions that dividends are removed from capital available in accordance with applicable accounting standards. I'm assuming this refers to dividends paid by the insurer to stockholders.

In any case, you should memorize the 7 items above. You don't have to memorize the line numbers however. An exam question may provide a bunch of financial statement items and you would have to know which ones to add together to get capital available. As I was writing this, I noticed that the first letters of the above items can be grouped to spell RC-CORNA. To me it sounds like RC-Cola. That's a Coca-Cola knock off. Their webpage is pretty dumb if you care to click on the link.

Category B and Category C capital are not broken out any further. An exam problem should give you these quantities directly. Note that the CCIR.Instructions do not mention anything about categories of financial instruments. The MCT source text seems to imply that category A shares is the same thing as common shares from line 510 of page 20.11. The syllabus excludes the entire subsections on category B and category C capital so it seems you don't have to know anything more about these.

Good News! Most of the published exams provide the capital available directly so you don't have to calculate it. Hopefully that will continue. (Note however that the most recently available exam is 2019-Fall because the CAS subsequently stopped publishing exams and examiners' reports.)

(2.2) Capital Composition Limits

The MCT procedure puts a limit on the amount of category B and category C capital that can be included in capital available. The text doesn't explain why there's a limit but I guess they don't want companies loading up too much on these types of financial instruments. Anyway, here are the 2 rules regarding capital composition limits:

• The sum of category B and C capital cannot exceed 40% of total capital available (excluding AOCI or Accumulated Other Comprehensive Income.)
• Category C capital cannot exceed 7% of total capital available (excluding AOCI or Accumulated Other Comprehensive Income.)

That seems simple but there's a little trick: You first have to have the total capital available. Unfortunately, the source text isn't very clear on how you get that. Here's a step-by-step procedure:

1. Calculate the capital available using RC-CORNA  ← I think of this quantity as the GROSS capital available
2. Apply all regulatory adjustments  ← this is covered in the next section and I call the result NET capital available
3. Subtract AOCI from NET capital available
4. Use 40% of the previous step for the "BC" test and 7% of the result for the "C" test.

Now, I realize that just listing the steps isn't very helpful by itself. The example showing how it works in practice is at the end of the next section because it needs some of the material covered in the next section.

(2.3) Regulatory Adjustments to Capital Available

In addition to the calculation of the deduction for capital composition limits and unregistered reinsurance, there are many other adjustments that can potentially be made to capital available prior to calculating the deduction for capital composition. Unfortunately, you have to know how to handle them as you can see from the exam problems referenced below but there is a trick to it. See Alice's pro-tip below the table. In any case, the source text also provides extremely detailed explanations of each of these adjustments but that seems like far too much for the exam. If you'd like to see these explanations, please refer to Section 2.3.1 in the MCT source text.

¹ The calculation for unsecured unregistered reinsurance exposures and self-insured retentions is not covered until section 4.3 in the MCT source text.

Type of Adjustment	Item	Comment
deduction	Interests in and loans or other forms of lending provided to non-qualifying subsidiaries, associates, and joint ventures in which the company holds more than a 10% ownership interest	--
deduction	1 Unsecured unregistered reinsurance exposures and self-insured retentions	see E (2015.Spring #23) (but calculation is outdated)
deduction	The earthquake premium reserve (EPR) not used as part of financial resources to cover earthquake risk exposure	see E (2015.Spring #23) (not a calculation)
deduction	Insurance acquisition cash flows	n/a
deduction	Accumulated other comprehensive income on cash flow hedges	--
deduction	Goodwill and other intangible assets	see E (2019.Fall #19) (not a calculation)
deduction	Deferred tax assets	see E (2019.Fall #19) (not a calculation)
deduction	Cumulative gains and losses due to changes in own credit risk on fair valued financial liabilities	--
deduction	Defined benefit pension fund assets and liabilities	--
deduction	Investments in own instruments (treasury stock)	--
deduction	Reciprocal cross holdings in the common shares of insurance, banking and financial entities	--
addition	Contractual service margin (CSM) associated with title insurance contracts	CSM is an IFRS 17 concept (click link)
deduction or addition	Adjustments to owner-occupied property valuations	--

Alice's Pro Tip: If you've memorized the main capital components (category A, B, and C capital, and non-controlling interests) and the subcomponents of category A, then the only items you have to memorize from the table above are: the addition item: CSM associated with title insurance contracts the deduction or addition item: Adjustments to owner-occupied property valuations Everything else is a deduction. That means if you get a "weird" line item in the given information that isn't the CSM for title insurance or an adjustment to owner-occupied property valuations then it must be a deduction. And if you scan the list of deductions of few times, there's a good chance you'll recognize them if they show up, especially the ones that came up on previous exams.

Here's a full example of calculating capital available. The only part not included is the calculation of the deduction for unregistered reinsurance but as noted above, that calculation isn't covered until chapter 4 in the source text. There's also a very good chance an exam problem will simply give the final value of capital available directly, but you can't rely on that. There have been past exam questions where you had to do at least a portion of the calculation shown below.

Side note on non-controlling interests: Section 2.1.4 on non-controlling interests is not excluded from the syllabus. It states that non-controlling interests in operating consolidated subsidiaries can be included in capital available if 3 conditions are met, but I seriously doubt you'd be asked to list these conditions for an exam question. The example below simply tells you whether or not these conditions are met. If you feel you want to memorize these 3 conditions, please refer to Section 2.1.4 in the MCT source text.

Here's the problem:

Here's the solution:

(2.4) Capital Treatment of Interests in and Loans to Subsidiaries, Associates and Joint Ventures

Recall the first deduction from capital available listed in the table for regulatory adjustments to capital available in the previous section:

• Interests in and loans or other forms of lending provided to non-qualifying subsidiaries, associates, and joint ventures in which the company holds more than a 10% ownership interest

The section is an extremely detailed elaboration of this point for various different scenarios, including where the ownership interest is less than 10%. For the exam, I think it would be unreasonable to expect you to memorize the appropriate adjustments to capital available for all these scenarios. This is the kind of detail you would need it you were actually doing the MCT calculation at work so you should know where to find it, but I think you can otherwise ignore these details.

Excel Practice: MCT Capital Available

mini BattleQuiz 2

Chapter 3: Foreign Companies Operating in Canada on a Branch Basis (Not on Syllabus)

• Chapter 3 is excluded from the syllabus.

Chapter 8: Diversification Credit

As promised earlier, this chapter is short and easy. First, here's the definition:

diversification credit: a reduction to capital required recognizing that not all risk categories are likely to suffer their maximum loss simultaneously

The formula was given in the Full MCT Example from earlier but here it is again:

Let:

• C   =   Credit Risk
• M   =   Market Risk
• I   =   Insurance Risk

Then define:

• A   =   Asset Risk   =   C + M

The formula for the Diversification Credit is:

• DC   =   A + I - SQRT( A² + I² + 2·R·A·I )

The quiz for chapter 8 is currently labelled as "quiz 3" because chapters 4,5,6,7 aren't available yet.

mini BattleQuiz 8

POP QUIZ ANSWERS

• Yes, she does! Click for Answer