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1997 December Report of the Auditor General of Canada

Main Points

30.2 A key to success for OSFI is having the right people with the right competencies and using them effectively. OSFI has the basic human resource management systems in place and operating, and is moving forward on a variety of fronts. However, at this point it does not have some important information that it needs to estimate the degree to which activities planned or under way will help it achieve its objectives. It needs to have a more strategic approach to human resource management and a more rigorous analysis of issues to ensure that current and planned activities will help it meet its goals and objectives.

30.3 Overall, we found that OSFI is highly regarded by the insurance industry and by provincial and foreign regulators. It has developed some key aspects of its risk assessment and risk management framework -- standards for sound business and financial practices, and guides to intervention. However, they are not yet complete. We identified gaps in the implementation of the framework that could prevent OSFI from meeting its objectives in the future. For example, it needs to apply its risk ratings more rigorously; focus its life insurance examinations on key risks; and improve the integration of its analysts, examiners and actuaries. In addition, communication and co-ordination with regulated entities and other regulators need to be improved.

30.4 The supervision of pension plans at the federal level is in a state of transition. OSFI has recognized the need for a new regulatory framework that includes a new mandate focussed on protecting plan members, greater powers to intervene when plans are in difficulty, and formalized procedures for risk assessment. OSFI plans to establish a Guide to Intervention and Standards for Sound Governance and Financial Practices for pension plans.

Introduction

Evolution of the Office of the Superintendent of Financial Institutions

30.6 Changes to investment and ownership rules. In 1992, important legislative changes were introduced to reflect the changing nature of the financial services industry. Restrictive investment criteria were replaced by "prudent person" criteria. Restrictions on cross-ownership among banks, trusts and securities firms were eased. These changes made it imperative that the financial regulatory framework provide a "level playing field" for the three pillars regulated by OSFI - banks, trust companies and insurance companies. The change from restrictive investment criteria meant that OSFI no longer needed to verify that investments met the detailed requirements of the legislation. Instead, it began to change its focus from compliance to issues of solvency and good corporate governance to ensure that regulated entities were managed prudently.

30.7 Introduction of "Standards" helped implement the new legislative framework. In 1993, Canada Deposit Insurance Corporation (CDIC) adopted as regulations the "Standards for Sound Business and Financial Practices" for deposit-taking institutions that are members of CDIC. These Standards, while further defining good corporate governance, helped OSFI and CDIC use sections of the legislation that permitted sanctions for poor practices. This allowed them to respond earlier when financial institutions deteriorated. Similar standards for life insurance companies were developed jointly by the industry and OSFI and were adopted in January 1997. Once those have been implemented, OSFI and the Insurance Bureau of Canada (IBC) will develop standards for property and casualty companies. OSFI is developing standards for pension plans as well.

30.8 Guides to intervention helped to develop the framework. In February 1995, the Guide to Intervention for Federal Deposit-taking Institutions and the Supervisory Guide Applicable to Federally Regulated Insurance Companies were introduced to promote awareness and enhance the transparency of the system of intervention in federally regulated financial institutions. The guides outlined the steps that OSFI could be expected to take if the financial condition of an institution deteriorated. They outlined the criteria for determining the degree of intervention required, ranging from "stage 0", for institutions of no concern, to "stage 4" for institutions on the verge of failure. The disclosure of this process and of the actions that are considered at each of the stages of intervention has improved the understanding of OSFI's supervisory role. The 1995 guide for deposit-taking institutions also covered CDIC's role in the intervention process. In January 1997, the actions of CompCorp, the compensation fund for policyholders of failed life insurance companies, were incorporated into the guide for life insurance companies. OSFI is developing a similar guide for pension plans.

30.9 OSFI reorganized to help meet the needs. In August 1995, OSFI reorganized in response to the increasing breakdown in the distinctions among the four financial institution pillars and to the creation of more financial conglomerates. Its supervisory work for all federally regulated financial institutions and pension plans was centralized in a new Operations Sector. Another objective of the reorganization was to establish a more consistent approach to policy development for financial institutions, regardless of type. The policy-making divisions of each OSFI financial services industry group were merged to create a new Policy Sector, which assumed responsibility for all policy development in OSFI. The new structure improved consistency in decision making with respect to financial institutions and enhanced the supervision of financial services conglomerates.

30.10 New legislative mandate helped. The basis for efficient and effective operations is a good accountability arrangement. This is particularly important for OSFI because its operations are funded primarily by the entities it regulates. In 1996, legislation was passed that provided a clear mandate for OSFI's regulation of deposit-taking institutions and insurance companies. The legislation set out a number of objectives specifying how OSFI should achieve its purpose of contributing to public confidence in the Canadian financial system. The mandate states that in carrying out its objectives, OSFI "shall strive to protect the rights and interests of depositors, policyholders and creditors having due regard to the need for financial institutions to compete effectively and take reasonable risks."

30.11 OSFI proposed a similar mandate for pension plans in its July 1996 White Paper. In addition to clearer authority, the White Paper proposed stronger regulatory and supervisory powers for OSFI and resulted in the tabling of Bill C-85, which died on the Order Paper when an election was called in April 1997.

30.12 Strategic objectives established. OSFI established a new mission statement and, in 1996, strategic objectives, as first steps in implementing its new mandate ( Exhibit 30.1 ). It also reviewed its legislated responsibilities, and began a process to transfer to other organizations some of the responsibilities not directly related to its mandate. (For more information see OSFI's Annual Report and Part III Estimates, on the Internet site http://www.osfi-bsif.gc.ca.)

30.13 Good progress in developing performance measures. OSFI is now in the process of developing key performance measures to compare results achieved with expected results for each of its strategic objectives. These measures will include indicators of change in industry-wide risk, the relative cost to industry of OSFI's regulatory requirements, and service standards. OSFI told us it intends to use the resulting information internally to manage its performance, and plans to publish some of the indicators in its 1998-99 Annual Report. In our view, OSFI is at the forefront in developing performance measures for a regulatory regime.

30.14 Linking goals to activities is a challenge. Completing its accountability framework will be the next challenge for OSFI. It needs to complete recent initiatives aimed at describing more clearly how its activities contribute to its strategic objectives and at what cost, and needs to use this information to allocate resources more efficiently and effectively ( Exhibits 30.2 and 30.3 ).

Changing environment will mean new ways of regulating

30.16 New complexities add risk. It is increasingly difficult to separate the business lines of insurance, investment and banking. To illustrate, the life insurance industry reported that insurers made payments of more than $30 billion to their Canadian customers last year, but less than 10 percent of this was in death benefits. About 60 percent of the balance was from wealth management and wealth accumulation products, with the other 40 percent split between life protection and health and disability products.

30.17 New products and increased competition were cited by industry people we interviewed as areas of high risk. In the past, products were fairly constant from one year to the next. Now there are new products on the market almost every day. The new products may compete with products in other sectors - annuities may substitute for guaranteed investment certificates, for example. The entities developing the products may not price them appropriately. Or they may risk promising too much to the consumer, resulting in huge liabilities from lawsuits like those seen recently over ``vanishing premiums". While industry rating agencies found that ratings of Canadian life and health insurers are high by international standards, they warned in May 1997 that a tough competitive environment may lead to downgrades in the ratings.

30.18 Restrictions on free trade continue to decrease. In July 1995, Canada signed an interim deal on trade in financial services under the General Agreement on Trade Services (GATS) of the World Trade Organization (WTO). Under this agreement, Canada retained certain limitations that could be changed when the interim agreement expires at the end of 1997. Increased trade in financial services provides an opportunity to Canadian companies to sell more products abroad. It also creates risk through increased competition and the difficulty of regulating the Canadian operations of companies based outside Canada. Regulating large, complex, international conglomerates or large, complex pension plans will pose challenges to regulators in the future.

30.19 Need for increased co-operation and speed. These changes all point to the need for increased co-operation with other regulators, both provincial and foreign, and the need for increased ability to respond quickly to new developments.

30.20 The former chairman of the U.S. Federal Deposit Insurance Corporation (FDIC), in a January 1997 speech, recognized the need to be proactive and to plan well. ``In containing the most recent banking crisis...two lessons [have been] learned...first...monitor and assess risks in the industry in a way that anticipates future problems...second...a more systematic approach to managing ourselves to assure continued success in the future...planning, organizing, directing and controlling what we do to meet our objectives...All other functions of management rest on planning."

30.21 Many regulators, including OSFI, have recognized that one way to improve regulatory response time is to establish incentives that enhance the industry's efficiency, such as linking regulatory charges to the level of service required, increasing public disclosure of entity information, and increasing the transparency of regulatory expectations and requirements.

30.22 For example, the U.S. Federal Reserve (the Fed) has streamlined the process for approving new activities, using disclosure as a regulatory tool. Well-managed and well-capitalized bank holding companies may now start certain new activities without prior approval. However, they must publish their application in order to allow for community input, and notify the Fed within 10 days. The Fed determines whether the company qualifies as ``well managed and well capitalized".

30.23 Recognizing the need for better co-operation, in December 1996 OSFI established the position of Special Advisor to the Deputy Superintendent of Policy. The Special Advisor is responsible for developing plans to improve relations with other regulators.

30.24 OSFI will need to continue evolving in response to increasingly rapid changes in the industries it regulates.

Focus of our audit

• has a clear mandate, roles and responsibilities as well as adequate performance measures, internal quality controls and reporting to meet its accountability requirements;
• has adequate and efficient systems, procedures and capabilities to safeguard policyholders and plan members from undue loss;
• contributes to public confidence by anticipating future challenges and adjusting its activities to meet them.

Follow-up of previous audit work

30.28 In 1995 we reported on OSFI's regulatory activities with respect to deposit-taking institutions. In accordance with our normal practice, we will conduct a follow-up audit on those recommendations in the future.

Observations and Recommendations

Human Resource Management

OSFI has identified some key human resource management issues

30.31 OSFI's framework for human resource management - the related philosophy, policies and systems, and the accountability and control framework - has been in revision for the past two years to make it more responsive to OSFI's changing needs. For example, clearly stated values and new performance assessment practices have been adopted, a new job evaluation and classification plan is being developed, and an employee survey is being carried out.

30.32 OSFI has identified a number of issues. OSFI has identified certain human resource management issues that need to be addressed. In its view, three key areas in particular - staff recruitment, retention and learning - need significant strengthening.

30.33 OSFI recognizes that its difficulty in obtaining qualified human resources and appropriate skills is related to its human resource management framework and to the effectiveness of systems for staffing, compensation, career management, and professional development. These issues and supporting systems are interrelated - action in one area can impact on another area.

30.34 Will corrective actions under way resolve the issues? A significant number of initiatives are under way to address these issues. For example, OSFI has undertaken a training needs analysis and published a new learning guide; is identifying core competencies and developing a career management structure; and is reviewing its separate employer status to determine if the flexibility currently provided is sufficient or if other avenues should be explored. Having taken these first important steps, in our view it is now time for OSFI to "pause and reflect" as important decisions on human resource management are considered and made. In doing so, OSFI needs to document its analyses of relevant issues as clearly and completely as possible. This would serve two important purposes. First, it would help senior management review and challenge recommended courses of action and their alternatives. This would help to ensure that decisions are timely, that activities are in the right sequence and that OSFI management has full knowledge of what will be gained and what will be given up. Second, it would help senior management demonstrate, to other stakeholders such as regulated industries and government organizations whose support may be required, that proposed changes are necessary and appropriate.

Need for improved tie-in to OSFI's vision for the future

30.36 The documents we reviewed showed activities planned for the current year only. Linkages were not clearly articulated between activities proposed or under way and OSFI's vision of its human resource management in the future, given the changes occurring in its environment and their impact on its regulatory strategy. Furthermore, OSFI needs to review its allocation of the priority of various projects to ensure that they are well integrated and conducted in the optimum order while taking into account operational priorities, such as staffing vacant positions. Seven human resource projects we reviewed had an A priority - the highest - all with completion dates of April 1998 or earlier. Two had a B priority, but also had completion dates of April 1998 or earlier. In our view, it will be difficult for OSFI to successfully complete all of these projects simultaneously, especially as some are interrelated.

30.37 OSFI has taken some steps in the right direction. OSFI is devoting significant efforts to improving its planning and the integration of the human resource management function with its Strategic and Business Plans. It believes that, once completed, these steps will provide a longer-term, more strategic approach that will respond to its regulatory strategy in the future.

30.38 OSFI should ensure that its human resource management activities are clearly linked to its vision of the future. In particular, OSFI should ensure that:

• the development of human resource policies and systems is guided by a clear definition of the way it expects human resources to be managed in the longer term; and
• priorities allocated to human resource projects optimize the sequence and integration of the various projects while taking into account operational priorities such as staffing vacant positions.

Some human resource issues require more thorough, documented analysis

30.40 Analysis of recruiting efforts. In a number of documents we reviewed, OSFI stated that chronic vacancies were responsible for delays in examinations and in issue analysis. Vacancy rates were especially high in examiner and support staff positions in Toronto. For example, at the time of our audit, 12 of the 20 life insurance examiner positions were vacant and managerial staff were performing examiners' work. In addition, OSFI reported a significant number of term or acting appointments. To the extent that a substantial number of positions are not filled, OSFI's work and its ability to meet its objectives could be seriously affected. In addition, the use of higher-level employees to perform lower-level duties impacts on staff utilization rates, motivation, and cost effectiveness. OSFI reported that non-competitive compensation was one of the major reasons for the loss of valuable employees and that non-competitive salaries and limitations imposed by the Public Service Employment Act were major reasons for difficulties in recruiting qualified staff.

30.41 We found that, while OSFI produces monthly establishment reports showing vacancies and staff movements, no summary report was available on the length of time it has taken to fill various positions, the reasons for any delays, and the impact this had on OSFI's operations. In addition, no detailed analysis of turnover was readily available.

30.42 In the sample of files we reviewed, we found that competitions for professional staff had taken some time to run their course. However, difficulties in identifying suitable candidates and filling vacant positions appeared to be attributable less to legislative requirements than to OSFI's internal processes and the fact it had not yet taken full advantage of the considerable authority available to it. We also found that despite concerns about salary levels and although it has referred to broader surveys of the financial industry, OSFI has not done a salary survey since 1989-90 in accordance with its decision to comply with government policy on salary freezes in recent years. OSFI needs more concrete data to demonstrate that remuneration levels have had a negative impact on its ability to achieve its staffing objectives and that it needs special flexibility in salary levels.

30.43 Options that could help. We found that OSFI has not taken advantage of some options available to it that could assist in expanding the pool of potential candidates and achieving its staffing objectives. These include, among others:

• enhancing its visibility as an employer of choice, by identifying and communicating, in the appropriate media, unique characteristics that OSFI possesses and that are liable to interest potential candidates, such as the opportunity to acquire an overview and understanding of financial institutions as a whole; and
• the development of an appropriate recruitment strategy - related to its new mission, strategic objectives and goals - that could then serve as a basis not only for recruitment but also for an approach to professional development. This could include decisions on such matters as whether to develop and maintain in-house expertise or hire experts on contract instead; recruiting recent university graduates or co-op students for a specified period of time; and recruiting retired people with experience in financial institutions.

30.45 OSFI should ensure that:

• changes it makes in its human resource management framework or in recruitment and retention strategies are based on rigorous, documented analysis; and
• its analyses consider the costs and benefits of alternative courses of action in light of its mission, strategic objectives and vision for the management of human resources in the future.

Importance of staff skills and professional development

30.47 Initiatives to address concerns. Nevertheless, OSFI officials expressed concerns about the need to have the highly qualified, up-to-date staff necessary to keep pace with the rapid changes in the industry. In part this was identified as a recruitment issue, but it is also related to OSFI's ability to provide a learning environment and training opportunities. A number of initiatives have been undertaken to address this. For example, OSFI has identified continuous learning as an important part of its strategic management; allocated three percent of its salary budget for professional development and training; and developed a learning guide and undertaken a training needs analysis of individuals. It has also sent employees on training programs in such areas as change management, has established a self-learning centre, and is designing a career management structure. OSFI has informed us that it is beginning to obtain feedback on individual courses and on the impacts of on-the-job training.

30.48 Technical training needs more emphasis. We found that additional work needs to be undertaken to arrive at a better balance between technical training needs identified from a strategic or corporate perspective and training needs identified through employee feedback or within divisions.

30.49 There is also a need to ensure better linkage between identified training needs and actual training delivered or undertaken. At the conclusion of our audit, it was unclear on what basis training was allocated to staff. OSFI needs to get a clearer picture of all the types of training and learning opportunities provided to its employees. It recognizes that it can maximize the return on its investment in learning through better tracking of training initiatives, and is starting to monitor initiatives and projects in that light.

30.50 OSFI should develop mechanisms to ensure that the organization's training and learning needs are met and controls are in place that will maximize the return on its investment in learning.

Insurance Supervision

30.52 OSFI is the court-appointed liquidator for the winding-up of most of the federally incorporated insurance companies in liquidation. OSFI told us that liquidations are managed by professional liquidators selected through a competitive process, in consultation with the industry and policyholder protection fund managers. It also told us that it carries out validation work to control and supervise the liquidations. As noted in the Scope section of About the Audit , we did not audit the liquidations operations of OSFI.

30.53 Property and Casualty Division. The Property and Casualty Insurance Division (P&C) has overall responsibility for the supervision of federally registered property and casualty insurance companies and branches of foreign insurance companies. As of 31 December 1996, there were 97 companies incorporated in Canada and 126 foreign companies operating on a branch basis ( Exhibit 30.5 ).

30.54 The Property and Casualty Insurance Division includes the following sections: Operations Analysis, Corporate Analysis, Examinations, Liquidations (for both life insurance and property and casualty insurance companies) and Actuarial Affairs. In this Division, the actuaries also perform the actuarial examination function.

30.55 OSFI is a leading regulator. Insurance companies we interviewed were unanimous in their view that OSFI's regulatory practices are further advanced than those of other provincial, federal or national regulators they deal with. Other regulators throughout the world visit OSFI frequently to study the Canadian regulatory framework. Many other regulators are only now adopting the integrated regulatory framework, described in the Introduction of this chapter, that OSFI has had in place for the past few years. For example, Ontario announced in the spring of 1997 that it intends to amalgamate its Insurance and Pensions regulatory bodies.

A need to implement the risk assessment and risk management framework

30.57 In our review of files, we found that OSFI's life insurance analysts generally do a thorough analysis of company filings, appointed actuaries' reports and DCATs (Dynamic Capital Adequacy Test - a key test of the sensitivity of a company's capital and earnings to economic, business and actuarial changes). They analyze early-warning test results to identify questions and risks that require attention, and prepare pre-examination reports for examiners, reports to OSFI senior management and monthly reports to the Minister on companies where there is a risk to financial viability or solvency (rated at stage 2 or higher).

30.58 The Property and Casualty (P&C) division has made particularly good progress in providing guidance to staff, with the practical application of the Guide to Intervention for Insurance Companies ; it could serve as a model for other OSFI divisions. The P&C Division analysts use an automated process that rates the companies using a point system based on ratios. The analyst reviews the results provided by the rating system and applies his or her judgment to determine whether or not to modify the suggested ratings.

30.59 Gaps could prevent OSFI from meeting its objectives. Although OSFI is a leader in developing regulatory practices, we found gaps in the implementation of its risk assessment and risk management framework that could prevent it from meeting its objectives in the future.

30.60 Difficulties with ratings. While most of the P&C automated system has worked well, we found one area that could be improved. The analyst is to provide a rationale if the rating suggested by the automated system is modified. We expected that there would be clear criteria to assist staff in making this judgment. However, we noted that the analysts' files did not always have a clear rationale for modifying the company ratings, or for the evaluation of qualitative elements such as the rating of management.

30.61 We noted in minutes of its advisory committee meetings that OSFI has been hesitant to inform a company when it moves to stage 3 because it believes moving a company to stage 3 could potentially result in public disclosure by the company, with significant impacts on public confidence and the viability of the company. It is concerned that public disclosure will undermine the effectiveness and efficiency of its work. However, OSFI has advised us that it now informs a company whenever its rating moves up or down a stage, thereby improving the clarity of the message given to company management.

30.62 OSFI may be reluctant to rate companies at a level higher than stage 2. OSFI managers have noted that the rating is very much a question of judgment. However, in three of the cases we reviewed it was questionable whether, in not rating companies at the stage 3 level more promptly, OSFI had followed its guide to intervention. Any reluctance can reduce the effectiveness of OSFI's early warning system: companies rated at a lower stage than is warranted may not receive adequate attention.

30.63 Examinations contribute to industry improvements. OSFI examination staff in Toronto, Vancouver, Winnipeg and Montreal conduct well-planned, systematic, thorough examinations of companies. Companies are selected for examination based on factors such as new incorporation, risk rating and size. During 1996, 50 percent of life insurance companies and 51 percent of P&C companies carrying on active insurance operations underwent an on-site examination. Examiners consider information from a variety of sources such as analysts' reports, prior years' management reports and files, external auditors' reports and files, minutes of boards of directors, press clippings, and rating agency reviews. They use some specialists such as actuaries, credit consultants or treasury specialists, as appropriate. At the conclusion of the examination they discuss their findings with company management, report to OSFI senior management and to the company's audit committee, and follow up on responses to their recommendations. Companies we interviewed agreed that the process generally contributes to continuous improvement in industry management and compliance with the Insurance Company Act and regulations.

30.64 Life insurance examinations need to be better focussed. We found that examinations of property and casualty insurance companies are well focussed on the key risk areas. Examination plans, reports and files provide clear support and rationales for the work done.

30.65 However, in about half the life insurance cases we reviewed, it was not clear that OSFI had focussed its examination on significant risks. While there were no apparent gaps in the examination procedures, examiners may be doing more work than necessary in low-risk areas and consequently less in-depth work in higher-risk areas. We observed that examination procedures could be better tailored to the particular risks in each company. As well, files do not adequately document how the previous year's examination findings were taken into account in order to reduce work or focus on key areas.

30.66 We noted that a limited amount of time is spent looking at the future business viability of companies, while much of the life insurance examination resources are spent on reviewing mortgages. We question the need for such a detailed review, since OSFI told us that most life insurance companies now have adequate systems to monitor their mortgages. We noted that OSFI reviews strategic plans, but there is little evidence of links between that review and the review of a company's report on Dynamic Capital Adequacy Testing (DCAT). In our review of files, we found little evidence of discussions with senior company management about the impact of the strategic plan and DCAT on the future of the company. Life insurance company managers we interviewed suggested that discussions with OSFI could help improve the examiners' focus on future viability as well as on key risk areas.

30.67 Although OSFI is placing reliance on the internal and external auditors, life insurance examination files do not contain a rationale linking specific work performed by the auditors to OSFI's examination procedures. Without this link, it is not always clear what work OSFI is relying on and therefore it is difficult to determine whether and how its examination procedures could be reduced or eliminated.

30.68 Focussing its examination efforts is particularly important given the significant constraints on OSFI's resources. As we have noted, at the time of our audit, 12 of the 20 life insurance examiner positions in Toronto were vacant.

30.69 Use of experts. OSFI relies on the work of the external auditors to assess the adequacy of the management information systems in the life insurance companies it examines. However, we found little documentation in the examination files to support OSFI's assessment of the readiness of many companies' systems for the impact of the Year 2000 systems changeover. (Interest charges, premium billings, dividend credits, etc. could be miscalculated if computer routines were to interpret year 2000 as preceding year 1999 by 99 years rather than following it by one year.)

30.70 OSFI has recognized the need for more expertise in the assessment of information technology. A recent OSFI study noted that in the future, examiners may be required to possess at least enough knowledge of the various systems and applications in use to judge their general adequacy and differentiate between those that minimize risk and those that create their own risk. Examiners may also have to exercise judgment in determining which potential problems they can address themselves, which ones require some additional expertise, and which require a great deal of additional expertise. However, we saw little evidence that OSFI had considered these requirements. For example, there was no mention of them in operating plans. Industry representatives whom we interviewed agreed that OSFI could make better use of contracts to obtain expertise in this area as well as in other areas, such as the evaluation of actuarial reports.

30.71 In order to give credence to its guide to intervention for insurance companies, OSFI should develop a more rigorous system of determining a company's rating - one that consistently includes the views of analysts, examiners and actuaries. If the impact of public disclosure is a real concern, OSFI should pursue changes to the legislation or regulations to prevent such disclosure.

30.72 OSFI should continue to work with the property and casualty insurance industry to define standards of sound business practices for the industry.

30.73 To enhance its efficiency, OSFI should better focus its examinations of life insurance companies on the key risk areas and on the assessment of the future business viability of the company, and improve its use of consultants with expertise in areas such as information technology and actuarial reports.

Avoiding overregulation

30.75 Capital requirements for life insurance companies are complex. OSFI has established well-defined, risk-based capital requirement standards and it monitors compliance with them to ensure the protection of policyholders through adequacy of capital. The standard for life insurance companies is called the Minimum Continuing Capital and Surplus Requirement (MCCSR). MCCSR is a ratio calculated by the company in accordance with OSFI's instructions. Determining the MCCSR is a complex process that attempts to take into account most aspects of the company's operations. OSFI's guideline to the industry setting out these instructions has changed frequently since its introduction in August 1992. Company managers we interviewed had difficulties with the MCCSR, including the detailed, lengthy review process, lack of a standing committee to ensure ongoing consultation, inconsistencies with other national regulators and ambiguous wording subject to misinterpretation. OSFI intends to avoid any further changes until it has monitored the impact of the current MCCSR guidelines.

30.76 OSFI and the Department of Finance should closely examine the compliance requirements and consider alternative methods to ensure that any negative impact on companies is minimized.

Integration of work of actuaries, analysts and examiners

30.78 OSFI's life insurance actuarial resources are limited. Our examination of OSFI life insurance actuaries' work in Ottawa and Toronto found that they do a competent, professional job of reviewing the work of companies' appointed actuaries (actuaries appointed by the company who have statutory duties under the Insurance Companies Act ). However, the actuarial staff resources in Ottawa are very limited. They include only one manager, two fully qualified actuaries, one analyst and support staff. The Actuarial Examination Section has been without a Director for the past three years, since 1994-95. There is no actuarial manager for the Toronto actuaries; all four actuarial examiners report to the Acting Director, Examinations. Actuarial staff in Toronto are involved in many aspects of the examination function beyond a review of the appointed actuaries' work. OSFI recognizes that it does not have the resources to do in-depth analyses of all actuarial reports.

30.79 Role not clear. The role of OSFI actuaries and the use made of their work are not clear. OSFI life insurance actuaries in Ottawa set up their own rating system for company reserves, independent of the rating system used by OSFI analysts. The actuaries' system rates the reserves on a scale of 0 to 3 rather than 0 to 4.

30.80 Actuarial work not integrated. In our review of both life and P&C examiners' and analysts' files, we found little evidence of attention to the work of OSFI actuaries. Examiners and analysts concentrate on other matters, or feel quite confident about reviewing the work of the appointed actuary themselves. We also noted that the actuaries' files indicated little exchange of information with the examiners and analysts. During 1996-97, the life insurance actuaries in Ottawa reviewed approximately 100 actuarial and DCAT reports and those in Toronto reviewed approximately 30 such reports. In our review of OSFI's files, we noted that the actuaries send a copy of their reports to the analysts. However, we found little evidence that analysts consulted with the actuaries or considered the information provided in their reports before rating the companies.

30.81 In our view, the examiners and analysts could gain a better understanding of a company and its risks from consulting with and seeking the advice of the OSFI actuaries on a regular basis.

30.82 Work of analysts and examiners sometimes not well co-ordinated. OSFI management told us that analysts consult with examiners when determining company ratings. However, we rarely found evidence of consultations in the files we examined, or in our discussions with examiners. In one case we noted, OSFI examiners and analysts had presented conflicting information to company management.

30.83 P&C division intends to improve. We found that P&C examiners do not always agree with analysts about company ratings. An April 1997 internal memo lists a number of companies to which the examiner and the analyst had assigned different ratings. However, by the end of our audit these inconsistencies had been addressed and a consensus reached on the appropriate rating. P&C division management told us it intends to implement a system of regular consultation.

30.84 OSFI should review the role of its actuarial staff and assess the level of resources needed to perform its regulatory role. It should improve the co-ordination of the work of actuaries, examiners and analysts.

Communication with companies needs attention

30.86 Frequency of meetings with boards of directors improving. Prior to 1997, OSFI met infrequently with the boards of directors of life insurance companies, other than those about which it had a significant concern. A list of meetings provided by OSFI showed that on average, it met with four boards of directors each year from 1992 to 1997. In early 1997, it began to increase this number by meeting with the boards of major life insurance companies and companies where findings are significant.

30.87 Communication of actuaries' findings. Findings by OSFI actuaries in Ottawa are usually not communicated to the companies' appointed actuaries. As we have noted, companies would like more feedback on the quality of their actuarial reports. Regular discussions between OSFI's actuaries and company actuaries could provide useful information to companies and help improve the quality of actuarial work.

30.88 Examination reports slow and inconsistent. OSFI's reports to life insurance company management on examination results are not timely; they are often issued four to six months after completion of the examination. While examiners meet with company senior management at the end of each examination to obtain its comments on their observations, it is only when the final version is issued that the audit committee of the board is informed of the findings and recommendations. Most companies we interviewed, in both life insurance and property and casualty insurance, felt that OSFI should issue its report within two weeks after completing the examination. They suggested that if there are complex, contentious or unresolved issues, these can be noted in the report as items to be dealt with at a later date. These issues are relatively rare and need not hold up the report.

30.89 Furthermore, the content of these reports is not always consistent. OSFI is aware that they sometimes include issues that are not important enough to warrant bringing them to the attention of the board of directors. It informed us that, in future, an experienced OSFI manager will review management reports prior to their release to companies to ensure consistent quality control.

30.90 Disclosing the stage rating. OSFI does not inform a company when it is first classified at stage 1. We feel it is important that management be made aware of OSFI's view of the increased risk at an early stage, consistent with its mandate to act in a timely manner. OSFI has told us that in the future, it will inform all companies as soon as they are rated at stage 1. It advises the company and the Minister when the company moves to stage 2 or above.

30.91 OSFI should increase discussion with insurance company officials to better understand the company, and communicate its findings on a more timely basis to achieve better relationships and encourage improvements in company operations.

Need for continuous, documented communication with other regulators

30.93 Little evidence of communication. In the files we reviewed, we found little evidence of communication with other regulators. Companies we interviewed said OSFI did not request copies of foreign regulators' reports, even when they were carrying out their examinations at the same time. During our file review we noted that in two cases, the foreign regulator advised OSFI that it had issued an Order of Supervision placing restrictions on the company's activities, and that no funds would be transferred to the Canadian branch. Although OSFI had been aware of problems with a branch of one of these foreign companies and had rated it stage 1, it had not initiated any communication with the foreign regulator of the company. A more consistent approach to communication with foreign regulators is needed.

30.94 OSFI has taken some steps. At a senior level, OSFI communicates informally with foreign regulators and participates actively in international organizations such as the International Association of Insurance Supervisors. In December 1996, OSFI established the position of Special Advisor to the Deputy Superintendent of Policy. The Special Advisor is responsible for developing plans to improve relations with other regulators. OSFI told us a draft plan was prepared in May 1997.

30.95 There are a number of other, less formal measures that OSFI could take to improve communication. For example, it could request copies of all regulators' reports from the entities it examines and discuss with entity management the results of the other regulators' reviews.

30.96 OSFI should finalize and implement its plan to strengthen its relations with other regulators and should also pursue both formal and informal communications, focussing on incorporating specific entity information into the analyst's risk assessment.

Private Pension Plan Supervision

30.98 Pension plans are contractual arrangements under which money is set aside during the working life of employees to provide them with income at retirement. There are nearly 16,000 registered pension plans in Canada today, covering over 5 million employees, or about 45 percent of all employed Canadians. Most of these plans are subject to provincial jurisdiction and are regulated by provincial authorities. Some 1,100 plans, covering a little over half a million members in total, are regulated by OSFI ( Exhibit 30.6 ).

Continue to press for less overlap

30.100 OSFI has taken steps to reduce overlap. To reduce the costs associated with regulatory overlap, OSFI has entered into agreements with provinces whereby it delegates authority to provincial regulators to supervise plans that have members who are subject to the PBSA , or accepts authority from the provinces to supervise plans with members who are subject to provincial jurisdiction. Currently, OSFI supervises some 25 pension plans on behalf of provinces. Supervision of approximately 124 pension plans has been delegated by OSFI to the provinces.

30.101 Reciprocal agreements do not reduce the largest part of the regulatory burden. These reciprocal agreements reduce regulatory costs by enabling plans to register with and be supervised by one regulator only. However, the regulator of a plan with members in different jurisdictions must apply separately the legislative requirements of the jurisdiction governing each plan member. This system can reduce the cost of compliance, the largest part of the regulatory burden, only to the extent that regulatory requirements are the same across jurisdictions. Unfortunately they are not, especially following changes to both federal and provincial pension standards legislation in the mid-1980s.

30.102 Multilateral agreements would be better. A more promising way of dealing with regulatory overlap is the "multilateral agreement" concept currently being promoted by the Canadian Association of Pension Supervisory Authorities (CAPSA). Unlike the reciprocal agreements now in place, multilateral agreements would allow multijurisdictional plans not only to register with a single regulator but also to be subject to the legislation of that regulator alone, regardless of the jurisdiction applying to individual plan members.

30.103 The compliance burden resulting from overlapping and inconsistent regulations has been a long-standing concern of pension plan sponsors and administrators. Despite recent initiatives through CAPSA and other forums, industry watchers and the industry representatives we interviewed say the situation is not getting better. As one of the major regulators of pension plans in Canada, OSFI can play a leading role in turning this situation around, by encouraging greater consistency in regulatory standards across jurisdictions and less overlap in supervisory requirements.

30.104 As part of its role in promoting greater consistency in the regulation of pension plans across Canada, OSFI should work actively with provincial regulators to promote the adoption of the multilateral agreement concept.

30.105 OSFI's focus is changing. The key objectives of OSFI's supervision of pension plans are to ensure that plan members can be reasonably confident that they will receive the benefits promised to them, and to monitor compliance with the PBSA . A major focus of OSFI's regulatory activities to date has been on verifying whether plans comply with PBSA provisions and attendant regulations. This is a time-consuming and costly exercise - and in OSFI's view, not particularly useful.

30.106 Plans for improvement. In December 1996, OSFI developed a draft guide to intervention for pension plans, similar to that for insurance. As part of its corporate plan for the next few years, OSFI has announced its intention to follow a more risk-based approach to regulating and supervising pension plans. It is currently in the process of developing a risk-rating system, an electronic database on pension plans similar to the existing database on insurance companies, and Standards of Sound Governance and Financial Practices . Once completed, these projects should make supervision of pension plans under the PBSA more effective and efficient.

Integrate monitoring and examination

30.108 Examinations and monitoring processes need improvement. The increased reliance on on-site inspections over the past several years has proved useful. However, our review of pension files revealed the same types of problems as we found in the insurance area - quality controls and attention to actuarial information need improvement. For example, the rationale supporting the risk rating of a pension plan was not evident. In fact, each analyst had his or her own risk-rating system and there was no evidence that senior management reviewed or approved the ratings. The implementation of OSFI's new guide to intervention for pension plans is expected to remedy this problem. We also found little evidence of the development of systematic action plans for dealing with troubled pension plans, and examination reports to plan administrators were not timely.

30.109 As in the Insurance Division, our file examination found little evidence of communication among pension plan analysts, actuaries and examiners. The examination process could be made more effective and efficient by integrating the monitoring and examination functions at OSFI.

30.110 Increased participation of OSFI's Ottawa analysts in the examination process could enhance communication between examiners and analysts, sharpen the focus of examinations, and cut down the time required to be on-site.

30.111 OSFI does recognize shortcomings in the existing examination process. It is planning to rectify them by narrowing the scope of examinations to areas sensitive to plan solvency and by allocating more of the examination work to analysts, actuaries and other non-examiner staff at headquarters.

30.112 In its ongoing review of the existing supervisory process for private pension plans, OSFI should encourage a closer integration of the monitoring and examination functions in the Pension Benefits Division. It should pay more attention to quality controls and actuarial information and strive for greater consistency in the risk-rating process.

Conclusion

30.114 Risk assessment systems need to be enhanced. Through the establishment of standards and guides, OSFI has improved its systems and procedures for assessing the risk that individual entities pose for policyholders or plan members, although implementation is uneven. OSFI's increased emphasis on key risks and solvency issues helps it to detect problems early. However, its ability to respond would be improved if operating units were better integrated and if co-ordination and communication with regulated entities and with other regulators were improved.

30.115 Human resource management requires better analysis and links to future strategic direction. OSFI management has expressed concern about difficulties in obtaining qualified staff with appropriate skills. A number of initiatives are under way to try to address these concerns. However, OSFI needs to clearly set out its assessment of these initiatives, based on well-researched information and a clear rationale linking them to its regulatory strategy for the future.

30.116 OSFI is making progress on meeting needs for the future. OSFI has conducted a number of studies in the past year covering potential risks facing the financial services industry in the future. While it has incorporated the findings of some studies into its operations, in other cases the use of study results has been less evident. OSFI has plans in place to meet the challenges of increased industry complexity and globalization, through harmonization of regulations and both formal and informal sharing of information with other regulators. However, it needs to pay more attention to regulatory incentives that enhance the efficiency of the regulatory system.

30.117 Continuous improvement needed in response to increasingly rapid changes in the financial services industry . OSFI has made significant progress since its inception 10 years ago. Its philosophy and processes are becoming increasingly sophisticated. Although OSFI meets the needs of today's environment, it nevertheless needs to address important gaps that could affect its ability to meet its objectives in the future.

OSFI's response: The Office of the Superintendent of Financial Institutions (OSFI) is in general agreement with the observations and findings arising out of the audit of OSFI's insurance and pension operations.

While there are a few conclusions that, in our view, miss the mark, we agree with the majority of the audit findings and accept the recommendations resulting from them. Indeed, in many cases, the recommendations support initiatives already under way within OSFI.

Beyond the audit's specific conclusions, we believe that the chapter fairly portrays the progress we have made to date in enhancing our regulatory and supervisory processes, while highlighting the significant challenges that we face in keeping pace with the rapid changes taking place within the financial sector.

The chapter is particularly supportive of the work under way within OSFI to develop an accountability framework, including a mission statement, strategic objectives and performance measures. We wish to acknowledge the advice and encouragement we are receiving from the Office of the Auditor General as we work to develop standards in a field in which few precedents are available.

About the Audit

Objectives

The objectives of this audit were to determine whether OSFI, with respect to its insurance and pensions operations:

1. has a clear mandate, roles and responsibilities as well as adequate quality controls and reporting to meet its accountability requirements, and more specifically whether it:

• knows if its objectives are met in a cost-effective manner for the entities regulated; and
• has complied with the requirement to administer respective Acts and regulations governing its operations.

• has adequate resources, including staff, to carry out its work;
• has developed and implemented the appropriate systems and practices to assess the soundness of insurance companies and pension plans under its jurisdiction as well as their compliance with relevant Acts and regulations;
• has the ability to detect early, and respond to, deteriorating situations; and
• is effectively communicating and sharing information on a timely basis with related organizations.

Scope

While our focus was on OSFI's Operations Sector, we also covered policy and corporate services where they have a major impact on Insurance and Pension operations. OSFI's own financial operations are audited annually during our public accounts audit. In 1994, we carried out a more detailed audit of OSFI's financial management for public accounts purposes. Based on our work, we consider financial management and control in OSFI's own operations a low-risk area and did not cover it in the scope of this audit.

We did not audit OSFI's activities with respect to the liquidation of insurance companies. In our 1986 audit of the Department of Insurance, the Department provided us with information on the process for handling insurance company liquidations and we commented on it. During the present audit, OSFI pointed out, and we concur, that the audit of the liquidation function is beyond our mandate. The Superintendent has been appointed, under authority of the Winding Up Act , as liquidator for many failed insurance companies. In this role, he is accountable to the courts. As a result, we were not able to examine whether the Superintendent, in his role as liquidator, has met the requirements under the OSFI Act to protect policyholders while taking into account impacts on competition (under recent changes to the legislation, the Superintendent will no longer be appointed liquidator). As a consequence of these limitations, we were not able to determine whether OSFI's monitoring under the new regime will be sufficient to protect policyholders. At the time of our audit, the Superintendent was in the process of liquidating 10 property and casualty insurance companies and two life insurance companies. OSFI was unable to provide us with the total estimated costs of liquidating these companies, including agent and legal fees and administrative expenses. The cost from the date of liquidation to 31 March 1997 amounted to $88.6 million, of which $46.2 million had been recovered from the estates of the liquidated companies. Costs that are not recovered from estates will be recovered from the insurance industry. The costs incurred in 1996-97 totalled $1.9 million.

Our audit also covered the Office of the Chief Actuary. However, certain parts of his work were excluded. The Auditor General's annual audit of the government's financial statements includes the Chief Actuary's valuation of government employee pension plans. Also, our audit of CPP Disability, reported in September 1996, included the valuation of the CPP. Therefore we did not examine the adequacy of actuarial valuations performed by the Chief Actuary.

Approach

Criteria

Risk assessment

OSFI should use a risk-based approach to identify companies/plans that require in-depth work and to identify key areas in a company/plan that require further investigation to ensure that potential problems are properly understood and evaluated on a timely basis.

There should be clear and timely communication of requirements and findings, with the company/plan, OSFI staff in related sections and other agencies or regulators.

Risk management

There should be an action plan that considers possible remedies to a problem and ensures that they are corrected in a timely manner.

Anticipation of future challenges

Mandate and accountability

OSFI should have in place effective agreements with provinces, related federal departments and guarantee agencies. OSFI should have in place documented procedures for liaising with foreign regulators. The agreements and procedures should provide a clear understanding of each organization's roles and responsibilities. The agreements and procedures should also provide an operational framework that includes the timely sharing of information and the best use of legislative powers, recognizing the limitations imposed by other regulatory frameworks.

OSFI should periodically measure its results against predetermined performance criteria and report those results to the Minister, to Parliament and to other stakeholders.

OSFI should make use of key performance measures, including quality control processes, to improve its operations and accountability.

OSFI should identify the key requirements of respective Acts and regulations and ensure that it meets those requirements. OSFI should identify on a timely basis the adequacy of the existing legislation and regulatory policies, including any gaps.

OSFI should make use of information technology for cost-effective operations.

Human resource management

Audit Team

For further information, please contact Crystal Pace, the responsible auditor.