Challenges in the Life Insurance Industry

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1 Challenges in the Life Insurance Industry Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the 2010 Life Insurance Invitational Forum Cambridge, Ontario November 8, 2010 CHECK AGAINST DELIVERY For additional information contact: Brock Kruger Communications and Consultations

2 Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the 2010 Life Insurance Invitational Forum Cambridge, Ontario November 8, 2010 Challenges in the Life Insurance Industry Introduction Thank you for inviting me to speak here today. This conference is being held at an opportune time given the challenges facing life insurers globally historically low interest rates, transformational accounting changes being proposed by the International Accounting Standards Board (IASB), and the overhaul of life insurance capital rules underway by most global regulators. The best way to face these changes is to prepare for them. These changes may mean that life insurance companies will have to face some fundamental questions about what business lines they are going to be in, and how they will manage them. If it s any comfort, banks are also in the midst of fundamental changes with the new Basel III accord, and the regulatory reform process is not over. Among other work, there is a review of capital requirements for trading activities on the horizon, contingent capital requirements in the making, and of course discussions about what makes an institution systemic from a global perspective. The best thing to say is that nothing is static and gone are the days when companies could go about their business in a relatively benign environment with few changes being imposed externally. Changes Faced by the Canadian Life Insurance Industry over Time Of course we should ask ourselves whether there ever really was a time when companies faced a benign environment. It may be useful to look back at the history of the Canadian life insurance industry. I won t go all the way back as that would take me to the mid-to-late 1800s. But if I go back years, I can say that the industry has been through a number of fundamental changes. 1

3 The 1950 s and 60 s were an era of mutualisation, and par policies were the norm; public health care and pensions also created new opportunities for insurers. But during the period of inflation and high interest rates of the 1970 s and 1980 s, traditional insurance products offered by insurers fell out of favour (the expression buy term and invest the rest was born, to the industry s chagrin). Competition with banks intensified, and companies responded by marketing non-par products with interest rate guarantees. The decreasing interest rates of the 1990 s put a squeeze on the long term guaranteed products sold in the previous decades. The 2000s were marked by an equity crash associated with the dot-com bubble, and demutualization and consolidation fewer companies with a need to meet market expectations and high ROEs. Then came the global financial crisis and a far deeper crash in equity markets, and now extremely low interest rates. What does this tell us? While the industry is considered to be in a long term business, a lot of things can fundamentally change in a year period. As such, companies need to be able to deal with a wide, wide range of events over the life of long term contracts. Extremely high interest rates, extremely low interest rates, stagflation, inflation, deflation - all are possible and life insurance companies need to be especially aware of this as they can be writing long term policies that do not re-price, as well as non-par policies where the risk is entirely borne by the company. So while I often hear people say that it s a long term business and as a result, companies should not have to respond to short term events, the opposite argument can be made because many insurance contracts are long term and can t be re-designed or re-priced once issued, companies need to pay very close attention to short term movements in the event that short-term changes signal a new normal. I have attended this conference on several occasions in the past and one that I remember particularly well was in November There was a session on the history of toxic products in Canada. A reinsurer provided all the gory details. He said that the first major Canadian insurance industry toxic product was Term to 100, offered in the 1980s. This product was a great idea at the time, but the problem was that early years premiums far exceeded expected claims, and later years premiums were far less than claims. The industry had assumed that lapses would be the same as with other products, and they were not the educated guesses turned out to be horribly wrong and the consumer response was more sophisticated than expected. He then talked about segregated fund guarantee risk and the market crash of the early 2000s (the main challenge being predicting the market). After that he moved on to critical illness, and then to long term care and cited some of the challenges in both (e.g. in long term care, the company needs to estimate a long 2

4 term investment rate, there are unknown future incidence rates given medical advances, and lapse assumptions on the early generations of product were far too optimistic). So offering long term products is a very challenging business and companies need to be prepared to face any sort of market. Company risk management processes, regulatory rules like capital requirements, and accounting rules need to be framed so that these risks remain top of mind. Accordingly, tonight I will talk a bit more about each of these topics: accounting, capital and risk management. IFRS The IASB is proposing an international accounting standard for all insurance contracts, so as to achieve transparent and consistent measurement, presentation and disclosures across jurisdictions and insurers. This initiative could significantly affect Canadian life insurers beginning in 2013 or While most of the new proposed accounting standard is similar to the current Canadian insurance accounting approach, the key change is to use a different approach for determining the liability discount rate. On the positive side, the new approach might better capture financial risks of companies, particularly equity and interest rate risks, and thus provide more early warnings of risks. On the negative side, the discount rate change could potentially lead to extreme earnings volatility especially given the large blocks of long-duration guaranteed product liabilities on the books of Canadian insurance companies. As such, we think the proposals may go too far in terms of capturing short-term interest rate movements on long-term exposures. Consequently, we are working on options to help deal with this issue. In fact we are encouraged by recent developments in this regard. One such development is that the IASB s Insurance Working Group is meeting later this week to discuss possible ways to minimize the effects of any inappropriate volatility. This group s objective is to analyze accounting issues relating to insurance contracts. The group brings together a wide range of interests and includes senior financial executives who are involved in financial reporting. Other developments closer to home are discussions by the Canadian Accounting Standards Board s Insurance Accounting Task Force and the Canadian Institute of Actuaries group to develop their comment letters to the IASB. Both these groups are discussing the volatility issue. In terms of options, many companies would urge the IASB to accept the status quo and model International Financial Reporting Standards (IFRS) off of Canadian Generally Accepted Accounting Principles (GAAP), the foundation of 3

5 which is Canadian Asset Liability Method (CALM), where the discount rate is linked to what the companies assets earn. However, the IASB has committed to the de-linking of assets and liabilities. The IASB s view is that a link would move IFRS towards industry-specific based accounting principles, which the IASB has repeatedly rejected in all standards. As well, the IASB has noted that the amount that companies are obligated to pay non-par policyholders is unrelated to actual returns on assets. It is also worth noting that current Canadian accounting rules, while often viewed positively in the past 20 years, came under considerable criticism in Canada recently given that they produced radically different numbers than US GAAP in terms of how they captured interest rate risk (losses under Canadian GAAP and a profit under US GAAP). There is a huge opportunity right now to provide the IASB with suggestions as to how their goals can be met while also dealing with industry and regulatory concerns about massive volatility. Some have suggested that a good Plan B would be for OSFI to fix the earnings volatility problem by adopting a regulatory measure of life company profitability, versus a GAAP measure, and using that measure for capital (retained earnings is part of capital). But it would be risky for OSFI to say that, from its perspective, profits are far higher than what GAAP financial statements say they are. Companies, investors and regulators should be using similar information and managing to one set of books. OSFI is committed to continuing to work with industry and other international stakeholders as we complete our response to the IASB, which is due November 30 th. We encourage the industry to contribute to this work; the more that we work together, the better the result will be. Segregated funds and Market consistent approach This brings me to capital. OSFI recently released a draft advisory relating to capital requirements for segregated funds. Current criteria for determining segregated fund capital requirements are based only on the performance of the TSX total return index from January 1956 to December So we are proposing three changes that we think are quite sensible. First, we are recognizing that segregated funds include significant exposure to US and international equities - not just exposure to the TSX. Second, we are reflecting equity return experience since 1999 as well as for periods prior to Both changes should better capture the risks. Third, we are introducing bond fund calibration into the modeling exercise to reflect interest rate risk in 4

6 segregated funds. These changes would apply to new business written on or after January 1, Beyond that, OSFI has indicated that it is reviewing its approach to segregated funds in general and plans to move to a more market consistent approach, approximately three years down the road. What is a market consistent approach and how does it compare to the approach used today? Today, in determining capital requirements for segregated funds that have guarantees tied to performance of the stock market or bond markets, companies make assumptions about how equity markets and bond markets will perform in the long run, based on historical experience, and based on their own judgments. While the current method involves making a best estimate about the market in the future which in some sense involves looking into a crystal ball it does include some very prudent aspects. For example, companies have to hold capital based on their prediction of the worst 5 per cent of severe scenarios that could be faced over the life of the product. The obvious shortcoming of the current method is that even with prudential features, no one really has special expertise in predicting the market (though some people have made very good calls). Put another way, calling the market is a very different thing than determining how many loans might go bad or how many life insurance policies will have to be paid out due to people dying. For bank loans and life insurance policies, you can pool thousands of contracts and predict the outcome to a certain confidence level. This is in part based on the law of large numbers. Further on this theme, one could say that at one end of the spectrum, are lives because they are independent (not everyone dies at once). Stocks and guarantees based upon them are at the other end of the spectrum (stocks can all go down at once and even stocks in completely different industries or countries can go down at once, as was demonstrated in the crisis). Loans are probably somewhere in the middle (they are independent but you can have some system wide defaults). So the nature of the risk has to be considered in setting capital requirements, especially for instruments with risks that are not diversifiable. Thus we plan to move to a more market consistent approach. What does market consistent mean? Consider many people (i.e. the market) deciding what returns might be. This so called market price will reflect the views of the optimists, the pessimists, the knowledgeable and the less knowledgeable. Under a market consistent approach, companies would no longer be basing capital largely on their own judgment of the market. That means that if they wrote a guarantee today, they should value it at a price that could find lots of 5

7 people in the market willing to take on that guarantee at the same price, or equivalently, hedge the risk. Under the current method they would only be able to sell it to the people in the market today who had as optimistic a view about the future as they did. A market consistent approach does not mean that the market is always right or always rational. If there has been one lesson learned from the crisis that was it. Indeed, while the market consistent approach involves starting with market values today, it also involves assuming that the market can be wrong (indeed markets can be overvalued or undervalued). Thus in determining capital requirements, companies would have to also assume that a significant shock occurs (with the shock being specified by OSFI for equities a shock might be something like a decline in equity markets more severe than the real life experience we have witnessed). In so doing, the amount that a company held against a guarantee would be sufficient to pay someone else to take that guarantee if current markets turned out to be overvalued. A major advantage of the market consistent approach is that you are now comparing apples to apples. It is based on market prices, as is hedging, and it facilitates working through the issues associated with whether and how much credit to provide for hedging. While the market consistent approach is based on market prices, I should also note that this does not mean that we are moving to mark-to-market capital requirements for all risks. While there is more of a link to market prices under a market consistent approach, we also want to ensure that capital requirements in respect to longer term guarantees are not driven by extreme short term market fluctuations. Our effort to move to a new approach also provides an opportunity to cover more of the risks, such as policyholder behavior (which was a major risk in the toxic product session referred to earlier). We know that predicting human behavior is an area that is quite difficult, and thus there needs to be a margin for error there. That is also part of our plan. Risk Management Given that I am between you and dinner, I will make only one comment about risk management processes. Companies are expected to carry out their own analysis and hold appropriate capital amounts for the risks on their balance sheets. The regulatory capital calculations are only a starting point for determining a company s requirements. OSFI will be focusing closely on pillar 2 i.e. what companies do to assess their risks and how they relate that back to 6

8 decisions on capital. It is not appropriate or sufficient to assume that the test is whether the company exceeds capital requirements that are set out in rules. Conclusion My main message tonight has been to emphasize the challenges that being in a long term business creates and that the changes being debated and implemented now will continue to transform the life insurance industry. I hope you will have a lot of productive discussions over the next day and a half. There is certainly a lot to talk about. 7

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