Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the 2009 OSFI Risk Management Seminar for Life Insurance Companies Toronto, Ontario Tuesday, June 9, 2009 CHECK AGAINST DELIVERY For additional information contact: Jason LaMontagne Communications and Public Affairs jason.lamontagne@osfi-bsif.gc.ca www.osfi-bsif.gc.ca
Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the 2009 OSFI Risk Management Seminar - Life Toronto, Ontario Tuesday, June 09, 2009 Risk Management in the Life Insurance Industry Introduction Welcome to the first annual OSFI Risk Management Seminar for the life insurance industry. A year ago OSFI decided to hold annual sessions with the Chief Risk Officers (CROs) of banks, life companies and property and casualty (P&C) companies. We began with a session for CROs of Deposit Taking Institutions (DTIs) in September 2008 and have now moved to life companies. P&C will be held in the fall, along with the second session for DTIs. This is a forum for OSFI to share its views and discuss some of our expectations, and of course to get input from you. These seminars grew out of the very positive response to other sessions we have run over the past several years with industry, covering areas such as Approvals and Precedents, and anti-money laundering. It also reflects a key learning from the global financial turmoil: there is a real need for regulators and financial institutions to focus on both the role of the Chief Risk Officer, and solid risk management practices. Industry and Regulatory change Like the Canadian banking sector, the Canadian life insurance industry has generally shown itself to be relatively prudent. Some mistakes have been made, as were made in the banking sector, but Canadian life companies entered the global market turmoil and recession with high levels of capital and relatively sound investment portfolios. Over the past 10 years, the Canadian life insurance industry has been significantly transformed. This transformation began with the process of demutualization, followed by a period of rapid consolidation. Moving from mutual companies to stock companies has created much more market pressure to perform well. Consolidation and expansion internationally in this period also led 1
to the creation of significantly larger companies that are much more complex to manage. Thus the role of CRO has become much more demanding. OSFI has also seen a significant change in its supervisory practices in the last 10 years. The way we supervise was completely overhauled beginning in 1999, with the adoption of risk based supervision. The International Association of Insurance Supervisors (IAIS) was also created around that time, and Canada has been a key player there from the start. In 10 years the IAIS has made up a lot of ground in terms of setting out sound practices in the life insurance industry, but the Basel Committee on Banking Supervision (BCBS) has an additional 20+ years under its belt, and in my view the IAIS needs to continue to push to raise the bar internationally. Also, in 2004 the industry itself formed a group called the CRO Forum. It is a risk management group focused on developing and promoting best practices in risk management. We see it as a good way for CROs to talk about the challenges they face, because while CROs are valued today, their advice may not be as valued when times are good again. The Forum has already enunciated a number of solid principles and they are worth re-discovering. If you re going to talk the talk, you ve got to walk the walk. OSFI Initiatives The G-20 Working Group 1 report (co-chaired by Tiff Macklem of the Canadian Department of Finance) recommended, among other things, that the regulatory and oversight framework should strive to treat similar institutions and activities consistently, with greater attention on functions and activities and less emphasis on legal status. The integrated approach that OSFI provides helps ensure that Canada is well placed to follow the G-20 Working Group recommendations. OSFI has expended considerable effort in its transformation to an integrated regulator but this process continues and remains challenging. This process involves ensuring that the same risks are treated equally, regardless of industry. Thus we look for the same rules, and the same oversight and management for the same types of risk. This process was aided by legislative changes in 1992 that ensured that, where possible, legislation applying to banks and life companies was identical. Much progress has been made in OSFI s supervisory activities as well. As an integrated regulator, today OSFI will send the same team of credit risk specialists into insurance companies as we do banks. Our market risk teams will look at market risk in both sectors, and our operational risk team will look at op risk in each sector as well. The same holds true for anti-money laundering, where the same teams do the same work in both banks and insurance companies. 2
In our quest to become more integrated, about four years ago we nominated one senior director to have responsibility for both bank conglomerates and life conglomerates. This helped ensure that one supervisory approach was used for both industries. Having a common supervisory approach in place has been important, but in early 2008 we decided to revert back to a system with two senior directors one specializing in banking, and one specializing in insurance. Having two senior directors will balance work load issues and some of the challenges of full integration. There are some differences between insurers and banks that do call for considerable specialization; the actuarial component is one such challenge. After a search process, we were pleased to have Gaetano Geretto join us in the fall of 2008 as the Senior Director of Life Insurance Conglomerates. Specialization at some levels allows us to see the merits of the various approaches to analyzing risk, while integration at other levels allows for robust discussion of these approaches. Stronger integration will continue to be a focus at the level of the Assistant Superintendents, and at the level of Senior Director, Capital (where capital rules for both banks and life companies are set). On the theme of integration, the banking industry likes to say it is different than the life insurance industry, and the life insurance industry likes to say it is different than banking. To a degree, that is true, but in many respects it is not. Every issue needs to be addressed with a balanced perspective, and while we are open to explanations of why you may be different, we are also going to be focused on why you might very well be the same. In this vein, I will quickly touch on a few areas that are important, whether you are a bank or life company, and where your approaches should be similar. Capital Both banks and life insurance companies need to understand their capital regime. The emphasis in banking is to have a robust internal capital adequacy assessment process, and banks should never be surprised at the impact of their business decisions on capital requirements. If a bank s capital is volatile, it usually means that it has a point in time methodology, versus a through-the-cycle methodology. A through-the-cycle methodology is the most appropriate, as it requires banks to base assumptions about the likelihood of default of a loan based on experience over a long time period, one that includes periods of stress. This adds an element of conservatism to a bank s approach to capital, which also 3
helps to mitigate procyclicality. If a life insurance company s capital is volatile, it likely means the life company has a large unmitigated segregated fund guarantee risk exposure, and uses an actuarial reserving method that amplifies any change in the overall requirements. As you know, in the fall of 2008, OSFI announced changes to the capital requirements for segregated fund guarantees. This substantially reduced the volatility in capital requirements that was otherwise present, through the use of an averaging formula for obligations payable in greater than five years. There will be more discussion of capital later in this session. This is warranted because one of the learnings of the financial turmoil (in both banking and insurance) is that people focused on how events might affect capital after those events happened, not before. Segregated Funds One important message we always pass on to both banks and life insurance companies is: know your risks. In the banking world, many global banks misunderstood the risks in structured products, which led to large write-offs. At the same time, many life insurance companies misunderstood the risk associated with segregated fund guarantees. Two points are worth noting in terms of segregated fund risk. First, unlike traditional insurance risk, segregated fund risk is non-diversifiable. As equity markets decline, the amount the insurer will have to pay out increases on every policy it doesn't increase on some policies and decrease on others. The implication of this is that a company cannot reduce its segregated fund risk by simply selling more policies (growing the business), as it might be able to do for life insurance. Selling more segregated fund policies does not reduce risk, it actually increases it, because when the markets decline all segregated fund policies get hit at the same time. The more non-diversifiable risk a life company holds the more attention it needs to pay to risk management and capital. Unlike the complex structured products that global banks had, life companies have more time to adjust and plan for segregated fund guarantees that may have to be paid, as guarantees do not come due for many years. The second point about segregated fund risk is whether segregated fund guarantee products are like defined benefit pension plans, and whether they can be managed in the same way as a pension sponsor manages defined benefit pension plans. 4
We would say pensions and segregated funds are very different. While segregated fund guarantee products may have some features that make the product pension-like for the consumer, the crucial difference is that defined benefit pensions do not depend on the performance of stock markets; in particular, workers and retirees do not get a better pension if stock markets perform well. Put another way, as opposed to pensions, the segregated fund guarantee business has two unknowns: (1) the liabilities are not fully known (liabilities change with market movements as well as when resets are built into the product), and (2) the cost of funding the liabilities, as in pensions, can be variable depending on whether hedging is used and how premiums are invested. This is a potentially troubling double whammy. Given the risks that have become apparent with segregated fund guarantees, OSFI expects companies to fully analyze this business and take necessary steps to manage the associated risk. Steps should include things such as changes to product features, slowing growth in the product line, making sure that valuation assumptions are consistent with the intent of capital rules (to hold capital for unexpected events), and hedging or other types of risk mitigation, including reinsurance. Governance As in banking, governance and risk management of life companies is extremely important, and companies must constantly be assessing how well situated they are, and where their weaknesses exist. The global banking industry has acknowledged that CROs should have been more front-and-centre at their firms. As a result of the global financial turmoil, most banks have made changes to ensure that CROs now report directly to the CEO. The status and visibility of CROs within a firm is important both with the CEO and the board. Many life companies are following suit and this is a development that I encourage. The global banking industry has also agreed that banks must do a much better job of defining their risk appetite, and that boards must be much more involved in approving and monitoring compliance with that risk appetite. The same holds true for the insurance industry. Boards and the senior management of life companies have a long history of stress testing, or Dynamic Capital Adequacy Testing (DCATs) as you call it in the life industry. The Basel Committee recently issued principles for sound stress 5
testing that are focused on risk management. The principles include new concepts such as reverse stress testing. In this regard, as noted by the Basel Committee, stress tests should feature a range of severities, including events capable of generating the most damage whether through size of loss or through loss of reputation. A stress testing program should also determine what scenarios could challenge the viability of the bank and thereby uncover hidden risks and interactions among risks. For an integrated regulator like OSFI, these banking principles are not only important for the banks; they are just as relevant for life insurance companies. In a recent speech on the topic of governance, I suggested that institutions should consider adding risk management expertise to their boards, as well as insurance expertise. As boards change, your role as CROs will change. Having people who truly understand risk management on the board will likely lead to deeper board discussions, which is never a bad thing. Some months ago I read an article in which Nouriel Roubini the bear of bears commented that it might be a good idea for boards or senior management to include a financial historian. The value of financial history has probably been under-estimated over the years. Indeed, whenever I hear people say that the events of the past few years were unprecedented and no one really thought they could happen, I think of the financial historians who point out that the same events have happened in the past. Stock markets have plummeted, banking systems have collapsed, and you do not need to go back as far as 1929 to see this. As CROs you might think about adding such expertise to your team, or having access to such expertise. Conclusion My main messages today are: As CROs you have an incredibly important role to play, and a difficult role. Seminars like these are designed to assist you in that role and we hope you will consider it time well spent. Capital is critical. It is important to understand capital drivers, as well as to focus on whether capital is representative of the risk. Companies must constantly be focused on how well situated they are. Defining your risk appetite, and expanding your scenario testing, are extremely important. 6
Pay attention to your segregated fund guarantees. The more nondiversifiable risk a life company holds, the more attention it needs to pay to risk management and capital. Thank you. 7