Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the Northwind Professional Institute 2008 Life Insurance Invitational Forum Cambridge, Ontario Thursday, November 13, 2008 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 Langdon Hall Life Insurance Forum Cambridge, Ontario November 13, 2008 Managing Risk in the Life Industry Global Financial Events This has been a challenging period for all of us regulators, financial institutions, and all Canadians, especially those with investments and pension plans. While Canada has benefited from a resilient financial sector, the events of the past few months have been difficult to experience, and extremely demanding if you have been in the midst of it all, as many of you have been. Extraordinary events call for extraordinary action and that is what we have seen on the part of governments around the world, and the situation continues to be challenging. One of the current challenges is determining how best to respond to some aspects of these unprecedented events. Obviously it will lead to a lot of soul searching internationally about the nature of regulation, and incentives in the financial services sector. World leaders are discussing the topic, the Financial Stability Forum (FSF) has made its recommendations, and more will be said on the issue. In recent weeks, a number of statements have been made internationally, such as assessing whether principles-based regulation makes sense (UK) and the need for a new global financial architecture (some European leaders). It could take time to sort out the future of regulation, but in the short-term OSFI is focused on what needs to be done now, and we will continue to build on what we have done in the past, while rapidly incorporating new lessons learned along the way. As has been often noted, the Canadian financial system went into the turmoil very well capitalized, and this is helping it deal with these uncertain times. But the situation is indeed serious, and that is one reason why OSFI recently acted to ensure that banks and life companies with normal course issuer bids did not execute share buy-backs without first clearing it with OSFI. It is important that capital be conservatively managed in these very difficult times. 1
It is also why we announced this week that we would provide added flexibility for financial institutions to issue high quality preferred shares, and have those shares included in Tier 1 capital. A lot of past decisions made in Canada have served the system well (for example, high capital targets, attention to quality of capital, and the leverage ratio in the banking industry). At the same time, a lot of previously held assumptions have been turned upside down, and it is clear that all regulators have a lot of thinking to do, as do financial institutions. I would also stress that, while we do this thinking, the ground is shifting in ways that are hard to predict, and considerable vigilance is required. The first lesson is capital, capital, capital. We have seen recently how strong capital cushions in Canada have paid off to the benefit of our institutions and overall financial system. With the new found appreciation for capital, everyone is asking what capital level is enough, particularly in the banking sector, which has been in the eye of the storm. While it is difficult to do a comparison of capital ratios across global life companies (due to differences in nomenclature and approach), it is easier to do in the banking sector, and that has been the focus of much attention. What we see in a comparison of international banks against Canadian banks is that our big five banks went into the turmoil with high capital levels (and we would say the same about life companies). Bank Tier 1 ratios at Q3 2008 ranged from 9.47 per cent to 9.81 per cent. This compared to Tier 1 ratios at other global banks that often started with the digits 6, 7 and 8 (versus 9 in Canada). If you look at what is contained in Tier 1 -- as they say, never judge a book by its cover -- you will find that Canadian banks have platinum quality Tier 1 when compared to banks in other countries. The percentage of common shares is skyhigh, something not replicated in other places around the world. Capital injections from governments into other global banks have tended to be in preferred shares (and sometimes preferred shares with step-ups or incentives to redeem that detract from their permanence, and permanence is a critical element for OSFI to consider something as Tier 1 capital). Canadian bank Tier 1 common ratios at Q3 2008 tended to be in the high 7s or low 8s. Elsewhere in the world the ratios were typically 5, 6, and low 7s. To summarize, quality, and level of capital, are equally important and the market needs to focus on that. Going forward, there is going to be an incredible amount of attention paid by regulators internationally on the level and quality of capital. I believe Canada is well placed to enter those discussions. I also think that decisions will likely only be taken once world economies strengthen, and financial institutions will be given plenty of advance notice regarding new requirements. 2
Life Insurance Capital In the life insurance sector, capital is also key. Recent events have shown us that existing life insurance capital models for segregated (seg) fund products need to be more closely aligned with Basel 2 approaches. In short, Basel 2 approaches tend to be based on through-the-cycle measures versus point-intime measures, so the capital requirements in banking are less volatile, but still generally representative of the risk. Life insurance company seg fund models were based more on point-in-time measures, which led to highly volatile capital levels as well as sharp increases in capital now for obligations that were not due for many years. This was behind our October 28, 2008, decision to change requirements for the capital models of seg fund products. Now you might ask, why were life company seg fund capital models so sensitive to market movements? Don t actuaries, the creators of such models, always think long term? I think the answer is that actuaries were indeed focused on the long term, and in the long term the models made sense, but in the short term the results made less sense. Some of the different approaches in the banking and life industries call for more discussion as to why such differences in approach exist and whether they should continue. There has been considerable discussion of permitting more modelsbased approaches for regulatory capital purposes in the life insurance industry, and OSFI had released a vision paper to set the stage. That said, I think we need to pause and re-think the timetable for adopting more advanced approaches in the life industry. This reflects three things: Not all companies have the same appetite for such approaches and you need a critical mass to get good data sets and model comparability; It is best to see the current cycle through before making major changes to Minimum Continuing Capital and Surplus Requirements (MCCSR); and We need a better balance between long-term thinking and short-term thinking, which is likely to involve looking more at banking and insurance experience and taking the best of both. While OSFI is slowing down the move to advanced Pillar 1 Basel-like capital approaches in the life industry, I do not think it is appropriate to slow down the other two Basel pillars in the insurance industry: Pillar 2 and Pillar 3. 3
Pillar 3 is all about disclosure and transparency. Shedding additional light on these issues will encourage better risk management. Sunlight is a great disinfectant and I think it encourages good risk management. Additional disclosures in the banking industry as a result of Financial Services Forum (FSF) recommendations while not huge in Canada because so much information was already disclosed enhanced the ability of analysts to assess risk at a crucial time. What we have seen is that removing some of the mystery has really paid off. With life insurance, we have the same objective. A few years ago we required disclosure of earnings by source of gain and loss, and that proved highly successful in terms of shining light on important drivers in insurance companies. I think the spotlight now needs to move to internal models and actuarial assumptions, as more disclosure would help analysts and investors assess company health. Going forward we will look at various options for increased disclosure. Pillar 2 is all about risk management. A clear lesson coming out of the financial turmoil is how important it is for banks and life companies to have rock-solid risk management. As a regulator we are often looking from the outside in we see the business after it is put on the books. We do have a lot of corrective powers, but we are not making the day-to-day business decisions, or creating the business culture within the institution. Thus, the first line of defense when it comes to safety and soundness is the bank or life company itself the business lines and the control functions, the Chief Risk Officer, internal audit, compliance, among others. Recent public reports by the global banking industry itself have laid out the weaknesses that prevailed in some of the largest global banks. These industry reports are essential reading for all financial institutions, and I have discussed the reports with the Chief Executive Officers (CEOs) of the largest Canadian banks. Many aspects of these reports are equally appropriate to the life insurance industry. All institutions need to determine whether they have weaknesses in any relevant areas, or, even if they are currently well positioned, whether they are positioned to meet future challenges. The triggers for disturbances and shocks are not easy to identify, but if controls and risk management are robust, the ability to deal with such events is greatly improved. We are seeing this now. 4
OSFI Focus The themes in two recent industry reports, the Institute of International Finance (IIF) report, released on July 17, 2008 and the Counterparty Risk Management Policy Group (CRMPG) III report, released on Aug 6, 2008, are similar. The reports are voluminous, but they contain several items worth noting for both banks and insurance companies. Companies need to take a good look at their investment in risk management and control functions. OSFI has always watched for any cost-cutting by financial institutions in these areas, but throwing more resources at a function does not mean that it will be more effective. The reports suggest that you need to critically assess both whether you are spending enough, and how you are utilizing your fire-power. Chief Risk Officers should periodically commission a review and assessment of the institution s investment in risk management, for presentation to the senior management and the board. This should not happen only after a big problem has occurred; it should happen as part of the normal course of business. Large institutions should be able to monitor material positions and risk exposures at all times and collect this information in a matter of hours. Institutions need to do more analysis of concentrations and correlations among exposures. This is all about aggregating your exposures, and when I refer to correlations, it does not mean for the purpose of getting a capital reduction. Firms should periodically conduct comprehensive exercises aimed at estimating risk appetite. Most financial institutions like to tell OSFI what their risk appetite is but knowing what your risk appetite actually is, is not a trivial exercise. Product approval processes need to be monitored, both before and after introduction, as products can morph and change their risk profiles over time. This clearly happened with structured credit and in products that have been offered by the insurance industry. Silos and failure to communicate across the firm have to be avoided. OSFI is especially able to ferret this out after the fact where a contributing factor to a problem can often be the failure of key functions within an institution to communicate. Given the importance these industry reports place on the issues I mentioned, OSFI will be focusing more and more of our supervisory attention in these areas. 5
Stress Testing A special comment on stress testing is warranted. Stress testing continues to require constant attention. At OSFI, we have typically held the view that life companies are used to doing stress testing and are relatively good at it. But the Dynamic Capital Adequacy Testing (DCAT) report only serves its purpose if management and the board discuss it and act upon it. We have seen lots of improvement in this area in the past few years, but more needs to be done. There may be value in the use of some standard scenarios to be applied by all insurers, in addition to the judgment-based scenarios already selected by the Appointed Actuary (AA). Currently, an issue we face is the variety of ways in which AAs create common scenarios (such as economic downturn scenarios). OSFI is considering some standard DCAT scenarios, so that certain scenarios across the industry are built with significant rigor. Our goal is not to take away from the AA s responsibility for creating scenarios of importance to the insurer. A side benefit of standard scenarios is that we can better assess system-wide risk. Accounting Much has happened in the accounting world in last few months. The biggest announcement is the guidance on Fair Value (FV) in illiquid markets, or more specifically, the statement that a good deal of judgment (or common sense) can be used to calculate FVs. Some are claiming victory and saying that FV has been suspended. The standard setters are saying that the flexibility on valuation was there all along, and recent moves to allow assets to be valued using judgment are simply a clarification of what was already there. For my part, I am particularly glad to see the guidance on FV because many regulators were of the view that guidance was needed. I think the fact that it took several months for the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) to issue the guidance demonstrated the complexity of the matter. I think it also suggests that FV accounting was put into place without enough consideration of the impact it would have in illiquid markets. But, to be fair, I do not think anyone expected markets like these. 6
I also think investors see merit in a methodology that arrives at values that uses judgment and consideration of all factors to arrive at values that are defensible and reasonable. The changes OSFI made to the seg fund guarantee capital requirements reflected the same thinking the need for something that stands up to evaluation and is reasonable. In the real world you want capital rules that are representative of the risk, and are stabilizing, not destabilizing. OSFI has similar concerns in the pension world, where funding requirements for pension plans are being partly driven by point-in-time interest rates versus longterm historical or prospective averages. This is by virtue of the commuted value standard, which is set by an independent standard-setter, and which is currently under review. It was, and is, incredibly difficult as a regulator to manage in a system of extremely volatile pension funding requirements. And it is incredibly difficult for companies with defined benefit pension plans when requirements shoot up, and then back down, based on monthly movements in long-term interest rates. It is equally difficult with equity markets that are extremely volatile (although the latter cannot be addressed by the Commuted Value Standard). I would note that when it comes to pension funding, the regulations already allow some averaging of pension fund assets over a five year period so that you do not have to take the values of assets on a particular day. However, under OSFI guidance, when you use the averaging method, values should not exceed the market by more than 10 per cent. This is an example of reasonableness that is already built into the pension funding system, and the issue that is being looked at is whether more needs to be done. None of this should be construed as me saying that we should not take into account real world events when calculating FVs, or setting capital requirements, or pension funding requirements. Rather, we need to be conscious of the fact that markets can overshoot, markets can be extremely volatile, and that point-intime measures tell you something, but they are not the whole story. Point-in-time measures may reflect transitory phenomenon, or and this is important they may be an early warning that a new world has arrived, bubbles have burst, and that things might not return to normal quickly (or the new normal may not be what we are used to). The latter scenario cannot be ignored; in short, a balancing of these risks is required. 7
Conclusion In conclusion, I have talked about three major issues: 1. Capital in the banking industry: A comparison of capital levels at Canadian banks with global counterparts indicates that Canadian banks remain very well capitalized, even though many global banks have had capital injections from governments. Common equity ratios of the big six banks are particularly high. 2. Capital and risk management in the insurance industry: It is prudent to take more time to develop Pillar 1 Basel 2 type capital approaches in insurance; however, we will not delay Pillars 2 and 3, given the focus on risk management, stress testing, and disclosure, which is a foundation for capital. 3. Point-in-time measures: Developments of late have shown that narrow pointin-time approaches to capital, accounting and even pensions may not be desirable in the financial sector. It is clear that the global financial system is experiencing extraordinary stress, although the spate of measures announced by governments worldwide is helping. Prudence, strong planning, risk management and an element of reasonableness are the key to successfully coming out the other side of this market. Thank you. 8