Although the International Monetary Fund (IMF) has given the industry good grades, the Office of the Superintendent of Financial Institutions (OSFI) has urged insurers and reinsurers not to rest on their laurels. The increase in long-term interest rates could be hiding other dangers.

According to data from the Bank of Canada, long-term interest rates have bounced back nicely. The ten-year rate for Canadian government bonds was 1.84% on April 1 last year, compared to the 2.50% they were offering on the same date this year.

Of even more importance to insurers, long term Canadian government bonds rates (i.e., beyond ten years) reached 3.01% on April 1, 2014 compared to 2.49% a year ago at the same time. This is quite an increase compared to the 2.20% that these bonds were paying on July 24, 2012.

As for the International Monetary Fund (IMF), it praised the insurance industry in a recent audit it conducted of Canadian regulatory rigour and discipline. The results of the IMF’s Canadian financial sector assessment program were released in March and showed the industry in a positive light.

Reduced vulnerability

Overall, the IMF praised the prudence displayed by both Canadian insurers and the Office of the Superintendent of Financial Institutions (OSFI). In a technical note on the impact low interest rates have had or may have on Canadian insurers, IMF insurance industry expert Ian Tower highlighted the efforts they have made to mitigate this risk. In an analysis of the three largest insurers’ results (Manulife Financial, the three life subsidiaries of Great-West Lifeco, and Sun Life Financial), the IMF noted that by taking this decline in interest rates into account, insurers have actually reduced their vulnerability to its lowest level since 2009. They accomplished this by, among other things, hedging their risks.

According to this analysis of the three big players, the steps they have taken should allow insurers to repair their balance sheets as and when rates increase. In particular, the overall Minimum Continuing Capital and Surplus Requirements (MCCSR) for the three insurers could increase from about 215% to 300% by 2017.

Tower pointed out, however, that there are risks in the Canadian market. The IMF notes that Canadian insurers are particularly exposed to fluctuations in interest rates because of long-term products such as whole and universal life insurance. “Life companies have sold many permanent life insurance policies having cash values supported by guaranteed rates. Certain annuities, long term care and segregated fund products…have created equity as well as interest-rate exposure,” writes Tower. He notes that several of these products remain available in the Canadian market, even though their prices have increased.

Tower also says that the risks arising from these long-term products cannot be matched to financial instruments of sufficiently long duration. “The long term nature of Canadian policies is not matched by longer term available assets. The longest duration instruments issued by the Government of Canada are 30-year bonds. Some provincial government issues have been made at longer than 30 year maturities, but in limited amounts. Corporate debt instruments do not extend to 30 years,” he writes.

Aware of these risks, OSFI superintendent Julie Dickson is keeping a cool head and avoiding complacency. In a speech at the 58th Annual Canadian Reinsurance Conference in Toronto on April 2, she said that Canadian regulators will remain vigilant. Dickson also encouraged insurance and reinsurance companies not to think of the crisis as a thing of the past. They should not believe that the economic situation has returned to normal.

“In reality, the current environment is far from normal,” said Dickson in her speech. “While we appear to be at the start of a normalization process, interest rates are still at historically low levels, the Federal Reserve must deal with its $4 trillion balance sheet and unwind Quantitative Easing (a few other central banks have similar challenges), growth in several advanced economies is still not at pre-crisis levels and, while the base case is for improvement, tail risks remain.”

Disaggregated data collected by the Bank of Canada prove her right. The 3.01% mark achieved by long-term bonds on April 1 remains below the post-crisis peak rate of 4.30% that these bonds were paying on Nov. 13, 2008. It also remains below the 3.33% average rate that these same bonds were paying between April 1, 2008 and April 1, 2014.

Uncertain times

Dickson is urging all industry stakeholders to reflect on how best to deal with these uncertain times, which is something she has done herself. “A whole lot of reflection has been going on regarding the global financial crisis, the huge impact it has had on global growth, whether we have re-wired enough in response, or too much, and lastly whether we are ready to resurge,” she said.

Dickson also noted that Canada emerged from the crisis in better condition than many other countries did. “As we at OSFI reflect on that, we continue to say that past success does not guarantee future success. OSFI and Canadian banks and insurance companies need to avoid complacency,” she warned.

She is pleased OSFI fared well in the IMF’s financial sector assessment. “The assessors were asked to look for any signs of complacency at OSFI. I am happy to say that they did not find any. They have concluded that we continue to be effective with a high level of compliance with international standards,” she said.

She believes the report also highlights the fact that OSFI’s strict supervision served Canada well during the financial crisis. “The FSAP team also noted that stress tests recently conducted show that major financial institutions would continue to be resilient to credit, liquidity, and contagion risks arising from a severe stress scenario,” commented Dickson.

However, she continued to insist on caution throughout her speech. As for insurers’ good stress test results, she had this warning: “I think it is very important, however, not to rest on laurels because the bar is constantly rising. So, we continue to seek information on what others are doing and how we compare.” As a result, OSFI continues to gather information and compare its actions with the measures taken by regulators around the world.

After having questioned the relevance of introducing the International Financial Reporting Standards (IFRS) rules for insurance contract this fall as they are currently written, Dickson was more willing to accommodate international regulators as far as capital requirements and solvency are concerned. “OSFI tends to strongly support global standards and practices, versus entering into endless debates about whether we need them,” she commented. She also welcomed the risk management culture that has developed worldwide.

OSFI certainly has plenty of food for thought. Despite the kind words it had for the Canadian regulator, the IMF still drew up a list of priorities for OSFI.

To deal with the difficulty of matching assets and liabilities, insurers may increasingly turn to higher yielding securities or non-traditional investments such as infrastructure. This being the case, the IMF suggests OSFI “improve its capacity to monitor any such increased investment in practice and the risks it may entail by collecting more information on the duration of investments and on actual returns.”

The IMF also says the Canadian regulator should consider revising its prudent management guidelines and increase requirements so that institutions can “invest only in assets whose risks it can properly assess and manage and on investments in complex or less transparent forms of instruments.”

In addition, The IMF is calling on OSFI to further develop regulatory measures to assist in its “micro-prudential” mandate for insurance. According to the IMF, these customized stress tests for insurers should continue to be a key element for OSFI to use when deciding on a course of action. Such measures could include limits on high-risk activities or additional provisions such as “counter-cyclical” capital requirements. They should also include liquidity reserves, the IMF added.

In her speech to re-insurers, Julie Dickson indicated that she intends to regulate with caution. “We must all absorb and apply the lessons learned from the financial crisis. We must adjust to changing times. We need to take care, when designing new rules, to do no harm. And in resurging, we need to keep an eye on new risks,” she said.