New seg fund capital requirements shake the market

par Mathew Kokas | August 20 2000 08:58PM

The entire segregated fund industry is preparing for the imminent announcement by the Office of the Superintendent of Financial Institutions (OSFI) imposing new minimum capital requirements on segregated funds. It isn’t a matter of ‘if’ they are coming, but of ‘when’ and these expected changes are already making waves. Two companies have recently bailed out of the market and reinsurance is practically unavailable.

Insurers expect the capital risk requirements model developed by the Canadian Institute of Actuaries (CIA) to be adopted as presented. The model was submitted to OFSI, said Murray Taylor, Chair of the CIA Task Force On Segregated Fund Investment Guarantees. Even though it is technically still a draft, because it has to be translated and approved by the board, he said he does not expect any changes to be made to the model itself.

He couldn’t say whether or not it will pass as is, but he said OFSI has expressed support for the structure, the methodology, and appreciation for the work. It will still be up to the regulators to determine if the capital requirements are adequate or not, he added. Although OSFI’s announcement will be made before the end of the year, there is no word on how quickly the new regulations will be phased in. It could be anywhere from one month to three years.

Getting out

For some companies the expected capital requirements will be too high, and for others, not enough. For Allianz Life of Canada and AIG Life of Canada, the pricing has already gone up too much, or is expected to go up too far for them to have stayed in the market.

Allianz Life, and consequently its partner, Templeton, discontinued the sale of new purchases at the end of last February. Tim Hague, Vice-President of Marketing with Templeton said the decision was because Allianz is of the view that the new requirements would have too big of an impact on pricing. “The decision was theirs. The contracts are their products,” stated Mr. Hague.

Templeton may be seeking another insurer subject to the regulations and pricing. “It’s an attractive market,” said Mr. Hague. He added, however, that Templeton would probably seek a new insurance partner, as getting back into the seg fund market is not on the list of Allianz’ priorities.

More recently, AIG Life of Canada and its distribution partner, Trimark, also closed its line of 23 segregated funds to new investors as of July 31, 2000. Oliver Murray, Executive Vice-President at Trimark, said the decision to leave the seg fund market was made jointly with its life insurer because the cost of reinsurance was too high due to the proposed capital requirements.

Mr. Murray said he was very pleased with the roll-out of the seg funds in June of 1998, and extremely pleased with the relationships made with the distribution channels, but the cost of reinsurance was a problem.

Trimark had a two-year agreement with a reinsurer that expired, said Mr. Murray. Trimark was unsuccessful in finding another that was willing to take on the extra risk. “The whole marketplace has dried up,” he said. “Prices are all over the map,” he continued, “and many reinsurance companies have abandoned the market. . . . So we decided, with AIG, that it was prudent to not sell [seg funds] at this time.”

He added that the company was very disappointed that it had to exit the market at this time and said he hopes Trimark will be able to return, “but that will depend on what the impact of the OFSI regulations will be on the capital requirements.” He also added that pulling out of seg funds now had nothing to do with the Amvescap purchase of Trimark. “It is unfortunate that this is happening at the same time.”

Could bailing out of seg funds this early in the game be a form of protest against the proposed guidelines? Not according to Peter McCarthy, President and CEO of AIG. “The main concern is meeting the profitability requirements,” he said. “With the addition of capital that may be required… we would not be able to meet the profitability requirement of 15% that we have on all our products.” He added: “The issue isn’t the capital, it is how to best use that capital.”

Both Mr. Murray and Mr. McCarthy said that they might get back into seg funds once the guidelines have been reviewed and the market stabilizes.

Reinsurers are out

Many reinsurance companies tried to enter the market, said Alan Ryder, President of the Life Division of Employers Reinsurance, “but they basically failed.” Now all the reinsurers have left the market, he continued. “We are technically the only ones still in the market but our prices are too high [for the insurers]. Our prices have always been high but they got higher in the past two years. Two years ago the marketplace was heavily reinsured but now not at all.” The reason for the increase in Employer’s prices, he said, is because the capital market conditions have become a lot more volatile over the last three years.

“There is too much unknown risk,” agreed Emile Elefteriadis Assistant Vice-President of Actuarial Services with Swiss Re, “and the marketplace is unwilling to pay a realistic cost.”

Mr. Elefteriadis said Swiss Re recently exited the market but maintains a small seg fund portfolio. He had no comment on whether or not Swiss Re would re-enter the market if the new capital requirements were to push up prices enough to make reinsurance viable once again.

“There are too many companies running their own risk… and the pricing is too low,” added Mr. Ryder. “Those companies running the risk on their own have a lot of risk. They risk extreme financial pain… They say third party hedging is too expensive, but I say that the product is too cheap.” Hedging is a strategy used to reduce possible losses by investing in options and other vehicles that safeguard against market downturns.

He continued: “any company running the risk which is not hedged is facing the Japan Nikkei meltdown situation. The Nikkei is 60% of what is was 10 years ago.”

He further explained that the capital requirements are not actually that important for Employers Re because of the hedging model used. The type of hedging used he said has a significant impact on the capital required and he hopes that OSFI will recognize this fact when it releases the requirements. “Our pricing will largely depend on how much credit is given to the type of hedging strategy,” he said. He added that there are a number of companies that do not hedge but take on the risk themselves and this is OSFI’s real concern.

A concern: edging

The other concern, he continued, is the type of hedging. The two main models are called dynamic and third-party hedging. Dynamic hedging, he explained, is an internal hedging method and third-party hedging involves going to an investment bank. He said the main differences are that third-party hedging carries a lot less risk but is significantly more costly. Furthermore, dynamic hedging, he said, is unproven. It requires sophisticated models and constant attention everyday and relies on the fund manager to watch the market. Third-party hedging, he said, is basically a promise that when the market goes down, they will get the money to cover the losses. The funds in this case are indexed-based, eliminating the active fund management element.

Mr. Taylor explained that the CIA’s proposed model does, among other things, take into consideration the risk of the fund and the type of hedging. The risk includes the type of guarantee, 75% vs. 100%, reset options, level of fees, etc, and the type of investment (high-risk equity funds vs. bond funds). As for hedging, dynamic hedging gets partial credit, he said, whereas reinsuring the product gets 100% credit. Reinsuring part of the risk will get 100% credit for the part covered.

Although companies have exited the market because of pricing uncertainty, Jeff Carrique, Vice-President of Segregated Fund Marketing with AIC, said this is not where the whole industry is going. “There will be upward pressure on prices,” he predicts, “but from our perspective we are planning to stay.”

Other companies are not only planning to stay, but said there will be little impact on pricing. “We support this CIA task force and its recommendations,” said George Turpie, Director of Product Development, Individual and Investment Services, with Great-West. “Our guarantees have been designed with the inherent risk of the product in mind and in anticipation that capital requirements would be put in place before long. Assuming OSFI adopts these recommendations without significant change, then we have no plans to withdraw our segregated fund product.”

Mark Tiffin, Vice-president, Marketing for Mackenzie Financial Services, said that the prospects for Mackenzie are very good because Great-West is very experienced, and the whole structure and design of the product was built in anticipation of these changes. He added that he even expects demand for seg funds to go up given that competitors have left the market.

Under review

Other companies are seriously reviewing their product designs to reduce the capital risk they may pose. George Foegele, President and CEO of Transamerica Canada, said the company is reviewing all of its products. The resulting changes, he said, will give the consumer more choice and products will be more specialized to meet the needs of the consumer. Transamerica also plans to look for additional seg fund distribution partners, added Mr. Foegele.

Peter Anderson, President of C.I. Mutual Funds, said the company is reviewing all its seg fund products with Transamerica. He said a decision on which products will be offered will be made shortly, but C.I. is planning to stay in seg funds assuming the proposed capital requirements go through without significant changes.

Ted Moffatt, Vice-President of Retail Administrative Services with Maritime Life, feels that the risk of a market downturn is not so great because the funds do not come to maturity on the same date; they are spread over a 40-year period. In addition, not all funds are as risky as others. Some funds have a reset option and others do not. He said that Maritime has been putting away sufficient capital so that if the proposed requirements go through, then the pricing will not be much different. He added that the original OSFI requirements started out too high but the CIA model now proposes an acceptable rate.

While a spokesperson for Dynamic Mutual Funds said the company is seriously considering whether or not it will keep its lines of segregated and life-protected funds, its insurer, Hartford Life Insurance of Canada, is planning to expand its product line with seven new seg funds. Dave Potter, Director of Public Relations for the parent company, Hartford Life and Accident Insurance US, said the pricing of the new funds, to be released before the end of the first quarter 2001, are designed for the Canadian market and take into consideration the potential new capital requirements. The company, he said, is typically conservative when it comes to pricing and setting aside capital. He added that the new regulations are not expected to affect the rollout of the funds or the relationship with Dynamic.