Ottawa urges insurers to fatten segregated fund reserves… again!

By Alain Thériault | October 19 2005 02:39PM

Five years after insisting that segregated fund suppliers radically restock their reserves, the Office of the Superintendent of Financial Institutions (OSFI) is now poised to tighten the screws. In fact, OSFI has no other options: its model was mangled by the stock turbulence of the new millennium. Worse yet, the Office admits it botched its calculations.

Who could resist an investment product that offers roughly the same returns as mutual funds without the risks? A product that guarantees the investor’s capital should the market crash, and that lets investors hoist the guarantee in the future? These arguments won over hordes to segregated funds in the ‘90s. Investors were regaled with guarantees that sometimes exceeded 100% of deposits, at death and at maturity of the investment. The institutions imagined that this growth would last forever.

But optimism has a cost. At the turn of the millennium, the regulatory authorities urged the industry to better capitalize these lofty promises, in case markets stalled. The new requirements sent management expense ratios (MERs) of many segregated funds skyrocketing.

But it’s still not enough says OSFI. In a letter sent in the spring, the federal body invited life insurers to submit their views of the proposed new requirements, which it plans to apply by the end of the year.

The OSFI letter was sent to “relevant industry associations,” and discussed a “draft revision of the capital requirement for segregated fund guarantee risk.”

In a summary attached to the letter, the Office defined the problem: “The factors contained in the current requirement were calibrated to the returns of the Toronto Stock Exchange Index between 1956 and 1999. Thus, they reflect the large increase in stock prices that occurred from 1996 to 1999, but do not reflect the subsequent declines that occurred in 2000 and after. Since higher stock returns decrease the likelihood that a company will be required to make a payment under an investment guarantee, the calculation underestimates the capital required.”

OSFI went on to say that: “In addition, an error has been identified in the margin offset adjustment (factor D). The table for this factor was constructed based on the issue date of a contract instead of the time remaining to maturity. This error could lead to required capital being further underestimated.”

Apparently, OSFI will use an electronic solution to resolve this complex technical problem. “The factors in the revised Section have been updated to reflect recent market experience, and to correct an error in the margin offset adjustment. At the same time, the format of the requirement has been changed: there is now a specific factor for each combination of policy characteristics. Because the factors in the new requirement are more numerous, they have been placed in an electronic database,” the letter reads.

Even the most experienced observers commented on the ongoing process sparingly. “It’s a very, very complex issue,” William Pargeans, senior financial analyst at A.M. Best told The Insurance Journal.

Insurance monitoring specialist, A.M. Best, is watching the process from a distance. “It’s difficult for us to make any general assessment for all companies because this issue will be resolved on a case by case basis,” Mr. Pargeans continued.

He foresees only a minor effect on the industry. “We think that the highest rated companies are well positioned to handle these changes. And smaller companies don’t have much exposure to that type of risk.”

Mr. Pargeans added that the change to the capital requirements for seg funds may lower the Minimum Continuing Capital and Surplus Requirements (MCCSR) by three or four basis points.

OSFI created the MCCSR measurement, comparable to a liquidity ratio, to gauge the financial health of life insurers operating in Canada. For several years, this ratio has been averaging above 200% for the entire Canadian life and health insurance industry.

“The MCCSR is already strong in the Canadian industry. We’re expecting nothing bad for solvency. But if it is, we will react,” Mr. Pargeans confirmed.

When the new rules for seg fund capitalization were introduced in 2000, The Insurance Journal reported a generalized downturn of 5% in the MCCSR.

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