The Regulatory Impact on Insurance Companies and the Products They - PowerPoint PPT Presentation

The Regulatory Impact on Insurance Companies and the Products They Offer January 31, 2013 Ottawa

OSFI and the “Third Pillar”

Principals of Regulation • Pillar 1: Required balance sheet ratios – Common, Tier 1 and Tier 2 capital for banks – MCCSR for insurance companies – No clear guidelines for insurance holding companies • Pillar 2: Prudential regulation – Risk management – “Soft” issues • Pillar 3: Market discipline – Require disclosure so market can evaluate company

Communication • For market forces to operate effectively, it must be aware of potential regulatory changes. – Consultations – Comments – Rationale for decisions

OSFI’s Failure • OSFI does not publish comments on its initiatives • OSFI does not sponsor or publish academic research (slight exception is actuarial calibration of return expectations) • OSFI provides exemptions to rules (e.g., Assets-to- Capital multiple) without public rationale • OSFI hurriedly changed rules during crisis (MFC) • Latest attempt at rationalizing a decision (Equity Mean Reversion) was an utter failure

OSFI Paper Mean Reversion in Equity Prices

Equity Mean Reversion (EMR) • When equity markets decline, are they more likely to rise? Or is the probability that they will increase “state-invariant”? • Important for insurance companies because of segregated fund guarantees • Impacts the amount of capital that insurer must hold to cover the potential cost of making good the guarantee

OSFI Paper: March 2012 “The paper “Evidence for Mean Reversion in Equity Prices” accompanying this letter explains the rationale behind OSFI’s decision. It is being released so that industry participants and other stakeholders can better understand OSFI’s views on this subject.” http://www.osfi-bsif.gc.ca/app/DocRepository/1/eng/notices/osfi/ mnrv_let_e.pdf

Fallacious Arguments • EMR violates Efficient Markets Hypothesis – There is no contradiction at the universe level • Economic Growth not mean reverting; equity performance linked to economic growth – Benefits of growth go to innovators • High cost of long-term puts shows market view on trends – Long term options are priced on cost of hedging

Lapses in Rigour • The model severely criticizes the “Drawdown Model”, but does not mention prior academic examination of this model. • There is an attempt at “Disproof by Counterexample” citing the Great Depression, the Internet Bubble and the Japanese Bubble, but no statistical analysis. • Existing actuarial calibration not discussed • Eight references: one to the Drawdown Model and seven dated 1993 or earlier

No Concern Regarding Cost • Risks of being undercapitalized are discussed, but not the cost of overcapitalization

Conclusions for Investors • OSFI should be lauded for communicating the rationale for its decision, but the rationale itself is extremely disappointing • OSFI paper is grossly inadequate as a basis for the formulation of public policy

OSFI Position “Low Trigger” Contingent Capital

What is Contingent Capital? • Contingent Capital is a Financial Instrument that behaves like debt during good times, but provides benefits to the company when things go wrong – Conversion of debt-like instruments to equity – Automatic write-downs – Insurance payouts • Replacement for non-common equity Tier 1 Capital, which was found to be deficient during the Panic of 2007

Critical Elements • Trigger Event – “High Trigger” CoCos convert relatively early in the deterioration of a bank’s health, e.g. when Tier 1 Capital falls below 7% (European standard) – “Low Trigger” issues convert later, perhaps at the point of non-viability • Conversion Price – Death Spirals a concern

OSFI’s Introduction • First notice to Canadian was an op-ed article by Julie Dickson in a foreign newspaper – Mentioned only Non-Viability Contingent Capital (NVCC) mechanism, lowest of low-triggers – Considers it an advantage that NVCC be priced as debt – No discussion of high-trigger – No acknowledgement that CoCos had been issued in other jurisdictions

A Little More Substance • First communication to Canadians was one month later, in speech – No references to academic papers or official studies were provided • Contradictions in desired attributes: – Should be priced like debt – but absorb losses prior to government intervention – and provide market penalties for riskier banks at time of issue – but not make the buyers take any losses at all on conversion

Should CoCos Be In Bond Indices? • Lloyd’s Bank issue (November, 2009) – £8.5-billion – Convert to equity if core capital falls below 5% – Conversion price is common price at issue time • Controversy regarding inclusion in bond indices – Merrill Lynch first said ‘Out’, then ‘In’, then ‘Out’ again – Pressure from UK authorities to have them in • Barry Critchley reported “Certainly OSFI wants them in the index and has make its plan very clear”

Current Status • OSFI Advisory on NVCC – Draft, February 2011 – Finalized, August 2011 • Did not grandfather extant issues • Lowest possible conversion trigger • Convert at market price at conversion-time (subject to cap) • Draft advisory stated applicability to insurers would be clarified “in due course” – Nothing yet, but a Draft “Definition of capital” for insurers has been promised for early this year

Visible Effects Annuity Pricing

Raw data from IFID; Calculations by Hymas

Regressions •

Could be related to low yields - Post-Crisis curve will merge with Pre-Crisis as yields decline Probably a permanent increase in price - Post-Crisis curve will remain above Pre-Crisis as yields decline

Hedging an Annuity (M75) • Pre-Crisis: Hedge with 11.5-year bond • Post-Crisis: Hedge with 14.5-year bond

References • OSFI and the Third Pillar (http://www.himivest.com/ media/advisor_0812.pdf) • Historical annuity payouts from The Individual Finance and Insurance Decisions Centre (http://www.ifid.ca/) • Jay Ritter, Economic Growth and Equity Returns, http://www.bm.ust.hk/~fina/FinanceSymposium/ 2003symposium/Papers_Dec15/JayRitter.pdf • Derman et al., Static Options Replication , http://www.ederman.com/new/docs/gs- options_replication.pdf

References (continued) • Hardy, Freeland & Till, Validation of Long- Term Equity Return Models for Equity-Linked Guarantees, http://www.actuaries.ca/afc/ documentations/Mary_Hardy_naaj0604_3.pdf • S&P, Standard & Poor's Response To The Basel Committee's Proposals On Bank Capital And Liquidity http://www.standardandpoors.com/ products-services/articles/en/us/? assetID=1245210157817

References (Continued) • Swiss Department of Finance, "Too big to fail" commission of experts, http://www.sif.admin.ch/ dokumentation/00514/00519/00592/index.html? lang=en • Paul Tucker (BoE), Speech, http://www.bis.org/ review/r110308c.pdf • Charles Goodhart, Basel on wrong path to tackle systemic risk, http:// www.financialregulationforum.com/wpmember/ basel-on-wrong-path-to-tackle-systemic-risk- 6574/

References (Continued) • Perotti & Flannery, CoCo design as a risk preventive tool, http://www.voxeu.org/ article/coco-bonds-way-preventing-risk • Pazarbasioglu et al., Contingent Capital: Economic Rationale and Design Features, http://www.imf.org/external/pubs/ft/sdn/ 2011/sdn1101.pdf

References (Continued) • Julie Dickson, Speech, http://www.osfi- bsif.gc.ca/app/DocRepository/1/eng/speeches/ jdlh20100506_e.pdf • Julie Dickson, Protecting banks is best done by market discipline, http://www.osfi-bsif.gc.ca/app/ DocRepository/1/eng/media/2010_04_10_e.pdf • Shaken & Stirred (OSFI and the Bond Indices), http://www.himivest.com/media/ advisor_1104.pdf

References (Continued) • Barry Critchley, Banks prepare for CoCos, http://www2.canada.com/business/ story.html?id=4188608 • Bayliffe & Pauling, Long Term Equity Returns, http://www.towersperrin.com/tp/ getwebcachedoc%3Fwebc=TILL/USA/2003/ 200309/Long_Term_Equity_Returns.pdf

Other Regulators Federal Reserve (http://federalreserve.gov) European Banking Authority (http://eba.europa.eu) Financial Services Authority (http://www.fsa.gov.uk) OSFI (http://www.osfi-bsif.gc.ca)