PrefBlog

On September 5 the Office of the Superintendant of Financial Institutions announced:

released a Life Insurance Regulatory Framework to provide life insurance companies and industry stakeholders with an overview of regulatory initiatives that OSFI will be focusing on over the period ending 2016. It outlines how the regulatory framework will evolve to ensure Canadians continue to benefit from a strong life insurance industry.

“In laying out OSFI’s initiatives, we hope to encourage discussion and strong participation by industry stakeholders in our regulatory development process,” said Mark Zelmer, Assistant Superintendent, Regulation Sector. “Canadians have benefited from a strong life insurance industry and a flexible, effective regulatory framework. Our initiatives aim to ensure this continues.”

The Framework outlines OSFI’s priorities and addresses issues such as corporate governance and risk management, evolving regulatory capital requirements, and promoting transparent information on the financial condition of life insurance companies to support the regulatory framework.

“This framework addresses OSFI’s key regulatory objectives and its approach to refining regulatory oversight and guidance that is already robust,” continued Mr. Zelmer. “By issuing the regulatory framework at this time, OSFI hopes it will help life insurers and industry stakeholders in their planning processes.”

I missed this at the time, but it was brought to my attention by Assuiduous Reader dudsy in the comments to another thread.

The document is titled Life Insurance Regulatory Framework. Naturally, my main concern is to parse the text for any hints about the application of the NVCC rule to insurers and insurance holding companies:

OSFI recognizes that life insurance companies are in many ways significantly different than banks, particularly due to the long-term nature of traditional life insurance business. Therefore, in considering these developments, OSFI will not indiscriminately implement any of them (e.g., Basel III) into the life insurance regulatory framework.
…
To achieve these objectives, OSFI will introduce enhancements to the regulatory framework for life insurance companies through:…Revised regulatory capital requirements guidance that:…Links risk measures to the quality of capital
available to absorb losses
…
OSFI is approaching the review of the regulatory capital requirements with the belief that, in aggregate, the industry currently has adequate financial resources (total assets) for its current risks.
…
Capital will improve in terms of its ability to absorb losses, from the perspective of both a “going concern” and a “gone concern” basis.

The last seems quite encouraging, as far as NVCC is concerned. More important to OSFI, however is plausible justification for mission creep and increased employment at OSFI:

OSFI may need more specialized resources as these initiatives are incorporated into our regulatory and supervisory frameworks.

They’re going to introduce something called ORSA, which does not, surprisingly, stand for OSFI Retirees Superannuation Arrangement, but Own Risk and Solvency Assessment:

The minimum capital requirements set in OSFI’s regulatory framework may not be adequate to address this institution-specific risk-taking, as the regulatory capital requirements are based on industry averages which, at any point in time, may not fully capture new risk exposures or product developments. For this reason, institutions should have their ORSA process. Life insurance companies should not simply rely on minimum regulatory capital requirements as a proxy or as a starting point for measuring their own risk profile.
…
ORSA should not be seen as an OSFI compliance requirement but as a sound business practice. This will be reflected in the principles-based approach OSFI will outline in the ORSA Guideline. The ORSA Guideline will build on existing industry practice and OSFI guidance while considering international practices, in addition to seeking input and perspective from Canadian industry stakeholders.

In the section titled “Evolving Regulatory Capital Requirements”, they say:

The objective of this review is to improve our regulatory capital requirements by:…Improving Risk Measurement…Recognize the quality of capital available to absorb losses on both a “going concern” and a “gone concern” basis
…
The evolution of regulatory capital requirements into a more risk sensitive framework may result in more volatile regulatory capital requirements (capital available and/or capital required). OSFI will consult with industry to assess whether that volatility provides a true reflection of the evolution of the risk and is thus “appropriate” for purposes of setting regulatory capital requirements, or whether the volatility in capital requirements amplifies the variations in risk and is thus “inappropriate.”

Of great interest is their commentary on accounting standards:

Where necessary, OSFI will consider measures to address inappropriate volatility. For example, we will investigate options to moderate the impact of volatility on regulatory capital requirements, when:
1. For remaining long duration liabilities, markets for matching purposes do not exist, and
2. For solvency purposes, accounting/actuarial rules do not appropriately reflect the long-term characteristics of these portfolios.

That might be code for “Don’t worry about the IFRS Insurance Contracts Exposure Draft, guys!” The Insurance Contracts issue is actually mentioned explicitly in the concluding section of the paper:

The IASB insurance contracts project (IFRS 4 Phase II) will have a significant impact. While the extent of the impact is not fully known (and will not be until the final standard is set), OSFI is committed to consulting with industry stakeholders on how the final standard should be incorporated into the regulatory framework. Ideally, our initiatives would incorporate a final IFRS 4 Phase II standard. However, should a significant delay occur in the IASB work, OSFI will continue to move its work forward using current international financial reporting standards.

The section titled “Capital and Risk Measurement”:

The level of protection being tested by OSFI in QIS 3 is for each risk separately to cover a 1-in-200 year event (a rare, but plausible scenario) over a one-year time horizon. OSFI believes this level of protection would be equivalent to the low end of the investment grade range. An adequate provision after one year is defined as the amount of assets required for the insurer to either fulfil its policyholders’ and senior creditors’ obligations over the remaining lifetime of the obligations or to transfer them to another company.

Of great importance is their admission that:

The current approach to determining liability and regulatory capital requirements for financial guarantees embedded in segregated fund products has the following drawbacks:
• It can produce values that are materially lower than the cost of hedging.

The closes that they get to addressing the NVCC issue with respect to preferred shares is:

OSFI believes that high quality capital instruments should form a substantial part of the capital resources of an insurer when times are good. This provides the company, and OSFI, with the flexibility to respond in a constructive way in times of stress.

OSFI will consider these elements in developing guidance for the level and quality of available capital in the revised regulatory capital requirements.
…
The review of the definition of capital component is necessary to incorporate lessons learned during the recent financial crisis. These relate to the quality of certain capital instruments during periods of stress, the appropriateness of deductions and adjustments made to regulatory capital. The review provides an opportunity to consider each available capital element and assess its contribution to two goals: financial strength and protection of policyholders and creditors.

Revisions will provide increased transparency with respect to the meaning and purpose of both total (protection of policyholders and senior creditors) and tier 1 (financial strength) capital elements.

OSFI believes going concern capital (tier 1) should be largely comprised of equity (common and perpetual preferred shares). Items not considered to be readily available to absorb losses in a stress scenario (i.e., not fungible, not permanent, introduce an element of double-counting) should be deducted from it. Going concern capital is important to support ongoing insurer viability over the longer term given the longer-term nature of the life insurance business.

Gone concern capital (total) helps ensure that policyholders and senior creditors can be paid when the insurer is in winding-up mode. Gone concern capital may include forms of lower-quality “additional” capital components, such as hybrids and subordinated debt instruments that meet minimum quality criteria.

OSFI plans to issue a draft Definition of Capital paper for public consultation in late 2012 or early 2013.

The phrase “lessons learned during the recent financial crisis” might – might! – be taken as a reference to hybrid capital not defaulting when financial institutions were bailed out, which is the justification for the NVCC rule.

However, the last sentence quoted implies that we’ll start getting some meat in the sandwich sometime around year-end … roughly TWO FREAKING YEARS after the NVCC rule was applied to banks.

The timeline section at the back gives the following estimates for “Definition of Capital”:
Project Initiation: 2011Q1
Quantitative Impact Study: 2013Q3
Public Consultation: 2013Q4
Final Guideline issued: 2014
Implementation Milestone: 2015

At this point, I see no reason to change my views regarding the potential for the eventual imposition of the NVCC rules on insurers and insurance holding companies in a similar manner to banks. The draft consultation to be issued around year-end may help firm up the matter; readers and investors should be aware that I may well change the “Deemed Maturity” date for insurers and insurance holding companies.

This entry was posted on Thursday, October 4th, 2012 at 7:06 pm and is filed under Regulation, Regulatory Capital. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.