OSFI calls for closer risk scrutiny

Life insurance carriers face a daunting challenge in the wake of last year’s equity market collapse as they grapple with the unforeseen risks tied to guaranteed products that have swept the globe in recent years.

“Unlike traditional insurance risk, segregated fund risk is non-diversifiable,” said Superintendent Julie Dickson with the Office of the Superintendent of Financial Institutions Canada (OSFI), speaking at the 2009 OSFI Risk Management Seminar for Life Insurance Companies in Toronto on Tuesday.

“As equity markets decline, the amount the insurer will have to pay out increases on every policy — it doesn’t increase on some policies and decrease on others.”

Segregated funds offering guaranteed minimum withdrawal benefits were immensely popular in the run-up to the market collapse, particularly among boomers who sought to shield their life’s savings behind the guarantee.

When the credit crisis hit, insurers watched as asset values melted away while guaranteed liabilities remained in place. The rapid decline of virtually every asset class eroded the capital base of insurers because the guarantees associated with segregated funds had to be shored up.

Billions in new debt and preferred share issuance helped, but recently insurers have been forced to readdress the terms of the contracts, upping fees and mandating more conservative asset mixes.

Segregated funds and other insurance products tend to become more popular in periods of volatility as investors seek a modicum of predictability. The problem the industry faces, says Dickson, is that the risks associated with segregated funds cannot be mitigated by additional sales.

The traditional bread and butter of the insurance industry — actual life insurance — allows risks to be mitigated by diversifying demographically. The odds of one carrier’s policyholders all dying at once are very slim..

The same cannot be said of guaranteed segregated funds, the superintendent insists.

“Selling more segregated fund policies does not reduce risk, it actually increases it because when the markets decline all segregated fund policies get hit at the same time,” she says. “The more non-diversifiable risk a life company holds the more attention it needs to pay to risk management and capital.”

She points out that insurers are not alone in miscalculating risks; in the past banks have also engaged in selling products that turned out to carry more risk than initially thought. These products, most recently structured debt, have had a tendency to blow up more quickly than those in the insurance industry.

“Our message is that you really do need to understand the risks that you are taking,” she says. “I think that there is more recognition in the industry now that the ways these products have been designed carry a lot of risk. I think all companies are looking at product features and questioning whether they might have been a bit too generous [with the guarantees].”

She says the industry needs to focus on finding balance, with companies keeping a close eye on hedging, reinsurance and other product features.

“OSFI, as a prudential regulator, is sending a message that there are a number of constituencies that have to thought of,” Dickson says. “I understand that the sales force likes to sell a product and consumers like the product. Where OSFI comes in, is that we want the industry to be strong and we want all companies to be managing their risks prudently.”

(06/09/09)