1. Introduction. 2. The Nature of the Insurance Business. Insurance Business Model Supports Long-term Investment

Transcription

1

2

3 1. Introduction With almost 90 per cent, or $540 billion of their $615 billion Canadian assets, held in long-term investments, life and health insurers are one of the largest long-term institutional investors in Canada. In operation since Confederation, Canadian life and health insurers also have a long, well-established history of providing long-term financial security to Canadians. This has typically meant providing benefits to Canadians in the case of death or disability. The industry also provides important savings products to meet the needs of older Canadians, including their retirement objectives. Access to such long-term assets is increasingly important for individual Canadians saving for retirement given the trend away from defined benefit pension plans, particularly in the private sector. The nature of the products of the Canadian life and health insurance industry results in predictable long-term liabilities. This inherent and structural advantage of the industry enables it to be an important and stable investor in long-term assets. The industry's investments often support longer-term capital investments, including infrastructure investments, which are critical to creating economic growth. Moreover, the industry's stable demand for long-term assets means that it is an important counter-cyclical investor that helps temper the swings in the market over business cycles as was evidenced by the industry's role in providing stability during the 2008 financial crisis. While insurers' demand for long-term assets is principally driven by its core business, government policy can also have an important influence on the industry's investment decisions. This paper explains the industry's contribution and the role that public policy plays in supporting long-term investment. It is important that policy and regulation in Canada be set with a clear understanding of how it impacts the long-term investment market in general and the unique characteristics of life insurers in particular. 2. The Nature of the Insurance Business Insurance Business Model Supports Long-term Investment In 2012, Canada's life and health insurers held almost $540 billion, or roughly 90 per cent of their total domestic assets, in long-term asset classes. Life insurance and pension products often result in several decades -- up to 50 years or more in some cases -- where the insurer is receiving premiums prior to paying related claims. The long-term and predictable nature of life insurers' liabilities means that they are naturally-aligned, significant investors in long-term assets through the capital markets. 1

4 In exchange for premiums, the industry promises to compensate policyholders through a range of products. Insurers must invest the premiums they collect from policyholders to pay claims and benefits on their policies and to cover their operating and capital costs. An insurer s investment strategy is heavily influenced by the profile of its liabilities. The duration of an insurer's liabilities determines the time horizon over which the insurer can invest. In turn, the degree of predictability of timing of the liabilities, which depends on the type of risk insured and the policyholder options built into the contract, determines the required liquidity of investments. Where insurers provide products with guarantees, the guarantee typically sets a minimum investment performance. Insurers will therefore build their investment strategies in such a way that expected returns exceed what is guaranteed. Investment returns represent a core component of insurance products. Protection products Investment returns allow insurers to charge lower premiums and offset the impact of inflation in cases where the claim amount is not immediately known. Life products with investment features Investment returns are an integral part of the product itself. Annuities and other products where the pay-outs to the policyholder are fixed and guaranteed Investment returns available when the customer buys the annuity will, together with life expectancy, dictate the level of annuity that the insurer is able to provide to the customer. Products with profit-sharing provisions The level of guarantee that can be offered on new policies is directly impacted by the available investments, while the level of profit-sharing on existing policies depends on the actual and prospective performance of investments. Insurers' Investment Profile In order to support its business model, the Canadian life and health insurance industry invests in a number of asset classes that also help to support businesses, governments and the economy. For example, investments include: liquid assets with defined maturity dates, such as government and corporate bonds; liquid assets without a specific maturity date, such as listed equities; as well as illiquid assets, such as infrastructure or private equity investments. 2

5 As a long-term conservative investor, the industry is a significant holder of government and corporate bonds. In 2012, the industry held about $106 billion in Canadian corporate bonds and $113 billion in government bonds in Canada (see Figure 1). Together, the industry's holdings of government and corporate bonds in Canada accounted for about 40 per cent of their long-term investments. Moreover, about 50 per cent of the industry's bond holdings had terms of 10 years or more. 1 The industry is also a significant investor in mutual funds (almost $140 billion), equities (almost $93 billion), mortgages (about $42 billion) and real estate ($18.5 billion) as a means to supporting its long-term business model. FIGURE 1: CANADIAN LIFE AND HEALTH INSURERS' LONG-TERM INVESTMENT ALLOCATION PROFILE OF INDUSTRY'S LONG-TERM INVESTMENTS, 2012 Other (e.g., securitization) 2% ($12B) Fed. $29.4B (26%) Prov. $73.3B (65%) Mun. $ 9.8B ( 9%) Equities 17% ($92.8B) Government Bonds 21% ($112.5B) Total = $539.5 Billion Mutual Funds 26% (139.7B) Corporate Bonds 20% ($105.7B) SOURCE: CLHIA Infrastructure 1% ($5.7B) Mortgages 8% ($42.4B) Real Estate 3% ($18.5B) Foreign Bonds (gov't/corp) 2% ($10.1B) 1 Based on a survey of CLHIA member companies. 3

6 The net result of the industry's overall investments is that the industry is one of the largest investors in a number of critical asset classes in the economy and therefore plays a key role in supporting economic growth. 3. How the Industry Helps Canadians Save through Long-term Investing Insurers' long-term investment strategy benefits Canadians in a number of ways. As set out below, this is accomplished through: Higher returns from access to long-term investments; Investment expertise; Lower investment costs; and Access to innovative product design. Higher Returns from Access to Long-term Investments Given the nature of their liabilities, insurers have the ability to hold assets over the long-term, allowing for diversification of risks across time as well as across asset categories. In addition, insurers' long-term, patient investment perspective allows them to have great flexibility over timing of asset sales and avoiding forced sales during periods of price volatility. Insurers, therefore, have structural investment advantages from which their policyholders can benefit. Investing long-term gives policyholders access to the risk premium and implicitly to the higher yields embedded in a wide range of investments, which compensate for the risk of holding assets with longer maturities. Investment Expertise Insurers have investment expertise and access to information services that individual investors cannot feasibly have themselves. For example, insurers are unique in that they can offer products with guarantees associated with them, something that requires a high degree of sophistication, in terms of risk identification and asset liability management. This means that individuals can improve their investment decisions by outsourcing them to insurers. The insurer will then take responsibility for carefully-researched investment decisions and for managing the trade-off between risk and return. Insurers' investment activities are guided by a strong risk management framework and governance, with Board approved risk appetite levels. 4

7 Academic literature shows that most policyholders do not want to take responsibility for constantly monitoring their own investments and for making regular investment decisions. In addition, as investors, policyholders suffer from behavioural biases that often cause them to make poor investment choices. Specifically, they are inclined to over-react to short-term price fluctuations and, as a result, end up buying high and selling low. In contrast, insurers long-term investment philosophy means they can overcome many of these biases. Lower Investment Costs Policyholders can also reduce the cost of investing by outsourcing their investment decisions to insurers. More specifically, the pooling of assets allows a greater scale than would be possible if investments were split into many sub-portfolios thereby reducing administration costs. Finally, by pooling the funds of many investors, insurers give them access to assets in which they would otherwise not be able to invest, such as private placements and other big ticket investments like infrastructure projects. Access to Innovative Product Design Insurers long-term view means they can provide policyholders with a range of options for the investment-related elements of their insurance products: from unit-linked exposure for those able to withstand full-market volatility themselves, through profit-sharing products where the risk is shared (and there is usually a capital protection or a minimum return guarantee), to fully guaranteed annuity-type products where there is no market risk for the policyholder. The combination of benefits described above is what allows insurers to offer long-term products at a cost that is acceptable to both policyholders and to those who provide the capital to back the risks. 4. How the Industry Contributes to the Growth of the Canadian Economy Counter-Cyclical or Stabilizing Role The nature of insurers' business model results in the industry being a key source of stability to the economy. Even in periods of market stress with significant market volatility, insurers receive a continual and steady flow of premiums (see Figure 2). This, together with predictable liability outflows, enables them to hold and continue to buy assets that are temporarily undervalued during a downturn and to sell or avoid assets that are temporarily overvalued during a boom. Insurers' long-term, conservative investment approach, therefore, plays an important countercyclical role in times of market stress. 5

8 FIGURE 2: PREMIUMS PROVIDE A STABLE SOURCE OF FUNDING EVEN DURING DOWNTURNS 40.00% STABILITY OF INSURANCE PREMIUMS 30.00% 20.00% Percentage Change (Annual) 10.00% 0.00% % % % Life and Annuity Premiums TSX Index % SOURCE: CLHIA The Industry's Investment in Canadian Companies Canadian companies raise capital in order to invest in profitable growth opportunities, to bring new products to market or to execute on a significant strategic expansion, all of which are critical activities to drive growth and raise living standards for Canadians. Generally, corporations prefer stable, patient funding over more volatile, shorter-term or speculative, sources of funds as it allows for more certainty for longer-term planning and investments. As such, the Canadian life and health insurance industry is an ideal provider of capital to corporations. The industry is a significant investor in corporate bonds and equity in Canada. In 2012, the industry held nearly $106 billion, or roughly 14 per cent of all Canadian corporate bonds. In addition, in 2012 it held almost $93 billion or about 4 per cent of all Canadian corporate equity (see Figure 3). 6

9 The Industry's Investment in Governments Governments use funds raised through debt issuance to supplement their tax revenues for a wide range of activities, such as infrastructure investments, capital investments (hospitals, schools, etc.) as well as any other government programs. A fundamental objective of debt management for governments is to raise stable and low-cost funding to meet its needs. 2 As such, it is important for governments to attract investors with a longer-term and sustained appetite for its debt. Governments need to have a mix of debt maturities to balance cost and stability. Life insurers can be an important investor, particularly for longer-term maturities to match long-term liabilities. As well, governments are interested in supporting a well-functioning debt market in government securities. This results in benefits not only for the government as a debt issuer, but also for other market participants. For example, a government debt market provides risk-free assets for investments of a broad range of investors (e.g., from individual Canadians to sophisticated institutional investors). It also acts as a pricing benchmark for other debt issues and a tool for managing risks. 3 Governments raise funds from both domestic and foreign investors, which is important in the context of diversification. However, it is also important that Canadian governments maintain an adequate supply of domestic funding for their debt as a means of retaining domestic control over fiscal needs. In this regard, as a very significant domestic source of funds to governments, the industry plays a key role in supporting this strategic goal. The industry is a major source of financing for Canadian governments at all levels. Overall, in 2012, the industry held about $113 billion in government bonds. This included holdings of about $29 billion in federal debt, $73 billion in provincial debt and almost $10 billion in municipal debt. As a proportion of total outstanding debt, in 2012, the industry held 6 per cent of federal bonds, 13 per cent of provincial bonds and 17 per cent of municipal bonds. 2 Department of Finance Canada. Debt Management Report, Department of Finance Canada. Debt Management Report,

10 FIGURE 3: INSURERS INVESTMENTS SUPPORT WIDER ECONOMY Policyholders pay premiums to insurers $540B in long-term investments in 2012 Corporate bonds who then invest in the wider economy via Government bonds Corporate equity $83.3 B in 2012 who also transfer risk to reinsurers 14% of all Canadian Corporate bonds Residential Mortgages 10% of all Canadian Government bonds Commercial Mortgages 4% of all Canadian Corporate equity Mutual Funds 1% of all Canadian Residential Mortgages 28% of all Canadian Nonresidential mortgages 16% of all Mutual funds Source: CLHIA The Industry's Investments in Infrastructure Infrastructure investments are a particularly attractive asset class for insurers. The industry's infrastructure investments support, for example, hospitals, airports, toll roads, energy projects and government facilities. The long-term nature of infrastructure assets and the predictable long-term cash flows provided by infrastructure assets are highly suitable for matching insurers long-term liability cash flows, particularly in markets where issuance of long-term bonds is limited. In addition, infrastructure investments also provide portfolio diversification benefits. The industry gets exposure to infrastructure projects either in the form of debt capital or equity capital. Both can be accessed through the public market (e.g., in the form of infrastructure bonds and infrastructure funds) or through private placements (e.g., direct loans and direct investment in infrastructure). While estimates vary on the need for infrastructure investments in Canada, the conclusion is the same -- significant investment is required. For example, the Federation of Canadian Municipalities estimated the infrastructure deficit was $123 billion to maintain existing municipal infrastructure and a further $115 billion to fund new municipal infrastructure needs. When federal and provincial needs are included, the Canadian infrastructure deficit could be 8

11 between $350 and $400 billion. 4 The long-term commitment of funds to such projects is important to the economy because it allows businesses and governments to engage in large projects that take many years to complete or to become profitable. Without committed longterm funding, there would be a risk that short-term funding might not be rolled over, which would mean that many of these projects would simply not be viable. Clearly, there is a need for long-term, stable funding to help renew Canada's infrastructure. The Canadian life and health insurance industry is well placed to invest in infrastructure assets. Currently, the life and health insurance industry holds almost $6 billion in infrastructure investments. While this is currently a relatively small amount in the context of their overall investments, the industry has a strong desire to invest more in infrastructure and supports recent initiatives by government to increase the number and breadth of infrastructure investments, including public-private partnerships (P3s), that are available in the Canadian market. 5 P3s are an attractive approach to infrastructure development for governments. They have a proven track record of delivering maximum value for taxpayers as they generally provide on-time, on-budget projects and effective infrastructure. 5. Role of Public Policy in Long-term Investing Underpinning insurers' appetite and ability to invest in long-term assets is the overall public policy environment that they operate within. There are many regulatory and economic factors that impact insurers' ability to invest long-term. It is important that policy choices in all of these areas be made in an informed way that reflects the unique characteristics of the insurance business model as a means to ensure a strong and sustained demand for long-term investment in Canada. Macroeconomic Policies The macroeconomic policies of governments and central banks can have a major influence on insurers investments. While a very low interest rate environment, such as we have now, has been important to support the economy through the down cycle, it presents significant challenges for Canada's longer-term investors such as life insurers. For instance, sustained low interest rates cause investment managers to reconsider their asset allocation and asset-liability strategies to compensate for the low underlying yields. They will sometimes push into relatively 4 PWC. Building Canada s Infrastructure. 5 Based on a CLHIA survey of member companies. 9

12 more risky asset classes, such as private equity, in search of the required yield to support their longer-term liabilities. A sustained flattening of the yield curve, as we have recently experienced, may also incent government debt issuance towards the short-term. This reduces the relative supply of longterm debt in the market and has important implications for long-term investors, such as insurers, that rely on a healthy supply of long-dated bonds to match their long-term liabilities. Increasing the availability of quality long-term investments that can match the duration of the underlying insurance contracts will serve to reduce the extent of the volatility in insurers' financial reporting. This enables insurers to optimize their cost of capital and provide protection at a reasonable cost to Canadians. Accounting Rules Accounting standards play an important role in standardizing how insurers prepare and present their business income, expenses and financial position. These standards can also be a significant driver of the types of products that insurers offer to the market, the cost of those products and the investment choices to support those products. As outlined above, insurers strive to match the term of their liabilities to the term of their assets as a tool to reduce the investment risk of offering long-term products. It is important that accounting standards recognize the vital connection that exists in the overall asset-liability management strategy and practices of insurers. If they do not, the ensuing earnings and capital volatility will negatively impact the ability of insurers to offer long-term products to Canadians at a reasonable cost. In this context, it is important to note that the proposed International Financial Reporting Standard (IFRS) for insurance contracts would likely result in increased volatility, as it does not generally take into account this critical asset-liability link of insurers' business model. Accounting rules are also critically important as financial reporting drives both prudential regulation and taxation rules for Canadian insurers. Prudential Regulation The prudential regulation of insurers aims to ensure that they hold enough capital to cover the risks they face and that they act in the interests of their policyholders. It is important that in setting prudential capital requirements, policy makers recognize and distinguish between the range of products in the marketplace and their inherent risks, the investments that support 10

13 them and effective risk management activities of the insurers, including portfolio diversification. It is important for regulators strike the right balance in setting prudential regulation and not create major disincentives in the selling of long-term products or in the investing in a well-diversified, well-managed product portfolio. Taxation Taxation has the potential to influence the flow of policy premiums and hence the investment strategy an insurer will adopt. Insurers liability profiles and investment strategies are strongly influenced by personal taxation rules, as their products are often designed to be tax-efficient for policyholders. Therefore, personal tax rules relating to insurance products and, especially, retirement savings may impact the flow of funds to the insurance industry. The taxation of investment gains also influences insurers allocation of funds to specific asset classes and/or to specific securities. Whether returns are treated as capital gains or as income can make a significant difference to the appeal of an asset class and the ultimate cost to the policyholder. In addition, any tax benefits associated with specific asset characteristics (e.g., tax benefits for long-term assets) will have the potential to impact insurers investment decisions. Moreover, the timing of taxation is an important factor in a long-term business model, as well as the alignment of tax policy for the insurer and the insured. Conclusion Long-term investment is critical to economic stability and growth. It is therefore important for Canada to have a framework that supports a vibrant long-term investment market. The Canadian life and health insurance industry is an integral part of Canada's long-term investment market. The nature of Canada's life and health insurance industry's business results in the industry having a natural and strong demand for long-term investments. Moreover, the industry plays an important countercyclical role in stabilizing the economy during periods of economic stress. As a result, the industry is an ideal source of long-term investment. The industry also supports Canadians' longer-term savings goals in a number ways. Investing through life and health insurers allows individual Canadians to leverage the scale and expertise of their insurer, to access asset classes that are otherwise unavailable to them, as well as to benefit from professional asset management at low cost. This ultimately helps Canadians reach their savings objectives, including for retirement -- something that is increasingly important in light of the continuing shift of responsibility to individuals to save for their own retirement. 11

14 While insurers' demand for long-term investments is a result of its core business, the government policy and regulatory environment also plays an important role. Indeed, government policy and regulation has an impact on how the industry makes its investment decisions, as well as the types of products and the cost at which they are offered to Canadians. It is important that, as policy and regulatory initiatives are developed and implemented, they are supportive of the long-term investment market in Canada, including the unique characteristics of the Canadian life and health insurance industry. 12

15

16