Canadian Institute of Actuaries. L Institut canadien des actuaires Annual Meeting Assemblée annuelle 2008 Québec

Transcription

1 Canadian Institute t of Actuaries L Institut canadien des actuaires 2008 Annual Meeting Assemblée annuelle 2008 Québec

2 LIQUIDITY MANAGEMENT LESSONS LEARNED FROM THE SUBPRIME CRISIS THE CASE OF CANADIAN LIFE INSURANCE COMPANIES Gilles Bernier, Ph.D. Professor of Finance and Insurance Industrial-Alliance Chair in Insurance and Financial Services Faculty of Business Administration Laval University it Quebec City Canadian Institute of Actuaries 2008 Annual Meeting Quebec City, June 19th,

3 «When financial markets experience a shock of one sort or another, liquidity black holes may develop. Liquidity then becomes very important to investors, and illiquid instruments often sell at a big discount to their theoreticalti values» Source: Hull, J. «Hull s Laws: What We Can Learn From Derivative Mishaps», Rotman Magazine, Spring 2007,

4 ASSET-BACKED COMMERCIAL PAPER EXPLAINED (Source: FitchRatings An asset-backed commercial paper (ABCP) program is composed of a bankruptcy-remote special purpose vehicle (SPV), or conduit, that issues commercial paper p (CP) and uses the proceeds of such issuance primarily to obtain interests in various types of assets, either through asset purchase or secured lending transactions. An ABCP program includes key parties that perform various services for the conduit, credit enhancement that provides loss protection, and liquidity facilities that assist in the timely repayment of CP.

5 SECURITIZATION STRUCTURE OF ABCPs Key parties involved Assets SPV Buyer Car loans Commercial Loans Mortgage loans Credit Cards Student loans Trust (conduit) Investor ABCP programs are typically structured with liquidity facilities to assist in the timely repayment of CP for reasons generally not associated with the credit risks of the underlying assets (e.g., cash flow timing mismatches or if unable to issue new CP to repay maturing CP)

6 WHO BUYS «ABCP»? Investors with short-term excess funds Money Market Investment Funds Pension Plans (Caisse de dépôt) Commercial Firms (Jean Coutu, Transat) Government entities (SGF, Crédit agricole) Financial Institutions (BNC, IAG, Desjardins) A wide range of investors, including L&H insurers, who are attracted by the higher interest rate on those instruments considered safe!

7 Market Value MARKET VALUE TREND OF «ABCPs» Exponential Growth in Canada $115 billion as of June 30,2007 ABCPs have been traded for many years and they represent 1/3 of the entire money market in Canada Source : Bank of Canada

8 WHAT HAPPENED ON AUGUST 13, 2007? Quality of assets backing ABCPs is questioned Assets Car loans Commercial loans Mortgages g Crédit cards Student Loans SUBPRIME CDOs SPV Trust (conduit) Liquidity Agreement Banks Confidence crisis Flight to quality!? // // Buyer Investors Banks refused to ensure liquidity of non-bank ABCPs because there was no general market disruption

9 Credit spreads MAIN CONSEQUENCE OF LIQUIDITY/CREDIT CRISIS Risk premia are higher Risk premia are higher Increasing borrowing costs

10 IMPACT OF LIQUIDITY CRISIS ON THE CANADIAN LIFE INSURANCE INDUSTRY? Source : Carrière, J, «Faire des relations avec les investisseurs,, dans la tourmente des papiers commerciaux», Laval University, April 14, 2008

11 REPUTATION RISK A component of every risk a company is exposed to, and arises out of every decision a company makes. Cash-flow implications Example: IAG repurchased $76.8 million in non-bank ABCP held in clients money market investments funds; No material impact on the firm s liquidity ratio (2%)

12 STOCK MARKET REACTION 118% COMPARATIVE EVOLUTION OF 4 LIFE INSURANCE STOCKS SINCE AUGUST 13, % 106% 100% 94% IA Great-West Manu Sun Life S&P/TSX

13 BEHAVIOR OF LIFE INSURANCE STOCKS SINCE 12/31/2007 TSX -1 % Manu -2 % IAG -9 % GWO -12 % Sun -13 %

14 STOCK MARKET CONCERNS Stock analysts ask questions w/r to a life insurer s s relativepositionintermsof: in terms of: Exposure to Asset-Backed Securities; Overall quality of investments in case of economic slowdown (as proxied by the overall % of net impaired investments); Sensitivity to equity markets. Great importance to show that the firm is in control and of ensuring full & timely disclosure to market.

15 EXPOSURE TO STRUCTURED CREDIT OF LISTED CANADIAN LIFE INSURANCE FIRMS Exposure of Structured Credit to Adjusted Common Equity (2007) Industrial Manulife Sun Life Great West Alliance Average 40% 47% 85% 41% 53%

16 EXPOSURE TO ASSET-BACKED SECURITIES: THE CASE OF IAG Direct U.S. Category Amount Exposure Comments Non-bank ABCP $104.1 M Minimal At ease with 15% write-down Bank ABCP $136.2 None Issued by large Canadian M banks Global liquidity clause No leverage Quality: 100% AAA rating Most rated by 2 or more credit firms Mortgage-Backed $156.7 None 100% insured mortgages Securities (MBS) M Quality: 100% AAA Commercial Mortgage- Backed Securities (CMBS) $182.5 M Other ABS $478.3 M None Less than $7 M Quality: 90% AAA Mostly credit cards Quality: 90% AAA

17 OVERALL QUALITY OF INVESTMENTS OF IAG RELATIVE TO PEERS Well-Positioned if Faced with an Economic Slowdown Net Impaired Investments t as a % of Total Investments BIG 3: 0.09 No investment in U.S. subprime mortgage market. Less than $200, in investments guaranteed by financial guarantors. Minimal exposure to in the news securities (aviation, auto, telecom, printing).

18 SENSITIVITY TO EQUITY MARKETS FOR IAG RELATIVE TO PEERS Sensitivity to Equity Markets Assumption 10% drop in equity markets Impact on Net Income to Common Shareholders % of Consensus % for Peers ($18.6 M) 7% 5-8%

19 RISK MANAGEMENT LESSONS FOR LIFE INSURANCE COMPANIES?

20 LESSON 1. KNOW THE RISKS OF FINANCIAL INSTRUMENTS YOU INVEST IN Buyers of non-bank ABCP should have conducted due diligence that went beyond a simple rate check. 95% of the non-bank ABCP was rated AAA by DBRS but only by DBRS; DBRS was mostly looking at the credit risk of DBRS was mostly looking at the credit risk of the underlying assets..but paid little attention to the liquidity risk involved.

21 LESSON 2. COMPLEXITY IS IN ITSELF A BIG RISK (Hofmann, 2008) The risk associated with complexity must not be underappreciated Interconnected t markets ensure thatt even small risks can have large systemic impact. Important to request more transparency from issuers Risk is difficult to understand if instruments are designed to be opaque; Securitization weakens the screening incentives of loan granting institutions (moral hazard).

22 LESSON 3. PAY ATTENTION TO MARKET SIGNALS S&P had raised a red flag in 2002 which was sort of ignored by investors «Investing in Canadian non-bank ABCP does represent an act of faith» Why? The Canadian liquidity agreement allows banks to refuse to ensure liquidity of issuers if there in no general market disruption. Much riskier than the global liquidity agreement.

23 LESSON 4. ASSESSING CREDIT QUALITY IS AN IMPRECISE PROCESS Many life insurers have decided to do their own internal credit risk assessment, even for short-term investments. Never rely again only on one rating agency s opinion; Do not underestimate agency risk when assets are valued by a third-party party. Credit risk may trigger liquidity problems due to mismatch potentially impacting a life insurer s reputation and its franchise value.

24 LESSON 5. LEARN FROM PAST CASES OF DERIVATIVE MISHAPS [Hull (2007)] Derivatives can be used for either hedging or speculation; that is, they can be used to reduce risks or to take risks; Most losses (Barings, Orange County, LTCM) occured because employees who had an explicit it or implicit it mandate to hedge their firm s risk decided instead to speculate; Importance of having clear and unambiguous policy statements plus internal controls to ensure policies are carried out; «When everyone is following the same trading strategy, beware!» Case of British insurance companies in late 1990 s all hedging their exposure to a fall in long-term interest rates at about the same time. The result? A fall in interest rates. (Hull, p.36)

25 LESSON 6. KEEP QUESTIONING THE COHESIVENESS OF THE CURRENT RISK MANAGEMENT FRAMEWORK Major Canadian life insurance firms are among the more advanced practionners of ERM. Pressure for life firms to adopt more effective risk management policies comes from many stakeholders (regulatory bodies, rating agencies, market analysts & investors). ERM, as a process, is a form of general management aiming at ensuring an organization s continuous improvement. However, ERM is not a panacea.

26 CONCLUSIONS It has been said that the only certainties in life are death and taxes. The only certainty in modern business, including the life insurance sector, is that there is no escape from risk!! Risk management processes in life insurance companies must evolve through the continual development of technical tools: W/r to insurance risks, computer technology now allows for better policy pricing and risk analysis through the modeling of the interest-rate sensitivity of policy cash flows; W/r to investment risks, ALM techniques and scenario testing can now be much more sophisticated as life insurers may rely on more consistent t valuation methodologies for both sides of the balance sheet. As a pillar of Canada s financial system life insurance As a pillar of Canada s financial system, life insurance companies must be concerned by the procyclical nature of modern financial markets. (Hofmann, 2008) (White, 2008)

27 REFERENCES Babbel D.F. & A.M. Santomero, «An Analysis of the Financial Risk Management Process Used By Life Insurers», in Changes in the Life Insurance Industry, edited by J.D. Cummins & A.M. Santomero, KAP, 1999, Carrière, J, «Faire des relations avec les investisseurs dans la tourmente des papiers commerciaux», Laval University, April 14, 2008 Hofmann, D., «A Risk Management Approach To Financial Crisis Prevention», The Geneva Association, Insurance & Financial No.3/April 2008, 6-7. Hull, J. «Hull s Laws: What We Can Learn From Derivative Mishaps», Rotman Magazine, Spring 2007, Smith, C.W., «Corporate Risk Management and the Insurance Industry» in Financial Management of Life Insurance Companies, edited by J.D. Cummins &J J.L. Tennant, KAP, 1993, White, W., «Past Financial Crises, the Current Financial Turmoil, and the Need for a New Macroeconomic Stability Framework, LSE Financial Markets Group & Deutsche Bank Conference, London, March ( )

28 THANK YOU!