OSFI’s two proposed capital charges could have severe negative fallout for P&C industry: CFO

CORRECTION: The following story clarifies and corrects an item posted on May 27, 2011. Canadian Underwriter apologizes for any confusion its initial report may have caused.

Two planned changes to the 2012 MCT/BAAT proposed by the Office of the Superintendent of Financial Institutions (OSFI) could have severe negative fallout for industry, according to Doug Hogan, The Dominion’s chief financial officer.OSFI’s proposed charge to cover interest rate sensitivity in its draft revised Minimum Capital Test (MCT) Guideline serves as an incentive for an insurer to de-risk its fixed income investments and reduce investment income and earnings, he said.Hogan spoke as a panel member during the Canadian Insurance Financial Forum’s CFO panel on May 26 in Toronto.In its draft revised guideline, OSFI proposes to introduce a capital charge to cover net interest rate sensitivity risk on interest rate-sensitive assets and liabilities. The principle behind the charge is to provide protection for when interest rates change, and the pool of capital that exists to protect the policyholder changes value. The introduction of the interest rate charge – the proposed changes to the MCT are scheduled to be implemented on Jan. 1, 2012 – will provide for the effect on capital of a 50-basis-point increase in the yield curve in 2012, said Hogan. “By 2013, it goes to 75 basis points,” he said.At the 75-basis-point mark, that would equate to a reduction of the industry’s MCT of 21 points, and a reduction of 50 basis points in the branch asset adequacy test (BAAT).”This is enormous,” Hogan said. “It is basically implying that OSFI wants us to hold cash to avoid this charge. That is very problematic. “I did some math, and if we were to avoid this charge, by shortening our duration and basically holding cash, we would be giving up 200 basis points on the ROE every year. That’s unsustainable and not a good result.”Another capital charge of 8% is being applied to insurers’ investments denominated in foreign currencies. Roughly half of The Dominion’s stock portfolio is in foreign issued currencies, he continued. “So, this would represent a significant charge for our company, and an above-average charge versus the industry overall.”Hogan noted that insurers already carry a 15% capital charge for holding common stocks. He argues the proposed change would have negative effects that outweigh the possible positive. “This additional charge is implicitly saying: ‘We [OSFI] don’t want your company to diversify your exposures. We want all of your stock exposure to be in the Canadian market,'” he said. “That’s an expensive hit to our capital structure, when we thought we were being good investment stewards by diversifying our stock exposure.”