Canadian Canadian L’Institut L’Institut Institute I I Institute tit t tit t canadien canadien di di of of of of des des des des Actuaries Actuaries actuaires actuaires 2008 Annual Meeting ● Assemblée annuelle 2008 2008 Annual Meeting ● Assemblée annuelle 2008 g g Québec Québec
LIQUIDITY MANAGEMENT – LESSONS LEARNED FROM THE SUBPRIME CRISIS LESSONS LEARNED FROM THE SUBPRIME CRISIS THE CASE OF CANADIAN LIFE INSURANCE COMPANIES CANADIAN LIFE INSURANCE COMPANIES Gilles Bernier, Ph.D. P Professor of Finance and Insurance f f Fi d I Industrial-Alliance Chair in Insurance and Financial Services Faculty of Business Administration L Laval University l U i it Quebec City Canadian Institute of Actuaries 2008 A 2008 Annual Meeting l M ti Quebec City, June 19th, 2008 www.fsa.ulaval.ca/chaire-industriellealliance
« When financial markets experience a shock of one sort or another, 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 theoretical values » di t t th i th ti l l Source: Hull, J. « Hull’s Laws: What We Can Learn , From Derivative Mishaps », Rotman Magazine , Spring 2007, 32-36.
ASSET-BACKED COMMERCIAL PAPER EXPLAINED EXPLAINED (Source: FitchRatings http://pages.stern.nyu.edu/~igiddy/ABS/fitchabcp.pdf • An asset-backed commercial paper (ABCP) program is composed of a bankruptcy-remote special purpose vehicle (SPV), or conduit, that issues commercial paper (CP) and uses the p p ( ) proceeds of such issuance primarily to obtain interests in various types of assets, either through asset purchase or secured lending transactions asset purchase or secured lending transactions. • An ABCP program includes key parties that 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 liquidity facilities that assist in the timely repayment of CP.
SECURITIZATION STRUCTURE OF ABCPs OF ABCPs Key parties involved Assets SPV Buyer Car loans Car loans Commercial Loans Trust Investor Mortgage loans (conduit) Credit Cards Credit Cards Student loans … 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 of the underlying assets (e.g., cash flow timing mismatches cash flow timing mismatches or if unable to issue new CP to repay maturing CP)
WHO BUYS « ABCP »? Investors with short-term excess funds • Money Market Investment Funds • Pension Plans (Caisse de dépôt) • Commercial Firms (Jean Coutu, Transat) Commercial Firms (Jean Coutu Transat) • Government entities (SGF, Crédit agricole) • Financial Institutions (BNC IAG Desjardins) • 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 instruments…considered safe! considered safe!
MARKET VALUE TREND OF « ABCPs » « ABCPs » Exponential Growth in Canada Market Market Value $115 billion as of June June 30,2007 ABCPs have been traded for many years and they ABCPs have been traded for many years and they represent 1/3 of the entire money market in Canada Source : Bank of Canada
WHAT HAPPENED ON AUGUST 13, 2007 ? Quality of assets backing ABCPs is questioned Quality of assets backing ABCPs is questioned Assets SPV Buyer Car loans Car loans Commercial // loans Trust Investors Mortgages g g // // (conduit) (conduit) Crédit cards Student Loans … ? ? SUBPRIME Liquidity CDOs Agreement Banks Confidence crisis – Flight to quality ! Banks refused to ensure liquidity of non-bank ABCPs because there was no general market disruption
MAIN CONSEQUENCE OF LIQUIDITY/CREDIT CRISIS LIQUIDITY/CREDIT CRISIS C redit spreads Risk premia are higher Risk premia are higher Increasing borrowing costs
IMPACT OF IMPACT OF LIQUIDITY CRISIS ON THE CANADIAN LIFE INSURANCE LIFE INSURANCE INDUSTRY? Source : Carrière, J, « Faire des relations avec les investisseurs , , dans la tourmente des papiers commerciaux », Laval University, April 14, 2008
REPUTATION RISK • A component of every risk a company is exposed to, and arises p y p out of every decision a company makes. • Cash flow implications • Cash-flow implications – Example: • IAG repurchased $76 8 million in non bank • 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%)
STOCK MARKET REACTION COMPARATIVE EVOLUTION OF 4 LIFE INSURANCE STOCKS SINCE AUGUST 13, 2007 118% 118% 112% 106% 100% 100% 94% 13-8-07 27-8-07 10-9-07 24-9-07 8-10-07 22-10-07 5-11-07 19-11-07 3-12-07 IA Great-West Manu Sun Life S&P/TSX
BEHAVIOR OF LIFE INSURANCE STOCKS SINCE 12/31/2007 SINCE 12/31/2007 TSX -1 % Manu -2 % IAG -9 % GWO -12 % Sun -13 %
STOCK MARKET CONCERNS • Stock analysts ask questions w/r to a life insurer’s relative position in terms of: insurer s relative position in terms of: – Exposure to Asset-Backed Securities; – Overall quality of investments in case of – 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 to market.
EXPOSURE TO STRUCTURED CREDIT OF LISTED CANADIAN LIFE INSURANCE LISTED CANADIAN LIFE INSURANCE FIRMS Exposure of Structured Credit to Adjusted Common Equity (2007) Industrial Manulife M lif S Sun Life Lif G Great West t W t Alli Alliance A Average 40% 47% 85% 41% 53%
EXPOSURE TO ASSET-BACKED SECURITIES: THE CASE OF IAG THE CASE OF IAG Direct U.S. Category Comments Amount Exposure Non-bank ABCP $104.1 Minimal � At ease with 15% write-down M Bank ABCP Bank ABCP $136 2 $136.2 None None � Issued by large Canadian � Issued by large Canadian M banks � Global liquidity clause � No leverage � Quality: 100% AAA rating Quality: 100% AAA rating � Most rated by 2 or more credit firms Mortgage-Backed $156.7 None � 100% insured mortgages Securities (MBS) Securities (MBS) M M � Quality: 100% AAA � Quality: 100% AAA Commercial $182.5 None � Quality: 90% AAA Mortgage- Backed M Securities (CMBS) Other ABS $478.3 Less than � Mostly credit cards M $7 M � Quality: 90% AAA
OVERALL QUALITY OF INVESTMENTS OF IAG RELATIVE TO PEERS IAG RELATIVE TO PEERS Well-Positioned if Faced with an Economic Slowdown Net Impaired Investments N t I i d I t t as a % of Total Investments BIG 3: BIG 3: 0.09 No investment in U.S. subprime mortgage market. Less than $200 000 in investments guaranteed by financial guarantors Less than $200,000 in investments guaranteed by financial guarantors. Minimal exposure to in the news securities (aviation, auto, telecom, printing).
SENSITIVITY TO EQUITY MARKETS FOR IAG RELATIVE TO PEERS Sensitivity to Equity Markets Impact on Net Income to Common % of % for Assumption Shareholders Consensus Peers 10% drop in equity ($18.6 M) 7% 5-8% markets
RISK MANAGEMENT LESSONS LESSONS FOR LIFE INSURANCE FOR LIFE INSURANCE COMPANIES?
LESSON 1. KNOW THE RISKS OF FINANCIAL 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 simple rate check. – 95% of the non-bank ABCP was rated AAA by y 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.
LESSON 2. COMPLEXITY IS IN ITSELF A BIG RISK COMPLEXITY IS IN ITSELF A BIG RISK (Hofmann, 2008) • • The risk associated with complexity must not be The risk associated with complexity must not be underappreciated – Interconnected markets ensure that even I t t d k t th t 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).
LESSON 3. PAY ATTENTION TO MARKET SIGNALS 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 • « 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 agreement.
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