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Canadian I tit t Canadian I tit t L’Institut di L’Institut di Institute

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Institute

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canadien des canadien des

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Actuaries

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Actuaries des actuaires des actuaires

2008 Annual Meeting ● Assemblée annuelle 2008 2008 Annual Meeting ● Assemblée annuelle 2008 g Québec g 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 f f Fi d I Professor of Finance and Insurance Industrial-Alliance Chair in Insurance and Financial Services Faculty of Business Administration L l U i it Laval University Quebec City Canadian Institute of Actuaries 2008 A l M ti 2008 Annual Meeting 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 di t t th i th ti l l discount to their theoretical values »

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

Car loans

SPV Buyer

Car loans Commercial Loans Mortgage loans Credit Cards

Trust (conduit) Investor

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

• f the underlying assets (e g

cash flow timing mismatches

• f the underlying assets (e.g., cash flow timing mismatches
• r 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 considered safe! instruments…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

Assets

Car loans

SPV Buyer

Quality of assets backing ABCPs is questioned

Car loans Commercial loans Mortgages

Trust (conduit) Investors // //

g g Crédit cards Student Loans …

(conduit) ? //

SUBPRIME CDOs

Liquidity 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

Credit 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

• ut 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

118%

COMPARATIVE EVOLUTION OF 4 LIFE INSURANCE STOCKS SINCE AUGUST 13, 2007

112% 118% 100% 106% 94% 100%

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

Manu -2 % TSX -1 % 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) M lif S Lif G t W t Industrial Alli A Manulife Sun Life Great West Alliance Average 40% 47% 85% 41% 53%

EXPOSURE TO ASSET-BACKED SECURITIES: THE CASE OF IAG 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 Bank ABCP $136.2 M None Issued by large Canadian banks Global liquidity clause No leverage Quality: 100% AAA rating Quality: 100% AAA rating Most rated by 2 or more credit firms Mortgage-Backed Securities (MBS) $156.7 M None 100% insured mortgages Quality: 100% AAA Securities (MBS) M Quality: 100% AAA Commercial Mortgage- Backed Securities (CMBS) $182.5 M None Quality: 90% AAA Other ABS $478.3 M Less than $7 M Mostly credit cards Quality: 90% AAA

OVERALL QUALITY OF INVESTMENTS OF IAG RELATIVE TO PEERS IAG RELATIVE TO PEERS

N t I i d I t t

Well-Positioned if Faced with an Economic Slowdown

Net Impaired Investments 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 Assumption Income to Common Shareholders % of Consensus % for Peers 10% drop in equity markets ($18.6 M) 7% 5-8%

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 I t t d k t th t – Interconnected markets ensure that 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).

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.

LESSON 4. ASSESSING CREDIT QUALITY IS AN ASSESSING CREDIT QUALITY IS AN IMPRECISE PROCESS

• Many life insurers have decided to do their own

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
• pinion;
• Do not underestimate agency risk when

assets are valued by a third-party assets are valued by a third party.

• Credit risk may trigger liquidity problems due to

mismatch…potentially impacting a life insurer’s reputation and its franchise value.

LESSON 5. LEARN FROM PAST CASES OF DERIVATIVE MISHAPS 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

b l h h d li it i li it d t t because employees who had an explicit or implicit mandate to hedge their firm’s risk decided instead to speculate;

• Importance of having clear and unambiguous policy
• 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)

LESSON 6. KEEP QUESTIONING THE COHESIVENESS OF THE KEEP QUESTIONING THE COHESIVENESS OF THE CURRENT RISK MANAGEMENT FRAMEWORK

• Major Canadian life insurance firms are among the

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
• ERM, as a process, is a form of general

management aiming at ensuring an organization’s continuous improvement.

• However, ERM is not a panacea.

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 – 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 i l i t t l ti insurers may rely on more consistent 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)

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 279-326 Santomero, KAP, 1999, 279-326.

• Hofmann, D., « A Risk Management Approach To Financial

Crisis Prevention », The Geneva Association, Insurance & Financial No 3/April 2008 6-7 Financial No.3/April 2008, 6-7.

• Hull, J. « Hull’s Laws: What We Can Learn From Derivative

Mishaps », Rotman Magazine, Spring 2007, 32-36.

• Smith, C.W., « Corporate Risk Management and the Insurance

Industry » in Financial Management of Life Insurance Companies, edited by J.D. Cummins & J.L. Tennant, KAP, 1993, 125 149 125-149.

• White, W., « Past Financial Crises, the Current Financial

Turmoil, and the Need for a New Macroeconomic Stability Framework LSE Financial Markets Group & Deutsche Bank Framework, LSE Financial Markets Group & Deutsche Bank Conference, London, March 2008. (http://www.bis.org/speeches/sp080326.htm )

THANK YOU! THANK YOU!