Life insurance companies in Canada have experienced challenges since the liquidity crisis of 2008, primarily due to additional capital requirements associated with segregated fund guarantees. Segregated fund guarantees could take the form of principal at maturity and/or a return of principal at time of death. While the funds are managed by either the life insurance companies or through a third party, segregated funds often carry additional fees paid by the investor.
Some of these guarantees were hedged in the capital markets: many were not. As such, the profitability of many life insurance companies in Canada was impacted by this line of business. Since 2008, several life insurance companies have either exited that line of business, effectively capping their exposure, or they’ve more actively hedged the risk associated with segregated fund guarantees. Furthermore, insurance companies continuously attempt to reduce risk exposure to long-term interest rates, which have been persistently low over the past few years. This has had a further, negative effect on their profitability.
Given the challenges faced by life insurance companies today, I thought it would be instructive to investigate whether the stock market has given credit to these firms for the positive steps they’ve taken in managing their risk exposures.
There are many ways to approach the problem of isolating life insurance company returns to provide the necessary analysis. I chose to compare life insurance company stock performance to that of banks for several reasons because I wanted to isolate life insurance company exposure by removing the general index and financial sector exposure. I also did this because banks generally do not have exposure to segregated fund guarantees and because they don’t carry the same exposure to long-bond yields.
In the chart below, we compare the excess returns of life insurance companies versus banks against both the TSX index and long-term interest rates. We calculate the correlations of the insurance company excess returns against each of these market indicators to determine how significant the relationship is between each factor and the insurance versus banking sector over time. This will give us a picture of how the market prices these factors into insurance companies’ relative value to banks. Correlations are calculated over one-year rolling time periods using weekly data. (click on chart to enlarge)
Source: MSCI, Greystone Managed Investments
If the market believed that insurance companies have effectively reduced exposure to both segregated fund guarantees and long-term interest rates, we would expect these correlations to be close to zero. A positive (negative) correlation would indicate that life insurance companies are more likely to outperform (underperform) banks when equity returns are positive (negative) or long-term interest rates are increasing (decreasing) in yield.
It appears that since 2009, the market has given greater credit to insurance companies for reducing segregated fund guarantees until the most recent data, when correlations have been a statistically significant 0.3. Since equities have positive performance over this period, it may indicate that the market believes life insurance companies are no longer efficiently hedged against their equity exposure. The extremely high 0.5 correlation to long-term interest rates over the past year also indicates that markets believe this is a large risk for insurance companies.
Correlation statistics change over time as relationships of assets change. At times, market participants attribute strong relationships between securities and at other times they do not, depending on the market environment. We have used correlation analysis to determine how tight the relationship is between insurance company performance in the market and long-term interest rates versus stock index performance. Our analysis that market participants believe insurance companies continue to retain risk on their books this relationship changes over time and that, in our most recent observations, the market attributes a degree of susceptibility to long-term interest rates that has not been present since 2009. The market has also been increasing its risk assessment of Canadian insurance companies to the Canadian equity index.