Regulatory History and Evolution
Regulatory History and Evolution
From the Canadian Insurance Regulation Reporter, November 2015
This article is based on a paper that was prepared for the School of Public Policy at the University of Calgary in 2014, as part of the university’s Financial Markets Regulatory Program. The paper is entitled From Trial to Triumph: How Canada’s Past Financial Crises Helped Shape a Superior Regulatory System. The paper describes the evolution of financial regulation in Canada, and focuses on how a spate of insolvencies during the 1980s gave rise to a completely different financial regulatory system at the federal level. That system, with on-going fine tuning, demonstrated remarkable performance during the financial crisis of 2008 and has gone on to become a model for regulatory system development in countries around the world. The paper ran to 60 pages and also covered other issues related to modern financial regulation and the financial crisis of 2008. Rather than attempting to summarize the whole document, the article below emphasizes historical developments in the regulation of the insurance business.
Since the time of confederation, the Canadian financial system has benefited from six major Royal Commission–type enquiries as well as a number of reviews by governments of the day. The investigations and findings of these various bodies provide a rich history of Canada’s development in the area of financial regulation.
The first Bank Act was adopted in 1871, and the first Insurance Act in 1876. Thus prior to the new Dominion of Canada having reached its tenth birthday, parliament had already focused on and adopted specific laws to govern its developing financial system.
Recognizing that most regions of Canada’s sparsely populated territory could not support local banks, the first Bank Act provided for a system of branch banking, under which centrally located institutions would be able to support small branches in the hinterlands. This set the pattern that led to our current environment where we have a few huge banks with thousands of branches across the country, as compared to the system south of the border where small local banks are much in evidence. An additional far-sighted provision of the first Bank Act was that it would expire in 10 years, establishing the precedent for required decennial revisions to our financial legislation (now every 5 years).
For the first 30 or so years after confederation, Canada’s banking and insurance laws were gradually expanded as required to accommodate the increasing volume and complexity of the country’s business and personal financial transactions. However, in 1904, there was a dramatic scandal in the life insurance world in the United States. A number of events occurred, which brought to public attention the fact that directors and officers of some of the largest insurers were leading what in those days could only be regarded as unbelievable and excessive lifestyles. The situation was similar to the public outcry that arose during the dot-com bubble of the late 1990s, when lifestyle excesses of some of the high tech company CEOs became public knowledge. The displays of wealth in 1904 were considered especially inappropriate because most life insurance at that time was sold on a participating basis, but returns to policyholders under those policies were miniscule. In 1905, the New York State legislature convened the Armstrong Commission to look into business practices in the U.S. life insurance industry. The findings were revelatory. The Commission learned that funds of U.S. life insurers were being “ruthlessly exploited for the personal advantage of the officers and directors and that nepotism was rampant”. Life insurers of the day were utilizing their substantial financial resources (funded by the premiums of participating policyholders) to take control of and to operate other major businesses such as railroads and utilities, where the life insurers’ officers and directors also became officers and directors of the controlled corporations. The Armstrong Enquiry ultimately generated ten volumes of testimony and documented widespread abuses of power as well as cases of outright fraud, leading to the indictment of a number of senior officers of the insurers involved. The Enquiry’s recommendations also gave rise to sweeping revisions to the New York Insurance Code and, in particular, greatly constrained the investment powers of life insurers.
The disclosures of the Armstrong Enquiry were also shocking to the general public in Canada, and, in 1906, the government established the McTavish Royal Commission on Life Insurance. Canadian abuses were found to be more limited than what had been evident across the border, and no actual fraud or other criminal activities were brought to light. Nonetheless, conflicts of interest were numerous, and there were calls for changes in the Insurance Act to parallel some of the amendments to the New York State laws. That occurred in 1910 with the adoption of a new and greatly revised Insurance Act. This landmark piece of legislation became the cornerstone of federal insurance law for the next 80 years.
Jumping ahead to the more recent times of the 1960s, we find that the largest life insurers were the Canadian mutuals: Canada Life, Confederation Life, Great-West Life, London Life, Manufacturers Life, and Sun Life. The property/casualty insurance business was highly fragmented, but most of the larger insurers were members of international groups with professional management. Canadian-owned property/casualty insurers tended to be smaller and were mostly controlled by members of the Canadian establishment. In fact, at that time, the financial system as a whole tended to be relationship driven with, for example, significant lending decisions being based more on the identity of the principals than on the underlying terms of the proposed deal. No insurance companies were publicly listed. All the insurers of the day followed conservative operating policies and had low levels of leverage. Property/casualty insurers were subject to a simple minimum solvency requirement. Life insurance companies were not subject to any specified minimum solvency requirement, mainly because at that time, the actuarial reserves tended to be so conservatively determined that even if a life insurer had liabilities equal to its assets (i.e., no equity at all), it was thought that it would still be able to meet all policyholder obligations.
Insurance regulation was the responsibility of the Department of Insurance (DOI), whereas bank regulation was through the Office of the Inspector General of Banks (OIGB). Both DOI and OIGB reported to the Minister of Finance although DOI did so directly, whereas OIGB was through the Department of Finance. There was virtually no coordination of policy or procedure between the two regulatory agencies, and the operational philosophies were quite different.
The Insurance Act required insurers to submit detailed annual financial filings to the DOI for review, supplemented by interim financial and investment filings during the year. The annual filings were extensive, running to more than 80 pages and were in addition to a requirement for annual audited financial statements. Insurers’ investments were highly constrained, having to be judged “eligible” under the conservative investment provisions of the Canadian and British Insurance Companies Act [C&B Act]. Notwithstanding a high statutory standard for eligible common share investments, the total common share investment of each insurer was limited to a maximum of 20 per cent of assets. Few insurers were anywhere near the 20 per cent limit. Debt securities were subject to a strict interest-coverage test, but if a corporation’s common stock qualified for investment, then all of its debt securities also qualified. The C&B Act included a “basket clause”, which provided relief from the strict investment rules for up to seven per cent of total assets. Even so, few insurers had any basket-clause holdings. These conservative investment rules were a legacy of the MacTavish commission recommendations and the 1910 Insurance Act that resulted therefrom.
While the regulatory framework of the C&B Act restricted straightforward related-party transactions, such as the loaning of insurance company funds to other corporations controlled by the controlling shareholder, there remained plenty of scope for self-dealing. For example, it was possible for shareholders to purchase an insurance company on a 100 per cent leveraged basis, but then for the new owners to strip funds from the insurer by way of management fees and other transactions, which, in turn, would be used to liquidate the borrowings that had been used to fund the original purchase. In other words, the insurer’s own funds could be used to pay for its purchase, leaving the insurer in a weaker financial position and its policyholders insured, but with a less secure institution.
An additional area that was open for non-arm’s-length exploitation was in the realm of reinsurance. Reinsurance transactions could be structured with shareholder-owned reinsurance companies based in jurisdictions of convenience. The many variables involved in reinsurance contracts made it relatively easy to strip funds from a Canadian insurance company and transfer them to a group-owned reinsurer in a tax-free jurisdiction.
Regulation at that time was mainly by moral suasion. If an operational policy of an insurer appeared to be in some way dubious, a call to the CEO or chairman (likely the same person) from the federal Superintendent of Insurance would almost certainly guarantee that the policy would be changed. In this type of environment, there seemed to be little requirement for complex legal and regulatory provisions or for invasive regulatory actions.
At this time, there was little or no consideration of risk at a regulatory level either in terms of planning work, carrying out on-site procedures, or taking regulatory action. A rule-based mentality dictated that moral suasion could be exercised when it became clear that problems had developed, but not before. (Of course, by the time problems actually develop, it may be too late to fix them—hence, the proactive, risk-based approach of today.)
If we take stock at the end of the 1970s, no Canadian life insurance policyholder had ever lost a dollar due to the failure of a life insurance company. It had then been more than 50 years since the last Canadian bank failure (Home Bank in 1923), and the last failure of a property/casualty insurer had also been far in the past.
What were the risks at that time? Given the extremely conservative investment stance, market risk would be judged as minimal by today’s standards. Because of the traditional approaches to running their businesses, simple products and no dependence on IT, operational risk also tended to be quite low. Strong capital positions further buttressed the insurers’ financial strength. Thus, perhaps one reason that risk assessment was not a significant part of the regulatory toolkit was that the business was carried out in a traditional manner, with little evidence of the dynamism, competitive forces, and volatility that are hallmarks of today’s financial world.
However, during the latter part of the 1970s, the winds of change began to blow through the tranquil insurance world described above. This was evidenced by changes taking place in the underlying ownership and management structure of the industry, along with the appearance of new market entrants, which had previously been few and far between. Entrepreneurial players began to be attracted to the business, probably for two reasons. First, there was a view, which had some basis in fact, that the insurance business was somewhat sleepy but had the potential to generate a high return on investment. And second, the somewhat simplistic regulatory environment with its lack of effective controls on self-dealing offered considerable potential for accessing what some perceived to be “excess” capital, which in their view could be better employed in other businesses.
By the early 1980s, the DOI found itself dealing with situations that would never have been envisaged during the 1960s and 1970s: a bogus reinsurance broker in the London market caused great financial damage to two Canadian insurers; several situations arose where disguised, non-arm’s-length reinsurance was used to suck capital out of Canadian insurers, hugely eroding their financial positions; a shareholder injected capital into his insurance company in order to support the renewal of its licence but then transferred the funds back to his personal account after the licence renewal had been granted; a Canadian insurer was restricted by DOI to a maximum specified volume of premium in a high-risk line of business being transacted in the United States, but the insurer ignored the restriction while misreporting the situation in its monthly financial submissions to DOI, leading to major underwriting losses that significantly contributed to the insurer’s ultimate insolvency. These are but a sample of the challenges that occupied DOI staff during the 1980s—completely different from the benign financial climate of the earlier years.
The implications of this changing environment were not lost on the insurance regulators of the day. Nevertheless, they were powerless to do anything other than harangue the companies and shareholders concerned in an effort to get them to change their practices. Unfortunately, by that point in time (i.e., the early 1980s), the concept of moral suasion had become pretty much meaningless to those for whom the message really mattered.
To be clear, the types of situations mentioned were certainly not occurring with main-line insurers, which continued to go about their business in a professional manner. Nevertheless, situations of the type referred to above tended to take up huge amounts of regulatory resources.
We suggest that directly as a result of the changing financial environment of the times, insurance companies, banks, and trust companies began to fail at an alarming rate during the early 1980s. For example, between 1979 and 1985, seven Canadian property/casualty insurers failed. In 1986, we saw the failure of two chartered banks: Northland Bank and Canadian Commercial Bank. During the 1980s, 23 trust companies collapsed, some of which were substantial institutions. And in the early 1990s, we saw the first ever failures of Canadian life insurers: Les Coopérants in 1992, followed by Sovereign Life in 1993, and then in 1994, Confederation Life, one of Canada’s oldest and largest life insurers.
After many years of seemingly trouble-free operation by Canadian financial institutions, these corporate failures, along with heart-rending stories of financial loss to depositors and policyholders, gave rise to considerable dissatisfaction for the general public as well as stress for the government. This was well reflected in the extraordinary number of investigative commissions and other initiatives that were put in motion to try to come up with answers and appropriate recommendations.
The author of this paper, who was head of the property/casualty insurance division at the DOI from 1977 until 1985, well recalls being dragged up to Parliament Hill on numerous occasions, with the then Assistant Superintendent of Insurance, Robert Hammond, to appear before the House of Commons Standing Committee on Finance, headed by MP Don Blenkarn. The Senate Committee on Banking, Trade and Commerce also carried out investigations and made recommendations to the government. The specific situation of the bank failures was investigated and reported on by Justice Willard Estey, and the CDIC perspective was considered by the Wyman Committee. Much of this input was coordinated by the Department of Finance, through the vehicle of a green paper entitled The Regulation of Canadian Financial Institutions: Proposals for Discussion.
Being at the Department of Insurance at the time, the worry was that all of this discussion would likely lead to a jumble of compromise proposals that would not be effective in dealing with the issues. Fortunately, however, that was not the case at all. The clear pattern that emerged was of financial institutions becoming insolvent not as a result of not adhering to the existing laws but rather to the fact that those laws said virtually nothing about how businesses were managed, how risks were measured and mitigated, and how boards of directors should oversee the institutions to make sure they were following sound business and financial practices. As well, regulators were powerless to intervene until the institution was virtually bankrupt, and even then, the nature of the intervention was very much of a blunt instrument—primarily the revocation of the insurer’s licence.
The regulatory framework was revamped relatively quickly, with OIGB and DOI being combined to form the Office of the Superintendent of Financial Institutions (OSFI) in 1987. In 1992, the Insurance Act was revised to stress a number of important new concepts and to provide increased emphasis on certain aspects that had not been emphasized previously. Key features were as follows:
- Integrated supervision through OSFI: The job of assessing risk in the financial system can be compared to putting together a jigsaw puzzle. The more people who are holding pieces of the puzzle, the longer it may take to recognize an image. Similarly, different regulatory agencies, each seeing only part of what is happening, will be delayed in recognizing the real pattern of risk.
- Risk-based approach: OSFI developed a sophisticated framework for assessing risk across different types of institutions, using formalized, consistent methodologies that are as objective as possible, to assign risk ratings to all institutions. Regulatory resources are allocated based on risk ratings, as well as the overall impact on the public in case of failure. This approach ensures that time is not wasted on activities where risk is low, as was often the case in the days of the Office of the Inspector General of Banks and the Department of Insurance.
- High standards of corporate governance: The quality of governance within an institution is the foundation for effective management of that institution. The board must establish a clear framework for the organization’s strategic direction, control framework, and risk appetite across the risk areas that are relevant to the institution’s operations. In this regard, one of the clear messages from the failures in the early 1980s was that boards of directors had not focused on the importance of effective systems of corporate governance. Many critical decisions were made by managers in different functional areas, without board oversight, resulting in inconsistent risk decisions and differing internal standards for different parts of the business.
- Sound capital requirements: When times are good, capital buffers are not particularly important. And when there are long periods of profitable operation, and continuing profits are expected, regulators may agree to reduced capital requirements. However, good times do not last forever, and when the situation changes, institutions may be caught short. OSFI has been successful in insisting upon relatively high capital levels in good times and bad, and there seems to be little doubt that these requirements helped Canadian financial institutions weather the storm of the recent financial crisis.
Escalating intervention based on risk versus compliance-based approach: OSFI has, and international standards require, the power to apply preventive and corrective measures on an escalating basis as risk increases. The regulatory agency is then able to adopt the same approach that would be followed by any competent management team in addressing a business issue: first there will be a plan to be implemented and tracked, and if it is not doing the job, more serious measures will be identified and implemented by management as required.
- Tight controls on related-party transactions: An important cause of institutional failure was the ability of financial institutions to enter into transactions with related parties. Financial institutions, by their nature, have access to large amounts of cash and liquid assets. When institutions have controlling shareholders that own other businesses, those shareholders may be tempted to reach into the controlled institution to obtain funding. (Note that related-party transactions were more of a regulatory issue for insurance than for banking, because the Bank Act revisions of 1967 prevented any individual shareholder, or group of related shareholders, from controlling more than 10 per cent of the shares of a chartered bank.)
- Disclosure of conflicts of interest: Directors and officers must fully disclose to their boards any conflict of interest that may arise in connection with their responsibilities to the financial institution. The director or officer concerned cannot be party to any discussions related to the transaction in question. Failure to disclose a conflict of interest results in the disqualification of the individual from his or her position and renders him or her ineligible to act as a director of a federal financial institution for 5 years from the date of the contravention.
Country comparisons can be made with regard to all of the points noted above. One finds that many developed countries have only some or a few of the listed attributes. For example, in the United States, we see that instead of an integrated system of financial oversight, insurers are regulated by 51 state governments, and there are eight separate federal regulatory agencies having shared responsibility for bank regulation, to say nothing of additional regulatory input coming from both state and municipal governments. Also U.S. regulators operate mainly through a rule-based/compliance-based approach, whereas in Canada the system is much more principle based.
The recent financial crisis highlighted two key points. First, the cost of financial institution failures can be enormous, with much of the cost being placed on the shoulders of the public at large. Second, with Canada as one example, judicious application of established regulatory approaches and principles can potentially avoid much the financial and economic impact of collapsing financial systems. For this reason, we see on an international scale, many developing and emerging market countries looking at the Canadian financial regulatory system as a template for systems in their own countries, with suitable adjustment to take account of local conditions.
In summary, the Canadian model as developed by OSFI, requires, firstly at a primary level by the basic terms of the statutes, but secondly and more profoundly at an operational level by OSFI’s policies and guidelines, to adhere to sound business and financial practices in the transaction of their businesses. In other words, the Canadian requirements for financial institutions are consistent with what one might include in an MBA textbook intended to guide management in the operation of a sound institution. In our view this is the optimal way to design a regulatory system: minimize rules and bureaucracy; maximize sound management practice.