Regulator Focuses on Risk

Within days after officially taking the reins as the new superintendent of the Office of the Superintendent of Financial Services (OSFI), Nick Le Pan was presented with possibly the most precarious and financially devastating event to have hit the insurance industry — the September 11 terrorist attacks. By the end of last year, the federal regulator had to contend with a host of new risk factors such as the fallout from the Enron fiasco as well as new money laundering reporting requirements as international pressure grew to freeze funds of suspected terrorist networks. All in all, the last eight months have been a busy period, Le Pan observes.

Events since September of last year have also proven that the risk environment within the financial services industries is far from a motionless landscape, and regulators have to accommodate such changes in order to effectively fulfill their mandate of public protection, Le Pan notes. This he believes is most efficiently achieved through open dialogue with the industries that report to OSFI. And, he adds, “I believe there has to be balance between regulation and cost” with regard to how OSFI operates. “We can’t stand still, a regulator has to periodically look [internally] to prune away inefficiencies.”

Risk management approach

OSFI’s approach to regulation of financial institutions has definitely swung toward a “risk management approach”, says Le Pan, with focus on the “risk profile” of each company reporting to the regulator. This means addressing the nature of the company’s business in terms of structure as well as its exposures. “…Our approach does not place priority on whether it [a company] is local or foreign owned.”

In this respect, Le Pan points out that the capital requirements placed on financial institutions are determined by the risk profile in question. “I don’t believe that a lower risk company should face the same capital compliance as a higher risk company.” Likewise, he notes that the regulatory compliance cost placed on companies is determined by the amount of time the regulator has to spend reviewing the operation in question. “Our regulatory costs have declined because we have adopted a more risk-based approach.”

Le Pan observes that, generally speaking, property and casualty insurance companies are smaller in size, both operationally and in capital, compared with most other financial services concerns. The p&c insurance industry is also unique in its structure to that of “wealth accumulating” companies such as banks and life insurers, and in this respect the industry has to be regulated differently. “Our challenge [OSFI] is to keep making sure that we maintain this uniqueness [in how p&c insurers are regulated].” Also, he adds, “you can’t expect the same level of risk management in a smaller company than large corporate operations like the banks. There has to be a balance between risk, and the ability to manage and monitor such risks, which doesn’t mean that smaller concerns are necessarily more risky.”

Furthermore, Le Pan notes that, “as an office, we have been saying that profitability is the first line of defense. I get concerned when profitability [within industries] drops.” Notably, he adds, the latest financial returns (2001 financial year insurer returns) clearly reflect the worsening results from within the p&c insurance industry. “The latest financials have led us to spend more time in monitoring companies. Given the nature of the results, it [monitoring of companies] has become a higher priority than a year ago.”

Cost of regulation

While insurers generally bemoan the cost of regulation placed on them individually and as an industry, Le Pan contests the notion that the financial burden placed on the p&c insurance industry has risen over the years. In fact, he stresses, the “direct cost” of regulation on the p&c insurance sector — namely OSFI fees — for the past seven years had risen by less than 5% in total while the industry’s revenue had increased by 40% over the same period.

“Indirect costs”, namely “compliance costs” incurred by companies individually, are a lot harder to keep track of, Le Pan admits, which makes it difficult to “get a handle” on the extent of increases. However, he points out, “there are now fewer things [actions taken by companies] that require approval, and generally we’ve simplified the approval system”.

New risks

The events of September 11 have clearly shown that the risk environment, and therefore exposures of insurers, has evolved and become considerably more complicated than in years past, Le Pan observes. The financial impact of the terrorist attacks has drawn attention to “off balance-sheet” transfer of risk by companies, including their reinsurance arrangements.

Besides the fact that the type and manner of risk transfer financial instruments have become more sophisticated, greater emphasis is now being placed on the financial credibility of the organizations that ultimately assume the risk. As a result, OSFI is paying more attention to insurers’ reinsurance arrangements in how a company’s risk profile is evaluated. “It is important to understand that our job is to respond to what we see in the industry.”

International standards

The financial services arena has definitely become more international, Le Pan says, with p&c insurance being no exception. From a regulatory standpoint, this trend has placed greater emphasis on the need for harmonization of the rules applying to capital, actuarial risk management, to accounting standards.

Le Pan concedes that, currently, there are “huge differences” between major countries in how financial services companies, and specifically p&c insurers, are regulated. As such, he notes that OSFI is working with several international regulatory organizations to achieve greater comparability in compliance procedures as well as how the inherent risk of companies is evaluated. “International comparisons are an important benchmark for OSFI in monitoring [industries]”. As such, Le Pan says OSFI is presently conducting a review of the regulatory processes applying to the p&c insurance sector. “We’ve asked the [p&c insurance] industry to work with us…to compare how the rules relate [on an international level] based on the 2001 financial year data.”

Open communication

Maintaining “open dialogue” with the industries and companies falling under OSFI’s regulatory mandate is crucial, Le Pan says. OSFI holds regular “surveys” of insurers to establish the effectiveness of this relationship. “Feedback would seem to indicate that we’re doing a good job.”

OSFI’s communication approach is twofold, Le Pan adds, at both the industry level, as well as with companies directly. As part of this process, the regulator has established “industry group” meetings to discuss new issues. “We have a full, rich dialogue [with p&c insurers], which I think is very important.”

Looking ahead, Le Pan says, “under my leadership, we won’t stand still”. OSFI’s priorities in how it goes about regulation procedures will depend on the environment prevalent in any given year, he adds. “OSFI has an important mandate, but there’s always room for improvement in how we fulfill it, and I look forward to working with the [p&c insurance] industry in doing that.”

Government man

Le Pan joined OSFI in 1995 as the assistant superintendent of financial institutions after a career of 21 years with the Department of Finance. He succeeded John Palmer as the superintendent of OSFI in the beginning of September last year. He is the third person to occupy the role of OSFI superintendent since the office was created in 1987 following the merger of the Office of the Inspector-General of banks and the Department of Insurance. Le Pan holds a BA honors degree in economics from Carleton University, and a Masters in economics from the University of Toronto.