The Face of REGULATION

John Palmer, superintendent of Ottawa-based Office of the Superintendent of Financial Institutions (OSFI) arrived at his position in the immediate aftermath of the collapse of Confederation Life, when confidence in the federal regulator had reached a low point.

But, Palmer argues that, as Confed Life policyholders each received 100 cents on the dollar (plus interest), is proof that OSFI fulfilled its mandate in dealing with the affair. Furthermore, a new legislative framework is likely to keep OSFI ahead of the playing field at a time when over capacity in the property and casualty sector and demand for higher returns is going to increase the level of risk and heighten the potential for failure within the industry. “Our mandate makes it clear that we can’t prevent failure,” Palmer points out. “Our primary role is to protect Canadians who put their [confidence] in bank deposits and insurance policies.”

Palmer arrived at OSFI by the way of a career as a chartered accountant in British Columbia. He had originally earned a degree in English and philosophy before leaving the world of literature and lectures for a more interesting and disciplined future in ledgers, here in Canada and the U.K. In the 1970s he helped implement tax reforms for the Trudeau government, before returning to Vancouver to work for a firm that was eventually folded into KPMG Management. He spent the last ten years prior to heading up OSFI, first as the managing partner of KPMG’s Vancouver office, later as managing partner for Canada.

This experience, he believes, prepared him for the challenges confronting OSFI. “During the time I was managing the national firm we were faced with many of the issues that are facing financial institutions and regulators now. We were trying to build a very strong Canadian network and create the specialist skills, the knowledge of particular industries to keep up with the changes in the marketplace. Perhaps, most importantly, we were trying to build a strong international network to respond to the globalization that was taking place even in the 1980s. I went through two major mergers in the course of my term as managing partner, so I’ve had hands on exposure to the benefits and the costs of mergers.”

Consolidation and competition

Consolidation will continue to be a fact of life in Canadian financial services according to Palmer. Interestingly, however, he argues that technology, and not mergers and acquisitions, will become the main defining point of financial institutions in Canada, noting that American-based credit card companies are already building substantial market positions through large investments in technology. “[They have an] ability to get processing costs down to a level which permits them to price very competitively against the traditional players,” he says.

The distance between credit card plastic and insurance policies is not that great a leap, especially when, according to Palmer, traditional financial institutions and non-traditional players are using technology and multi-channel distribution to stake out major franchises in specific (and already crowded) markets. “The challenges affecting the insurance industry are not totally unique to the insurance industry,” he notes.

These challenges include more competition, over-capacity (especially in the p&c business) and the need to deliver higher returns. “Life insurance companies, for example offered products with embedded guarantees at a time when returns were in double digits. Now when you’ve embedded guarantees of 4% and you’re earning interest rates of 5% to 6%, the margins are getting pretty tight and that puts pressure on people to move up the risk curve in order to meet their obligations and still earn the increasingly high returns that capital markets are demanding from the companies they favor.” The risk is often compounded by the speed and scope that decisions are being made inside corporate boardrooms.

Palmer says that moving up the risk curve is not a bad thing provided the journey is supported with good controls, added capital, and appropriate reserves. In response, the federal government is expected to strengthen the financial industry’s regulatory framework this spring by adding three new “arrows” to OSFI’s “quiver”:

The ability to remove officers and directors

Tighter controls regarding related party transactions, and

Greater flexibility to impose controls

These regulatory add-ons should be sufficient to keep OSFI relevant in a changing financial services environment, which includes the dual issues of consolidation and convergence.

On the subject of convergence of federal and provincial regulators, he does not see it happening anytime soon — too many provincial barriers stand in the way, although, he is encouraged by the level of cooperation among Canadian securities commissions. “They’re trying to do in a de facto way what the legislators could not do in a legal sense. That will be the kind of [regulatory] convergence we will see in Canada. It will be through more co-operation amongst different regulators.”

On the topic of whether demutualization inside the life insurance industry will open the door to increased ownership of lifecos by the banks after the two-year breathing period, Palmer is more reluctant to advance a view, noting that OSFI remains a “policy implementor” rather than a policymaker. He is optimistic, however, that the federal government will open the ownership rules to create ownership combinations such as holding company structures that are not currently allowed under Canadian rules.

One area where Palmer has expressed serious concern is the impact that consolidation has had in the reinsurance sector, and whether reserves among a shrinking number of reinsurers are sufficient to cover claims resulting from “Acts of God”, which is increasing concern he notes given the higher number of natural disasters already buffeting our environmentally fragile planet. “Earthquake risk has been an issue for sometime,” he points out. “We’ve been a bit disappointed when we’ve assessed the size of the reserves unfolding. They’re certainly not as large as expected. That’s something we’re going to be watching more closely. Imagine for example that you had not only the big [quake] off the West Coast of Canada, but you had something more massive up and down the East Coast. Would the reinsurance capacity be there?”

The industry has responded to his concerns by pointing to the broader base of areas requiring reinsurance. But Palmer remains concerned that most of the capacity to cover a significant disaster is flowing into the hands of five major players which now dominate the Canadian reinsurance landscape. OSFI has introduced voluntary guidelines to build up earthquake reserves and has worked with the industry in pressing the federal government for tax relief. Palmer will not rule out compulsory reserving. “We’ve made no decision to go that route at the present time. That’s an initiative we’ll be thinking about,” he adds.

In addition to larger issues such as reinsurance, Palmer will have to focus on that which has slipped through the cracks, such as Eaton’s self-insured disability fund for employees, which disappeared with the collapse of the retailer. He insists that his office is “running hard” to keep up with emerging issues and new products. More importantly, he says, OSFI is attempting to be more strategic in the way it operates.

Still, the misconception of his office as an industry fail-safe remains a problem when articulating OSFI’s mandate. “We would like the recognition [by] Canadians that we’re not running a foolproof system. If you increase the risk in the system then it’s inevitable that more is going to slip through our fingers. We are organizing ourselves to adapt to the new realities in the system. But we’re running a reliance-based system of supervision. We’re relying heavily on internal controls and government’s processes within existing institutions. I can’t tell you that we’ll always get it right — we’re not purporting to provide 100% protection.”