August 1, 1999 by Sean van Zyl, Editor
Alan Greenspan only has to mention inflation and interest rates in the same breath to send the investments markets into spasm. His most recent economic brief, presented toward the end of July, knocked off close to 3% of the value of the Dow Jones and the TSE-300 index in a single day. The capital markets also gyrated with the message he presented — that being the U.S. Federal Reserve will act promptly and without mercy in raising borrowing rates to quell any inflationary rise in prices in what is looking to become an overheated U.S. economy.
In response, Bay Street commentators point out that a rise in U.S. inflation, and a responding interest rate hike, should have little impact on the Canadian economy and the local rate environment due to the different economic circumstances ruling the two countries. In terms of the fundamentals, it therefore stands to reason that Canadian investment markets should shrug off any adverse conditions developing south of the border. That’s a great theory, and in my books, one strongly laced with the frantic hope of security analysts whose jobs rest on keeping the calm even when a tornado is winding its way up the front garden path.
The reaction of the Canadian financial markets to Greenspan’s July brief clearly suggests that the opposite is most likely to be true. Past experience also shows that when the U.S. markets cough, the Canadian market, and for that matter the global investment scene, catches a cold. So much for the fundamentals behind investment decision.
What is particularly alarming as we head into the traditionally volatile trading season of September through to November is that Greenspan is almost anticipating a crash in asset prices. In his June 17 testimony to the Joint Economic Committee, Greenspan expressed concern over “asset inflation” and the need for the U.S. to economically prepare for a dramatic downturn in the investment markets. Albert Friedberg, director general partner of Toronto-based investment dealer Friedberg Mercantile Group, astutely observes that Greenspan was almost hinting in his speech of an orchestrated crash of equity markets to bring back asset prices. In the event that Greenspan is correct in his view to the markets, and equity bourses do indeed plummet this fall, what would the result be for Canadian property and casualty insurers?
Although a global stock market crash would be hardly welcomed, the impact on local insurers would be fairly minimal for several reasons: unlike the U.S p&c sector which has a high level of public-listed companies, Canadian operations are mainly unlisted subsidiaries of larger global groups. As such, the negative impact on share price and shareholder value would be minimal (at least at the local level for those with offshore listed parents). Secondly, from an investment portfolio perspective, the sector’s relatively low exposure to equities would also shield against the devastation that other financial service companies would be subject to.
Don Smith, chairman of Canadian Insurance Services Ltd., notes that an equity market crash and subsequent rise in interest rates would serve to boost the sector’s income yield. The negative flip to this, however, is that rising capital market yields would also wipe out capital values of bond portfolios — thereby eroding the opportunity for realized capital gains. A significant decline in asset prices (bond values) could deplete surplus book values, which, in some cases, would place a capital regulatory restraint on the ability to write new business.
Although a stock market crash akin to that of 1929 would leave some companies in trouble, the market overall is well positioned to absorb a significant capital market decline, Smith says. He notes that the Canadian industry is currently operating at a ratio of one dollar in capital to every two dollars in premium written. The regulatory position to surplus is one dollar in capital to every three dollars in premium. As such, insurers could incur almost a 50% reduction in surplus values before running into capital restrictions, Smith says.
In a similar vein of thought, Paul Kovacs of the Insurance Bureau of Canada (IBC) adds that the prospect of a major equity market crash is an issue of concern. The erosion of the industry’s unrealized gains for the 1998 financial year, resulting from the broad market correction in September of that year, shows the degree of influence an investment market decline can have on industry results, Kovacs observes. But, he agrees with Smith that a 50% reduction in the industry’s capital — which would result with an equity market crash equivalent in severity to that of 1929 — would leave most companies “technically okay”.
In addition, Nathan Sambul, managing director of Guy Carpenter & Company Inc. (New York), does not expect an investment market crash, should one occur, to match that of 1929. The monetary authorities have become adept at adjusting to volatile market conditions and taking appropriate action. The level of liquidity which the Fed maintained in the U.S. economy following the 1987 crash suggests that any future event will be handled responsibly, Sambul says. In fact, a “well managed crash” limiting the fallout damage could spur investors into the bond market boosting prices to the benefit of insurers.
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