Canadian Life Insurers Poised to Boost ETF Investments
Canada’s exchange-traded fund (ETF) market is on the cusp of a significant shift. A recent regulatory update from the Office of the Superintendent of Financial Institutions (OSFI) is set to encourage greater investment from the country’s life insurance companies. This change, which took effect January 1, could channel substantial capital flows into ETFs.
Previously, the regulations made it challenging and less cost-effective for life insurers to allocate capital to ETFs within their general accounts, where premiums are deposited and ultimately used to fund operations and policyholder payouts.
“It’s definitely a positive development,” says Linda Ma, vice-president of ETFs and financial products research at National Bank Financial Inc.
OSFI’s new guidelines for the life insurance capital adequacy test (LICAT) have changed how ETFs are assessed. “Before this change, capital requirements for exchange-traded funds were calculated based on the fund prospectus,” said Cory Harding, OSFI’s communications advisor. The agency’s regular review of LICAT led to a reassessment of risk measurement so that it better reflects the underlying assets of an ETF.
Andres Rincon, head of ETF sales and strategy at TD Securities Inc. in Toronto, explains that “previously, the regulations measured risk based on the worst-rated security in the ETF. It was basically a worst-case scenario.”
The Impact of Revised Rules
A TD Securities report from last year provides a clear example: Under the old method, a Canadian investment-grade aggregate bond ETF tracking the FTSE Canada Universe Bond Index would be rated BBB. This rating was based on the bond in the portfolio with the lowest credit rating. An ETF with an “effective maturity” of seven years had a credit risk factor around 4.75%. For a Canadian insurer holding $100-million in that ETF, the required capital for credit risk would be $4.75-million.
The new rules employ a weighted average credit rating exposure for an ETF, accounting for all underlying holdings. The same ETF in the example is now rated AA, which reduces the credit risk factor to 1.75%. As a result, the required capital for a $100-million holding drops to $1.75-million — a substantial 65% reduction.
This substantial reduction in capital risk means insurers can hold significantly more ETFs in their portfolios, enabling them to meet their liabilities more efficiently.
According to Mr. Rincon, a growing number of insurers are “externalizing management” of fixed-income assets. The lower fees associated with ETFs offer considerable cost-saving benefits.
ETF Advantages
Prior to this year, insurers often found it most cost-effective to invest in individual bonds, which can be cumbersome to manage. With the advent of ETFs, investment managers no longer need to source individual bonds from a market maker.
Ms. Ma highlights the BMO Aggregate Bond Index ETF (ZAG-T) as an example. It’s among the largest and most liquid bond ETFs in Canada. With a single trade, an insurer can gain diversified, low-cost exposure to the markets, with a bid-ask spread of only 8 basis points (bps). “That’s much smaller than if you were to trade 1,600 unique bond positions,” she says, referring to the approximate number of underlying bonds in the ETF’s portfolio.
ETFs also help investment teams implement portfolio changes more rapidly following opportunities.”
Mr. Rincon adds that ETFs trade on exchanges, unlike the over-the-counter nature of bond trading. This difference leads to improved liquidity for ETFs.
Potential Benefits for Investors
The increased institutional presence of insurers in the ETF market could bring other advantages for ETF investors, including financial advisors, potentially decreasing bid-ask spreads.
The TD Securities report estimates that Canadian insurers managed roughly $1-trillion in assets in 2023, with over $400-billion in fixed-income assets. Ms. Ma expects insurers to gradually increase their investment in fixed-income ETFs because of the benefits they offer. This, in turn, should improve ETF liquidity and push ETF fees down as issuers compete for market share. “The fees can be much more competitive given the economies of scale,” she says. “All that translates into benefits for the end users, including advisors.”
