Canada’s financial regulator has struck the life insurance industry a mild blow when it comes to calculating capital levels.
Some of the insurers had sought permission from the Office of the Superintendent of Financial Institutions’ to use “mean reversion assumptions” in the models they use to determine where stock markets might go. These models help insurers to calculate the levels of capital required to back their segregated fund guarantees - guarantees that forced insurers such as Manulife Financial to dramatically bolster their reserves after stock markets plunged in late 2008.
Mean reversion is basically a negative correlation between stock prices in one period and subsequent periods (as OSFI explains in a letter to the industry: “if a stock showed a below-average return during one period and its price movements were mean reverting, then the price would be more likely than usual to show an above-average return during the subsequent period”).
When it comes to this concept, OSFI is a skeptic.
“The claim that equity returns revert to the mean over the long term is not completely unfounded, and cannot be dismissed out of hand,” OSFI’s letter says. “However, there is at least as much evidence to refute this claim as there is to support it, and there is certainly no consensus answer within the economics profession.”
It notes that some research papers have concluded that, for periods between three and five years, long-term mean reversion was present in stock market returns between 1926 and 1985. But OSFI raises a number of concerns, including the fact that the results could plausibly be due to pure chance.
For the time being, OSFI says its doubts are strong enough that it won’t let insurers use this assumption.
That’s bad news for insurers. As OSFI noted: “From the perspective of an insurance company writing equity guarantees, mean reversion is highly desirable, as any decrease in stock prices during a period is more likely to be offset by stock price increases in subsequent periods, which lowers the likelihood of having to make a guarantee payout.”
So models that assume stock prices revert to the mean over the long term will result in lower capital requirements than those that say stock prices are random.