Property insurers warn proposed federal tax change to preferred shares could hurt the sector

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Canada’s largest property and casualty insurer, Intact Financial Corp. IFC-T, says a proposed tax measure in this year’s federal budget would likely have negative consequences for insurers, their customers, and companies seeking to raise money in the capital markets.

The federal government’s March budget proposed an amendment to the tax treatment of share dividends that banks and insurers receive from Canadian companies. Currently, dividends received from shares of a Canadian company, including both common and preferred shares, are tax-exempt. That means they are excluded from business income, providing a significant after-tax benefit.

Now, Ottawa wants financial institutions to record those dividends as business income – a move that could raise costs for insurers who hold a large portion of preferred shares and make it harder for public companies to raise new funds by issuing preferred shares.

Louis Marcotte, Intact’s executive vice-president and chief financial officer, told The Globe and Mail that the company has been a significant investor in Canadian dividend-generating securities for decades, and is encouraging the government to “consult widely” on the proposed change to ensure it is supporting its “local market champions.”

“Most Canadian equity investments held by Canadian insurers like Intact Financial Corporation, are held for the long term with a view of providing a safe return for policy holders and investors,” Mr. Marcotte said in an e-mail. “The loss of the dividend deduction could have a knock-on effect on premiums but also on the availability and diversity of funding sources for Canadian corporations.”

The loss of income from the dividends deduction would effectively raise Intact’s tax rate by almost two percentage points, the company said.

“It also would increase the tax imbalance for us but also all Canadian insurers when facing their foreign counterparts,” Mr. Marcotte added.

Canadian property and casualty (P&C) insurers hold at least 12 per cent of all outstanding preferred shares in Canada – about $6-billion, according to a recent report by SLC Asset Management, Sun Life Financial’s asset-management division.

“Preferred shares are the third most popular asset class among Canadian P&C insurers, after bonds and common shares,” Ashwin Gopwani, head of Canadian client solutions at SLC Management, said in an interview. “When you look at other developed economies, preferred shares make up a much larger percentage of the assets of a Canadian P&C insurer.”

As a result of the proposal, Mr. Gopwani said he expects an increasing number of P&C insurers to look at reducing their overall exposure to the asset class.

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In Canada, the S&P preferred share index, which captures a large portion of the market, had approximately $37.7-billion in assets as of May 15.

For insurers that are regulated by the Office of the Superintendent of Financial Institutions, preferred shares account for about 4.2 per cent of the total invested assets in their portfolios, or $2.7-billion.

But that number has been slowly declining, Mr. Gopwani said, as there has been a long line of challenges to the preferred-share market over the years.

The asset class has seen diminishing liquidity as banks have been increasingly issuing Additional Tier 1 bonds (AT1s) – a type of convertible bond – in place of preferred shares. As well, new accounting standards known as IFRS-17 could make it difficult for insurers to use preferred shares when calculating the value of their liabilities.

However, it’s the federal government’s latest proposal that has sparked his firm’s institutional clients to begin discussing alternative investments, Mr. Gopwani said.

Definity Financial Corp. chief executive Rowan Saunders addressed the budget proposal during a recent fireside chat with National Bank of Canada, saying the proposed tax measure was “not good news.” Definity, the country’s sixth-largest P&C insurer, holds preferred shares valued at $298-million as of Dec. 31.

“From our perspective, it’s not a major impact but we do feel it,” Mr. Saunders said. “It’s about $2-million a quarter for us of taxable implications from that change.”

Mr. Saunders said it’s still early days for the company to consider what implications the change would have for its future asset allocation and mix.

“When we think about structuring the investment portfolio, we do think about the taxable implications and the taxable returns of those classes,” he added.

Intact Financial held approximately $1.4-billion in preferred shares as of Dec. 31.

Intact said the proposed rules might have the effect of changing how Canadian insurers approach their asset-allocation mix. “The change could incentivize insurers to reduce their position on Canadian dividend generating securities including preferred and common shares in favour of other securities, Canadian or foreign,” Mr. Marcotte said.

With the budget likely to pass soon, Mr. Gopwani is already recommending several replacement options to P&C insurers. AT1s have largely been viewed as the logical successor to preferred shares, given similar issuer type and capital. However, the tax treatment of AT1s is “comparably worse.”

Other options he suggests include commercial mortgages that provide similar yield and investment-grade short-term private fixed income that offers similar after-tax yield to preferred shares.

“However, as a privately transacted asset, short term private fixed income is less liquid than preferred shares.” Mr. Gopwani said.

With a report from David Milstead