In 2025, insurers are navigating a complex landscape shaped by Bank of Canada rate cuts, historically high bond yields and record equity market volatility – all against a backdrop of geopolitical uncertainties and evolving regulations. While tight credit spreads and environmental, social and governance (ESG) developments add layers of complexity, strategic credit allocations remain crucial. In this newsletter, we make the case for continued strategic credit allocations and highlight some recent regulatory developments relevant to Canadian insurance investors.

The compelling case for fixed income

Despite rate cuts by the Bank of Canada in 2024, bond yields remain elevated across the term structure, often exceeding their end-of-2023 levels and 10-year averages. Some fixed income investments can offer equity-like return potential but with significantly lower capital requirements, making them a potentially attractive option for insurers. However, tight credit spreads introduce challenges, requiring insurers to weigh return potential against investment risks carefully.

The credit conundrum: balancing attractive yields and tight spreads

Insurers can navigate credit allocation challenges through three key lenses: total return, excess return and liability-driven frameworks.

1. Total return: Tight spreads do not necessarily lead to lower returns. Historical data show yield as a more reliable predictor of future returns for investment-grade credit. As demonstrated in Figure 1, forward one-year and three-year returns are often higher in periods of tight spreads, contrary to expectations. These findings highlight the importance of assessing opportunities in even the tightest spread environments.

Figure 1: Tight spreads ≠ lower subsequent total returns

2. Excess return: Here we define excess return as the performance difference between credit-sensitive securities and duration-matched risk-free (Government of Canada) alternatives. For credit-sensitive securities to outperform, their credit spreads and spread fluctuations must generate higher returns than risk-free options.

In the following exhibit, the one-year break-even spread change indicates how much spreads must increase to yield a 0% excess return over the next 12 months.  Short- and mid-term spreads generally offer better protection than longer-term ones due to lower spread duration.
 

Figure 2: One-year break-even spread change (in basis points) going into 2025 – a decreasing margin of safety

3. Liability-driven frameworks: Under International Financial Reporting Standards (IFRS) 17, the decoupling of asset and liability valuations has necessitated closer management of credit exposure. Maintaining some level of credit allocation helps stabilize balance sheets, even during periods of tight spreads, underscoring the need for insurers to balance liability-driven strategies with return optimization.

In 2025, insurers face a complex credit allocation landscape. A comprehensive strategy should balance total return, excess return and liability-driven approaches. Additionally, Canadian insurers can benefit from expanding into the U.S. bond market, which offers access to a wider range of issuers and structures, potentially improving yield, portfolio resilience and exposure to diverse credit sectors. By broadening their investment horizon, Canadian insurers can refine their credit portfolios, capitalizing on relative value opportunities across borders.

Regulatory issues: the 2025 LICAT Guideline and climate risk management

The 2025 Life Insurance Capital Adequacy Test (LICAT) Guideline, effective January 1, 2025, introduces key changes to the capital requirements for life insurance companies, specifically concerning segregated funds guarantee (SFG) risk calculations to replace the current method. Under the standard approach, capital requirements will be determined by applying shocks to SFG liabilities, replacing the current internal models and factored approach. Another significant update allows “true look through” for exchange-traded funds (ETFs) under specified conditions, enabling insurers to calculate credit and market risk factors based on the underlying exposures. This change could make ETFs as capital efficient as direct holdings for life insurers.

OSFI Guideline B-15 update

In 2023, the Office of the Superintendent of Financial Institutions (OSFI) introduced climate risk management initiatives for Canadian insurers in Guideline B-15: Climate Risk Management. This guideline aims to strengthen insurers’ climate risk capabilities and enhance transparency in addressing climate-related risks. These regulations require Canadian insurers to report on climate risks related to their operations and investments, with a key focus on financed emissions – the greenhouse gas emissions tied to their investment portfolios.

In February 2025, OSFI announced that it would update Guideline B-15 to align with the corresponding requirements of the Canadian Sustainability Standards Board (CSSB), which were released in December 2024. These requirements include pushing back disclosure dates for financed emissions. OSFI released the updated Guideline B-15 on March 7, 2025. On-balance-sheet financed emissions must now be disclosed for fiscal year 2028, while financed emissions for insurers with asset management activities are to be disclosed for fiscal year 2029. OSFI intends to hold consultations on disclosure expectations for off-balance-sheet assets under management later this year.

Next steps for insurers include:

1. Understanding Partnership for Carbon Accounting Financials (PCAF) standards – The PCAF provides a standardized framework for measuring financed emissions across various asset classes, such as corporate bonds and equity. OSFI requires insurers to use the latest PCAF standard, which has become the industry norm.
2. Identifying what is in scope – The ability to calculate the financed emissions of an insurer’s investments varies by financial instrument. For many asset classes, data or methodologies may not be available for calculating financed emissions.  For asset classes that do not have PCAF methodologies, insurers are generally not expected to report on them but will need to provide this rationale in their disclosures.
3. Establishing a documented process – Accurate and consistent reporting requires documenting the methodologies used, disclosing assumptions and addressing gaps.

At SLC Management, we can provide support in financed emissions calculations, process documentation and preparation for broader OSFI and Autorité des marchés financiers (AMF) climate reporting obligations to help our clients meet their climate reporting needs.

Navigating uncertainty in 2025

Looking ahead, the broader investment landscape remains uncertain, with factors like inflation, geopolitical tensions and central bank policies continuing to drive volatility. However, amid these challenges fixed income investments can remain a compelling option for insurers, with certain issues able to offer attractive returns with low capital requirements. By staying agile and informed, insurers can navigate uncertainty and position themselves for long-term stability in 2025 and beyond.

Sources: Bloomberg, Office of the Superintendent of Financial Institutions, 2025.