Previously, dividends received from shares of a Canadian company (including both common and preferred shares) were effectively tax exempt, providing a significant after-tax benefit for these asset classes relative to other investments. The new budget indicates that the government aims to amend the Income Tax Act to effectively treat dividends received from Canadian shares held by financial institutions as business income.
Through an analysis of regulatory filings, we estimate that Canadian insurers are holding at least 12% of all outstanding preferred shares in Canada.1 In fact, preferred shares are the third most popular asset class among Canadian property and casualty (P&C) insurers, after bonds and common shares. This is in part due to historically favorable tax and capital treatment.
This new treatment is the latest in a long line of challenges faced by preferred shares:
- Banks have been increasingly issuing Additional Tier 1 bonds (AT1s) – hybrid contingent-convertible bonds – in place of preferred shares. This has resulted in diminishing liquidity in the preferred share market.
- International Financial Reporting Standards (IFRS) 17 rules on discount rate setting could make it difficult for insurers to use the yield on a preferred share to contribute to a higher liability discount rate.
With the change in tax rules, we expect insurance companies to increasingly look to reduce their exposure to preferred shares. We have highlighted a few likely beneficiaries of this change.2
Capital adjusted return vs. annualized volatility
Source: Bloomberg, Office of the Superintendent of Financial Institutions, 2023.
These securities were created after the 2008 global financial crisis and have been largely viewed as the logical successor to preferred shares, given similarities in issuer type and capital stack. These new-style capital securities allow banks to satisfy tier-one capital requirements and were introduced by the regulators to help recapitalize a given bank during a time of stress. However, the comparably worse tax treatment of AT1s historically has made them a poor direct replacement.
These shares have the potential to provide a higher after-tax return than preferred shares. However, they add a higher degree of volatility and a higher capital charge. As common shares are the second most popular asset class for P&C insurers, many insurers might already have substantial allocations to this asset class and might not increase them further. Furthermore, insurers who previously focused on Canadian dividend-paying common shares may also be looking to exit this asset class because of the proposed changes.
Investment grade short-term private fixed income (PFI)
Short PFI can provide a higher after-tax yield than preferred shares. In addition, short PFI attracts a relatively lower capital charge. However, as a privately transacted asset, it is less liquid than preferred shares. In addition, because short PFI may be considered a commercial loan under the Insurance Company Act, P&C insurers who are close to the 5% limit on commercial loans may not have the capacity to invest.
These mortgages can provide a similar yield to preferred shares, with a lower capital charge. However, like short PFI, commercial mortgages are an illiquid asset class. Commercial mortgages are less likely to be considered commercial loans, depending on the implementation structure, and therefore might not be considered as part of the 5% limit on commercial loans referred to above.
Narrowly syndicated bank loans
These securities are expected to provide a higher after-tax yield than preferred shares, along with lower expected volatility. However, they attract a higher capital charge, and the below-investment grade nature of this asset class may pose challenges for some investment boards. Some insurers may choose to replace preferred shares with a combination of narrowly syndicated bank loans and provincial bonds to mitigate the higher capital charge.
With the budget likely to pass soon, we recommend P&C insurers review their asset allocations and specifically their exposure to preferred shares. We believe that several asset classes that are gaining popularity among P&C insurers provide good replacement options while also diversifying portfolios.
We’re happy to discuss any of these options further to see how they might apply to different clients on an individual basis. For more information, connect with your SLC Management sales contact.
1. Sources: Office of the Superintendent of Financial Institutions, AM Best, TMX Group Limited, 2023.
2. Sources: Office of the Superintendent of Financial Institutions, FTSE, TMX Group Limited, 2023. All data as at 12/31/2022 unless otherwise stated. Expected return for S&P/TSX Preferred Stock index reflects total current yield. Expected return for S&P/TSX Preferred Stock before proposed changes reflects the benefit of not paying taxes, assuming a 27% tax rate. Expected return for S&P/TSX Common Stock index reflects an 8.2% expected return assumption. Expected return for all other asset classes shown reflects yield to maturity. Short term private fixed income calculated based on the yield of the FTSE Short Corporate Index + an assumed illiquidity spread of 157 basis points (bps). Narrowly syndicated bank loans calculated based on the yield of S&P Leveraged Loans index + an assumed small cap spread of 345 bps. The Estimated MCT Credit/Market Risk Charges have been calculated internally based on OSFI’s Minimum Capital Test (“MCT”) rules. Capital adjusted return has been calculated by deducting a cost of capital charge of 10% based on the estimated MCT Credit/Market Risk Charge, from the expected return of each asset class.
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