Academic journal article Revue Canadienne des Sciences de l'Administration

Capital Forbearance: Depression-Era Experience of Life Insurance Companies

Academic journal article Revue Canadienne des Sciences de l'Administration

Capital Forbearance: Depression-Era Experience of Life Insurance Companies

Article excerpt

Abstract

The multinational Sun Life Assurance Company was insolvent at market values in the 1930s as a result of a diminution in the value of its heavy investment in common stocks. Many of its competitors were also insolvent when their asset portfolios are marked to market. Industry-wide forbearance in the form of regulatory accounting window dressing misrepresented true technical solvency and helped Sun Life and a number of its major competitors to remain in business during the Depression years. We conclude that widespread capital forbearance, and not portfolio diversification, explains the survival of many large financial institutions in the 1930s.

Are larger, highly diversified financial institutions more likely to survive large macro shocks because they are more economically solvent or because it is more likely that regulators will regard them as too big to fail? Recent research addressing this question focuses on the experience of the 1930's when one-third of US banks failed while Canadian banks experienced no runs or closures. Kryzanowski and Roberts (1993) argued that highly concentrated financial intermediation systems are robust to large macro shocks, not because of portfolio diversification, but rather because when the number of intermediaries in small, regulatory control is sufficiently practical to make forbearance workable. Using a market value accounting model, they find that 9 of the 10 Canadian Banks of the day were insolvent in the worst years of the Depression. Although buttressed by archival evidence and sensitivity analysis, their results remain dependent on the precision with which nontraded assets such as bank loans can be marked to market. In contrast, Carr, Mathewson, and Quigley (1995) drew solely on archival research to argue that no capital forbearance occurred as Canadian banks were solvent due to diversification scale economies, and effective management.

In order to advance the case that forbearance did occur, the present article provides extensive evidence of the insolvency of Canada's largest life insurance company of the day, Sun Life. It also shows that six of nine of Sun Life's Canadian competitors were also probably insolvent. In the case of Sun Life, the insolvency occurred due to declines in values of publicly traded assets (common and preferred shares held in its investment portfolio). Unlike the evidence on banks presented in Kryzanowski and Roberts (1993), the evidence of forbearance in the present article is independent of the controversy over market value accounting for nontraded assets.

Industry-wide forbearance in the form of regulatory accounting window dressing masked the true insolvency of Sun Life (and other insurers). If securities had continued to be marked to market and technical insolvency had resulted, it would have been more difficult, both legally and morally, to allow the firm to continue to operate and to ask the policyholders to continue with the firm. The proposal to use higher authorized values instead of lower market values (MVs) for valuing securities was the result of a collaborative initiative of the Canadian provincial and US state Superintendents' Valuation Committees. The proposals were adopted by the US and Canadian governments and by all US states (except Connecticut) and all Canadian provinces. The rules were a variant of those used by North American insurance regulators and companies in 1907, 1914, and 1917-1921 to deal with similar unusual conditions. As is subsequently shown, these regulations probably masked the true technical insolvency of other insurers who invested in risky assets in conventional proportions.1

These policy actions to maintain public confidence were necessary because the firms could continue to operate as long as new insurance policies and annuity contracts were sold, old policies were renewed, and policyholders did not start a run on the companies by exercising their policy loan and cash surrender value options. …

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