The Office of the Superintendent of Financial Institutions has ruled that, at least for regulatory purposes, mean reversion in equity prices is not a valid theory.
OSFI posted a letter, and a supporting paper, that it sent to the life insurance industry explaining the rationale behind its decision not to allow insurance firms to use internal models that incorporate mean reversion in equity returns to calculate capital requirements for segregated fund guarantees.
The regulator indicates that it has had discussions with some life insurance industry representatives on equity return models that incorporate mean reversion assumptions, and it has considered the question of whether such assumptions are prudent. Ultimately, it decided that it will not review requests for approval to use internal models that incorporate mean reversion in equity returns.
In the paper it published Monday, OSFI notes that assuming that mean reversion occurs within a model will lead to a significant decrease in the reserve and capital requirements that firms have to hold manage their seg fund guarantee risk.
“If mean reversion really does exist, then there is little need to hold reserves for, capitalize or hedge guarantees that are payable beyond a period of about five years. According to this view, while there may be some short-term market drops that will trigger guarantee payouts, over the long term mean reversion will make up for them, thereby rendering the prospect of payouts on the bulk of a company’s business unlikely,” it says.
OSFI says that, given the large reduction in guarantee reserve and capital requirements that would result, “it would not be prudent for OSFI to approve equity return models that are based on the assumption of mean reversion without strong evidence that mean reversion actually occurs in the market and is likely to continue in the future.”
It concludes that the evidence for mean reversion just isn’t strong enough. “The current state of research does not provide such evidence to a sufficiently high degree of certainty,” it says. The paper notes that the claim that equity returns revert to the mean over the long term is not completely unfounded, and cannot be dismissed out of hand. However, it finds that there is at least as much evidence to refute this claim as there is to support it, and that there is no consensus among economists.