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Maximising value from capital management

Insurance Consulting and Technology
Insurer Solutions

By Matthew Ford and Franck Pinette | November 20, 2019

Disciplined capital management is fundamental to the way life insurance works. And with increased pressure on the industry, now is an ideal time for insurers to incorporate innovative capital optimisation techniques into their planning and throughout the business.

Building value by transforming capital management

For good capital management, it is critical to have a clear framework which is also aligned to a successful risk management strategy. Clear thresholds and clear intervention actions in the case of over- or under-capitalisation are equally essential, as are clear messaging from the Board and buy-in throughout the company to ensure the business is working towards common goals.

As the industry’s focus increasingly turns to strategic considerations and growth, insurers will benefit from dedicating more resources to developing a better understanding of how the most efficient use of capital can protect and create value.

Interestingly, our research shows that many firms still do not have a capital optimisation strategy in place and therefore do not have the means to determine where and how capital would be best deployed. Companies that pursue a capital efficiency agenda that systematically permeates all aspects of their business model, paying close attention to their strategic aims, are most likely to have the best chance of success.

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Figure 1. Capital management interacts with the core aspects of any insurance business

Strategic asset allocation and ALM post Solvency II

Solvency II has changed insurers’ perceptions of risk and reward for different asset classes, as well as the correlations between them, particularly for those insurers who have had to carry out their own analysis to build an internal model. The sensitivity of regulatory balance sheets to market conditions has typically increased under Solvency II. The recent fluctuations in the size of the Risk Margin for many firms is one such example, as well as the additional complexity arising from maintaining Matching Adjustment portfolios and from transitional measures. All of these factors are leading insurers to reassess their strategic asset allocation, consider the merits of alternative asset classes, and evaluate and improve their hedging and management of interest, equity and credit risks.

In addition, the current low interest rate environment has led to many companies seeking higher investment returns by widening the range of assets in which they invest, such as alternative classes, geographies or credit rating profiles. In addition to the risk management implications of these changes, companies are faced with a trade-off between the potential higher returns and the associated capital requirement implications.

A culture of continuous improvement

Ongoing engagement between the risk function and capital management teams is key to assessing an insurer’s risk profile, ensuring all actions are in line with the company’s risk appetite and identifying capital management opportunities. The capital management activity chain in Figure 2 shows the process as a continuous cycle of deliberate actions a company will need to take, whether it be reactively, for example in response to market shocks, or proactively to crystallise opportunities. Applying this framework will help drive future decision-taking activity and intervention, including identifying risks to which the company is potentially over-exposed and where there is appetite to take on additional risks.

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Figure 2. The capital management activity chain

Reinsurance remains a core tool

Life insurers are coping with a number of critical challenges that are undermining growth potential and threatening profitability. Despite these conditions, insurers that possess the combination of sophistication and the adaptability needed to optimally manage capital will likely be the market leaders. As an invaluable capital and risk management tool, reinsurance remains fundamental to this strategy, helping insurers to maintain a competitive bottom line.

Under Solvency II, the life capital required is a function of stress scenarios on various risks. A well-designed reinsurance approach could reduce the tail risks on mortality, longevity and lapse, ultimately reducing the capital required.

The cost of reinsurance can be significantly cheaper than raising hybrid debt. Take the example of pandemic and lapse risks, where for many years life and health insurers have identified pandemic as a peak risk. To insurers, a pandemic represents a low frequency catastrophic risk with associated high severity in terms of accumulated losses. At the same time, modelling pandemic risk remains highly complex due to the scarcity of events, mobility of populations and improvements in healthcare and sanitation over time.

Stop-loss is a form of non-proportional reinsurance initially designed to limit the impact on earnings of a steep increase in claims frequency. It is therefore a particularly efficient capital management solution for pandemic risk and any other life risk that could lead to an adverse development in claims ratio and which would tie up a large proportion of available capital.

Furthermore, a mortality stop-loss is well suited to short-term portfolios. The shock for the Cat Solvency Capital Requirement (SCR) runs over a single year, and so its weight in the aggregated SCR is all the more important. Consequently, a stop-loss offers an attractive solution for institutions involved in writing significant volumes of group life business.

For many markets, especially in northern Europe, the main scenario is mass lapse, which effectively requires capital to be held against the potential loss of future profit streams. Under Solvency II, insurers are required to hold capital against the risk that 40% of their business lapses overnight, but reinsurance can help diversify that risk and reduce solvency margin requirements. A mass lapse reinsurance cover is one approach insurers have found where it makes sense to pass risk to the reinsurers because the reinsurance price is competitive.

Another option is to transfer the asset and liability to the reinsurer, allowing the insurer to kill two birds with one stone. By doing this, the insurer is able to reduce their SCR on both aspects. Although simple in theory, the implementation is complex in practice and can take up to a year to complete. This is because the assets have to be transferred to a third party, which requires collateral and therefore a decision needs to be made as to what type of pledge asset the reinsurer is going to include within the collateral.

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Figure 3. Increase the eligible capital required through reinsurance

The value of in-force business (VIF) is recognised as eligible capital but the contract boundaries are not. It is possible to increase available capital through a short-term financing reinsurance contract, which is a traditional reinsurance quota share treaty.

Pressure from investors has led insurers to more sophisticated metrics, such as return on equity and economic capital. Reinsurance is used increasingly for earning protection and volatility reduction by insurers whose purchasing is guided by risk appetite statements deployed to optimise capital management and profitability targets. This is particularly relevant for public companies where perceived volatility can severely impact share price.

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Improve Solvency Ratio
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Reduce Volatility
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Improve ROE
Figure 4. Reinsurance Benefit

Today’s life insurers face pressure to reinvent their businesses on many fronts. They must keep pace with rapidly shifting technologies, competition, regulations and customer expectations. These new technologies will create new risks. Insurers, through partnerships with customers, employees, other businesses and governments, will be in a stronger position to evolve, innovate and harness the power of these new tools while mitigating their risks. Along the way, insurers will also be empowering their own growth. There is life in life.

Matthew Ford is the UK’s Life Practice Development and Innovation Leader at Willis Towers Watson and Franck Pinette is Managing Director of International Life & Health at Willis Re.

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