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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

Solvency II clarity drives reinsurance appeal

When Solvency II introduced a clearer regulatory connection between risk and capital nearly four years ago, it seemed a recipe for life and health insurers to turn more extensively to reinsurance to reduce their capital requirements. Yet, while transactions continued to take place to reduce capital requirements for traditional risks, such as longevity, lapse, pandemic and mortality – they were not as numerous or as widespread as expected.

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Improve Solvency Ratio
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Reduce Volatility
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Improve ROE
Figure 3. Reinsurance Benefit

The situation, however, does now seem to be changing and one word perhaps sums up the various factors more than anything else – clarity. Nearly four years into the Solvency II regime, knowledge of what is efficient from a capital modelling standpoint is much clearer, as is the likely reaction of regulators to various capital strategies and instruments. Even though, admittedly, there is still not total consistency between regulators in different countries, the consensus view is that regulators want to avoid companies using reinsurance for regulatory arbitrage. Most view positively companies that have an internal model and use reinsurance to reduce risk and reduce capital.

Another outcome of Solvency II for life insurers is that it has thrown into sharp focus the comparative capital implications of new and legacy business. Because of the need to better match capital to long-term liabilities, the latter can be a huge drain on companies’ abilities to use capital effectively. Many companies are catching on to the fact that one way to free up capital for new business is to reinsure legacy books. And, in the process, they can also minimise the impacts of interest rates and volatility on those books and, in turn, on their capital requirement.

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Figure 4. Increase the eligible capital required through reinsurance

This is certainly the case for companies, particularly on the continent, with extensive closed books of business that include guaranteed returns. Many get, or are resigned to the fact, that they need to pay to be immune from the vagaries of continued low interest rates. That said, reinsurers are typically more aggressive in pricing mortality and lapse risks anyway. Those that may have hesitated in the past on the assumption that rates would go back up relatively quickly to more recognised historical levels are increasingly coming round to the position that five years of static or declining rates are fairly indicative of a new normal.

A market-fit approach

More broadly, what we are seeing is that the business model of life insurance that perpetuated for 50 years or more, and which was based on providing policyholders a minimum level of return, is being superseded. Today’s providers are increasingly focused on pushing market risk on to the policyholder through unit-linked and other products. And with the regulatory environment having changed to accentuate the link between risk and capital, the optimal ways for life and health insurers to use capital are changing too.

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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