Using hindsight to gain foresight
This blog has been authored by group of Life actuaries led by IFoA Fellow Rosalind Rossouw*. This group has a focus on Capital Management and is working as part of the .
The first wave of Covid-19 and the associated severe stock market impact potentially put life insurers’ solvency under significant strain. We have looked back at what happened in the UK and internationally, with a view to lessons that may be learned from such events for the future, especially in the context of a potential second wave, a further stock market downturn, or any other financial crisis. This blog considers the capital and management actions taken by life insurers, both prior to and during the crisis, as well as those planned for the future.
We have not considered the operational impacts of actions taken by life insurers to move to a remote business operating model, or the societal impacts of insurers suspending dividends.
Retrospection: solvency coverage ratios and market risk exposure
The severe stock market impact associated with the first wave of Covid-19 had the potential to put the solvency of both UK and international life insurers under significant strain. Our initial view formed from the evidence reviewed was that typically insurers weathered the immediate crisis quite well, with moderate but not extreme reductions in solvency ratios as a result of the market volatility experienced during the crisis. We found examples where solvency remained well above regulatory solvency minimum requirements, but fell below internally managed target levels. We found an example of an Italian insurer where the solvency of two of its life subsidiaries fell below the minimum capital requirement and Italy’s insurance regulator asked the Italian insurer to raise €500m to boost its capital.
To understand this observed resilience further, we examined year-end solvency ratios and market risk exposure. An analysis1 of life insurers’ Solvency and Financial Condition Reports (“SFCRs”) by Milliman shows that preceding the crisis, insurers in the UK and Europe showed strong average year-end 2019 solvency coverage ratios. The analysis1 also includes year-end 2019 average components of the Solvency Capital Requirement (“SCR”) by risk module and shows that market risk was a significant proportion of undiversified SCR for both European (60%) and UK (49%) life insurers.
Considering the year-end 2019 solvency coverage ratios in combination with the substantial exposure to market risk, we might have expected to see a more significant reduction in average solvency coverage ratios over 2020. So why didn’t we?
Retrospection: Reasons for resilience
We examined the reasons for why life insurers remained solvent and resilient during the crisis and found this to be a combination of:
- the relationship between Own Funds and the SCR: we found a few examples in SFCRs which confirmed that in an equity down sensitivity, any reduction in Own Funds was offset by a reduction in the SCR, with no consequent overall impact on the solvency ratio. This relationship could have influenced the resilience in solvency ratios observed.
- built-in mechanisms to limit pro-cyclicality, including Solvency II transitional arrangements, the matching adjustment, and long-term guarantee measures.
- regulatory guidance: we recognise that many insurers were placed under regulatory pressure to take measures to preserve their capital positions and to follow prudent distribution policies.
- management actions in place prior to the crisis, including hedging arrangements
- capital planning and management actions taken during the crisis.
In this blog, we consider the final two reasons in greater detail, and further consideration for the balance of reasons will be included in future blogs.
Management actions and capital planning
We reviewed a sample of UK and European life insurers’ year-end 2019 SFCRs to better understand the capital planning and management actions in place prior to and during the crisis. To maintain confidentiality, we have not directly quoted the names of the life insurers sampled. We found evidence of insurers having taken actions prior to the crisis as a result of lessons learned from already having experienced a financial crisis in 2008 and the multi-year European Debt Crisis which began in early 2010, albeit both under a different capital regime.
We found examples where insurers had efficient investment strategies in place prior to the crisis, including hedges to limit exposures to adverse equity movements, with one example of an insurer having done so to mitigate risks relating to financial market volatility caused by Brexit. SFCRs also indicated insurers have had a well-developed understanding of their exposure to market and credit risk and had appropriate mitigants in place to manage these risks. Capital planning accompanied a clear understanding of solvency under severe economic stress scenarios.
The management actions taken during the crisis were predominantly operationally focused. Digital capability, business continuity and operational resilience themes were consistently apparent, in addition to more capital focused actions detailed below. It remains challenging to confirm without asking insurers directly whether management actions taken were in line with their regulatory calculations and their Own Risk and Solvency Assessment (“ORSA”), however some SFCRs have confirmed they were in line with Risk Management Frameworks.
We categorised the capital planning and management actions taken during the crisis into eight areas:
- Regular solvency monitoring put in place
Insurers implemented regular, and in some cases daily, solvency monitoring. This was to monitor both the impacts of market volatility on the solvency position as well as to assess the current affordability of any (possibly deferred) dividend.
- Additional stress and sensitivity testing
SFCRs showed insurers understood the impact of various stresses on their solvency coverage ratios in isolation, for example, one SFCR noted that a 25% reduction in equity values resulted in a decrease of 5% in solvency coverage ratio. SFCRs clearly highlighted that stresses in reality do not occur in isolation. We found examples where insurers carried out additional sensitivity analyses, stress and scenario testing in order to better understand the impact that changes in various risks would have on their risk profile and SCR under alternative risk calibrations and correlation assumptions. Results were used to demonstrate resilience to interest rate, credit spread and equity impacts. Insurers also reviewed their balance sheet exposure and stated actions were taken to protect the solvency position and to further reduce the sensitivity of the balance sheet to economic shocks, although details of the actions taken were not specified.
- Capital model validation and re-calibration
For insurers with an Internal Model, key market risks are typically modelled as statistical distributions calibrated to historical market data. Work to understand how the crisis will impact Internal Model re-calibration in the longer term is ongoing. Any re-calibration of internal models consequent on the recent crisis is likely to increase rather than reduce the estimated risk associated with any given exposure.
- Capital projections updated to reflect Covid-19 as best as possible
Insurers updated their strategic and capital projections to reflect the market impacts of Covid-19. Many insurers stated it was too early to understand the impact of changing mortality, policyholder behaviour and new business on short-term and longer-term capital projections.
- Existing hedging strategies reviewed / new hedging strategies implemented
Where insurers had existing hedging strategies in place, SFCRs indicate that these existing strategies were reviewed during the crisis to ensure they remained appropriate when considered against a backdrop of an expected extended period of market volatility. Market falls during the crisis were accompanied by a drying up of liquidity in fixed income markets and to some extent equity markets2. For insurers with existing dynamic hedging strategies in place, the liquidity drought complicated any risk mitigation or hedging strategy which required dynamic changes to asset allocation as markets moved.
These factors may partly explain the responses to a survey by Insurance Asset Risk (published in April 2020) which asked ‘How prepared do you feel insurers’ investment functions were to weather the kind of turbulence we witnessed in Q1 of 2020?’. The survey results showed that about 30% of respondents felt insurers’ investment functions were ‘prepared in asset allocation but not in hedging’, and that a similar proportion were ‘insufficiently skilled in navigating such high volatility’. Interestingly, just over 10% of respondents felt insurers’ investment functions were ‘completely prepared’ and between 5% and 10% were ‘totally unprepared’. Even so, SFCRs have shown a few examples where insurers successfully implemented new dynamic hedging strategies during the crisis, including currency hedges and tactical derivative hedges.
- ALM reviewed
Where possible, insurers actively managed their asset and liability positions in response to market movements during the crisis. Actions were taken to reduce exposures to equity, property, interest rate, credit spread and counterparty default risk. Examples of these actions include asset disposals and asset reallocations.
- Insurers’ own decisions to pay or suspend dividends
Insurers had existing capital plans which included the reduction or non-payment of planned dividends and any other appropriate management actions to strengthen the capital position in the event of a market downturn. Prior to the crisis, some insurers had additionally considered pandemic risk when calculating the capital held in excess of regulatory requirements. In April 2020 many insurers announced that they would comply with the call from regulatory bodies to postpone or suspend paying dividends following the statements published by the European Insurance and Occupational Pensions Authority.
- Additional management actions
During their Sixth Annual Life & Financial Services (Virtual) Seminar Series, Hymans Robertson noted additional management actions taken by insurers, including the management of interest rate volatility through reinsurance of longevity risk, thereby reducing the risk margin and improving solvency. They highlighted examples of insurers who took advantage of low rates to raise debt, and managed their investment portfolios to take advantage of existing market conditions. They also noted that insurers were experiencing lower new business strain, acknowledging that this is not a direct management action, but rather a natural consequence of the current environment.
Foresight: The longer term
We believe that the longer term impact of the crisis lies principally in the likely consequence that risk free interest rates and yield curves will remain at exceptionally low (or negative) levels for even longer than originally anticipated. The implications of this vary between life and non-life insurers, types of product, geography, existing asset allocation/hedging strategy, and of course by the particular circumstances of individual insurers. The implications are potentially more immediate for life than non-life insurers since the duration of the guaranteed liabilities is typically longer. This means that the ultimate impact of a fall in interest rates on solvency is greater to the extent that the liabilities are not fully hedged. In Europe, this is perhaps most apparent in Germany where the duration shortfall has been around 10 years3 (though the impact of this has been mitigated by the required build-up of provisions to cover the cost of meeting guarantees in a low rate environment4).
Geographically, it is worth noting that the scale of the interest rate reductions (though not necessarily their impact on insurers) was more marked in the US than Europe since prior to the crisis interest rates had begun to rise from their previous lows so that the Covid crisis represented a more marked reversal. For example, 10-year US treasury yields reduced from 1.88% at the beginning of January to 0.79% on 9 October. In contrast, the corresponding change in Eurozone 10-year AAA government yields was from -0.17% to -0.51%.5
Lower rates also affect the yields that can be offered on new business incorporating a rate of return guarantee. Although the impact of the crisis might be to make savers more risk averse and prepared to accept even a low return if it is guaranteed, it is perhaps more likely that such lines of business will see further reductions in demand from savers. And plausibly one longer term implication of the crisis is that individuals will in any case be poorer and less able to save. This suggests (along with wider implications for insurers’ corporate and product strategy) possible complications for liquidity management.
Not only will risk free rates likely remain low, the willingness of governments to intervene in corporate as well as government bond markets to dampen any further increase in spreads associated with a resurgence of the crisis suggests that corporate spreads may remain relatively low. This may limit the ability of insurers to boost the yield on their assets by purchasing undervalued investment grade corporates when opportunity arises. It is worth noting too that although credit spreads peaked in March 2020, net downgrade rates remain elevated and (speculative grade) default rate are not expected to peak until 20216.
We have also observed an increased interest in private equity and debt investment. Insurance Europe commented on the responsibility insurers play in their response7 to the IAIS consultation on Covid-19, “During the COVID-19 pandemic, while larger listed corporates have been able to access new funding via financial markets, smaller companies have relied on debt backed by government schemes. For many of these companies, debt has increased to unsustainable levels and so solutions now need to be found to recapitalise them and return them to long-term viability and ultimately growth. In the UK, a recent report8 by industry body TheCityUK outlines the role that financial services firms, including insurers, could play in supporting smaller businesses via new equity investment and more sustainable long-term debt.”
It is likely that we will see increased use of strategies that combine some high quality liquid government bonds with selective use of illiquid lower grade and privately sourced credit, including infrastructure debt, and perhaps a greater willingness to invest in (for example) local currency emerging market debt. The objective will be to diversify by source of credit risk while harvesting an illiquidity premium and limiting exposure to those sources of credit offering a relatively low yield.
Possibly there will be an increased role for equity within a diversified portfolio of risk sources, for example if option or other protection strategies can be used to limit potential losses in a capital efficient manner, or where insurers are able to exploit the more generous capital provisions under Solvency II for long term equity holdings. However it is difficult to see equity playing a role within portfolios designed to meet traditional guaranteed fixed liabilities. The move to remote working and online purchasing, to the extent that this proves protracted rather than a temporary response to the crisis, adds uncertainty, perhaps particularly to the prospects for commercial and residential real estate.
Foresight: Adequacy of management actions and potential risks
While it appears that life insurers have weathered the initial crisis quite well, there remains considerable uncertainty surrounding the scale of any potential future wave(s), the responses of governments and monetary authorities, and the impact on the economy and financial markets. We are therefore not in a position to confirm whether life insurers have done enough to be able to withstand a second crisis. Solvency ratios and previous success provide some comfort, but we must allow for additional complicating sources of uncertainty such as the outcome of the US elections, and for UK insurers, of Brexit negotiations, and hence for the possibility that an unknown adversary would take on a very different shape or form.
Climate change poses an additional risk to insurers’ solvency positions. As detailed in the PRA’s letter to CEO’s9 “Climate change represents a material financial risk to regulated firms (firms) and the financial system. Whilst the Covid-19 pandemic is a present risk and an understandable priority for firms, minimising the future risks from climate change also requires action now.” We were encouraged to find examples in SFCRs of insurers already considering both the potential short and long-term implications of climate-related risks in their existing risk management frameworks.
Even in the midst of the pandemic, we have seen that the crisis has resulted in opportunities for M&A activity to take place. We have found examples of activity in the UK and India, with some M&A activity being accelerated by the crisis, and other transactions being delayed.
Looking ahead to our next blog, “Using international insight to gain foresight”, we discovered that life insurers in Australia and South Africa have undertaken industry-wide initiatives to collect claims experience data related to Covid-19, both directly and indirectly, to understand the impacts better and therefore improve risk assessments and capital planning for future pandemics. We are not aware of similar industry-wide collaborative initiatives being undertaken by insurers in the UK or Europe, although they may exist.
We also believe that an increased focus by insurers to Environmental, Social and Governance (“ESG”) investment will significantly contribute towards the route to an international greener recovery. In their latest Investment Advisory report analyses10, EY highlighted ESG as “the most interesting theme to gather even greater momentum since the pandemic”. This shift was echoed in the IFoA’s 2020 Autumn lecture where Professor Elroy Dimson highlighted that current market conditions have not only resulted in a resurgence of private equity investments, but a “truly astonishing change” in insurers’ ESG focus.
The crisis has given life insurers an opportunity to look back and assess whether their capital planning and models, investment strategies and risk management frameworks operated during the crisis as intended. We are aware of life insurers testing the validity of their ORSA scenarios by back-testing and reviewing their year-end 2019 sensitivity tests to confirm the results obtained were consistent with the actual solvency results observed during the crisis. With foresight in mind, we hope the lessons gained in hindsight during the crisis will further enhance the resilience of life insurers in future.
*This blog was authored by the following IFoA members: Rosalind Rossouw (lead), Nicholas Miller Smith, Hervé Vignalou, Thomas Harrington, Ranjan Pant, Kamakshi Chawla and Benjamin Horsfall
 Source Swiss Re, ‘Lower for even longer: what does the low interest rate economy mean for insurers?’ (Sep 2020), et op cit. (https://www.swissre.com/institute/research/topics-and-risk-dialogues/ec…)
 BNP Paribas, ‘European Life Insurers - demise of duration demand’ (Nov 2019) (https://markets360.bnpparibas.com/evo/content/eyJhbGciOiJIUzI1NiJ9.eyJp…)
 Source: US Treasury, ECB