Articles - How good are insurers at measuring market risk?

Every year at PwC we train our new graduate intake on the basic intricacies of the insurance business. And recently I have asked myself whether this model is still the right one to teach. As we all know too well the building blocks of the insurance business model are pricing risk well, pooling it effectively, being efficient in acquiring and administering the portfolio and investing premium income wisely so that it hopefully exceeds the cost of running the business. I don’t need to ask which of the blocks has eroded in the last ten years.

 By Kareline Daguer, Director PwC

 Making any decent return on investments has been very difficult in such a persistent low interest rate environment. Solvency II made matters even more challenging from 2016 in particular for life insurers. So, what is the way forward for insurers?

 A decade ago the financial crisis triggered a dramatic fall in interest rates and since then insurers have struggled with a set of circumstances that are now the new normal. Rates are not only low but the question of how low they can get is pertinent, with many reaching into negative yield territory. Some insurers are just surviving, waiting for the wind to change. However, those that have been more proactive in trying to adapt their strategy to the new environment are likely to come out of the battle stronger. Although insurers can continue to survive in this environment, their long term profitability has suffered - making the business model as a whole less viable.

 There are two main courses of action for insurers adapting to this environment. The first involves changing the product offering towards less capital intensive products. In this environment the cost of guarantees has grown steadily, driving insurers to either limit their offerings or sell their more capital intensive back books. The second option is to focus on the investment strategy and asset liability matching. Again over the past couple of years we have seen some insurers slowly moving into more complex asset classes in a quest for a yield still capable of supporting their business. In the UK we see this trend in the increased popularity of investing in equity release mortgages, infrastructure bonds and even secured forms of direct lending. Although both strategies are not mutually exclusive, in my experience we are witnessing insurers choosing between the two, with some acquiring back books and going for more complex investment strategies, while others are simplifying their product offering and trying to get out of business that could turn loss making without an adjustment to investments. What are the risks of these strategies and what is the regulator doing about it?

 The PRA is clearly concerned about the viability of some life insurers’ business models. Every year the benefit created by applying transitional measures on technical provisions (TMTP) is decreasing and the capital position of many insurers might be put in jeopardy. Some insurers have been forced to carry out formal business model viability reviews. On the other end of the spectrum the insurers who moved into more complex asset classes are also under increased scrutiny. Many are still calculating their Solvency Capital Requirement under the Standard Formula but the regulator might distrust the ability of the standard formula to provide the most accurate quantification of market risk. This might push some insurers into applying for partial internal models and strengthening governance around market and liquidity risks.

 One clear sign of the regulator’s concern about market risk in the insurance industry is their recent supervisory statement on Data collection of market risk sensitivities (SS 7/17). The PRA is requesting insurers to report their sensitivity to a number of market risk stresses twice a year. They have to report the quantification of the impact on assets, liabilities, own funds and also the solvency capital requirement itself. Considering how much regulatory reporting insurers are subject to, the PRA must feel very strongly to request even more reporting. This request will primarily be aimed at the biggest life insurers (supervisory categories 1 and 2) but it provides insight into the regulator’s areas of focus.

 What does this mean in practice? I see the increased regulatory scrutiny in these areas as a wake-up call to those who have not yet started to consider their strategies. No business can survive in the long term without the prospect of turning a profit. Having said that, it would be foolish to expect insurers to reject a quest for better shields. It is essential that insurers articulate their market risk appetites and are able to demonstrate their understanding and measurement of the risks they are getting into. Those looking at disposing of books or moving into different product lines should also plan their journey with care and be mindful of the many risks involved. This will ensure that when the regulator comes asking questions the insurers will have the answers.

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