Niamh Carr and Kamran Foroughi discuss the importance of pursuing greater resilience in time of market volatility
The insurance sector has delivered solid returns during the past decade. Before this year’s COVID-19-related market turmoil, the sector had outperformed the wider market in six of the past eight years, as well as substantially outperforming the banking sector. During the past 10 years, the insurance sector has delivered a total return of 116%, versus 72% for the market and -60% for the banking sector. While there is room for improvement, the stable and steady nature of the business model – coupled with its ability to manage balance sheets and pay dividends – is clearly appreciated by investors.
A notable change since the 2007-08 financial crisis has been the advent of Solvency II, which has put the market in a stronger position to react in times of volatility and uncertainty. In response to COVID-19, some insurers were quick to announce more up-to-date estimated Solvency II capital ratios in order to prove resilience and demonstrate support for intended dividends, with figures published a week or so after the valuation date. In the immediate aftermath of the outbreak, we understand that a number of investors also asked analysts to produce estimated weekly Solvency II ratios. The majority of insurers have proved to have good capital resilience on this basis, showing that a key aim of Solvency II has been met.
The UK government recently announced plans for the Treasury to review the UK’s implementation of Solvency II in light of Brexit. This review will include the matching adjustment and risk margin, and it would be no surprise if any revisions moved the regulation closer to what was in place under the old Financial Services Authority’s risk-based capital regime. Although such a review may be welcomed by the UK insurance industry, it provides additional layers of uncertainty around forward-looking valuations in the current climate, and its equivalence with Solvency II.
Impact on the UK life market
Like others, life insurers are facing exceptionally difficult conditions on multiple fronts. They are focusing on securing the right outcomes for their customers while navigating a challenging market environment and maintaining business continuity.
The financial impact will be different for different companies, depending on their product portfolio, asset portfolio, extent of debt leveraging, Solvency II capital buffer and the degree (and performance) of risk mitigation they have in place – not to mention increased expenses in the short term.
For annuities, increased defaults and decreased creditworthiness will lead to pressure on the asset side of the balance sheet, although the immediate impact of spread widening will be absorbed by an increase in the matching adjustment, provided assets continue to be applicable to fall under the matching adjustment portfolio. There is some potential offset from unusually higher mortality in the year, although in practice this may not be so material.
Unit-linked business will see the linked liabilities fall and likely consequential decreases in the value of future fee income.
For with-profits business we expect liabilities to fall, but by less than the assets, as most funds with a reasonable equity backing ratio will have more guarantees biting. Funds will need to consider actions that will protect the future of the fund, such as revising bonus rates, market value adjusters, asset strategies and any estate distributions on closed books.
Protection writers may see a mortality impact similar in size to their capital allowance for life catastrophe risk, and the impact will vary depending on the extent and effectiveness of reinsurance arrangements in place (considering exclusions, caps etc).
As well as these impacts on existing business, all insurers will need to consider the long-term impact of COVID-19 on their distribution model and overall business model. Some customers tend to prefer to meet face-to-face with financial advisers, and insurance is typically sold, not bought. This, combined with a potential increase in lapses for protection and savings business due to the economic impacts on policyholders, may reduce the size of an insurer’s book over time.
Analysis of movement and sensitivities
Solvency II has, without question, moved risk and capital management forward, but its published results (solvency and financial condition reports, or SFCRs) are complicated by a lack of consistency in the practice of firms, particularly as there is no requirement to publish a complete analysis of movement (AoM) or sensitivities. The Solvency II proposals published 1 July 2020 by the European Commission do not appear to address these weaknesses with original Solvency II SFCR disclosure requirements. Interestingly, the Bank of England in October 2017 published Supervisory Statement 7/17, requiring some firms to privately submit market risk sensitivities.
While value and new business metrics have generally moved from being based on old embedded values to a new adjusted Solvency II basis in the UK and Europe, the AoM and sensitivities were dropped or scaled back by many firms on Solvency II adoption.
Overall, inconsistencies in presentation, granularity and definitions persist, meaning that investors are not able to fully understand the underlying financials. It is not always clear to investors how insurers make money and therefore how they might lose money, nor what the expected timing of distributable profits is. This often leads to simpler and easier to understand companies being given a higher valuation, even if they offer lower long-term expected growth.
Faced with such an extraordinary crisis, Solvency II AoM and sensitivities become a critical information tool for investors, as these areas support the understanding of how solvency changes and are vital early indicators of the impact of change.
Opportunities arising from meeting the IFRS 17 challenge
Some firms initially underestimated the level of work that would be required to implement IFRS 17 and so started later than they would have liked. The one-year delay to the effective date of IFRS 17, to 1 January 2023, has consequently been widely welcomed by the industry. This extra time should significantly de-risk the implementation timetable, although the impact of COVID-19 has created some operational challenges, with some firms losing key resources to other projects or taking longer to onboard the support they require.
COVID-19 has shown that insurers that have already automated their reporting processes and moved calculations into the Cloud are benefiting significantly from greater operational resilience and only having to rely on minimal human intervention. Rather than allowing momentum to be lost during the IFRS 17 extension, insurers could derive significant benefits by using this time to effectively implement the right technology and processes, in order to fully embed operational resilience.
It is also important that companies learn from the Solvency II market communication issues, where inconsistency and a lack of clarity persists within investor communication – especially since IFRS 17 will, for many insurers, move primary accounts away from Solvency II and cash disclosures. The use of technology and automation opens up opportunities to address the shortcomings of Solvency II if insurers provide the additional supplementary AoM and sensitivity information desired by investors across the key metrics.
Set against a rapidly evolving COVID-19 world, addressing the needs of investors will depend more than ever on how successful insurers are able to mitigate undesired impacts to their business by using all the tools they have – and developing new ones – to build greater resilience, maintain trust and position for long-term success.
Niamh Carr is a senior director within the Insurance Consulting and Technology business of Willis Towers Watson
Kamran Foroughi is a senior director within the Insurance Consulting and Technology business of Willis Towers Watson