David Leach examines why life insurers are investing so heavily to boost their capital projections capability
The right amount of capital needs to be available at the right time for firms to take advantage of market opportunities and to avoid financial distress. Hold too much capital and returns will suffer; hold too little and business failure will have more damaging implications. It is essential for firms to have reliable, forward-looking information.
Projections are required under different conditions to understand how the capital position moves in potential adverse scenarios and to explore mitigating actions.
With Solvency II looming large, insurers are investing in their capabilities to project Solvency II and economic capital positions and to make their projection processes speedy and robust. A recent study found that 13 out of the 17 life insurers surveyed are intending to significantly change their capital projections approach or process during 2012/13.
The starting point
Before creating new or modifying existing projection capabilities, it is essential to have a clear idea of the questions that need answering. Projections fill the gap where time-zero stresses cannot provide sufficient insight - such as where there are complex interactions over time.
Examples of questions that projections can help to answer include:
- Are current new business/growth plans affordable from available capital, or will new funding be required, and if so when?
- Will the business continue to generate sufficient surplus cash to enable debt repayments to be made?
- If a block of business is acquired, how will this affect the capital position and future dividend-paying capacity of the business?
- What return on capital is expected?
- In pricing new insurance contracts, how much capital should be allowed for over the lifetime of those policies, taking into account diversification between the risks in the new business and the other risks in the portfolio?
- What risk margin do I need to hold in the Solvency II balance sheet, both now and over my business planning horizon?
- How should bonuses be set so that it is possible to equitably distribute the estate of a closed with-profits fund?
- How would all of the answers to the questions above differ under alternative economic conditions?
- What types of conditions would cause the dividend strategy to be unsustainable?
- Why is the current capital position different from what I expected it to be 12 months ago?
With answers to questions like these, decision-makers are better placed to take the right actions in areas that are commercially important.
Figure 1 shows the broad areas where capital projections are being used now and insurers' expectations for two years hence.
Providing clarity on what capital projections will be used for, and why, is critical in getting key stakeholders on board. As an added benefit, a number of companies are intending to provide projections in their internal model application process (IMAP) submission as supporting evidence for the use test - even if the projections are produced outside the internal model itself.
Planning and prioritisation
Defining uses naturally leads to prioritisation of requirements, which is an important step in developing a roadmap for projection capabilities. Clearly there are other important dimensions; for instance, technology and people, and the target operating model. Yet even the most basic plan can help to highlight what steps can safely be started in the short term without fear of wasted investment.
For many insurers the key challenges are:
- To improve capability to project eligible own funds (regulatory capital resources).
- To develop/improve capability to project capital requirements.
The effort required to project own funds should not be underestimated as this needs solid foundations. Moreover, own funds can be more sensitive to economic conditions than capital requirements.
Areas that need attention include consistency of asset and liability projections, treatment of derivatives, reinsurance, tax, and restrictions to own funds arising from ring-fencing and tiering.
For projection of capital requirements, there are a range of approaches, including:
- The risk carrier approach.
- The project and stress approach.
- The full recalculation approach.
The risk carrier approach expresses future capital requirements as some function of time-zero capital requirements and one or more carriers, the value of which can be calculated in future time periods.
The project and stress approach involves the projection of assets and liabilities for a block of business to each future time period, whereupon a stress is applied and a capital amount is directly produced at each future point in time. This is computationally more demanding than the risk carrier approach.
Some firms are producing full capital distributions at time zero, for instance by evaluating the change in net assets in each of thousands of different scenarios. The full recalculation approach involves producing capital distributions at future points in time. This is challenging as proxies for liability movements are likely to be required, particularly where best-estimate liabilities are themselves the result of stochastic calculations, and time-zero replicating formulae or portfolios might not be robust over the full projection horizon. Other fitting methods such as least squares Monte Carlo provide interesting possibilities.
Pros and cons
This decision on the capital projection approach is an important one. The objective is to produce timely projections in which the business has sufficient confidence to be willing to use them when making decisions. If the projections do not meet these basic requirements then return on investment will disappoint. Three factors are important:
- Whether the approach is robust technically.
- Whether the approach can be industrialised into an efficient and controlled process.
- Whether the approach gives business units ownership of their projections.
Not all users will require the same level of technical accuracy and granularity. Neither does a single methodology need to be applied to all product groups, provided that the results can be appropriately aggregated. For instance, it is possible to project 1-in-200 capital by risk for annuity business and combine these amounts with those derived from a risk carrier approach for other business.
Figure 2 shows that the 17 firms participating in the Capital Projections Survey 2011 are either using or intending to use different approaches for projecting Solvency II solvency capital requirement (SCR) and economic capital. Some are expecting to use more than one approach - hence the bars do not sum to 100%.
Firms are already using capital projections of varying sophistication to help answer key commercial questions. Solvency II raises the bar and is forcing firms to reassess the adequacy of their solutions.
The starting point should be a clear articulation of the uses to which projections will be put, and a prioritisation of these. An appraisal of alternative projection approaches will help to ensure that investment in development of projection capabilities is made wisely.
Projections will never be borne out perfectly, but they should bring valuable business benefits.