Pamela Hellig argues that when it comes to managing their balance sheet, insurers would benefit from considering those seemingly insignificant balance sheet risks that are capital intensive
Common sense would have us believe that the most material assets on our balance sheets are those with the most zeros behind them. But this kind of thinking may lead insurance companies to miss risks posed by some of their most capital-intensive assets. Companies should really be looking at the capital impact, or riskiness, of each asset on their books when setting materiality limits.
When it comes to guidance on materiality for Pillar III reporting, EIOPA and the PRA pass the buck back to insurance companies. Short of Article 305 of the Delegated Acts (" the information submitted to supervisors shall be considered as material where its omission or misstatement could influence the decision-making or judgement of the supervisory authorities "), the regulators do not say much about how thoroughly asset look-through requirement should be applied - it is up to the insurers themselves to define their materiality thresholds.
Given these parameters, it is tempting to focus on the chunkier, more obvious assets - the equities and bonds which generally make up the majority of insurers' investment portfolios. Naturally, size does contribute to materiality. This is convenient, because performing a look-through analysis and capital calculation for these conventional asset types is usually straight-forward enough. What insurers should be shifting their focus towards, however, are the smaller, more obscure assets, which may look like lightweights on the balance sheet, but pack a hefty punch in the Solvency Capital Requirement (SCR) arena.
Derivatives of various types (e.g. forwards and contracts for difference) are very often used by asset managers to manage the risk profile within unit-linked funds. These derivatives are the most obvious examples of assets whose (typically) small balance sheet values belie their inherent riskiness. Although liabilities may be perfectly matched by assets under Solvency II, the present value of future profits (ie. Value In Force) underlying these funds is classified as Tier I capital, and is required to be stressed under a total balance sheet approach as dictated by Solvency II regulations. All the more reason to pay attention to the capital impact of derivatives
This concept may best be illustrated by comparing the impact of a market risk stress on the underlying asset to the market value of the derivative itself. A good example of how extreme the effect may be is the humble forward contract, the value of which, in a low interest rate environment (as we currently see in the UK), should be close to the difference between the market value of the underlying asset and the agreed forward price.
Just after the contract is concluded, the value of the underlying asset will be very similar to the forward price, making its value on the buyer's balance sheet very small. And because the capital requirement of a derivative is calculated based on the risk exposure of the underlying asset, the capital requirement as a percentage of the forward contract's market value could be very high. The possibility of this kind of scenario should not slip through the cracks when setting materiality thresholds; hence the need to consider capital impact of assets, and not just market value.
Forwards are just one example of this phenomenon - any time a company is exposed to assets where the market exposure is significantly different from the market value reflected on balance sheet, it is important to take a closer look in order to understand the risks to which they are truly exposed, and make sure they are accounted for. Assets with embedded options, e.g. convertible bonds, give rise to similar issues, albeit to a lesser extent.
Materiality is one of the areas in the Solvency II regime where participants are still trying to find a balance between accuracy and pragmatism. But as data becomes more accessible and insurers gain a better understanding of where their risks lie, there is no reason not to have both.
Pamela Hellig is a senior actuarial manager at MBE International