The Solvency II balance sheet is volatile by construction: on a mark-to-market basis, “fair-valued” assets are used to back liability cash flows that are discounted using a risk-free curve. Technical provisions are valued on a market-consistent and best-estimate basis, capturing interest rate movements and removing prudence (and smoothing) respectively.
Even if market risk were to be fully hedged, technical provisions are exposed to a range of traditional underwriting risks, including loss events and customer behavior. Shifts in these bases introduce a further asset-liability mismatch, unless rebalanced; however, in practice, they are hard to manage given the time lags between cause and recognition. To add further complexity, the presence of options and guarantees, as well as profit-sharing contracts, means that market-risk exposures are often non-linear and path-dependent.
The Solvency II balance sheet is not fully market consistent. The discount rate curve is complex and includes a number of non-hedgeable adjustments, including the credit risk adjustment, UFR and last liquid point, the VA reference portfolio, and fundamental spread revision risk, among others.
Moreover, there is a duration mismatch between the official balance sheet and the true economic balance sheet. For example:
- The SCR and risk margin technically have zero duration for the purposes of calculating the interest rate shock.
- Contract boundaries exclude some future premiums and associated liabilities that would be reflected on a fully economic balance sheet.
- The ability to recalculate transitional measure technical provisions provides a significant cushion against interest rate sensitivity on business written prior to 1 January 2016.
Other sources of volatility are off-balance-sheet exposures, in particular arising from defined benefit pension schemes, which can be both material and difficult to manage. Also, it is impracticable to hedge the capital ratio and absolute surplus at the same time. Since there is no clear answer as to what is the right measure to manage to, stakeholders may have differing views.
Why does capital volatility matter?
Volatility of capital matters because regulators require insurers to hold a minimum amount. Falling below that minimum amount has a direct cost to investors as, at best, dividends are reduced, and, at worst, further capital is needed.
Balance sheet volatility is not new. Indeed, managing market volatility as well as underwriting risk is arguably a key objective of traditional guaranteed and profit-sharing business. The life insurance industry has a track record of introducing market-sensitive measures and managing the messaging around earnings volatility by emphasising “operating” earnings. Insurers have told investors to focus on long-term returns resulting from anticipated mean reversion.
For the first time, however, Solvency II has caused the regulatory balance sheet to be volatile. Regulators are unlikely to distinguish between short-term and structural causes of a breach of the minimum requirements when it comes to approving a dividend payment.
How has volatility management changed?
There are two fundamental differences in volatility management under Solvency II:
- Solvency II is a balance sheet construct, not a measure of earnings. In other words, there is no “below the line” in Solvency II. All movements on the balance sheet matter. There may be some leniency in capital policy, but an adjusted solvency position based on long-term investment conditions is unlikely to be acceptable to regulators if limits are breached.
- A large part of capital volatility is driven by interest rate risk, which is unrewarded and may not be mean reverting, especially in current times of unconventional monetary policy.
A clear capital management framework is needed
We believe that a clear capital management framework focusing on capital generation and volatility will be the most effective and most likely industry response. Such a solution will take time to implement and refine. Insurers need to focus on internal audiences and metrics, including embedding and reviewing these, while they also manage the expectations of external audiences. We suggest the following components:
- A clear capital management framework that articulates both risk appetite and strategic financial risk management. We would expect the former to have clear ranges of capital appetite (red, amber, green) and explicit linkage between risk appetite and financial impacts, and the latter to consider hedging approaches for all risk exposures and incorporate a range of dynamic and structural hedges. While the key principles of the framework should be disclosed, the finer details are likely to remain private.
- A comprehensive capital generation approach that provides credible guidance externally and robust forecasts and sensitivities internally. The latter is noticeably absent for many European insurers; forecasting and planning is dominated by the income statement, and sensitivity analysis tends to be simplistic and static.
- A balance between “income statement” and “change in balance sheet” measures. Ultimately, investors will be looking to assess the underlying earnings capacity of the insurer, and management will want to take capital off the table. However, for the reasons outlined above, capital will always remain a constraint on distributions and ROE and will need to be monitored and its management challenged.
Such an approach, if implemented effectively, will move the focus from capital adequacy and capital volatility to capital generation. Capital generation is increasingly seen as the primary metric to assess sustainable dividend capacity. This is due partly to the expectation that Solvency II will be the main constraint at the operating company level for internal distributions, and partly to a view that capital generation is a better measure of underlying earnings than IFRS.
These challenges extend beyond life insurance. Property and casualty insurers will face a more complex narrative in a world of discounted reserves and capital requirements. Understanding capital generation will no longer be the sum of margins on premium and invested assets.
Forecasting capital generation
Sound capital planning and forecasting is a key capability for management to improve control of their business. It is a way to avoid surprises and improve decision-making through better understanding of the business. Capital planning and forecasting is a three-dimensional problem:
- Establishing the base financial projection for the balance sheet
- Deriving a full suite of sensitivities
- Modeling path dependencies
This requires a thoroughly parameterized and validated proxy model with the capability to run model stresses, scenario tests, transactions, and recovery and resolution plans. However, timely decision-making requires compromises relative to a full model run.