DOES REGULATORY CAPITAL HELP OR HINDER DURING A CRISIS? PART 1
BY SHADRACK KWASA
As the insurance industry grapples with the impact of the COVID-19 crisis, there are a range of challenges specific to insurers that have come to the fore – one of which is around the impact of regulatory capital regimes on insurers. As insurers saw the value of their investment portfolios plummet during March whilst markets came to terms with the realities of lockdown, some insurers also started to come under increasing underwriting pressure as COVID-19-related claims emerged.
The question we want to pose in this three-part series is; do regulatory capital requirements help or hinder during a crisis such as COVID-19?
IMPACT – SOLVENCY POSITION
These kind of risk scenarios are often looked at and modelled independently, so to see simultaneous shocks across both the asset and liability sides of the balance sheet has been a wake up call for many. It has resulted in a material hit to the solvency position of many insurers subject to a number of regulatory regimes across the globe. Most regulatory regimes are designed to ensure insurers hold minimum levels of capital calculated to help weather exactly these types of crises. This minimum level of capital is meant to; bolster balance sheets and ensure that insurers have the liquidity and strength to pay claims and serve their policyholders in the most difficult of environments.
However, the irony is that regulators have been getting tougher on these minimum capital levels, even in the midst of this crisis. We are seeing that some insurers are having to add to these capital positions (even where they’re running close to but not breaching the required levels), instead of being able to utilise them as a shock absorber for this textbook ‘1 in 200 year event’.
For most insurers, the investment portfolio is an obvious lever to pull given the pressures to raise regulatory capital – even if they can only eek out small capital efficiencies. The danger is that where these ‘regulatory-capital raising’ activities have been done in an ad-hoc or mechanical manner, there is a risk that an insurer finds itself with a sub-optimal, inefficient portfolio from both an investment and regulatory capital perspective.
Inefficiency may come about as a result of holding more risk than is rewarded in the market (or holding too little risk) or, from a capital management perspective, from holding assets which provide regulatory savings in inefficient ways. For example, it may be possible to achieve the same level of capital savings one would receive through holding low risk assets such as cash by holding a diversified portfolio which would have a higher expected return. While regulatory capital considerations are crucial, we must be careful to ensure the tail is not wagging the dog.
How L&C is helping insurers: We are working with insurers to help them accurately reflect the current investment environment and their outlook into their capital positioning going forward, resulting in clearer, more efficient decision making. This is done by working closely with insurance teams and their advisers (actuaries and accountants) to identify the most efficient methods to provide capital savings without materially impacting profitability/return targets where possible and reflecting the underwriting and investment environment.
In the second part of this series, we’ll be addressing the long-term impact of adjusting insurance investment portfolios to free up capital.