DOES REGULATORY CAPITAL HELP OR HINDER DURING A CRISIS? PART 2

22.06.2020
BY SHADRACK KWASA

The first part of this series covered some of the common issues insurers face when looking to raise the level of regulatory capital available to their business – particularly in the context of investment portfolios. Our second part of these series digs into the long-term impact of adjusting insurance investment portfolios to free up capital.

What are the common risks involved in adjusting your investment portfolio? What are the factors that need to be considered today to protect the long-term positioning of the portfolio?

IMPACT – EROSION OF LONG-TERM STRATEGIC ALLOCATIONS

Building on the theme of consistent decision making, another area where we are beginning to see inefficiencies emerge is in the overall make-up of insurance investment portfolios, that is, the strategic vs tactical asset allocation.

Some insurers are making quick decisions in reaction to the current economic environment in order to bolster their solvency positions. Within the right investment governance framework, that can be a laudable conclusion but it’s important to take into account the short, medium and long-term implications of asset allocation decisions – both from an investment and regulatory perspective. Asset allocations that have drifted from the strategic long-term goals, or a portfolio that is simply not positioned correctly for today’s environment (especially given the changing outlook for most asset classes) are a major catalyst for making changes without a clear consideration for wider risk management considerations.

In a world with active Central Bank Governors determined to support the real economy through unprecedented monetary policy, any shifts in asset allocation require insightful investment advice. The crisis is likely to result in a long-term, low interest rate environment which will bring with it a range of implications for insurers on both sides of the balance sheet. A tactical shift to cash or government debt may provide short-term regulatory-capital relief but could be significantly detrimental to investment income in the medium term, as well as opening the insurer to more longer-term regulatory-capital expense once one considers the investment return profile, net of capital cost.

How L&C is helping insurers: We are working with insurers to help them understand not only where they can find capital relief but also leverage the most efficient sources of that relief from an investment . Please see the case study below for more information.

CASE STUDY: CONSIDERATIONS FOR  SOLVENCY CAPITAL MANAGEMENT IN A CRISIS

 

 

Asset Class Pre-crisis Allocation Post-crisis Outlook Required Capital Post-crisis Allocation Points  to consider before taking action
Investment Grade FI 75% Strong Low 85%
  • Falling Yields
  • Government QE programmes
  • Liability matching  requirements
  • Downgrades (& of BBB holdings)
  • Capital Efficiency
  • Portfolio Diversification
High yield 5% Weak Medium/High 0%
  • Defaults and downgrades
  • Correlation with equity
  • Return per unit capital cost
  • Liquidity
  • ‘IFRS 9’ implications on balance sheet
Equity 10% Weak/Moderate High 5%
  • Portfolio/Balance sheet volatility
  • Return per unit capital cost
  • Sector exposure
  • Any correlations to underwriting exposure
  • V vs U shaped recovery impact
Alternatives* 5% Moderate High 0%
  • Capital cost
  • Volatility
  • Diversification
  • Illiquidity
Cash 5% Weak/Moderate Low 10%
  • Low and negative interest rates
  • Inflation/deflation
  • Liquidity requirements

*Including but not limited to property, commodities, private assets, hedge funds and derivative instruments not held for risk management purposes.

Clearly, all prudent insurers will be reviewing their regulatory capital allocations and their investment portfolios. When we review making changes to investment portfolios, we talk about ensuring the long-term success of the investment portfolio by reviewing a range of factors including:

  • Any changes in risk appetite following the crisis
  • Asset-liability requirements (for example, changes in liquidity requirements following COVID-19 related losses).
  • Target capitalisation of the insurer – that is, how much more capital does the insurer need following the crisis and given a negative economic outlook.

It is vital that an insurer works with their advisors and asset managers to ensure that any action taken immediately following a crisis does not hinder their long term investment goals and continues to meet regulatory capital targets.

The third and final part of this series will open a discussion on  determining what the right level of regulatory-capital actually is – particularly given the experience of insurers during COVID-19 and the desire to continue to protect against these kind of high impact events.

FOR FURTHER INFORMATION OR TO ARRANGE A DISCUSSION WITH SHADRACK, PLEASE  CALL 020 7396 3239 OR E-MAIL INSURANCE@LONDONANDCAPITAL.COM


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