DOES REGULATORY CAPITAL HELP OR HINDER DURING A CRISIS? PART 3

24.06.2020
BY SHADRACK KWASA

We are now at the last part of our series on regulatory capital considerations for your insurance investment portfolio. Having looked at common issues insurers face when looking to raise the level of regulatory capital in their investment portfolios and the long-term impact of adjusting insurance investment portfolios to free up capital, it’s natural to turn to the core issue of how to effectively review whether appropriate buffers are in place in your investment portfolio.

The long-term positioning of insurance investment portfolios should be resilient enough to weather short-term market volatility without having a negative impact on regulatory capital but how can insurers set their risk budget appropriately to ensure that’s the case?

IMPACT –  REVIEWING WHETHER  THE APPROPRIATE BUFFERS ARE PLACE

If the regulatory minimum capital is not in fact designed to be a buffer during crises and insurers need to raise the level of regulatory-capital in their business, what is the right level of regulatory-capital to protect against high impact events such as the COVID-19 crisis?

Unfortunately, there is no silver bullet (or silver calculation!) to this problem. Some insurers choose to hold a fixed amount of additional capital above their regulators requirements. Others hold capital across their group in line with the strictest regulatory regime in which they operate. Whether these capital levels are appropriate ultimately depends on the fallout from a crisis and the subsequent capital management decisions taken – information which will only be truly known following the event.

For this reason, a ‘high watermark’ level tends to be targeted to protect against extreme events. For example, in Europe the Solvency II regime targets capital to protect against a 1-in-200 year event (99.5% Value at Risk in investment terms). Whether to hold more capital than this boils down to an internal discussion around risk-appetite and an understanding of the vulnerabilities of the business. Some insurers choose to set-up a risk budget where an overall level is targeted across the business (perhaps at a 1 in 200 year event level) and this is then budgeted across the business with some areas receiving an additional buffer and others with less capital where the business is more predictable. For example, if the view is that underwriting a particular line of business adds uncertainty to the overall group, then more capital is devoted to underwriting that line of business than another. Likewise, if the underwriting line is general is more predictable than the expected return of the investment portfolio that would suggest that capital be set aside to allow for the portfolio. The overall balance clearly cannot be static and needs to be monitored over time.

HOW L&C IS  HELPING INSURERS:

Working with insurers to help them understand shifts in investment risk appetite and collaborating on portfolio reviews to reflect changes in underwriting risk appetite is an exercise we regularly carry out with insurers. It allows them to more efficiently allocate capital as well as make clear, structured investment decisions. While we may still be in the grip of the COVID-19 crisis, this exercise has already been extremely helpful for insurers who have needed to rethink their capital allocation following investment losses. For insurers where their balance sheet has also been impacted by COVID-19 related claims, this exercise has been pivotal in positioning the business for an uncertain future.

CASE STUDY: MOTOR INSURERS CAPITAL BUDGET CONSIDERATIONS

 

The above budgets are representative of a typical budget. Source London & Capital

For some insurers the impact of COVID-19 has been material on their investment portfolios but positive on their underwriting as a result of the lockdowns imposed by governments. This has led to a shift in their risk appetite and risk budget, which has allowed them to focus on investment portfolio diversification and long-term investment opportunities. For example, increasing their allocation to asset classes which have suffered short-term set-backs during the crisis. Being able to take advantage of investment opportunities quickly is all the more important when new policies and renewals may be significantly impacted from the COVID-19 crisis as investment portfolios may have to do more work going forward to support overall profitability across the business.

Insurers are also considering including or strengthening risk buffers to deal with any unexpected changes in regulation, target underwriting markets or investment markets moving forward.

Insurers should work closely with their asset managers to make sure any risk budgeting decisions are made with an understanding of the future outlook in markets as well as the implications for solvency from a regulatory and economic perspective.

CONCLUSION

Having looked across three implications of COVID-19 on investment portfolios and it is clear that an ad-hoc, mechanical approach to rebalancing an insurer’s regulatory capital and, in turn, investment portfolio will not result in optimal positioning. If rebalancing is done with little reference to the economic environment, we find ourselves in and without consideration of any changes in the risk appetite, insurers will likely be working against their own long-term goals and targets.

Insurers should strengthen their governance framework to consider the full implications of solvency capital management across their business. Importantly, insurers should be making their capital work for the business rather than treating it as a regulatory tick-box exercise.

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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