Tag Archives: Sinead Clarke

Central Bank of Ireland review of Solvency II life insurance pricing and reserving assumptions

In February 2017, the Central Bank of Ireland published letters on its website relating to its review of the consistency of Solvency II life insurance pricing and reserving assumptions. This briefing note by Milliman’s Aisling Barrett and Sinéad Clarke summarises the contents of these letters. The authors also reference the contents of the December 2016 industry letter on the standard formula Solvency Capital Requirement.

The emergence of lapse risk transfer

This blog post is part of an ongoing series of blog posts on capital efficiency. To see past posts in this series, please click here.

In recent months, we have seen the emergence of lapse risk reinsurance following the introduction of Solvency II. Lapse risk is one of the key risks that life insurers, and particularly unit-linked life insurers, are exposed to and it is a key component of the Solvency II Solvency Capital Requirement (SCR) for many life insurers. One of the benefits of lapse risk reinsurance is that it can be used to reduce the life underwriting risk capital charge, in addition to reducing the undertaking’s exposure to lapse risk. Many reinsurers are active in this area, and as undertakings begin to consider Solvency II capital efficiency in more detail, it may be an area where we will see further growth during 2017.

Reinsurance treaties
The nature of lapse risk transfer will depend on the most material lapse risk exposure of the cedant—either mass lapse, lapse up, or lapse down.

The mass lapse scenario under Solvency II is calibrated as an instantaneous loss of 40% of the in-force business (for retail business). While the actual occurrences of mass lapse scenarios are difficult to predict, the risk of lapses exceeding 20% to 30% in a given period may be low based on historical data. Reinsurers can therefore offer treaties that cover losses caused by lapses in excess of 20% to 30% in a given period, often setting a maximum threshold of 45% to 50%. In reinsurance parlance, the reinsurance treaty attaches at a level of 20% or 30% and detaches at 45% or 50%. The relevant period would be defined in the reinsurance treaty. The cedant would retain the risk exposure to lapses below the attachment point and above the detachment point.

We are also aware of some reinsurers considering lapse up and lapse down reinsurance. However, there may be significant practical challenges associated with lapse reinsurance of this nature, in particular with regard to defining when an increase or decrease from the long-term average, or best estimate, lapse rates has occurred.

Considerations
There are a number of general considerations in respect of lapse risk reinsurance (as well as other potential considerations, depending on the specific terms of an individual treaty). First of all, there is the premium charged by the reinsurer for transferring lapse risk. The cost is generally set with reference to the reduction in SCR achieved by the transaction. We understand that costs generally vary between around 2% to 3% per annum of the reduction in the lapse risk SCR, depending on the type of deal and the availability of data.

Buy-in from the regulators will be key for these contracts to be effective. There is likely to be a concern that reinsurance could be used to reduce the SCR without a real reduction in the underlying risk. It is difficult to argue that there is no reduction in lapse risk exposure in the example attachment points outlined above. However, it may be more difficult to justify real risk transfer where the treaty is set up in such a way as to only indemnify insurers when a mass lapse of exactly 40% occurs.

Other considerations include the following:
• The interaction between the different lapse risk components of the SCR needs to be considered. If the risk exposure to mass lapse is reduced through the use of reinsurance, the lapse up or lapse down risk module may bite instead. Therefore, the impact of mass lapse reinsurance will be limited to the margin over which the mass lapse SCR capital charge exceeds the next-highest lapse risk capital charge. Understanding this interaction will be an important factor in determining the optimal attachment point for a mass lapse reinsurance treaty.
• Reinsurance introduces additional risks to the balance sheet such as counterparty risk, which is also considered in the Solvency II SCR calculation.
• The impact of such a transaction on the financial statements or International Financial Reporting Standards (IFRS) balance sheet should also be considered.
• If the reinsurance contracts are short-term in nature, there may be a risk associated with getting renewal terms on the same basis.

An alternative
Insurance-linked securities offer an alternative approach to transferring risk compared with traditional reinsurance. Under these transactions, insurance risk is effectively securitised and bought by capital investors through an investment fund. We are aware of a number of insurance-linked security firms that are active in transferring lapse risk.

The solutions can be structured in a similar way to traditional reinsurance deals in terms of attachment and detachment points, although the deals tend to be longer in term than traditional reinsurance contracts (circa three to five years, as opposed to 12 to 18 months). This provides additional benefits in terms of impact on the Solvency II risk margin and also may be more preferable to regulators than short-term contracts. However, this results in slightly higher costs compared with traditional reinsurance deals.

One disadvantage is that insurance-linked security firms generally do not have credit ratings, which can result in a high capital charge for counterparty risk under Solvency II. However, it is possible to reduce this through the use of collateral.

Solvency II reporting: Year-end 2016 and beyond

The Solvency II annual Quantitative Reporting Templates (QRTs) is required of many European (re)insurers for the first time in May 2017, as are the Solvency and Financial Condition Report (SFCR) and the Regular Supervisory Report (RSR). In addition to the annual reporting requirements, the deadline for submission of the 2017 quarterly QRTs has been reduced by one week compared with what was required during 2016. In this briefing note, Milliman consultants Ciaráin Kelly and Sinéad Clarke provide a timeline summarising the reporting requirements in 2017 for both solo entities and groups (assuming a year-end reporting date of 31/12).

At last: Product innovation in the European life insurance market

The Solvency II requirements, combined with the low interest rate environment, have resulted in a trend toward insurers seeking innovative product structures to improve customer return, while minimising capital requirements. In Germany, a number of large insurers have effectively stopped marketing their traditional insurance products to focus on more innovative products, including Constant Proportion Portfolio Insurance (CPPI), index-linked products, static and dynamic hybrids, variable annuities, etc. However, there is often a balancing act between increasing customer return, through the inclusion of investment guarantees, and minimising capital requirements for market risk.

My colleagues in Germany recently published a research report analysing three products in the German market from a capital efficiency perspective. The products include Allianz’s “Perspektive” and “Index Select” and Zurich’s “VorsorgeInvest Premium.” Each product offers attractive investment guarantees to policyholders, with the type of guarantee varying by product. However, the guarantees are structured in such a way as to reduce market risk, compared with traditional insurance products in the German market, resulting in improved capital efficiency.

Asset management techniques need to be considered to fund the investment guarantees offered by these products. In a low interest rate environment with high volatility, the costs associated with hedging investment guarantees can be very high. However, volatility control techniques have emerged as a way to reduce the costs of hedging investment guarantees. Using such techniques, a dynamic investment strategy can be adopted to invest heavily in equities to maximise return when markets are relatively stable, but limit equity exposure during periods of high volatility. The Milliman Managed Risk Strategy (MMRS) is an example of such an investment strategy. The research report discusses this in more detail and compares MMRS to a CPPI investment strategy in terms of policyholder return and capital efficiency.

For more information on this topic, please see the Capital Efficient Products in the European Life Insurance Market research report, authored by Marco Ehlscheid and Dr. Matthias Wolf.

This blog post is part of an ongoing series of blog posts on capital efficiency. To see past posts in this series, please click here.

Capital efficiency under Solvency II: Part II

clarke-sineadOur continuing series of blog posts addresses some ways in which companies may be able to achieve capital efficiency under Solvency II. This post looks at three additional capital management techniques that have become popular since the introduction of the new Solvency II capital regime.

Internal reinsurance
We have seen an increase in the use of internal reinsurance to improve Solvency II capital. The use of internal reinsurance can reduce the capital requirements of solo entities through risk transfer to the internal reinsurer. The group may also benefit from greater capital efficiencies through diversification at the reinsurer level.

Aviva significantly increased the amount of business ceded to its internal reinsurer,* Aviva International Insurance, during 2016. AXA also has an internal reinsurer to manage reinsurance for the insurer’s global property and casualty (P&C) business, which was recently upgraded by AM Best, and the Belgian insurer Ageas set up an internal reinsurance vehicle in 2015.*

Corporate restructuring
We have seen a large increase in mergers and acquisitions (M&A) activity and corporate restructuring as a result of Solvency II. Recent M&A activity includes:

• Scor announcing plans to merge its three French businesses* to reduce its risk margin by €200 million under Solvency II
• AXA’s exiting of the UK life and savings market with the sale of its offshore investment bonds business, Axa Isle of Man, and its UK portfolio services business, Elevate
• Aegon selling two-thirds of its UK annuity portfolio business to Rothesay Life with the aim of freeing up capital in its UK subsidiary
• Allianz selling its Taiwanese traditional life insurance portfolio* to a local Taiwanese life insurer to improve the group’s capital efficiency under Solvency II

Unit-linked matching
We are aware of a number of unit-linked providers that are currently rethinking unit-linked matching. The Solvency II regulations state that the technical provisions in respect of unit-linked benefits must be matched as closely as possible with unit-linked assets. Under Solvency II, the technical provisions for unit-linked benefits generally include a best estimate liability, which is lower than the unit value. This opens up the possibility to invest a lower amount in unit-linked assets than the outstanding unit value, i.e., “mismatching” the unit-linked assets and liabilities, which can enhance the capital position of unit-linked portfolios and stabilise economic balance sheets.

However, as usual, such benefits come at a price, and insurers will have to decide whether or not the capital savings are sufficient to offset the operational complexities, coupled with a more volatile solvency coverage ratio. Unit-linked matching is considered in more detail in our briefing note entitled Unit-linked matching considerations under Solvency II.

We have published a number of papers on this topic including Capital management in a Solvency II world, which focusses on life (re)insurance business, Capital management in a Solvency II world: A nonlife perspective (looking specifically at nonlife or P&C issues) and Unit-linked matching considerations under Solvency II.

If you are interested in more information on capital management under Solvency II please contact your usual Milliman consultant.

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Capital efficiency under Solvency II

clarke-sineadFollowing its implementation on 1 January 2016, Solvency II should now be “business as usual” for European (re)insurers. For years, (re)insurers were focused on understanding the Solvency II requirements and putting them into operation within their businesses. Now that this has largely been achieved, companies are beginning to really turn their attention to considering ways to better manage their capital in a Solvency II world. In a new series of blog posts, we will address some ways in which companies can achieve capital efficiency under Solvency II.

We have already seen some capital management techniques put into effect this year, most notably in the space of longevity risk transfer and corporate restructuring, including the use of internal reinsurance. These large-scale projects are generally undertaken by sizeable European groups, but that’s not to say that they are not also relevant for smaller (re)insurers. This blog post will look at three techniques that companies may be able to use to improve capital efficiencies under Solvency II.

Contingent debt
In August, a Norwegian insurer, Gjensidige Forsikring, announced that it plans to become the first insurer to issue bonds that can be written down in the event of a breach of its Solvency II capital thresholds. The firm plans to sell approximately $120 million of these restricted tier 1 notes to enhance the structure of its own funds. The instrument is intended to aid insurers in times of stress. Bond holders will be the first to suffer any losses if the insurer breaches its capital thresholds through deferred coupon payments. Under Solvency II, up to 20% of the Solvency Capital Requirement (SCR) can be covered by bonds with high loss-absorbing capacity, which includes this type of contingent bond or “restricted tier 1 debt.” Similar instruments were issued by reinsurers in the past to provide capital in the event of a major catastrophe.

Operational risk bonds are another area for consideration. In May, Credit Suisse Group issued approximately $220 million in operational risk bonds to help insure against certain risks such as cyber risk, rogue trading, system failure, and fraudulent behaviour. The bond is underwritten by Zurich Insurance Group and is designed to reduce the operational risk capital charges of the Swiss bank. The bond is similar in structure to a catastrophe bond, with the principal being written down upon the occurrence of aggregate operational losses above a certain amount.

Longevity risk transfer
The longevity risk transfer market has been growing steadily as undertakings attempt to reduce capital requirements and technical provisions in respect of longevity risk. Such deals are particularly relevant to UK annuity providers. Legal and General recently completed another longevity reinsurance deal, a key outcome of which was to reduce the insurer’s risk margin. Rothesay Life has also hedged a significant amount of its longevity risk exposure through the use of reinsurance.

However, in the UK, the Prudential Regulation Authority (PRA) is concerned about the additional risks involved in annuity risk transfer, particularly where these transactions are entered into solely to reduce the Solvency II risk margin and not to genuinely transfer risk. A key concern relates to increased counterparty risk, where longevity risks are transferred to a small number of reinsurers. The PRA intends to closely monitor trends and developments in this space.

VIF monetisation
Value of in-force (VIF) is the term often given to the economic value of future profits associated with an in-force book of business. Under Solvency II, the VIF of profitable business can be recognised on the balance sheet through the calculation of the best estimate liability. VIF monetisation involves realising a portion of the value included in the best estimate liability by “selling” a share of the expected future profit stream to a third party in exchange for an up-front payment.

The main benefit of a VIF monetisation is to enhance liquidity and raise finance, and it is, therefore, a potentially attractive alternative to debt or equity issuance. It can also be used to significantly remove variability in the technical provisions over time, essentially via “hedging” a portion of the VIF asset by taking it off risk. This can protect the insurer from future variability in the risk drivers that affect future profits.

In recent years, there has been significant activity in Spain and Portugal in this space, primarily driven by the financial crisis. We have also seen transactions in other European jurisdictions, such as the UK and Ireland.

We have published a number of papers on this topic including Capital management in a Solvency II world (which focuses on life (re)insurance business), Capital management in a Solvency II World: A nonlife perspective (looking specifically at nonlife or property and casualty [P&C] issues) and Unit-linked matching considerations under Solvency II.

If you are interested in more information on capital management under Solvency II, please contact your usual Milliman consultant.