April 13, 2016

Balance sheet optimization after Solvency II

 

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Insurers have delivered Solvency Capital Requirement (SCR) models and re-organized their risk management services to comply with Solvency II Pillar I and Pillar II requirements. Let’s now look beyond Solvency II.

 

Solvency II does not address all the risks that insurers are currently facing; next to enhancing SCR models effectiveness, CROs agendas are broadening to address emerging new risk types, not captured by regulations nor internal models.

 

Solvency II also has to be embedded in day-to-day decisions and in strategic business and finance management processes: The CFOs agenda is changing.  Risk and finance functions cannot work within silos anymore: risk, performance and capital management have to be synchronized.

Moreover, comprehensive governance is changing, with Boards being more and more involved in risk strategies and risk culture embedment, to establish the appropriate incentives in business development.

 

 Which are the new risk challenges for insurers today? 


CROs are facing a potential overestimation of capital requirements and have to improve the appropriateness and stability of model outcomes.
Therefore, model risk management is emerging on the agenda, to reduce excessive conservatism and uncertainty around SCR calculations and to mitigate the risk of potential regulatory capital add-on.  In parallel, management of concentration risks and of diversification benefits becomes critical in order to build a robust competitive advantage in the cost of capital. 


Simultaneously, CROs are also facing a potential risk of underestimating capital requirements, due to the emerging of new risks.
Banks are contributing less to the credit and liquidity supply to the economy, and persistently low interest rate and credit spreads make fixed-income markets more fragile before a quantitative easing (QE) exit. Therefore, insurers [as institutional investors] are becoming more exposed to systemic liquidity risk in fixed-income assets, while investment in less liquid loans (mortgages, infrastructure, real estate, etc) increases sensitivity to credit default risk.


Moreover, insurers business models within all financial institutions are changing not only due to digital transformation (with consequences on data and cyber security risk), but also due to incentives from European policy makers for a broader contribution from insurers to the market-based finance of the economy (Capital Markets Union, simple transparent and standardised (STS) securitisation consultation, etc). These trends are emphasizing the growing relevance of value – and related internal and external risks-, notably when strong human capital, culture and brand can often compensate for asset concentration in high grade but systemic exposures (e.g. sovereigns, mortgages, etc).

 
How to manage capital, risk and performance after Solvency II? 


Both target performance and tolerance for risk (Risk Appetite) should be managed at the top along four complementary performance domains which, unfortunately, have different measurement practices and benchmarks: Solvency (regulatory, S&P and economic capital buffers), profitability (medium term average return on capital and yearly IFRS earnings), liquidity (short term and long term liquidity buffers), and franchise (internal, external).

For internal performance management and allocation of (scarce) financial resources, the economic and market dimensions are generally most appropriate, all sources of risks and of value creation being incorporated.
The accounting and regulatory dimensions are of course very important constraints, which may not be excluded from the overall risk appetite but are insufficient when considering all risk types and sources of financial and non-financial value creation. 


To establish the appropriate risk culture, targets and tolerance in terms of risk profile cannot only be managed at the consolidated level. They have to be cascaded down to Legal Entities (LE) or Lines of Business (LoB) for a fair performance comparison among them, and because capital is not necessarily fungible across legal entities.  If the purpose is to prioritize capital allocation, this comparison should be based on a comparable and stand-alone assessment of capital usage and risk-adjusted performance on capital. Of course, this metric, comparable to RAROC or Economic Value Added (EVA) metrics in banking, should incorporate the weighted average cost of the target total capital buffer and be enriched by the cost of target liquidity buffer. 


Allocation and optimization of diversification benefit across business lines is key for performance management at LoB level and throughout day-to-day decisions in life, non-life and investment businesses.  The allocation of the diversification benefit should be aligned with the institution’s values and business management practices.  For mutual insurers, for example, every business should receive the same diversification benefit, to promote collaboration among LEs/LoBs by (stable) discount on hurdle rates on capital.  This choice will have implications on balance sheet optimization at various levels of the organizations, e.g. on balance between life/non-life and investment businesses, on group finance and risk mandates, as well as on investment, customer and product strategies. 


In parallel, to maintain performance within the expected range of risk tolerance,Risk Appetite should be cascaded down per risk type level for concentration management in systemic risk (ex: liquidity, sovereign) and in event risk (ex: overall impact of a large peril, a large default, a large operational loss) across all business lines and legal entities.
The complexity of accumulation / concentration risk assessment is also growing due to interconnections between risk types.

Finally, financial plans cannot anymore be limited to a base case but should be complemented by plausible but adverse scenarios. These forward-looking stress tests will allow to estimate not just the capital but also the earnings, the liquidity and the franchise which are exposed at risk, and consequently take pro-active actions to maintain compliance with regulatory constraints and internal Risk Appetite.


How to ensure a sustainable business under Solvency II? 


Insurers need to optimize their financial and non-financial performance under Solvency II and internal Risk Appetite constraints, recognizing all sources of risk and value growth.


Balance sheet and Franchise Optimization requires a comprehensive set of targets and tolerances, covering all performance domains (solvency, profitability, liquidity and franchise), and integrated into the financial plan and challenged by plausible but adverse stress tests.


Performance optimization will take place at various levels, from product, client, life & non-life investments to the overall B/S, with sound central control on concentrations and management of a robust diversification benefit that re-enforce insurers’ value for the community, their clients and their staff.

 

Risk Dynamics has assisted multiple clients in different industries designing, calibrating and cascading down, their risk appetite to incorporate all sources of value and risk – both financial and non-financial– and to identify the sources of performance and risk optimization at various levels of the organization.

 

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About the Author: 

Tamar Joulia is Senior Advisor at Risk Dynamics. Within Risk Dynamics Tamar focuses on governance, portfolio strategy, appetite for risk, stress tests, as well as balance sheet optimization for banks and insurance companies in the perspective of Basel 3 and Solvency 2. Click here to email Tamar.

 

Tags: Insurance

Author:

Tamar Joulia

Tamar Joulia

Tamar Joulia is Senior Advisor with Risk Dynamics since 2011. She has 25 years leadership experience in risk and portfolio management as well as in capital markets for global financial institutions active in banking, insurance and asset management. She supports the development of Risk Dynamics activities in the asset management industry, and facilitates regular forums of CROs dealing with hot topics in financial services. Tamar is also guest professor in post-master classes of risk management.

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