The topic of solvency can get complex very quickly. In the wake of COVID-19, questions about insurance company solvency positions have been raised. It's been discussed in some of the regulatory commentaries that have been released; analysts have been focusing on the topic; many ratings agencies have negatively changed their industry outlooks; and of course, insurance companies themselves are just at the beginning of making public disclosures.
When considering this topic, it's helpful to start with some grounding definitions. Put very simply, Investopedia says that “solvency refers to an enterprise's capacity to meet its long-term financial commitments”1. Wikipedia says that “a solvency ratio measures the extent to which assets cover commitments for future payments, the liabilities”2.What everyone wants to know is - how will COVID-19 and the related financial markets impacts affect the insurers' solvency positions? But more importantly, will the impact be so significant that it threatens the very existence of certain insurance companies themselves? Reviewing several of the 2019 year-end filings, multiple analyst reports and commentaries, it is safe to say that as an industry, and across several geographies, it was generally felt that insurers were well capitalized. Now, all of these views were largely prior to the difficult events that started in late 2019 and have really taken off in earnest in March 2020 (for most of the world).
This means that if insurers were generally well capitalized, the question at hand is not will solvency ratios decrease? - let me answer that right now. For most if not all insurers, solvency ratios will likely decrease as a result of the volatile financial markets impacting insurers' assets as well as other impacts on the liability side. But just because solvency ratios decrease, this does not mean that there is a big problem in the insurance industry.
The questions really should be about:
While we do not expect mass insolvencies, the risk of insolvencies in the industry is certainly not zero and this situation has started to bring some challenges to the forefront. So what are some potential hot spots for insolvencies? One area would be thinly capitalized companies. These might include: small or medium-sized insurers in certain markets; private-equity owned enterprises where the drive for ROI leads to minimal capital injected; or simply companies that are thinly capitalized by design. The current environment is likely to put stress on the ability to pay dividends to shareholders or parent companies.
External factors can also create risks of insolvencies. In the US, for example, COVID-19 business interruption insurance coverage is becoming a topic of legislative debate. Elected officials in New Jersey and other states3 are in discussions or have proposed legislation that require insurers that provide business interruption insurance coverage to cover COVID-19 related claims, despite virus exclusions in many policies4. The US is not the only country where this type of pressure has been raised. Industry groups like the NAIC (National Association of Insurance Commissioners) have issued a statement aligning with the insurance industry “cautioning against and opposing5” these types of proposals. The NAIC went on to say that:
“Business interruption policies were generally not designed or priced to provide coverage against communicable diseases, such as Covid-19 and therefore include exclusions for that risk. Insurance works well and remains affordable when a relatively small number of claims are spread across a broader group, and therefore it is not typically well suited for a global pandemic where virtually every policyholder suffers significant losses at the same time for an extended period.”6
Considering this discussion above, the risk of mass insolvencies is generally low subject to some of these examples. The risk of course starts to increase in the situation of a sustained period of difficult financial markets or global recession, but that is true for any industry and is not unique to insurance.
Regulatory capital varies greatly by country and in the case of the US, even varies by state. The details are vast and can often drive significant differences in the calculations. At a high level, most regulatory regimes include a combination of quantitative measures and qualitative information that is produced. Focusing on the basic solvency calculations (meaning ignoring any stress or sensitivity testing), I have categorized the calculations into three basic approaches:
All three approaches determine capital requirements by assessing the impact of adverse events on the assets and liabilities of the insurer. This can include changes to interest rates, reductions in asset value, increases in claims or other adverse events such as credit defaults and losses from operational events. The more sophisticated regimes allow for the complex interactions and dependencies between these adverse events. In addition, the more advanced regimes, full re-quantification of the balance sheet in response to specific shocks are required.
The more sophisticated regimes tend to look at current asset values and liabilities valued with best estimate assumptions. They therefore tend to be more volatile and react more significantly to adverse events than simplified approaches which may not use current market values (e.g. assets, interest rates to discount liabilities).
The big discussion happening right now is the impact of the financial markets on solvency ratios. This is in fact dominating the discussion more than impacts on underwriting risk (mortality, morbidity, catastrophes, premiums and reserves) for the moment, at least this is true for the direct insurers, reinsurers may be different. And while life and non-life insurers have significant asset portfolios, the life and annuity insurers are particularly vulnerable given the longer duration of their asset portfolios to meet their generally longer duration liabilities. In some markets where protection or risk products dominate the landscape, there is the additional challenge of potential impacts on mortality and morbidity.
Global insurers today are managing more than $20 trillion in assets under management, and more than 50 percent of those assets are government bonds7. Some of the key drivers of the reduction in solvency ratios on the asset side are:
The good news for some companies is that they had previously invested in hedges and/or derivatives which may have resulted in offsets in these more extreme periods of volatility. But the use of these types of assets varies significantly by company and by country. And given the volatility today, choosing to use hedging now can be very expensive.
The movements in interest rates and spreads, in particular, drive changes in the liability discount rates used in many regimes. These reductions lead to increases in the valuations of the liabilities and a lengthening of their durations. The extent to which the increases in liabilities exceed the changes in asset values drives a reduction in solvency.
The variable annuity and group annuity business is particularly susceptible to financial market volatility. Much of this business sits in the US, though there are pieces of it in a number of other markets as well. The capital impacts are due to the cost of guarantees becoming 'in the money' with falling markets. A new variable annuity statutory regulation in the US called VM21 is effective for Q1 2020 reporting (some adopted early). VM21 allows for a more accurate reflection of the hedging position taken by insurers to manage the risks of the guarantees, hence it more closely reflects the true economics. This means that hedging mitigation strategies may in fact have an offsetting reduction of capital given the reserve levels for companies. Meaning that hedging strategies may in fact have a mitigating impact on required capital levels in times of market volatility, versus the prior regulation.
Insurers will also see some impacts on underwriting or other parts of the capital calculations. These will generally be less volatile than the impacts on the asset-related risks. Some of these include: insurance risk, catastrophe modeling, reserves, and net written premiums (for non-life business).
The regulatory response to all of this has been quite fluid. Regulators have been generally focused on giving certain concessions to insurers to support the insurance industry in these difficult times. Concessions center on giving more time to prepare formal reports and disclosures, reducing non-essential requests and investigations and providing some relief in selected countries around the capital calculations themselves and/or delaying stress tests.
EIOPA (European Insurance and Occupational Pensions Authority) went so far as to comment in their March 17, 2020 statement around COVID-19 that “recent stress tests have shown that the sector is well capitalized and able to withhold severe but plausible shocks to the system”.8
Here is a selection of some specific actions being taken or comments that have been made (not a full comprehensive list):
As much as we've seen concessions, regulators are generally increasing touch points and requests in two areas; (1) business resiliency and (2) real-time updates on solvency calculations, up to weekly or even daily in some cases. It is also likely that regulators at the country level will be watching capital levels and continue to dialogue with companies about whether or not they are comfortable with certain levels of parental dividends being paid, at least in the short term.
Looking across insurers in a particular market, one role that ratings agencies often play is to provide some level of relative strength within the insurance sector and down to sub-sectors. The largest ratings agencies are S&P, Moody's, Fitch and AM Best but certain rating agencies may dominate in certain countries (e.g. Moody's in China).14
The rating agencies are involved in ratings on at least three levels, all of which impact insurers to a greater or lesser extent:
In addition to the capital ratios, which differ from regulatory calculations, and also differ between rating agencies, most of the rating agencies also strongly consider ERM (Enterprise Risk Management) practices as part of their ratings process. One of the questions that will be asked and was asked of ERM departments in the 2009 financial crisis is - what went wrong and why wasn't this anticipated? Two other important aspects will be (1) volatility of earnings and (2) diversification of the business.
One regulator has announced that they are developing a stress test that they plan to conduct on its rated insurance agencies' balance sheets to assess the effect of COVID-19 on their risk-adjusted capital levels, investment portfolios, reserve adequacy and other risk factors.
Other rating agencies may be focused on liquidity. This has not been a significant issue yet for insurance, and given that the claims activity has increased somewhat but not significantly, the concerns on this front are pretty minimal in the short term. Of course, as insurers are encouraged to give concessions like premium payment holidays, if lapses/withdrawals start to increase along with potential decreases in new business and continued financial markets volatility, liquidity will need to be monitored by companies.
First and foremost, insurers should avoid knee jerk reactions. Moving investment portfolios around too much can lead to realizing losses followed by reinvestment risk in a reduced interest rate environment. Still, there may be certain investment opportunities like reviewing concentrations in certain at-risk industries like energy, health care, retail, hospitality and travel - these could be experiencing ratings downgrades which could negatively and immediately impact solvency ratios.
Reviewing asset-liability management strategies and mitigations such as hedging could still be practical but costly in the short term. There are also open questions being posed about commercial real estate holdings given that companies are learning that a more remote workforce is possible and may reconsider their corporate footprints.
Another strategy is to dig into the details of capital models - there may be little pockets of value in multiple places all of which can lead to a larger impact. More frequent capital modeling with these types of analyses and reviews of the parameters are happening today.
There are two schools of thought on new business. Right now, growth is challenged especially in countries where the primary method of sale is through tied agents and face-to-face visits. So slow growth in new business can be a 'good guy' when it comes to capital because new business often results in capital strain in the year of issuance. However, slower growth of the top-line will undoubtedly impact liquidity, a company's ability to invest as an organization and would not be seen as favorable by the market.
It is not surprising that some insurers are starting to look at possible debt issuances. This may be a good way to raise cash quickly. While liquidity has not yet been a major issue for insurers, especially compared to banks, the calling of 'cash is king' is just starting to get louder.
Questions about dividends have already been raised, as mentioned earlier by EIOPA, and by other regulators. This is certainly a lever that can be pulled by companies both internally through parental dividends as well as externally to shareholders or policyholders. It may be harder for companies to dividend to the parent in this environment as local regulators are increasingly concerned and protective. This potential for lower dividends, combined with lower expected future earnings should financial markets remain depressed, could also impact deferred tax assets.
While the insurance industry has been touted as 'well capitalized' in a variety or commentaries during year-end 2019, there may be a new normal in terms of capital levels. These levels will be above the minimums on a regulatory basis but perhaps not at the high levels seen during year-end 2019.
One of the primary concerns for longer-term solvency ratios is a sustained period of low interest rates or threats of a global recession. In the longer-term, companies may be looking at re-evaluating their investment portfolio mix, reconsidering hedging strategies and reviewing their asset-liability management approaches. Also, for savings-oriented products like participating business and universal life, we will likely see more active use of management actions to reduce bonuses and crediting rates.
Another possibility is that capital or solvency calculations could undergo changes to upgrade to more sophisticated or complex methods. Companies may make those changes on their own, for example in their internal models, or regulators/rating agencies may also undergo adjustments. One example is Hong Kong where possible early adoption of the incoming Risk Based Capital regime may be considered. All things are probably possible at this stage.
One of the surprising aspects of COVID-19 has been the correlation between COVID-19 and the impacts on global financial markets. Previously these were thought of as uncorrelated risks, but this could change in the future given what we have seen over the last few months. This could be one of the changes incorporated for companies that use Solvency II internal models, as well as being incorporated into stress tests used by regulators to understand industry exposures. Some say that 'in a real crisis, all the correlations are 1'.
Will all of this re-invigorate certain aspects of reinsurance? Companies may have a new appreciation for the totality of their exposures and may be more open to paying for reinsuring risks that they previously kept. Will reinsurance continue to innovate, as they always have, to create new products around pandemic risk that can help insurers with their business? And then of course there is the opportunity for capital relief, but that does not apply in all countries. Similarly there are open questions about how the captive market will do in this environment and what will be the future of that market.
One question that has been raised is how will small and medium-sized insurers fare relative to larger insurers? The general view is that this will challenge them even to the point of potential insolvencies or at least more distress than may be felt by the larger insurers. This could point to more M&A activity and further consolidation in the market.
The rating agencies will no doubt be pushing hard on ERM practices, along with regulators. It has been a while since a pandemic has so swiftly closed down businesses across various countries. Boards, too, could have an increased role and expectation in this new normal. The Financial Reporting Council (UK, Ireland) recently commented that Boards need to “pay attention to capital maintenance, ensuring that sufficient reserves are available when the dividend is made, not just proposed.”15
Finally, as COVID-19 continues, creating anxiety for societies, companies and governments, will there be more external pressures on insurers like the situation around business interruption insurance today? There are many lessons learned and more still to come, but the solvency of insurers now and in the future is core to the stability of financial systems in any country. This brings that into focus more than ever.
Ferdia Byrne, Global Head of Actuarial, KPMG International and Partner, KPMG in the UK
Laura Gray, Partner, US Head of Actuarial, KPMG in the US
Tal Kaissar, Global Head of Tax, KPMG International and Partner, KPMG in the US
Zeeshan Rehmani, Managing Director, US Head of Capital Solutions, KPMG in the US
Alison Rose, Partner, Life & Pensions Actuarial practice, KPMG in Canada
Michael van Vuuren, Partner, ASPAC Head of Actuarial and Insurance Risk Management, KPMG China