The expanding role of ESGs in Insurance businesses
For the insurance industry, the low interest rate environment creates challenges when producing new and competitive products. These products need to take into account the current decrease of profitability due to the current financial market, especially from products highly linked to the assets performance. This is particularly the case for saving products which use profits made on bonds and equities to offer high profitability to the clients and stakeholders.
Even though in the UK only 20 to 40 % of the total reserves is related to savings products, UK life insurers’ profitability will still decline as expected returns decrease. Historically, UK life insurers focused on matching their asset investments to the expected claims to mitigate risk. Such mechanisms however, are based on pricing assumptions which are becoming highly challenged as they are based on both long and short term outdated interest rate forecast.
Regarding this upcoming issue, we emphasize the challenge of understanding the on-going financial markets. This is especially true as current insurers focus on modelling the expected economic environment via adaptive solutions. The Economic Scenarios Generators (ESGs) are powerful predictive tools for forecasting what could happen in the financial markets and can be viewed as the new “do or die” investment for insurers. ESGs permit good asset modelling on the balance sheet which could support the top level management in market anticipation and so aid in the creation of new competitive insurance services.
Why is there a new challenge for UK insurers?
Historically, interest rates were prolific in the UK: the Government Bond 10Y averaged 7.13% from 1980 until 2015. This environment allowed assets managers to perfectly match their Assets and Liabilities (AL) Cash-Flows. The Liabilities related to life insurance products could be forecasted with relative ease, so the assets could be adjusted accordingly thanks to this high interest rates context (figure 1).
Since the 2010 crisis, matching has become increasingly difficult to maintain due to the current low interest rates (record low of 1.36% in January 2015) and life insurers are being force to rethink their reinvestment strategies.
A standard approach is to manage the generation of high profitability by increasing the equities ratio in the assets portfolio. In case the assets do not match the liabilities cash-flows, either the surplus earned is reinvested or part of the assets are sold out to reach the matching target (figure 2). This solution is riskier but appropriate if the life insurer wants to maintain the profitability promised to both the insured and stakeholder.
This example highlights the necessity of investing in assets producing high profitability if the life insurance companies want to maintain the matching between Assets and Liabilities. The ESGs can model the performance paths for assets and can be the key to success for such reinvestment strategies.
Why is ESG the solution?
As mentioned, the Assets and Liabilities Management function is facing a new challenge. Insurers now need to think about more complex insurance products to fit the current market environment. They also need to find adjustable modelling solutions to maintain the profitability promised to their insurers and stakeholders. To meet this challenge, ESG is the appropriate solution. Currently there are a large number of ESG’s available in the market, ranging from basic to advanced. This range allows the Insurance companies to link their liabilities to the appropriate financial modelling assumptions.
Insurers must choose an ESG in line with its own risk appetite. For example, if an insurance company chooses to be competitive by massively investing their assets in the equity market, it will then need to select an ESG which will fully challenge this assets management. In that case, the appropriate ESG should deliver as reasonable as possible non-standard scenarios to focus on this risky assets management.
The ESG in the Solvency framework
Considering the current Solvency II regulation context, insurers can use their own ESG as an input to implement their internal model. Where they do so, it must be used to develop management information as part of the decision making framework for top management. It can then be used to inform the setting of the risk appetite and to inform key hierarchy components: financial reporting, Risk management, ALM management, Transactions (M&A) and Product pricing.
As we understand, the ESG is at the heart of the technical inputs due for key calculation processes, especially in the Solvency II framework (figure 3).
Even as a key component for the Solvency Capital Ratio (SCR) calculation, ESGs are not highly controlled by the EIOPA so far. The regulator recommends the use of an ESG in line with the company risk appetite, without mentioning specific technical rules to apply. This current lack of requirements can be the new challenge as Solvency capital rules come into force across the EU from 2016.