MILLIMAN – Navigating Uncertainty: The vital Role of Sound Balance Sheet Management in an Ever-Changing Macro-Economic Landscape

Article written by Milliman as part of the sponsorship of ACA Insurance Days 2023, whose content is the sole responsibility of its author.

Introduction

The current macro-economic environment is characterised by a continuation of volatile interest rates and inflation rates that are not yet back to their pre-2022 levels. This significantly impacts risk exposures of insurance companies and could lead to undesirable balance sheet volatility. In this context, having a sound balance sheet management in place is key, as it allows insurance companies to further improve and stabilize their financial results.

Balance sheet management concerns optimising the relationship between risk, return and capital through an insurer’s balance sheet. Having a strong balance sheet management in place puts the insurer in a better place during turbulent market conditions. It also allows for a more efficient use of resources, freeing up capital that can, for instance, be used to invest in higher yielding assets or increase new business which can positively contribute to capital generation.

When looking at the average Luxembourg based insurance company, we observe that balance sheet management is not a theme that is on top of everyone’s mind. As a result, there are still plenty initiatives that can be considered to further improve an insurer’s balance sheet and finances, leading to competitive advantages. This article highlights three of these initiatives.

Reinsurance

The use of reinsurance can help insurance companies improve their financial stability protecting against extreme events such as (multiple) large losses or catastrophic events. Besides these traditional uses, reinsurance can also be used to reduce the solvency capital requirement (SCR) allowing thereby primary insurers to take more diverse risks with almost the same amount of capital. An example of this is the use of reinsurance to mitigate the effects of catastrophe risk, where some exposures can lead to undesired large amounts of required capital in the Solvency II Standard Formula.  

Reinsurance enables insurers to increase underwriting capacity by transferring a portion of their risk to reinsurers, strategically positioning them to take on more exposure while maintaining financial stability. When optimising a reinsurance program (i.e. determine both the level and type of reinsurance) the risk appetite and strategic objectives (including capital management and analysis of its needs) of the company should be considered. A quota share reinsurance could typically be a solution to manage the SCR when growing the business.

Furthermore, reinsurance allows insurers to leverage the expertise of reinsurers in underwriting and claims management, providing them with valuable insights and support in these key areas. Monitoring the claims’ evolution on a regular basis can provide useful insights on the adequacy of the reinsurance program in place and whether a modification should be made.

Unit-matching

Several Luxembourgish life insurers have large books of unit-linked business ([1]). These books are exposed to market and life underwriting risk through related future expenses, charges and guarantees, resulting into capital requirements and volatility in their Own Funds. Fortunately, Solvency II regulations create opportunities for life insurers to strengthen the capital position of these unit-linked portfolios while maintaining a stable Solvency II balance sheet. Matching requirements under the Solvency II Directive allow for holding unit-linked assets to only cover unit-linked provisions, not the face value of liabilities. This underfunding approach permits investing excess unit-linked assets elsewhere, potentially yielding higher expected returns.

Several approaches can be considered when implementing unit matching, each with their own benefits and disadvantages. More detail can be found in several Milliman briefing notes ([2], [3]). In short, these mainly concern a choice between stabilising the net asset value (NAV) and stabilising the Solvency II ratio. The NAV is being stabilised when fully matching unit-linked assets and unit-linked liabilities. The Solvency II ratio on the other hand, is stabilised when matching unit-linked assets, liabilities and the associated SCR. Unit matching is a well-known strategy which is already implemented at various life insurers across several European markets ([3]). When insurers started implementing a unit-matching strategy, its implementation and maintenance did require considerable operational efforts, making it less suitable for the average Luxembourgish unit-linked portfolio. However, in recent years some alternative, less operationally heavy approaches were implemented in the UK market, making unit-matching a management action worthwhile considering.

Loss-Absorbing Capacity of Deferred Taxes (LACDT)

The LACDT is one of the SCR components worthwhile optimising, as it provides the potential to significantly reduce the SCR by considering the tax relief arising from the future losses under the SCR stresses. The concept of the LACDT is defined in Article 108 of the Directive 2009/138/EC.

Regulations include the definition of its maximum permissible value. Our analysis of the 2022 Solvency and Financial Conditions Reports (SFCR) for Luxembourg insurance companies [1] show that most of insurance companies reported a LACDT that is lower than or equal to their reported Deferred Tax Liabilities (DTL), suggesting a larger LACDT amount could be applied when following these regulations. As a result, the Solvency II ratios of many insurers could potentially be improved. To do this, insurers should perform an additional substantiation to assess potential LACDT improvement such as conducting stress testing to assess the resilience of LACDT under various scenarios and integrating LACDT considerations into ALM strategies. More information on this can be found in [4].

Conclusion

Balance sheet management creates value to insurers by increasing profitability and improve their financial stability. It is not without cause that several insurers have established balance sheet management departments distinct from Finance, recognizing the complex nature of the insurance industry and the evolving regulatory and economic landscape.

In this article, a few management actions particularly relevant to Luxembourg based insurers were discussed. However, there are plenty of other areas to consider. Navigating the selection of a strategy, weighting its associate benefits and trade-offs, and considering all pertinent factors, including regulatory and economic shifts, constitute a challenging problem demanding careful considerations.

Milliman not only assists insurers with the technical aspects of balance sheet management but also guides them in integrating it within their organisation, ensuring an effective approach.

If you are ready to explore tailored solutions for your needs, we invite you to reach out to us. A natural first step is to undertake a feasibility study to assess the potential benefits, costs and challenges of the various actions that can be applied to your organisation. Milliman has all the resources and expertise available to guide you along the way and make your balance sheet management journey a success!

Kevin Vetsuypens – kevin.vetsuypens@milliman.com
Rik van Beers – Rik.vanBeers@milliman.com
Peter Franken – peter.franken@milliman.com