Category Archives: Risk management

Risk management frameworks are changing alongside the climate

Financial services firms are focusing on risks associated with climate change more than ever now. In part, the heightened attention results from increased regulatory activity in this area.

Firms are now required to evaluate the potential financial impact of climate change and include climate change considerations within their risk management frameworks.

A typical risk framework is anchored around the risk appetite associated with a firm’s key objectives. Milliman consultant Neil Cantle provides more perspective in his article “Look, learn, predict.”

Can innovation and governance coexist?

Big data, technology, and demographic changes have increased competitive pressures to the point where innovation has become essential for insurers. However, innovation is often at odds with many insurers’ governance structures. Governance seeks to define a framework under which business decisions are determined and executed.

In contrast, innovation by definition seeks new methods, ideas, and products. Viewed by many as a natural, or even acceptable, state of affairs, this tension can edge out a potentially profitable initiative, recasting it into a familiar mold with few growth possibilities.

In this article, Milliman’s Paul Fedchak and Stacy Koron discuss whether the process really has to be that way.

Reinsurance and IFRS

In July 2020, Milliman professionals published the research report “Reinsurance as a capital management tool for life insurers,” written by consultants Eamon Comerford, Paul Fulcher, Rik van Beers, and myself.

Capital management is an increasingly important topic for insurers as they look to find ways to manage their risks and the related capital requirements and to optimise their solvency balance sheets. Reinsurance is one of the key capital management tools available to insurers. The paper investigates common reinsurance strategies, along with new developments and innovative strategies that could be implemented by companies. This blog post is one of a series being released in relation to this research. Each blog post will give an overview of a certain section of the Milliman report.

Reinsurance and IFRS

The new International Financial Reporting Standards (IFRS) accounting standard for insurance contracts, IFRS 17, is expected to have an effective date of 1 January 2023. This will change the accounting treatment of reinsurance contracts under IFRS reporting. IFRS 17 requires a reinsurance contract to be accounted for separately from the underlying insurance contract, which hasn’t previously been the case under IFRS 4.

Both insurance contracts and reinsurance contracts held will have a separate contractual service margin (CSM) on the balance sheet, which is a mechanism to spread profit over the lifetime of the contract.

The separate accounting treatment of reinsurance and insurance contracts will mean that there may be earnings volatility due to mismatches between the accounting treatment of the contracts.

Accounting mismatches may occur in a number of areas:

  • The underlying insurance contracts and reinsurance contracts may have different terms, which may lead to different measurement models being used to value them. If the coverage period of a reinsurance contract is one year or less, it may also be possible to model the reinsurance contract under the premium allocation approach. A mismatch will occur if the underlying insurance contracts are modelled using the general measurement model.
  • Differences in contract boundaries can occur between reinsurance contracts and the underlying insurance contracts. Reinsurance contracts often have cancellation clauses where contracts can be cancelled prematurely, leading to instability in financial results.
  • Aggregation of contracts into units of accounts may also differ between insurance and reinsurance contracts. Insurance contracts may only be aggregated into cohorts that are incepted no more than one year apart, whilst reinsurance contracts may cover many years of insurance contracts.
  • Coverage units used to allocate the CSM over an accounting period may differ between the underlying insurance contracts and the reinsurance contracts, which may result in differences in the timing of profit and loss recognition.
  • The CSM of the reinsurance contract can be both positive and negative, but the CSM for an insurance contract must be positive or floored at zero. Losses from onerous groups of insurance contracts are recognised immediately in the profit and loss (P&L) statement. Onerous reinsurance contracts can have a negative CSM which is spread over the lifetime of the reinsurance contract. This can lead to an accounting mismatch between the reinsurance contracts and the reinsured portfolio.
  • Inception dates of reinsurance and reinsured portfolios often differ as reinsurance is taken out after insurance contracts have been written. This will lead to different locked-in rates being used to value contracts, leading to a mismatch in finance income and expenses.
  • The separate presentation of insurance and reinsurance contracts can lead to balance sheet accounting challenges. The risk adjustment is the compensation that an entity requires for bearing the uncertainty about the amount and timing of nonfinancial risks. The risk adjustment of the reinsurance contract is not netted against the risk adjustment of the underlying insurance portfolio. This leads to the question of how to allocate diversification benefits to the reinsurance contract.

As a result of changes in financial reporting impacts, including possible additional earnings volatility, some insurers may require some elements of reinsurance treaties to be commuted or rewritten (where possible) to remove some of this earnings volatility. This will affect both internal and external reinsurance contracts and will depend on the reinsurance treaty terms.

As insurers develop familiarity with IFRS 17 reporting requirements, their appetite for reinsurance solutions
will evolve.

Insurers taking out new reinsurance contracts for capital relief should also consider the impact on financial reporting in addition to capital optimisation.

Milliman research paper

The full research paper can be found on Milliman’s website here. At the same site, you can also find an executive summary version that notes some of the key highlights of the research and acts as a guide to the full paper.

Using ORSA to navigate new COVID-19 risk environment

The economic impacts along with the epidemiological aspects of the COVID-19 pandemic will reshape the outlook for the insurance industry over the next three to five years.

Insurance companies will need to adapt their overall operating models, incorporating the effects of the virus to continue to achieve their strategic objectives and goals. These effects will include elevated operational risks like cyber threats related to new remote work environments for employees.

The Own Risk and Solvency Assessment (ORSA) process provides the framework for insurance companies to understand, evaluate and quantify their risk profiles. It is inevitable that the ORSA will form a major part of the backdrop to work in 2020 and likely further into the future.

In this paper, Milliman’s Ian Penfold, Sophie Smyth and George Barrett discuss how insurers can explore their future exposures to COVID-19 through the ORSA.

Overview of Climate Financial Risk Forum guide

In March, the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) hosted the first meeting of the jointly established Climate Financial Risk Forum (CFRF). The CFRF was established to build capacity and share best practice across financial regulators and the industry to advance financial sector responses to the financial risks from climate change.

The CFRF produced a guide to help firms understand the risks that arise from climate change and to provide support on how to integrate these risks into strategy and decision-making processes. The CFRF emphasises the importance of greater transparency and consistency regarding firms’ disclosures of climate-related financial risks, the benefits of effective risk management and scenario analysis and the opportunities for innovation in the interest of consumers.

The forum set up four working groups to explore the risks that climate change poses in each of these areas and developed practical guidance. In this paper, Milliman’s Amy Nicholson and Sophie Smyth summarise the key guidance from each of these four working groups.

COVID-19: What have we learnt from Solvency II reports from UK life insurers?

In March, the European Insurance and Occupational Pensions Authority (EIOPA) published its recommendations on the implications of COVID-19 for supervisory reporting and financial disclosure. EIOPA recommended that insurers consider the pandemic as a “major development” and publish appropriate information in their Solvency and Financial Condition Reports (SFCRs) on the effect of COVID-19 on their business.

However, EIOPA did not prescribe the possible format or extent of such disclosure. As a result, different approaches were taken by insurers to meet the disclosure requirements. They ranged from having dedicated sections for the impact of COVID-19 to having a few lines giving a brief description of the potential impact at much higher levels.

In this paper, Milliman’s Paul Fulcher, Sihong Zhu, and Samuel Burgess review the SFCRs recently published by major life insurers in the United Kingdom to examine the disclosures made on the impact of COVID-19 and what can be learnt about the impact the epidemic has had.