Tag Archives: capital management

Reinsurance and IFRS

In July 2020, Milliman published the research report ‘Reinsurance as a capital management tool for life insurers,’ written by our consultants Eamon Comerford, Paul Fulcher, Rik van Beers, and Rosemary Maher.

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.

Capital management and reinsurance considerations

Life insurance companies face multiple risks that evolve over time and they must hold capital as a buffer against these risks. 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.

Given the traditionally long-term nature of the insurer’s liabilities, effective capital management can be complex. Insurers may face capital pressure due to their solvency coverage level, shareholder demands, regulatory concerns, etc. Reinsurance is one of the key capital management tools available to insurers. Several reinsurance structures are available, each with its own advantages and disadvantages and requiring experience and expertise to make optimal decisions.

In this paper, Milliman professionals explore a range of reinsurance strategies that could be used by life insurers for capital management purposes. They investigate more common reinsurance strategies along with new developments and innovative strategies that could be implemented by companies.

Capital management techniques life insurers should consider

Solvency II has changed the mindset of European life insurers, especially with new entities like private equity houses, hedge funds, and insurtech firms joining the fray. One reason these entities have entered the market is to extract value for the shareholders, not only by investing in complex assets with higher returns, but also through the optimisation of capital resources.

Insurance capital management opportunities under the new regulatory regime are regularly discussed but implementation has generally lagged. However, with increased pressure on the industry, now is an ideal time for insurers to incorporate innovative Solvency II capital optimisation techniques into their planning.

In this article, Milliman’s Paul Fulcher and Securis Investment Partners’ Luca Tres examine several techniques using innovative capital market transactions. The authors focus on actuarial and technical risks while providing insurers with options to exploit capital benefits on the asset side of the balance sheet.

Capital efficiency under Solvency II: Part II

clarke-sineadOur continuing series of blog posts addresses some ways in which companies may be able to achieve capital efficiency under Solvency II. This post looks at three additional capital management techniques that have become popular since the introduction of the new Solvency II capital regime.

Internal reinsurance
We have seen an increase in the use of internal reinsurance to improve Solvency II capital. The use of internal reinsurance can reduce the capital requirements of solo entities through risk transfer to the internal reinsurer. The group may also benefit from greater capital efficiencies through diversification at the reinsurer level.

Aviva significantly increased the amount of business ceded to its internal reinsurer,* Aviva International Insurance, during 2016. AXA also has an internal reinsurer to manage reinsurance for the insurer’s global property and casualty (P&C) business, which was recently upgraded by AM Best, and the Belgian insurer Ageas set up an internal reinsurance vehicle in 2015.*

Corporate restructuring
We have seen a large increase in mergers and acquisitions (M&A) activity and corporate restructuring as a result of Solvency II. Recent M&A activity includes:

• Scor announcing plans to merge its three French businesses* to reduce its risk margin by €200 million under Solvency II
• AXA’s exiting of the UK life and savings market with the sale of its offshore investment bonds business, Axa Isle of Man, and its UK portfolio services business, Elevate
• Aegon selling two-thirds of its UK annuity portfolio business to Rothesay Life with the aim of freeing up capital in its UK subsidiary
• Allianz selling its Taiwanese traditional life insurance portfolio* to a local Taiwanese life insurer to improve the group’s capital efficiency under Solvency II

Unit-linked matching
We are aware of a number of unit-linked providers that are currently rethinking unit-linked matching. The Solvency II regulations state that the technical provisions in respect of unit-linked benefits must be matched as closely as possible with unit-linked assets. Under Solvency II, the technical provisions for unit-linked benefits generally include a best estimate liability, which is lower than the unit value. This opens up the possibility to invest a lower amount in unit-linked assets than the outstanding unit value, i.e., “mismatching” the unit-linked assets and liabilities, which can enhance the capital position of unit-linked portfolios and stabilise economic balance sheets.

However, as usual, such benefits come at a price, and insurers will have to decide whether or not the capital savings are sufficient to offset the operational complexities, coupled with a more volatile solvency coverage ratio. Unit-linked matching is considered in more detail in our briefing note entitled Unit-linked matching considerations under Solvency II.

We have published a number of papers on this topic including Capital management in a Solvency II world, which focusses on life (re)insurance business, Capital management in a Solvency II world: A nonlife perspective (looking specifically at nonlife or P&C issues) and Unit-linked matching considerations under Solvency II.

If you are interested in more information on capital management under Solvency II please contact your usual Milliman consultant.

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Capital efficiency under Solvency II

clarke-sineadFollowing its implementation on 1 January 2016, Solvency II should now be “business as usual” for European (re)insurers. For years, (re)insurers were focused on understanding the Solvency II requirements and putting them into operation within their businesses. Now that this has largely been achieved, companies are beginning to really turn their attention to considering ways to better manage their capital in a Solvency II world. In a new series of blog posts, we will address some ways in which companies can achieve capital efficiency under Solvency II.

We have already seen some capital management techniques put into effect this year, most notably in the space of longevity risk transfer and corporate restructuring, including the use of internal reinsurance. These large-scale projects are generally undertaken by sizeable European groups, but that’s not to say that they are not also relevant for smaller (re)insurers. This blog post will look at three techniques that companies may be able to use to improve capital efficiencies under Solvency II.

Contingent debt
In August, a Norwegian insurer, Gjensidige Forsikring, announced that it plans to become the first insurer to issue bonds that can be written down in the event of a breach of its Solvency II capital thresholds. The firm plans to sell approximately $120 million of these restricted tier 1 notes to enhance the structure of its own funds. The instrument is intended to aid insurers in times of stress. Bond holders will be the first to suffer any losses if the insurer breaches its capital thresholds through deferred coupon payments. Under Solvency II, up to 20% of the Solvency Capital Requirement (SCR) can be covered by bonds with high loss-absorbing capacity, which includes this type of contingent bond or “restricted tier 1 debt.” Similar instruments were issued by reinsurers in the past to provide capital in the event of a major catastrophe.

Operational risk bonds are another area for consideration. In May, Credit Suisse Group issued approximately $220 million in operational risk bonds to help insure against certain risks such as cyber risk, rogue trading, system failure, and fraudulent behaviour. The bond is underwritten by Zurich Insurance Group and is designed to reduce the operational risk capital charges of the Swiss bank. The bond is similar in structure to a catastrophe bond, with the principal being written down upon the occurrence of aggregate operational losses above a certain amount.

Longevity risk transfer
The longevity risk transfer market has been growing steadily as undertakings attempt to reduce capital requirements and technical provisions in respect of longevity risk. Such deals are particularly relevant to UK annuity providers. Legal and General recently completed another longevity reinsurance deal, a key outcome of which was to reduce the insurer’s risk margin. Rothesay Life has also hedged a significant amount of its longevity risk exposure through the use of reinsurance.

However, in the UK, the Prudential Regulation Authority (PRA) is concerned about the additional risks involved in annuity risk transfer, particularly where these transactions are entered into solely to reduce the Solvency II risk margin and not to genuinely transfer risk. A key concern relates to increased counterparty risk, where longevity risks are transferred to a small number of reinsurers. The PRA intends to closely monitor trends and developments in this space.

VIF monetisation
Value of in-force (VIF) is the term often given to the economic value of future profits associated with an in-force book of business. Under Solvency II, the VIF of profitable business can be recognised on the balance sheet through the calculation of the best estimate liability. VIF monetisation involves realising a portion of the value included in the best estimate liability by “selling” a share of the expected future profit stream to a third party in exchange for an up-front payment.

The main benefit of a VIF monetisation is to enhance liquidity and raise finance, and it is, therefore, a potentially attractive alternative to debt or equity issuance. It can also be used to significantly remove variability in the technical provisions over time, essentially via “hedging” a portion of the VIF asset by taking it off risk. This can protect the insurer from future variability in the risk drivers that affect future profits.

In recent years, there has been significant activity in Spain and Portugal in this space, primarily driven by the financial crisis. We have also seen transactions in other European jurisdictions, such as the UK and Ireland.

We have published a number of papers on this topic including Capital management in a Solvency II world (which focuses on life (re)insurance business), Capital management in a Solvency II World: A nonlife perspective (looking specifically at nonlife or property and casualty [P&C] issues) and Unit-linked matching considerations under Solvency II.

If you are interested in more information on capital management under Solvency II, please contact your usual Milliman consultant.

Top 10 worldwide Milliman publications of 2014

In 2014, Milliman published a range of articles and videos, covering issues including retirement ideas for Millennials, the pros and cons of catastrophe models, the value of enterprise risk management (ERM) programs, and the impact of the Patient Protection and Affordable Care Act (ACA) on financial statements. We also published on challenges related to healthcare costs and insurance and risk management issues—and about real insurance for fantasy football and insurance for ride sharing. To view this year’s 10 most viewed articles and reports, click here.