2017 Framework for action: valuation uncertainty for insurers
17 March 2017
The European Insurance and Occupational Pension Authority (EIOPA) and National Supervisory Authorities (NSA) of the EU and EEA plan to introduce substantial changes to the recovery and resolution framework for insurers in mid - 2017. Regulators have identified a number of gaps and shortcomings in their existing framework, with valuation uncertainty - part of the prudent valuation framework - identified as one of the main areas of focus as valuation of less liquid assets commonly presents increased valuation risks.
European insurance industry risks
February’s EIOPA Quarterly Risk Report for the European insurance industry revealed some movements in the assessed macro and insurance market risks. The transition to Solvency II (SII) has brought some downward adjustments in solvency ratios at the market level, better reflecting the risk profile of insurers. The report also shows that SII indicators, together with slightly increased liquidity and funding risks across the industry, gave a higher solvency risk level to the life segment.
Stress test for insurers
This risk assessment reinforces the vulnerabilities of European life insurance companies, which EIOPA highlighted after its December 2016 stress testing results. The test, comprising a “low-for-long-yield” and a “double-hit” scenario analysis, showed the low interest rate environment and a pronounced reassessment of risk premia pose a significant challenge for the 236 participating insurers. The results prompted EIOPA’s recommendation to NSA to consider cancelling or deferring dividend distributions when companies’ business models are at risk.
The stress test also triggered EIOPA’s publication of the Discussion Paper on Potential Harmonisation of Recovery and Resolution Frameworks for Insurers. This shows that while valuation uncertainty and a prudent valuation framework have been addressed on some level by authorities of member states, including the UK’s PRA (Prudential Regulation Authority) - the existing frameworks generally do not contain a requirement for the development of pre-emptive recovery and resolution plans, including assessments of resolvability.
Various case studies provided by NSA and analysed in the report resulted in a number of recovery and resolution scenarios and some common impediments, with valuation of assets and liabilities one of the main impediments referenced. Valuation of less liquid assets commonly presents increased valuation uncertainty risks and thus, if not properly assessed, may lull management into a false sense of security.
Valuation uncertainty framework
The PRA’s definition of valuation uncertainty relates to the risk that the actual realisable value of a position at the measurement date and time is less (from company’s point of view) than the value given to it in the financial statements. In 2016, PRA reviewed valuation models and related risk frameworks for a number of UK insurers; and is continue this in second half of FY16-17. The reviews of valuation uncertainty frameworks are designed to address relative limitations in valuation methodologies which have been applied by companies in their valuation processes.
Typically, we observe the following improvements being embedded in the valuation uncertainty framework post PRA review by insurers:
- Results are addressed based on a portfolio basis, split by asset classes and between vanilla and exotic
- Other portfolios that do not fall into these categories (i.e. emerging markets/hybrids/etc.) are shown separately
- Downside and upside valuation estimates of the possible range of valuation uncertainty after diversification benefit with the portfolio but before cross-asset diversification
- Portfolios excluded due to extreme valuation subjectivity are shown separately, including the required capital add-ons
- Independent price verification is made where possible, and all valuation adjustments are appropriately quantified
- All the above are properly documented and included in the overall process of the valuation risk assessment, and linked to the company’s governance framework.
This can be a complex and occasionally confusing area, so get in touch with me if you’d like to discuss any of the issues raised.