Insurance - resilience against a potential downturn

21 February 2019

A general economic slowdown has led to negative market sentiment in recent months, with equities falling and credit spreads rising.  Risks of a further economic deterioration remain.

One can envisage a downside scenario – not necessarily a central case - in which equities fall further, credit spreads widen, interest rates fall in response to a flight to quality, FX rates fluctuate, and property prices continue to stagnate, or fall.  Inflation might also rise in the short term, in response to currency movements, and short term interest rates may exhibit particular volatility in response.  Complicating matters further, it is possible that a downside scenario may reveal itself only gradually, with asset prices appearing stable for periods of time, despite being vulnerable to sell-offs.

While insurers are capitalized to withstand a 1-in-200 shock, such a scenario might nevertheless have consequences for the balance sheets of insurers.  These can be both intuitive and counter-intuitive:

  • Rising credit spreads, particularly if coupled with credit downgrades, may negatively impact the solvency of annuity funds.  Credit spreads may also be move volatile than previously, in the post QE environment.
  • Assets may become less liquid, and harder to value.  The former may make it more challenging and expensive to sell assets under stress; the latter may lead to complications for insurers seeking to calculate the fair value of their portfolio.
  • Conversely, for insurers which are under-invested in credit, such a scenario may lead to opportunities to increase portfolio yield.  If sustained, it is possible that wider credit spreads may lead to more attractive annuity pricing.
  • Insurers which have invested in USD denominated credit and swapped back to local currency using cross-currency swaps, may experience a liquidity strain if derivative valuations change due to FX movements, and high quality collateral needs to be posted as a consequence
  • Insurers with direct or indirect exposure to equities may suffer reduced solvency.
  • Insurers with exposure to real estate, e.g. via equity release mortgages or commercial property holdings, may experience balance sheet losses, e.g. if the ‘No Negative Equity Guarantee’ on equity release mortgages rises in value.
  • Insurers may experience changes in solvency position, to the extent they have not fully hedged the interest rate exposure of the Solvency II balance sheet, including Risk Margin.  This could be exacerbated by basis risk between government bond and swap yields, e.g. if government bonds cheapen relative to swaps.
  • A combination of the above factors may increase the value of guarantees in With Profits funds, and reduce solvency levels.

Insurers can adopt various mitigating actions against a downside scenario, including:

  • Pro-active management of credit portfolios, e.g. adjusting the average credit weighting, using credit derivatives to hedge spread widening scenarios.  Alternatively, simply increasing the cash allocation (vs physical assets) provides downside protection, and helps insurers position themselves to take advantage of wider credit spreads.
  • Careful liquidity management and planning, considering a range of downside scenarios, avoiding ‘trapped liquidity’ and making full use of market instruments to mitigate the risks of  liquidity strain.
  • Hedging or reducing equity exposure, and carefully monitoring and managing firms’ overall exposure to property markets, across different types of investment.
  • Reviewing interest rate risk management strategies. In particular, firms may consider whether to hedge the Risk Margin. While this might increase the SCR, it also reduces volatility of the solvency position from period to period, and may offer protection against the impact of lower interest rates
Shazia Azim

Shazia Azim | Partner, Head of Strategy and Chief Operating Officer, Financial Services
Profile | Email | +44 (0)7803 455549

William Gibbons

William Gibbons | Director
Profile | Email | +44 (0)7711 589 097

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