Discussions of principles-based regulation (PBR) tend to focus on reserves. This is understandable: current regulations for level-premium term and certain UL policies force insurers to maintain redundant reserves, an issue many insurers hope PBR will alleviate. But to focus solely on reserves misses PBRs potential effects on required capital.
While slower in development for life insurance, work is already underway to apply the more dynamic, risk-focused principles of PBR to capital. Ratings agencies have already drafted new capital calculations reflecting this view or are in the process of doing so.
The concept of economic capital, already adopted by most countries, is gaining traction with insurers and regulators in the US. While its development may lag the progress on PBR for reserves, we think it is only a matter of time before similar principles are applied to an insurer’s required capital. Actual experience will depend on the design of such programs, but we expect that reserve and capital movements, while independent of each other, will be at least moderately correlated with each other.
Possible Accordion Effect
Last quarter, we examined the impact of deterioration in mortality on a hypothetical block of business. The end result is an increase in required reserves, likely without the tax benefits normally afforded to retaining higher reserves. Trickle-down effects include greater regulator scrutiny, depressed shareholder and ratings outlooks and ultimately a higher cost of capital.
In this scenario, we would expect regulators and ratings agencies to require insurers to retain higher PBR capital ratios as well. This would cause both required reserves and capital to expand almost simultaneously, leading to an “accordion effect” on the right side of the balance sheet. Required capital and reserves would swell, while all other elements of a balance sheet – assets on the left side of the balance sheet and equity and surplus on the right side – remain static or decrease.
Chart 1 - Mortality Deterioration Increases Both Required Reserves and Capital
The chart illustrates a hypothetical example. On the left, the company’s mortality assumptions result in liabilities of $100 million and required capital of $10 million. This offsets assets of $110 million, leaving excess capital of zero.
However, as experience emerges, mortality suffers a 10 percent deterioration. As a result, reserves must be raised by $15 million and capital by $10 million as well, for $135 million total reserves and capital to support the business. Required reserves exceed assets, resulting in a net available capital of - $5 million. Furthermore, we have negative excess capital of $25 million, the difference between reserves and required capital and the assets available to support the business.
Funding the Solution
In case of a jump in both reserve and capital holdings, the only remaining source for funds is retained earnings or shareholder equity (available capital). This could create unexpected capital strain and exacerbate the insurer’s financial situation, which could become self-perpetuating. We expect the majority of life insurers to be able to bear such strain, yet the experience could be financially painful to reverse.
In such a situation, the insurer has limited options, few of which are particularly appealing. These include issuing new equity or debt, retaining earnings, cross-business subsidization and reinsurance. Each of these options has some potential pitfalls in execution.
Another question is how share prices for life companies will be affected by PBR. Markets traditionally reward more transparent companies with higher share prices. Under PBR though, shareholder risk becomes more apparent. Investors may determine that an insurer’s share price is no longer justified. In this situation, risk diversification becomes a genuine asset.
The current reinsurance marketplace focuses on financing redundant reserves while managing earnings volatility is secondary. PBR may shift the market back to managing statutory volatility, including managing reserves and capital via risk transfer.
Coinsurance in particular can be used to send the risk of capital and reserve changes to reinsurers. Reinsurers have the advantage of risk diversification through mortality aggregating, while direct writers have comparatively higher concentrated mortality risk. Talking to your reinsurer (who has the advantage of seeing many blocks of business) could be valuable to the direct writer when setting the PBR assumptions.