Caught up in all the recent excitement over AI technology and natural language processing, I asked ChatGPT to set out the key points to be addressed in a global insurance newsletter to see what it would come up with. Its cutoff date for information is September 2021 but the results, summarised below, were surprisingly on point!
- Market Volatility: Global financial markets have become increasingly volatile, influenced by factors including geopolitical risks and technological disruption.
- Geopolitical risks such as trade tensions, political instability, and sanctions, can introduce uncertainties in insurance companies’ investment portfolios
- Technology disruption such as the rise of artificial intelligence, big data analytics, and blockchain, is transforming the investment landscape. (Does ChatGPT know irony?)
- Regulatory Changes: Investment activities are impacted through new requirements for capital calculations, risk management, and reporting standards
- ESG and Sustainability: Companies are increasingly expected to incorporate ESG considerations into their investment strategies. Challenges arise with data availability, measurement, and reporting
In this newsletter we delve into regulatory change, this time without the aid of our AI friend.
IFRS 9 and 17: the case for credit
Do new perspectives warrant a new approach?
Under the International Financial Reporting Standards (IFRS) 9 and 17, insurers’ financial results reflect an economic measurement of both assets and liabilities, as opposed to a static or non-market driven valuation approach. And for firms subject to risk-based capital regimes (RBC) for their asset and liability exposures, IFRS leads to closer alignment of the regulatory valuation (for solvency purposes), and the accounting valuation (for financial performance measurement).
In the long run, this convergence will make it easier for insurers to manage these two balance sheet presentations at the same time. However, in the short term, it calls for practical changes for some insurers, especially those who have placed more emphasis on their accounting balance sheets in the past and are used to asset-liability management (ALM) on a book accounting, rather than economic, basis.
Recent bond market changes, in both risk free and spread terms, are a further cue for insurers to review their investment strategies and make sure that these are still fit-for-purpose. For instance, now that investors are able to achieve non-trivial returns from government bonds, how should insurers think about the relative attractiveness of credit allocations?
The illiquidity premium conundrum
In contrast to the previous approach in many countries of using a prescribed discount rate, IFRS 17 requires the construction of discount curves which are consistent with “observable current market prices”. Much has been written about potential ways to implement the so-called “bottom-up” or “top-down” approaches to curve construction, but in essence they should both result in a yield curve comprising:
Risk-free rate + Illiquidity premium.
The “illiquidity” here refers to the characteristics of the liabilities, not the assets. IFRS 17 makes no requirement that either approach should refer to the actual assets backing the liabilities being discounted.
Nevertheless, consistency between the discount rate used and spreads achievable in firms’ ALM portfolios is an important consideration. A portfolio of assets which do not earn the illiquidity premium implied by the liability discount curve would create inadequate reserves. So whilst the illiquidity premium gives firms an additional lever to manage their IFRS balance sheet values, the only responsible way to use it is to earn it. This means adding spread to ALM portfolios through judicious portfolio construction; firms subject to RBC commonly look to optimise spread earned vs capital charges generated - the IFRS discount rate construction adds a further dimension to this exercise.
Explore global markets
To take advantage of the opportunities on offer in the evolving fixed income marketplace, insurers should not shy away from globalising their portfolios. For example by being open to opportunities in USD for non-USD denominated liabilities, investment grade investors can greatly increase their accessible market size. This provides not only opportunities to harvest attractive yields, but also greater sector, geographic and issuer diversification.
To best capture value presented by the market, both local and global perspectives are important. Local presence across global markets allows investors to gain local perspectives, and a global coordinated approach enables local feedback to be processed, and cuts through the noise of the market.
A multi-currency bond portfolio can be effectively managed with FX hedging to match domestic liability currency (where required), and to reduce or eliminate RBC currency mismatch charges. And with IFRS 9 and 17 coming into effect, the good news is that hedge accounting is now simpler to apply than under previous accounting standards. With robust risk management practices and adequate documentation, there is really no reason to forego global opportunities.
US GAAP Long-Duration TargetedImprovements
The LDTI overhaul
IFRS are not the only accounting standards subject to a revamp. Insurers reporting on a US Generally Accepted Accounting Principles (GAAP) basis are also getting to grips with changes that may, directly or indirectly, influence the way they formulate their investment strategy.
FASB Accounting Standards Update 2018-12 sets out revised accounting rules - Long-Duration Targeted Improvements (LDTI) -which will impact life contracts, annuities, disability and long-term care. These changes have the same aims as IFRS; better risk capture, reflecting more current economic and actuarial circumstances.
Discount rates 2.0
One major change is how the discount rate for valuing liabilities is determined. Previously the discount rate was ‘locked in’ at policy inception using the then expected portfolio yield on assets backing the liabilities. This rate would only be revised to a current best estimate in the event of a loss-recognition trigger indicating reserve inadequacy.
With the advent of LDTI, the discount rate is now based on an observable upper-medium grade (taken to mean ‘A’) fixed income yield, and updated on reporting dates. This rate is to be used for all long duration contracts in scope. Note that the requirement doesn’t actually specify a yield curve structure or even an underlying instrument.
This change represents a significant move from historic rates to a more current market yield (albeit, as with IFRS 17, not connected to the actual investment portfolio).
Will this impact investment strategy?
With a revised discount rate there will be a change in the value of liabilities, the magnitude of which being driven by the difference between the prevailing ‘A’ yield and the locked in rates.
Assets may need to be re-positioned to generate higher returns where a lower liability discount rate results in a reserve increase; note that allocation to higher spread credit or illiquid assets may solve for enhanced returns but not necessarily match the shape of liability cashflows.
Conversely, in a decreased reserve scenario there may be increased flexibility in tactical or strategic asset allocation where investments can be apportioned under an enhanced risk budget.
Scenario testing of both the reserves and the investment portfolio under varying portfolio return and ‘A’ valuation scenarios will reveal if / where risk can be taken or should be limited.
The sway of effect versus the agency of intention
As with IFRS, these are measurement changes – the underlying economics of the business will be unchanged. However there will be financial impacts if equity, earnings volatility, or investment flexibility are impacted, and firms change their portfolio or hedging strategies as a result.
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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.