September 11th, 2013

Annuity Settlements Could Crystalize Into Sizeable Risk Margins

Posted at 1:00 AM ET

victoria-jenkinsspeed_morley_bioVictoria Jenkins, Managing Director, and Morley Speed, Managing Director

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For bodily injury claim settlements in Europe, the trend is shifting away from lump sums and towards annuity-type settlements, which come with risks related to longevity, inflation and hedging. Insurance companies with significant casualty business may see their risk profiles transform over time to be more like pensions funds - but without working members and with even longer lasting liabilities. While the insurance industry is beginning to understand the implications of this move to annuity settlements, it does not have a clear understanding of the implications for an increasingly important regulatory balance sheet metric: Risk Margin.

The Risk Margin Metric

An insurer’s Risk Margin represents the amount in excess of the discounted best estimate reserves that would be required by a third party to take on the insurer’s obligations. In other words, Risk Margin would be the load required above best estimate to put in place a loss portfolio transfer with an implicit adverse development cover. The Risk Margin is not only a regulatory concept under Solvency II, but also an economic charge under International Financial Reporting Standards. It is related to the capital requirement, particularly for reserve risk, but it is a separate and quite distinct item. Moreover, the Risk Margin sits on the liability side of the balance sheet, and therefore its amount dictates the amount of free assets that are used in judging solvency.

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Solvency II utilizes a cost of capital approach to calculating Risk Margin: the Solvency Capital Requirement (SCR) net of reinsurance required for each future year until the portfolio is completely run off, multiplied by the cost of capital and discounted using the risk-free rate. So although the capital requirement (SCR) under Solvency II is only considered over a one-year period, the Risk Margin considers holding capital for multiple years. So time therefore, becomes an important factor in capital management. For annuity-type risks, capital costs must be considered for the long term - even as much as 100 years or more in cases with very young claimants. Given the nature of building up reserves for annuity business, it could take 40 years or more to get to a steady state with respect to the quantum of the Risk Margin.

Hedging and Diversification

Another nuance to the calculation of Risk Margin is that it only needs to be held with respect to “non-hedgeable” risks. Hedgeable risks are those that can be transferred into a “deep and liquid” market at low or zero cost. However, there is no deep and liquid market for overall longevity risk and even less investor appetite for impaired longevity risk associated with catastrophic injury claims. With a portfolio of annuities, risks for specific instances of longevity can be diversified quickly, but the systemic risk remains for increased longevity in the population and for critically impaired lives.

Additionally, catastrophic injury risk is likely to be unhedgeable since annuity payments may well be linked to an inflation index where there are no assets available to match liabilities, such as the Annual Survey of Hours and Earnings in the United Kingdom. Hedging using financial securities would be very difficult as well, given the duration of annuity liabilities.

The Risk Margin calculation allows for diversification benefit, so in theory an insurer with a well-diversified portfolio across property and casualty business should benefit from this spread. However, diversification has much less of an impact in the context of the Risk Margin calculation than it does in the capital requirements calculation. Because property lines are short-tailed, they drop out of the Risk Margin calculation quite quickly, whereas the longer-tailed casualty lines, particularly annuity settlements, can stay for decades accruing that cost of capital charge.

The Role of Reinsurance

As Risk Margin grows as a consequence of impaired life annuity settlements, is the solution to try to make the unhedgeable hedgeable? Maybe, but markets need time and financial incentives to develop new risk transfer mechanisms. In the meantime, there is a tried and trusted means of risk transfer that is actually very effective at reducing Risk Margin: reinsurance. In countries where reinsurers are sharing in the “unhedgeable” risks, insurers will see the benefit in the Risk Margin calculation. Conversely, where reinsurers are commuting or capitalizing their liabilities with respect to annuity payments, insurers are importing additional “unhedgeable” risk.  

Because of the time dimension, reinsurance purchased years ago on long-tail lines mitigates the size of Risk Margin today. The presence of the Risk Margin metric reinforces the need for a long-term reinsurance purchasing strategy for casualty business. Insurers should incorporate an evaluation of lifetime capital cost/benefit in their decision-making to avoid unpleasant Risk Margin surprises in the future. By addressing the Risk Margin issue while it is still relatively small and manageable, insurers can head off more significant challenges later on.

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