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Covid-19 and life insurers: we’re not in Kansas anymore
Estimated reading time: 7 minutes
In any normal year, April and May might allow actuarial teams to draw breath, reflect on the year-end valuation well done and turn attention to projects and plans for the year ahead. This year, unfortunately, is no normal year.
Firms will have no sooner produced a full valuation of the business at December 2019, to find that the balance sheet, the business and the world is no longer the same.
Many assumptions made in early January can now go straight in the bin and insurers may have used a large number of management action levers at their disposal. As a result, many insurers could be looking to re-evaluate their position.
"In the words of Dorothy, "Toto, I've a feeling we're not in Kansas anymore"."
Most firms have now overcome, or are in the process of addressing, the initial operational hurdles related to the current situation. With that done, boards and management can now turn more of their attention to understanding how the value of the business has changed and assessing the impact of further stresses on the balance sheet.
So, a valid question to ask is, where should life insurers look to now?
In this blog, we provide an overview of four of the areas that will be affecting the solvency positions, financial strength and business operations of most life companies. We will be carrying out more detailed work in these areas over the coming weeks.
The impact of Covid-19 on investment markets
As we would expect, one of the first impacts of Covid-19 on the financial sector has been the market’s reaction to the strong government responses across the globe. As schools and businesses have closed, the markets have reacted, with an approximately 25% fall in equity values over the first quarter of 2020 and significant widening of credit spreads.
Firms that have embraced and embedded the ORSA (own risk and solvency assessment) in the management of their business should have a strong idea of what level of market drop hurts their business. Furthermore, they will have thought about the actions they would take in the event of these market drops.
The market drops seen will be a good test of firms’ monitoring systems, the appropriateness of the actions they planned to take, and their ability to execute these actions in practice. Where firms have implemented actions from their management action plans, they will want to consider what additional levers they have in case of further deterioration.
For equities, the Solvency II standard formula offers some relief, thanks to the symmetric adjustment, although this supporting mechanism is currently already providing its maximum benefit, with no more help to give if markets fall further.
"At this point, we need to ask questions. Will the market fall further? Will the market rebound? Or will the economic impacts of the virus mean that the new share prices represent the long-term value of businesses?"
We must remember that the symmetric adjustment is designed to absorb short-term shocks and uses a three-year average, so firms who are reliant on this measure will need to remember that it will not be there forever. Views on the market will influence whether an insurer wants to change its investment strategy.
What else can firms do?
If firms have used up their planned management actions then they will need to review whether additional credible management actions are available, and will need to consider how they reflect these in their valuation. Similarly, firms with hedging strategies in place before recent events will want to review their continued appropriateness and what rebalancing is required.
The market movements resulting from Covid-19 have materially weakened some firms’ financial strength. Firms should consider enhanced solvency monitoring to give them the best possible footing to react to future changes.
Turning to fixed interest assets, life insurers have always used these assets to match long-term liabilities, particularly for products like annuities. Solvency II also has measures in place to help firms absorb spread increases, through the volatility adjustment and the matching adjustment. However, these measures are only able to reflect a proportion of the spread and not all firms use them in the first place.
Firms need to weigh up the long-term value of these assets and form a view on how much of this spread represents default risk at this time, which is far more worrying than illiquidity, where asset-liability matching absorbs the risk.
Where they have sold with-profits business, firms should be having robust discussions with their with-profits committees and with-profits actuary. These discussions need to cover if and how these market movements would affect bonuses, whether there are any changes to sustainable bonus levels, what market value adjustments may need to be applied, or if interim bonus levels need reviewing.
Looking to future new business, firms will need to consider product pricing and policy design, alongside the impact that this will have on ongoing financial strength. For example, do guarantees need to be reduced, or charges increased?
Claims from Covid-19 sickness or death
Income protection policies are typically sold with a deferred period between 4 and 52 weeks. The average expected sickness period from Covid-19 is approximately two weeks. So it is still unclear whether the impact of Covid-19 claims on these policies is going to be significant.
Where insurers have sold policies with shorter deferred periods, there has been an observable increase in claims. Similarly, firms are likely to see an increase, albeit smaller, in death claims on assurance business.
In both cases, firms will need to keep a careful eye on liquidity and cashflow to ensure they have the ongoing ability to pay claims. Unfortunately, there is a heightened risk of claims being made where policy conditions are not being met.
"Insurers will need to ensure their claims management processes are robust, whilst ensuring they continue to treat policyholders fairly."
Firms will need to review policy terms of new policies being sold to check that they remain appropriate and mitigate risks arising from Covid-19. If they decide to make any changes, then they will need to make sure that they have been through the appropriate governance and are satisfied that the updated terms are fair and clear for policyholders.
We are monitoring sickness experience closely and will be publishing our findings. We have published two blogs* looking into the impact of Covid-19 deaths on mortality rates and longevity projections. The conclusions of these are that the number of Covid-19 deaths is likely large enough to be more than statistical noise, However it is too early to tell what the impact on future reserving assumptions are likely to be. We are continuing to monitor this and will cover it in more detail in later blogs.
Policyholder behaviours in light of Covid-19
One of the most difficult aspects insurers should be looking at is to try to predict how policyholders will react over the next 12 to 18 months. There is no doubt that money is likely to be tight as the economy absorbs this shock and people will be looking to cut costs and access savings, so lapse rates are likely to increase. However, if ever there is a time to have insurance and appreciate the value of it, then it is today.
Firms must look to understand how the value of their product to policyholders has changed. Life insurance may feel the effects a little less than general insurance, where, for example, travel insurance is unlikely to be a priority for the next few months. Nevertheless, life insurers must not be complacent. They should look to challenge assumptions and test the business’ value to material changes to any, and all, policyholder actions.
Fall in risk free rates
The Covid-19 pandemic has seen UK base rates fall to the lowest level in the Bank of England's 325 year history. Without hedging and matching strategies in place, interest rates are one of the most material assumptions used by life insurance companies.
Even if firms have strong hedging strategies and good matching of assets and liabilities, they are not out of the woods. In particular, firms writing long-term protection business and annuities will find the risk margin very sensitive to risk free rates. Firms must look to evaluate the impact of the fall in risk free rates and may therefore consider the below.
- Review their investment strategies. Firms will need to consider the ongoing appropriateness of existing interest rate hedges, whether they need rebalancing, or whether new hedges are required.
- Reconsider new business pricing to ensure that appropriate levels of profitability are maintained.
- Take up the Prudential Regulation Authority’s (PRA’s) invitation to consider applying to recalculate the transitional measure on technical provisions, which would mitigate some of the impact on the risk margin.
Here at Barnett Waddingham we are helping clients to navigate these challenges. This includes independent challenge to assumptions, providing advice on capital management and developing ORSA scenarios to test the business plans to the key uncertainties we find ourselves in. Our insights are designed to help management make decisions with the “what ifs” in mind.
If you would like to talk about this topic or have any questions in general, please get in touch with your usual Barnett Waddingham contact to find out how we can support you. Alternatively, please contact me below.
Visit our Covid-19 hub for all the latest analysis on the impact of coronavirus on insurance, business, pensions and investment.
*Possible longevity impact of Covid-19 on pension schemes and annuity portfolios
*Covid-19 – what the latest death data means for longevity projections
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