Economic Capital
Life insurers protect policyholders from mortality risk, longevity risk, and investment risk. Consequently, life insurers need a far more comprehensive risk management than, say, banks.
Economic Capital for Life Insurance companies simply means the amount of surplus capital that is sufficient to cover potential investment (credit) losses in the future. The insurer’s management decides the extent of protection to seek, i.e., the duration and extent of market stress that the insurer should prepare for. The regulator typically does not help here, and in fact, can increase the strain with newer and stringent reserving standards.
Economic Capital just cannot be replenished at a time of crisis.
Can lower rates boost economic capital?
Lower rates will not be able to rescue insurers. Credit sress is typically the main precursor of lower rates. Therefore, a lower-rate environment will cause their existing asset book to experience some mark-to-market gains. But let’s not forget the mark-to-market losses due to capital losses on their riskier debt.
Moreover, insurers will reinvest at a lower yield, while liabilities remain locked at a higher rate. Such liabilities (policies that offer above market yields) tend to be stickier, i.e., they exhibit lower lapse and disintermediation risk. Lower rates also tend to push insurers into riskier assets – eventually leading to capital losses in future.
Can product discounts help boost economic capital?
Theoretically, steep discounts on life insurance and annuity products can bring in a lot of new money into an insurance company. That cash can be crucial life support and a solvency aid in the very short term. However, we realize that insurance products in India are already selling at greatly discounted levels on an actuarial basis, with insurers looking up to the investment profits to realize any gains. Any more discounts are unfeasible, if not outright impossible, in a scenario where investment profits turn into losses.
Measuring Economic Capital
Traditional measures fall short: There is a lot of empirical evidence that suggests that simple measures such as standard deviation, VaR or Conditional Tail Expectation, are not sufficient to adequately measure economic capital.
We think that the most practical framework of measuring Economic Capital is using stochastic economic scenarios. The framework must allow the various risks to have covariance. Interest rate risk (asset-liability), mortality risk, and lapse risk are going to be the primary drivers of economic capital for a life insurance company.
And although economic capital tends to focus on investment outcomes, operational risk cannot be ignored. For instance, if an insurance company faces risk in its distribution channels, such as with commissions, or with marketing (branding), then such risk needs to be modeled as well. The model risk with respect to the valuation of assets must be assessed. Policyholder behavior is another key risk, particularly around unit-linked products. As insurers race to innovate and create more attractive and unique policy features, the risks of those features will not be captured anywhere other than economic capital.
At Annuity Risk, we are eager to assist insurers in developing a robust framework for measuring economic capital. There are great many uses of such a framework, all of which greatly strengthen the insurer and add to its competitive advantage.
- Economic Capital framework must cover:
- Policyholder Behavior
- New riders and product features
- Operational Risk
- Model Risk
Copyright © 2021-2024 Annuity Risk India Pvt. Ltd.
Copyright © 2023 Annuity Risk India Pvt. Ltd.