Insurance risk management challenges:Overcoming depressed yields whilstavoiding a ‘race to the bottom’

parker-fitzgerald.com

parker-fitzgerald.com | 2

Executive Summary

The Low Interest Rate Environment – Challenges and Responses

Liquid Assets – a Migration Down the Credit Curve

Illiquid Assets – Continued Growth in Allocations

Risk Management Observations – Key Industry Challenges

What Next?

Appendix: Regulatory Focus

Related Publications

About the Authors

3

4

5

6

7

8

9

10

11

Contents

parker-fitzgerald.com | 3

Low yields are a persistent concern for the insurance sector. As firms attempt to overcome this by investing further down the credit scale, thorough credit risk management is increasingly necessary to avoid an altogether more imminent and sharper shock as a result of credit defaults and downgrades.

Over recent years, the protracted low interest rate environment has started to cause difficulties for insurers looking to re-invest their maturing asset portfolios and secure sufficient yields to match liabilities. Recent European Central Bank (ECB) data shows that 72% of all insurance company and pension fund bond holdings are yielding <1%.1 Firms usually have three options to increase returns – adjust duration, decrease liquidity, or decrease credit quality of assets.

Firms are already utilising these options, with 64% of net bond transactions in H1 2019 rated BBB or lower.2 More fundamentally, asset allocation strategies are shifting, with illiquid assets increasingly used as a source of high yielding, long duration and capital efficient investments. EU-wide, across the past 18 months levels of investment grew by almost 10% in absolute terms, to a total value of over £610B.3

Thorough credit risk management of both liquid and illiquid assets is a fundamental business priority. As firms adjust asset allocation strategy to improve returns, they must also upgrade risk management practices to optimise the risk-adjusted performance. In our work across the industry, we identified four focus areas: The governance and organisational structures in place, an overreliance on asset managers, the tools used for internal credit assessments, and the systems underpinning credit risk management as a whole.

Macro-environment

• Slow economic growth • Continued low interest rates • Increased levels of debt

2020 INDUSTRY OUTLOOK

Insurance industry

• Simplification & automation • Continued high levels of consolidation and de-risking e.g. bulk annuity transfers • Major transformations (IFRS17 / 9, IBOR, SII)

Executive SummaryThere has also been a fresh wave of regulatory scrutiny, with concerns of a ‘race to the bottom’ in asset origination, particularly focused on illiquid assets. Scrutiny has been followed by intervention, with regulatory challenges observed across the whole risk management framework – from board level credit risk understanding, through to Commercial Real Estate rating methodologies and the risk identification process.

An overarching concern for both market analysts and regulators is the state of industry preparedness for any potential significant deterioration in credit quality. As we enter the later stages of a credit cycle in which debt has built to levels higher than in 2008, there are particular concerns around the monitoring of existing exposures and the appropriateness of workout procedures in place.

Thorough risk management is therefore essential to reduce business risk and regulatory exposure. Leading firms are going one step further, through the development of technology solutions for credit risk management such as credit analytics, rating and monitoring tools. This results in a competitive advantage, by improving decision making and increasing efficiency by removing duplication of effort with other activities.

1, 2 European Central Bank, Financial Stability Review, November 2019 3 European Insurance and Occupational Pensions Authority [https://www.eiopa.europa.eu/tools-and-data/insurance-statistics_en, February 2020]

parker-fitzgerald.com | 4

Insurers in Europe collectively manage assets worth €11 trillion,4 however the returns of many of these assets are under pressure:

Lower interest rates globally, exacerbated by actions such as ECB bond purchasing. This has driven down bond yields, which in many cases have become negative.

As insurers progress down this path, the potential consequences of the next financial crisis will be broader and deeper than the previous. Levels of debt now exceed 2008 levels,5 and with the record low interest rates regulatory authorities/central banks have limited scope to support the financial markets in the event of a crisis. These concerns were effectively summarised in EIOPA’s financial stability report in December:

“...further search for yield behaviour by insurers and pension funds, which could add to the build-up of vulnerabilities in the financial sector if not managed properly. Moreover, a combination of weakening economic outlook, concerns over debt sustainability and stretched valuations across financial markets could give rise to a sudden reassessment of risk, in particular for riskier assets, which could trigger losses in the investment portfolios of insurers and pension funds.”

6

UK Gilts are trading at near zero rates, with other EU bonds already yielding negative returns.

As higher yielding portfolios mature, insurance companies face ALM challenges.

The low yield environment has long-term profitability implications, as insurers struggle to meet guarantees issued in the past.

In the search for higher returns, insurers can adjust the following levers: • Liquidity (lower) • Credit risk (higher) • Duration (longer*)

*Lengthening duration may not always increase returns. When the yield curve is inverted firms often opt for short-term investments with a view to reinvestment when yields have improved.

Recent data demonstrates that insurers are increasingly utilising these levels, both in the features of their liquid investments, alongside a greater allocation to illiquid/alternative assets.

Statistics show a migration down the credit scale for liquid assets, and a significant upturn in illiquid investments (although levels vary between Life and GI).

The low interest rate environment – challenges and responses

4 European Insurance and Occupational Pensions Authority [https://www.eiopa.europa.eu/tools-and-data/insurance-statistics_en, February 2020] 5 Institute of International Finance, Global Debt Monitor, November 2019

6 European Insurance and Occupational Pensions Authority, Financial Stability Report, December 2019

parker-fitzgerald.com | 5

With 72% of insurance company and pension fund bond holdings yielding <1% (up from 50% a year prior), insurers are migrating down the credit curve to find increased yields. Bond data clearly shows this migration, as insurers reinvest their maturing asset portfolios with a higher allocation to lower credit quality assets (chart 1). Also evident is the acceleration in this trend, with 64% of net bond transactions over H1 2019 in high-yield and BBB (chart 2).7 Reading chart 1 and 2 together, we can infer that BBB bonds are the primary driver, likely due to the regulatory and capital implications of sub-investment grade assets.

1.Insurer bond allocation by rating, as a % of total

3. US corporate bond spreads

5 year maturity

25 year maturity2. Quarterly net bond transactions by insurance companies

An important question around this migration relates to risk premium pricing, specifically are insurers being appropriately rewarded for this additional risk?

US Corporate bond data (chart 3) shows that spreads are narrowing, with yields for lower rated assets dropping significantly.8

Liquid assets – a migration down the credit curve

7 Source: European Central Bank, Financial Stability Review, November 2019 8 Source: S&P Global Ratings Research, Credit Trends: U.S. Corporate Bond Yields as of Jan. 1,2020, January 2020

2013 20132019 2019BBB High-yield

Other investment grade

%

%

%

Inve

stm

ent v

alue

(€bn

)

306

630

408

8

10

10

12

12

14

14

45

60

20 4

415

10 2

20

00

0-15

BBB & High-yield

Q1/17

1/7/20

04

1/7/20

04

1/7/20

10

1/7/20

10

1/7/20

06

1/7/20

06

1/7/20

12

1/7/20

12

1/7/20

08

1/7/20

08

1/7/20

14

1/7/20

14

1/7/20

17

1/7/20

17

1/7/20

05

1/7/20

05

1/7/20

11

1/7/20

11

1/7/20

07

1/7/20

07

1/7/20

13

1/7/20

13

1/7/20

16

1/7/20

16

1/7/20

09

1/7/20

09

1/7/20

15

1/7/20

15

1/7/20

18

1/7/20

18

1/7/20

19

1/7/20

19Q3/17 Q1/18 Q3/18 Q1/19Q2/17 Q4/17 Q2/18 Q4/18 Q2/19

27

37

4 3

Spreads have narrowed and yields dropped, for example BBB asset yields are <70% of the long term average

Sub-investment grade asset yields have dropped c.40% over the past six months

U.S. TreasuryAAAAAABBBBB+

parker-fitzgerald.com | 6

As a result of the low interest rate challenge, along with other factors such as diversification and capital efficiency benefits, illiquid asset investments continue to rise across the EU. The extent of this rise varies according to geography, sector and product type.

Across the EU, illiquid asset investment is growing in absolute and proportional terms.

This is primarily driven by the UK market, with a 15.4% YoY increase in absolute terms. Significant increases have also been observed in Germany (6.7% YoY). The average percentage allocations to illiquid assets are now at material levels:

In the UK market, Life insurers are driving the growth as result of the additional capital and ALM advantages, and the increased availability of funds due to corporate balance sheet de-risking.

The material jump in Q1 2019 is at least partly influenced by the changing outlook around interest rate rises and the subsequent impact on valuations of longer dated assets with fixed cashflows.

Within life insurance, there is further deviation between the volumes of illiquid assets used to back unit-linked and non unit-linked products.

By stripping out the unit-linked element, it is clear to see the level of dependency that products such as defined benefits pensions have on illiquid assets (25.2%), highlighting the need for thorough credit risk management of illiquid assets.9

Illiquid assets – continued growth in allocations

2017 Q4

2017 Q4

2017 Q4

2018 Q4

2018 Q4

2018 Q4

2018 Q1

2018 Q1

2018 Q1

2019 Q1

2019 Q1

2019 Q1

2018 Q2

2018 Q2

2018 Q2

2019 Q2

2019 Q2

2019 Q2

2018 Q3

2018 Q3

2018 Q3

2019 Q3

2019 Q3

2019 Q3

548,799.13 92,866.13117,907.20

611,154.88116,304.68142,840.95

159,542.02

26,536.286,684.83132,461.96 25,041.08

6,805.03

9 Source: European Insurance and Occupational Pensions Authority [https://www.eiopa.europa.eu/tools-and-data/insurance-statistics_en, February 2020]

EU (overall) UK Life Excluding unit-linked Unit-linkedUK (overall) UK non-Life

Illiq

uid

inve

stm

ents

(€m

)

5% 6% 7% 23%

EU/UK insurers UK insurers UK life insurers

11.36%

25.24%21.15%

20.44%5.97%-1.77%

65

parker-fitzgerald.com | 7

Through our work across the industry, Parker Fitzgerald have identified a number of key challenges that the industry must overcome to optimise the balance between risk and return. Improvement in these areas helps to ensure that undue risks can be avoided, and that there is no ‘race to the bottom’ in terms of credit quality.

Separation of duties between and within first/second line is not always clear.

An increasing number of firms are relying on asset managers for their investment operations, this includes industry players with in-house teams who are looking for more specialist access to certain products or geographies: 56% of firms expect illiquid assets to be sourced in this way.10

The need for formalised risk identification process, especially for illiquid assets where data is lacking.

The challenges of monitoring against risk appetite and other key risk metrics e.g. sector/counterparty limits on a real time basis.

Second line teams are often under resourced in comparison to their responsibilities.

Potential misalignment in risk vs. return preferences between asset managers and insurers.

Inconsistencies between the risks reflected in the credit rating and those reflected in the internal models.

Credit risk tools and processes involve unnecessary duplication across multiple functions and business activities. E.g. investment valuations and accounting, credit analyses, capital modelling, stress testing etc.

Rating performance, including the tracking of ratings through the cycle, expert judgements, notching etc, is not systematically used to monitor and improve these models.

Third line to play a more prominent role when considering the credit risk management of illiquid assets.

The need for a thorough assessment of asset manager capabilities by insurers, especially with regards to transparency of the credit risk assessment process, including cases where there is an affiliate manager.

Where insurers use their own internal credit rating tools: • Overreliance on ECAI methodologies; • Use of expert judgements, notching, and proxy data use throughout the rating process is poorly controlled/documented; • Validation of rating models is not carried out at appropriate intervals.

KEY INDUSTRY CHALLENGES

Governance / Organisational Structure

Many of these observations are reflected in the latest regulatory consultation papers and supervisory statement updates, such as CP23/19. For more detail on regulatory updates please see the appendix.

Risk management observations – key industry challenges

10 AM Best, European Insurers and Illiquid Assets – An Upwards Trajectory, November 2019

Overreliance on Asset Managers

Risk Management Tools

Systems and Data

parker-fitzgerald.com | 8

The search for yield in a low-rate environment creates a myriad of challenges. As firms invest down the credit scale and/or expand their holdings of illiquid assets, they are exposed to greater credit risks.

To date, however, firms’ progress in improving credit risk management practices has been inconsistent.

Enhancing risk management frameworks, practices, tools, systems and outsourcing approaches will be key to reducing regulatory exposure and to responding to economic headwinds, especially as the credit cycle turns. Scaling up of risk management operations, particularly around credit risk, will also help to future-proof insurance firms as they expand illiquid investments – 65% of firms are planning to expand their illiquid investment portfolio by 5%–15% of their funds.11

As a next step, insurers should prioritise activities to revamp governance and organisational structure, gain a greater level of control over asset managers, bring risk identification to the core of the credit assessment process, and develop technical solutions. These are key to enable insurers to:

1. Improve ability to respond to a turn in the credit cycle 2. Increase efficiency and the ability to upscale 3. Reduce regulatory exposure

Why Parker Fitzgerald?

Trusted across the industry, having been engaged by numerous major insurers to strengthen credit risk management practices.

Understanding of the evolving risk landscape and demands on the risk function, embedded into client solutions.

Risk modelling experts, with hands-on experience of model development and review.

Clear line of sight on downstream business impacts and financial performance.

Deep knowledge of regulatory requirements, complemented by strong regulatory engagement.

Large scale delivery capability

Targeted data and technology solutions

What next?

11 AM Best, European Insurers and Illiquid Assets – An Upwards Trajectory, November 2019

parker-fitzgerald.com | 9

Appendix: Regulatory Focus

Segregation of duties – “clearly demonstrate the independence of the internal credit assessment function.”

Key regulation for credit risk management of illiquid assets (proposed updates in CP 23/19). Whilst focused on Income Producing Real Estate Loans, the PRA view is that principles of CP23/19 should be applied to other illiquid assets.

In light of recent changes in investment patterns by insurers, CP 22/19 clarifies requirements of the Prudent Person Principle.

Primarily focused on implications of technology outsourcing, nevertheless introduces additional oversight requirements for firms using outsourced providers.

Covers liquidity risk management, including forced sale discount on the asset side.

SS 3/17 (incl. CP 23/19)

CP 22/19

CP 30/19

SS 5/19

Risk identification – “the starting point for an internal credit assessment process is the identification of risks relevant to the asset under consideration / Expects firms to use the risk identification exercise to influence the scope, methodology and calibration of the internal model.”

Look-through – “the expectations... also apply where a firm has outsourced its internal credit assessment process” / “demonstrate that they have effective systems and processes in order to oversee the outsourcer.”

Scaling – “the robustness of risk management systems and controls would increase commensurate with any increases in the scale, complexity or concentration of investments in non-traded assets.”

Board oversight – “the board and any relevant sub-committees of the board should receive appropriate, accurate and timely management information on the firm’s investment risks.”

Rating methodologies – “justify its internal credit assessment methodology and recognise any limitations.”

Third line involvement – “Head of Internal Audit is responsible for independent assurance on the adequacy and effectiveness of these processes.”

Limits – “firms must develop an investment risk management policy that…includes internal quantitative investment limits for assets and exposures / such limits would encompass at least asset class, geographic, single-name, sector and off-balance sheet exposures.”

Continuous improvement – “identify potential refinements needed to their methodology by monitoring their own credit experience against the internal credit rating assessments and changes made by ECAIs to their methodology and criteria.”

Compliance – “firms that outsource their investment function…remain subject to the requirements of the PPP.”

REGULATORY FOCUS AREAS (SELECTED QUOTES)KEY REGULATIONS

GOVERNANCE

RISK MANAGEMENT TOOLS

OVERRELIANCE ON ASSET MANAGERS

SYSTEMS & DATA

parker-fitzgerald.com | 10

Related Publications

Between a rock and a hard place: IFRS 9 and IFRS 17August 2019

A harmonised IFRS 9 / IFRS 17 solution is required to overcome the challenges of combined delivery and implementation timelines. To enable this, the insurance sector’s focus on IFRS 9 needs to be intensified to understand the impact on business performance and change requirements.

Optimising the risk-return of illiquid assetsNovember 2018

This report considers the opportunities and threats of illiquid asset investments for insurers, and the steps that should be taken to optimise risk-return and satisfy the regulators in the face of increasing scrutiny.

Optimising the risk and return of climate changeSeptember 2019

The financial sector must transform its management of climate risks, as changes in climate policies, new technologies and growing physical risks prompt reassessments of the values of virtually every financial asset. This report explores how banks can integrate climate risks into their efforts to optimise risk-adjusted performance.

This report is the latest in a series of publications examining the economic, regulatory and technology environment, and its implications for the financial industry’s strategic risk agenda. For further publications, please visit our website.

MONETARY POLICY AND FINANCIAL STABILITY - THREE PRIORITIES FOR THE CROJune 2017

This report considers concerns over whether banks have been pricing in risks properly in an accommodative monetary policy environment and the challenges of potential interest rate hikes.

parker-fitzgerald.com | 11

About the Authors

Lotfi has over 20 years’ experience in all areas of insurance and reinsurance with a special focus on Operating Models and Risk & Capital Management.

Lotfi advises the Boards of leading financial institutions on key strategies in relation to strategic performance management and prudential regulations. He currently serves as an Independent Non-Executive Director at Old Mutual Emerging Markets – UAP (East Africa) and is Chairman of the Risk and Governance Committee.

Prior to joining Parker Fitzgerald, Lotfi held senior roles at Aspen (NYSE:AHL) as Global Head of Risk Management, Chubb (NYSE:CB) as Chief Risk & Compliance Officer – Europe AND Citibank (NYSE:C) as Senior Country Operations Officer deputy – Tunisia.

Lotfi holds a bachelor’s degree in Industrial and Operations Engineering from the University of Michigan and a master’s degree in Operations Research and Industrial Engineering from Cornell University.

Lotfi Baccouche Partner Parker Fitzgerald Group

Christian is a principal in Parker Fitzgerald’s Insurance Practice, specialising in the provision of advisory and project delivery work across the insurance sector.

Christian has an in-depth knowledge of the risk and regulatory requirements for insurers, and was instrumental in the design and build of the illiquid assets credit risk assessment framework for the PRA in 2017. He has subsequently lead Parker Fitzgerald’s projects for insurers in this space, including risk framework design and enhancement, credit scorecard development and validation, investment due diligence, and the implementation of credit risk management systems and analytical tools.

Prior to specialising in insurance, Christian worked in a variety of roles across retail and investment banks. He holds a double first BA in Geography from the University of Cambridge.

Christian Preece Principal Parker Fitzgerald Group

Parker Fitzgerald, now part of Accenture, is an award-winning strategic advisor and consulting partner to the world’s leading financial institutions.

Headquartered in London, our global network of senior industry practitioners, technical experts and change specialists is trusted by the leaders of the world’s largest financial institutions, regulatory authorities and government agencies.

We are experts in all areas of financial and non-financial risk, regulation and financial technology. We provide independent advice, assurance and market leading solutions to help our clients navigate their most critical issues, reduce complexity and improve their overall risk-adjusted performance.

Our unparalleled knowledge and experience in financial services, world-class thinking and excellence in delivery has seen Parker Fitzgerald recognised as one of the most dynamic and progressive consulting firms in Europe.

Areas of expertise include:

• Risk Management • Financial Regulation • Banking Technology • Digital Innovation

About Parker Fitzgerald Group

• Cybersecurity • Financial Crime • Strategic Change • Transaction Support

Disclaimer The information contained in this document has been compiled by Parker Fitzgerald and includes material which may have been obtained from information provided by various sources and discussions with management but has not been verified or audited. This document also contains confidential material proprietary to Parker Fitzgerald. Except in the general context of evaluating our capabilities, no reliance may be placed for any purposes whatsoever on the contents of this document or on its completeness. No representation or warranty, express or implied, is given and no responsibility or liability is or will be accepted by or on behalf of Parker Fitzgerald or by any of its partners, members, employees, agents or any other person as to the accuracy, completeness or correctness of the information contained in this document or any other oral information made available and any such liability is expressly disclaimed. © 2020 Parker Fitzgerald

+44 (0) 20 7100 7575 info@parker-fitzgerald.com www.parker-fitzgerald.com @p_f_g Parker Fitzgerald

Parker Fitzgerald Level 18 Heron Tower 110 Bishopsgate London EC2N 4AY