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The financial crisis, particularly with respect to asset impairments and increases in variable annuity reserve and capital requirements, has reduced life insurers’ capital adequacy ratios and increased the volatility of their actual and required capital levels.
Capital adequacy ratios and rating agency assessments are critical, because a significant decline in ratings can lead to lower sales, lower profit margins and higher surrenders of existing policies.
As a result, companies, rating agencies, regulators and, increasingly, company boards are laser-focused on capital ratios and underlying capital efficiency strategies, capital forecasting and stress testing.
Rating agencies are demanding better visibility into how balance sheets will behave in different macroeconomic scenarios, as well as in response to changes in policyholder behavior and sales volume and mix.
Management wants more frequent forecasts, consideration of a wider range of business and economic scenarios, quicker response times and more adept handling of reserves and capital, hedging programs, asset impairments and taxes.
The new strategic focus on capital has also dramatically affected product pricing, product portfolio mix and hedging strategies.
Companies have redesigned and repriced their VA products. Some completely pulled entire products from their portfolios or at least the richer and more exotic guaranteed benefit riders.
Product developers are designing new products with more conservative benefits and less risk, including types of term life insurance, universal life and variable annuities, and doing so at new, much higher risk-based price points.
While such products benefit companies’ capital positions, they present the challenge of educating the distribution channels and managing customer expectations.
Hedging strategies are also being reassessed, with a focus on managing the risks and liabilities inherent in portfolios of the new products. Companies are altering their hedge objectives and strategies to place greater emphasis on preserving statutory capital and less on hedging economic results or GAAP/IFRS earnings.
As market conditions improve, companies will likely seek to further hedge their interest rate and volatility exposures on existing business. Given the uncertainty as to whether interest rates will rise or fall, old-fashioned asset-liability management will become an even stronger focus.
As the recession continues to ease and markets gradually gain ground, the lessons learned from the financial crisis are still emerging. Clearly, the current consumer and investor appetite for risk has changed dramatically. Consumers and advisors are just starting to understand how new, more conservative products should fit in retirement portfolios.
As new statutory requirements emerge, principles-based regulatory approaches will extend to risk-based capital and statutory reserve requirements for life insurance and other products. The new requirements may be significantly more onerous than prior reserving practices for some companies and less onerous for others, depending on product design, product mix and other factors. At the same time, rating agencies will be recalibrating their capital requirements and risk management expectations in response to the financial crisis and changing regulation.
Insurance companies need to use this unique period—after the crisis and before new regulation arrives—to look at the performance of their risk and capital management programs. At the same time, they should assess their readiness to comply with new regulation and develop strategies for renewed growth and competitiveness.
Over time, companies and investors will once again focus on earnings growth and return on equity. However, the greater emphasis on capital adequacy and capital management appears to be here to stay.
Tara Hansen is an executive in the financial services office of Ernst & Young LLP, in New York City. Michael Hughes, based in Chicago, is a principal in the financial services office of Ernst & Young LLP and leads the insurance and actuarial advisory services life/health practice. Their respective e-mail addresses are tara.hansen@ey.com and michael.hughes@ey.com