GERARD ANDERSON: Yeah. Thanks, Mark. Very pleased to be here. So I'm Gerard Anderson. I'm an associate director at WTW in the Private Assets and Capital Management team within the Insurance Consulting and Technology division. I'm based in London and I have nearly five years experience working on investments and capital calibrations as a consultant within the UK insurance market. Prior to that, I spent around three years working in-house at an insurer.
MUHAMMAD AMJAD: Hi, Mark. It's Muhammad Amjad. Thanks for hosting us. I'm a Director within the Private Assets and Capital Management team within ICT, Insurance Consulting and Technology, WTW. I've recently joined WTW but most of my experience has been around quantitative risk management, internal models at a variety of firms within the UK insurance industry.
MARK MENNEMEYER: Great. Thanks, both of you. Clearly very relevant background. So let's get right into the topic. And Gerard, starting with you. So recent years have been pretty eventful for markets generally. Can you talk about how life insurers have been coping with that?
GERARD ANDERSON: Yeah. So fairly recently in the UK-- appreciate we probably have an international audience here. But in the UK in particular, it was quite a turbulent time over the last few years. The main driver of this were dramatic increases to interest and swap rates, which were driven by the Bank of England's base rate increases. Just to give an example of the 10-year swap rate that increased by around 275 basis points. Which, we'll come on to that in terms of severity later on.
This was in part caused by and coincided with inflation hitting rates not seen in decades. And we're still not yet back at the Bank of England's target rates. And all of that had come in the aftermath of the COVID-19 pandemic, which had, of course, disastrous macroeconomic impacts and affected pension schemes and other areas of the financial services sector. But with this interest rate rises and the increase in swap rates from an insurance perspective, focusing on life insurers, there were some winners and some losers, but mostly winners across the board.
The increase in swap rates has had the effect of reducing insurance liabilities. And notably, if we're to focus on solvency coverage ratios, we do see a few examples, such as PECK and LNG seeing 50% increases to their solvency capital requirements. And across the board, it was true that many other firms ended up in a better capital position.
To explain this briefly to our non-EU listeners, the Solvency Coverage Ratio, or the SCR, is the capital that insurers need to hold under Solvency II to withstand the so-called 1-in-200 level severity event. The calculations of this capital amount are quite complex. But to keep it brief, economic insurance market and other variables are stressed to a 1-in-200 confidence level. And then they are combined to give an overall figure that the insurer has to hold over and above the best estimate liabilities.
The calibration for this 1-in-200 severity is in part based on historic data. So under truly extreme macroeconomic scenarios, we would expect that there is some movement in the coverage ratios. As macroeconomic events and conditions worsened, we would expect to see reductions in coverage ratios and vice versa.
So given the severity and given the dramatic increase in interest rates, it's really no surprises that the coverage levels were so volatile, particularly over 2022 and last year as well. What we see when we dive into the detail of the calibrations is quite different.
MARK MENNEMEYER: And so given how extreme that sounds, how did those insurers risk calibrations stack up to the events?
GERARD ANDERSON: So to give an example, and this definitely warrants some further analysis, given how important this is for the financial stability of the insurance market, we have done a bit of digging into the median calibrations across the UK insurance industry through running a survey that we run on an annual basis.
So to give a few examples, before discussing interest rates, just to set the scene over 2022, we will focus on spreads. And these, across the board, at a BBB level, widened by about 100 basis points. Which was quite a large movement in spreads.
However, when looking to the survey results that we ran, the UK median 1-in-200 calibrations, we can see that the stress for this would be around 500 basis points. So to not do any fancy maths on this at the moment. It is safe to say, however, that the 2022 experience was quite comfortably within the 1-in-200 event. We've got a hundred experienced versus 500 for the calibration.
So let's look at another calibration. We can focus on UK equities. And over this year, from year end to year end, it was basically flat. And this is compared to the 45% drop in the median 1-in-200 stress. Again, this would be in line with the expectations. But not to cherry pick, as it was quite a benign year for equities.
If we were to go back to another recently extreme event, we can focus on, say, 2007, with the great financial crisis. And from year end 2007 to year end 2008, the fall in equities was around 30%. So even that very extreme event that I'm sure many of us remember, we're still very comfortably within our 1 in 200 calibration.
So let's go back to swap rates, which is the topic of conversation right now. If we're to focus on the risk calibration survey, the median calibration for a 1-in-200 year swap rate increase would have been about 2.35%. The actual experience over 2022 was 2.75% This suggests that it was outside and beyond the 1-in-200 calibration.
And, it should be noted, this is only when considering interest rates as a univariate stress. But it still gives a bit of a flavor for how extreme this was compared to our calibration. If we were to naively extrapolate the 2.35% at a 1-in-200 level, what we see is the 2.75% over the year is roughly equal to a 1-in-750 year event. Which I think we can all agree is quite extreme.
Now, it was quite a turbulent time. And I definitely know a few pensions actuaries that were losing their head over this. But to call this a 1-in-750 event feels a bit over the top. So again, we'll dive back into some other data. And this time we have looked to the Bank of England data going back to 1975.
What we can see is that there are similar short, sharp rate rises that have happened about five times. And these have all been of a similar severity as to what happened in 2022. So given this has happened five times since 1975, again, not going to go into any complicated maths here, but it really doesn't feel like this is indicative of a 1-in-750 year event.
So if we're to go back to the topic at hand, which is the UK insurance market and how this was affected, we would see that this sudden rate rise has led to better capitalization across the board. Which, on the face of it, does sound good. But it's not going to be a good thing if the models are wrong and if the underlying calibrations are deemed to be inaccurate.
If the process is carefully managed from end to end, capital levels increasing could lead to good things such as rating bigger and more BPA deals, known as Bulk Purchase Annuity deals, where life insurers take liabilities off of pension schemes. There are other good things that can happen as a result of outsized capital levels, such as repaying dividends to shareholders. However, that would all deplete the capital position.
And if the calibrations are wrong, then this increase in capital coverage could be a sort of fake. And any sudden reversal of fortunes, which we can definitely see happen when we look back to the Bank of England data again, would be disastrous for firms if they were not capitalized well enough to withstand these downturns.
I think the key thing here is to maintain a healthy skepticism when deploying capital and taking a prudent view, particularly when coverage ratio improvements have happened so quickly. So it's going to be important to make sure that all of the relevant historic data has been included in your calibration and ensure that your models are up to scratch and also correct.
MARK MENNEMEYER: Great. Thanks for taking us through the macroeconomic landscape and the risk calibrations. Muhammad, let's shift over to you and talk about, what do the internal models have to say about this?
MUHAMMAD AMJAD: Yeah, sure. Thanks, Mark. I think what I would say-- I would answer your question from two different lenses. One, from the perspective of, how come internal model calibrations turned out to be so wrong, let's say, for interest rates that they weren't able to capture the 2022 experience? Or they were assigning a very remote probability to them, even though, as Gerry said, there's several examples, when you look at the history from 1970s up until now, of sudden sharp increases in rates. So that would be the one perspective.
And then the other one would be what Gerard has touched on previously as well, around the sudden change in capital ratios and looking at the output of the internal model, whether we could have guessed, without actually taking a position on the quality of the interest rate risk calibrations, that the solvency ratios of insurers can be volatile.
So coming, to the first bit, I think probably fair to say that, for a lot of the insurers, interest rate calibrations are not killer risk. Or interest rates aren't the killer risk from an SCR perspective. Now, the interest rate risk can be very annoying from a day-to-day management of the business perspective, given rates are volatile and they can cause you to bleed capital over the course of the year.
But if you're thinking about the SCR calculation as a fight between heavyweight boxers, you tend to find that it's the heavier risks that tend to dominate. So if you're a with profits fund, chances are that's something along the lines of equity, spread risk, that's going to be dominating. If you're a life insurer with a lot of credit exposure, it's likely going to be longevity and credit that are going to be dominating in interest rates.
They end up being like a diversifying factor. The other historical context is over the last period since the financial crisis, rates had been coming down consistently year on year. And what we found was that rates down is typically worse for solvency ratio. But it's better from a net asset value perspective.
So you actually make money from a own funds perspective when rates go down. But you actually have to hold more SCR, which makes your capital position worse and vice versa. When rates go up, you might lose money on your own funds, which is the net of your assets and your liabilities. But your SCR also goes up.
So then, you end up maybe gaining on your-- sorry, your SCR goes down, so you end up gaining on your solvency ratio. So there's this weird counter-cyclical thing that happens between the own funds and the SCR itself.
And remember, the SCR calculation does not look at what happens to the SCR under a stress. It's only looking at what would happen to your assets in the liabilities and your net asset value position. So in defense of interest rate calibrations before 2022, I think having been responsible for leading an internal model team, I know you tend to focus on risks that are more material.
And even if firms had a calibration where the experience over 2022 did not breach their 1-in-200, it wouldn't really make a meaningful difference on their SCR. Now, this brings us to the second part of the question. Why is it important then? It's important because when you're managing your balance sheet, you don't just care about your net asset value. You also care about your solvency ratio.
And, particularly, in the UK pensions risk transfer market. If you're operating in that space, you want to show a healthy solvency ratio to the trustees so that you can acquire or originate business. Now, essentially, if you're bleeding capital too quickly, it's going to put you in a bad space from that perspective. So you do need to manage capital effectively.
Managing capital effectively means also understanding how your capital ratio behaves under a variety of different circumstances. And if the calibrations were better, maybe you could have identified that your solvency ratio can take a wide swing due to rates. But actually, even if you step aside from rates for the time being, I think what you will find or what insurers will find is if they carry out extensive scenario testing on their solvency ratios, they will find the solvency ratios to be surprisingly volatile.
Which means a surprisingly large number of scenarios can cause their solvency ratios to swing up to 50%, as Gerard was saying was the UK insurance industry experience over 2022. So even with a 40 interest rate calibration. Firms could have put themselves in a position of knowing that their solvency ratios are sensitive and then decided whether to do any sort of risk mitigation to protect themselves against big swings.
Because, as Gerard was saying, easy come, easy go. If you can gain a lot of solvency ratio by accident, you can also lose a lot of solvency ratio by accident as well.
MARK MENNEMEYER: So given all that, what actions should insurers be taking to help manage this?
MUHAMMAD AMJAD: I think the first thing they should be doing is really trying to leverage their internal model capability. So a lot of people don't realize internal models are very powerful scenario analysis tools. So typically insurers will be running anything north of half a million scenarios for their calculation. Unfortunately, they stop at the point at which the SCR is calculated.
Now, they might have a handful of what's called risk appetite scenarios, looking at 1-in-10s, ups and downs for specific risks. But, essentially, what they can do is say, well, they've already got this scenario engine, which is just generating all these different scenarios. Wouldn't it be good if there were a way of just recalculating the SCR in a very large number of these scenarios?
So that they could understand how their solvency ratio behaves under a very wide range of circumstances. I think the scenario analysis that's typically carried out, this 1-in-10, up versus down for a single risk basis actually provides probably false comfort. Which is evident from the swing in the solvency ratios that we saw in 2022.
If firms saw that their solvency ratios can move 30%, 40%, 50% due to a very large number of scenarios, and anything could be driving those scenarios from a mini budget to a pandemic to something else, then they would probably be quite mindful of that when setting their hedging strategy and so on.
MARK MENNEMEYER: Can you talk about what we're doing with our clients in this space?
MUHAMMAD AMJAD: Yeah, sure. So the first thing is we're trying to educate the clients that they don't need to be surprised every time something like this happens or some macroeconomic shift happens. That they can actually put themselves in a better position by leveraging what they already have. So the first step is bringing this into their conscious awareness that there is something that they can do with their existing technology.
The second bit is helping them understand that doing this analysis does not mean that they need to invest in a completely different internal model system. It's more helping them understand that by making slightly better choices around the granularity of their output, or understanding these trade offs between speed of a calculation and accuracy, that they can make different choices when it comes to those things. Which will allow them to carry out this scenario analysis on a much larger number of scenarios.
So helping them on this journey is what we're trying to achieve at this point. And I think finally, there's also this appreciation that almost in a way that once you become aware of a shortfall within the calibrations, you should try and fix it as well. So if there are firms who have found that their calibrations fail this 2022 back test, then helping them take that forward in answering the question of how their calibrations need to change, that they are fit for purpose.
And the answer may be that actually, for internal model purposes, because it's an immaterial risk for the SCR, that it's not really a requirement at this point. But it is a requirement for risk appetite because the solvency ratio is sensitive. So it's also helping them understand why they should focus on improving their calibrations, even if it's not important for their SCR.
MARK MENNEMEYER: Great. Yeah. Thanks for that. Lots of good things for insurers to consider as they manage their capital. Well, Gerard, Muhammad, it was great to hear your perspectives and to all our listeners, thanks for joining us. We'll catch you again on the next episode of (Re)thinking Insurance.
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