It’s a sign of the times. Up until now, the finance chiefs of life insurance companies often chose to put away just enough capital to satisfy the requirements of regulators and rating agencies. Famously cash-rich, life insurers enjoyed big buffers against economic volatility, and their CFOs felt they had little need to sock away extra money for a rainy day. That, however, is starting to change.
Prompted by the recession, many top finance executives in the life insurance business say their companies will attune their cash allocation more to economic conditions. Although they haven’t yet changed their approaches, most North American life insurance CFOs plan to adjust their strategies over the next 12 months, according to data culled from a survey of 30 finance chiefs in that industry by Towers Watson, a benefits and insurance consulting firm.
To be sure, 67% of the respondents say their companies use regulatory or rating-agency capital requirements to manage the cash needs of their businesses. That’s a small rise from 60% in January 2008, according to Towers Watson. But over the next 12 months, only 45% of the respondents expected that their companies would be using those definitions of required capital to manage their business. (Not all the same companies and respondents are included in the 2008 and 2010 surveys, but the results are basically comparable, according to representatives of the firm.)
Like banks, insurers are required by regulation to set aside assets in excess of their liabilities to pay the claims of insureds and to manage their businesses. On top of that, publicly traded insurers must post minimums of capital to avoid downgrades from rating agencies. As downgrades grew increasingly common during the financial crisis, life insurance CFOs gauged their capital allotments to avoid them, according to Todd Erkis, a Towers Watson director.
The image of an insurer can be greatly tarnished if a rating agency casts doubt on the company’s claims-paying ability or its creditworthiness. “A lot of companies saw what happened in other industries,” Erkis says, noting that “insurance is very much a reputation and a trust business.”
During the downturn, however, some life insurers suffered what Erkis calls a “near-death” decrease in their capital positions. Such companies rarely incur hits to both the asset side and the liability side of their balance sheets at the same time, but that’s what happened to a number of insurers in the recession.
On the asset side, life insurers saw their huge bond holdings walloped by the downturn, says Erkis. On the liability side, many of them sold variable annuities — retirement vehicles that fluctuate according to the rise and fall of stocks or bonds. The problem was that insurance companies often guaranteed the performance of the products. When the markets fell, they were exposed to large losses.
Chastened by the double-whammy, life insurance CFOs seem to be taking the economy more seriously in their risk management plans, says Erkis. Since regulatory capital and rating-agency capital are based on preset formulas, they’re of little use in responding to market fluctuations, he notes. Accordingly, finance chiefs increasingly intend to bring economic capital (EC) metrics into play. (Towers Watson defines EC as “the amount of capital a company should have to support all of the risks embedded in its business based on current market conditions.”) They expect to use EC more widely, increasing from 10% of respondents currently using the metric to 21% of respondents over the next year, according to the survey.
But the fear of the consequences of a rating downgrade or regulatory punishment won’t be going away anytime soon. The percentage of life insurance CFOs who expect to use the maximum of regulatory, rating-agency, and economic capital to set their capital allotments will increase from a current 21% to 31% in the next 12 months, says the survey.