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The sudden change in the economy in 2022 means European insurers are facing urgent challenges in optimizing their balance sheet management. After more than a decade of exceptionally low interest rates, dormant inflation and modest economic growth, conditions are now radically different. Inflation is high, interest rates are rising and major economies are on the brink of recession, increasing insurers’ credit risk exposure.
In optimizing the relationship between risk, return and capital through their balance sheet, insurers are facing three interlocking challenges. The shift in economic conditions over the past 12 months has intensified each of them:
- 1Short term: The main immediate concern is to address the key financial risk factors that prevailing market conditions present and so mitigate balance sheet volatility and position the company to generate long-term value.
- 2Medium term: Insurers need to implement regulatory requirements including IFRS 17 and the revisions to Solvency II, as well as update internal models and the data that drives them. Key metrics, including the new – but loosely defined – Net Capital Generation KPI must be disclosed and explained in line with stakeholder expectations.
- 3Long term: Strategic value creation based on an assessment of the long-term economic outlook is critical to insurers’ viability, but has become much more difficult in a low-interest rate world. The ongoing shift toward non-traditional assets in search of enhanced yield requires new skills and techniques in asset evaluation, risk management and regulatory optimization.
Nine key areas for effective balance sheet management
To help insurers position themselves effectively to address the short, medium and long-term challenges they face, we have identified nine imperatives that should drive companies’ decision-making. Effective balance sheet management in these areas can make a material difference in steering insurance companies toward successful outcomes. We group them under three headings that correspond to the short, medium and long-term challenges outlined above.
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1Short term: Coping with turbulent financial markets
The recent change of regime in financial markets requires a comprehensive response. For more than a decade, insurers have positioned themselves to manage risks, notably falling interest rates, that are receding, while focusing less on areas such as credit risk that are now re-emerging.
They should therefore re-evaluate risk management strategies in light of the new situation. This means revisiting hedging and reinsurance programs and designing capital-efficient asset-liability matching strategies. To manage the effects of cost inflation and protect value creation, they need to cut expenses and increase operating efficiency. This is likely to involve consideration of opportunities to outsource non-core and even some core activities. Access to real-time risk management information is also vital. Implementation of risk dashboards will enhance decision-making and provide timely insights into evolving risks, profitability and capital requirements.
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2Medium term: Explaining, steering and disclosing on key metrics
The changing regulatory background requires insurers to align steering metrics with changed frameworks. This means revising the KPIs and management information that they use to match regulatory and shareholder requirements such as IFRS 17, the updated Solvency II rules and the Net Capital Generation measure - despite the lack of clarity to date from regulators on how this is to be implemented.
Insurers need to increase governance around models and data to enable management teams to make decisions in a controlled fashion that are based firmly on the outputs of their models. ESG has become a central consideration in balance sheet management and insurers therefore need to explore the impact of ESG on investments by implementing metrics and using ESG-based scenario analysis as part of their balance sheet management activities.
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3Long term: Enhancing strategic value creation
Insurers’ continuous search for yield to drive strategic value creation will involve increasing exposure to private-market, non-traditional assets. They must understand the risk attached to alternative investments and ensure they have the data, models and expertise to satisfy the Prudent Person Principle. The relative illiquidity of alternative investments will make liquidity risk a key concern. The search for yield also requires insurers to explain to stakeholders the trade-offs implicit in their alternative investment strategies: adding exposure to relatively illiquid alternatives is likely to pressurize short-term Solvency ratios while increasing potential long-term value creation.
Insurers must also embed the valuation of complex products in key processes. For traditional assets that contain embedded options and guarantees, this means defining and embedding valuation methodologies that encompass capital requirements, pricing and valuation models. Finally, insurers need to strategize on existing insurance books to define their business model and identify strategic actions that may result, including outsourcing or acquisitions.
Aligning with best practices in balance sheet management brings major benefits for insurers, as evidenced by our experience of working with clients in this area. In recent projects, we have helped European insurers to align their risk appetite and capital management by developing quantitative metrics based on key risk principles. We also helped one insurer monitor its evolving risk profile by developing a framework that links movements in the balance sheet to changes in key risks. This allowed the company to manage solvency and capital generation in line with its risk appetite. In a third case, we worked with an insurer to strengthen the company’s onboarding and valuation of alternative assets, which had increased significantly as a share of the company’s assets under management (AUM).
In each of these cases, the foundation for the applied solutions was an understanding of the interlocking short-, medium- and long-term challenges insurers are facing in optimizing their balance sheet management.
This is the third article of our series of detailed deep dive articles on the transformation of the insurance industry. Also check out the other articles on cost and distribution as well as the other upcoming blogposts on people, technology, and ESG.
