Centre for Risk & Insurance Studies enhancing the understanding of risk and insurance

Life Insurers' Financial Strength

Life insurance companies' returns to
Financial Services Authority (end-2003): a preliminary survey

by Chris O'Brien, Director, Centre for Risk and Insurance Studies,
Nottingham University Business School

We have now completed our preliminary analysis of the top 20 with profit life insurers' returns to FSA.

Several life insurers have now published a "realistic balance sheet" as part of their returns to the FSA: this shows that, on average they have 2.4 times the capital that would be needed to meet the effect of specified adverse financial conditions (the "risk capital margin").

The traditional measure of solvency shows that life insurers' finances are healthier than a year ago, with the free asset ratio up by 2.7% points to 9.3% on average (though it was 22.5% in 1999).

Chris O'Brien, Director of the Centre for Risk and Insurance Studies, commented:

"The new figures from the realistic balance sheet are more helpful than the traditional but artificial approach to solvency: the liabilities rightly reflect asset shares, and contain a more robust calculation of options and guarantees."

"However, the realistic balance sheet is not realistic in showing financial strength: it fails to include other capital that life insurers have available if needed; and the risk capital margin requirement does not cover all relevant risks."

"Part of the improvement in the traditional free asset ratio arises because 9 of the 20 companies have used waivers from the traditional rules in calculating their liabilities: these remove some of the artificialities in the calculations (which has been a well-known problem) but it also means comparisons are difficult."

"Insurers are making less use of financial engineering: in 2002 they used £8.8bn of future profits and £2.4bn of other forms of financial engineering (such as financial reassurance): these figures are down to £4.2bn and £2.2bn respectively."

"We are in an interim stage as FSA develops its new reporting rules. This means companies are using different methods and assumptions."

"Until the new rules are introduced fully we cannot make a true assessment of the financial prospects of the sector; the current mixture of methods leaves us in a muddle."

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The survey covers the 20 top with profit companies1. It shows that, at the end of 2003, the average free assets ratio2 was higher than in 2002, although still lower than in 2001.

We need to emphasise that there are a number of issues surrounding the calculation of free assets ratios. The free assets ratio can be calculated in different ways: different ratios have different characteristics and none is ideal; we calculate it as the excess of assets over liabilities, divided by liabilities. We calculate, separately, the ratio after subtracting the minimum solvency margin that companies are required to hold.

The ratio is given for the company's business as a whole. However, to gain a better understanding of an individual company, one needs to consider the mix of its business (e.g. whether it transacts unit-linked business, which has fewer risks, and where the policyholders are not entitled to share in the surplus).

The free assets ratio depends on the company's liabilities. The rules require prudence in the assumptions used to calculate liabilities (including testing resilience to more adverse economic conditions) but many would also say that the methodology prescribed is artificial. We also need to recognise that companies carry out the calculations in different ways, and make different assumptions.

FSA has granted waivers to a number of companies, enabling them to place a lower (but still prudent) value on their liabilities. For example, these waivers may enable companies to make different assumptions regarding the rate of interest, surrenders and the premiums used, and the way they treat resilience reserves. The difficulties of comparing firms are compounded where there are waivers: some firms have used a waiver with only a small impact on their liabilities.

The figure used for assets, which is calculated in accordance with the regulations, may also understate the resources available to the company.

Bearing in mind that the standard valuation of assets and liabilities typically contains significant margins for prudence, the rules allow companies to use "implicit items" in certain circumstances. The implicit item used by certain companies is "future profits". Companies may choose not to use this facility, or to use less than the maximum amount that would be permitted. We calculate the free assets ratio (after the minimum solvency requirement) both including and excluding future profits. The regulators are planning to phase out use of future profits (although, for some insurers, it may be a reliable asset).

The ratios can also be affected by the company's reinsurance and financing arrangements. We have information in the returns on "financial engineering adjustments". These adjustments comprise implicit items, financial reinsurance, outstanding contingent loans and any other charges on future profits. Although such adjustments raise some issues, they can represent prudent financial management, stabilising the fund, increasing investment flexibility and improving the security of policyholders' benefits: this takes into account that assets and liabilities, as calculated, can contain significant margins. Note also that some insurers have subordinated loan arrangements; such financing is considered elsewhere in the insurers' returns.

It is clear from the above that simple comparisons of free assets ratios should therefore be treated with extreme caution.

The average free assets ratio has been:

Note: the top 20 companies have not been the same each year

The free assets ratios have been assisted by the rise in the stock market, although the benefit has been less where insurers have sold equities. Over 2003 the FT-Actuaries All Share Index rose by 17% from 1894 to 2207 (it was 2524 at the end of 2001).

Furthermore, interest rates rose somewhat - the yield on 15-year gilts increased from 4.45% to 4.78%, which will have led to a reduction in the value attributed to insurers' guaranteed liabilities.

We are also able to show the "realistic balance sheet" (RBS) of the 12 insurers who have provided it (insurers who have not used waivers during or at the end of 2003 do not have to provide it). This aims to show the assets available to, and liabilities of the with profits business more "realistically". It is worth saying that this is still at a developmental stage, and it does not necessarily represent a coherent approach to placing values on with profit business (the Accounting Standards Board is considering similar issues for companies' accounts, as distinct from their returns to FSA). Note that the RBS figures apply to with profit business only, whereas the traditional calculations relate to the company's total business. Insurers are still developing the approach to calculating RBS numbers and FSA have not required the figures to be audited; the outcome may be considered as an interim stage towards meeting final FSA requirements.

The RBS liabilities include the asset shares on with profits policies: this aims to give a better indication of insurers' obligations than the traditional calculation, which includes an implicit allowance for future bonuses. It also includes a liability for options and guarantees that is intended to be consistent with market conditions.

The RBS assets include the assets available to the with profit business, on a market value basis and including the embedded value of non-profit (including unit-linked) business; FSA may consider waivers from the standard guidelines if appropriate. Note, though, that the embedded value may not reflect a fully market-consistent calculation.

The RBS includes a "risk capital margin": this is the amount of capital the insurer would need to cover specified adverse changes in financial markets (market risk and credit risk). In accordance with its Consultation Paper 195, FSA plans to extend the RCM to include an allowance for persistency risk; some insurers may see a material increase in their RCM as a result of this. Operational and other risks to which insurers are exposed are not reflected in the RCM. Note that RCM can also be managed in a number of ways, including the choice of investments: for example, it may be reduced by switching assets from equities to bonds. Actions that firms take to reduce the RCM may help reduce the risk to which the business is exposed, but note that this may means lower payouts for policyholders.

We show the "capital coverage ratio", derived from the RBS figures, being the excess of assets over liabilities, divided by the RCM. We also show a "restricted capital coverage ratio", calculated excluding additional assets outside the with profits fund backing with profits business. Again, these ratios need to be interpreted with caution, as they cannot reflect all companies' individual circumstances, including their actual mix of business.

A capital coverage ratio of 1.00 may be perfectly acceptable, depending on the capital support available when needed. Indeed, some funds will aim to distribute surpluses such that retaining a high capital coverage ratio would be inappropriate. Also bear in mind that this is an interim stage of development, and there will inevitably be some inconsistencies in insurers' calculations.

FSA will also be requiring insurers to calculate their "initial capital assessment", i.e. what capital the directors regard as needed to cover the risks of the company, taking into account its particular circumstances. This is leading to additional work by life insurers on modelling and risk management.

Chris O'Brien
27 May 2004

1 The with profits life offices with the highest long-term fund admissible assets at the end of 2002.
2 Using form 9 of the returns: line 21 (long-term fund admissible assets) plus line 22 (other assets) minus liabilities*, minus required solvency margin (where "after required solvency margin"), plus line 31 if applicable (future profits#), expressed as a proportion of liabilities. *Liabilities are the sum of lines 23 (mathematical reserves) and 24 (other liabilities). #For the purpose of this calculation, future profits were restricted to 5/6 times the required solvency margin. Note: some commentators use other definitions of the free assets ratio.

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