UK: Insurance Market Update - The Deloitte View For Life Insurers

Last Updated: 10 July 2009
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

This month, we take a step back and look at how finance functions within life insurers felt the strain during the last financial reporting year end and how they responded to unprecedented market conditions. In their article, Andrew Holland and Paul Stephenson consider how life insurers can take advantage of this experience to be better prepared for the future.

In our second article, as a follow up to the April issue, Cathy Lynch and Simon Claydon discuss the implications Solvency II is likely to have for tax functions of insurance companies, and explore the main themes that emerged at a recent Deloitte Solvency II seminar.

We hope you find this edition informative and, as always, your comments and suggestions for future themes or topics are welcome.

Marylène Lanari-Boisclair

COPING UNDER DIFFICULT MARKET CONDITIONS

During the recent year end process, insurers' finance functions faced considerable challenges dealing with a plethora of demands including solvency management, stress testing, investment valuation and credit risk provisioning. These demands arose from all sides – management, the Financial Services Authority ("FSA"), the International Accounting Standards Board ("IASB"), the Financial Reporting Council ("FRC") and the market.

Solvency moved from being a "given" to a headline and a differentiator, bringing finance functions much closer to the sharp end. Best practice emerged in real time from the need to respond to market developments, making it difficult for finance functions to keep up with the pace.

In this article, we consider how life insurers can take advantage of this experience to be better prepared for the future.

Into unchartered territory

Perhaps the single most significant impact felt by many insurers, particularly those more exposed to equities, was the demand for stress tested solvency positions from the FSA who was determined to find out whether the insurance industry was heading for a similar crisis to the one suffered by the banks.

Although not anticipated, these requests were understandably of the highest priority and clearly non-negotiable. Life insurers must – the thinking went – be running scenarios to stress test their solvency position on a regular basis and have clear plans to implement management actions when defined trigger points are breached.

For many life insurers, Individual Capital Assessment ("ICA") is a process linking defined risks to quantified levels of capital, involving stress testing the results and giving consideration to potential management actions. Finance functions were not used to producing this in such short timescales and, in general, life insurers were not geared up to do this.

In addition, because of the credit crisis, finance functions needed to consider investment valuation carefully, including asset impairment and credit risk provisioning. There was much more effort required to understand and challenge asset values in an illiquid market, although generally, information and analysis available from investment managers. Insurers' management typically debated long and hard on the appropriate credit risk assumptions with, inter alia, consideration given to being consistent with the peer group. The level of the credit risk provision continues to be an area of ongoing focus for the FSA.

Pressure on the system

Having to respond to the FSA within short timeframes took critical members of staff out of the year end financial reporting process to focus on the solvency position and scenario modelling. This reactive approach required tremendous effort from those individuals; they faced the challenging task of converting businessas- usual actuarial and risk management into a suitable demonstration for the FSA's consumption. As a result, a significant amount of management time was tied up, putting additional pressure on reporting timetables, on other business critical project work and on the evaluation of potential business opportunities.

This resource constraint undoubtedly added risk to the standard year end process. Key individuals who would ordinarily perform the quality assurance reviews were not available, eroding the level and quality of challenge. Some of these risks may well materialise as financial reporting errors over the course of the next year.

Being better prepared for the future

Finance functions no longer have the luxury of "downtime" between key reporting phases. Significant demands are being placed on the same members of staff; better discipline around planning and scheduling is a key to avoid such critical bottlenecks occurring. There should also be clear accountability of each milestone and contingency plans to deal with slippage. Having a "Plan B" and knowing who to reach out to should be clear to finance function managers from the outset. Proactively managing the regulator, a key stakeholder, may help reduce the number of demands for information.

A more granular view of all activities in the annual cycle will enable management to make informed decisions around deferring or even cancelling non-essential activity to create capacity. Time created during these periods should be used to challenge any new requirements before they are implemented and to predict and test responses to different scenarios. Life insurers should seize this opportunity to embed all the useful analysis and models into the business-asusual ICA process, particularly around the use of the sensitivity analysis, and with a view to Solvency II.

It should be possible for management to monitor at any point what the solvency position is and how it is impacted by a number of different relevant scenarios which take into account the complexity and volatility of the business. In much the same way that disaster plans work to ensure business continuity, emergency solvency management plans should detail the actions to be taken in response to stressed conditions materialising. The thresholds at which intervention is required, for example accessing new capital or amending the investment strategy, should be defined and tested for feasibility. These plans should include wider implications too, such as the impact on group solvency requirements and implications for treating customers fairly.

There are cost efficiencies to be gained from having a more flexible workforce. Investing time and effort in cross-training the organisation's existing workforce will reduce the need to call on expensive, short term contractors to complete urgent pieces of work. For example, by having marketing actuaries trained before the year end so they can back fill in reporting roles as necessary. This will provide a greater level of confidence approaching the busy periods and greater level of control over how much risk the company is taking.

It is also critical that life insurers base their decisions on the right information relating to the underlying assets. This information should be an accurate reflection of the nature of the assets, indicate the extent of subjectivity in the valuation and provide an understanding of how these are marketed to clients. This will require, for example, appropriate processes and governance in place between the investment manager pricing process and the life insurer for both unit linked and non unit linked business.

Life insurers should consider how well the controls environment responded to the pressure this year end, gaining assurance that controls are designed and implemented effectively. For example, not only is it important for management to review investment watch lists but it should also challenge the parameters for identifying investments to be flagged on the watch list and whether those criteria need re-evaluation in stressed conditions.

Conclusion

Many life insurers have realised that the business-asusual processes need to be adapted to become more proactive and pre-emptive. Whilst the difficulties were partly due to market conditions, the need to be better prepared in future is clear.

Taking the initiative on the lessons learned from a difficult year end by embedding the useful analysis, models and controls that were developed will help to achieve this. A strong and effective finance function is one with sufficient flexibility and capacity to absorb unexpected demands.

The increased scrutiny on the financial sector should act as a catalyst for improving the internal control environment which should go some way to restoring market confidence in life insurers.

TAX, SOLVENCY II AND LIFE COMPANIES – WHICH WAY TO GO?

In a recent seminar hosted by Deloitte, Insurance Companies' senior tax representatives discussed the implications of Solvency II for tax functions. The extent of change will depend on each firm's own profile and appetite to treat Solvency II as an opportunity to take a strategic view of the business. Our article explores the main themes that emerged from the discussions.

Reporting and modelling

Solvency II will be a risk-based regulatory regime focusing on the balance sheet. To the extent that they use them, an individual firm's internal models will need to be robust and produce realistic estimates including those for tax charges and tax balances.

The complexity of the UK life tax system means that simplistic assumptions may no longer be sufficiently robust. Insurers will need to review and document the assumptions underlying tax estimates to ensure the results produced are reasonable. Benefits from increased robustness will include:

  • a better ability to explain variations in the tax position from one reporting period to another; and
  • a greater understanding of the impact on the balance sheet e.g. deferred tax assets and the timing of crystallisation of liabilities/assets. (CEOIPS Consultation Paper no 35 specifically included comments on deferred tax accounting.)

Impact on the life tax system

The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) and the FSA are considering changes to the regulatory return, although EU-wide discussions on the precise form are at an early stage. In the UK, tax legislation is linked to specific forms in the regulatory return; changes will mean that the tax rules have to change too – whether adapting them to fit with a new return or taking the opportunity for a more widespread reform of the "I-E" system of life tax in the UK.

There are two main concerns at this stage. One is that an industry consensus on which way to go might be difficult to achieve; the other is timing. Legislative changes would be needed at the latest in the Finance Bill 2011, so agreement on the way forward would be needed probably no later than Q3 2010 to allow time to develop and implement the necessary changes. This is not simply a corporate tax issue but one that requires a review of products sold and the consequent tax impact under new rules.

CEOIPS and the FSA will be issuing consultation papers and tax teams need to keep track on how these develop and contribute to any subsequent debate.

Capital and tax efficiency

Finally, tax efficiency is an integral part of evaluating capital efficiency. Even where tax considerations point in a different direction, they remain important to decisions such as:

  • the location of the business and its capital;
  • the use of reinsurance; and
  • the corporate structure – i.e. branches vs. companies, within or outside Europe.

Conclusion

It is critical that tax departments contribute to the firm's Solvency II projects and monitor the wider debate on the future of the I-E system so that they can consider the best outcome for their firm, both in terms of modelling capability and aligning the efficient use of capital with tax efficiency.

The wider debate on the future of the I-E system is something that senior life company executives should develop their views on – if only to ensure that unwelcome change is not thrust upon them further down the line.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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