2022 0610 - IPAC Report - Potential Impact of the International Association of Insurance Supervisors' Insurance Capital Standard on the Life Insurance Industry, Policyholders and Markets in the United States - 68p

  • 2022 06 - IPAC Report / FRB - IPAC to FRB - Potential Impact of the International Association of Insurance Supervisors' Insurance Capital Standard on the Life Insurance Industry, Policyholders and Markets in the United States  ---  [BonkNote]  ---  68p
  • p39 
  • (p1) - The objective of the report is to assess potential implications of the ICS to the U.S. insurance industry, markets, and policyholders, with a specific focus on long-duration life insurance and retirement products.
  • (p18-19) - For example, UK insurers have traditionally sold large volumes of long-term guarantee products, including annuities, which have been backed by investments in a diversified range of assets.
    • However, since non-traditional assets in a diversified portfolio are not appropriately reflected in the MA and the VA, the Sll experience in the UK has therefore been to limit investment in illiquid, real-return assets.33
    • In turn, this has contributed, together with the low interest rate environment, to the decline in the attractiveness to insurers of continuing to offer long-term savings and investment products that would otherwise have been supported by these assets, and to a corresponding decline of their availability to consumers in the marketplace.
    • Similar trends have been noted in other European countries with a shift away from long-term guarantee products to other products, such as unit-linked policies, where market risks are passed on to the consumer.
  • Similar to the experience in Europe with Sll, if IAIGs that write such long-term guarantee business in the US become subject to the reference ICS as a PCR, they may also experience such impacts on long-term business.
    • This may be a policy aim for the EU, but it would be less appropriate for the US, where the balance between public and private retirement funding is decidedly different, and there may be more need for long-term guarantee products.
    • EU countries spend a significantly higher proportion of their GDP on public pensions than the US. The OECD reports that the US spends 7% of GDP while many EU countries spend significantly higher percentages; for example, Germany spends 10%, France 14% and Italy, with the highest percentage, is at almost 16%.34
  • (p20) - To address this concern, the IPAC stylized insurer model included the following:
    • `Asset and liability data were provided by data providers based on their actual long-term business portfolios.
      • These portfolios include the following products which play a prominent role in US markets: term life insurance, non-participating whole life insurance, payout annuities, long-term disability income products, structured settlement annuities, universal life and participating whole life insurance. 
  • (p39-40) - Of note, the methodology used for this stratification is based on cash-flow matching criteria that are inconsistent with ALM practices generally used by US insurers in managing their long-term business.
    • To support long-term business, US insurers typically invest in a diversified range of assets including both fixed-income and real-return assets, e.g., real estate, infrastructure, and public/private equity, with a focus on managing economic mismatch rather than purely on cash-flow matching.
    • In the US, as in many other jurisdictions, financial markets are not deep and liquid beyond 30 years, and yet a small portion of the liability cash-flows can extend beyond that time frame.
      • The focus on economic matching allows an insurer to limit its economic risk, earn more spread on shorter assets while limiting the tenor of credit exposure, and reinvest over time to extend the asset cash flows.
  • Such ALM practices of US insurers also are consistent with Insurance Core Principle 16 Enterprise Risk Management for Solvency Purposes, which states, "ALM does not imply that assets should be matched as closely as possible to liabilities, but rather that mismatches are effectively managed."55
    • The over-emphasis on cash-flow matching in the Three-Bucket Approach should be addressed, both in the criteria used to assign products to the three buckets and in the determination of liability discount rates for each respective bucket.
  • (p42) - The types of assets defined as ineligible are investment income receivable, convertible notes, insurance-linked securities, equities, hedge funds, private equity, real estate, infrastructure equity and other investment asset types.
    • These asset types are all appropriate investments when held as part of a well-diversified ALM strategy for long-term business.
    • Holdings of asset classes with historical average returns above the risk-free rate and not dependent on trading should also be considered for eligibility by the supervisor, with risk charges based on the underlying economics. 
  • (p46) - The potential impact of regulatory capital requirements on an insurance group is illustrated in the following examples that leverage the results from the IPAC stylized insurer model.
  • Product Strategy
    • A high percentage of US long-duration life insurance and retirement products fall within the General bucket under the ICS MAV liability discounting methodology.
      • This translates into lower levels of capital resources, higher capital requirements and, ultimately, a lower ICS ratio attributable to these products with a need for a higher capital cushion, all as compared to what the ICS result would be if those products were assigned to the Top or Middle buckets.
  • As observed in the results of the IPAC stylized insurer model in Table 6 above, these General bucket impacts are tempered by offsetting impacts of the other buckets, to the extent the insurance group has business that can be assigned to those other buckets.
    • However, if an insurer subject to the ICS primarily sold traditional life products such as universal life, whole life and term life which, under the current ICS MAV bucketing criteria, would likely fall into the General bucket, the impact to capital resources from conservatism in valuation under ICS MAV could be very significant.

Capital Markets and Cost of Capital

  • (p50-51) - Due to the nature of their investments and business models, insurers can help mitigate liquidity issues in financial markets.
    • Unlike banks, the vast majority of life insurers' liabilities are long-term and illiquid, as compared to the short-term deposit liabilities of a bank that may be withdrawn on demand.
    • For life insurers, there is much smaller risk of a bank-like run or "contagion" effects caused by interrelated business activities.
    • As a result, insurers are able to hold the majority of their assets until maturity, thereby reducing the risk of a forced sale of assets in a stressed market.
    • Within the ICS, undue deference to temporary spread movements, and the temporary impact such spread movements have on asset values, are likely to distort signals on capitalization and financial strength.

Competive Landscape

  • (p51) - US insurers have been moving away from sovereign and even corporate debt toward infrastructure, private debt and other assets that offer a higher illiquidity premium, and often much-needed longer durations, with a sufficient level of return to provide consumers with attractive minimum guaranteed insurance and annuity products.
    • As noted earlier in the section, Strategic Asset Allocation (SAA), the ICS disincentivizes insurers from investing in these kinds of investments and, as a result, IAIGs subject to the ICS would be less able to compete on equal footing with non-IAlGs that would not be subject to the ICS.

Impact of Long-Duration Insurance Products

  • (p51) - As noted in previous sections of this report, long-term life insurance and retirement products sold in the US would be primarily assigned to the General bucket for purposes of ICS valuation and subjected to excessive conservatism that is not aligned with common and sound ALM and SAA practices in the US.
    • The calculation of risk charges further exacerbates these issues.
    • Insurance groups subject to the ICS would need more initial capital and capital cushion to
      support such products.
    • Over the long term, such groups would then be economically pressured to reduce or stop selling such products, pass additional capital-associated costs on to consumers, or change the product design to make it make more capital efficient (with lower benefits or guarantees to consumers) under the prevailing capital regime.
  • If the ICS were to apply only to IAIGs, as is presently intended by the IAIS, non-IAlGs would have
    an economic advantage and could increase their market share relative to IAIGs.

    • This would essentially create an arbitrary capital differentiator within the US based on whether a US-based group is selling enough insurance in non-US markets to meet the international business criteria to qualify as an IAIG.
  • Some jurisdictions have signaled that they are moving towards ICS-like regimes for all insurers of
    a certain size and complexity, regardless of whether they meet the criteria to be identified as
    IAIGs.

    • If the US were to follow a similar approach, the ICS design issues identified in this report
      would impact all US insurers and translate into higher cost and/or reduced product availability market-wide, thus adversely impacting consumers to an even greater degree. 

4.2 - Regulator Perspective

The ICS as a PCR

  • (p54) - Given its intended use as a PCR, the more conservative results of the ICS (which can include non economic elements) may motivate supervised groups to take risk mitigation actions to address supervisory constraints which run counter to sound economic objectives.
  • In addition, as a PCR, the ICS would obligate the group supervisor, whenever capital resources
    fall below the minimum requirement, to:

    • Require management to establish and execute plans that would cause capital resources
      to return to levels in excess of minimum requirements, and under extreme circumstances, or
    • Place the holding company into rehabilitation, an act that transfers full management
      authority of the business, including subsidiaries, to the regulator.
  • (p54) - While there is a range of possible regulatory actions in the event that an insurer dropped below the minimum capital requirement in the ICS, the consequences for a regulated group and its
    policyholders can be adverse.

    • Poor solvency ratios create the perception to policyholders, distributors, employees, owners, suppliers and other stakeholders of the group that the group's going-concern status is in doubt.
    • Such doubts from important stakeholders can further exacerbate the group's difficulties.
    • The desire to avoid such adverse impacts on a group is partly why state insurance regulators in the US, unlike banking regulators, appropriately place less emphasis on the "run" risk that justifies rapid intervention.
    • As compared to banking regulators, insurance regulators set "mandatory control" solvency ratios closer to the level where the regulated entity's condition would be deemed hazardous. It is then left to the insurance regulator's discretion and due process, informed by trend tests and other measures and tools, to decide whether a rehabilitation order is necessary.
  • Given the high probability for providing inappropriate signals and significant negative ramifications of such inappropriate signals, the ICS, as currently designed, would not be appropriate as a PCR for US IAIGs.