Proposal of the Future 2.0 - Widescreen

May 2020

COVID-19Implications for insurance investment offices

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Contents

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Portfolio considerations in a crisis

Now: Risk assess the portfolio

Next: Determine new opportunities

Beyond: Evaluating long-term impacts

COVID-19: Implications for insurance investment offices

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Portfolio considerations in a crisis

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Financial markets have suddenly become more volatile than at any point in the last 10 years and governments are releasing extreme amounts of sovereign finance to address short-term issues. In this environment, insurers need to consider the role they have to play, at a time when a public interest purpose is vital for the long-term health of the economy. If we agree that insurers invest longer than almost any other investor, then it should be natural for investors to take a view on long-term value and the public interest opportunities that arise during a crisis.

Can insurers see today’s change in asset re-allocation as an opportunity to be more responsible investors? Are there opportunities to lend to the government, providing finance in a way that insurers can use their balance sheet to generate a return but provide liquidity and loan capacity to the market?

Now: Next: Beyond:

Insurers balance sheets have now been weakened and to protect themselves for the next period looks very expensive. Insurers must understand the resilience of their balance sheet through this economic turbulence to facilitate effective decision-making.

The ability to assess portfolio impacts and take mitigation actions is paramount for insurers, Nowmore than ever.

Some insurers have started taking steps to identify the next set of opportunities for the portfolio reallocation to offset some of the downturn.

Can all insurers effectively select the right opportunities, given resources, through this period of transition and reallocation? Are they implementing appropriate mitigation in order to protect balance sheets against the Next phase of this crisis?

We are witnessing unprecedented times with increasing levels of uncertainty. Firms must consider long-term impacts of the decisions they make in the present – which can be very difficult in a ‘survival mode’ environment.

Do insurers have the expertise to navigate through the downturn effectively and sustainably? Insurers must understand future impacts to the consumer and to the wider society which means looking Beyond immediate financial implications.

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Firms will be considering how to effectively manage their investments and portfolios through the current environment. However, it is vital when taking these decisions to consider impacts Now, Next and Beyond!

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EquityPossible risksThere is reasonable risk of further equity downside which may lead to further deterioration of solvency rations and profits ► Reduction in annual management charges for firms which

have not unit matched or got shareholder hedges► There is an impact from the European Central Bank

requesting firms not to pay dividends and freeze share buy backs

► Likely reduction in equity backing ratios for many others that have otherwise strained solvency capital requirement (SCR) ratios

Possible mitigations► Derivatives, e.g., put options, can be used to reduce

exposure to sectors with further downside

Interest ratesPossible risks► Downward pressure on rates are likely to be net negative

across Europe, given most have shorter asset duration than liability duration. As solvency ratios weaken, there will be pressure to hedge further downward movements

► Across Europe, much of the interest rate movement will be offset by the ultimate forward rate (UFR ) and the transitional measure on technical provisions (TMTP)

Possible mitigations► Swaptions are possible hedging options, however they are

likely to be too expensive at this point► It is critical to understand how to manage accounting,

economic and solvency balance sheet volatility

Credit spreadsPossible risksCredit spread widening will systematically reduce the value of the asset side of the balance sheet. The extent to which it results in a fall in solvency ratio will depend on:► Matching adjustment should dampen the movement entirely

for UK annuity writers► Volatility adjustment (VA) should dampen only 65% of the

movement for European players. The rest will hit own funds and increase transitional measures, noting that the impact of sovereign spreads is still very significant for VA

► Credit SCR will likely reduce until downgrades are experienced. The impact may be quite idiosyncratic for those with internal models

Possible mitigations► Enhanced credit screening on portfolios for all sectors.

Regular monitoring of market risk indicators to divest risky credits before downgrades

► Individual and index credit default swaps (CDS) can be used for default protection if spreads widen further. This is likely to be expensive

PropertyPossible risksValues are expected to fall and liquidity completely dried up. This is likely to be an issue for:► Insurers with large exposure and property allocations have

some potential for guarantees to ‘bite’ in with-profit funds► For unit-linked (UL) funds with property exposure

Possible mitigations► Balance sheets should be stress tested to ensure that

insurers aren’t forced to sell these assets► UL funds will require sufficient gating ability and market

value reductions will be needed to protect against lapsing► Property index hedges may be expensive alternatives

CurrencyPossible risksCurrency volatility is high and sterling is at all time lows versus the dollar (most common cross-currency basis). This won’t have systematic impacts but there are some firms with large currency exposure. For these firms, there are challenges on margin calls which impact liquidity

Possible mitigationsTo mitigate future foreign exchange risks, firms should review existing hedging positions


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Now: Risk assess the portfolioPublic markets

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InfrastructurePossible risksAll prices currently stale, liquidity non-existentand spreads likely to have widened, potentially by more than corporate credit markets. Sectoral considerations include:► Transport — likely to be heavily hit ► Renewable energy — usage likely to be

reduced ► Hospitals — potential challenge for some

operational covenants ► Defence — no impact

Possible mitigations► Insurers should be trying to reach out to

individual borrowers for solutions on restructuring of existing credit, noting that credit risk may significantly differ by sector

Private creditPossible risks► Valuations may not have fully reflected

market conditions, so mark-to-market losses may have not been realised

► Risks associated with downgrades due to short-term liquidity issues or links to sovereign credit is a large concern for insurers

Possible mitigations► For larger issuances, credit default swaps

may be an option ► Engaging with borrowers to restructure

existing debt could protect ratings, default outlook and also create opportunities to negotiate more favourable terms

Commercial real estate (CRE) debtPossible risks► Anecdotal evidence suggests that tenants are

not paying rent in the short-term. This could move CRE projects into technical default

► Hits to property values may also move projects into technical default

► This could bring about new opportunities if some withdraw from the market and spreads stay wide. Otherwise, insurers may have to work out some of these loans

Possible mitigations► Credit risk will likely differ by sector and

region ► Certain borrowers may request restructures,

which is likely to be mutually beneficial

Residential mortgages Possible risks► Arrears and defaults likely to increase due to

pressure on consumers► Valuation uncertainty is high given market

liquidity is effectively nil during lockdown ► New volumes are likely to dry up given

practical issues regarding moving home or viewings

Possible mitigations► Haircut to valuations used to determine loan-

to-value in underwriting, or imposing lower loan-to-value thresholds for new mortgages may help mitigate risks on new issuances

Equity release mortgage (ERM)Possible risks► As rates fall we tend to see providers cut

lifetime mortgage rate. However, this did not happen after the more recent rate falls

► Reduced rates are partly due to origination volumes drying up, due to a fall in consumer demand but also initial operational issues with underwriting loans which have since been overcome through short-term product innovation

► That being said, lifetime mortgages are arguably still a good long term investment and opportunities to buy a third-party portfolio may be particularly attractive given firms are unlikely to be hitting their current volumes targets

Possible mitigations► Purchase no-negative equity guarantee

(NNEG) protection► Restructuring of ERM notes to assist with

liquidity within securitisation structures


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Now: Risk assess the portfolioPrivate markets

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Next: Determine new opportunitiesBuilding a stronger portfolio

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Re-risking: Equity market

► Presence of some under-valuations may boost expected equity market returns through selective value stock picks with consideration of whether future dividends will be supported

► Merger and acquisition opportunities may exist in times of valuation ‘corrections’ or divestment market opportunities

► Speculation around downgrade and default risks may create lucrative buying opportunities for cheaper higher-yielding credit► Identification of sectors or names where price corrections and spread widening do not fairly reflect risk may be appealing

Re-risking: Credit market

and illiquid debt

► Declining property valuations can create large illiquidity risks however it also provides a long-term purchasing opportunity for those with sufficient liquidity looking to expand their property portfolio

Re-risking: Property

► Frequent review of key hedging strategies is required to ensure optimum performance in this difficult environment ► Rationalising and consolidating hedge positions to manage costs could prove to be significant

Volatility and hedging

► Accessing credit opportunities with special guarantees: Leveraging the internal bank relationship to access funding from the European investment fund (EIF) which is issuing special guarantees to European banks to provide liquidity to European small and medium-sized enterprises (SMEs) and mid-cap companies who may have been economically hit by the pandemic

► Accessing liquidity or disposing of certain credits: The Bank of England (BoE) agreed on the Corporate Bond Purchase Scheme (CBPS) — allowing UK lenders to issue new low cost debt or sell existing credit which may present an opportunity to divest for bancassurance groups

► Accessing liquidity with options to provide consumer lending: The BoE is introducing a term funding scheme allowing eligible banks/building societies access to 4 year funding at rates very close to the Bank rate; designed to incentivise participants to provide credit to SME’s and households

Government and Central Bank

policy stimulus


There are a range of potential risk mitigation steps and opportunities presented to consider when operating and investing in the current environment.

Balance sheet management

► Funded longevity or overseas reinsurance opportunities may help to protect the balance sheet from credit default and downgrade scenarios, and could lead to capital releases

► Solvency may benefit from optimisation of asset hypothecation; or rebalancing collateral accounts to reduce capital requirements where there is flexibility in Credit Support Annex (CSAs)

► Maintaining liquidity positions through use of bespoke liquidity facilities and special purchase vehicle repacks

► Firms should adapt risk limits with respect to high risk sectors or asset classes in the short to medium-termRefresh risk management

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Beyond: Evaluating long-term impacts

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To the extent that there is a choice over short/medium-term actions, future long-term impacts should be considered when determining strategy.


► Provides protection from potential future losses but at what cost? For example, reputational implications can damage existing relationships and future opportunities when markets rebound

Reducing certain lending and exposures

► Improving long-term credit performance for the portfolio for some upfront cost – potentially a “win-win”Credit screened portfolios and eliminating risky credit

► Firms will need to balance stability of the balance sheet in the short/medium-term with potential loss of future earningsBalance sheet management actions

Strategy Implications

Customer-focused strategies ► Develop new and strengthen existing customer base during a time when market segmentation is uncertain ► Demonstrating the firms ability to prioritise the interests of policyholders will undoubtably reflect the brand and company reputation for

years to come

Wider societal-focused strategies

► Decisions that are aligned to corporate values and aligned to responsible investment strategies can help lift future economic output which creates a substantial multiplier effect when firms act in cohesion

► Working with the government through their intervention policies may support preservation of value. Government support is likely to be focused on sectors which generate the greatest societal impact

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► High cost of hedging and potential loss of future value in exchange for greater balance sheet stabilityNNEG hedging

► Improving long-term performance of the credit portfolio and relationships with borrowers and business partners► Being willing to renegotiate terms (e.g., payment holidays/deferrals) may lead to an increase in the value of loans

Reach out to individual borrowers for solutions on restructuring of existing credit

Derivatives: swaps (CDS), options for debt, equity, currency and base rate risks

► Worsening of liquidity position► Potential loss of future value if option derivatives aren’t exercised ► Protect balance sheet from further deterioration if bear markets persist

Negotiate changes to eligible collateral on CSAs with banking partners

► Banks would typically expect to be permitted similar flexibility in postable collateral as part of any renegotiation of CSA terms, which may impact a firm’s counterparty default capital assessments over the long-term

► Should provide long-term flexibility to support with liquidity risk management and efficient management of cash

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Contacts

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Simon Woods

Commercial Optimisation Lead

Email: [email protected]

Tel: +41 (0)79 701 03 59

Ernst and Young LLP

Gareth Mee

Sustainable Finance Insurance Lead


Tel: +44 (0) 7734 862 860

Ernst and Young LLP

Naomi Burger

UK Insurance COVID-19 Lead


Tel: +44 (0) 7917 836 353

Ernst and Young LLP

Sam Tufts

UK Investment Advisory co-Lead


Tel: +44 (0) 7468 357 674

Ernst and Young LLP

Ben Grainger

UK Investment Advisory co-Lead


Tel: +44 (0) 7831 136 525

Ernst and Young LLP

Cameron Johnson

Investment Advisory team


Tel: +44 (0) 7385020638

Ernst and Young LLP

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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.

Proposal of the Future 2.0 - Widescreen

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