Navigating Insurance Capital Requirements in Asia

The insurance landscape in Asia is undergoing significant transformation, driven by evolving regulatory frameworks and dynamic market conditions. At the heart of this transformation is the management of insurance capital, a critical aspect that ensures policyholder security, operational resilience and sustainable growth for insurers. As these shifts redefine the contours of the industry, I believe understanding and adapting to them becomes paramount for success.

This article comprehensively explores the intricacies of insurance capital management. It examines measurement methodologies, challenges posed by regulatory transitions and actionable strategies for optimization (based primarily on the Taiwan market), offering insights for navigating this evolving landscape in all Asian markets.

Maintaining Assets to Support Future Liabilities

Insurance policies are often one of the most valuable and reliable sources of income or protection for many people, particularly in times of need. To help guarantee the financial security of policyholders and ensure their benefit expectations can be met, insurers typically maintain a specific amount of assets to support their future insurance liabilities—namely, the policy reserve and the additional amount of capital to be held on top.

Therefore, insurance professionals and actuaries face two main questions daily:

1. How much reserve and capital should an insurance company hold?
2. How can the balance sheet be optimized to ensure the amount of free assets (assets above and on top of the reserve and capital requirement) is optimal?

Insurance companies maintaining an optimal level of assets is also beneficial to policyholders, as this can prevent policyholders from paying the cost of excessive capital through higher premiums. As the calculation of reserves and the way to manage them are often more constrained than managing capital, the focus of the upcoming discussion is on the level of capital in addition to policy reserve.

Measurement of Capital

To optimize the balance sheet of an insurance company, I believe it is essential to first understand how to measure capital, both in terms of capital resources (or available capital) and capital requirements. However, the measurement of both the available capital and the capital requirement is evolving in insurance markets across Asia, with many in the process of reviewing and enhancing their solvency regimes, which dictate how capital is defined and calculated.

Looking back a decade, life insurers in Asia typically were required to calculate required capital based on one of two approaches:

1. A factor-based approach (similar to Solvency I) where the required capital level is determined by multiplying drivers of prescribed factors without explicitly considering the risks the insurance company faces. The reserves included under available capital are calculated using prudent assumptions, and assets are not always valued on a market basis.
2. A “U.S. risk-based” approach where the required capital considers the level of specific risks the insurance company faces, by requiring companies to quantify this through multiplying prescribed factors against exposures. This approach is similar to the capital regime in the United States and typically includes life insurance risks, asset risks, interest rate risk, counterparty default risks and operational risks. The reserves incorporated under available capital are calculated using prudent assumptions, and assets are not always valued on a market basis.

The primary limitation of the aforementioned approaches is that they are not based on an economic balance sheet approach. With assets not valued on a market basis and reserves determined using prudent assumptions (which do not always fully reflect changes in market conditions), there is sometimes an economic mismatch between the movement of assets and the movement of liabilities when both are captured in the same balance sheet. In some cases, the economic balance sheet (assuming assets and liabilities were valued on a fair-value basis) may be at risk, while the statutory capital balance sheet is not.

Therefore, it is not surprising that many markets in Asia have already transitioned, or are in the process of transitioning, toward an economic balance sheet approach. Under this approach, the available capital (including an assessment of both assets and liabilities) is primarily evaluated based on a fair-value approach, and required capital is predominantly determined based on a risk-based capital (RBC) approach using stress scenarios for each of the material risks the insurance company faces.

For each risk module considered in the capital balance sheet, this approach requires stressing the economic balance sheet with a specific list of factors at a specific stress level that the local regulator prescribes. Regarding the direction of developments, Asian markets that have transitioned or are transitioning toward an economic balance sheet and risk-based capital approach can be categorized into two groups (although arguably, the two groups share the same objective of being compliant with the International Association of Insurance Supervisors [IAIS] Insurance Core Principles [ICPs]):

1. Markets that have developed their own economic solvency regime, often with reference to more established frameworks such as Solvency II and Insurance Capital Standard (ICS). Examples include Hong Kong’s RBC, Singapore’s RBC 2, Thailand’s RBC, China’s C-ROSS Phase II and Malaysia’s RBC. It is interesting that some markets, such as Singapore and China, have already transitioned to a second version of their own RBC framework.
2. Markets that have adopted the IAIS ICS framework, with certain localization measures or localized parameters based on local market characteristics. Examples include Korea-ICS, Japan’s economic value-based solvency regime (ESR, expected to be largely in line with ICS) and Taiwan-ICS.

While these regimes aim to take an economic balance sheet approach, there are still significant differences across areas such as the recognition of available capital, calculation of assets and liabilities, and determination of required capital both in the approach and the stress parameters. For more information on these regimes, refer to Milliman’s “Life Insurance Capital Regimes in Asia.”

Capital Measurement Challenges: Economic Balance Sheet Approach

In Taiwan, the current required capital is measured using a U.S. risk-based approach, but a plan has been set out for the industry to transition toward the Taiwan-ICS framework in 2026 (together with the adaptation of the International Financial Reporting Standard [IFRS] 17 framework at the same time, although a transition period of 15 years from 2026 has been granted to insurers to ensure a smooth transition). Companies have been required to perform regular impact studies to allow the Taiwanese regulator, the Insurance Bureau, to understand how companies’ economic balance sheets behave over time, with the objective of finalizing the design of the capital regime. Based on what has been observed in the market, there are a few challenges or obstacles that companies are still trying to navigate.

Material Increases in Resources When Calculating and Managing Capital (Including Actuarial Resources)

Under Taiwan-ICS (or similar economic balance sheet regimes), the breadth and depth of human power (and machine power) required to produce, analyze and explain both the available and required capital have increased significantly compared to the existing basis. It is not just about having actuarial resources to calculate the numbers; it also requires support from other departments such as investment, finance, IT, internal audit and more, on the end-to-end production process. Additionally, there is a need for extra training for senior management, including the board of directors, for them to be able to make informed business decisions under the new capital regime.

Developing a sizable and skillful team to support the end-to-end capital production and management process takes time. It typically requires insurance companies to invest significantly in staff, training and systems, as well as setting up appropriate and efficient processes.

Change in Focus on Product Strategy

The insurance market in Taiwan historically has been more focused on savings-oriented insurance products, with interest-rate sensitive products (savings products with guaranteed components, as well as nonguaranteed benefits that are declared on a regular basis) and unit-linked business making up the largest proportion of life insurers’ in-force and new business portfolios.

While companies have a long and solid understanding of their key in-force products and the associated risks, the nature and quantification of the risk could change, potentially significantly, when assessed under the lens of the new Taiwan-ICS capital basis. One reason is due to the level and cost of guarantees associated with traditional life insurance products, which would have a more negative impact on an economic and risk-based balance sheet like Taiwan-ICS. Another reason is due to the importance of matching assets and liabilities (in terms of cash flows, duration and currency) under Taiwan-ICS, which may have a more material negative impact on certain product lines. Ultimately, the move to Taiwan-ICS might affect how companies decide which product lines to prioritize.

Overall, the move to new capital regimes tends to force companies to shift their strategy toward more “economic balance sheet and RBC friendly” products, such as protection products and savings products with a lower level of guaranteed benefits or a higher proportion of nonguaranteed benefits (where the nonguaranteed benefits can be lowered upon stress to absorb losses and hence lower capital). Such directional change in product strategy is consistent with what other markets subject to an RBC framework—such as Singapore, Hong Kong, China and Malaysia—have experienced, although other considerations also need to be factored in (e.g., customer needs, distributor requirements or shareholders’ expectations).

The Importance of Managing the Increasing Capital Cost of Market Risks

Using Taiwan as an example (the same discussion would apply to markets transitioning from a Solvency I type of regime to an economic balance sheet approach), the expected required capital under the Taiwan-ICS would be more onerous than under the existing framework. For example, the required capital for domestic listed equity is 21.65% of its market value under the current basis but 35% under the Taiwan-ICS basis (35% is based on a localized parameter; prior to localization, the originally proposed stress level was 49% as Taiwan local listed equity is classified as “emerging market equity” under ICS). The equity stress also would apply to collective investment schemes or funds where a full look-through approach is not applied, and Taiwanese insurers are finding it challenging to perform timely look-throughs on their large number of investment funds.

If the increased required capital for equities is not sufficient to demonstrate how onerous capital requirements could become, let’s also look at interest rate risk. Under Taiwan-ICS, the required capital for interest rate risk will be proportional to the change in the net asset value of the company’s balance sheet under five interest rate scenarios with yield curves being stressed differently. Therefore, any existing mismatch between assets and liabilities will be directly translated into required capital for interest rate risk. In my experience, asset and liability management (ALM) has become one of the highest-priority tasks on life insurers’ agendas. However, ALM is not an easy task given various local issues, such as legacy business with high guaranteed rates; lack of availability of long-tenured fixed-income assets denominated in Taiwanese dollars; and lack of established ALM processes and tools, just to name a few.

New Metrics to Define Risk-adjusted Performance Across Different Internal Processes

Under the existing regime, all companies would have a list of key performance indicators (KPIs) within each department. These KPIs would be used to measure financial performance and form the basis for making business decisions.

From a profitability perspective, under capital regimes with no or simple risk considerations, companies tend to focus directly on return. However, under an economic capital regime, companies will need to focus more on risk-adjusted return. This means more consideration will need to be given to the additional required capital needed for any management decisions.

This concept will be translated into a new set of KPIs. For example, during the insurance product pricing stage, the pricing team will need to assess profitability based on the trade-off between the value of new business and incremental, risk-based required capital. Similarly, the investment or asset management team will need to consider new risk-adjusted KPIs when carrying out investment or ALM activities. Similar considerations would also be key when producing the business plan, reviewing the strategic asset allocation or setting the risk appetite and the subsequent risk limits.

These issues are just a few of the topics insurers in Taiwan have discussed recently in my observance, and they do not capture all the challenges each individual insurer faces. However, these issues alone are sufficient to lead to a common question: How can life insurance companies assess, manage and optimize their capital position?

“Toolbox” for Capital Management?

To discuss potential optimization strategies, let us define “optimization” as either lowering required capital or increasing available capital under an economic balance sheet. Ultimately, the objective is to increase the free surplus available to insurance company shareholders. We also will assume that such “optimization” is the sole objective of effective capital management.

For actuaries or senior insurance executives who are tasked with capital optimization, we hope for a single toolbox containing all potential approaches to capital optimization. While I would like to say it exists, that would be an overpromise, as the effectiveness of such tools ultimately depends on the exact technical specifications behind the solvency framework and the characteristics of the life insurance company.

Having worked with multiple companies in their journey toward an economic balance sheet framework, I attempt to group the solutions into a few categories. I hope that these can assist readers in constructing their own toolbox. Under an economic balance sheet framework, capital optimization could be achieved through different angles.

Financial Risk Management

As market risks are often the top contributor to a company’s required capital, multiple solutions for managing and containing such risks exist. For example:

• Reviewing the strategic asset allocation (SAA) study process to revisit the ideal SAA based on appropriate metrics that balance risks and return.
• Enhancing the ALM process to minimize mismatch for a smaller interest rate risk charge.
• Implementing or enhancing hedging programs to control market risk, especially under extreme scenarios.
• Potentially transferring risks to a third party (e.g., through reinsurance or consolidation of business).

Product Strategy

Given that there are products with lower capital consumption (e.g., protection products) and varying levels of free surplus generation (e.g., unit-linked products versus traditional products and products with high or low time value of options and guarantees), I believe it is crucial to include these dimensions in a thorough product comparison before making any product-related decisions. Actions that can be taken include reviewing the overall product strategy, incorporating pricing KPIs, reassessing the ideal product mix within a portfolio and refining the exact product design by revamping existing products or launching new products.

Reviewing Capital Structure

Available capital under an economic balance sheet framework typically is grouped into tiers based on a number of factors (loss-absorbing capacity, level of subordination, availability to absorb losses, permanence and any encumbrance or serving costs), with a limit set for how much lower-tier assets can be recognized as available capital and an exclusion for inadmissible assets that cannot be traded for cash easily. Companies should review whether the existing capital structure is efficient. Then they could maximize the amount of equity or debt instruments forming the shareholders’ equity that can be recognized as available capital. Also, such constraints will need to be considered when the company attempts to raise capital.

Other Considerations

Management actions can be utilized in most (but not all) economic capital regimes to absorb losses under stressed scenarios and reduce the level of required capital. Companies can revisit whether possible management actions (e.g., changes in nonguaranteed benefits or more advanced actions permitted in some regimes) already have been identified and properly modeled. Other detailed areas, such as dynamic policyholder behavior, also might be able to provide relief in certain cases if modeled properly.

Operational Process

Ensure that the methods and models used to produce results do not include unnecessary proxies or assumptions that could lead to more onerous results than necessary. Also, ensure that the entire process is as efficient as possible to optimize operational efficiency and reduce the use of proxies.

Conclusion

I believe effective insurance capital management is essential for ensuring policyholder security, operational resilience and sustainable growth in an increasingly complex and dynamic landscape. By understanding measurement methodologies, navigating regulatory transitions and implementing proactive optimization strategies, insurers can address the challenges and capitalize on the opportunities evolving regulatory frameworks and market conditions present.

While this article has outlined key challenges and strategies for optimization, it is essential to recognize that every challenge presents opportunities for growth. These evolving circumstances can be catalysts for refining our strategies, bolstering our risk assessment processes and stabilizing our organizations and the broader industry. While the perspectives shared here offer one interpretation of these complexities, they are not exhaustive. I believe fostering a culture of continuous dialogue, welcoming diverse viewpoints and exploring alternative strategies are steps to collectively steer our industry toward a future rich in innovation and progress.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.

Copyright © 2024 by the Society of Actuaries, Chicago, Illinois.