03 September 2012

Risk.net: Liability insurers need to embrace life ALM techniques

When it comes to asset-liability management, general insurers face less of a challenge than their life counterparts given the considerably shorter duration of their liabilities. Yet, the growth of periodical payment orders in personal injury cases is requiring them to think more like life companies when it comes to ALM.

The challenge for insurers is that PPOs – a series of index-linked annual payments awarded instead of a single lump sum in settlement of large personal injury claims – can give rise to liabilities lasting 60 years or more – a far cry from the more typical three-to-five year duration of general insurance liabilities. As a result, these orders present insurers with new risk-management challenges. One example is in respect of inflation. PPOs are not linked to RPI but to a different index for which there are no direct hedging instruments. There is also insufficient life expectancy data on PPO recipients, which makes managing the longevity risk more difficult.

The number of PPOs made has been rising year-on-year since their introduction in 2005. Insurers such as Zurich and Chartis are starting to explore the best ways to manage their PPO liabilities. Risk management practices in this area are still evolving, as each insurer’s exposure to PPOs is still small. But if the number of awards continues to increase as expected, insurers will need to become more sophisticated in how they manage these long-term liabilities.

Turning to a different ALM challenge, the implications of the proposed method for determining the risk-free yield curve under Solvency II continues to be analysed. The proposals being debated by European policy-makers, whereby the risk-free curve is extrapolated from a last liquid point set at 20 years to an ultimate forward rate, is expected to present significant ALM challenges for insurers, dramatically changing the interest-rate sensitivity of their liabilities and their hedging needs.

One perceived problem with the proposed extrapolation method is that the convergence algorithm relies too heavily on a single point on the forward curve, leading to market distortion and hedges that are too far removed from their underlying economic counterparts. This problem could be addressed by a minor revision of the algorithm, which enables market data to be used beyond the last liquid point.

The latest piece in the industry’s lobbying efforts on the matching adjustment for discounting long-term liabilities comes in the form of a paper by consultancy Towers Watson. The consultancy argues that European policy-makers should adopt a more liberal approach to the application of the matching adjustment. The paper’s analysis has been welcomed by the insurance industry. With negotiations on Omnibus II and the matching adjustment scheduled to take place from September 18, it remains to be seen how policy-makers respond.

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