Designing a business risk model

Designing a business risk model

The economic upheaval and volatile financial markets amid the Covid-19 pandemic have proved challenging for insurers.

At the same time, the decrease in swap yields will have increased the value of their liabilities on their Solvency II balance sheets.

However, we do not believe all is grim for insurers.

Instead, it is worth focusing on certain high-level considerations in relation to the development of stress and scenario testing for multi-asset insurance investment portfolios.

Immediate impact of Covid-19

The global pandemic and its immediate impact on the drawdown in equity prices (and now subsequent partial retracing) and widening credit spreads had adversely affected investment performance over the first five months of 2020.

However, significantly lower interest rates and higher volatility associated with equities and credit spreads have, together, reduced expectations for forward-looking returns and increased the risk around them for the short to medium term.

Does this imply that we should increase the time devoted to global pandemics? I think not.

There is a common behavioural bias encountered in investing – the so-called recency bias.

Key points

  • The current situation has been challenging for insurers
  • Recency bias is a common behavioural bias in investing
  • Some are concerned about credit-related events

This describes our tendency to focus on events that have recently occurred in lieu of more distant experiences and use the recent events to predict and prepare for the future. 

While it is true that the global economic slowdown and potential recessions in various parts of the world are a direct result of the Covid-19 pandemic, it may not be the case that the event we should be modelling and considering is the same one that is occurring now.

Lightning does not strike in the same place twice – or so we are told. We noted that after the 2008 global financial crisis there was a reactionary focus on credit risk and systemic financial risk.

It was a natural response to the crisis of 2008. Generally, we need to think in broader terms to prepare for and increase our knowledge around potential future outcomes.

What could be coming next?

There is growing concern that the events that should be most under consideration are credit-related events that are currently partially hidden under the cover of the overwhelming central bank intervention that has placed a cap on credit spreads.

One of a number of possible medium-term events playing out over the next several months and into next year could be related to a deterioration of performance of credit and its implication on sovereign debt, municipal bonds, corporate debt and structured credit. 

The Prudential Regulation Authority’s supervisory statement on the prudent person principle, issued in May 2020, explicitly states the expectations from the PRA on companies to “pay particular attention to the measurement and control of credit spread and default risk, including credit transition downgrade/upgrade risk”.

Market commentary

We have begun to see some of the fault lines in the credit space. In emerging market debt, the spotlight is on Argentina, where a technical default has recently occurred. This is after Argentina issued a 100-year bond only three years ago.