Reforms to Bermuda’s Scenario Based Approach

On 24 February 2023, the Bermuda Monetary Authority (BMA) released a consultation paper detailing proposed reforms to the Scenario Based Approach (SBA)1 and recommending additional enhancements to the current regulatory framework. This article delves into the intricate challenges life (re)insurers face when using the SBA and elucidates the BMA’s latest proposals.

Asset Eligibility

The paper clarifies that eligible assets encompass investment-grade bonds, mortgage-backed securities, and other debt instruments that yield stable and predictable cashflows. Assets with features like prepayments for mortgage-backed securities or call options for bonds are deemed ineligible unless these characteristics can be prudently accounted for. All such features must be transparently modelled to fit the BMA’s benchmarking process, necessitating enhanced disclosure.

Furthermore, the BMA stresses that assets typically viewed as unsellable, such as sub-investment grade assets or commercial real estate, should not be assumed as sellable within the SBA. Insurers must adeptly manage their portfolios to avoid potential sales of these assets. Should a pressing need to liquidate such an asset arise, it ought to be replaced with an eligible one.

Reinvestment and Disinvestment Strategies

Within the SBA framework, asset cashflows are compared against liability cashflows for every projection year and across all scenarios. If asset cashflows fall short of liability cashflows, assets are presumed to be sold to bridge the gap. Conversely, when asset cashflows exceed liability cashflows, additional assets are presumed to be purchased, in line with the firm’s investment policies. Ultimately, SBA projections should end with a balance of zero assets and liabilities.

The consultation emphasises that assumptions concerning asset purchases must mirror the insurer’s current asset allocation, along with its Asset Liability Management (ALM) and investment policy. Moreover, assets earmarked for potential purchases should already be part of the insurer’s approved SBA portfolio.

Disinvestment assumptions primarily focus on selling assets to address cashflow deficits. The SBA prohibits rolling negative cashflows into subsequent periods. Furthermore, illiquid assets must not be presumed as sellable. Instituting a comprehensive disinvestment strategy, which considers factors such as asset sale sequence and currency denomination, is crucial.

Default and Downgrade Costs

The BMA intends to standardise the computation of ‘default and downgrade costs’ in the SBA. These costs will be manifested as negative adjustments to the investment spread. The BMA plans to publish the default and downgrade costs for specific asset classes while delineating guidelines for others requiring approval. For assets outside the BMA’s designated list, the Authority’s approach should serve as a baseline, albeit with necessary adaptations. In cases where assets have limited default data, a conservative approach must be adopted, ensuring that the SBA default projections are more stringent than those for analogous assets with the same credit rating. A minimum uncertainty adjustment set at 1.5 standard deviations from base default costs is proposed.

Finally, the insurer’s chief actuary and chief investment officer must attest to the appropriateness of these default assumptions, ensuring they adhere to regulatory guidelines.

Enhanced Liquidity Requirements

Prioritising liquidity enhancement is evident on BMA’s agenda. Insurers must understand the intricacies of cashflow requirements and establish a board-approved liquidity risk appetite, influenced by liquidity stress and scenario testing. Maintaining a cash ledger that systematically logs liquidity needs and potential pitfalls is indispensable. Insurers will be mandated to establish a liquidity buffer, made up of highly liquid assets, to meet potential cashflow shortfalls.

Lapse Risk and its Implications

Concerning lapse risk, the proposal suggests an adjustment to the base lapse assumption for Best Estimate Liability (BEL) computations under the binding scenario. This involves adjusting the base lapse assumptions either upwards or downwards, capped at a single standard deviation range. Furthermore, insurers are compelled to demonstrate that residual risks associated with any policyholder options are immaterial. To substantiate this, the proposal demands stress tests and also allows for insurer-specific lapse stress tests, but these are contingent upon BMA’s approval.

These evaluations are designed to measure an insurer’s liquidity resilience during stress, underlining that surplus cash outflows must be managed using High-Quality Liquid Assets (HQLA). Post-evaluation, insurers are mandated to hold sufficient assets to cover all policyholder liabilities and comply with liquidity standards.

Conclusion

The BMA’s proposed reforms spotlight intricacies of asset and liability management (ALM) within the SBA framework. Through this consultation paper, the BMA provides clear guidance on these challenges, specifically in relation to asset eligibility, liquidity risk management, and lapse risks. The anticipated reforms will compel insurers to adapt and reassess their strategies to ensure both compliance and resilience. Crucially, the cascading implications of investment decisions highlight the importance of skilfully constructing optimal portfolios.

Further reading from the Bermuda Monetary Authority:

Proposed Enhancements to the Regulatory Regime and Fees for Commercial Insurers

Guidance Notes for Commercial Insurers and Insurance Groups’ Statutory Reporting Regime