In December 2021, S&P Global Ratings released a request for comment on proposed changes to its methodology for assessing insurer capital adequacy. The proposed changes included a variety of technical adjustments to the calculation of both total adjusted capital (TAC) and the risk-based capital requirement.
Reactions from stakeholders quickly converged on a specific element of the proposal that would have penalized investment holdings rated by S&P’s competitors. Faced with concerns from industry groups and a warning from the U.S. Department of Justice, S&P withdrew this element of the proposal in May 2022 and announced plans to update the proposal later in the year.
Amid this controversy, it would be easy to overlook other significant elements of the proposal that have not received the same degree of criticism and are likely to reappear in the updated proposal. Of particular note is the potential inclusion of 100% credit for the value of in-force (VIF) business, which would increase TAC (partially offset by the inclusion of a corresponding risk charge) and improve the capital adequacy ratio. Insurers who calculate VIF already benefit from improved insights into managing their business. Assuming this component is adopted, those same insurers will gain an additional advantage in their S&P rating.
The VIF business represents the present value of expected future earnings from existing business, with adjustments for the cost of holding capital and the value of any options and guarantees embedded in the policies. Various principles have been established within the insurance industry to formalize the VIF framework; however, these principles incorporate a certain degree of flexibility, and insurers that implement VIF must make some key decisions, including what discount rate to use, what measure to use for target capital and how to allocate expenses.
Life insurers use VIF — along with its counterpart, value of new business (VNB) — as a consistent measure for assessing performance across diverse lines of business. Unlike traditional statutory and generally accepted accounting principles (or GAAP) measures, VIF provides an economic view of value, not distorted by conservative assumptions or smoothing impacts from past actions. Typical applications include:
Calculating and reporting VIF on a regular basis produces strategic insights in a number of key areas. In addition, the S&P proposal raises the possibility that VIF could improve an insurer’s capital adequacy ratio and the associated rating.
Companies that already calculate VIF should ensure they have a robust system of governance and controls, including external review.
Companies that are not yet calculating VIF should establish a road map and begin making decisions on the methodology and assumptions. Engaging financial modeling and reporting teams early in this conversation can help ensure existing processes are leveraged for greater efficiency
Mark is a Senior Director in the Insurance Consulting and Technology business. He has over 15 years of experience working with U.S. domestic and international insurers on topics that include capital modeling, risk management, financial modeling and reporting, and M&A.
