In this article, we will explain what management actions are. Our main focus will be the regulatory requirements of management actions and what insurance companies need to do in order to be able to subsume their future actions under Solvency II. In Part II of this series, we will describe methods for evaluating management actions with regard to the solvency capital requirement (SCR).

INTRODUCTION

The future cannot be predicted. Throughout history, no one has been able to forecast how the stock market, interest rates, foreign exchange rates, or commodity prices will develop over a longer period of time. The same goes for systemic events with major worldwide implications. However, this does not mean that financial risk originating from uncertainty cannot be managed. What in many ways sets the modern economy of today apart from historical ones, is our ability to identify and measure risk; and to act accordingly after pre-decided action plans. This article series will focus on the latter, i.e. decision rules or management actions, as in conjunction with the EU Solvency II Directive.

So what are management actions? In the insurance industry, management actions are decisions that are available to the board and the delegated authorities of an undertaking, and usually serve to manage a company’s capital more efficiently. These actions can be taken in discretion, in response to changing economic conditions. Thus, management actions are no different than any other action carried out by an undertaking’s principal decision makers.

Examples of possible management actions insurers can consider extends over a variety of different areas such as reinsurance, corporate structure, and risk management. Here, our primary focus is on the category of management actions that can be described as risk management actions. Further examples of risk management actions taken into account as management actions by insurers include (EIOPA, 2011):

  • Changes in asset allocation,

  • Changes in future bonus rates,

  • Changes in product charges or expense charges,

  • Changes in the reinsurance programme, and

  • Dynamic hedging

REQUIREMENTS UNDER SOLVENCY II

The concept of using management actions in conjunction with regulatory frameworks is not entirely a new one. Allowance for management actions has previously been made as early as of 2004 in the UK for the calculation of technical provisions, although it has become more of a hot topic since the introduction of the Solvency II directive. (Varnell et al., 2012)

Management actions can impact the Solvency II balance sheet in two areas, namely the best estimate (BE) liability element of technical provisions and the SCR. The requirements on management actions under the directive is however challenging. Many undertakings are consequently concerned to ensure that they can take full credit for their planned actions, regardless of if they have applied management actions before or not. In order for future management actions to be applicable, the undertaking needs to establish and fulfil the following criteria (EIOPA, 2014):

  • Realistic and consistent underlying assumptions, and

  • A comprehensive future management action plan

REALISM AND CONSISTENCY

In order for future management to be realistic, a comparison of future management actions with management actions previously taken is required. Any relevant deviation found from such a comparison, shall upon request be explained to the supervisory authorities. The requirement for consistency simply means that stated future management actions cannot contradict one other, and that they are aligned with current business practices and strategies. A comparison between planned future management actions and actions taken previously is also required. (EIOPA, 2014) (Lloyd’s, 2010)

MANAGEMENT ACTIONS PLAN

In addition to the requirements for realistic and consistent assumptions, an undertaking is also required to establish “a comprehensive future management actions plan” in order to set clear goals and objectives that are widely accepted within the organisation of the undertaking. This plan needs to be approved by the administrative, management or supervisory body of the insurance company and has to provide the following:

  • A record listing the identification of relevant future management actions,
  • The specific circumstances in which the identified management actions would be carried out,
  • The specific circumstances in which they would not be possible to carry out,
  • In which order the identified management actions would be carried out,
  • Specify ongoing work needed to be able to ensure that the insurer is in a position to carry out these actions,
  • Specify ongoing work needed to be able to ensure that the insurer is in a position to carry out these actions,
  • Specify how the future management actions have been reflected in the calculations for best estimate or, for an internal model, of the probability forecast, and
  • Specify descriptions for any internal reporting procedure covering future management actions

STATIC VS. DYNAMIC ACTIONS

In the past, many insurance companies’ financial and actuarial models have relied on static rules for future management actions. With increased demand for more sophisticated risk modelling, and Solvency II entering into force, realistic modelling of dynamic management are becoming more crucial to the management of insurance companies. 

One important distinction of management actions are management actions of dynamic and non-dynamic nature. Non-dynamic, i.e. static, actions are activities where future decisions will be executed in the same way regardless of actual circumstances. A decision calling for a pre-decided action without consideration of future conditions would be considered as static. E.g., an action defined as “when assets are required to be sold, sell all possessions proportionately regardless of future conditions” does not qualify as a dynamic management action. The strategy’s outcome is here already known from the outset. (Milliman, 2012) In contrast, an action based on constant re-balancing of the assets in order to target a pre decided asset allocation level is a decision depending on future circumstances and thus a dynamic one.

Single period models such as the standard formula for calculating SCR, is designed to capture risk at a time horizon of a fixed time period, e.g. one year. They assume that scenario stresses are performed instantaneously. As a result, the standard formula for calculating SCR do not naturally extend to include dynamic management actions over the one year horizon. (Moody’s Analytics, 2015) Dynamic management actions aimed at reducing the SCR of an undertaking do therefore in practice require a partial or full internal model.

SUMMARY

In this article we have given a brief introduction to the meaning of management actions from the perspective of an insurance company. We have also cited and explained the requirements an undertaking need to fulfil under the Solvency II regulation framework, discussed the difference between static and dynamic management actions, and explained that dynamic actions require a partial or full internal models for SCR calculations. In the next article of this series, we will focus on methods for evaluating management actions within an internal model under Solvency II.

REFERENCES

EIOPA. 2011, March 14. Report on the fifth Quantitative Impact Study (QIS5) for Solvency II. Accessed: 2015-10-12.

EIOPA. 2014, October 10. Commision Delegated Regulation (EU) 2015/35. Article 23 and Article 236. Accessed: 2015-09-17.

Lloyd’s. 2010, March. Solvency II - Technical Provisions under Solvency II Detailed Guidance. Accessed: 2015-09-16.

Milliman. 2012, July. Dynamic management actions. Accessed: 2015-10-02.

Moody’s Analytics. 2015, January. Quantifying the effect of dynamic hedging on 1-year VaR capital. Accessed: 2015-10-02.

Varnell, E., Kent, J., Ward, R., & Gilchrist, A. 2012. Insurers face challanges on management actions. Accessed: 2015-09-16.