In a thought-provoking dialogue, Nassim Taleb critiques VaR and highlights the dangers of portfolio insurance and dynamic hedging strategies. Here are key arguments from his 1997 forceful response to Philippe Jorion’s support for VaR.

Misplaced Precision and Concrete Metrics

Taleb warns that the unique precision of VaR creates a false sense of certainty. He describes this as a form of “misplaced concreteness,” where risk managers mistakenly believe they have a comprehensive understanding of potential losses based solely on point estimates. This can lead to dangerous oversimplifications in risk assessment, potentially masking the underlying complexities of market behavior.

The Risks of Portfolio Insurance

Dynamic hedging, often employed in portfolio insurance, is particularly perilous. Taleb argues that these strategies can exacerbate market downturns, relying on flawed statistical models that underestimate tail risks. When events occur that fall outside expected parameters, the repercussions can be catastrophic, as seen in past financial crises where such strategies failed to provide the intended safety net.

Standard Error vs. Point Estimates

A critical issue Taleb raises is the phenomenon where the standard error of a risk estimate can exceed the estimate itself. This stark mismatch reveals the inherent dangers of relying on these calculations. The history of financial crises shows that bizarrely improbable events—deemed unlikely by VaR—frequently materialize, often with devastating consequences that could have been better anticipated with a more qualitative understanding of risk.

Forecasting Volatility

Taleb emphasizes that accurately forecasting volatility is exceptionally challenging. The reliance on historical data and models leads to a blind spot regarding unpredictable market dynamics. This difficulty only compounds the risks associated with tools like VaR and portfolio insurance, which may provide a false sense of security in the face of uncertainty.

The Illusion of Credibility

Moreover, the widespread adoption of VaR among financial institutions is not a measure of scientific credibility. Instead, it often reflects a collective oversight of significant risks, leading to disastrous outcomes. Financial institutions may become overly reliant on VaR, neglecting other qualitative assessments of risk that could better inform their strategies.

While we are all familiar with George Box’s quote, “All models are wrong, but some are useful,” Taleb’s perspective might be paraphrased more pessimistically: “All models are wrong, and most are downright dangerous.” This insight serves as a crucial reminder that while models can aid in decision-making, they are not infallible and should not be the sole basis for risk management.

Conclusion

For 2025, let’s all recognise the limitations of our tools and the potential pitfalls of over-reliance on quantitative metrics. By fostering a deeper understanding of risk through both quantitative and qualitative lenses, we can better prepare for the unpredictable nature of financial markets.

🔗 Explore the full discussion for deeper insights: Nassim Taleb Replies to Philippe Jorion, 1997

Understanding the Basics: Banks vs Insurers

The classic banking model of liquidity risk is straightforward: banks transform short-term deposits into long-term loans. This maturity transformation creates inherent liquidity risk – even a perfectly solvent bank can face a crisis if too many depositors demand their money simultaneously. This fundamental risk drives the existence of central banks as lenders of last resort.

Insurance traditionally operated differently. With predictable claims patterns, regular premium income and unoptimised balance sheets, insurers weren’t thought to face significant liquidity risks. However, modern insurance practices and product designs have created more complex liquidity dynamics that challenge traditional frameworks. These liquidity-risk-increasing practices include some risk management choices (hedging and use of derivatives) and balance sheet sweating.

Sources of Liquidity Risk for Insurers

Insurance companies face several distinct sources of liquidity risk, some traditional and others emerging from modern practices:

Derivatives and Modern Asset Management

Modern investment strategies create significant liquidity demands:

• Use of illiquid assets through debt origination, greater use of corporate paper in general to provide higher yields for annuities and guaranteed/fixed bond products, private equity and other alternatives seeking additional yield
• Variation margin calls on derivatives require immediate cash as markets move
• Derivative roll risk creates periodic liquidity needs
• Rolling medium term corporate paper maturities into new instruments has elements of liquidity risk as part of the broader roll-risk universe
• Repo arrangements require careful liquidity management
• Hedging programs, while reducing other risks, increase liquidity demands

Policy Surrenders and Lapses

The liquidity impact of surrenders and lapses varies significantly by product type:

• Savings policies backed by liquid assets present limited liquidity risk
• Corporate policies often include liquidation notice periods
• Market value adjustments can share losses with policyholders
• Risk policies with negative liabilities create complex dynamics – while lapse might improve solvency ratios, the loss of positive cash flows can create future liquidity strains
• Loss of shareholder value is still likely the major risk for lapses and surrenders – and as a result it usually gets plenty of attention without the liquidity risk lens.

Internal Hedging and Optimisation

Insurance liquidity isn’t just about having assets to meet claims. Insurers often use positive cash flows from some policies (particularly risk policies with negative liabilities) to fund claims on other, especially older or maturing policies. This practice, while potentially efficient in normal times, creates hidden liquidity risks.

If these positive cash flows diminish (through lapses or reduced new business), the liquidity characteristics of the underlying assets become crucial. An insurer might appear to have strong liquidity based on expected premium inflows, but this can quickly change if those inflows reduce or stop.

Further, using negative liabilities (from profitable, early duration risk policies) to match positive ones (e.g., guaranteed savings products) creates hidden liquidity risk. This practice is another example of the “improvement” of an old, “lazy” matching approach that missed this opportunity for internal hedging, but perhaps reduces implicit buffers we may have come to rely on.

Claims Concentration

Sudden spikes in claims can create liquidity pressure:

• Natural catastrophes affecting property insurance
• Pandemic-related death claims
• Industrial accident clusters
• Legal or regulatory changes triggering multiple claims

Throughout these claim concentration risks, the performance of reinsurance and cash timing is also critical.

Premium Collection Disruption

Disruption to premium income can occur through:

• Economic downturns affecting customer ability to pay
• Operational disruptions to collection processes (South Africa experienced this a few years ago with the failure of a notable, concentrated exposure to a single premium collector)

Investment Portfolio Liquidity

Asset liquidity can become constrained through:

• Property/Real Estate holdings requiring time to sell
• Private equity/debt with limited secondary markets
• Complex structured products becoming illiquid in stress scenarios
• Market-wide liquidity stress affecting even traditionally liquid assets
• Money market fund holdings proving less liquid than assumed when stressed

Regulatory plans for improved liquidity risk management and reporting for insurers

Regulators are understandably keen to get a better handle on liquidity risk within the insurance sector – and are keen for insurers to take liquidity risk more seriously. Existing measures are widely considered imperfect (at best).

While we don’t want perfect to be the enemy of the good, there seems to be an opportunity to aim for better than current proposals.

The High-Quality Liquid Assets (HQLA) Paradox

A crucial distinction between banks and insurers lies in their access to central bank facilities. Banks can convert HQLA to cash via central bank discount windows, making these assets effectively cash equivalents. Insurers, lacking this access, face a different reality: even “highly liquid” assets can become illiquid during market stress. Insurers and other non-bank financial institutions may want access to the discount window, but my understanding is that this idea is a non-starter.

This creates an interesting regulatory paradox. Bank-style liquidity reporting, with its focus on monthly reporting, micro bucketing of asset maturities, but with implicit and assumptions about central bank access, may be suboptimal for insurers. Yet some regulatory frameworks still look to apply bank-centric thinking to insurer liquidity management.

Systemic Risk and Money Market Funds

A particular concern arises with money market funds, often assumed to be perfectly liquid. While an individual investor can usually liquidate their money market holdings easily, this isn’t true for the market as a whole. If the underlying instruments become illiquid, large-scale redemptions become impossible.

This creates a systemic risk: the appearance of liquidity in normal times masks the potential for market-wide liquidity crises. When multiple institutions rely on the same sources of apparent liquidity, the system becomes more fragile.

Testing Liquidity – Easier Said Than Done

Testing the ability to liquidate assets remains challenging. Current approaches to estimating liquidation costs are still maturing in many markets. Desktop exercises and historical analysis of liquidity crunches provide insights but have limitations.

Testing available liquidity by transacting in large volumes under normal conditions is expensive and, more importantly, tells us little about the ability to transact in disrupted markets. Tests of notional volumes may generate a false sense of security rather than inform real liquidation measures.

The true test of liquidity often only comes during stress events – precisely when you most need it to work.

When “Liquidity” Masks Solvency Issues

Some apparent liquidity crises are actually solvency issues in disguise. A prime example is minimum surrender guarantees in a rising rate environment. When interest rates rise significantly, policies with guaranteed surrender values can become deeply unprofitable. Each surrender crystallizes a real economic loss – no amount of liquidity support solves this underlying problem.

Policyholders can withdrawn their funds, benefit from the rising interest rate environment and re-invest in a new policy or other structure taking advantage of higher interest rates. It should be no surprise that this is the result of the dangerous combination of higher interest rates and guaranteed surrender values. (There are ways, complex, expensive ways, to manage this risk, but that first requires an appreciation of the risk. This requires at least adequate liability measurement, robust scenario testing that doesn’t assume prior low volatility periods will continue, and consideration of dynamic policyholder behaviour.)

Is this a liquidity risk? Firstly it is a solvency risk. Th value of “matching” assets has declined while the value of liabilities has not. A liquidity risk is only a liquidity risk if the provision of liquidity solves the problem.

When measuring liabilities and therefore solvency, it seems dangerous to rely on assumed policyholder irrationality (expecting them not to surrender when it’s clearly in their financial interest to do so) to support solvency calculations. Good risk management and appropriate liability measurement must recognize that policyholders will likely act in their financial interests, especially when the benefits of doing so become obvious.

Now there may also be a liquidity risk. If surrenders require liquidation of illiquid assets that may further depress asset prices, increasing yields and/or spreads. Resultant concerns around insurer solvency can also lead to a run on the insurer. It’s a mistake to think of all of this as a liquidity risk.

Implications for Risk Management

Liquidity risk is real, and may still be underestimated by many insurers. Insurers should be carefully evaluating their risk management systems for adequate coverage of liquidity risk.

These complexities demand sophisticated risk management approaches:

• Regular stress testing must consider both solvency and liquidity impacts
• These stress tests must be severe enough and must consider interactions
• Liability measurement needs to incorporate realistic policyholder behavior assumptions
• Investment strategies must balance efficiency with liquidity needs
• Liquidity buffers should consider both immediate and slow-burn scenarios
• Risk frameworks must recognize the limitations of market liquidity assumptions
• Consider when your sources of liquidity (money market fund contractual promises) may necessarily fail in systemic liquidity challenges

Even for a leanly capitalised (re)insurer (SCR cover 1.2x) this implies a CQS of 8, better than the largest, most conservatively capitalised insurers in South Africa.

No externally rated insurer or reinsurer in South Africa has a CQS of better than 11 or 12. The table in 10.9 ignores sovereign or country risk in the default risk assessment. Therefore, it significantly understates spread and default risk.

The question here is not whether there is an absolute sovereign cap that no South African entity can be rated above. The issue is that applying this table almost certainly understates the risk and CQS relative to rated entities because it ignores sovereign risk.

In terms of the sovereign cap, the risk of exposure to South Africa is (and should be) factored into the rating for entities with significant exposure (asset, operations, profit sources, regulatory risk, inflation, appropriation et al) in South Africa. This usually results in predominantly South African businesses not having a credit rating better than the sovereign.

There is more to reinsurance optimisation that interpreting the FSIs. The application of the sovereign cap is also mostly a distraction from the choices of reinsurer and reinsurance programme to manage risk and capital.

#capitalmanagement #reinsurance #CQS #optimisation #sovereigncap #creditrisk

Suggestion – Introduce the equivalent of the UK’s Skilled Person Review

We must find ways to intervene with struggling insurers well before it’s time for a statutory manager or curator. Curators and statutory managers are expensive, invasive, and disruptive – and because of this, implemented as a last resort, meaning the prognosis is usually poor.

The UK’s FCA and PRA have the power to ask for a “Skilled Person Review† often termed a Section 166 review after the section of the Financial Services and Markets Act it falls under.

A skilled person review can entail a variety of roles, including assessing a firm’s governance, risk management, systems, controls, and compliance with regulatory requirements. The skilled person may also recommend remedial actions and provide oversight during their implementation.

These reviews might be triggered by a low or declining solvency level, a question around governance, risk and compliance practices, concerns over product designs and the treatment of customers, or questions related to regulatory compliance in any area.

Early intervention through a skilled person review can help identify and address potential issues in a struggling insurer. This proactive approach can prevent larger problems from arising and potentially avoid the need for more invasive and expensive measures such as placing the insurer into curatorship.

A Skilled Person Review will involve an independent third party with the appropriate skills to perform the review. The review itself could take several weeks or months, with the scope defined by the specific need.

However, insurers might request similar reviews for their internal purposes if the management team or Board have concerns in a particular area.

Benefits for the insurer include:

• Identifying and addressing weaknesses in risk management, governance, and controls.
• Reducing the likelihood of regulatory action due to non-compliance.
• Improving the insurer’s reputation and relationship with regulators.
• Gaining independent insights and recommendations for business improvements.

In South Africa, our regulator doesn’t have the same specific tool in current legislation. There is arguably enough general “investigations† scope in the Financial Sector Regulation Act or the Insurance Act to implement this. The clarity provided by the Section 166 review scope and format, and history of application in the UK provides regulatory certainty for everyone. It also means this regulatory action is less likely to be opposed by insurers.

Earlier investigations that get to the bottom of issues quickly, or allay concerns, may have a role in improving outcomes for policyholders and shareholders alike

With a hefty additional dose of approximations, I get about the same figure all the way back to 1998.

This amounts to an insurer failing every other year.

The primary causes? In every case it’s more than one thing. Here are some of the recent common causes – I’ll expand on each of these in a series of posts.

1 Underwriting risk and pricing

Mispricing, particularly when moving into new markets or new lines of business is a common starting point.

Funeral insurers feeling competitive pressures are looking for new markets – typically semi-underwritten life products, misguided savings products, niche legal expense cover products, or further afield into non-life proper. Here be dragons.

For all the benefit of diversification from a statistical perspective, the research says that focussed insurers fail less often.

Climate change is going to break underwriting and pricing models, meaning that even previously well understood risks increase the chance of failure.

Non-life insurers need to get claims inflation under control – or at least continue the unpopular premium and excess increases to restore sustainability to premium rates.

2 Cost of customer acquisition outstripping funding and VNB

Rapid growth may be many insurers’ dreams.

However, too rapid growth can strain capital adequacy. Rapid growth can also be a telltale sign of under-pricing, leading to large volumes of unprofitable business. Selling many policies that don’t cover their acquisition expenses is a short cut to real trouble.

A worrying sign here is the reduction in VNB margins across broad sectors of the underwritten life insurance space. This ramps up pressures to dilute new business metrics, which is a terrible idea.

3 Misuse, and misrepresentation of (financial) reinsurance

Reinsurance is a fundamentally important tool to manage risk, manage capital requirements, gain expertise in a new market, and to provide liquidity.

Reinsurance, especially financial reinsurance when misused, can obscure the deteriorating solvency position of an insurer and lead to a false sense of security for risk managers, NEDs, and regulators.

The principles on how to treat financial reinsurance and contingent commissions are about right – but the detailed rules and the rigour and honesty with which those principles are implemented sometimes are not.

The overall lesson is – the improvement in your solvency should reflect the actual risk transferred and economics of the transaction.

The most egregious error is claiming that a FinRe deal has resulted in an increase in assets without an increase in liabilities. Tricks of claiming that repayment of the commission (a loan) is contingent on future profits and therefore isn’t a liability are invalid. Games with contract boundaries include recognising the upfront commission (which is to be repaid over many years of renewing contracts), but not recognising years of future reinsurance premiums because the in-force policies have annual contract boundaries.

On contingent commissions, the key question to ask is “has my SCR gone down by more than the risk transferred?”. If one reinsures 70% of the portfolio using QS, but 90% of that risk comes back through contingent commission, then applying the FSIs blindly can result in a 10x overstatement of the benefit of reinsurance. You have shared 7% of the risk, not 70%.

My rule of thumb is not to take advice on the regulatory, solvency, or accounting treatment of the reinsurance from the one selling you the reinsurance.

4 Complex, incestuous asset transactions, and poorly controlled ALM

Aggressive asset valuations, typically of unlisted, illiquid investment that have some related party in the mix, are one of the clearest red flags for an insurer about to fail.  There is always the next Warren Buffet wanting to “invest the float† and make money in some undeveloped property, associated business, or beautiful basket of tulips.

Careful ALM is critical for long-tailed policies. There it needs to be managed carefully and regularly. Monitoring isn’t enough – there needs to be a mechanism to change the portfolio when mismatch parameters breach thresholds.

For other portfolios, sometimes a simpler portfolio that introduces less complexity, fewer tax risks, less operational and liquidity risks, is better than a supposedly more ALM-tuned portfolio that actually increases risks of catastrophic failure.

Asset concentration has been a primary cause of at least one major South African insurance failure before too. Although, as always, this wasn’t the single cause.

5 Taking large (binary) risks when already in trouble

As solvency positions decline, some CEOs, seeing the writing on the wall, choose to take significant risks that will either solve their solvency problem, or increase the impact of insolvency to policyholders.

Something as simple as continuing to write business, especially long-term business, when the solvency capital isn’t available to support this business places existing and new policyholders under additional risk.

Pinning hopes (and management bandwidth) on big-bang investment deals without addressing underlying operational concerns usually don’t pay off.

6 Failed corporate governance

Corporate governance failures are usually the second or third thing to go wrong. Poor internal controls, ineffective or insufficiently independent risk and compliance teams, and outright financial statement fraud mean that serious problems are overlooked, sometimes for years.

Fraud is more often a response to problems (especially where management believes they are in the right and it’s just a matter of time before markets/the cycle/business turns). In select cases, insurers are used as vehicles to instigate fraud as first step

Some boards and shareholders deprioritise good governance. When times are good it’s easy to emphasise good governance. What about when governance gets in the way of decisions executives want to make? Or when it raises awkward questions about pet projects? Or where the business is struggling but management is confident they can trade out of the difficulty as long as they are given the space and time?

It’s easy to do the right thing when it doesn’t come with costs.

7 Slow regulatory intervention

Too often, regulatory intervention is too slow and not targeted at the underlying causes. It’s hard to blame the regulator entirely, given the massive opposition to statutory managers and curatorships.

There are many amazing, skilled, and experienced individuals at our regulator. Are there enough? Is the quality and approach consistent? Are they hamstrung by insurers under resourcing their own control functions and lines of defence?

Can anything be done to decrease failure rates?

Having a strong, experienced, and independent actuary who pays close attention to the regulations and guidance is crucial. Your head of actuarial function should provide good advice on business issues. They should also occasionally constrain your options and make you rethink your positions.

A solid, experienced, and independent Head of Actuarial Function goes a long way.

Appropriate risk management and governance practices are defined in multiple different places, and they can all work well enough if followed diligently. Making sure the teams are experienced and skilled and empowered to tell truth to power is rather more difficult.

That’s the ballpark figure I usually work with as the minimum number of micro insurance policies required for scale. The expenses of running even a micro insurer are not that trivial.

For underwritten products within a full life licence? Larger premiums per policy but definitely more complexity. Competition is tougher too. Hyper local brands don’t translate into trust at this level. Viable niches may exist, but at what volumes?

You might wonder if there is scope to sell greater value products at higher premiums that can bring that number down in some contexts?

The rise of embedded insurance

Turns out this has been given plenty of thought already – “micro” insurance is the less popular name these days from a product and provider perspective. Inclusive Insurance certainly sounds better and more inclusive (!)

I think part of that push though was recognising the challenges and limits of truly “micro” insurance, at least at an individual level in providing commercially viable options that meet needs at the scale necessary.

Inclusive Insurance has been eclipsed in some words for “embedded insurance”, a term that talks less to the needs and objectives for society, and more to one that is practical and viable commercially. Embedding insurance in other products are services can drive down some of the costs, but then by virtue of being embedded, the absolute amount of premium is even further limited. Volumes may go up – and there have been some success stories here – but margins typically remain fine so I’m going to guess that my 40,000 may be too low in these instances. The success stories are in the 6- and 7-digit volume space.

Microinsurance licence restrictions

Back to “microinsurance” and the regulatory restrictions that apply in South Africa:

• Savings elements might seem attractive to increase premium size and provide “value” rather than a set price point. But savings elements are not permitted in microinsurance policies in South Africa.
• Loyalty schemes or cash back may be a way to attach greater value to a product, but again are not permitted in the microinsurance framework.
• Fairly large sums assured are possible within microinsurance – often attracting increased adverse selection or outright fraud.

Can product tailoring increase average premium?

Product tailoring can be expensive and can counter plans for
economies of scale while simultaneously targeting a smaller market. I’d still like to see more of this rather than pure commodity products. I’d be happy to be wrong if this approach meant a viable micro insurer could provide genuine value, see strong demand, and require fewer than 40,000 policyholders or comfortably sell more than that.

Microinsurance pros and cons – an important choice

A key point here is whether a standalone microinsurer is the right vehicle for a truly niche insurer? The increased governance and compliance policies effected by the major cell providers have frustrated cell owners and entrepreneurs, slowed down innovation and led them to look elsewhere. A microinsurance licence is a great option for some, but not a panacea for everyone.

I’ve helped insurers apply for licences, buy licences, consider alternative arrangements, and I’m sure at some point I’ll be working with micro insurers to transfers portfolios to other insurers and close down licences.

There is also opportunity to apply to the Prudential Authority for scope to do more with the licence, with careful consideration of the risks and capital.

Does digital fix everything?

Digital sales is a complex area. Some insurers have had some success with purely digital sales. But when these distribution channels are owned by someone else, the costs are not as low as “digital† might make you think. If NTUs are high, and premium collections are low, it can quickly become expensive. There’s a fine line between removing friction from a sales and underwriting process (which definitely improves sales) and making it so easy to “sell† that the customers haven’t really decided that they want what they’ve bought.

Parametric insurance – watch this space!

We should be doing far more with parametric insurance in South Africa. Thinking around climate risk and the positive role insurers can provide in this space (rather than only worrying about the risks it poses to them) may present some new opportunities. Insurers can apply their expertise in understanding and pricing risk, while providing a socially and economically beneficial product at a price that shows value and profit.

Insurers, unlikely retirement funds, have to hold risk-based capital against the risks inherent in their investments. This makes it more difficult to underestimate the risks and services as a deterrent to large allocations.

Infrastructure assets can play a part in linked funds for life insurers, where the investment risk is passed straight back to the policyholders and no market risk capital is held by the insurer.

Under this policy construction, the risks can be similar to a defined benefit retirement fund. These include the practical challenges of pricing and valuation, and conduct and fairness issues of managing investment and divestment prices, liquidity with large withdrawals and transparency of pricing.

These liquidity constraints also make this a poor investment for non-life insurers or smaller life insurers, especially where they primarily write risk business.

Where are alternative assets used in insurance?

The three areas where infrastructure assets have a meaningful place to play in insurance are:

1. As a part of a portfolio of assets for long-dated, predictable and illiquid annuity liabilities.

2. Part of a with-profits portfolio, whether this is accumulation phase or with profit annuities in payment.

3. Part of large, well-capitalised insurer’s shareholder portfolio, subject to risk appetite constraints.

How are infrastructure assets treated for insurers for regulatory purposes

In 2014, EIOPA started to consider whether the Solvency II regulations would discourage insurers to invest in infrastructure assets. It was carefully phrased as “removing disincentives† but the line between that and deliberate incentives for insurers to invest in infrastructure assets is invisible.

Right towards the end of the development of South Africa’s Solvency Assessment and Management (SAM) regulatory overhaul, Task Groups of the SAM project were asked whether any adjustments were recommended.

Technical Provisions adjustments for infrastructure assets

The answer from the Technical Provisions Task Group was “no†. Technical Provisions were intended to be market consistent and, with possible exceptions for illiquidity premium / matching adjustments (already a part of the regulations) returns on assets should not, in general, affect the measurement of liabilities.

The illiquidity premium is still very much relevant. Up to 50bps can be added to the risk-free yield curve for discounting life annuity cash flows, provided the backing assets are a good cash flow match and are managed separately from the rest of the portfolio. The illiquidity premium is calculated as 50% of the spread achieved on the matching assets.

In South Africa, most of the available corporate paper available to generate spreads has a term of five years or less. This greatly reduces the effective average spread that can be applied. Longer-term (20 or 40 year) infrastructure debt-based investments are very welcome in this scenario.

This allowance is not specific to infrastructure assets, but is important as part of the overall capital assessment of infrastructure assets.

It’s worth mentioning that the European Solvency II “matching adjustment† is far more generous. I regularly experience actuaries or consultants from the UK talking up great plans for assets in a SAM environment, assuming that the rules are the same in South Africa as they are across Europe.

(The volatility adjustment in theory also has a place in this discussion, but that’s a bigger topic and typically a smaller impact in any case.)

Solvency Capital Requirement (SCR) adjustment for infrastructure assets

The Capital Requirements Task Group followed the European lead and allowed reductions in the equity shock and spread shock that would be applied to qualifying, high quality, infrastructure investments.

• 33% shock for equity (which is 77% of the “SA equity† shock, or about 70% of “Other Equities† shock, which I’d argue would be the most typical classification in the absence of an infrastructure asset class)
• Symmetric adjustment = 77% of SA equity
• 70% of spread shock for debt
• 65% illiquidity premium shock

The 65% shock to the illiquidity premium is not specific to infrastructure. It’s also complete irrational and greatly reduces the benefit of the very limited illiquidity premium in the first place.

• The stated risk here is a narrowing of the illiquidity premium, but this could only be realized through an increase in the relevant asset prices, matched with an increase in liabilities with no net impact. Since the shock is defined as “A 65% fall in the value of the illiquidity premium used in the valuation of technical Provisions† there is no offset for the asset of this calculation.
• The actual risk, if there were one, would be an increase in illiquidity premiums in the market, resulting in a decrease in asset values, only partially offset by a decrease in liability values due to the 50bps cap.) 

Impact of SCR relief

The impact of lower SCR on after cost-of-capital investment returns needs to be calculated for the specific portfolio and how it interacts with other risks within the business. One might expect a 1% to 2% increase in penalized returns.

Qualifying criteria

To qualify as an “infrastructure asset† and benefit from the lower capital charges, a fairly lengthy set of criteria must be met. For insurers already intended to invest in only high quality (and therefore lower return) infrastructure assets, these criteria may overlap with existing due diligence and investment analysis processes.

Non risk-based criteria

Risk-based criteria

The Infrastructure project entity can meet its financial obligations under sustained stresses that are relevant to the risk of the project.

• Must be externally rated (in theory it doesn’t have to be, but in practice it really should be and questions would be asked by the Prudential Authority if it weren’t.)
• The off-taker must be either the South African government, or there must be a large number of, ideally independent, diversified customers.

• The Infrastructure assets and Infrastructure project entity are governed by a contractual framework that provides debt providers and equity investors with a high degree of protection
• For bond investments, significant additional covenants are required
• The cash flows that the Infrastructure project entity generates for debt providers and equity investors are predictable. This must be demonstrated through one of the following:
  • Availability based revenues
  • Rate of return regulation covering revenues
  • Take or pay contract
  • Output or usage and price imply low risk

Should insurers invest in infrastructure?

It’s unhelpful to say “it depends†, but of course it does. However, with appropriate due diligence and consideration of the financial and capital implications, life insurers with large with profits or annuity books can benefit shareholders and policyholders, as well as potentially the country as a whole, by investing judiciously in infrastructure assets.

The risk is that they are outbid by retirement funds with less risk sensitivity to the investments.

Many researchers are comfortable with a range for Equity Risk Premiums of between 3% and 5%. Many corporate finance practitioners use a range from 5% to 8% or even higher. My nearly eight-year-old blog post on mis-estimating the ERP covered these differences in detail.

This post is a little different. Forget about what theory says, what are the implications of using a high risk discount rate (RDR) when calculating embedded values and then trying to maximise value.

Solvency II and SAM suggest a 6% (excess over risk-free) cost of non hedgeable capital. Most South African insurers calculating real-world embedded values use risk-free + 3.5% as their RDR.

Some insurers want to use an RDR closer to 15% or even 20%. The problem here is one of conviction. If the cost of capital was truly felt to be 20%, then capital optimisation, value optimisation and therefore reinsurance decisions should be made with this in mind.

It will almost always be the case that reinsurance will have an implied cost of less than 20%. Thus, the consistent action would be to grab as much reinsurance as possible, at least up the point where the reinsurer was concerned about skin in the game.

I don’t see this happening in practice.

Some insurer will argue that they don’t want to give away all their profits to a reinsurer. This fundamentally misunderstands how reinsurance is priced and the impact of return and profit commissions to facilitate reasonable commercial terms.

Similarly, the pursuit of greater investment returns usually results in more risk and more capital required. At a 20% return on capital requirement, pretty much no avoidable market risk should be retained. Yet I still see insurers opting to take on more credit risk (even at current depressed credit spreads) in pursuit of a little extra yield.

We can have a debate about the range of reasonable RDRs to use. But there is a credibility problem if this rate isn’t also used to decide on reinsurance and investment strategies.

I don’t remember looking at this, but the blog entry was actually about insider trading and the information content of directors’ dealings. Here is a quote showing some wisdom and a near miss:

Am I going to invest in Steinhoff? Well, no, not yet, not until I have actually done some proper research into the fundamentals of the company. And also not until I have understood the reasons for the decline in price over the last year properly. If the market thinks they are worth less, I had better know why the market thinks so before I disagree too strongly.

Having said that, I pay careful attention to knowledgeable insiders when they put their money where there collective mouths are and vote with their personal wealth and risk appetites that a company is a good bet.

I never sufficiently understood the fundamentals of the business and how it related to their accounts and valuation. Score one for then not investing.

However, I was also saying that I saw value in following directors’ dealing and possible positives from directors investing in their own stock. In the case of Steinhoff, it’s hard to separate out:

• true belief in their business;
• attempts to demonstrate confidence in the shares (whether or not the confidence was actually held); from
• artificial attempts to prop up the share price

I have less time for fundamental analysis these days so low cost trackers is more my flavour. Given my mixed success in the past, perhaps that’s just as well.