November 11th, 2008

Get Credit for your ECM with S&P

Posted at 1:00 AM ET

Susan Witcraft, Managing Director and Head of the Financial and Capital Advisory
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S&P has released a new framework for determining whether a carrier’s own ECM can receive partial credit in the S&P capital adequacy evaluation. Companies with a Strong or Excellent ERM capability rating, a sufficiently rigorous model, and a substantial reliance on the results in making major decisions will be most likely to receive partial credit. The use of third-party modeling solutions—such as Guy Carpenter’s MetaRisk® platform—may be helpful not only in the rating process but also in overall capital management diligence.

The S&P Criteria

Standard & Poor’s (S&P) has established a process for allowing a company’s required capital estimate, based on its own economic capital model (ECM), to be blended with the required capital from the S&P risk-based capital (RBC) model. The process was explained in two criteria papers published by S&P earlier this year: Criteria: Methodology: Assessing Insurers’ Economic Capital Models and Criteria: Application Guide: Assessing Insurers’ Economic Capital Models. These publications explain the framework that S&P will use in ascertaining whether the required capital calculated by a firm’s proprietary ECM can receive partial credit in the S&P capital adequacy evaluation process.

S&P offers three specific qualification criteria:

  1. 1. A Strong or Excellent ERM Capability rating
  2. A sufficiently rigorous model and supporting validation process to produce reliable capital adequacy estimates
  3. The insurer’s substantial reliance on the ECM result in making major decisions

In determining whether the second criterion is met, S&P will evaluate assumptions, methodology, data quality, process and execution, results, and testing and validation. It will also create a benchmarking database of key inputs.

The S&P RBC model will continue to remain an important part of the rating process. However, S&P acknowledges that, over time, it expects to be able to rely more heavily on insurers’ ECMs. As part of the blending process, S&P will produce a credibility factor, known as the “M Factor,” to be assigned to the insurer’s model. M Factors are expected to be low at first, but they are then expected to increase gradually as S&P gains experience with assessments and reviews a company’s model a number of times.

S&P is establishing a fee-based consulting service (similar to what it does for debt ratings) to perform ECM validations. Carriers are not required to pay S&P for an ECM validation; it will also consider internal and third-party validations.

According to S&P[1]:

“The ECM review is intended for companies that already have a sophisticated ECM that is integrated into their strategic decision-making process…

The qualitative review…would especially include documentation of the validation exercises that have been performed to assure management that the model inputs (e.g. data and assumptions) and output were fit for use…

These validations might be performed by internal staff or they might be a part of a third-party review…

These reviews will also enable us to compile data on best practices for various ECM measures, approaches, and assumptions…

[W]e are unlikely to be prescriptive with parameter assumptions.”

Source: S&P Ratings Direct. Criteria: Methodology: Assessing Insurers’ Economic Capital Models. May 15, 2008

ECM Review Framework[2]

1) Assumptions – including process and governance to set up.

2) Methodology – identification and quantification, including diversification across risk categories and spot concentrations and correlations; consideration of capital fungibility between entities or countries.

3) Data quality – data quality used for asset valuation and liability valuation as well as to set the model assumptions and parameters.

4) Process and execution – model construction, quality of integration between data warehouses and risk engines, model results, and reporting tools.

5) Results – quality of results and reporting tools; comparison with benchmark database and S&P RBC.

6) Testing and validation – including stress and scenario testing.

Review Process

S&P offers a six-step process for reviewing ECM:

  1. Request for information
  2. Preliminary analysis
  3. Company meeting
  4. Final analysis and rating committee review and decision
  5. Deliver detailed report to management
  6. Publish “full analysis review”

Source: S&P Ratings Direct. Criteria: Methodology: Assessing Insurers’ Economic Capital Models. May 15, 2008

The initial step in the review process will be submission of a comprehensive packet of information from ten broad areas:

  1. 1. Model set-up – tools, approach, and descriptions of key risk measures
  2. Model validation and control – processes to implement, change, and reconcile
  3. Asset valuation – methodology and reconciliation to accounting valuation
  4. Liability valuation – methodology and reconciliation to accounting valuation
  5. Risk modeling – description of approaches used to estimate asset, liability, and other risks in the model
  6. Assumptions setting
  7. Diversification/aggregation – description of interaction of risk drivers
  8. Risk-mitigation activities – reinsurance structures, hedging, and securitizations
  9. Stress and scenario testing – describe purpose and how parameters were derived
  10. Results of the model – detailed reports used by the insurer to validate model & copies of final reports to risk committee and Board of Directors

The preliminary analysis includes (1) certification that the insurer rigorously employs the ECM model and (2) comparison of model results to the S&P RBC model. The company’s model validation process will be examined. Assessment of any external independent ECM reviews will be made. S&P will also consider the depth of integration between data warehouses and the risk engine, and between model results and reporting tools.

S&P then will set an agenda and provide a list of questions for a meeting with the company.

A final ECM review report will be produced and a determination will be made as to whether the information will affect the company’s rating.

The final report will be given to the client with positive and negative findings, as well as a conclusion as to the model’s credibility factor. Finally, a summary of the ECM report will be published on S&P Ratings Direct.

Comparison with Regulatory Solvency Monitoring

S&P’s process is similar to that of the UK Financial Services Authority (FSA) and the proposals for Solvency II. In particular, there is emphasis on model usage – what is known as “passing the Use Test” in the UK, and which is also considered in the Solvency II proposals – as well as the requirement for having a strong or excellent ERM process in place before any credit to the outcomes of an ECM will be considered.

Continental European companies are already in the process of receiving (pre)approval of internal models with some regulators. Other regulators are requiring a minimum level of risk management readiness before reviewing the internal model.

S&P will request any information on a company’s ECM that has been shared with regulators, particularly in the UK. This approach suggests the convergence between internal models for solvency purposes and ECM for rating purposes will increase.

S&P Process

The S&P Use Test conditions appear to be somewhat aggressive. S&P’s decision to not review an ECM model before it is used in the management of a company could slow the development of these tools for some companies. For example, S&P’s approach does not encourage the pilot testing of an ECM used for capital calculation before it is used for the management of the company. Incentives from S&P in this area could push more companies to speed up development of these tools.

Guy Carpenter’s MetaRisk tool as an ECM

MetaRisk is Guy Carpenter’s proprietary risk and capital modeling tool, currently available for licensing by clients and prospects. S&P will not pre-approve any modeling platform. S&P’s ERM personnel have seen a demo of MetaRisk, and are familiar with its capabilities. When implemented and integrated into a strong risk management framework, MetaRisk gives companies the analytic capabilities necessary to meet S&P’s criteria for an ECM.

Those interested in hearing more about MetaRisk should contact their Guy Carpenter account team.

Footnotes:

  1. From Methodology: Assessing Insurers’ Economic Capital Models. May 15, 2008, S&P Ratings Direct. The application guide provides additional detail on the categories of the ERM Framework.
  2. The ECM review framework is from Methodology: Assessing Insurers’ Economic Capital Models. May 15, 2008, S&P Ratings Direct.

 Guy Carpenter & Company, LLC provides this material for general information only. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only. Guy Carpenter & Company, LLC makes no representations or warranties, express or implied. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such.

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