March 18th, 2009

Capital Management: Quantify Capital Risks

Posted at 1:00 AM ET

Gary Venter, Managing Director, Instrat®
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The determination of a target capitalization must occur within the context of risk measurement and analysis. Enterprise Risk Management (ERM) practices seek to bring discipline to the risk and capital management process, with every decision made based on a single risk’s marginal implications to the firm as a whole. This approach will not indicate necessary capital levels, but it does equip insurers and reinsurers to optimize their deployment of cash.

Know Your Risk Levels

A strong capital position becomes valuable only when it is made productive. Of course, this calls for more than flooding the market with thoughtless capital in the hopes of achieving success through volume. Carriers need to identify the opportunities most likely to lead to a satisfactory return. In the past, risks were assessed on a standalone basis. If a particular peril or policy seemed fine on its own, the carrier committed capital. In doing so, many firms unwittingly exposed their portfolios to disproportionate levels of risk-or ended up not taking advantage of the diversification effect on capital. The risk whole can be greater (or less) than the sum of its risky parts.

ERM is intended to remedy the mismatch of risk and capital. Risk managers use a holistic view of the firm to choose the appropriate risks to take and those to avoid. Analysis and judgment are applied to each opportunity-relative to the entire portfolio-ensuring that exposures are not magnified. An ERM framework allows a firm to quantify risks and compare them to its capital. While this does not determine the optimal capital level for an insurance or reinsurance company, it does provide quantification of the risk of the current composite position and that of strategic alternatives.

Modeling Capital Risk … and Adequacy

Capital risk modeling historically has begun with a target premium-to-surplus ratio of 3:1. Recently, market forces (like rating agency and customers’ security demands) have pushed this ratio to approximately 1:1 for top-ranked primary insurers and reinsurers. The movement of carrier behavior relative to traditional expectations toward increasingly cash-rich positions underscores the need for more than one approach to ascertaining adequate levels of capital for specific risk thresholds.

The first step past the premium-to-surplus threshold has been to gauge appropriate capital levels relative to liabilities. Historically, carriers view a capital level in the range of ¼ of liabilities (including reserves and unearned premium) to be appropriate.

Capital = 1/4 X liabilities (including reserves and unearned premium)

This approach, unlike the premium-to-surplus ratio, addresses the impact of reserves, accounting for an important variable in the firm’s risk management program. The limitation, though, is that risk levels vary among liabilities. This has led to the rise of the risk-based capital (RBC) approach:

Capital = Σ(risk factors X income statement and balance sheet items)

Yet, even the advances in capital modeling addressed by the RBC method still provide only rough measures of risk and the capital needed to support it. Increasing the adequacy of premium or reserves, for example, usually increases the RBC-stated capital needed exactly when less is necessary. A sensitivity to some important company variables is missing.

The Effective Use of ERM

ERM doesn’t actually yield a firm’s optimal capital levels; there are more complex market-oriented issues involved. What ERM does well, however, is facilitate the quantification of the actual risk levels to which a firm’s capital is exposed. Using a variety of ERM-based tactics, insurers and reinsurers can reshape their capital management practices based on tangible information.

Sometimes, it may make sense to use multiple ERM-based measures, such as:

Capital (may) =
1. 4X standard deviation of earnings
2. 3X 1:100 TVaR
3. 4X 1:100 cat occurrence
4. 1.5X two consecutive 1:100 aggregate loss years

These tools move the firm from the limited “capital = ¼ X liabilities” method to a more insightful “capital = 4X 1:100 loss” level-moving from a general benchmark that means different things for different companies to real risk quantification.

So, How Much Is Enough?

Appropriate levels of capital can only be determined on a firm-by-firm basis, but advanced risk quantification techniques and ERM practices can reduce unnecessary exposures and shed light on alternatives that might be missed otherwise. This creates a solid foundation for determining how much capital a carrier needs.

Previous articles in this series:

A Renewed Priority >>

Zero in: Target Capitalization >>

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