Lately, discussion about the use of capital models in Europe has been driven by Solvency II. A major regulation is on the horizon and is progressively introducing considerable change in the how the insurance industry will manage risk. Important investment has already begun and will continue, as companies have to integrate this new regulatory regime in their management approaches. With Solvency II compliance driving the adoption of economic capital models, though, many (re)insurers could miss an opportunity to secure a competitive advantage. Instead of using compliance as the impetus for capital modeling, strategy should come first.
By implementing capital modeling capabilities to reach clearly defined business objectives, European (re)insurers would deploy their capital more effectively and would be more likely to attain their financial goals. At the same time, they would be creating a platform for Solvency II. The compliance effort thus would follow from an investment in growth.
Economic capital models can be used to inform many aspects of corporate decision making — including identifying risk sources and quantifying them, determining capital requirements and formulating plans for making deployed capital as productive as possible. Together, these factors add up to comprehensive strategic planning and execution on an enterprise-wide basis. The management of risk and capital becomes targeted, based on clear financial objectives.
The process begins with an understanding of how risk enters the portfolio and then quantifying it. Economic capital models, such as Guy Carpenter’s MetaRisk® platform, help (re)insurers understand the various scenarios that could deplete capital, as well as the extents involved. This baseline makes it possible to gauge the capital needed to cover the risks in a portfolio. Or, it may signal to a carrier that it should adjust its positions to coincide with its appetite and tolerance for risk — which have to be defined as part of the Solvency II path. Risk managers are equipped to make capital allocation decisions that are likely to yield the largest returns for the risks assumed.
The outcome, of course, should be strategy formulation and execution. Decision making is wrapped into this larger endeavor in which goals are set, alternatives are reviewed and courses of action are plotted. Once executed, a strategy’s progress can be measured using capital models, allowing for any adjustments that may be necessary based on changes in market conditions.
Of course, the same capabilities that facilitate judicious capital management also contribute to Solvency II compliance. Used appropriately, capital models should maximize returns relative to risk thresholds, which is effectively the thinking behind Solvency II’s 99.5 percent requirement — i.e., the likelihood that a company will remain solvent for the coming 12 months. The directive’s standard becomes just another factor to consider in a broader capital modeling and management effort. So, the use of capital models to pursue portfolio optimization and to hit company financial targets can address compliance simultaneously, turning what would have been a cost into an investment in growth.
Solvency II is defining a new approach to risk management. A new approach could imply changes to underwriting, pricing, reserving and risk mitigation — with these decisions encompassed in a comprehensive framework. But, capital models are only part of this effort. (Re)insurers’ own evaluations, documentation and disclosures of risk will become fully integrated in the companies’ cultures. And, each decision process will look at the value generated on the risk metrics selected by each company.
Start with compliance, and spend to keep pace with the industry … use strategic planning as the motivator, on the other hand, and generate value while addressing regulatory requirements. Something as simple as the reason behind a course of action can have a profound financial impact.
Statements concerning, tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice which we are not authorized to provide. To the extent that you discuss such statements with your clients, be sure to advise your clients that all such matters should be reviewed with their own qualified advisors in these areas.