November 23rd, 2009

Capital Modeling in the Age of Systemic Risk, Part I

Posted at 1:00 AM ET

mango_smallDonald Mango, Chief Actuary
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Hidden risks lurk in nearly every insurance portfolio. Unexpected accumulations, correlated threats and unimagined financial market developments can take shape quickly and severely. When disaster strikes — either because of a storm or an economic shift - insured and asset losses can drain balance sheets, impair return on equity (ROE) performance and destroy shareholder value. The cost of systemic and hidden risks can impact every link in an insurer’s financial supply chain, with today’s losses causing capital costs to rise for months, even years.

Fortunately, (re)insurers can take control of their risk and protect their capital. A combination of Enterprise Risk Management (ERM) and robust economic capital modeling can provide a foundation for making value-accretive decisions based on the overall impact to the company. Addressing systemic and hidden risks thus has the near-term benefit of capital preservation and the long-term advantage of creating a competitive edge.

Last year, we saw the impact of systemic and hidden risks on the (re)insurance industry. A financial catastrophe struck, causing credit markets to seize and equity values to fall, ultimately leaving risk-bearers to wonder about the availability of capital in the coming year. Using the Guy Carpenter Global Reinsurance Composite as a proxy, shareholders’ equity fell 18 percent. The severe loss of capital was offset only by the large positions with which carriers entered 2008. This cushion enabled them to absorb the financial market shock, but it left the industry with a lesson regarding the potential severity of the hidden and systemic threats that often go overlooked by conventional risk management practices.

Traditional risk management techniques have been particularly effective for discrete threats that are readily identifiable, but they tend not to support the management of systemic and correlated risks that may be obscured by economic factors, trading relationships and other connections derived from an increasingly intertwined global community. Book value losses are concern enough, but for public companies an even greater concern is shareholder value. Unexpected losses tend to be magnified in their impact on market capitalization, as shareholders may view the unexpected as portending other disappointments to come.

Yet, myopia has been a critical weakness in most financial institutions. A narrow, line-item view of risk may give the appearance of overall macro control by aggregation of micro controls. However, such a bottom-up, tactical perspective cannot grasp or process strategic, systemic issues. To understand these systemic risks, companies need a holistic model of individual risk factors and the dependency structure that connects them.

It is important to point out that envisioning that dependency structure (as 2008 taught us) requires imagination. Beyond conceiving of the traditional factors that can come to bear on a (re)insurer’s portfolio, risk managers need to consider possibilities once thought too remote to matter, such as the simultaneous landfall of a major hurricane and eruption of a worldwide financial crisis. The unknown is the greatest threat to a risk-bearer’s balance sheet: the only remedy is to “expose the exposure.”

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This article was originally published in Contingencies.

 

This article is intended for general information only. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. Statements concerning accounting, legal, regulatory or tax matters should be understood to be general observations based solely on the author’s experience in the reinsurance industry, and may not be relied upon as accounting, legal, regulatory or tax advice which he is not authorized to provide. All such matters should be reviewed with your own qualified advisors in these areas.

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