November 24th, 2009

Capital Modeling in the Age of Systemic Risk, Part II

Posted at 1:00 AM ET

mango_smallDonald Mango, Chief Actuary
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To derive the greatest benefit from an ERM investment, risk management by metrics becomes essential. Every risk assumption, retention or transfer decision must be analyzed using the holistic model to determine whether it is shareholder value-accretive. A rigorous, disciplined capital modeling effort will help a carrier move confidently by supporting strategic decisions with an objective, quantitative foundation.

ERM and capital modeling should not only be thought of as extreme protective measures reserved for stress scenarios. In fact, firms gain many operational advantages from the discipline itself. One of the most important is capital optimization. Identifying and modeling the full range of risks that can be brought to bear on a portfolio will reveal not only the total capital needed to support a portfolio, but also the intricate nature of the contribution each component makes to that total capital need. The portfolio manager will have the tools to operate as an internal capital market, allocating underwriting capacity and judging profits in relation to the aggregate portfolio risk and the component contribution by line of business to that risk. This increased transparency and capability will lead to greater understanding of the dynamics and subsidies underlying all portfolio planning efforts.

ERM and capital model output can also be used to inform the evaluation of a company by rating agencies. Rating agencies are very receptive to (re)insurers bringing their analyses to rating meetings. A well-developed capital model, embedded in a comprehensive risk management process — understood by senior management and used in critical decision making — can become an important additional factor in the rating process.

The same dynamic can be seen with regulatory compliance, already in place in the UK with the Internal Capital Assessment (ICA) framework, and coming soon to Europe (and the rest of the world) with Solvency II. The regulatory standard capital factors are based on industry data, with conservatism, with no refinements specific to the unique aspects of a specific portfolio. With some regulatory regimes (such as UK Financial Services Authority and Solvency II) allowing for the use of approved internal models, required capital will be based on a company’s own internal view of the magnitude and nature of the risks in its portfolio. If the model-advised capital levels are higher than those required based on standard approaches, the carrier benefits from having identified areas where additional protection is necessary. Likewise, the determination that standard formula calculations require more capital than is really necessary to support a risk can turn the situation into a revenue opportunity, as the results of the internal model offer some capital flexibility.

Read the first installment in this series >>

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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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