Beneath the surface, systemic risks, hidden accumulations and correlated threats also must be explored. These are the risks that cannot be diversified away. Others may result from a chain reaction, such as a casualty catastrophe caused by a class action lawsuit, affecting vast numbers of policyholders. In the extreme, (re)insurers should be ready for simultaneous major loss events that are accompanied by a plunge in asset values, inflation and a disproportionately high replacement cost of capital.
Yet, companies can realize considerable value from their ERM investments between the extreme stress scenarios. Many, in fact, can use ERM to improve their operations — in particular the optimization of capital deployment. By modeling the full range of risks that can affect a (re)insurer’s portfolio, it is possible to understand both the amount of capital necessary to support a collection of risks (including integrated threats), along with the intricacies involved in the contribution of each risk to the total capital need. With a robust ERM framework, a risk manager has the resources on hand to operate the portfolio as an internal capital market, allotting underwriting capacity and evaluating profits relative to the total portfolio risk and the contributions of individual component risks. Transparency increases, resulting in a better comprehension of the interplay among all portfolio planning activities.
Internal capital model output will be important in rating agency discussions, operational discipline, capital optimization, and regulatory compliance. In the UK, it is important today, with the Internal Capital Assessment (ICA) framework, and it’s coming to Europe (and everywhere else) with Solvency II. The standard capital factors involved in compliance are based on industry data, with no specificity regarding the risks contained in a portfolio. The availability of an internal modeling alternative, in Solvency II, for example, shifts the perspective. Companies can determine capital requirements for their own situations, rather than relying on a one-size-fits-all industry model. This presents an opportunity: a lower model-driven requirement can free capital for more productive use elsewhere in the market.
Opting for an approved internal model instead of the standard formula thus provides a competitive advantage. The flexibility that comes with additional capital can be used to address a variety of strategic alternatives, from writing more business to moving into new lines and regions. As a result, the use of internal models for Solvency II enables “competitive compliance,” the process by which addressing regulatory requirements can be turned into a competitive advantage and yield a return on the capital invested in the compliance effort.
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