Corporate Decision Making Using Economic Capital Models: Part I: Introduction, Quantifying Corporate Risk
In the 1980s many large general insurance companies investigated the use of dynamic financial analysis for corporate decision making. Only a small number of insurers and reinsurers, (1) many of which were European, were able to develop dynamic financial models that were adequate for use in decision making. The primary obstacles
to implementation were actuarial knowledge and computer technology. By the early 2000s, technology had improved, actuaries had developed techniques that allowed better quantification of insurance risks and dynamic financial analysis had evolved
into enterprise risk management (ERM) supported by economic capital models. With these improvements, regulators began to develop solvency rules that create incentives for insurers to implement economic capital models. Although the current impetus for economic capital models is regulatory, the original purpose of enhanced strategic decision making is still valid and companies that use their economic capital models for ERM will be industry leaders.
Economic capital models can be used to inform many aspects of corporate decision making, including:
- quantifying corporate risk;
- identifying capital needs as viewed from different perspectives;
- understanding of the sources of risk that drive capital needs;
- cost allocation;
- risk-adjusted measurement of returns; and
strategic decision making.
Quantifying Corporate Risk
Traditional models have focused on the individual risks of an insurance company in isolation or point estimates: such as reserve levels, the range of reasonableness around the reserve estimate, rates to be charged, the corporate plan and the riskiness of the current accident year result in light of the selected reinsurance structure.
With an economic capital model, an insurer can understand the threats to its overall financial position from the aggregation of the risks it assumes. For example, an insurer might be interested in understanding the probability of an underwriting loss, the probability that its operating ratio will exceed 100 percent, the probability that
its net worth (2) will decrease by a stated percentage, the probability that its solvency ratio will fall below a certain minimum, or the probability that a rating agency metric will fall below that required for a particular rating. An economic capital model provides probabilistic financial projections from which all of these probabilities can be estimated.
Figures 19.1 and 19.2 illustrate probability distributions of net income and Best’s capital adequacy ratio (BCAR) for a hypothetical general insurance company. As can be seen, this company has a slightly more than 20 percent chance of a net loss and median net income of approximately USD150 million.
In an ERM framework, companies define their risk appetites, risk profiles and risk tolerances.
- Risk appetite represents the risks that a company is willing to accept in order to earn its target rate of return. Some insurers are willing to write very large risks or highly concentrated catastrophe risks to earn a very high return on average. Other insurers prefer to write lower-risk business in exchange for a lower return.
- Risk profile describes the characteristics of the business written, for example, lines of business, geographic spread and limits written.
- Risk tolerance puts boundaries on the risk that a company is willing to assume in the aggregate, such as the maximum amount that a company is willing to lose at certain return periods for a specific event or on a per annum basis or the probability that its capital adequacy ratio will fall below a certain threshold.
The distribution in Figure 19.1, along with key metrics such as the mean, can be used to evaluate whether the business written by the company is consistent with its stated risk appetite and risk tolerances. The model, of course, reflects the company’s risk profile. If there are inconsistencies in either the average net income or the probabilities of adverse events, the company can use its economic capital model to test changes in its risk profile to bring consistency with its risk appetite and risk tolerance.
When using an economic capital model, it is critical to understand its limitations because there are many risks for which insufficient information is available for specifying distributions of results. A scenario approach can be used for some of these risks. For example, scenarios could be selected for emerging risks or for specific high-severity low-frequency risks. The model can also be tested with some specific scenarios for risks that are included in the model but for which the historical data and therefore the modeled distributions may not include extreme events.
(1) “Insurers” will be used and will be assumed to include reinsurers as all concepts discussed apply to both types of entity.
(2) Net worth will be used to represent capital as measured under an accounting paradigm. Depending on the context and jurisdiction, it is sometimes referred to as economic capital, policyholder surplus, net assets or net worth, among others.
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.
Excerpted from Susan Witcraft’s contribution to “The Solvency II Handbook,” which brings together highly regarded practitioners and academics working in the Solvency II area to provide a practical guide for implementing internal models - the focus of Pillar I and the area demanding greater attention in preparing Solvency II.