June 28th, 2010

The Time Profile of Risk: From the Desk of Guy Carpenter’s Chief Actuary

Posted at 1:00 AM ET

mango_smallDon Mango, Chief Actuary

According to the draft European Union Solvency IIc directives, companies will need to provide an “own risk and solvency assessment” (ORSA). The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) has prepared an issues paper that provides guidance to assist (re)insurers in implementing the ORSA.

The guidance describes the ORSA as:  “the entirety of the processes and procedures employed to identify, assess, monitor, manage, and report the short and long term risks a (re)insurance undertaking faces or may face and to determine the own funds necessary to ensure that the undertaking’s overall solvency needs are met at all times.”

The issues paper also offers foundational principles to further facilitate the ORSA implementation. An overarching principle states that the ORSA should “reflect the undertaking’s management practices, systems and controls,” and “be forward-looking, taking into account the undertaking’s business plans and projections.”

There is an implied emphasis on a business plan horizon and a sequence of management actions and responses. These highlight the need for a risk measurement approach that includes a dimension for the passage of time. This change requires the introduction of a concept that may be called the time profile of risk-a means of measuring and communicating risk and return over time.

Current Approach: Single Period
Current risk measures are (implicitly or explicitly) single-period. They convey the risk-reward tradeoff of an action (e.g., underwriting a line of business for one renewal period) as a one-time proposition or “bet” in which critical assumptions (e.g., expected outcome, standard deviation or “volatility”) are known at the time the bet is made. A common risk metric for this situation is risk-adjusted return on capital (RAROC), which can be compared to other single period investment opportunities.

Under such a single period framework, with known volatility parameters by line, choosing the best underwriting portfolio is a straightforward constrained optimization exercise, supported by numerous tools and techniques.

An Evolution in Risk Metrics
Unfortunately, real (re)insurers are not single period investment propositions. They are going concerns operating with the intent to continue serving policyholders in perpetuity, by both servicing prior and existing claims, as well as providing ongoing coverage into the future. Also, a company’s ORSA will be a capital adequacy assessment based on a multi-year future projection including management responses. How will risk metrics need to evolve to capture this time element profile?

We need to conceptualize risk in a new way in order to make directional predictions regarding multi-period risk.

Time Element and Metrics

  • Single period risk metrics are like shock trauma-essentially instantaneous, without any notion of duration while multi-period risk metrics are like illnesses-for how long must a firm (ill person) endure what level of exposure or deficit? Movement from the “instantaneous” to the “enduring” requires the integration of the “force of risk” over time.
  • Single period metrics are silent on how the adverse outcome manifests itself, especially with respect to a delay in time. Multi-period metrics must differentiate between finding bad news out now versus finding it out later. We need an assessment of the risk impact of information lags.

Cycle Effects

  • Much of what single period models represent as “non-catastrophe underwriting volatility” is a single period collapsing of a phenomenon observed over cycles.
  • Cycles introduce autocorrelation (across underwriting periods) and therefore accumulation effects over time, especially from the reliance on immature (and autocorrelated) underwriting periods as base points for forecasting profitability of future underwriting periods.

Management Response

  • Single period risk metrics only reflect risk mitigation strategies put in place pre-event (before the trauma). The need for formulated response strategies will require extensive new dialogue within firms to flesh out their response strategies in a concrete, objective and quantifiable manner.
  • Using overly simplistic or even static strategies can result in an overstatement of the accumulated risk over a multi-year timeframe.

How Guy Carpenter Can Help

Developing this concept of a time profile of risk will challenge our fundamental understanding of what it means to be a(n) (re)insurer. However, Guy Carpenter believes that this evolution will benefit the (re)insurance industry by providing more realistic and actionable indications of risk.

Guy Carpenter’s Enterprise Risk Management Advisory practice helps (re)insurers address these needs as their capital modeling and ORSA processes advance. We are committed to advancing our risk management relationship with each of our clients.

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