August 5th, 2010

Long Tail Liabilities and Reserve Volatility: Dynamic Reserve Model (DRM™)

Posted at 1:00 AM ET

Janis Berger, Managing Director and Spencer Gluck, Senior Vice President

The convergence of a variety of pressure points at this time is leading to a set of unique circumstances that present opportunities around business strategy and capital allocations for the insurance industry. Future inflation is one of the pressure points. Inflation and uncertainty about its extent and timing is a function of untested but powerful monetary and fiscal policy actions. In addition to inflation’s potential effect on insurer liability management there is also an impact on the volatility of assets backing the liabilities. A reignition of the kind of severe inflation last seen in the 1970s is most likely not factored into any current insurer management practices for establishing reserves or setting capital levels.

A prolonged soft market fueled by increasing competition and capacity is currently pressuring industry value. This is occurring during a period of accelerating change of the risk issues, from climate change to nanotechnology. The political environment impacts the expression of these liabilities over time through changes in tort costs, medical inflation, untested litigation and regulatory trends. Occurrence coverage exposes insurers to potential emerging risks for decades. Even in risk areas with a long history Conning and Company recently noted the adverse development of older years, particularly those over ten years old, in the workers compensation line.

Recent events in the news demonstrate the destructive impact of systemic risk, including its reach, magnitude and correlations. Systemic risk of long term liabilities is among the most difficult to manage. Even though business is experiencing the exact opposite of a static business model, standard reserve models in use today assume the future looks like the past and that the trends in the data never change. The question of how future trends can differ from past trends is not addressed. Without an analysis of trends in data across time, the risk of future changes cannot be understood.

Guy Carpenter & Company, LLC has developed a powerful solution that identifies, measures and models these risks. The Dynamic Reserve Model (DRM) is Guy Carpenter’s proprietary product that models facets of risk the standard models may miss. The systemic risk that is not captured by the standard models may constitute a large part of an entity’s total risk. At the industry level, most of the risk is systemic, and a Guy Carpenter study of industry workers compensation reserves found that the standard loss reserve risk models missed 90 percent of the forecast risk. A deeper understanding of the systemic volatility of reserves also has important implications for pricing and underwriting. The uncertainty inherent in reserving creates risks for and is highly correlated with prospective underwriting risk. This risk is in turn exacerbated by the changing underwriting cycle and market conditions.

DRM achieves a more informed approach to the utilization of contingent capital, including reinsurance. As with many unique Guy Carpenter tools, DRM provides valuable input for MetaRisk. This modeling platform houses other models, combining loss reserve risk, underwriting risk, etc, to develop capital models. Various reinsurance options can be evaluated that examine the future value of reinsurance over the long term in offsetting reserve surprises.

These decisions play critical roles not only in an insurer’s business strategy and capital allocations, but are also becoming increasingly important to rating agencies looking to assess the enterprise-wide management of risk. Higher certainty around levels of reserve risk facilitates acquisition of the necessary capital underpinning the business plan.

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Guy Carpenter & Company, LLC provides this report for general information only. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only. Guy Carpenter & Company, LLC makes no representations or warranties, express or implied. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. Please consult your insurance/reinsurance advisors with respect to individual coverage issues.

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. All such matters should be reviewed with your own qualified advisors in these areas.

Readers are cautioned not to place undue reliance on any historical, current or forward-looking statements. Guy Carpenter & Company, LLC undertakes no obligation to update or revise publicly any historical, current or forward-looking statements, whether as a result of new information, research, future events or otherwise.

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