Companies that optimize the use of economic capital models to holistically manage portfolios may gain a powerful advantage in the marketplace. Improved risk decision-making and capital allocation can translate to profitable growth and an increase in shareholder value. But, it takes a commitment: ongoing integration and evaluation of the models in the operation may create ongoing benefits to results.
Insurance Company Portfolio Management Challenges
Insurance companies run into several challenges as they manage their portfolios and when they seek to optimize the deployment of their capital. In establishing a risk tolerance threshold for their firms, insurance company risk managers need to measure their portfolios against established risk tolerances. To do this effectively, they need metrics based on:
- Pre-tax operating income, or an acceptable loss of earnings or loss of surplus threshold
- Probable maximum loss (PML) for a given confidence level or a maximum foreseeable loss (MFL)
- Changes in BCAR results or other rating agency-focused thresholds
Some risks held in insurers’ portfolios, of course, are un-modeled, which makes it quite difficult to hedge them effectively. Nonetheless, they must be addressed to ensure the appropriate management of capital. Traditionally un-modeled risks include flood and contingent business interruption.
Additionally, the implications for residual markets on catastrophe loss potential must be considered. There are constraints on data completeness and accuracy, which lead to modeling deficiencies and introduce more risk into a portfolio that cannot be hedged optimally. To mitigate the effects of these factors, risk managers need to consider how much data deficiencies related to a particular risk could impact the portfolio and the methods that could be used to measure changes in data quality over time.
Meanwhile, there’s plenty of temptation to accept un-modeled or partially modeled risks. The lure of high premium business in a catastrophe-prone area may be attractive to an underwriter, though it is less likely to appeal to the reinsurance department or chief financial officer. For excess and surplus (E&S) lines, for example, what an underwriter sees as being a good rate (and thus a “good risk”) may not adequately compensate the firm for the exposure it is assuming.
The situation can be complicated further by the tendency of personal and commercial lines business units in large companies to operate separately but write business in the same geographical locations, which can create friction for reinsurance costs and severity drivers. On the other hand, efforts to manage catastrophe exposure thoroughly can constrict agents and underwriters located in offices in high catastrophe risk areas.
Even modeled risks have their limitations. Catastrophe models are not exact, and they do evolve. Sometimes, the fastest change to a portfolio comes not from any action taken by an insurance company: rather, it’s the result of a model update. This can have implications for reinsurance costs, rating agency perception of a portfolio and the firm’s expected profitability - not to mention its ability to retain current clients and attract new ones in the future.
The other challenge regarding catastrophe models is the reason why models change, specifically the continual improvement of underlying deficiencies and inaccuracies. As shortcomings are remedied through innovation and an increase in the industry’s institutional knowledge, the outcome can impact the capital allocation and risk management decisions of insurers of all sizes.
Catastrophe models help insurers establish perspectives on maximum foreseeable loss to use in risk management practices and various metrics important to underwriting. However, the pace of change in recent years can present perceptions of instability in underwriting approach and philosophy. Market forces cause companies almost to live by model output. Used prudently, catastrophe models with multiple views of risk, in conjunction with adjunct business plans where models seem to be at odds with risk management knowledge and underwriting experience, can inform the capital management process and deliver actionable intelligence. That intelligence can be used in value-accretive decision-making.
Further, insurers need to ensure rates remain adequate, determining (and obtaining approval for) rates that cover reinsurance costs, expenses and expected catastrophe and attritional losses -and deliver a profit. In the process of doing so, insurers need to figure out which geographic areas and lines of business offer the best (and worst) return on capital. Where returns are deficient, they need to ascertain the impact to the company and determine what steps it is willing to take either to improve financial results or accept degraded performance.
Surrounding the set of alternatives open to insurers are regulatory constraints. Risk and capital management decisions as well as rates are subject to prevailing laws and rules. Rate approvals, non-renewal restrictions (e.g., in New York) and mandated premium credits for mitigation features, which may be too generous to support the cost of writing the policy otherwise (e.g., in Florida), must be factored into modeling and portfolio analysis efforts. The constraints will affect the overall risk profile and tolerance of a carrier.
Of course, none of this matters without execution. There are plenty of barriers to entry when it comes to applying models, including surplus size, niche underwriting expertise required and A.M. Best rating. And technology can prevent effective implementation. However, there are significant opportunities for improved risk and capital management.
Implications of an Unbalanced Portfolio
An insurance company’s inability to balance its portfolio can have profound implications for capital management, the cost of reinsurance and its ability to grow profitably. For all carriers, rate approvals can be difficult, especially in the most catastrophe-exposed states - a problem that can be exacerbated by catastrophe model changes. For E&S writers, competition for market share can also lead to a tougher rate-adequate environment. Further, portfolio re-adjustment can be a costly and long process, especially if premium volume declines (if expense ratios increase, surplus may decline).
Florida comes with a set of issues unique to the state. The uncertainty in the Florida Hurricane Catastrophe Fund (FHCF) from year to year complicates matters for the reinsurance market in the state, which can impact available capital and reinsurance pricing. Also, carriers must balance their portfolios geographically, which can be difficult if they incepted by assuming policies from the state’s Citizens Property Insurance Corporation.
Carriers also may encounter circumstances particular to their size. Smaller mutuals tend to be regional and rely on independent relationships, forcing them to compete with other insurers for agents’ business at the commissions they want. This results in a decline in flexibility to attract the target insured that the carrier wants - ultimately impeding efforts to increase profitable revenue. Competition with larger firms to diversify portfolios in the areas/lines of business needed can be difficult to handle, as well. Further, these smaller insurers are more susceptible to catastrophe model impacts and abrupt changes in reinsurance costs, particularly when geographic scope of their book is limited.
For larger mutuals, there is the potential clash between lines of business, and stress is put on capital from a combination of both property and casualty lines. This leads to the potential for unexpected outsized losses. As competition spurs many to grow through acquisition, the outcome can be an increase in the cost of reinsurance, the testing of any established risk tolerance thresholds and a disruption of the balance of written premium to pre-tax operating income. Larger stock companies face many of the same challenges as large mutuals, but simultaneously have to cope with market expectations for acceptable returns and stability of earnings.
Take Control of Your Portfolio
Guy Carpenter & Company LLC’s (Guy Carpenter) accredited actuarial professionals and catastrophe modeling specialists provide informed analysis and risk advisory expertise, bringing to bear multiple specialties and resources. As a result, we are equipped to help our clients manage their portfolios fully and comprehensively, from individual risks to integrated threats that have the potential to create a chain reaction of losses throughout the company.
Guy Carpenter’s MetaRisk® provides consistent measurement of a company’s desired risk tolerance and rating agency capital adequacy ratios over time. We also apply capital allocation methodologies driven by experienced actuarial and advisory teams that are recognized leaders in enterprise risk management (ERM). Using client provided expense ratios and attritional loss ratios, Guy Carpenter complements that data with other key elements for a holistic view of the firm’s property risk, including catastrophe expected losses, reinsurance cost allocation and cost of capital.
With MetaRisk, clients can access reinsurance cost allocation details (e.g., by rating territory, by policy form or even on a policy-by-policy basis) for use in rate adequacy and cost of risk analyses.
MetaRisk can provide expected catastrophe layer loss allocations based on each exposure unit’s contribution to the overall loss, which can be evaluated using each simulated event generated by the catastrophe model(s). Reinsurer expenses are expressed as an expense ratio and quantified based on exposure. Reinsurer risk margin is allocated according to measures of volatility by exposure unit, most often based on the preferred covariance method for property catastrophe treaties.
Guy Carpenter’s broad experience with catastrophe models and depth of market knowledge can be used to find insights into a company’s individual and integrated portfolio risks, not to mention the allocation of its capital for profitable growth in accordance with its stated risk appetite, profile and tolerance.
Working with our catastrophe modeling capabilities and experienced teams, insurers can gain multiple views of risk and gain actionable insights allowing them to make informed decisions regarding risk management, capital allocation and, ultimately, firm value.
i-aXs®: Users of i-aXs will have immediate access to vast amounts of exposure data along with reporting tools, including data quality and hazard data. They may access industry-leading views of a portfolio’s flood and wildfire susceptibility, all of which can be tracked over multiple periods of time.
Property Specialty Practice: Clients working with this Guy Carpenter team will gain the ability to track changes in residual market portfolios and their reinsurance programs, as well as their ability to pay claims to better understand the potential impact of residual market participation. For example the growth of wind pools has driven carriers to evaluate how they may optimize their assessment strategies in coastal areas by using Guy Carpenter’s Portfolio Management analytics.
Florida Market Team: Our team evaluates changes in legislation, the FHCF and reinsurance market conditions leading up to and during renewal season. We also monitor rating agency and other developments for Florida insurers. In particular, clients can use Guy Carpenter’s Portfolio Management expertise to help modify the distribution of their writings in order to optimize the purchasing and structuring of low-cost FHCF reinsurance and traditional open market reinsurance programs.
With Guy Carpenter’s advisory expertise in portfolio management and catastrophe modeling, companies gain insights into their portfolios so they can more effectively add economic value to their firm. Using advanced solutions to assist companies in growing their portfolios, rating business appropriately, and using their capital effectively, Guy Carpenter leads the way for strategic business intelligence and analysis.