October 30th, 2012

Capital Model Embeddedness

Posted at 1:00 AM ET

Paul Silberbush, Managing Director
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Capital models are becoming more and more “embedded” into property and casualty (re)insurers’ business processes. These models are typically constructed with two distinct and often contrasting purposes: 1) measuring capital for rating agency and/or regulatory requirements and 2) risk management and strategic business planning.

In Europe, property and casualty (re)insurers have greatly increased their use of internal capital models. While best practices in enterprise risk management (ERM) have always been a motivating factor, the ultimate driving force for their use has really been requirements around the Solvency II regime.

Because internal models need to “accurately represent an insurer’s risks and the interaction of those risks,” the models have become increasingly complex and unwieldy, at the expense of utility around flexibility, responsiveness and speed.

Contrast this increase in complexity against the concept of the “use test.” This requires companies to use their models to make business decisions in areas such as strategic planning or evaluation of reinsurance options. The models are not to be used solely in the setting of capital levels for regulatory purposes.

In the United States companies have been focusing on the use of capital models primarily as part of a set of best practices in the deployment of ERM. More recently, another factor prompting interest in capital modeling has been the views of the rating agencies. They are increasingly assessing a company’s readiness and/or actual implementation of a capital model as a qualitative component of the rating process. Finally, the United States is clearly moving towards a regulatory framework involving internal models, as seen by the National Association of Insurance Commissioners’ (NAIC) model act on Own Risk and Solvency Assessment (ORSA), which is targeted to be effective in January 2015. The Model Act as it stands now will exclude carriers under USD500 million in premium and groups under USD1 billion in premium. It is conceivable, however, that smaller companies may be subject to similar regulations at a future time.

While nothing in the NAIC Guidance Manual refers to a “use test,” there are numerous hints within that the regulator will be looking for evidence of the practice of ERM - insurers should have sound processes for assessing capital adequacy and the process should be integrated into the company’s management and decision-making culture.

Guy Carpenter is already seeing unprecedented interest in internal risk and capital models and software platforms from our U.S. clients and we expect the trend to continue. We are uniquely positioned to provide industry-leading advisory services to our clients via both our intellectual capital contributions and industry-leading modeling software.

For their use in business decision making, internal models need to be far simpler, faster, flexible and more transparent than many of those that are in use now.

MetaRisk® is Guy Carpenter’s proprietary risk and capital modeling platform. It is a fast and powerful desktop application that is flexible enough be the platform for a company’s model(s) that may be used for strategic planning and reinsurance evaluations, measuring risk for internal ERM best practices and measuring capital for rating agency and regulatory requirements.

MetaRisk ReserveTM is a powerful Excel-based add-in that may be used to measure reserve risk including hidden inflationary trends, and it may be used as a stand-alone tool to measure reserve volatility to ultimate or provide the needed one-year measures that seamlessly feed into a full capital model, such as one built in MetaRisk.

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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.

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