April 4th, 2013

What About the “S” in ORSA? Actuaries Raise Their Hands: Part II

Posted at 1:00 AM ET

Micah Woolstenhulme, Senior Vice President
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This post is Part II of an earlier post that reviewed a session held at the Casualty Actuarial Society Annual Meeting.  In that session, attendees hypothetically viewed the P&C industry as a single large company. Audience members were shareholders and session panelists adopted various executive and leadership roles in the company. The meeting’s task was to vet an economic capital model before the board of directors, allowing individual shareholders the freedom to openly question the model’s input and results. This model, if properly developed and embedded into the company’s strategic management, would represent a key component of the Own Risk and Solvency Assessment (ORSA) Summary Report that will be required of large companies in the industry as early as 2015. Along the way, the presentation and board discussion were interrupted to poll the audience members on several interesting questions.

Read Part I >>

Tallied Responses to the Questions Put to the Stakeholders

Presentation of Model Inputs

Q: Was the presentation of model inputs sufficiently clear for the board to understand? 

mikat1-chart

The first section of the presentation provided an overview of key model inputs. The USD507.5 billion of industry statutory surplus at 12/31/2011 was down 1.5 percent from 12/31/2010. Overall reserve duration is 3.85. Expected combined ratio for 2012 is 106 percent, of which 4.1 percent is average annual loss from property catastrophe events. Finally, a projected increase in the yield curve leads to a significant difference between the expected change in statutory surplus and GAAP equity.

Adequacy of Risk Parameterization

Q: Rate the adequacy of risk parameterization on a scale of 1 to 10 (10 being the most adequate).

mikat2-chart

Average: 6.5

The model is comprised of the following components:

(1) Statutory filing data provided by SNL

(2) Risk parameters from the industry risk benchmarks research produced by Guy Carpenter and Risk Lighthouse

(3) Economic Scenarios provided by Barrie and Hibbert

(4) AIR version 14 event files for modeling losses on residential property, commercial property and auto physical damage for three perils: hurricane, earthquake and winter storm.

(5) The MetaRisk® modeling platform

The most common written comment for improvement to the parameterization was that the model should be extended to a multiple-year projection, as opposed to its current single-year specification. Whereas property risks diversify across time, casualty risks accumulate, and a multiple-year projection would better facilitate risk analysis and capital allocation between these lines.

Strategic Value

Q: Do you believe the model is sufficient to influence strategic decisions?

mikat3-chart

Where could a model of this specification be used in the hypothetical company? Among the applications cited were capital allocation, reinsurance strategy, business strategy, target capitalization and risk decomposition.

Risk Preferences

Q: Do you find the risk preferences expressed (50/50 weighting of 1-in-7 and 1-in-100 TVaR) appropriate?

mikat4-chart

The capital allocations presented from the model were based on contributing losses from two Tail Value at Risk (TVaR) metrics, one interpreting capital as a buffer for short-term volatility, and the other interpreting capital as insurance against extreme potential losses.

It can be shown that weighting the two together (and potentially including additional TVaR levels) is an exercise analogous to probability transforms such as the Wang transform, except that the “Riskiness Leverage Function”(1) is a step function rather than a smooth curve. The advantage to using weighted TVaR is transparency and ease of communication with executive leadership.

Overall, industry stakeholders favored the risk preferences demonstrated in the presentation, but it is important to note that choices for an individual company are unique and strongly related to the business strategy, capital structure and risk profile.

Industry Capitalization

Q: Do you believe the industry is overcapitalized, adequately capitalized or undercapitalized?

mikat5-chart

Whereas the prevailing view on industry capitalization is clear from the numbers, perhaps it is useful to consider the written comments of an alternative opinion. Another participant noted that not everything that is critically important can be quantified. In addition, the impact of uncertain economic situations such as deficits, taxation and the “fiscal cliff” are large enough to justify maintaining higher levels of capital for many companies, even if some would consider this overcapitalization.

Summary

Facilitating dialogue around ORSA, risk tolerances and capitalization serves several valuable purposes. Given the changes in regulatory requirements we expect in the next few years, actuaries need to become key voices at the tables of process change. With the power of more sophisticated data retrieval, modeling services and software, this type of model-driven dialogue on prospective industry financial health is possible like never before. Let’s take it to the next level and keep the computers running.

Notes:

1. http://cas.confex.com/cas/annual12/webprogram/Session5533.html
2. See Kreps, Rodney E. “Riskiness Leverage Models,” Proceedings of the Casualty Actuarial Society XCII, 2005, http://www.casact.org/pubs/proceed/proceed05/05041.pdf.

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Reprinted from Actuarial Review, Vol. 40, No. 1, ©2013 Casualty Actuarial Society. Used by permission.

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.

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