Here we complete the review of the contributions to GCCapitalIdeas from Guy Carpenter’s Chief Actuary, Donald Mango, in the last year.

ERM Offers Competitive Compliance for Solvency II:  (Re)insurers face a labyrinth of capital management challenges. Financial markets have proved that they can change the industry’s view of risk swiftly - and with little warning. New risks are emerging, as well, some of which can be difficult to identify, lurking in portfolios for years without detection. The need for Enterprise Risk Management (ERM) is palpable, and risk-bearers are beginning to appreciate that preserving their capital requires metrics-based management and a robust capital modeling discipline. With regulatory requirements such as Solvency II on the horizon, the stakes are even higher, as capital optimization must be accomplished within a compliance framework.

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Five Ways to Manage Innovation:   To cut through the claims of innovation in the market, you need to know what you’re looking for. There are plenty of capital models, catastrophe models and Enterprise Risk Management (ERM) practices in the (re)insurance industry, but which are the most valuable innovations? The right choices can protect your capital, help you deploy it optimally and ultimately bolster shareholder value … but faux innovation can slow your growth - or leave you exposed to unexpected risk or still leave you exposed when you thought the gap had been filled.

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Risk Management Lessons from the Olympics: Guy Carpenter’s Chief Actuary Offers Some Observations: We were all thrilled with the spectacle of the just-completed 2010 Olympic Winter Games from Vancouver. Winter sports are known for their inherent high levels of riskiness, so it should not be too surprising that some valuable lessons related to “personal risk management behavior” can be drawn from the way the athletes make decisions and how the competitions are conducted and judged. As risk professionals, when we watch the action on the snowy mountains and icy rinks, we can get another view on the choices made in the taking of risk or in mitigating risk.

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The Time Profile of Risk:   According to the draft European Union Solvency II 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.

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Here we begin a review of the contributions to GCCapitalIdeas from Guy Carpenter’s Chief Actuary, Donald Mango, in the last year.

ERM Did Not Fail: The profound financial damage that began last year has left the insurance industry looking for answers. Diligent underwriting and conservative investment strategies were not enough to prevent natural and financial catastrophes from bleeding balance sheets. Both firm leadership teams and key stakeholders have questioned the value of Enterprise Risk Management (ERM) frameworks, yet the conclusion that ERM failed may be hasty. After all, the insurance industry actually survived the events of 2008 reasonably well, with at least some of the credit going to their ERM efforts. Where risk management did fail, the underlying causes were deeper.

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Optimize Capital Allocation with Co-xTVaR:  In choosing a capital allocation method, firms must balance the sophistication of the method with calculation time and resource commitment. One approach, co-xTVaR, strikes a balance between theoretical soundness and efficiency. In a capital-constrained environment, using co-xTVaR to allocate the cost of capital can provide a clear competitive advantage.

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ERM Advanced by Financial Crisis:   As expected, insurers have continued to accelerate their development of Enterprise Risk Management (ERM) practices following last year’s financial crisis. The impact to both sides of the balance sheet emphasized the importance of tracking every risk a carrier faces and protecting capital from a wide range of threats. As ERM practices evolve, clear definitions and terminology become critical. A common language and framework will facilitate process and technical innovation, improving the transfer of practices across companies and simplifying the disclosure process - all of which will lead to more accurate risk evaluation.

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Capital Modeling in the Age of Systemic Risk, Part I:   Hidden risks lurk in nearly every insurance portfolio. Unexpected accumulations, correlated threats and unimagined financial market developments can take shape quickly and severely. When disaster strikes - either because of a storm or an economic shift - insured and asset losses can drain balance sheets, impair return on equity (ROE) performance and destroy shareholder value. The cost of systemic and hidden risks can impact every link in an insurer’s financial supply chain, with today’s losses causing capital costs to rise for months, even years.

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Capital Modeling in the Age of Systemic Risk, Part II:  To derive the greatest benefit from an ERM investment, risk management by metrics becomes essential. Every risk assumption, retention or transfer decision must be analyzed using the holistic model to determine whether it is shareholder value-accretive. A rigorous, disciplined capital modeling effort will help a carrier move confidently by supporting strategic decisions with an objective, quantitative foundation.

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Capital Modeling in the Age of Systemic Risk, Part III:   The net impact of prudent capital modeling and management - in regards to both rating agency evaluation and regulatory compliance - is a competitive advantage. (Re)insurers that accept the outcomes of rating agency or standard regulatory calculations may wind up either with gaps in cover (where de facto approaches are insufficient to address a carrier’s risks) or unproductive capital (where the norm requires over-allocation). The use of an internal capital model, on the other hand, allows a carrier to optimize its analysis to its own situation, with more accurate results and more informed decision-making.

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Capital Modeling in the Age of Systemic Risk, Part IV:  Even in the early stages of ERM and economic capital modeling, progress continues. Investments are being made in better risk identification methods and more resilient ERM structures. Capital modeling technology is advancing as well, including better coverage of asset-side risks. With property-catastrophe modeling fairly well established, attention is now turning to casualty catastrophes - a far tougher modeling challenge, as the dimensions of correlation are broader and more complex. Economic bubbles expand and burst with greater frequency and severity. Government intervention policies and practices could be reducing the relevance of the past for forecasting the future. Global interdependency, trading relationships and economic shifts are colliding with property catastrophes, which may be showing the effects of climate change.

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Click here to read Stories from Guy Carpenter’s Chief Actuary: Part II, Conclusion >>

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Guy Carpenter’s Global Chief Economist Joan Lamm-Tennant describes how economic capital is a function of the risk profile that comes from simulation based models, but it also requires knowing the company’s risk tolerance. She reviews how hedging frees up the need for economic capital and reduces volatility.

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Guy Carpenter’s Global Chief Economist Joan Lamm-Tennant reviews emerging themes, post financial crisis, around enterprise risk and risk capital.

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John Major, Senior Vice President, Instrat
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Guy Carpenter’s Firm-Value Risk Modeling (FVRM) approach, described in two previous GCCapitalIdeas.com articles, takes Dynamic Financial Analysis (DFA) a step beyond existing techniques by modeling the impact of risk on the shareholder value of the (re)insurer.  This puts the two dimensions of DFA - risk and reward - on the same scale: value. The output of an FVRM analysis is the M-curve, that relates the (re)insurer’s book value (surplus) to its market (shareholder) value. When the (re)insurer is in financial distress, with insufficient surplus to cover its risks adequately, its market value reflects the possibility of imminent liquidation, and will typically be not much greater than book value. On the other hand, when the (re)insurer holds a generous capital buffer, its market value reflects a going-concern potential to generate a stream of profits and dividends, and will include some franchise value above and beyond its book value. There is a point, however, where the (re)insurer has so much capital that adding more does nothing to enhance its franchise value.

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Chris McKeown, CEO of Global Analytical and Specialty Practices                                                                                    Contact      

The threats to which (re)insurers’ capital is exposed seem to multiply with alarming regularity. Today, the industry is contending with risks that were barely imaginable (at best) 20 years ago. In an age when carriers must respond to casualty catastrophes, the possible effects of climate change and financial market calamity - perhaps all on the same earnings call - it’s natural to wonder if the right tools and techniques for the job are available. Risk and capital management have only grown in complexity, a trajectory that is quite likely to continue - and probably accelerate.

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