Because modelling makes it possible to measure the effects that decisions and strategic changes would have on a re/insurer’s financial performance, it is increasingly at the heart of the business planning process.
It helps to determine all aspects of portfolio management, including capital allocation. By measuring the potential profitability of each class and weighing it against the inherent risks, it provides the information needed to determine what types of business to write and also your pricing strategy.
How you use the information that modelling provides will depend on corporate priorities. For example, if long-term return on capital is the number one objective you may respond differently than if it is profit stability and differently again if it is high security ratings. Whatever your goals, however, you need to have reliable information and analysis in the first place.
The brief case history below provides a simplified outline of how it can work.
Case history
A personal lines insurer with approximately two million motor and two million household policyholders used financial modelling to make decisions about capital allocation, product pricing and volumes, investment strategy and reinsurance purchase. Annual premium was £800 million for Motor and £180 million for Household.
The exercise concentrated on three types of risk as being the most business-critical:
• Insurance risk.
• Reserve risk (i.e. the danger of under-reserving);
• Asset risk (including stock market volatility, bonds and broker solvency)
The equity strategy (15% equities, 15% cash, 35% gilts, 35% corporate bonds) was found to be unduly conservative. A modest increase in the equity holding would significantly boost long-term returns with only a marginal effect on asset risk.
Reinsurance purchase placed undue emphasis on the relatively stable (albeit larger) Motor book. The main potential for volatility lay with Household, where the company had underestimated its vulnerability to catastrophes.
The Household book, being the more capital-intensive and accounting for 33.5% of net premiums (c.f. motor 12.4%), was found to be overweight.
In response to this information, the company made the following decisions:
• A 5% increase in equity investments;
• A 10% increase in Motor premium income and a corresponding reduction in Household;
• Increased Excess of Loss reinsurance purchase for Household, but less Motor reinsurance.
As a result, the insurer was able to increase its expected profit and the probability of meeting its target return, whilst reducing its overall capital requirements.
