Insurers who are currently worried about the implications of Solvency II should take a positive view of the process, says Richard Rodriguez of EMB. Far from threatening to be an unnecessary burden, it can help them achieve their financial objectives.
Many senior insurance and reinsurance executives find Solvency II, and specifically the proposals around risk-based regulation, a daunting prospect. This applies not just to people based in Europe, but also to Asia, southern Africa and other regions where they are watching the process with great interest. There is a view that whatever Europe decides will form a benchmark for much of the rest of the world; indeed this has already started to happen.
There are essentially two possible attitudes to the inevitable arrival of risk-based regulation. Insurers can approach it defensively as an additional burden. Alternatively, as many of the larger companies are already doing, they can see it positively as little more than a natural extension of best practice. Those who take the second approach will have significant competitive advantage over the rest.
We are, of course, to some extent walking in the dark here. Whilst everyone agrees that Solvency I is out of date, there remains considerable debate over its replacement. In broad terms, there is an issue over whether Solvency II should be purely risk-based or whether there should be an element of rules-based regulation. There is an associated question over the role of financial models in measuring risk. To what extent should they be applied to all insurers and what alternatives might be acceptable for smaller or less sophisticated entities?
Without wishing to become part of that debate, it is my view that insurers should assume an outcome in favour of pure risk-based regulation, even though that may not necessarily be the case. The important point is that the disciplines and processes encouraged by such regulation will make insurers more profitable and more stable than they might otherwise be. They should welcome them, regardless of what the authorities may or may not require.
The benefits include information and analysis that will facilitate more effective allocation of capital, better use of reinsurance and other risk transfer mechanisms and higher returns. Contrary to what many people believe, risk-based regulation does not lead inevitably to increased capital requirements. In fact, they sometimes go down.
The approach is increasingly compatible with the ratings agencies. Standard & Poor’s announced last year that they were moving towards enterprise risk management, heralding a fundamental change in methodology that has been echoed since by other agencies. In future, a risk-based approach towards capital management will satisfy the expectations of regulators and analysts alike. Furthermore, as I shall explain, it will help keep your shareholders happy.
To illustrate this point, let’s look in more detail at the UK experience, because the FSA is a very high profile example of a European regulator to go down the route of risk-based regulation.
The basic principle of the FSA regime is simple enough. An insurer or reinsurer is required to demonstrate that it has understood all the risk inherent in its business and then taken steps to control it. The expectation is that the company should have at least a 99.5% probability of meeting all its obligations in any one year.
At the centre of the process is the Internal Capital Assessment (ICA), which involves quantifying the risks inherent in your insurance business and then deciding the amount of capital you need. As with the Solvency II proposals, it takes into account Operational Risk, Group Risk, Insurance Risk, Market Risk, Credit Risk and Liquidity Risk. Within these categories, there are many smaller types of risk to be analysed.
As well as aggregating the capital requirements of all the risks, the FSA demands that you demonstrate an understanding of how they interrelate. For example, a big insurance event could trigger a fall in equities (as after 9/11) and so accentuate the strain on capital.
In practice, all but the smallest insurers find that the best way to conduct this exercise is through the use of stochastic models. These are financial models that enable you to test your business by simulating any number of possible scenarios, predicting their effects on critical areas such as cashflow and profitability.
It then becomes relatively easy to adjust your model to make it more stable, if that is necessary. You may find, for example, that your company is unduly exposed to the stock market, in which case you might move from equities into bonds. Or you may be overweight in certain lines or territories and decide to diversify either through changes in underwriting strategy or by opening up in new locations. Whatever your choice, you should be able to demonstrate to the regulator that you have a good understanding of your risk – provided, of course, that your calculations are based on sound data and assumptions in the first place.
That, however, is only Part One of the story. With a few exceptions, most UK insurers have found that a risk assessment’s potential uses are far more widespread than just keeping the regulator happy. In fact, it can become a central strategic tool, because the information and analysis enables you to exploit your capital more effectively and leads ultimately, therefore, to improved profitability.
A key benefit is that, once you have completed the risk model, you can test the financial impact on your company of any number of potential strategies. Of course, the models are no substitute for human judgement, and any decisions must take into account wider corporate priorities. Nonetheless, the results will help senior management plan ahead by giving a strong idea of the potential financial consequences of different courses of action.
Specifically, financial modelling can support the following strategic activities, among others:
• Capital allocation;
• Reinsurance purchase;
• Product and pricing strategy;
• Business expansion;
• Mergers and acquisitions;
• Alternative Risk Transfer mechanisms;
There is insufficient space to consider each of the activities mentioned above in detail, so let’s just look at the second of these, reinsurance purchase.
Identifying a better reinsurance strategy
Buying reinsurance is one of the most basic functions of any insurance company, and often an area where a company’s analysis is weak. Yet the programme’s effectiveness is bound to have repercussions for the entire financial performance, including return on capital.
Once you have captured all the risks inherent in the business, as you must under the FSA and any likely Solvency II regime, all the reinsurance options can then be tested with regard to their impact on overall company performance. This exercise will measure the outcomes of any number of different reinsurance strategies.
They could be quite simple such as just assuming an increase in excess points. Alternatively, the analysis might turn into a wholesale review of reinsurance strategy looking at, for example, combinations of changing aggregate deductibles, excesses, limits, reinstatements and placement percentages with the outputs from each scenario being a number of key statistics.
Armed with this information, management can then arrive at the best reinsurance programme, taking into account corporate priorities.
Graph 1
The graph below shows the gross versus net underwriting result for a class of business. It can be seen that when there is a high gross underwriting profit there is a lower net one as the reinsurance programme is being paid for with few, if any, reinsurance recoveries. Conversely, if there is a gross underwriting loss the net result is better due to the operation of the reinsurance programme.
Graph 2
Additionally, for each reinsurance contract that has been included explicitly in the Dynamic Financial Analysis model, a graph of the reinsurance premium versus the reinsurance recoveries can be examined.
The graph above shows that for nearly 90% of the time there is no reinsurance recovery from the contract. However, when there is a claim it is likely that the recoveries will exceed the premium paid, including reinstatements. It can also been seen that the reinsurance limit of £50m is breached a small percentage of the time and benefit is achieved when reinstating the limit.
Reinsurance purchaseis just one example of how you can extract all kinds of business benefit from risk-based management of capital, which lies behind much of the thinking in Solvency II. Insurers who embrace these principles will have a significant advantage over those who fail to do so.
This article appeared in Insurance Regulation & Accounting in April 2006
