Strategic Risk Capital Management
1. What are good models for combining strategic, risk, capital and financial analysis organizationally?
2. What are the prospects for effective global convergence of accounting, regulatory and performance measurement standards?
3. What are the implications of standard convergence on insurance company strategic, risk, capital and financial management?
4. How have ERM developments helped to integrate measurement methods?
5. How will these changes provide new product/market opportunities for insurers?
Strategic planning and capital, financial and risk management have often been separate activities within insurance/reinsurance companies. With natural and man-made disasters, financial crises and longevity increases, these activities need to come closer together. Computer and information technologies have facilitated new forms of integrated analysis. The industry now needs to further develop and integrate these tools for an effective strategic risk capital management system.
Convergence of industry measurement systems is making this process easier and more critical. IASB and FASB are progressing toward a more uniform approach to insurance accounting through IFRS. IAIS, the EU and other national regulators are developing common principles for regulatory solvency standards (e.g., Solvency II), consistent with the direction the Basil Committee has taken with banks. Many countries are moving toward these developing global standards voluntarily to promote consistency and clarity. Internal measurement of profitability, long subject to a wide range of approaches and measures, seems finally headed for some greater agreement (e.g., the European CFO Forum’s MCEV).
As public measures of industry performance change and converge, companies need to evaluate how they affect them in terms both of economic reality and public perception. This will lead to a more effective risk and economic basis for corporate strategies and regulatory assessment.
All of the current trends are built on the same foundation – a sound enterprise risk management (ERM) system. Companies are expected to understand the wide range of business risks they face (e.g., insured, investment, financial, credit, operational) by regulators, rating agencies and shareholders. Insured risks include natural hazards made more extreme by climate change and man-made hazards that can impact several lines of business at the same time. They also include new demands for retirement savings products and services as pay-as-you-go public pension systems come under increasing pressure. Investments that back insurance reserves and capital remain under scrutiny as markets and regulators respond to the recent financial crisis, raising questions about existing products and offering potential for new ones. Companies need to have in place systems for identifying, monitoring, avoiding, mitigating and transferring these risks. They also need to determine appropriate levels of capital and pricing to address them.
The recent financial crisis, the Japanese earthquake/tsunami , tensions in the Middle East and long-term concerns such as climate change have highlighted the need to look beyond normal risk distributions to the potential for extreme tail events. These might involve rare insured losses occurring or may arise from external political or economic sources. They may involve sudden events or damage from long-term problems. Extreme events do not negate the value of traditional analytical techniques. They do require that each form of analysis be understood within the parameters of its assumptions and limitations.
A comprehensive ERM program should provide early warning of risks from many sources. But, particularly in insurance, it is not merely a matter of avoiding negatives. Good risk analysis offers insight into new product and pricing opportunities. It may suggest more efficient reinsurance structures for both cedents and reinsurers. It may suggest new application of capital market structures and products. Despite the recent concerns about risks associated with mixing financial services, it may suggest additional, controllable approaches to integrated financial services.
Analytical tools such as economic capital modeling can help to align risks in alternative lines of business with efficient use of capital. It can also help with efficient use of reinsurance as a capital management tool. Analysis uses a wide range of financial models such as cash flow projections of future results often used in evaluating new ventures and valuing acquisitions. Such models depend on the identification of ranges of assumptions that reflect best estimates of future performance. These may include stochastic analysis of a large number of scenarios or select best case, worst case, expected case and stress test deterministic scenarios (e.g., to account for extremes). Aggregation tools help to reflect the combined effects of multiple factors that impact insurer and group results (e.g., reflecting diversification).
Integrated consideration of risk, capital, financial and strategic issues may also help companies address some of the historically intractable industry problems. Insurers, particularly life insurers, have faced the continuing problem of keeping distribution costs within the bounds of competitive pricing allowances (see separate leader on this topic). Adding distributor incentives increases cost but may not improve sales at the level needed. Attempts to cut distribution costs may reduce sales beyond the value of the cost saving. This kind of analysis won’t solve the strategic issue of how to design efficient distribution approaches but can be useful to test the cost/benefit projections of available alternatives.
As we become more aware of global risks, the industry has the potential for creating new markets. The usual challenge with a new market is to define insurable risks and establish appropriate pricing. Improvements in data collection and analysis of catastrophic natural hazards (e.g., windstorm, earthquake) may allow for extending coverage to areas of the world previously avoided. Cell phone service may provide the means for informing a broad new audience of the potential for insurance and facilitate its sale, service and loss control (e.g., microinsurance). These new opportunities need to be included in integrated analyses.
Better risk capital management also has the potential for improving the management of operations around the world. Multinational companies face constant questions about potential expansion to new geographic markets, restructuring, divestiture and the placement and functions of local, regional and head offices. Economic capital and other analysis can provide risk-adjusted capital requirements and other measures of local and regional operations to help manage these strategic choices. The same analysis can be used in efforts to secure new financing and inform investors of the strategic investment story behind short-term performance results.
Insurance is a complex business. Capital investment, pricing and management of existing business over decades requires constant monitoring of key factors that drive future performance and profitability. Company managements face new risk exposures and business opportunities and need to use available tools to understand them and keep ahead of the game.
1. How have the economic crisis and aftermath affected insurance lines, e.g., higher claims, decline in sales, growth in sales, new products?
2. How has the experience in financial services affected the direction of insurance regulation? Is insurance regulation affected by mistaken assumptions about industry needs and norms, e,g., excessive restriction on the use of needed hedging facilities?
3. How will the recent experience change risk management practices in the industry?
4. Will problems in the derivatives markets reduce or change the use of capital markets for insurance activities?
5. What new market opportunities are created by the recent crisis?