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5 ways a CRO can use economic capital models to drive strategy

Risk & Analytics|Insurance Consulting and Technology
Risk Culture

By Chris Bird , Rob Collinson , Gavin Hill , Stas Eratt and Alice Underwood | January 9, 2020

Insurers use economic capital models mainly to extract a risk capital requirement, but it can provide so much more. We offer five suggestions.

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About our 'A Year in the Life of the Strategic CRO' series

In our ongoing A Year in the Life of the Strategic CRO series, risk experts from our Insurance Consulting and Technology team, Willis Re and other parts of Willis Towers Watson cover how a strategically focused CRO can drive corporate strategy through the enterprise risk management planning process and throughout the year.

Economic capital models are powerful tools. Many insurers use them mainly to extract a single number — the company’s risk capital requirement — but an economic capital model can provide so much more. Here are five suggestions from the Willis Towers Watson Insurance Consulting and Technology practice for ways chief risk officers (CROs) can use their organizations’ economic capital models to drive better strategic decisions.

  1. 01

    Move beyond box-ticking.

    If your economic capital model has been relegated to the doldrums of compliance, how can you unlock more value?

    • Relevance. The model must be meaningful to its users. This requires models to reflect users’ day-to-day reality of underwriting, reserving, pricing and business planning. If business users don’t recognize their parameters and priorities in the model, it’s extremely difficult to create traction and interest outside the core modeling team.
    • Reliability. One silly or obvious error in model output can confirm doubters’ prejudices. Getting another opportunity is very difficult, so it’s especially important to validate results in the early days of model use.
    • Metrics. Standard yardsticks help users evaluate the success of a given strategy and rank potential new approaches. Creating an innovative, unique analysis for every decision may entertain the modeling team but it’s not helpful to senior decision makers.

    It is important that the model presents pragmatic and useful insight in a repeatable, consistent manner — irrespective of the question being asked. This assessment typically requires not only reviewing profitability and sustainability but also demonstrating how a particular action moves the business relative to the constraints expressed in the risk appetite.

    Finally, recognize the model’s limitations. Business decisions are inevitably driven by experience, personal insight and qualitative considerations. However, a robust analysis with transparency of assumptions and the range of results provides a justifiable and solid basis on which to overlay such expert judgement.

    Today, economic capital models are at a crossroads. Strategic CROs deploy what might otherwise be an expensive compliance tool to provide a holistic representation of the business. A relevant and reliable model can:

    • Use consistent metrics to deliver genuinely new insights to “old” situations
    • Suggest new and valuable courses of action
    • Provide greater confidence when reviewing current plans

  2. 02

    Determine the significance of diversification from a proposed acquisition.

    Given tight time frames for insurance M&A due diligence, it’s rare to see an explicit capital efficiency analysis for the combined entity. Most deals are done looking at the best estimates for reserves and prospective loss ratios. So, two deals could potentially have the same purchase price but significantly different risk profiles, e.g. one being much more volatile.

    Normally acquirers are seeking to diversify their businesses. Using an economic capital model, the acquirer can apply correlations explicitly and measure the level of diversification, as well as assess the combined risk profile across not just reserve risk but also prospective premium and catastrophe risk as well as market risk.

    Parametrizing the model using the target company’s data might be unrealistic given time constraints, so it may be necessary to use some form of benchmark. It’s important to test sensitivity of the calculated capital efficiency in relation to the correlation and benchmarking assumptions, but this kind of analysis can support a much more informed decision than simple point estimates.

  3. 03

    Create the story of risk profile changes over time.

    Capital models are, by their very nature, complex beasts; they contain vast volumes of information. Reports on capital requirements often run to hundreds of pages — and that‘s before opening the appendices.

    However, we have found that firms that take the time to craft a concise narrative of their capital model can achieve a significant return on the resources invested in articulating this shorter story.

    As part of a major model change combined with a Brexit-related internal model application, we helped a client craft a simple, targeted, graphically-based narrative. It contributed to a positive outcome and minimal challenge from a regulator known to deluge firms with additional requests.

    The narrative made clear:

    • The materiality of different risks
    • Whether the amounts of risk had changed due to movements in exposure or volatility
    • How movements in the quantum of risk related to underlying business activity
    • That the firm was alert to and monitoring for the possibility of model drift
    • How the board and executive understood the risk profile

    This narrative is now a valued model output that is created automatically whenever the model is run.

    The real benefit of such a short “story” is that stakeholders instinctively “get it” and can engage with and question the messages delivered almost instantly.

  4. 04

    Don’t settle for solvency: Drive to thrive.

    If you’ve got an economic capital model but are only using it to measure tail risk, you’ve got an underutilized asset. By all means, use the model to help give your regulators, debt holders and policyholders confidence in your company’s solvency. But don’t stop there. Using your economic capital model to inform strategic decisions that affect quarterly and annual earnings will bring benefits to investors, management and employees — and truly help your company thrive.

    While it’s true that insurance is a heavily regulated business, it’s still a business. Publicly traded and privately held insurers are answerable to their investors, who are looking for a good return on investment. Although mutual insurers don’t face the same sorts of investor pressures, they’re still seeking to do more than just remain solvent: They want their businesses to flourish and provide excellent service to their members.

    That means risk isn’t only about solvency.

    Solvency is necessary but not enough. A company whose leaders are worried about solvency on a day-to-day business is in big trouble. Leaders of thriving insurers are focused on near-term risk such as earnings. We see this, for example, in the factors they consider most important in making reinsurance decisions.

    Earnings protection: 52% Solvency management: 31% Expertise in product development, underwriting, expansion: 11% Other: 6%
    Figure 1: Which of the following measures/needs are more important to your reinsurance decision?

    In Willis Towers Watson’s most recent Global Reinsurance and Risk Appetite Survey, Earnings protection — including both the actual result and earnings volatility — was by far the leading consideration. And increasing pressure from investors over recent years means insurers are less tolerant of missing earnings targets.

    The good news for insurers that have a sophisticated economic capital model is that they can readily assess both remote tail risks and risks to earnings — it’s simply a matter of focusing on a different part of the probability distribution.

    Indeed, a well-structured and appropriately calibrated model is able to assess earnings volatility with a much higher degree of confidence: Parameter risk is inherently greater when assessing events out in the remote 1-in-200 or 1-in-250-year return period range.

    Providing insight on earnings-related decisions is an important way for the strategic CRO to deliver value.

  1. 05

    Develop multi-year projections to inform mid- and long-term strategy.

    Soon after the first firms were up and running with internal models, initially assessing risk over a one-year period, they started thinking about the possibilities for longer term projections.

    A few firms tried to develop models with a projection period of three years or longer. They quickly realized that there are many practical challenges with this. The real killer is management actions.

    Say a firm makes a big loss in a year: How will management respond? They are unlikely to carry on with the original strategy as if nothing happened but will likely revise the plan. How can you model their decision making? You may attempt to codify some rough rules for different scenarios, but then are you tying management down? If a bad event occurs, does management have to follow what your model says they would do?

    Firms have had better traction building a series of one-year models: assuming the first-year runs to plan and then running the model for the second year. Likewise, for the third year, assuming the first two ran as planned.

    Unlike a three-year continuous model, this approach can’t yield risk information for the full three-year period (e.g. the chance of defaulting at some point in the next three years). But it does offer some very valuable insights into how the current risk profile is expected to evolve over that time.

    Your firm may have plans to grow over the next three years. The model can show how your risk profile and capital requirements will grow with it. Management can see if they are likely to face a capital strain and can then set dividend or capital management strategy accordingly.

    In soft market conditions, it’s common to see several red flags against risk appetite metrics. A multi-year projection can help assess remediation strategy over the medium term, hopefully with a green flag at the end. In the short term an account may be in trouble, but management may be satisfied if things are positive in the medium term.

    Going further, you can also wargame different strategies under possible future scenarios — for example, testing out possible different plans for year two assuming there was a market changing event in year one.

    All very valuable insights, from an approach that is far more practical than the continuous projection.

Authors

Chris Bird
Senior Director - Technology Program Management 
Insurance Consulting and Technology

Global Leader for Capital Modeling

Gavin Hill
Director – Risk
Insurance Consulting and Technology

Director – Risk, Insurance Consulting and Technology

Alice Underwood
Global Leader of Insurance Consulting and Technology

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