ERM Developments: 2007 at a Glance
By Jonathan Bilbul, U.K. Correspondent
At the stroke of midnight on New Year’s Day, we have the custom in English-speaking countries of singing an old Scottish song called “Auld Lang Syne.” The title, which refers to “old long since” or “days gone by,” is appropriate as we reminisce about the past and make plans for the new year.
The year 2007 has certainly given us much to think about in the insurance industry. In Europe, government bodies, regulators, rating agencies, and insurance companies have all played a part in strengthening the foundations of our industry, as we make plans for the future and move towards implementing Solvency II. Much progress has been made in the push for a more risk-sensitive approach to measuring capital required and benefiting from capital held. These changes coincide with efforts in the United States to implement enterprise risk management (ERM) practices at many companies. Let’s now consider some of the important developments of the past year in Europe.
In October, the Financial Services Authority (FSA), the U.K. regulator, published a report called “ICAS—Lessons Learned and Looking Ahead To Solvency 2.” Individual Capital Adequacy Standards (ICAS), which came into effect at the end of 2004, moved away from rules-based regulation and adopted a principles-based approach. The onus now is on the company to justify the amount of capital held, as the management should be in the best position to properly understand the risk inherent in the business. The report provides a useful progress report. Its main conclusions:
- The level of capital in the industry is relatively unchanged since the implementation of this regulatory regime.
- Insurance risk, composed of underwriting risk on projected new business and reserving risk on prior year claims, accounts for 68% of capital allocated for general insurance companies. The other risk types are market, credit, liquidity, operational, and group risk.
- If there is a gap between the regulator’s and the firm’s view of capital, an individual capital guidance (ICG) is issued by the FSA. The ICG was on average 14% higher than the assessments of capital made by each company, and most fell in the range of 0-10%. This signifies that most companies are assessing their capital adequately.
- The regime has encouraged a risk management culture. The investment in capital modeling has been a success, with most firms using the models for reaching key decisions such as dividend payment, reinsurance purchase, or due diligence on acquisitions. However, further work is required so that firms fully embed their models into the risk management framework.
- Integrating an economic capital model can take five years, including the time for the initial build, further refinement, calibration, and having the model used across the organization.
On the Solvency II front, the new regulatory regime for reinsurance companies in Europe, there have been many developments.
In July, the E.U. Commission published a framework directive on Solvency II. This directive pushes back the implementation date by a couple of years to November 2012, but it provides a clear picture of the way forward.
Solvency II will resemble the ICAS regime in many respects. It, too, will have a risk-sensitive approach to regulation and will allow internal models to assess capital, although this is not a requirement. Here, too, satisfying the “use test” will be crucial to validate an internal model, as it will demonstrate that management actually uses the model and believes in its results.
As an alternative, insurers can adopt a standard formula for calculating regulatory capital or even a hybrid assessment, using the standard formula for some risk types and a partial internal model for the others. The directive also emphasizes the importance of having robust risk management practices to mitigate against insurer failure, and clear disclosure of these practices. Thus, the aim is to align risk measurement and risk management.
In November, the Committee of European Insurance and Operational Pensions Supervisors (CEIOPS) published the “Report on its third Quantitative Impact Study, QIS3, for Solvency II.” Each study allows firms to test different aspects of Solvency II and comment on their suitability based on their company-specific information and certain proposed calculation methods and factors.
QIS3 had the highest response yet. Some highlights include:
- The regime would not require extra insurance capital overall, but there would be big variations among companies. Surplus, the excess of available capital over regulatory capital required, would increase by more than 50% for 30% of firms, while it would decrease by more than 50% for 34% of firms. Furthermore, 16% would have to raise additional funds to meet surplus requirements.
- Only 13% of respondents used internal models to quantify results. This may be partly because some respondents were unwilling to disclose results. The reduction in total required capital for nonlife insurance companies seems to be about 25% as compared with the standard formula.
- In calculating diversification benefits, the standard formula set out in QIS3 did consider interaction between risk types according to a predefined correlation matrix. However, when setting capital the correlation of events in the tail of the distribution has the greatest impact.
- Many firms regretted that, for reasons of simplification, expected profit/loss in nonlife business was no longer considered in the calculation since it is important in valuation of capital required in the nonlife component. From an economic perspective, expansion into new lines of business has a favorable effect on capital as long as it is profitable.
- Firms felt it important to recognize quality of operational risk management; factor-based calculations do not give incentives to develop adequate risk management systems.
- To assess the impact of catastrophe losses under the standard approach, insurers must quantify the impact of a list of prescribed scenarios on their balance sheet and income statement. It is, however, difficult to choose standard scenarios appropriate for the risk profiles and reinsurance arrangements of every firm. Catastrophes represent a serious threat to insurance company solvency and must be treated in a coherent manner across all countries and legal entities.
- Although feedback was limited, the report did reach some initial conclusions about diversification benefits within groups, which can vary both from their sources and their amount. Many global insurance groups gain significant diversification benefits from insurance holdings outside Europe. How would diversification be allocated within and outside the European Community? These are areas of research for QIS4 to be released next spring.
All the shortcomings of the standard formula identified by QIS3 are addressed if a company builds a full internal model. Solvency II creates incentives for companies to do so, as models provide a far more realistic representation of the degree of risk in company operations. They treat risk consistently across legal entities, are based on economic values, reward better risk management, and allow for the full effects of diversification.
Meanwhile, the Standard & Poor’s Second Pan-European Insurance Symposium was held in Brussels in June. Here, too, ERM is gaining in importance. In her introductory remarks, S&P President Kathleen Corbet stated:
Over the last five years, the shift towards greater transparency, the intensifying focus on risk management and rapid emerging securities-linked insurance market have changed the global insurance landscape, and a revolution in regulation is under way. Together these changes have created potential for the industry to embark on an era of consistent success…Will the industry seize this opportunity?
There was talk about recent changes to the way financial strength ratings are set. In the context of evaluating ERM practices, S&P use their capital model as a tool for discussion with companies. They compare their own results with the results from the company’s economic capital model. The absolute answer from either model is less important than the resulting interpretation and understanding of risk.
Paul Sharma of the FSA, who chairs the CEIOPS Pillar I Expert Group, developed the theme of revolution in his keynote speech. He foresaw a possible move away from the cyclical nature of the insurance industry towards a period of stability, security, and success, with economic capital models playing an important part in this new era. Sharma said that “The potential for capital savings, if you can quantify your risks to a high standard, I think is going to be significant—significant enough to drive pricing, significant enough to drive competition.” Although Solvency II is a driving force, these changes are already taking place in jurisdictions across Europe.
Another noteworthy event was the Royal&SunAlliance (RSA) capital presentation to the investor community in September. George Culmer, Group CFO, demonstrated how their economic capital model is an integral part of running their business and delivering financial results. The model is used at all levels and to support a broad spectrum of applications.
The eight key areas where it provides more informed decisions are (1) capital structure evaluation, (2) insurance risk management, (3) investment management, (4) transaction evaluation, (5) reinsurance purchasing, (6) performance management, (7) product pricing, and (8) strategic and operational planning.
The key message is that RSA is well managed and taking steps to achieve optimal return on capital. In the weeks following this presentation, RSA’s stock price significantly outperformed the FTSE All Share Non-Life Insurer Index.
There has been much progress towards implementing ERM practices in the insurance industry during 2007, as evidenced by these developments in Europe. In the United States as well, rating agencies, the Minnesota and New York state regulators, and individual companies have all pushed forward the case for ERM.
Although we may yearn for “Auld Lang Syne” or “days gone by,” the progress on ERM in the insurance industry suggests the best is yet to come.
Jonathan Bilbul, FCIA, FCAS, is a consultant at EMB Consultancy in England. He can be contacted at email@example.com.