Financial Modelling - A Capital Idea

Financial models are helping insurers and reinsurers to understand the strategic implications of catastrophes. By Richard Weston of EMB. 


No individual can be totally confident that his or her house will be standing in a week’s time. In the same very bad week they can lose their car, their pet can get sick and their holiday be cancelled. The fact that each of these events is unlikely and the three together almost unheard of is not the point. We buy insurance in case the worst happens.

For the insurer, by contrast, things should be different. The management team controls a pool of risks; bad experience on one should be more than offset by good experience on another. The management team then considers the chance of, and the extent to which, bad performing risks can outweigh the good. Then they set aside the necessary capital (or transfer the risk using reinsurance) and set premiums such that the price adequately rewards the provider of the capital.

That, at least, is the theory, but catastrophes pose a bit of problem. They are difficult to quantify both in terms of their likelihood and the extent of the damage and are one of the most significant items in capital setting exercises. If a firm is over-cautious in its catastrophe assumptions and sets aside too much capital this results in wasted resources and restricts business flexibility. When the opposite happens and insurers lose more than they have bargained for, headlines are written, shareholders, regulators and ratings agencies are unhappy and, in extreme cases, the whole firm collapses.

Catastrophe models may provide some limited assistance. For the areas where these models are available they will convert an insurer’s exposure into a distribution of natural catastrophe losses.

What the catastrophe models don’t do is identify which areas of the portfolio are most at risk, the impact of man-made catastrophes or the significance of liability catastrophes. The catastrophe models deal with natural catastrophes as a stand-alone issue and ignore the more strategic concepts such as interactions with the rest of the insurer’s portfolio and how the loss will come through in company accounts.

For most insurers and reinsurers the best holistic solution is to create a financial model that mirrors the company’s individual characteristics. It is then be possible to feed any number of possible scenarios (including the output of catastrophe models) into your model to see how your company would cope financially if they happened for real.

What would be the bottom line impact of a natural catastrophe if the rest of the portfolio performed as expected? What if the catastrophe was so large it also impacted stock market values?

The output from the model then needs to be combined with the insurer’s ‘appetite for risk’. In the same way that the man who does not mind getting wet does not need an umbrella the insurer who does not mind being rated ‘A’ does not need a ‘AAA’ capital provision.

Armed with the output of the financial model and given your appetite for risk, strategic management and underwriting decisions can be made to plug the gaps and adjust your portfolio to make your company more profitable and better able to withstand adverse circumstances.

Reinsurance purchase is one area that comes under the spotlight during these exercises, often with far-reaching consequences. Firms may find that they have bought cover unnecessarily in some areas, whilst being unacceptably vulnerable to catastrophes in others. With a few corrections it can be possible to create a program that is simpler, more effective and cheaper.

The financial model does not just deal with catastrophes and reinsurance buying; it is increasingly being seen as a key risk management and capital modelling tool by regulators and ratings agencies. It reflects the priorities of a growing number of national authorities in Asia, including Singapore, and is central to the Solvency 2 reforms currently taking place in Europe. With recent announcements by Standard & Poor’s and A.M. Best that they intend to place greater emphasis on Enterprise Risk Management in future, it is relevant to any insurer that values high security ratings.

Many smaller companies are suspicious of modelling as a concept in case it is unduly complex and time-consuming. Like buying household insurance, it may require a bit of shopping around to find something that suits, but even the most simplified model may help avoid a crisis.

Above all, however, modelling need not be as expensive as some people think provided they have a clear idea of what they want to achieve. One approach sometimes used it to start with a simple, well-defined project covering one aspect of the business. Once the company feels at ease, it can then build on the model, which becomes progressively more ambitious and complex over time.

It is important that insurers and reinsurers understand their catastrophe exposures but catastrophe models are only a part of that. The financial model is the tool that allows the big picture to be seen, the capital implications understood and the strategic decisions made.

This article appeared in Asia Insurance Review in June 2006