Written by Jonathan Bilbul - EMB Consultant
The business benefits of capital allocation have become a reality for many European insurers as a result of implementation of financial risk models. Although initially driven by regulatory advances such as Individual Capital Adequacy Standards (ICAS) in the U.K. and Solvency II across Europe to monitor a firm’s overall capital adequacy, insurers who embed these capital models into daily business practices stand to gain significant advantages. Insurers who use capital allocation for enterprise risk management, pricing, and performance management are able to achieve greater stability and performance of results for their stakeholders.
The need for capital allocation in insurance is peculiar as the capital of the entire company stands behind each risk. In other industries, such as manufacturing, capital allocated is the capital used by a particular business area. In contrast, in insurance the capital allocated to a class of business can easily be used by another depending on the class’ actual losses. When capital is needed it will be very different from what is allocated. The value of capital allocation, however, is in the understanding it brings of the underlying business. The capital allocation technique used depends on the desired objectives, as each will highlight different strengths and weaknesses of the component pieces.
From a risk management perspective, the objective is to determine the drivers of adverse scenarios and the insurance company components that contribute adversely to the overall risk profile. Firstly, risk may be broken down by insurance risk type, whether asset risk, underwriting risk, reserve risk, operational risk, or strategic risk. Capital allocation in the risk management case can be used as a measure of each component’s degree of risk and thus help management decide where to focus their efforts to improve results. For example, a capital allocation exercise might reveal that an investment strategy is imprudent, so a more conservative approach might be tested in the financial risk model. Alternatively, capital may be broken down by peril, line of business, contract, or layer. Here it may be discovered that catastrophes or large losses contribute significantly to the overall risk profile. The impact of a variety of reinsurance treaties can be measured to see which are the most effective in saving capital. Focusing on the individual components with the greatest amount of capital allocated can reveal the areas where risk mitigation will achieve the greatest gains.
From a performance management perspective, the central issue is how the mix of business should be optimized to achieve maximum return on total capital. Allocation for performance management can reveal classes of business for potential growth and classes which should be cut back. In a book of business with an optimal mix by class, the return on allocated capital will be equal for all classes if an appropriate allocation method is used. In this case, understanding the relationships between different risks is key. Certain classes of business might not generate enough profits when held on their own. However, when classes are held in a portfolio in the right proportions, risks can be offset due to diversification benefits, and each class may achieve the target return on equity. In this way, capital allocation can be used for business planning and for setting growth objectives for all classes of business in the portfolio.
From a pricing perspective, allocation of capital is used to determine the cost of underwriting a risk. Although the risk’s price is set in a competitive environment, the decision whether to accept or reject a risk at the market price is reached by examining the internal cost. In this case, capital allocation methods that yield negative allocations are not useful; it is far from obvious what a negative return on capital means in a pricing context. Here, an issue central to the choice of allocation method is the extent to which diversification benefit is credited to a risk. Should new risks only bear the marginal contribution they make to capital given the pre-existing portfolio, or should they also bear some of the stand-alone capital cost? Using capital allocation for pricing has the added difficulty that a change in one class of business can affect capital required for another. For this reason, allocation methods that yield more stability might be chosen.
Huge advancements have been made in implementing capital allocation methods due to the Monte-Carlo simulation techniques employed in building capital models. Over the last two decades, many articles on capital allocation have been written in the domains of finance and insurance; however, simulation modeling has opened the door to using methods that were once highly theoretical in practice. Nonetheless, much work remains for the creative spirit to test new methods and explore the advantages and disadvantages of each. One thing is certainly clear: Those insurers who embed their capital models in their daily business practices can gain significant business benefits.
This article first appeared in the Casualty Actuarial Society - Actuarial Review (http://www.casact.org/newsletter/index.cfm?fa=viewart&id=5489)
