Written by Tom Hettinger
A revolution is taking place in the way regulators assess the financial stability of insurance and reinsurance companies in much of the western world. It is being driven mainly by the Europeans, who are exploiting modern methodologies and software developments to move regulation onto a new level.
The United States, however, is remaining aloof from the process. Perhaps this is because it has avoided the scale of insurance company disasters that have afflicted some other centers in the past or maybe because the method of regulating solvency among 50 different states would make the reform process too unwieldy and fragmented to contemplate.
Either way, with recent downfalls of companies like Reliance, Kemper, and Superior National, is it time the US sat up and took notice? This question goes beyond asking how best to protect buyers, important as that is. Despite their initial skepticism, insurers who have experienced the new type of regulation find that it has all kinds of other benefits. It encourages disciplines and processes that optimize both profitability and the use of capital. It could also improve transparency in compliance with the requirements of Sarbanes-Oxley.
The article will focus mainly on Europe and, specifically, the United Kingdom, which has chosen to take a pioneering role within the European Union. The Australians and Canadians should not, however, be forgotten as they claim to be the first to go down this route.
The whole world watched as Australia suffered a series of insurance and reinsurance disasters at the end of the last decade, but hardly anyone seemed to notice when in mid-2002 they installed a rigorous new regulatory regime, effectively re-licensing all players. They swung in a relatively short space of time from a one-size-fits-all system based mainly on premium income and reserve levels to a much more sophisticated risk-based method of appraisal.
At the heart of the new system is the principle that insurers should assign a risk charge to a variety of sources of risk, with the precise weighting dependant on the type of risk. They must be able to demonstrate to APRA (the Australian Prudential Regulatory Authority) that they have enough reserves set aside for a 75% probability of sufficiency. They must, in addition, hold capital charges in excess to bring the total probability up to at least 99.5% over a one-year time horizon.
The Canadians, since the mid 1990’s, have required a Dynamic Capital Adequacy Testing (DCAT) analysis of each company. This approach is more of a stress test of the balance sheet based upon several plausible adverse scenarios and does not address the range of probabilistic events or ask for an opinion on a prescribed threshold being met.
The European Economic Area (consisting of the European Union and non-EU countries such as Switzerland) has, of course, a far bigger insurance and reinsurance industry. It is now going through its own process using many of the same underlying principles as in Australia. Coming under the Solvency II banner, it aims to introduce a Risk Based Capital approach to insurance regulation in 2009.
The United Kingdom, meanwhile, has decided to take its own initiative. It has, according to some estimates, the world’s second largest property-casualty insurance sector. Lloyd’s and the London market are, of course, leading suppliers of reinsurance and surplus lines insurance to the United States.
The first major decision of the UK’s new regulator, the Financial Services Authority (FSA), when it assumed its powers in 2001 was to introduce a new approach to prudential regulation for the insurance and reinsurance industry. This is coming into force during 2005.
Like the United States, the UK has decided to utilize a Risk Based Capital approach. In addition, however, the FSA requires each insurer and reinsurer to make an Internal Capital Assessment. It is a critical difference.
As the name suggests, an Internal Capital Assessment is a form of self-certification, confirming that an insurer or reinsurer has enough capital to support the business it is writing and the other risks inherent in the business. In essence, it requires the company to build a model that identifies the potential different outcomes based upon the specific risks of the company. This is not too different in principle from company-specific catastrophe models, but in a much broader scale. The list of risks includes the following categories, though their relative importance and weighting will vary from company to company:
• Reserving risk on prior business
• Underwriting risk on planned business
- Attritional
- Large
- Catastrophe
- Reinsurance programs
• Credit risk on reinsurance past and future
• Asset risk
- Market/Credit risk
• Liquidity risk
• Operational risk
• Group risk
While this list may seem similar to the risks the NAIC RBC formula tries to address, the methodology is fundamentally different. The FSA has not set out a formula by which companies can measure themselves against directly-given specified criteria. They expect, instead, that all but the small insurers will create stochastic models for their businesses. These are financial simulation models that enable you to test the resilience of your operation in any number of possible real-life scenarios such as high loss experience, stock market or reinsurer failure or adverse claims development.
One of the models' strengths is the ability to take full account of variability and also of the dependency that exists between different types of loss, which proved so devastating to balance sheets after September 11. This enables companies to see where they are most vulnerable and to devise capital-efficient strategies for anticipating extreme events.
The FSA are under no illusions about their ability to rule out the possibility of insurance or reinsurance failure. Trying to achieve such a utopian state of affairs, as well as being a quest for the impossible, would be utterly capital-exhaustive. Instead, they require companies to demonstrate through their models that they could withstand a one-in-200-year combination of adverse circumstances. An approach somewhat similar to how rating agencies have addressed catastrophe management in the US, but now looking at all risks impacting on the balance sheet.
If this were simply an exercise to keep the regulators at bay, it would add no lasting value beyond creating more paperwork. In fact, the FSA are insisting upon good practice, and UK-based insurers and reinsurers are coming to appreciate that it has widespread business benefits. Simulation modeling enables the company to understand the drivers behind the business and the likely financial consequences of any change of strategy.
While the NAIC approach is risk-based, it stops short of what the other regulatory entities are trying to do. It does not quantify the true underlying variability potential of a company and what are the actual dependencies between different risks for the company. This shortcoming has caused companies to see the NAIC approach as a “plug and chug” approach (or just another accounting hoop) to get a final answer without asking “How is my company different?” and trying to better understand the risk characteristics.
To address this concern, the NAIC has tried to install some soft variability qualifications into its actuarial opinion requirements by asking the actuary to comment on the reasonable range of outcomes or areas for potential adverse development, but this only addresses the area of reserving risk. In its present form, furthermore, it does not ask the actuary to consider the full range of potential outcomes or, for that matter, to have the company hold capital to offset the potential deviations noted in the opinion.
Many US insurers and reinsurers are already familiar with the principles of stochastic modeling, having seen a need to run catastrophe models to address rating agency queries. As many companies became more comfortable with this process they dived into the modeling and the use of a risk measure, Probable Maximum Loss (PML), to really understand the catastrophe risks of their book of business. Companies embraced the technology to design better reinsurance programs, adjust pricing needs, focus marketing efforts, and in general manage their PML’s.
In a similar way, meeting the FSA requirements may lead to improvements in the following areas, amongst others:
• Capital adequacy and allocation;
• Product and pricing strategy;
• Scenario testing;
• Reinsurance purchasing;
• Security ratings;
• Business expansion;
• Mergers and acquisitions;
• Transparency.
Some of these points are now discussed in more detail, starting with the first three, and then moving on to the final one about transparency.
In the chart below, the model has produced a simple response to a demanding question, does the company have its product mix right? It shows the likely outcome of a series of alternatives for an insurer that specializes in two lines of business, with strategy four representing the status quo or base. It investigates the capital required, expected returns and profits and the probability of meeting financial targets in a series of different scenarios.
How management reacts to this information will depend on a number of non-actuarial factors, including risk appetite. A reasonable response, however, would be to increase the proportion of business in line 1 by 10% and make a corresponding reduction in line 2 as per scenario five. This maximizes the likely return on capital and probability of meeting targets, while reducing the capital required to a minimum.
A similar type of chart or graph could be created for pricing, measuring the relationship between rating levels and profitability. The most revealing areas, however, often tend to be in reinsurance purchase and asset risk. Starting with reinsurance, companies almost invariably find that they are leaving themselves unnecessarily exposed in certain areas, while being over-reinsured in others. The resulting change in purchase strategy can often reduce reinsurance expenditure while also enhancing corporate stability. An internal reinsurance strategy model can also be used as an effective and healthy challenge to the status quo.
One aspect of a rigorous modeling exercise is that it both demands and creates transparency. Of particular interest in the current environment, it will answer the question as to whether a particular finite reinsurance or other ART transaction represents a genuine transfer of risk. Stochastic scenario testing will flush out any failure to provide balance sheet protection. Companies that meet the criteria, on the other hand, will be able to demonstrate compliance with this aspect of Sarbanes-Oxley.
Although insurers and reinsurers do not normally welcome increased regulatory impositions, it may be time regulators, rating agencies, and companies look towards a different model that can be beneficial in its own right. Indeed, several Bermudan companies already choose to carry out such modeling exercises. There is no regulatory imperative, but they can see the business advantages of doing so.
By the end of this decade, if everything goes to plan, the insurance and reinsurance industry throughout western Europe will have introduced a similar regulatory regime to the one described in this article. Can we honestly say that the current American system has nothing to learn from their experience? Businesses and markets will prosper as long as they adapt to changing circumstances; we should take a close look at ourselves and what others are doing.
This article appeared in A M Best in February 2005
