Economic Capital Modeling: Are Insurers Fully Realizing the Long-term Benefits?
Economic capital (EC) modeling has the potential to transform the way organizations control risks and manage their businesses right across the global insurance industry. However, a KPMG International survey of the world’s top insurers shows that a lack of understanding at the very top could hinder its effectiveness.
According to the KPMG survey, EC modeling is a way of calculating how much capital a business needs to meet its future risk. Over the past 10 years, companies have started to integrate EC frameworks into their operations for two key reasons.
A fully integrated EC model gives companies the tools they need to better understand risk, and potentially price it better. If used effectively, EC allows management to identify and quantify the risk exposure of a firm explicitly.
Introducing an EC framework enables insurers to comply with growing rating agency and regulatory requirements. Rating agencies increasingly regard it as an indicator of best practice, while the world’s regulators are looking to EC modeling to improve insurance market regulation and increase protection for policyholders.
“A well understood and properly implemented EC framework offers not only a road map for compliance but also invaluable information for risk appetite, risk management, capital allocation, pricing and underwriting, and strategic decisions,” says Ferdia Byrne, Partner, KPMG in the UK.
KPMG’s survey indicates most global insurers now use EC methods, in some way, to support their risk management systems. All respondents surveyed in Europe are using EC modeling, while North American and South African insurers are adopting it to some extent.
In Asia, the rate of adoption differs depending on whether the insurer’s operations are international, regional or national. Overall, 63 percent of companies operating in the region have implemented an EC framework, with the remaining 37 percent intend to introduce a framework within the next three years.
While 79 percent of survey respondents are using EC modeling for risk management, fewer of them are realizing the potential advantage of using it to other strategic decisions such as to support pricing and underwriting decisions (55 percent).
These results suggest that a short-term focus on regulatory compliance is masking a lack of understanding of the longer-term strategic advantages of having a fuller appreciation of the business’s risk and capital profile. Forty percent of respondents indicated that management understanding of EC is limited. European companies tended to rank management understanding higher than other territories, which is not surprising in light of Solvency II modeling requirements. But even in this region, KPMG found that management understanding needs improvement.
Improving management understanding is critical. Insurers risk losing competitive advantage by not using techniques to drive value, or worse, by placing too much reliance on model results without fully understanding how they should be interpreted. If used ineffectively, EC modeling can mislead management into falsely believing risks are adequately covered, or force them into actions that go against sound business principles.
On the other hand, companies that embrace an EC framework and use it throughout their business will undoubtedly enjoy a competitive advantage. They will ensure appropriate returns are achieved for risks they take on, and they will be less likely to take on risks that they don’t fully understand. Moreover, through the full integration of an EC framework, they will have a better understanding of the limits of EC modeling and where not to rely on it.
David Honour, principal advisor in the UK firm, said: “By ensuring senior management of insurance companies fully appreciate the scope of EC techniques – and their strengths and weaknesses—they can ensure their business is more risk aware, better protected and sustainable over the long term.”