Assessing Capacity

Risk management tools and practices across the insurance industry have advanced significantly in recent years — and it’s a good thing they have. The industry has experienced a number of events and trends since the turn of the millennium that have exposed, and will continue to expose, insurers to increased levels of risk and uncertainty.

Developments such as the implementation of enterprise risk management (ERM) programs, internal economic capital models, more sophisticated catastrophe management and dynamic hedging programs have headlined efforts of the insurance industry to manage its growing exposure to potential volatility in earnings and capital. These recent additions to the industry’s risk-management arsenal are the latest evidence of ongoing efforts to respond to changing risk dynamics. Another effort involves a global movement towards principles-based solvency requirements.

PRINCIPLES-BASED SOLVENCY REQUIREMENTS

One of the key drivers of change in the insurance industry’s risk management landscape has been the convergence of regulatory and economic views of capital adequacy. Regulators around the globe, including those in Europe, the United States and Canada, are moving away from their traditional factor- or rules-based solvency platforms to a more dynamic, principles-based regime. Furthermore, Solvency II in Europe and the most recent proposals prepared by the Minimum Continuing Capital and Surplus Requirements (MCCSR) Advisory Committee (or MAC) in Canada both embrace core concepts that integrate risk management, corporate governance, internal capital modelling and increased transparency and disclosure as key components of the capital adequacy framework.

MAC VISION

MAC’s Canadian Vision for Life Insurer Solvency Assessment, published as a draft for comment in June 2007, is an example of the sophisticated solvency platforms that regulators are developing across the globe. The MAC solvency assessment model builds on the existing Supervisory Solvency Framework in Canada. This framework is a multi-level approach to insurance supervision recommended by the International Association of Insurance Supervisors (IAIS). The three framework levels are:

* Pre-conditions for Solvency Assessment — the establishment of a supervisory authority with appropriate powers and resources to perform its duties;

* Regulatory Requirements — the establishment by the supervisory authority of comprehensive financial, governance and market conduct requirements; and

* Supervisory Assessment and Intervention — the process of supervisory, self, and peer review that supports timely intervention by the supervisor.

MAC’s vision focuses on incorporating insurance industry and supervisory best practices into the regulatory requirement level — in particular, within the financial guidelines. One of the major components of the vision includes a new principles-based solvency requirement aimed at better reflecting each individual company’s risk profile and risk management practices. This is accomplished primarily by allowing insurers to use internally-developed scenario or stochastic models as the basis for reporting their regulatory solvency requirement (assuming they meet certain minimum standards set by the regulators). This is referred to as the Advanced Approach.

A factor-based Standard Approach will also be part of the new solvency platform; it will be used by any insurer not meeting the standards set for the Advanced Approach.

Both approaches will reflect all key risks to the insurer, the benefits of risk mitigation strategies and the potential impact of risk dependencies within and between risks.

In addition to the focus on more sophisticated financial requirements, the new solvency framework calls for an integrated set of regulatory requirements that consider risk management, corporate governance, market conduct and disclosure – as well as a dynamic and constructive internal risk assessment process by insurance company management — as key elements of a comprehensive solvency regime.

COMMON THEMES: BEST’S APPROACH TO SOLVENCY

A.M. Best strongly supports the core concepts underlying principles-based solvency regimes. A.M. Best believes these integrated platforms for the assessment of insurer capital adequacy promote greater emphasis on many of the same quantitative and qualitative aspects of financial strength and long-term capital adequacy that are the foundation of Best’s interactive rating evaluation. Some of the common themes shared by these emerging solvency requirements and Best’s rating approach are summarized below.

Focus on risk management as part of a quantitative and qualitative review.

The assignment of an interactive Best’s Rating is derived from an in-depth evaluation of a company’s balance-sheet strength, operating performance and business profile (as compared to A.M. Best’s quantitative and qualitative standards). A.M. Best believes risk management is the common thread that links balance-sheet strength, operating performance and business profile. Risk-management fundamentals can be found in:

* the strategic decision-making process used by a company to define its business profile;

* the various financial management practices and operating elements of an insurer that dictate the sustainability of its operating performance; and

* its exposure to volatility in its capital.

As such, if a company is practising sound risk management and executing its strategy effectively, it will maintain a prudent level of risk-adjusted capital and provide a sustainable earnings base — common objectives of both A.M. Best ratings and risk management.

Insurers that can demonstrate strong risk management practices — practices that are integrated into its core operating processes — and effectively execute its strategic business plan will maintain favorable ratings in an increasingly dynamic operating environment. A.M. Best believes risk management becomes embedded in an insurer’s “corporate DNA” when risk metrics are integrated into corporate, business line and functional area objectives. Similarly, risk-return measures should be incorporated into financial planning and budgeting, strategic planning, performance measurement and incentive compensation.

Support for development of internal capital models.

A.M. Best uses a proprietary risk-based capital model, Best’s Capital Adequacy Ratio (BCAR), as one of the primary tools used in the evaluation of balance-sheet strength. The BCAR model provides a quantitative measure of the risks inherent in a company’s investment and insurance profile, relative to its capital. A.M. Best reviews the BCAR model on an ongoing basis and makes modifications to enhance the model in response to industry dynamics — including changes in financial reporting requirements, significant regulatory and product developments and industry trends.

Even so, Best recognizes this method provides only one view of capitalization, using public financial statements as a base. To develop a more comprehensive view of an insurer’s prospective financial strength and flexibility, A.M. Best’s assessment of balance-sheet strength also includes an analysis of an organization’s regulatory filings, including the GAAP or IFRS balance sheet, corporate capital structure, financial leverage, operating leverage, fixed-charge coverage, liquidity, and historical sources and uses of capital.

In addition, A.M. Best is expanding the use of company-provided capital models in developing capital requirements within the rating evaluation process. A.M. Best takes into account the output of company-provided capital models for analytical purposes; however, the BCAR still will be published as a common, industry-wide baseline for capital adequacy. In the rating evaluation, one key factor in determining the weight given to internal model results is manageme nt’s ability to demonstrate how the model and its output is incorporated into strategic decision-making. Members of management should be ready to show how the model helps them to understand the volatility of their risks, the underlying correlations of those risks and the drivers of the volatility.

Recognizing the insurance industry’s evolving risk profile and the significant recent advancements made in risk management tools and practices, A.M. Best is also exploring ways to incorporate stochastic modelling techniques in the development of risk factors within the BCAR model. It is also looking into ways to tie the probability of default more directly to the determination of capital required to support individual rating levels. The probability of default factors will be based on insurance company insolvency and impairment statistics compiled by A.M. Best.

Risk management and capital modelling is not “one-size-fits-all.”

A.M. Best believes to remain competitive in today’s dynamic environment, build sustainable earnings and capital accumulation and, ultimately, maintain high ratings, complex organizations — such as insurers participating in the global reinsurance and retirement savings markets — must develop and constantly refine an ERM framework, including the development of internal economic capital modelling.

For organizations with a more limited operating scope, focusing on more stable, traditional lines of business, the ERM (and capital modelling) process may be less comprehensive or complex at this time. However, pending implementation of principles-based capital requirements, as well as the significant efforts of sophisticated insurers to raise the bar on the risk management front, will ultimately become a competitive issue driving continued improvement and integration of ERM concepts for all insurers regardless of size.

WHAT’S AHEAD

There is still much work to be done and many bridges left to cross. The proposed solvency frameworks must progress from a vision to actionable, detailed guidelines that provide an advanced — yet realistic — platform for solvency assessment. In a similar fashion, A.M. Best needs to continue its ongoing efforts to improve the rating tools and processes that form the foundation of our insurance rating franchise. While there is a long road ahead, Best believes that the industry is headed in the right direction.