Enterprise Risk Management model increases If capacity

To consolidate its position as the leading insurer of major risks in the Nordic countries, If has increased its capacity. This growth in capacity has also been supported by If raising its own retention during recent years. As a token of our commitment to the Nordic market, If recently increased the upper limit on automatic Property per risk capacity available to €200m; thereby placing us, among our peers, at the top-end in terms of capital available for Nordic clients. The Casualty and Cargo capacity of If also supports the needs of most Nordic based clients. This capacity increase is also supported by the gradually increased net retention for If over the last few years.

In this article our aim is to describe how
• Holistic risk management perspective utilizing state-of-the-art analytical techniques (DFA modelling)
• Diversification across all perils in If
• Allowing for "unbalanced" local portfolios
• Underwriting combining individual responsibility and team-work approach through standardized processes form the basis of our philosophy regarding capacity and risk appetite.

Hopefully, this also offers some inspiration to our clients in the continuous search for the optimal risk based management of your operation.

Capital allocation, investment versus insurance risk and reinsurance strategy

The capitalization versus risk appetite, the investment policy, the reinsurance strategy as well as the allocation of capital to individual lines, countries and risks is in If governed through a centralized actuarial unit running a DFA (Dynamic Financial Analysis) model. These models have been gradually refined in If through the last decade or so. Currently, we consider our expertise in this area to be world-class. In addition to supporting us in today’s business decisions, the development of new regulatory regimes within the insurance industry (Solvency 2) make these types of tools strategically important for the total ERM (Enterprise Risk Management) work going forward.

The DFA tool aims at deriving a holistic view on all risks in If, ranging from insurance risks, investment risks, credit risks, business risks to operational risks. The latter ones, however, are still in an early phase when it comes to quantitative models.

Based on combining regulatory requirements, rating agency requirements (preserving our S&P A rating) and the DFA model, there are 3 pillars leading to the risk profile of the different insurance operations in If:


Balanced risk taking in the investment operations
The main principles behind If’s investment strategy are asset-liability matching and diversification. In the allocation of investment assets, the structure and requirements of the technical provisions are taken into account in order to reduce the overall risk for the company. Duration targets for the fixed income investment portfolios are set based on the durations of the liabilities, in order to hedge the economic exposure of assets and liabilities. Furthermore by having investments spread across various asset classes and markets, diversification is achieved and thereby contributes to a balanced risk profile of the investment operations.


Capital allocation based on risk contribution
All insurance companies need capital to support the risks of its business. The need for capital will depend on the level of the risk. The main principle behind allocating the total capital (essentially shareholders’ equity) in If to individual lines of insurance is the idea of risk contribution: We are not primarily interested in the risk in a portfolio on a stand-alone basis. Rather, we analyze how a risk class contributes to the total volatility of the operating result of the whole of If.

Since risks are not fully correlated, some in fact work in opposite direction creating hedges, diversification benefits are achieved. Being a large insurance company, writing insurance in different geographical areas and across several classes of insurance is one of If’s key advantages. This is taken into account when allocating capital to different insurance classes. This is also to a large extent the key behind the risk taking ability of the industrial organization where we are able to write business at a risk level which as an isolated portfolio would be considered as quite unbalanced. The diagram below – based on actual analysis of BA Industrial’s portfolio –illustrates the effect of the aggregation of two insurance classes that are not fully correlated.

If Industrial’s Loss ratio volatility for Property and Liability insurances
In this diagram the fully correlated dotted line shows that there is clearly a wider spread in the range of Loss Ratio compared with the Aggregated one. The narrower this range is the more stable the insurance carrier’s Loss Ratio is also from year to year. As another example, the 1,8 bn € Nordic and Baltic motor portfolio of If balances by its non-correlation much of the large fire risk volatility of Industrial.

If’s reinsurance strategy
Supporting the holistic view on capital allocation through risk contribution, reinsurance in If is always purchased from a corporate perspective (though taking into account the solidity of the different legal entities). In essence, this means that we buy a highly efficient and stream-lined reinsurance program protecting the total capital for If, but allowing for significantly higher result volatility for individual lines or countries than with a more conventional “balancing each portfolio” way of looking at reinsurance. However, it is fair to add that If also lives in the real world of quarterly capitalism leading to some protections being installed simply in order to protect our more short-term key ratios.


In this graph the basic reinsurance program takes a capital protection point of view. The stabilizing reinsurance program (if any) should then protect the (quarterly) financial results of an insurance company.

Capacity and retention for If
The somewhat theoretical considerations above result in If being able to
• Provide a higher amount of capacity for individual risks than traditionally seen.
• Retain more of our clients' risks on a net basis than in earlier days.
• Lead to a more efficient price for capacity.

The automatic treaty capacity for If, which enables a swifter response to clients and brokers, has been raised in cooperation with our re-insurers as a consequence of a long-term stable relationship. Thus as the international reinsurance market trusts our underwriting and insurance skills, we are able to lead in an efficient manner the whole programme for our Nordic clients.

Of course this also demonstrates the trust in our own organization; underwriters are equipped with considerable mandates leaving short decision making processes. On top of this, the underwriter is supported by analytical tools, where the price for all layers and sections are included.

For the underwriting decision, capacity only is one factor, and not even the most important one; as risk profile, wording and pricing are also of utmost importance. However, modern analytical techniques definitely have shed light also on this highly traditional discipline of large corporate client underwriting.


Revitalized underwriting

One interesting consequence of this corporate managing of risks is that the portfolio of each underwriter can not offer a stable financial performance by itself. This has lead to the development of concepts such as 4 eye underwriting, re-underwriting meetings and generally more team-work and cooperation securing same treatment and risk evaluation for all risks and clients. However, the authority and responsibility of each underwriter is maintained. In this way we combine the best pieces of analytical tools and collective approach without compromising the importance of each individual underwriter’s responsibility and the use of each individual’s uw-knowledge.

Client trends

Do we see similar trends among our clients? Firstly, the Enterprise Risk Management (ERM), prompted through the Sarbanes-Oxley (SOX) at the aftermath of Enron, WorldCom and other corporate scandals alike has given an enhanced focus on a holistic view on all risks in a company. Guidance on the implementation of ERM has been provided by the Committee of the Tredway Commission (COSO) ERM framework.

The SOX together with ERM emphasize the fact that companies need a clear picture of potential risks, an idea on how to deal with them and prior to this, management has to evaluate and decide on a company’s risk appetite. Among other things ERM clearly has raised the interest toward more efficient insurance programs.

The clearest trends we see among our clients are
• Lift of program trend • Holistic risk management approach
• Service and quality expectations from the insurer
• Clarification of captive strategies

Lift of program trend
We clearly have seen a need for higher capacity. When mapping risks and corresponding risk management measures – including insurance – companies have started to check if the old worst loss scnarios and sums insured are sufficient for their current business operations. At the same time requests for broader wordings have increased as protection for the more unlikely events are sought. And naturally this does not just concern the working layers. It has become even more important with similar coverage also on the upper layers of insurance programmes. This trend can be seen in both property and liability insurance programmes. This corresponds also with the way If evaluates reinsurance. The graph below demonstrates the relationship between the probability of a risk and the financial magnitude of a possible risk.

Holistic risk management approach
This is the result of the same type of awakening process as If has been through, where for many of our clients, e.g., financial risks more severely could violate bottom-line performance than, say, the fire exposure.

However, also business (e.g., share price), operational and other risk factors need to be considered. A major fire in a key facility or a large product liability claim, could affect the share price of the company to a much larger extent than its purely financial effect would indicate. Thus, a holistic risk management perspective is needed in order to assess the appropriate insurance cover to set up.

Service and quality expectations from the insurer
ERM also puts pressure on the effective and efficient use of a company’s resources – not only limited to capital resources. In order to have a finger on a company’s risk management pulse one has to be able to trust external service providers’ capabilities. For insurance carriers this means serving clients not only on clear underwriting issues, but also on claims handling, risk management and global and also local services wherever our clients have their business operations.

As an example If Industrial acknowledges this trend by tailoring Claims Models in order to find the most suitable claims service package to match a client. In addition, we are now further improving our service standards for handling international insurance programmes (ISM models).

Clarification of captive strategies
When the captive evolution started in the Nordic region back in the 1970s, Captive insurance companies used to be considered more of a financial vehicle than a real risk management tool and were mainly run by the companies’ CFO.

The development during the 1990s made captives more of a risk management tool for the companies’ CRO. After careful evaluation of the company’s risk map and appetite, the captive is used as a method for retaining part of the risks and also a tool for insuring risks that do not fall within the basic scope of property and casualty risks - like some of the pharmaceutical or automotive industries´ risks.

However, captives should be subject to the very same holistic risk management considerations as for any other risk carrier. As for insurance companies in general, companies using captives have to consider at least the following issues:
• Operational risks, e.g., claims handling and international service for global units
• Cost for reinsurance versus retaining risks
• Reserve setting / balance sheet risks
• Market risks
• Exit possibilities from the captive solution

Example 1: With a widespread international/local insurance need with many locations it could, say, be more beneficial from an operational point of view to utilize a reinsurance captive rather than a direct captive.

Example 2: In order to prepare the company for being divested, one stops writing liability in the captive in order to avoid putting old exposures up for sale.

Summary

Regulatory environment such as solvency 2, SOX and thereby ERM has put a lot of positive pressure on our and our clients’ risk management and capital allocation. We have to be well aware of our risk map and at the same time evaluate how to allocate the capital in use in the most efficient manner.

If has increased its treaty capacity in order to respond to the needs of our Nordic clients. At the same time we increased our service level to match the requirements of holistic risk management and larger risks. Consequently, I believe we have an excellent foundation for dealing with the challenges of large risks and capital efficiency together with our clients.

Espen Husstad

http://ifnews.if.fi/en/