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Capital Models - Forging ahead with capital modelling in Asia

Source: Asia Insurance Review | Jun 2016

(Re)insurers are forging ahead with the use of capital models, even when there is no push from regulators. Mr Paul Maitland of Aon Benfield explains why this is so and lists the numerous advantages of using capital models for your business. 
 
 
Regulators are often the drivers for insurers and reinsurers to implement economic capital models. These are models which calculate the capital required based on a ground-up assessment of the risks a company faces. 
 
   However, in the Asia Pacific region, some companies are forging ahead with capital models to help them manage the business even where there is no regulatory push. They are using capital modelling as part of an enterprise risk management framework to get an advantage over rivals in a competitive market.
 
Solvency II regulation
In Europe, Solvency II regulation finally arrived this January after many years of discussion and development. This regulation has been the key factor for many European insurers’ implementation of capital models (also called internal models). 
 
   Solvency II has also been influencing a new wave of solvency regulation around the world including Asia Pacific. Different countries in the region have chosen slightly different approaches, keen to reap the benefits but wary of imposing unnecessary costs. 
 
The three typical pillars of solvency regulations
The new wave of solvency regulation typically has three components or pillars: Pillar 1 on capital calculation, Pillar 2 outlining internal assessment of risk, and Pillar 3 involving disclosure to the regulator. 
 
   Pillar 1 typically has a factor-based calculation for the capital and in some regulatory regimes such as APRA (Australian Prudential Regulation Authority), there is an option to replace this with a capital model. 
 
   In addition companies may use a capital model as part of their Pillar 2 own risk and solvency assessment (ORSA). In Japan, forthcoming solvency regulations may encourage the larger companies to use a capital model or internal model.
 
Using a capital model
There is some work and expense involved in building a capital model, but there are many benefits beyond satisfying the regulator. Compared to a factor-based formula, a stochastic capital model allows management to evaluate different financial strategies and scenarios with much greater precision, and to make better decisions. 
 
   For example, Aon Benfield’s ReMetrica platform enables insurers to make investment decisions for optimal risk/return on the asset portfolio, design the optimal reinsurance protection scheme, or undertake more general business planning for the next few years. 
 
   Hong Kong-based Peak Re uses ReMetrica as its capital modelling tool. Mr Eckart Roth, Chief Risk Officer and one of the founders, stated: “An economic capital model is essential to our enterprise risk management. It helps us to have a consistent view of risk across reinsurance classes (life and non-life) and investments. This is critical for a risk adjusted performance management in strategy setting, capital management and hedging decisions. In a competitive environment, a strong analytical capability combined with a strong risk culture becomes a key differentiator.”
 
What is a capital model? 
An economic capital model (ECM) or internal model is typically a stochastic model which looks at thousands of possible future scenarios to estimate the full range of potential financial results to the company. 
 
   The required capital is then typically the 1 in 200-year Value at Risk – in other words, it is the loss to the company which happens once every 200 scenarios on average. 
 
   Strictly speaking, a capital model or internal model has to cover all of the risks to the company including underwriting risk, reserve risk, asset risk, credit risk and operational risk. In practice, people often build partial internal models covering just some of the risks, and loosely speaking, this can be called capital modelling as well. 
 
   Capital modelling is a key part of a more general enterprise risk management culture, providing quantitative input to a more general awareness of risk in decision making and operations. 
 
Rating agencies’ interests in ERM culture
In addition to the regulators, the rating agencies also take a keen interest in companies’ enterprise risk management culture. Standard & Poor’s has a specific ERM component in its rating, and if the ERM is rated as robust, the agency will look at the company’s economic capital model and factor this into the insurer’s overall capital assessment. 
 
   One European reinsurer achieved a reduction in capital requirement of EUR400 million through this approach. So in addition to the management benefits, there are potential rating benefits to companies that invest in this area. A.M. Best does not have a specific separate component but does include ERM in its overall assessment.
 
Modelling for reinsurance purchasing
Many of the most interesting business questions take place at the level just below the full capital number and are more related to modelling of specific risks. For example, investment decisions are at the level of asset risk and reinsurance purchasing is looking at insurance risk. 
 
   In particular, reinsurance protection is highly non-linear and is of material consequence to a company’s capital position, and so is a prime candidate for this type of modelling. Catastrophe risk is normally assessed using specialised models but then feed into capital models where analysts can measure the impact of the catastrophe reinsurance protection. Many companies produce partial internal models just to evaluate the catastrophe risk net of reinsurance, and many more rely on their broker to produce this for them.
 
   So whether companies are using full economic capital models or partial models, Asia Pacific is witnessing a trend for insurers to forge ahead to gain a competitive advantage, and reap a host of benefits for their businesses.
 
 
Mr Paul Maitland is Head of ReMetrica at Aon Benfield.
 
Aon Benfield is the 2015 winner for Reinsurance Broker of the Year at the 19th Asia Insurance Industry Awards.
 
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