A holistic approach to solvency

Lending Strategy March 2010

Forgive me if I don’t jump for joy at the news that we came out of recession at the end of January. Growth of just 0.1% is precious little to cheer about, particularly as many economists have warned that we could slide straight back into recession.

And the fact that the Bank of England remains cautious over growth prospects highlights the fact that a business’s ability to use the tools at its disposal to ride the storm has never been more important.

In my book, that makes an integrated risk management approach to decision-making fundamental to success.

In difficult economic times it is all too easy to become internally focussed. The temptation is to focus on mitigating your own organisation’s risks relative to your appetite and the adequacy of your systems and controls. But as I discussed last month it is also essential to look beyond your own four walls.

You must understand the effect of your decisions on your business partners. Failure to properly identify and understand the risks your business relationships present could have significant consequences for your firm’s per- formance and reputation.

Lenders and insurers have worked hand-in-hand for many years. Our core activities complement each other. We have enjoyed mutually beneficial relationships, although naturally some have fallen by the wayside and some lenders have chosen to replace insurers with their own captives.

A new solvency regime
But I wonder if the advent of Solvency II will mean a review of relationships and if so, how important a factor insurers’ approach to the new regime will be.

Solvency II is the new solvency regime for all European Union insurers and reinsurers, due to come into effect in 2012. It’s really about ensuring that an insurer can manage the risks it undertakes relative to its appetite for a given risk, and the capital required to support that strategy.

There’s not much in the new regime that a firm wouldn’t want to do to build a sustainable business that consistently meets shareholder returns.

Like Basle II it has three key pillars - capital resources, risk management and disclosure. The big decision for insurers is whether to adopt the standard formula to be dictated by the EU or take the opportunity to fully embrace the ambitions of Solvency II and take a long-term view in creating internal models for driving sound decisions.

A sustainable approach to Solvency II involves greater commitment and much more work for firms but the benefits to insurers and their business partners will more than compensate

I believe an organisation that develops its own model will have more sophisticated systems and controls, and an optimal capital structure. It will offer greater stability, be more transparent and respond more efficiently to changing market conditions. Ultimately, it will offer greater stability to its business partners. While it might be less painful and take a whole lot less work, a business that chooses the standard approach will miss the chance to truly understand how it can use risk management to drive better business decisions, make more effective use of its capital and ultimately offer its partners a competitive proposition.

The effective and practical application of risk management tools will have a positive effect on calculating an insurer’s capital position.

For example, as part of the internal modelling process an insurer will have to ask itself whether it has the right balance of products in its portfolio and question the volatility of each line.

If you write a large book of business such as personal property protection with a stable loss ratio it will deliver a solid return even in an extreme trading environment and therefore have a low capital requirement.

A more volatile book such as credit insurance is likely to see poorer returns in extreme conditions and therefore have a higher capital requirement.

Balancing out the portfolio will enable the insurer to blend its capital requirement and achieve the desired re- turns while continuing to write the volatile lines.

Reinsurance is another tool that can be used to provide a smooth path in tough times but clearly there are costs associated with it. The risk modelling process should result in a business determining its risk appetite, whether reinsurance is appropriate, and if so how much it is willing to pay.

For example, would it prefer to avoid the cost of reinsurance, see a return on equity of 20% over, say, a three-year period and risk seeing that drop dramatically in a tough environment? Or would a lower but more stable ROE be desirable, with the comfort of having transferred some risk off the balance sheet via reinsurance?

An internal risk model can test reinsurance options and determine whether they are likely to change as appetite for risk changes.

Failure to implement Solvency II effectively could have a negative impact on a company’s attractiveness to partners. If it fails to show that its data is of sufficient quality, its procedures and policies are documented accurately and that it uses its model to drive business decisions it runs the risk of further capital requirements.

And the cumulative effect of these failures will result in instability which ultimately affects its partners and their customers.

So the holistic approach involves greater commitment but the benefits to an insurer and its business partners will more than compensate.

By optimising the use of its capital an insurer will be in a better position to deliver more competitive propositions to its partners.

The firm will also have a more efficient decision-making process enabling it to quickly respond to changing conditions. And the quality of the data available to share should improve the man- agement of its partners’ portfolios.