Tag Archives: risk management

Beautiful Models

It has been a while since I posted on dear old Solvency II (here). As highlighted in the previous post on potential losses, the insurance sector is perceived as having robust capital levels that mitigates against the current pricing and investment return headwinds. It is therefore interesting to look at some of detail emerging from the new Solvency II framework in Europe, including the mandatory disclosures in the new Solvency and Financial Condition Report (SFCR).

The June 2017 Financial Stability report from EIOPA, the European insurance regulatory, contains some interesting aggregate data from across the European insurance sector. The graph below shows solvency capital requirement (SCR) ratios, primarily driven by the standard formula, averaging consistently around 200% for non-life, life and composite insurers. The ratio is the regulatory capital requirement, as calculated by a mandated standard formula or a firm’s own internal model, divided by assets excess liabilities (as per Solvency II valuation rules). As the risk profile of each business model would suggest, the variability around the average SCR ratio is largest for the non-life insurers, followed by life insurers, with the least volatile being the composite insurers.

click to enlarge

For some reason, which I can’t completely comprehend, the EIOPA Financial Stability report highlights differences in the SCR breakdown (as per the standard formula, expressed as a % of net basic SCR) across countries, as per the graph below, assumingly due to the different profiles of each country’s insurance sector.

click to enlarge

A review across several SFCRs from the larger European insurers and reinsurers who use internal models to calculate their SCRs highlights the differences in their risk profiles. A health warning on any such comparison should be stressed given the different risk categories and modelling methodologies used by each firm (the varying treatment of asset credit risk or business/operational risk are good examples of the differing approaches). The graph below shows each main risk category as a percentage of the undiversified total SCR.

click to enlarge

By way of putting the internal model components in context, the graph below shows the SCR breakdown as a percentage of total assets (which obviously reflects insurance liabilities and the associated capital held against same). This comparison is also fraught with difficulty as an (re)insurers’ total assets is not necessarily a reliable measure of extreme insurance exposure in the same way as risk weighted assets is for banks (used as the denominator in bank capital ratios). For example, some life insurers can have low insurance related liabilities and associated assets (e.g. for mortality related business) compared to other insurance products (e.g. most non-life exposures).

Notwithstanding that caveat, the graph below shows a marked difference between firms depending upon whether they are a reinsurer or insurer, or whether they are a life, non-life or composite insurer (other items such as retail versus commercial business, local or cross-border, specialty versus homogeneous are also factors).

click to enlarge

Initial reactions by commentators on the insurance sector to the disclosures by European insurers through SFCRs have been mixed. Some have expressed disappointment at the level and consistency of detail being disclosed. Regulators will have their hands full in ensuring that sufficiently robust standards relating to such disclosures are met.

Regulators will also have to ensure a fair and consistent approach across all European jurisdictions is adopted in calculating SCRs, particularly for those calculated using internal models, whilst avoiding the pitfall of forcing everybody to use the same assumptions and methodology. Recent reports suggest that EIOPA is looking for a greater role in approving all internal models across Europe. Systemic model risk under the proposed Basel II banking regulatory rules published in 2004 is arguably one of the contributors to the financial crisis.

Only time will tell if Solvency II has avoided the mistakes of Basel II in the handling of such beautiful models.

Divine Diversification

There have been some interesting developments in the US insurance sector on the issue of systemically important financial institutions (SIFIs). Metlife announced plans to separate some of their US life retail units to avoid the designation whilst shareholder pressure is mounting on AIG to do the same. These events are symptoms of global regulations designed to address the “too big to fail” issue through higher capital requirements. It is interesting however that these regulations are having an impact in the insurance sector rather than the more impactful issue within the banking sector (this may have to do with the situation where the larger banks will retain their SIFI status unless the splits are significant).

The developments also fly in the face of the risk management argument articulated by the insurance industry that diversification is the answer to the ills of failure. This is the case AIG are arguing to counter calls for a breakup. Indeed, the industry uses the diversification of risk in their defences against the sector being deemed of systemic import, as the exhibit below from a report on systemic risk in insurance from an industry group, the Geneva Association, in 2010 illustrates. Although the point is often laboured by the insurance sector (there still remains important correlations between each of the risk types), the graph does make a valid point.

click to enlargeEconomic Capital Breakdown for European Banks and Insurers

The 1st of January this year marked the introduction of the new Solvency II regulatory regime for insurers in Europe, some 15 years after work begun on the new regime. The new risk based solvency regime allows insurers to use their own internal models to calculate their required capital and to direct their risk management framework. A flurry of internal model approvals by EU regulators were announced in the run-up to the new year, although the amount of approvals was far short of that anticipated in the years running up to January 2016. There will no doubt be some messy teething issues as the new regime is introduced. In a recent post, I highlighted the hoped for increased disclosures from European insurers on their risk profiles which will result from Solvency II. It is interesting that Fitch came out his week and stated that “Solvency II metrics are not comparable between insurers due to their different calculation approaches and will therefore not be a direct driver of ratings” citing issues such as the application of transitional measures and different regulator approaches to internal model approvals.

I have written many times on the dangers of overtly generous diversification benefits (here, here, here, and here are just a few!) and this post continues that theme. A number of the large European insurers have already published details of their internal model calculations in annual reports, investor and analyst presentations. The graphic below shows the results from 3 large insurers and 3 large reinsurers which again illustrate the point on diversification between risk types.

click to enlargeInternal Model Breakdown for European Insurers and Reinsurers

The reinsurers show, as one would expect, the largest diversification benefit between risk types (remember there is also significant diversification benefits assumed within risk types, more on that later) ranging from 35% to 40%. The insurers, depending upon business mix, only show between 20% and 30% diversification across risk types. The impact of tax offsets is also interesting with one reinsurer claiming a further 17% benefit! A caveat on these figures is needed, as Fitch points out; as different firms use differing terminology and methodology (credit risk is a good example of significant differences). I compared the diversification benefits assumed by these firms against what the figure would be using the standard formula correlation matrix and the correlations assuming total independence between the risk types (e.g. square root of the sum of squares), as below.

click to enlargeDiversification Levels within European Insurers and Reinsurers

What can be seen clearly is that many of these firms, using their own internal models, are assuming diversification benefits roughly equal to that between those in the standard formula and those if the risk types were totally independent. I also included the diversification levels if 10% and 25% correlations were added to the correlation matrix in the standard formula. A valid question for these firms by investors is whether they are being overgenerous on their assumed diversification. The closer to total independence they are, the more sceptical I would be!

Assumed diversification within each risk type can also be material. Although I can understand arguments on underwriting risk types given different portfolio mixes, it is hard to understand the levels assumed within market risk, as the graph below on the disclosed figures from two firms show. Its hard for individual firms to argue they have material differing expectations of the interaction between interest rates, spreads, property, FX or equities!

click to enlargeDiversification Levels within Market Risk

Diversification within the life underwriting risk module can also be significant (e.g. 40% to 50%) particularly where firms write significant mortality and longevity type exposures. Within the non-life underwriting risk module, diversification between the premium, reserving and catastrophe risks also add-up. The correlations in the standard formula on diversification between business classes vary between 25% and 50%.

By way of a thought experiment, I constructed a non-life portfolio made up of five business classes (X1 to X5) with varying risk profiles (each class set with a return on equity expectation of between 10% and 12% at a capital level of 1 in 500 or 99.8% confidence level for each), as the graph below shows. Although many aggregate profiles may reflect ROEs of 10% to 12%, in my view, business classes in the current market are likely to have a more skewed profile around that range.

click to enlargeSample Insurance Portfolio Profile

I then aggregated the business classes at varying correlations (simple point correlations in the random variable generator before the imposition of the differing distributions) and added a net expense load of 5% across the portfolio (bringing the expected combined ratio from 90% to 95% for the portfolio). The different resulting portfolio ROEs for the different correlation levels shows the impact of each assumption, as below.

click to enlargePortfolio Risk Profile various correlations

The experiment shows that a reasonably diverse portfolio that can be expected to produce a risk adjusted ROE of between 14% and 12% (again at a 1 in 500 level)with correlations assumed at between 25% and 50% amongst the underlying business classes. If however, the correlations are between 75% and 100% then the same portfolio is only producing risk adjusted ROEs of between 10% and 4%.

As correlations tend to increase dramatically in stress situations, it highlights the dangers of overtly generous diversification assumptions and for me it illustrates the need to be wary of firms that claim divine diversification.

Lessons from Lloyds

There is little doubt that the financial services industry is currently facing many challenges and undergoing a generational change. The US economist Thomas Philippon opined that the finance industry over-expansion in the US means that it’s share of GDP is about 2 percentage points higher than it needs to be although he has also estimated that the unit cost of intermediation hasn’t changed significantly in recent years, despite advances in technology and the regulatory assaults upon the industry following the financial crisis.

The insurance sector has its own share of issues. Ongoing low interest rates and inflation, broader low risk premia across the capital markets, rapid technology changes such as big data and the onset of real time underwriting are just the obvious items. The Economist had an article in March that highlighted the prospective impact of data monitoring and technology on the underwriting of motor and health risks. This is another interesting post on a number of the new peer to peer business models such as Friendsurance, Bought by Many, and Guevara who are trying to disrupt the insurance sector. There can be little doubt that the insurance industry, just like other financial sectors, will be impacted by such secular trends.

However, this post is primarily focused on the short to medium term outlook for the specialty insurance and reinsurance sector. I have been asked a few of times by readers to outline what I think the next few years may look like for this sector. My views of the current market were nicely articulated by Alex Maloney, the Group CEO of Lancashire, who commented in their recent quarterly results statement as follows:

“The year to date has seen a flurry of activity on the M&A front within the industry, much of this, in my view, is driven by the need to rationalise and refocus oversized and over stretched businesses. We also continue to see a bout of initiatives and innovations in the market, the sustainability and longer term viability of which are questionable. These are symptoms of where we are in the cycle. We have seen these types of trends before and in all likelihood, will see them again.”

Lloyds of London has had a colourful past and many of its historical issues are specific to it and reflective of its own eccentric ways. However, as a proxy for the global specialty sector, particularly over the past 20 years, it provides some interesting context on the trends we find ourselves in today. Using data from Lloyds with some added flavour from my experiences, the graphic below shows the dramatic history of the market since 1950.

click to enlargeLloyds Historical Results 1950 to 2015

The impact of Hurricane Betsy in 1965 upon Lloyds illustrated a number of the fault-lines in the structure of Lloyds with the subsequent Cromer report warning on the future danger of unequal treatment between insiders (aka working Names) and “dumb” capital providers (aka all other Names). The rapid influx of such ill informed capital in the late 1970s and the 1980s laid the seeds of the market’s near destruction largely due to the tsunami of US liability claims resulting from asbestos and pollution exposures in the 1980s. These losses were exacerbated by the way Lloyds closed underwriting years to future capital providers through vastly underpriced reinsurance to close transactions and the practice of the incestuous placement of excess of loss retrocession for catastrophe losses within the market, otherwise known as the London Market Excess of Loss (LMX) spiral. There is a clever article by Joy Schwartzman from 2008 on the similarity between the LMX spiral and the financial risk transformational illusions that featured heavily in the financial crisis. Indeed, the losses from the sloppy “occurrence” liability insurance policy wordings and the tragedy of unheeded asbestos risks continued to escalate well into the 1990s, as the exhibit below from a 2013 Towers Watson update illustrates.

click to enlargeTowers Watson Asbestos Claims US P&C Insurers

What happened in Lloyds after the market settlement with Names and the creation of the “bad bank” Equitas for the 1992 and prior losses is where the lessons of Lloyds are most applicable to the market today. The graphic below shows the geographical and business split of Lloyds over the past 20 years, showing that although the underlying risk and geographical mix has changed it remains a diversified global business.

click to enlargeLloyds of London Historical Geographical & Sector Split

Released from the burden of the past after the creation of Equitas, the market quickly went on what can only be described as an orgy of indiscipline. The pricing competition was brutal in the last half of the 1990s with terms and conditions dramatically widened. Rating indices published by the market, as below, at the time show the extent of the rate decreases although the now abandoned underwriting indices published at the same time spectacularly failed to show the impact of the loosening of T&Cs.

click to enlargeLloyds of London Rating Indices 1992 to 1999

As Lloyds moved from their historical three year accounting basis in the 2000s it’s difficult to compare historical ratios from the 1990s. Notwithstanding this, I did made an attempt to reconcile combined ratios from the 1990s in the exhibit below which clearly illustrates the impact market conditions had on underwriting results.

click to enlargeLloyds of London historical combined ratio breakdown

The Franchise Board established in 2003, under the leadership of the forthright and highly effective Rolf Tolle, was created to enforce market discipline in Lloyds after the disastrous 1990s. The combined ratios from recent years illustrate the impact it has had on results although the hard market after 9/11 provided much of the impetus. The real test of the Franchise Board will be outcome of the current soft market. The rating indices published by Amlin, as below, show where rates are currently compared to the rates in 2002 (which were pushed up to a level following 2001 to recover most of the 1990s fall-off). Rating indices published by Lancashire also confirm rate decreases of 20%+ since 2012 in lines like US property catastrophe, energy and aviation.

click to enlargeLloyds of London Rating Indices 2002 to 2015

The macro-economic environment and benign claims inflation over the past several years has clearly helped loss ratios. A breakdown of the recent reserve releases, as below, show that reinsurance and property remain important sources of releases (the reinsurance releases are also heavily dependent on property lines).

click to enlargeLloyds of London Reserve Release Breakdown 2004 to 2014

Better discipline and risk management have clearly played their part in the 10 year average ROE of 15% (covering 2005 to 2014 with the 2005 and 2011 catastrophe years included). The increasing overhead expenses are an issue for Lloyds, recently causing Ed Noonan of Validus to comment:

“We think that Lloyd’s remains an outstanding market for specialty business and their thrust towards international diversification is spot on from a strategic perspective. However, the costs associated with Lloyd’s and the excessive regulation in the UK are becoming significant issues, as is the amount of management and Board time spent on compliance well beyond what’s necessary to ensure a solvent and properly functioning market. Ultimately, this smothering regulatory blanket will drive business out of Lloyd’s and further the trend of placement in local markets.”

So what does all of this tell us about the next few years? Pricing and relaxed terms and conditions will inevitably have an impact, reserve releases will dry up particularly from reinsurance and property, investment returns may improve and claim inflation may increase but neither materially so, firms will focus on expense reduction whilst dealing with more intrusive regulation, and the recent run of low catastrophic losses will not last. ROEs of low double digits or high single digits does not, in my view, compensate for these risks. Longer term the market faces structural changes, in the interim it faces a struggle to deliver a sensible risk adjusted return.