Economic capital modelling (ECM) is a process widely used by large commercial insurance companies and, as premium in the captive market gets higher and higher, it’s something more captives are also turning to. In this Q&A, Esther Becker, a partner in P&C actuarial consulting at Oliver Wyman, explains what ECM is and when it might be something to consider for a captive
Captive Review (CR): Can you start by explaining the concept of economic capital modelling and how it is used by the insurance industry in general?
Esther Becker (EB): In the simplest terms, capital modelling – often referred to as ECM or economic capital modelling – is an analytical and strategic process that aids insurance companies in determining a prudent amount of capital to hold to protect their financial position against adverse outcomes. But as I hope to point out in the rest of this discussion, it can be so much more. Granted, most insurance domiciles require carriers, including captive insurance companies, to hold a minimum amount of capital.
Unless a company is operating under a much more capital-prescriptive regulatory regime such as Solvency II in the EU, it can press the ‘easy button’ and get by with putting up a minimum capital amount (noting US-based, non-captives must conduct risk-based capital calculations to establish their minimum capital requirements). But in doing so, they will miss out on opportunities that an ECM affords including ensuring capital is sufficient to protect solvency in the long run, that held capital is being deployed to its best purposes, and gaining the strategic insights of an ECM. Insurance carriers that invest resources in a full capital model are guaranteed to find it a strategic planning partner. It is a framework for assessing nearly every type of uncertainty an insurance company faces – adverse loss outcomes, unanticipated underwriting mix, investment, liquidity, reputation, human resource, underwriting and pricing risk, and numerous others.
Employing a statistical model that anticipates potential outcomes across all of these risks creates the ability to uncover ‘diversification benefit’ across the risks – which accounts for correlation among all the considered risks – and which is conducted over a multi-year time frame. It also enables a carrier to make strategic decisions about where to take more or less risk and how to achieve growth goals wisely. Nearly all large commercial insurance carriers have moved towards using capital modelling in this way. Many captives, as they advance their purpose in serving their parents’ and stakeholders’ needs, want to achieve the sophistication of a commercial carrier, and an ECM is an important step in this direction.
CR: What does the process of capital modelling generally involve?
EB: It is important in this discussion first to clarify how loss reserves and capital differ because it sets the stage for how the process of determining these amounts differs. Loss reserve liabilities are established to cover expected losses. But insurance liabilities are typically uncertain and can have a wide range of outcomes. Capital is required to cover unexpected shortfalls in not just loss reserves but also varying investment, liquidity, economic and other uncertain factors that can impact an insurer’s balance sheet, and ultimately solvency. A first step in building an ECM is for the insurer to decide which risks they want to consider. Even the most basic models will at least consider underwriting risk (the risk that future premiums are insufficient to pay future losses) and reserve risk (adverse development beyond reserves on past losses).
Catastrophe risk may be considered separately as well, depending on the extent of exposure. Some will also consider the impacts of varying investment outcomes. Other fuller models will consider a longer list of risks, such as those noted in the question above. A range of potential outcomes and their drivers will be studied and an appropriate statistical distribution and parameters will be determined for each risk. A simulation model will be run, creating typically thousands of simulated results, which will simultaneously consider potential outcomes across all the modelled risks in a period of time, typically one go-forward year, and/or across longer time horizons.
It will model not just the outcomes of an upcoming underwriting year, but prior accident periods as well. The output will show balance sheet impacts and needed capital of each simulated result, which forms a probability level distribution. This allows the carrier to be able to determine a reasonable capital amount by blending its own risk appetite with the modelled results. Simply speaking, it allows finance to say, for instance, ‘We will set capital at the level which is predicted to cover the financial downside of 95% of all modelled scenarios’, or stated another way ‘5% of the modelled scenarios will deplete the current capital amount’.
CR: What has historically been the uptake of capital modelling services from captive insurance companies?
EB: I’d say the percentage of non-EU captives using capital models falls below 20%. That said, in recent years we’ve seen a significant uptick in captives interested in ECMs and in those deploying them, having a desire for a better understanding of economic capital requirements beyond minimum capital level requirements.
Factors influencing greater use of ECMs are:
- Large captive premiums. A captive with assets of less than say $10 million may not warrant a full capital model, but beyond $100 million warrants the same close attention as an investment of a similar amount.
- Third-party coverage offered by the captive, thus risks and operations are closer to that of a traditional carrier.
- Corporate parent is a multinational with EU exposure and therefore has greater awareness of Solvency II and IFRS 17 requirements – may want to modernise towards these requirements.
- Captive is including lower frequency/ higher severity potential risks in captive such as cyber and natural catastrophe exposure – this significantly increases the potential volatility of losses and an ECM is the best way to get a line of sight into potential adverse outcomes.
- In addition, a capital model adds more value to a captive when there are multiple risks. The diversification benefit that insurers achieve can be quantified and the capital level set to ensure solvency of the captive to a probability.
CR: Are there ways captives could better utilise capital modelling to retain more risk or achieve better underwriting performance?
EB: Absolutely, in fact those are two of the most fundamental benefits to an ECM. As we’ve discussed, an established ECM can essentially function as a partner in decision-making and can provide critical insights into the risks of taking on new or more risk in a captive. A captive can essentially ‘ask’ the ECM questions and the modelling can be re-run countless times with questions such as ‘what is the impact on capital if we start to take on a cyber retention in the captive’ and ‘what is the maximum amount of additional retention on workers’ compensation we can bring into the captive and still have our established capital be sufficient?’.
CR: What is the interaction of a captive’s actuary and an ECM?
EB: ECMs are typically designed by actuaries, often with the help of an ECM-focused software. ECM software aids the efficient running of simulations, use of multiple statistical distributions, helps parameterise the models and generally speeds up the process. But assumption-building, studying the appropriate distributions and incorporating use of historical loss and underwriting data, making judgements about the range of outcomes and interpreting the results typically starts with the actuary. It’s important to note that in a good ECM-building process, the captive’s financial and underwriting leaders’ inputs into the assumptions are mission-critical to the process. It is also important to incorporate market-pricing for the coverages into this process to evaluate the trade-off between retention and transfer.
CR: How can capital modelling complement a wider risk-management portfolio?
EB: One of the greatest advantages of an ECM is that it can consider almost every type of risk facing the captive – including all the insurable risks in the portfolio, plus investment risk and many others noted already. So instead of just assessing the trade-offs of retention and transfer line-by-line, a capital model does just that: evaluates the entire portfolio simultaneously for a truly holistic perspective.
Additional risk portfolio benefits include:
- Helps with insurer renewal negotiations – the company has an option to retain the risk in its captive.
- Can cover hard-to-insure risks like cyber (which often has coverage gap limitations or sub-limits) or even more esoteric risks where there is a limited insurance marketplace.
- Greater control of claims process.
CR: Is capital modelling as effective for an international risk programme where there are varying levels of data quality?
EB: Just as with estimates of losses used for reserving and pricing, the accuracy of an ECM is heavily influenced by data quality. That said, good insights are still possible as long as the actuary/modeller seeks appropriate benchmark data, relies as far as possible on the captive’s own historical data and acknowledges the model’s limitations. Here is another important point: an advantage of a capital model is that it actually considers the volatility caused by not having perfect parameters, so in the face of less-reliable data, the model can explicitly adjust for this risk, leading to a wider range of estimated outcomes and suggesting a capital level that may be a bit more conservative for this reason. And it is worth noting again that captives domiciled in the EU must adhere to Solvency II regulation, where they may either use the standard formula or an ECM.
CR: What discussions are you having with captive owners around their capital modelling needs currently?
EB: We have been speaking to and writing about this topic quite a bit and it has been generating a great deal of interest in our captive clients, leading to numerous exploratory discussions. We are currently conducting ECMs – many on an annual recurring basis – for approximately 10% of our clients. As noted before, at this time this tends to be our largest captive clients or those who either have or are considering retaining more of the low frequency/ high severity risks like cyber, property and directors’ and officers’ liability insurance. But as I said, there has been a great deal more interest in deploying these models over the past two or even three years. Some captives ‘start small’ with a capital model that only considers reserve and underwriting risk. These less involved models can be conducted in a faster time frame and at a lesser expense, but still provide many breakthrough insights for their users.
CR: How does the risk appetite of captives compare to commercial insurers when it comes to capitalisation levels?
EB: Ownership structure plays a big role in risk appetite, driving much of the difference between captives and commercial carriers. Commercial carriers are often publicly traded or owned by shareholders, so their appetite is influenced by market or investor expectations, and typically more stringent regulatory requirements. That said, they may also have more diversification in their insurance portfolio than a captive which, again relative to size, may create more diversification benefit than would be experienced by a captive. Given captives are typically owned by a single parent or a group of companies, their risk appetite tends to align with that of the parent(s). Generally, captives may have a higher risk appetite relative to their size than commercial carriers, and thus be willing to hold relatively lower amounts of capital. This is in part because they can also leverage their parental relationship to access additional financial support if needed. All this said, captives still want to maintain sufficient capital levels to sustain their operations and serve their purpose.
CR: Do captive owners generally prefer to have risks capitalised beyond the minimum regulatory requirements, and, if so, how does this affect interest in ECM?
EB: Most captive insurers have more capital and surplus than the minimum regulatory levels, in part due to regulatory reviews but also captive owners tend to prefer it. By maintaining higher capital, captives can demonstrate their financial strength and ability to absorb adverse outcomes, which enhances their credibility and provides greater confidence to their owners. This is particularly important for captives that retain low frequency/high severity, unique or specialised risks. Many may set this higher level judgementally, but as we’ve discussed, an increasing number of captives are choosing to conduct a capital model for the clarity and justifiability of process, and for the strategic insights it affords.
CR: How would you expect a softening commercial market in the next few years to impact interest in capital modelling services among captive owners?
EB: Markets may soften in some lines, but it seems clear volatility will remain in lines such as cyber liability and property due to increasing cybercrime and weather activity, and even general liability with continuing social inflation. As a result, we expect companies will keep looking to their captives to retain large portions of these lines. This could lead to a shift in the complexion of a captive’s portfolio with a higher concentration of low frequency/high severity potential risks. Given a hallmark of these lines is greater volatility, the need for capital modelling will be even greater to enable captive leadership to understand and plan for greater uncertainty.