Growing Number of Insurance Companies Use Economic Capital and Enhanced Stochastic Modeling to Better Manage Business and Help With Strategic Decision Making
New York, N.Y., May 6, 2004 — Rating agency demands (71%), financial reporting issues (55%), shifting product preferences (55%) and changes in regulatory requirements (48%) are driving the industry’s need for improved risk and capital management practices, according to life insurance company CFOs surveyed by the Tillinghast business of Towers Perrin in its latest CFO Survey.
As a result of such pressures, 86% of the CFOs surveyed say they are paying more attention to risk and capital management practices. Four out of five (81%) of the executives polled are going one step further; they are proactively implementing them.
“Many of Alan Greenspan’s recent comments on strengthening risk and capital management in the banking industry are transferable to the insurance industry,”says Jack Gibson, Life Insurance and Financial Services Practice Leader. “Insurers are strengthening their risk management systems following years of a down equity market, diminished reinsurance capacity and increased regulatory scrutiny, including Sarbanes-Oxley. Implementing more comprehensive risk management practices can help companies be more strategic about the risks that they take in order to achieve an optimum balance between risk and return.”
How Are Insurers Managing Risk?
Companies are enhancing their risk and capital management practices through a combination of organizational changes, revised responsibilities, improved processes and new, more sophisticated tools. Key survey findings include:
Nearly two-thirds (64%) of respondents now calculate economic capital, up from 40% in 2002. Typically, economic capital is defined as sufficient surplus capital to cover potential losses, at a specified risk tolerance level, over a given period of time; it is company-specific and based on sophisticated financial modeling.
More than three-quarters of companies are using economic capital to better manage their overall business (79%) and to more appropriately allocate capital to specific lines of business (82%).
Stochastic Scenario Testing
Nearly all respondents (86%) are using stochastic scenario testing to analyze and/or mitigate future earnings volatility. This is up from 73% performing these analyses in 2002.
The main driver for the increased use of scenario testing has been compliance with regulatory requirements (39%). However, more than three-quarters of respondents plan to enhance and increase their use of stochastic scenario testing—which tests a wider range of possible results—to respond to internal demands from Directors or senior management (74%). An equal percentage of CFOs anticipate using results to improve strategic decision making.
“Although companies are at different sophistication levels with these financial modeling tools, the vast majority are taking a major step forward,” notes Mr. Gibson. “New modeling techniques have pushed companies to take a broader look across the entire enterprise to analyze a variety of risks and how they might impact the volatility of future earnings and profitability.”
Enhanced financial modeling can help improve consistency among divisions/product lines and provide a company with a deeper understanding of its earnings volatility and key earnings drivers, ultimately making an impact on the transparency of financial statements.
“A better financial model cannot improve financials on its own. It is essential for companies to analyze the results in a timely manner so that management can turn these into actionable solutions,” says survey leader Hubert Mueller, Principal. “Key risks must be monitored on an ongoing basis to ensure that current market conditions do not create tail exposures outside of the company’s established risk tolerance limits.”
Equity-Based Products Face Specific Challenges
Writers of variable annuity and other equity-based products are especially cognizant of risk and capital management concerns, because of the rapidly changing regulatory environment. Of specific interest is the proposed C-3 Phase II regulation of investment guarantees, which is expected to be enacted at the end of 2004. This will affect all companies selling variable annuities with guarantees, setting additional capital requirements that necessitate very detailed stochastic modeling. Over 40% of the companies surveyed offer variable products with guarantees, and two-thirds have completed or are currently conducting scenario testing to prepare. According to recent Tillinghast analysis, the required capital for living benefits on variable products is expected to increase up to six-fold from current levels, if no risk management actions are taken.
“New protection features on variable annuities have been a major driver of the recent growth in sales of these products. Given the lack of reinsurance alternatives available, annuity writers are turning to hedging of guarantees as a way to manage the downside risk. Implementing an effective hedging program is also expected to alleviate the increase in required capital from proposed regulatory changes,”says Mr. Mueller. “Ultimately, hedging the risk is becoming more attractive because of its ability to minimize the volatility of earnings, capital and reserves.”
About one-quarter of respondents currently hedge tail exposure for equity product guarantees. An additional 34% plan to do so within the next 12 months to help minimize the impact of expected regulatory changes. With no reinsurance available and little sensitivity to price observed in the marketplace, capital market pricing is increasingly being applied to the options embedded in variable annuities, leading to higher costs for guarantees.
“Capital management continues to be an intense focus for CEOs and CFOs, and a growing number of insurers are using advanced analytics to manage their businesses. When companies can demonstrate and validate superior risk management techniques, this can result in adjustments to Standard & Poor’s capital adequacy models,” says Kevin Ahern, Director, Standard & Poor’s Financial Services Ratings. “An analysis grounded in advanced modeling techniques supported with solid assumptions and management oversight can provide Standard & Poor’s additional comfort in the quantitative risk assessment of capital and qualitative assessment of risk management capabilities. As a result, companies are allocating more resources to these functions.”
Positive Outlook for the First Quarter
For the first quarter, nearly two-thirds of respondents predict a growth of at least 4% in new life and annuity premiums compared with the same period last year. More than three-quarters also expect revenues to increase by at least 4% over the first quarter last year, and 40% expect net income to increase by more than 10% over the same period.
These results reflect the CFOs’ broad industry outlook at the time they completed the survey and may or may not reflect company performance that actually emerges. CFOs’ views on future financial results for the industry will be a regular feature of the Tillinghast Life Insurance CFO Survey to track the direction of the industry over time.
About Tillinghast’s Life Insurance CFO Survey
The Web-based survey was conducted in March 2004 and is the seventh in a series of Tillinghast pulse surveys, which explore issues important to the North American life insurance industry and its CFOs. This three-part survey, which examined issues relating to risk and capital management, had a respondent base of 36. Respondents primarily included CFOs from large and midsize North American life insurance companies; 53% had assets of $5 billion or more; and 19% were multinationals.
About Towers Perrin and Tillinghast
Towers Perrin is a global professional services firm that helps organizations around the world improve their performance through effective people, risk and financial management. Through its Tillinghast business, Towers Perrin provides global actuarial and management consulting to insurance and financial services companies and advises other organizations on risk financing and self-insurance. Areas of focus include mergers, acquisitions and restructuring, financial and regulatory reporting, risk, capital and value management, and products, markets and distribution. The firm’s other businesses are HR Services, which provides human resource consulting and administration services, and Reinsurance, which provides reinsurance intermediary services. Together, these businesses have over 8,000 employees and 78 offices in 76 cities in 24 countries. More information about Tillinghast is available at