The very nature of the life insurance business requires insurers to put capital at risk in exchange for the prospect of earning a return. An insurer's ability to identify threats, uncertainties and, indeed, opportunities, relies heavily upon its risk and capital management methodologies.
The insurance industry, and the world as a whole, got a stark reminder about the importance and limits of risks management during the financial crisis. In its wake, a consensus has emerged that companies failed not for want of risk management practices, but because they didn't adhere to the ones they had in place. Insurers largely avoided the conflagration that consumed investment banks, notes Nancy Bennett, senior life fellow at the American Academy of Actuaries.
"Prior to the crisis you would hear a lot about how advanced risk management was at banks and how far behind the life insurance industry was," she says. "What we're seeing post crisis is some vindication that life insurers are really doing a much better job managing risk than was previously acknowledged. However, some of the credit belongs to the regulators."
Yet, Bennett adds, insurers can't rest on their risk management laurels, as several key deficiencies came to light during the past few years. One was a general lack of understanding of the relationship between the assets insurers hold and the liabilities they present. This disconnect was evident in the severe losses recognized throughout industry investment portfolios.
Another under-appreciated risk specific to life insurers was the complexity engendered by living benefits guarantees contained in many variable annuities. Some insurers poorly designed these contracts with insufficient hedges, so when the stock market tanked, policyholders selected against them and put them in a tough spot. Even now as the stock markets recover, insurers need to account for the impact a prolonged low interest rate environment will have on bond yields. "If we go through five or six years of potentially low interest rates, what does that do to portfolio rates?" asks Greg Smith, VP Insurance Research and Consulting, for Hartford, Conn.-based Conning Research & Consulting.
Bennett says the crisis drove home the widening breadth of financial risk for life insurers and underscored the need to better understand how these seemingly disparate risks interact. In order to maintain proper capital requirements, he says, carriers will have to project stochastically for a broader range of economic conditions. "Thirty years ago it was mainly mortality risk for life insurers, but now the products being sold are asset accumulation products, so life insurers are now much more exposed to the capital market risk."
THE WILDCARD
In addition to a better understanding of these capital-market incurred risks, life insurers are also looking to better account for their traditional antagonistic risks-mortality and longevity. While the risk of a short spike in mortality claims presents near-term risk to life insurers, the corollary of populations with increasing life expectancies also presents risk management challenges. Traditionally, insurers could hedge one against the other, because the 40-year old making premium payments on a life insurance policy was not likely to be receiving annuity benefits. However, this balance has become an increasingly difficult one to achieve. An insurer overestimating longevity risk may hold too much capital in reserve, instead of employing it to better effect elsewhere in the business. Underestimation brings its own set of problems.
A recent report from Zurich-based Swiss Re, "A Short Guide to Longer Lives: Longevity Funding Issues and Potential Solutions," notes that underestimating life expectancy by just one year can increase liabilities for insurers or pension plans by up to 5%. "One thing that is the wildcard is systemic longevity risk," says Donna Kinnaird, President of Swiss Re Life & Health America.
Since a universal base table for life expectancy does not exist today, life insurers will need to develop internal models to get a better grasp on life expectancy.
"Our ability to model the risk is certainly improving," Kinnaird says. "Reinsurers and actuarial societies that have access to large amounts of data are doing the things we need to do to model longevity risk."
Conning's Smith also perceives modeling techniques advancing. "The state of practice for modeling has improved quite a bit," he says. "The models are well aligned to blocks of business that people are projecting with them."
Andrew Coburn, VP for the Emerging Risk Solutions business unit of Newark, Calif.-based Risk Management Solutions Inc., says life insurers are beginning to catch up to property/casualty (P&C) and reinsurers in blending a number of scientific and engineering disciplines together with actuarial science. Much as catastrophe modelers have incorporated the research of meteorologists and structural engineers into their models, the efforts of life scientists and mathematical biologists can now help shape how life insurers model for mortality and longevity.
One salient difference between life and P&C modeling is that when modeling for a hurricane, the worry is about an event happening (a matter of "if").
With longevity and mortality, everything is time-based (a matter of "when"). "You know everybody is going to eventually die, so it's more of a time-based, cash-flow management problem," Coburn says. "Longevity is a slow-moving catastrophe."
To help insurers get better sense of when, RMS released in July a new medical-based model to help modelers and actuaries quantify longevity risks. The model takes measure of medium and long-term dynamics in the medical field and identified three major drivers of future mortality change: advances in the treatment of cancer, regenerative medicine techniques spurred by use of stem cells, and the retardation of aging process driven by potential treatments to slow the process of cell degeneration.
"The life insurance industry is going through the same sort of transformation that we saw in the natural catastrophe world 10 years ago," Coburn says. "Actuarial science is already well-honed so there's a lot of good technique, but there's still a need for more contextual information. There's a huge wealth of research published by the medical community and the drug industry, we have to filter through it and plug it back into actuarial models."
Kinnaird cautions that there's only so much modeling can do. For example, a cure for heart disease or cancer will be difficult to account for. "If something suddenly causes the population as a whole to live longer, the modeling will struggle with this."
MORE THAN MODELS
To be sure, insurers cannot view more granular or encompassing modeling as the zenith for better risk management.
"Risk management is not all about modeling," says Bob Wolf, an actuary and staff fellow, risk management, at the Society of Actuaries. "Risk usually doesn't come from some exogenous event. Most of the risk comes from the decisions and behaviors of people. You need a holistic view of risk because of the domino effects of decisions."
Wolf says getting this holistic view may require a periodic review of the assumptions underlying risk models. "Actuaries need to think outside the box when it comes to enterprise risk management," he says. "Our profession is paid to be anxious."
A broader push to reinvigorate a risk management culture across the enterprise may also be required.
Bennett says the shock of the financial crisis went a long way toward accomplishing this goal. "Before, you really had convince boards and non-technical executives to focus on the downside," she says. "Nobody wants to think that the market can drop 30%, but it could happen and we have to be prepared."
Now that the need to hard-sell that type of sober analysis has gone away and executives and boards are asking the right questions, actuaries and risk managers have to stand up in other directions and fight to get sufficient tools to perform their jobs.
"We have to be careful to say that the models are not going to give you all the answers," Bennett says. "Also in our zeal to answer these questions, let's make sure that enough human resources and technology resources are brought to bear. It's incumbent on the risk manager to say 'this is all I can answer for now.' It's not an easy place to be."
MANAGING COMPLIANCE RISK
If the near implosion of the world's financial system wasn't sufficient cause for a reexamination of risk management, a multitude of new regulations may well be. Just as the damage wrought by Hurricane Andrew served as an impetus to tighten risk management practices among P&C insurers, these new rules may serve as a similar function on the life side.
The European Union's pending Solvency II regulations will further codify principles-based reserving methodologies when implemented in 2012. This move from a static, formulaic approach toward an approach that favors dynamic, scenario-based models will be profound. "In a sense, Solvency II is the Hurricane Andrew of the life insurance industry," Coburn says.
Interestingly, principles-based methodologies have been taking hold in the United States, albeit in a more modest, piecemeal manner. In 2005, the National Association of Insurance Commissioners' C3 Phase II requirements required writers of variable annuities to employ stochastic models and base risk-based capital requirements on principles-based methodologies. "There was a general acknowledgment at this point in time for the life insurance business that the world was becoming more complex and that the capital standards really did need a model to capture the risks associated with these benefits," Bennett says "Right now it's still a bit of a hybrid approach. We still have a lot of rules that govern the way the life insurance industry is regulated, but we're moving toward principles slowly."
The NAIC's Life Risk-Based Capital Working Group is currently working on its C-3 Phase III requirements.
Smith says the gradual roll-out of these new rules is a good thing. "C3 Phase III requirements are going to hit insurers, but the lead times are long," he says. "It's take years of work to find an approach and then get everybody comfortable with it."
Bennett agrees that some growing pains are inevitable as insurers and regulators move from a rules-based environment to a principles-based one. "It's simple to say we're moving to a principle-based approach. It's much more difficult to implement it."
BETTER TOOLS
One technology challenge surrounding compliance risk management Smith foresees is with data aggregation and extraction. "It's probably not models that are going to be hit in the near term," he says. "Legacy administration systems can provide problems not just to modelers but also to the people doing the financial reporting. It will be the data requests, and the new forms, formats or level of detail needed to in order to satisfy these new regulatory requirements [that present challenges]."
As a result, insurers may need to reassess how various processes are structured and the technologies that enable them. Indeed, there's an argument to be made that the principles-based approach only became feasible as the underlying technology got better.
As insurers need to stress their balance sheet under different scenarios, the focus right now is to expand actuarial models to better capture the effects of the ups and downs in the economic environment, says Van Beach, director of business development at Seattle-based Milliman Inc. "Rather than doing a single scenario, you now work across a set of 1,000 scenarios," he says. "You'll then use actuarial models to capture policy-specific behavior under each of those 1,000 scenarios. Rather than coming up with a single answer, you'll look at 'what's the capital level I need to ensure solvency across 99% of these scenarios.'"
As they feed ever-larger data sets into their computational models, actuaries in particular have benefited from advances in hardware, grid and parallel computing in recent years.
"These types of models are extremely hungry for computing power," Coburn says. "For example, you can run a stochastic model on an individual about how their life may pan out. Then you have to run that for 100,000 individuals in a given portfolio. Then you have to account for the thousands of ways that mortality might play out. When you have stochasticity on top of stochasticity, it gets pretty ugly, pretty quickly."
With computational horsepower at a premium, Beach says cloud computing has the potential to shift the way actuaries conduct their modeling. "One thousand-scenario projections have become the bread and butter," he says. "Those scenarios are independent and are easily parallelizable tasks. My only concern is that these cloud platforms were not developed with computational modeling in mind, they were developed to handle Web sites."
No matter what advances happen on the technological front, Beach argues against a brute force approach. "Risk management has become more of a wisdom issue as opposed to being able to shove in a lot of parameters into a model and see what comes out."
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Risk and Opportunity
With life expectancy increasing, life insurers, pension plans and governments are confronting a growing longevity problem. Individuals are also incurring greater longevity risk as they outlive their savings. "You are seeing longevity risk being transferred back over to the individual and it's a pretty sophisticated risk for individuals to handle on their own,"says Donna Kinnaird, president of Swiss Re Life & Health America.
However, one concern is finite capacity in the reinsurance market as Swiss Re estimates that globally more than $17 trillion worth of pension assets are exposed to longevity risk. "We'll eventually get to the point where there's just too much risk for reinsurers to be of assistance," she says.
Accordingly, Kinnaird says cooperation between governments, employers and the financial services industry will be needed in order to create the mechanisms to share this risk with the broader capital markets. To this point, a group of insurers, reinsurers and banks have set up the Life and Longevity Market Association to promote a dedicated capital market for longevity and mortality-related risk.
