Rating Agencies Driving Insurers to Stochastic Modeling to Enhance Risk and Capital Management

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 New York-based 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."

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%).
  • 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."

Source: Tillinghast, Towers Perrin

 
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