Insurance: A Little Earning is a Dangerous Thing…

Earning volatility
As Alexander Pope so nearly said, re/insurance company earnings are key to the firm’s valuation. Recent research from Citigroup provides more evidence that insurance firms with low earning volatility have higher stock multiples and better shareholder returns.

It is a mistake to think that Solvency II and similar regulatory regimes that may follow the recently introduced International Association of Insurance Supervisors (IAIS) guidelines are focused solely on capital—the Own Risk Solvency Assessment (ORSA) elements of each have far broader scope.

The ORSA require companies to be explicit about their objectives, their risk appetites and their risk tolerances. Companies will be required to demonstrate that their actions, including reinsurance purchasing decisions, are consistent with these measures. It is very likely that every organization will have defined targets for earnings volatility and business sustainability in addition to pure capital protection. NAIC’s ORSA exposure draft would lay a similar requirement on US operations.

Reinsurance Comes to the Fore

Falling investment returns will place even greater emphasis upon underwriting results. The use of reinsurance to not only provide proxy capital but also to smooth earnings has never been more apparent or more valuable.

Reinsurance strategy, and tactical reinsurance purchase, will be transparently determined against stated company risk appetites/tolerances and also against stress and scenario tests required by the ORSA. Very often internal capital models will be used to assess the value of different options and derive an optimal solution.

Reinsurance solutions should be explicitly customized to the specific needs of each insurer, but with a transparency such that it can demonstrably meet the requirements of the business, regulators and rating agencies.

Finding Opportunity in Risk

These regulatory developments present both opportunities and threats to insurers, brokers and reinsurers alike. All will be required to raise their game. Judging the value of reinsurance against multiple targets is difficult. It is too easy to reject a particular transaction if models show it has little capital benefit whilst overlooking its impact on earnings volatility. There are examples of careers ruined by such mistakes.

This is not just a model issue; psychology is important. Markets will react differently to losses they expect to ones they do not. After a major hurricane or earthquake, for example, all catastrophe-exposed reinsurers will be hit and marked down. But if you are hit more than expected relative to your peers then the impact is higher: it becomes a reputational as well as a financial event. Similarly, suffering losses when others do not or from unexpected and/or unrecognized risks may have implications beyond their quantum value.

Composite Risk Measures

There is no simple answer to the sophistication of decision making that this implies. Composite risk measures, such as that proposed by Ruhm, Mango and Kreps some years ago, may appear to offer the solution, boiling everything down into a single measure. Such methods weight outcomes depending upon their impact on the firm—perhaps missing an earnings target could have weight 1, missing that target from an unexpected event weight 2, a capital event weight 3 etc.

Whilst appealing in theory, composite risk measures can hide key implicit assumptions and end with a firm targeting an essentially meaningless number, arguably failing the transparency and comprehensibility requirements of both the business and regulators. A nuanced approach is required, different objectives and risk measures must be balanced.

Earnings stability cannot be ignored. By definition earnings events are more frequent than capital ones, failure to meet an earnings objective is more likely during your career. Making sure that your reinsurance meets result stabilization needs is a personal as well as a corporate imperative.

About David Simmons

David is a Managing Director in the Willis Re Analytics team in London. He focuses on Enterprise Risk Management, i…
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