So what direction is your company headed regarding risk? Are you expecting to:
- Grow your risk faster than your capital, using up excess capacity;
- Grow your capital faster than your risk, building up capacity; or,
- Keep risk and capital in balance just where they are now relative to each other?
We call the answer to that question the risk trajectory of an insurer. I also call it the Fundamental Question of Risk Strategy.
To achieve alignment between company strategy and risk strategy, the choice of risk trajectory must be included when all decisions regarding risk management plans are being made.
We asked this question to 58 insurers and almost 60% said balancing risk and capital was their risk trajectory. For each risk the insurer accepts, management must choose among four general strategies – Exploit, Manage, Minimize and Avoid.
The Exploit strategy seeks profits when a business has a competitive advantage that allows it to make more money when more risks are accepted. Risks that are exploited will grow.
The Manage strategy carefully accepts risks in a very controlled fashion. Managed risks usually grow at approximately the same rate as the underlying activity being insured; this fits closely with the balancing risk and surplus trajectory.
The Minimize strategy takes as little risk as possible while continuing to pursue business strategy. Operational risks often fall under this strategy; accepting more operational risk will usually not increase profits. But operational risks are unavoidable, so a minimize strategy often makes sense.
The Avoid strategy applies to risks outside the risk tolerance of the insurer. These risks are often outside the insurer’s expertise.
When asked about their preferred approach at the enterprise level, 70% of insurers said used a Manage strategy, which is compatible with the balance risk trajectory.
In addition, there is a Fundamental Equation of Growth, Risk, Profitability and Surplus (GRPS). To achieve the risk trajectory, there must be a balance among the four elements of the Fundamental Equation. The Fundamental Equation is blindingly simple. For insurers who wish to balance risk and capital growth:
Earnings must provide for a growth in surplus at a rate equal to the business growth rate.
For insurers with a trajectory to build up surplus, the growth in surplus should exceed the rate of business growth. For insurers with a trajectory to grow risk faster, the rate of growth of surplus will be lower than the business growth rate. So, we can define the Target Growth Rate as the business growth rate adjusted for the risk trajectory. Then the General Fundamental Equation is:
Earnings must provide for a growth in surplus equal to the target business growth rate.
As we said above – blindingly simple. From this equation, an insurer can tell what their target combined ratio must be to balance GRPS.
Combined Ratio = Premiums – (Target Growth rate – Earnings rate) x Surplus + Earnings rate x Reserves ÷ Premiums
Where the Earnings rate is the expected average after-tax return on invested assets backing reserves and surplus, and the combined ratio would be net of tax on underwriting income.
For more on this topic, go to the Willis Re Webinar on Balancing Risk and Capital where Ralph Cagnetta and I provide further insights on how to achieve this balance, along with a case study of one insurer’s approach.