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Dynamic Corporate Management

Maintaining olvency ver Time

Report f he Dynamic Solvencyorking Party o he

General nsurancetudy roup

Membership: Richard ulmer

Francis hackoJames DeanAndrew MacnairRavi anjrekarNicholas ichaelides,hairPeter Rains

August 1993

155

1993 General Insurance Convention



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CONTENTS

1

2

3

4

5

6

7

IntroductiontoDynamic Solvency

Why Solvencyatters

What is ynamic Solvencyesting?

Where is orporate lanning Today?

Integrationf olvencynd Planning

Modelling he Company in a Market Context

Selectibliography

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If e consider he personalityrofilef a typicalnsurance ompany

manager, s)he s ikelyo be task riented,ith short-termerspective

and a tendencyo e pragmatic.ver-anxiouso ind olutions,s)heill

make decisionsefore nderstandinghe problem or the implicationsf

what is ecided. t s hen ittleonder hat he ndustryas the problems

that t oes. n idealistic,isionaryeadershiphich sees through the ups

and downs of he ycleo the real needs of the customer might generate

some immunity rom the orse xcessesf rice ompetition.f it is true

that people ill lways eed insurance”,e reallyave no excuse for

losingo much money.

The primary urpose f this aper s o engthenhe horizon of thinking

about he usinesso as oencourage ealisticecisionaking that will

create ustainabledvantage ithout irstripplinghe balance sheet.

The golden ule s hat here re o golden ules o do not xpect o find

all he nswers ut rytoanswer he uestionse pose.

Read on . . . . .

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Dynamic Corporate anagement - aintainingolvency ver Time

1 Introductiono Dynamic Solvency

The working arty ame to the ubjectn the elief hat his as to be

virgin erritorynd that simple, ntroductoryaper would break new

ground. It came as quite shock to discover ust ow insularhis

perspectiveas. Within he ibliographyre some of the papers we have

consideredut each of these s he tip f the extant iterature.ach

carriests wn listf papers and the Brender et al paper is an extremely

valuableibliographynd commentary n tselfnd highly ecommended

reading.

It uicklyecame evident hat e could ll oo asilyeplicatehat has

gone on elsewhere.owever, f his aper chievesothing lse,t ill t

leastause s to onsiderur ctivitiesn a wider stage and point towards

previouschievements.

This roup s n amalgam of two; t ncorporateshose ho expressedn

interestn the ost f maintainingear-end olvency. hile this s f

interest,t s perhaps ubsidiary.he cost of meeting the statutory

hurdles by (ab-) using certain accounting mechanisms, financial

instrumentsnd so forth ay representhe tacticsf a company whichhas not, n previous ears, ully ncorporatedhe concept f dynamic

solvency.

To be solvent s o be able to pay all ebts. In the short erm, ny

company with positiveash low hould hereforee solvent. strong

flow f ash nto he ompany today ay, owever, imply be indicativef

underpricedusinesshich will enerate large outflow at some future

date. hus there s strong esponsibilitylaced on the management to

ensure hat t ll imes he ompany currentlyas the resourceso meet

all the commitments it has incurred. In most markets,

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managements re not trustedo do this without somebody looking over

theirhoulder.

Being inancialnstitutionsf he orm that ncome s nown-ishut costs

are not, t is imperative or many interestedartieshat insurance

companies an demonstrateubliclyhat hey ave the esourceso meet

theirommitments n easonablyoreseeableircumstances.n the UK at

present,ost of the focus as been on the situationhe company finds

itselfn t ome arbitraryate. n eneral,he uestionsked is whether

the ompany can meet all ts iabilitiesrom its xistingssets.n the UK

and the est f the C, the est s hether et ssetsxceed minimum

required argin. To calculatehis argin, oth premium written nd

claims ncurredre taken as measures of exposure. Fixed percentages

are pplied o hese iguresnd the argerf the two outcomes is taken to

be the inimum margin. he effectf his ethod is enerallyo require

the ame margin or ll ompanies f given ize rrespectivef heirix

of business. ong-tailedines ill,ver time, build up proportionately

largerechnicaleserveshan hort-tailednes. s reservesre ubjecto

fluctuation,given ercentagehange in those of a company with a long-

tailedias would have a bigger impact on the margin than in, say, a

personalinesffice.

This s ut one limitationf the static,ear-end pproach. Dynamic

solvencyakes he orizon ut to futureate when we can try to assess

the company’s trengthiven he execution f its usinesslan in the

meantime. In dynamic solvency esting,e try to understand the

circumstanceshich would place he ompany under the reatesttress

given ts urrent trategies.t can then decide the extent to which

strategieshould e amended to balance tress otentialith profit

potential.his rings olvency ssessmentrom a concern with keeping

supervisorsappy o se s management tool. e need, hough,o look

at both perspectives.

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1.1 Supervisor’sole

United Kingdom

The DTI assesseshe eturnsubmittedy a company within six months

of its inancialear-end o determine ts bilityo continue writing

soundly. he EC requirementor solvencyargin of at least 16% of

net remiums was (perhaps ptimistically)ntended o protectn insurer

againstnderwritingossesustainedetween ts inancialear-end and

the oint t hich the ompany’s eturnsave een prepared,ubmitted

and analysed. he quasi reak-up ost nd valuationasis equiredy

UK law does ot ake xplicitccount f he ompany’s ntentionshich

is hy the DTI has started series f informal isitso companies to

understandheiruturelans.

Canada

in Canada, lans re afoot o implement ynamic olvency hrough he

establishmentf appointed ctuaries.ere the focus ill e on the

business lan and the abilityf the company’s esources o sustain

planned activitiesver at least the next twelve months. The stated

objectivef anadian ynamic Solvencyestingr DST is to

“enable he ctuary o rovide dvice bout rends n urplusnd threats

to the ompany’s olvency,nd to identifyourses f action which may

mitigatehe threats”.

This s mplifiedn ne of the ootnoteshich ays, It s mportant o

realizehat he primary urpose f this xercises ot to find ut if

company will e solventr not t future ate, ut he xtenthat certain

factorsr elements an adverselyffecthe olvencyf a company”. This

pro-activetance hould elp ompanies void trategicead ends as long

as management is prepared to amend its trategy nd introduce

appropriateontingencylans. It is probably at this point that thesupervisornd management may be expected o onverge,f not clash.

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The United tates f merica

The USA is pproaching olvencyrom the so-calledisk-basedapital

approach here capital equirementsre based on the scale of the

balance heet isk,oth of assetsnd liabilities.nother working party

has he rief o over his evelopmentnd we do not attempt to emulate

them here.

1.2 Manager’s Role

Most managers are interestedn keeping their jobs and getting

promotion. etermininghe impact tomorrow of what they decide today

has not always een one of their trong oints et is ssentialf their

primary nterestsre to be fulfilled.usiness lanning s stilln its

formativeears n he eneral nsuranceusinessnd has mostly been the

preservef the ccountant.ence, much of the work has been on point

estimatingnd budgetaryontrol.

The horizon f the ise anager ill e much longer than that of either

the TI or the anadian uthorities.lso, t s mperativehat even the

sacred ows re acrificedn he nterestf n objectivessessmentf the

future.or example, istoryeaches us that nobody ever learns from

history.o, ho is o ay hat he ext ownturn f he nsuranceycleill

not it s or be even more severe han ast ime? hat corporatelan

ever ncluded uch scenario?hey all seem to show growth and chirpy

loss atios.e hope that e may help o pen a chink f ightn hisark

corner.

1.3 Our Objectives

Within his aper e shallndeavour o ink he upervisor’snterestith

that f the management. t is learlyital hat the company remains

solvent n the eyes f the upervisor.lso, n order hat irectorsan

continue to allow their company to trade, they must at all times

reasonablyelieve hat t s urrentlyolvent.owever, that may not be

sufficientor ong erm viability.very ailureas once solvent!OW do

we ensure hat ur mployer r lientoes rom strengtho strength?

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In other ords, how o We manage our company capitaltrengthn he

lightf the elativeositionf our competitorsnd the absoluteest f

solvencydopted y the articularegulatoryramework we are working

within?iven hat apitals elativelycarce,ow do we best llocateur

resourcesn rder o maximise he alue reated y their se? To what

extenthould isk e managed by the nsureratherhan the shareholder?

As buying einsuranceeduces he ong-termrofitabilityf the business,

it ould not appear o be in the interestsf the shareholdero what

factorshould otivatets urchase If einsurances bought for capacity

purposes,hy not et he capitalrom the current nvestorsnd reward

them rather han he hareholdersf the reinsurer?

We considerrieflyhe erspectivesf the arious takeholderso show

both he ommon interestn olvencys ell s ome of he ifferencesn

perceptions to what makes a company solvent. e then xamine he

role f corporate lanning n helping he management to ensure he

prosperityf the company. Next is section n the ways in which

assessmentf olvencyan be incorporatednto he lanning rocess.t s

this section which addresses the key issues raised in the previous

paragraph. he featuresf a market-orientedodel are then briefly

discussed.inally here ollows select ibliographyhich includes

comments n the apers isted.e suggest hat e raise ore questions

than nswers ut perhaps here s lesson here. et us not resume toknow but be ready to find out.

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2 Why Solvencyatters

While we can define olvency n this ontext s “at all times currently

having he esourceso meet all he ommitments lready ncurred”,he

relevance nd even understandingf this ill ary according o the

perspectivef the stakeholder.

2.1 Managers nd Employees

Good management will onsider he aims and needs of policyholders,

shareholders,upervisors,tc., nd so will have an eye to all the

considerationsentioned n sections.2-2.5elow. It will also have

regard o he ositionf the ompany workforce nd of the irectorsnd

managers themselves.

Generally,anagers nd workforce ill e interestedn the continued

solvency f the company, o that alariesontinue to be paid and the

pension fund topped up. Some bonus schemes can encourage shorter

term thinking lthough ontinued mployment should be a sound

incentiveo manage a financialnstitutionn a long erm basis. lso

senior anagers n a company which has failed inanciallyay find it

difficulto obtain similar ost elsewhere. The degree to which

reputationsufferill epend on the easons or ailureut it s arely

wise move to have such an association,ither from the market’s

viewpoint,r hat f he upervisorhere, s n he K, the atteras the

power of eto ver eniorppointments.

Many of the onsiderationsill uggestonflictingourses f ction,nd

management will ometimes need a pragmatic olution n order to

balance he eeds f he arioustakeholders.his s ost clearlyeen n

the distinctionetween a company’s bsolute ositionnd its position

relativeo tsain competitors.

When considering,or xample, he level f exposure o equitiesn the

company’s nvestmentortfolio,anagement may decide that the dangers

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from over- r underexposurere smaller han he risks rom a level f

exposure hich s ut f line ith that of the company’s peers. If a stock

market rash its ll ajor insurersqually,he supervisorannot (the

argument uns) lose hem all own; the suppliersf capitalill not

desert he ectorntirely;he ore talentedanagers annot ll lee;nd

so on.

There is subjectivelement o thishich can be seen in the Canadian

approach f dynamic olvency estingsing range f assumptions. n

some scenariosll nsurersill e insolvent,hile n thers racticallyll

will e solvent. he importance f assessinghe relativeositions

reflectedn he rowth f agencies hich valuate he inancialtrength

of insuranceompanies nd allocate rating. ost companies ill ave

passed he tatutoryests ut some will ave cleared he hurdles ith

greater argin han thers. he assessment y these genciess takeninto ccount y those ho buy insurancend it s ikelyhat etteruality

businessill o to he trongerompanies, hus cceleratinghe decline

of those hich are already eak. Management of all spectsf risk

commensurate ith apitalesourcess hereforeitalo avoid becoming

frailelativeo he arket nd startingsteadilyallingpiral.

2.2 Shareholders

It as been argued hat n a perfectarket ompanies hould ot, romthe erspectivef their hareholders,ake ctionso rotect olvencyn

the rounds hat t s or hareholderso diversifyheir wn investment

portfoliosf hey ish o reduce isk.he argument runs that any actions

taken o rotectolvencymply xtra osts,uch s he eductionn return

from investmentshich do not maximise ield r the profitargin

element f reinsuranceremium.

In the real orld, ealing osts revent hareholdersrom diversifyingtheirortfoliosompletely,o they ook or ertainompanies o xercise

a degree f prudence. f shareholdernvestsn companies ith isk-

taking rofiles,hen e/she hould ot be too discontentf here s he

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occasionalailure. owever, insuranceompanies ecessarilyresent

quite he opposite rofile,nd so serve heir hareholdersy following

low-risktrategies.f nsuranceuturesver re enerallyvailable,his

will ecome even more true,s nvestorsill hen have a choice between

investingirectlyn insurance hrough uturesr investinghrough the

risk-filteringedium of n insuranceompany.

It ould not e impossibleo imagine n insurancearket onsistingf

major nd minor nsurers,ll ollowingow-risktrategies,lus range f

specialistnsurersollowingigh-risktrategiesuch as not seeking o

reduce underwritingisk by reinsurance)ny further han occurred

naturallyhrough he pooling f risks. hile this ould requirepecial

treatmenty policyholderswho would themselvesave to diversifyy

spreading heir over) nd regulators,uch a market could erve he

interestsf shareholdersetter y making available spread of risk

levels.

However, it hould e a feature f such a market that most of the

insolvenciesould occur among the specialistompanies and be

attributableo identifiedigh-riskauses. n reality,he majority f

failureseems to resultrom poor management practicef one sort r

another,ather han rom following high isk/rewardtrategy.his is

reflectedn the une 1991 eport f AM Best n primary auses f USinsolvenciesrom 1969 o 1990

Deficientoss eserves/inadequatericing

Rapid growth

Alleged fraud

Overstatedssets

Significanthange in business

ReinsuranceailureCatastropheosses

Miscellaneous

28%

21%

10%

10%

9%

7%6%

9%

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While here ill e elements f igh isknd poor management in at least

the econd nd sixth f these,e could, omewhat arbitrarily,lassifyhe

firstour s oor management and the atterour s high isk/reward.lt

is rue hat o investn a company with poor management is a high risk,

but t s lso ikelyo ead o ow rewards.)hus we could ivideailures

into 9% poor management and 31% high isk trategy,nd say that the

insuranceorld f he ast wentyears does not appear to have rewarded

an investoreeking o invest fficientlyn high-risk/rewardnsurance-

based ventures. n view of this,hareholdersf insuranceompanies

should e presumed to be expectinghe management to seek a low-risk

strategy.

Finally,hareholdersay need a steady tream f dividendsn order to

budget ccuratelyr to eet theirwn capitalommitments. This should

be less f problem or shareholderith diversifiedortfolio,ut will

be particularlymportant for one which is a holding company for the

insurer nd which has no other assets. If it is financed by debt or

cumulativereferencehares,t ill e dependent n a reliablencoming

dividendtream o pay its wn interestr preferenceividends.learly,

the bilityf an insuranceompany to maintain ts ividends related to

its inancialtrengthnd to ts bilityo enerateoth cash and profit.

2.3 Policyholders

It egates he hole point f insurancef n insuranceompany cannot

pay laims ullynd promptly. ven where policyholdersre protected in

the vent f nsolvency,uch as in the UK through the PPB, there is likely

to be an increased elay, he loss f any claims dvice ervice,nd

perhaps a deduction from the amount refunded (10% in UK for non-

compulsory nsurance). owever, such protectionoes reduce the

importance f solvency o the olicyholder,hich perhaps xplainshe

predominant ffect f price n the current K private otor market.Whether such mphasis n cost ather han nsurerualitys appropriate

is uestionable,ince t eems likelyhat a strong company will assess

claims ore fairlyhan a weak one.

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From a statisticaliewpoint,hat an insuranceompany is ellings ot

the repaying f the cost f insured ncidents,ut the removal f the

variationn his ost. In ffect,he part of the premium which represents

the verage ost f incidentshich he nsured ight xpect o ufferver

the olicyeriod an be separatedrom he est,nd indeed is sometimes

reduced r even emoved completelyy deductibles,etentionsnd other

forms of self-insurance.

From the insurer’siewpoint he remaining art of the premium

representsrokerage,xpenses,rofit oading,einsurer’soading,nd

other osts,ut for he insured t s uch more straightforward.t s

simply hat mount which e/she s repared o ay to ransformhe cost

of the insured ncidentsrom an unknown, highly ariableigure o a

known quantity.

It ollows hat n insured ill nly e prepared o pay such sum if he

uncertaintys enuinelyemoved; if here s significantemainingisk

that he insurer ill ail o pay claims hrough nsolvency,hen the

company is ailinghe policyholdero the extent hat he latteright

decide hat here s o value n aying he xtraost.

A large ommercial olicyholderill e able o pread nsurancemong

a number of companies, aking he solvency f individualompanies

less riticalactor han or small ommercial irm ith singlensurer.Equally,he ecurityf individualeinsurersecomes less mportant f

broker an et everalignatureso the slip.

In the case of a mutual, here the members are in effect oth

policyholdersnd shareholders,heir nterestsall omewhere between

those et ut in sections.2 nd 2.3. owever, they re likelyo lean

towards he latterince heir rime concern ill e protectiongainst

insured isks nd the remarks bout iversificationf shareholdingsonot come into play.

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2.4 Regulatoryuthorities

A regulator’srimary im is ikelyo be the rotectionf policyholders

againsthe isk hat nsuranceompanies ill ot eet theiriabilities,r

will ot ulfileasonablexpectations,hough n ome countrieshere is a

secondary,nd sometimes onflicting,im of controllingricing. he

regulatoryrganisationay also ave a role n ponsoringhe insurance

industryf its country and hence in helping it to appear sound to

prospectiveolicyholders.here are parallelsetween these aims

(protectionnd fair ricing)nd the twin aims of the policyholder

(securitynd value),hough he ttitudesowards he use of the country’s

protectionund illiverge.

There should, owever, e a strong istinctionetween the aims of a

regulatorith regard to a company and the aims of the company’s

managers. s discussedbove, he atterill egard he reservationf

the company as their rime concern, nd so will ometimes e more

consciousf their ompany’s elative,han of its bsolute,osition. n

contrast,he regulatoryuthorityhould look mainly at the absolute

positionnd should e prepared o encourage r require ompanies n

difficultieso ease o rite usinessf such is the only means of avoiding

an otherwise ignificantisk f future nsolvency,ven if everalther

companies re n imilarositions.

Such culling s ctuallyart f a healthy nsurance arket since, y

reducing apacitynd hence permittinghe survivorso raise remium

rates,t an ring bout he nd of soft arket. lso t reatesoom for

providersf resh apitalo move in to the market. There is a Darwinian

theme to this,ith the survivorseing the companies with the fittest

capital, marketing, underwriting, claims handling, investment

management and ultimatelyanagement,

The approaches sed y supervisorso try o etect nsolvencyisksary

considerably.t s lear hat upervisionust combine n assessmentf

company’s eported osition ith a view as to its possible future

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development.

In Canada this ill e done by requiringctuarialrojectionsn various

bases.

In UK the DTI is currentlypdating ts ethods of analysisf the

Financialear end positionnd is sing ompany visitso try to assess

future lans, ith he introductionor wo types f company of more

frequent hort isitso enhance this im. The Institutef Actuariess

promoting ertificationf reservesy actuariesr other uitablyualified

persons,nd should erhaps e advocatinghe ullanadian pproach.

2.5 Other stakeholders

2.5.1 Third PartiesA third arty’snteresties nly n the ecurityf the nsurerrotecting

the arty gainsthich the claim is made, since the cost of the cover is

paid y the latter. t ill ormally ave had no say in the choice f

insurer,o its nterestsre representedy the laws which make certain

types f insuranceompulsory,y any protectionunds which will allow

the claim to be paid should he insurer ail,nd by the supervisor.

Politicallyt ight be difficulto pass aws enforcingertain ypes f

insurancef he ountry’snsurancendustrys not seen to be sound.

2.5.2 Reinsurers

Reinsurershould void ompanies hich they onsideruffer serious

risk f becoming insolvent.t is a poor use of management time to

cultivateelationshipsith customers which have no long-term future,

and it an harm a reinsurer’seputationo be associatedith a direct

insurerhich becomes insolvent.

A furthereature s hat, n the event f administrationr liquidation,

there ill e a desire o come to terms s quickly s possible. hile

reinsurersometimes enefitnitiallyrom delayingayment of debts o

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customers n ifficulties,here ay eventuallye a significantpeeding-up

of ash utflowt the same time as one source of revenue has dried up.

2.5.3 Coinsurers/Market

If n insurerails,he epercussionsan affecthe hole market. n the

UK, this could be through the levies made by the Policyholders’

Protectionoard which uarantees0% of all ersonal nsurancelaims

and 100% of ompulsory nsurancelaims.he nasty shock that even the

Weavers businessould e deemed to fallithin PB realms reinforces

the value even to the stronger ompanies f participatingn a well

regulatedarket.

Where the claims all utside PB scope, here an be moral and

commercial pressuren co-insurerso pick p the unprotectedhare.

There is suggestion,or xample, hat ILU members should meet claimsmade against ndrew Weir to maintain he reputationf that market.

Lloyd’s,espite laims o the ontrary,perates n a “mutual” asis n

extremis hrough he entraluarantee und or hat ery eason. rade

Associationsenerallyight e expected o want their ood name to be

linked ith ompanies hich remain solvent.

2.5.4 Intermediaries

Securitys eing aken ery uch more seriouslyow than ven in therecent ast nd it ill arnish clientelationshipf xpensivensurance

policiesurn ut o ave een worthless.ntermediariesay need to be

able to demonstrate hat they have taken suitable recautions n

recommending a particularnsurance ompany should it fail n due

course, f hey re o avoid eing nvitedo make good the non-existent

cover.

2.5.5 Rating Agencies

These organisationsndeavour o dd value o he ublishedccounts y

analysis nd direct contact with both the market and individual

companies. y gettingeneath he iguresnd applyingertainests,hey

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attributeo insuranceompanies range f securityatingsrom those

which re thought o representery ood securityo those which are

consideredo e barely olvent.hrough this eedback o nsurersf he

agencies’eports,ompanies ight e expected o give onsiderationo

balance heet anagement. This ill e both on a continuousasis s

well s to ddress uch ssuess “how much capitaloes y parent eed

to njecto o from BBB to ?”

Historyhows hat hese atingsave a very hort helf ife a significant

proportionf the 1992 and 1993 UK failuresnd withdrawalsad “A”

ratingss recentlys March 1992. Eg English nd American, Municipal

Mutual and General, NW Re, Orion Insurance, Prudentialbroking

only)).

Even where the ratingsay be successfuln warning of insecurity,hismay have something o do with elf-fulfillingrophecies. nglish and

American, or nstance,ubliclylaimed hat heir ithdrawalrom the

London Market in 1993 was directlyttributableo their downgrading

from “A” to “B”. They felt that they would only be shown second rate

businesshich would be unprofitablend hinder rather than assist

recoveryf heirreviouslyood securityating.

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3 What is ynamic Solvencyesting?

In the bibliography,e outline the current state of the Canadian

approach see ection .4]. he intentionere would appear mainly

supervisorynd to provide early warning that a company is heading for

problems, f ot insolvency,nless t hanges ack. he nature s f a

prospectiveudit ver he est welve onths. hile the ntentionf he

process is to aid management and the tone of the guidance notes

encourages he ctuary o be part of the management team, his whistle-

blowing esponsibilityo he oard ight ut strainn that relationship,

What might be of greater value to the industry and aid better

management of capitalould be to incorporateynamic olvencyesting

into he strategiclanning process. We outline below the current

perceivedtate f corporatelanning nd then uggest ow this ould beenhanced y what is ffectivelycenarioesting.

Effortsave been made to llocateapitalo lines f businesseflecting

their articularualities.cenario esting,aking allowance or these

features,hould ighlightny strainn the overallusinessnd enable

particularlyapitalntensiveenturesr trategieso be identified.

We could ontrasthe irectionroposed n ection to the developmentin eservingor utstandinglaims.e startedhere y producingoint

estimateshat ere often ore reliablehan itherhe laims epartment

or accountantsould anage, particularlyhen inflationas rampant.

This has developed nto statisticalodels of the claims settlement

functionhich nable s to nderstandhe ature f any olatilityithin

the process.

Until ow, lanning as ocused n singleiguresnd it s ften nclears

to whether these are best estimates,ptimisticargets or simply

arithmeticxtrapolations.he principlesf dynamic solvencyesting,

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principallyhrough arying he base planning ssumptions bout the

future,rovide he tartingoint or range.

The Daykin and Hey work [see he Bender et al paper referredo in

section.1 or ummaries f heir tudies]nitiallyssessedhe variability

of outcomes given break-up from a year end position. By extending

trading or one year and repeatinghe exercise,hey tarted own the

path f modelling arious utures.his nables s to try o answer he

questions o hether hat xtra ear as ade the ompany more or ess

risky. t might not, hough, ell s so much about what could have

occurred uring he ear tself,esources ave ot hus ar nabled s to

reassesshis ork to onsiderhether t rovides steppingtone n he

directione are heading for.

One of the rawbacks, hough, f any “black-box”echnique s hat eryfew people n he ompany will nderstand hat goes n inside he ox.

The transparencyf deterministiccenarioestingay prove f greater

value o management simply hrough ts ery omprehensibility.f hey

see nd accept he utcomes f given et f ircumstances,hey ay be

more readyto ct.

So, hile e could oncentrateurely n the ontextf the supervisory

perspective,e consider hat more fruitfulnitialaper might look at

the undamental anagement problem: how do we manage the business

and its esources eople nd capital o tay n usinessorever?“.

Any scenarioestingeeds o be firmly lanted n the real orld. We

keep coming back to “management” hence the itlef this aper, wo

management questionshich he anadians ncludere:

The nature of management information vailableo detectchanges in experience

and

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Management’s bilitynd willingnesso mplement hanges n ey

management policies.

Put another way, does management know what is going on and would it

do somethingbout bad news if it noticed?

17s



4 Where is orporate laning Today?

4.1 Corporate lanning in General

It s enerallyegarded hat he level nd sophisticationf corporate

planning n General insurance ompanies fall behind that of other

industries.his is ummed up in the management consultant’sament:

“To run an insuranceompany you need to know a lot about insurance

and that does not leave room for anything else.” The special

complicationsf the insurance ndustryave given rise to additional

difficultieso management theoristsn applying onventionaltrategic

analysis.

The theoreticalevelopment f he pplicationf orporatelanning nd

corporate trategyeveloped s a separate opic n the 1960’s. his

occurredith he ublicationf seriesf ooks ainly manating romauthorsssociatedith he arvard usinesschool.t as backed p in

the 1970’s y a substantialmount of empiricalork predominantly

relatingo American companies. One such programme- the PIMS

programme- comprises detailed information from over twenty-six

hundred usinessnits nd allowed esearcherso analyse he mpact f

market onditionsn profitability,y the arly 980’she ast ajorityf

the argestS corporationsad separate nits esponsibleor strategic

planning.

Analysisf the arkets n hich company operatesad always een a

part of the strategicanagement process.his aspect of strategic

management, owever, ained major impetus ollowinghe work of

Michael orter ublishedn 1980. e proposed ethods f nalysinghe

industryn hich company operates nd the ompany’s ositionithin

it. n particularompetitiveressuresere splitnto five sources (i)

currentompetitorsii)otentialew entrantso he arket iii)roduct

substitutesiv) upplierso the ompany includinghe supply of labour

and (v) uyers. his method of analysisas formed a major part of

subsequent trategicanagement approaches. Although there is little

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agreement mong the pecialistsn his rea, n the efinitionf strategy

for example, everal ools ave been developed. hese include the

strategyodel, he roduct-market/portfolioodel and the risk/return

model.

Other topics n strategicanagement have included the appropriate

organisationaltructure or differentypes of company and the

development f he trategyunctiontself.cKinsey as uggestedour

stagesf trategicanagement development:-i) ompany budgetingii)

company forecastingiii)nalysisf the externalarket (iv) strategic

management- including well defined strategicramework and

widespread trategichinkingapability,

4.2 Corporate lanning n General Insurance.

A varietyf planning echniquesas been used and various ompany

approaches ave been documented y the eneva Association.ost of

the ocumented pproaches ave een unsophisticated.here have een

some exceptions,erhaps nsurprisinglyostly n the United States

where many insuranceompanies ave een using onventionaltrategic

management methods. urvey ata hows hat n he arly 980’sery ew

US companies were taking ccount f external nfluences n the

company. Also, survey n the UK in 1987 suggested nly few UK

insuranceompanies sed onventionaltrategicanagement techniques.

Turning o modelling,ost surveys how a majorityf companies ake

some use of modelling echniques.owever, urveys oth n he K and

the US show a low use of modelling f overall nsurance ompany

activities.

A previous eneral nsurancetudy roup working arty Akhurst t al

1988) looked at corporate planning using conventional strategicmanagement techniques.owever, his oes ot ddress he difficultyf

integratingolvency testing models into conventional strategic

management theory.

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4.3 Diffrencesetween nsurancend other Industries

One reason or he low evelopment f corporatelanningn insurance

is he ajor ifferencesetween nsurancend other ndustries.s such,

much of management theory has to be modified before being applied.

Also, he omplexityf he nsuranceusinesseans that t s ot n easy

area or anagement theoristso encompass. As stated arlier,nlike

most other ndustries-here costs an be easilyredictedut ncome s

more difficulto orecast-n nsuranceot nly an income be difficulto

predict,ut costs re also ncertain.o be consistentith he pproach

in other ndustriesncome could e defined o include olelyremium

income. Then the predictionf costs ncludes ot only the unknown

claims xperience,ut also reductionn costs eflectinghe eturn n

the invested remiums and any associatedolvency argin- hich

commonly includesquities.

Despite he additionalncertaintynvolved,he insurance business

excludinghe solvency argin an be analysed ith he same methods

used or ther ndustries,he solvencyargin, owever, dds a particular

difficulty.nce equity nvestment s considered,he applicationf

corporateanagement theory o his art f he usinesss more difficult,

especiallyorter’sheoriesn competitiveositioning.evertheless,he

importance f the erformance f the nvestedssets n etermininghe

company’s verall eturn akes a suitable reatment ecessary.he

1980’srovided salutaryessonn his egard.

It s ossibleo have a more efficientnsuranceusinessxcludingsset

management, ut stillower overall eturns. Also, those firms that

produce igh sset eturns ay be encouraged o lower heir remiums

making other firms unprofitable.ne approach is to consider he

shareholders’nvestedssetss n investmentrustnd adopt approaches

used by the investment anagement industryith articularegard ocompetitor ositioning. he effectiveesult would be that overall

management of costs- hich in the insurance ase would include he

reductionn osts rom the eturn n investedssets-ould pay regard o

competitiveressures.trategicost nalysisould then e set n terms

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of the nvestmentoliciesf competitorss well s the ostsssociated

with ure nsurancetrategies.

4.4 Settingbjectivesor orporatelans.

While anagement will eed to e aware f the eeds f ariousarties,

its ain aim will e satisfyinghe hareholdersf company. o this nd

it ay be useful hen consideringanagement objectiveso consider

directlyow shareholdersre likelyo gauge company performance

retrospectively.nsurance nalystsommonly use dividend rowth nd

share rice erformance ompared ith ompetitorss the main criteria

for ssessingistoricerformance.sually isk djustments ot ade to

the returns. This approach implies that not only is performance

compared with competitors he main influencen the survivalf a

company but also ne of the main criteriay which shareholdersudge

company performance. This has some common ground with

policyholders’easonable xpectationsn Life assurance. If this s

accepted hen he ettingf, or xample, eturn n capitaln absolute

terms as imitedse as a guide o atisfyinghareholders.ne reason s

that iews n acceptableeturnsre likelyo change ecause f market

circumstances.

Some authors ave uggestedhat he ore bjectivef company should

be to increasets ppraisalalue nd that xecutiveemunerationhould

be set n hose erms. ne consequence f this s hat he doption f a

suitableisk iscount ate ecomes crucialn udging erformance oth

prospectivelyut also n the eriod etween aluations.owever the

benefitsf, or xample, ower isk ay be lost n investorsn company.

There are usually ew objectiveriteriaor establishingisk discount

rates. herefore,t ay be difficultn racticeo refute laims hat he

incrementaleturns ere the result f superior management insight

rather han ncreasedisk. urthermore hareholders’isk ill epend ontheir wn objectives,hich may have littleonnection ith the risk

assessmentsed n he sual ppraisalalue pproach. he objectivesor

individuallassesf business hich are set eed to be consistentith

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overallbjectives.ere again, f competitor ositioningpproach is

taken hen companies ill ttempt o adopt new strategieshat differ

from their ompetitorso the extent hat hey are confidenthat he

returns re above or below the average. Nevertheless,ncremental

activityill eed to be consideredy deciding he ffectn the utlook

for he ompany as whole.

4.5 Risk ssessment

Many approaches ave een suggestedor isk ssessmentome of hich

have een referredo elsewhere n the aper. An approach dopted y

US regulatorsn heir ttempts o set ppropriateremium rate evelss

to onsiderhe xposure o he on-diversifiableisk f linef business.

The argument s hat hareholdersn n insuranceompany should nly

be rewarded or risk hat hey cannot iversifyway by having ther

investmentsn heir ortfolios.ne example f an insuranceine ith

significanton-diversifiableisk s Mortgage Indemnity uarantees

(MIG). The exposure f he erformance f his ine o eneral conomic

conditionsay be difficulto iversifyway to he xtent hat ost other

enterprisesre also xposed o general conomic conditionso some

extent.he estimationrocessor he on-diversifiableiskf individual

lines s extremely mprecise. hen consideringndividualnsurance

companies he non-diversifiableisk or eta) s quallyard to assess.

This akes risk ssessmentf ifferenttrategiesased n theirorecast

Betas problematical.

Another pproach s o onsiderhe hareholders’unds as an investment

trust hat the policyholdersave a right to in certain adverse

circumstances.F his oncept is adopted then it is in the shareholders’

interestso minimize heir nvestmentn he ompany. This ill educe

the extent f the policyholders’ight n their unds. n practicehe

financialtrengthf company affectsts bilityo o business.his ay

be reflectedn the profit argin it an include n its remiums, r

alternativelyhe riskinessf its sset ix. Therefore eductionsn

solvencyo not ecessarilyead o igher eturnsn capital.

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There are other isk ssessmentrocesseshat look from a regulatory

standpoint.hese include he urrentolvencyegulations,he isk ased

capitalpproach, nd various tochasticodels of dynamic solvency.

While these are very useful n consideringolicyholderisk, some

adaption is required if full allowance is to be made for competitor

positionings escribedy Porter.

4.6 Consistentpproach o ssetsnd Liabilities

One particularifficultyn corporate lanning for General insurance

companies s in producing onsistentrojectionsor the assets nd

liabilities.actors uch s economic rowth nd inflationave an impact

on both he ssetsnd liabilities.ne specificxample s he ffectf the

UK recession n UK property.his had an impact on both asset

portfoliosnd through ortgage ndemnity ontractshe liabilitiess

well. uch factorsre, owever, ikelyo have an impact cross he full

range f asset nd liabilitylasses.lthough ome work has been done -

on allowingor he effectf inflationcross he assetsnd liabilitiesn

some stochasticodels - theoreticalork in this area is limited.

Therefore t s suallyecessaryo dopt scenariopproach - possibly

based on specificeriods f history when attempting to produce

consistentcenariosf hisype.

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5 Integrationf olvencynd Planning

A phrase hich provides link etween olvencynd planning is “the

practicalanagement of capitalequirementsn a dynamic framework“.

This ections ntended o be practicalo the extent that it will include

very ittleheory. t hould rovide ome furthernswers to the question,

“why plan?“.

A barriero lanning n nsuranceas been that we are here to protect

againsthe nknown - that eing he ase, e cannot, y definition,lan!

Such conservatismeems to miss fundamentaloint. If an insurance

company cannot lan ts utureith reasonableegree f ertaintyhen

it as possiblyecome a concentratorf risk,hether through accepting

excessiveolumes f non-diversifiableisk r inappropriateeinsurance

structures.f he insuranceompany is roperlytructuredhen it has

transferredn the right ix of “unknowns” nd converted hem into an

aggregationhich is “knowable” within reasonable bounds. The

integrationf solvencyestingith lanningill measure the extent to

which he urrenttrategys ulnerablend has oncentratedisk.

Although he ynamic olvencyestingeferredo n ection.4 is largely

supervisory,he eneral pproach oes at eastrovide a framework for

integration.he startingoint s he base scenariohich is generally

taken to be the corporate lan. From there, varietyf alternative

futuresan be considerednd their mpact n financialiabilityan be

examined. he extent o which the company is dependent on a specific

future r arrow ange f uturesan then be determined.

This rocess an be relativelyimple ith ne variableeing considered

at a time r complicationsncorporated.t one level,hese ould be

where there ould e interactionsetween ariables. classicxample swhere an insurers rovidingarthquake over n propertiesn hich t

also olds ignificantnvestments.

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Also of particularnterest o this orking party is where these

relationshipsre direct s with mortgage ndemnity nsurance nd the

property ortfolio.he same harsh economic environment f high

interestates nd growing nemployment hich educed ropertyalues

on the sset ide f the alance heet, lso riggeredIG coverage n

100% mortgages ssued n he eady property oom of the 1980’s. his

near-disasterllustrateshe danger of failingo address scenarios

imaginativelynd without eep understandingf the ery ature f the

businessnd itsrivers.

The next evels here the cenariosre embedded in the market place

and the ompany considershe actionsf its ompetitorsnd potential

new entrants.t lso eeds o hink hrough he mplicationsf seriesf

small hanges hich might ventuallyesult n structuralhange. s a

parallel,he echnologyf he ax achine ad existedor ecades efore

it uddenly ecome genuinely opular. hat were the featureshich

brought t ver he hresholdrom the rcane orld f newspapers nto

everyday sage Are there imilar evelopments hich appear o be

tickingver but which could soon erupt into daily use and drastically

change our way of doing business?

5.1 Integrityf he ase Plan

In ur experience,he tandard f corporatelanning ariesignificantly

throughout he industry.his is not just a comment on the final

documentationut n the rocess tselfnd how closelyelatedo reality

it is or is expected to be. The plan may be the mechanism by which

strategicecisionsre aken r reflected;t ould e a forecastroduced

by a staffepartment n plendid solation;t might be for the directors

alone r widely irculated.he output ould e thousandsf detailed

numbers t ne extreme r a few isionaryords at the other.

Another mportantuestion s he ccuracy f the lan tselfs a model

of ompany behaviour.his s ot reflectionf he ncertaintiesithin

the ata tself,o much as how well onstructedhe lanning odel is. n

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other ords, f ll he ssumptionsctuallyeld rue, ould the alance

sheet nd profitnd loss ccount ctuallye the ame as hat ppearing n

the lan?

If t s o have value, he lan needs o reflecthat the usinesseally

wants to achieve nd considerso be possible.he planning process

should hereforenvolve hose ho will ake it appen so they now

their art n it nd believe hat t s chievable.t eeds o be as up to

date s possible.he figureshould xtend o balance heet tems nd

any other aspects hich are considered ignificantrom a solvency

perspective.n other words, the components of the plan and the process

used o produce t, eed to relateo those spectsf the usinesshich

have n effectn solvency.

For example, here eems to e good evidence hat xceptionalrowth is

quite ighly orrelatedith ubsequent inancialeakness section.2]

Within he lanning rocess tself,ny aggressiverowth lans hould e

carefullyhecked hrough o examine hether hey hare he eaturesf

observed ailures.oes management understand he business?s his

new area? What controlsre n lace o nsure hat oor ualityusiness

will e kept t ay? hus, ome at eastf the essonsf he ast an be

incorporatedithin the planning process itself. Once the plan is

complete, Canadian-styleST can e carriedut.

We have thought ong nd hard about he nature f the esting“what

ifs?” s “Monte Carlo”. one of us is aturallyrawn to deterministic

approaches ecause f their rbitrarinessnd lack f igour ut they re

probably he nly racticalay to pproach varietyf cenarios.his s

because f the current tate n the development f stochasticodels -

they re not onsideredccuratenough for he ser o e sure hat he

outcome s ot ue to the rudenessf the odel ratherhan a potentialevent. here is ome progresseing ade in uildingtochasticodels

of some elements ut we are a long ay from fillinghe aps and then

integratinghe components.

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One of the rawbacks f deterministicodels is the tendency to confine

the iew o relativelyarrow ange bout he est stimate.ne way to

introduceome .stochasticlement ould e to expressome of the estsn

terms f the underlyingariability,he tandard eviationf the item n

question.t s he nexpected hat auses trainut 20% range or he

value f cash ould have a very ifferentevel f validityhan 0% for

equitiesnd the tandardeviationasis ecogniseshis.

5.2 How Will anagement Ride he ownturn?

The literature,xperiencend common sense uggesthat he ey to ong

term solvency n the ajorityf companies s he ualityf the current

management. ven those hich ave inheritednsolubleroblems rom

the past ave some responsibilityo recognisehat ooner ather han

later. esting he plan in a variety f outcomes will dentifyhose

circumstanceshich lace he company under the greatesttress. he

base lan ay or may not ecognisehe nsuranceycleut most certainly

the cenarioestinghould o so. herefore,lthoughven an unrealistic

plan ight e accepted s he ase cenario,he ature f its etachment

from realityhould ecome apparent hrough he ynamic estingrocess

itself.he Canadian pproach, y consideringpecificcenariosather

than imply laims plus bit”,oes elp o chievehis.

This rocess hould elp anagement to evelop ts trategiesatherhan

simply ry o trip hem up. For example, lthough he capitaltructure

may appear erfectlydequate n he base cenario,hat happens o it

after he mpact f the ext rice ar Would management do better o

maintain arket hare r keep its ricesigh? How would these nswers

vary f e look t ndividualerritoriesnd/or lasses? o certainreas

emerge as more capitalungry han thers,erhaps ndicativef non-

diversifiabler under-diversifiedisk? Does management have some

convincingnswers o hese uestions?an they dapt o he ynamics fthe usiness? an it uild efensivelliancesith he istributionhain

and end customers o increasentry osts or nvaders nd protect he

existingusinessithout aving o esorto riceuts?

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5.3 Capital mplicationsf lan

Much thinkingn solvency as been focused n the relativeosition.

There is ome validityn this.or example, the whole UK insurance

industryannot, olitically,ll e forced o stop rading.he same must

be true f he anks; n he vent f crisis,lind eyes are turned or rules

re-written,he overnment as to do something.

In an increasinglylobal market, this focus on the local market rather

than he orldwide arket egins o ook yopic. hile he K market

fritteredway its apital n the years ollowing 988, ach company

consoled tselfith he hought hat ts ompetitorsere doing uch the

same.

While some of the weaker insurers ay have been eradicated,he

remaining arket has been left pen to the predators new capital

unencumbered y the cars f he ecent ast. his s articularlyrue f

reinsurancehere millionsf dollars ave poured into ermuda and

some new or revitalisedubsidiariesf oreignompanies ave rrivedn

London. So each ompany needs o onsiderbsolutetrengthnd, hen

checking n its elativetrength,nsure hat he eal eer roup s eing

evaluated.

It lso eans that he ompany needs o e consideringts trategiesndpotentialtrategiesnd the ossiblempact n itswn capital.

5.4 Has Management the bilityo ee t hrough?

Financialheory has shown that there is no premium for accepting

diversifiableisk,ence the cost f reducing ariabilityf resultsrom

such business mpinges n profitability.f the shareholder as a

diversifiedortfolio,e should refer he isk o be retainedather han

see rofitilutedhrough einsurance.owever, there are other interests,not east hose f the olicyholder,o e considered.s we have already

186



noticed,here s lso elf-interest.rovided hat his s nlightened,t

may he healthy.

A competent anager hould ave ome notion f eing ble o ffer he

market omething nique, omething hat ill e valued y at least

segment of that market. He can only continue to offer that

service/productf is mployer emains n usiness,ence n incentiveo

protecthe olvencyf the ompany. Given a true nd thereforealued

competitivedvantage,rofitabilityhould be assured. It is profitability

that s he rerequisitef ustainedolvency.

It s ar oo asy o orget hat nsurances businessnd, o hrive,eeds

to ave omething ttractiveo ffer ts ustomers n eturnor the price

they re repared o pay. As a generality,iddling ompanies ryingo

sell t middling rices ave returns n capitalo low that they cannot

sustain hemselves. t is likelyhat this is also true of insurance

companies o, as the company a clear ompetitivetrategy?s it well

understood nd consistentlymplemented? s t ryingo mix strategies,

to e all hingso ll eople?

There s idespread greement hat he ualitynd stylef management

matters n consideringhe riskinessnd future olvencyf an insurance

company. Determining hether he management is ppropriates alsocommonly accepted o be notoriouslyifficult.ow can we judge them

before e find ut the ard ay At a seminar rganisedy the Society

of Fellows f the Chartered nsurance nstituten May 1993 on the

subjectf insuranceompany solvency,number of suggesteduestions

emerged. [Journalf the Society f Fellows,ol 8 part July 993]

selectionollows:-

Is anagement too racy”,oo oncerned ith ts wn comfortsndpublicmage?

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If he ompany seems to be the nly ne with he rightnswers,

how come they are not being copied?

What is heir nderwritinghilosophy?s it well known?

Is ts nternaltructurefficientnd appropriate?

These and many others eed to be incorporatedn any assessmentf

whether the company will respond to emergent problems in such a way as

to see them through.

5.5 Externalactors

In traditionallanning,ompanies ill arry ut a SWOT analysiso try

to identifyhose actorshich could dverselyffect ts ortunes.or

example, t may consider hanges n regulations eg EC Directives

concerningiscountingnd the reedom o o business and in the wider

environment:-echnological,olitical,ocial,inancialnd economic

aspects.

These areas re obvious andidatesor cenario esting. hat would

happen if ne or more of the identifiedhreats aterialised? he

company may already ave ontingencylans n lace ut his rocessill

help to identifyriorityreas here the survivalf the company ispotentiallyt risk unless trategy s changed to reflect he new

circumstances.ithin he cenarioesting,ny contingencylans could

be testedor alidity,hus iding heirefinement.

5.6 Planning Outputs

If he planning rocess s ffectivelyxtended o incorporatecenario

testing,t ould be helpfulf the content of the planning documents

reflectedhe ature f the esting.hose ratioshich are onsideredobe reflectivef financialtrength hould ertainlye generated. In

additiono hose onsideredmportantnternally,indow dressings also

188



a feature nd output ould nclude ro-formasf the various security

agencies’atioests.

It s lso ssentialhat rends t lower evel re dentifiedtargetsor

people t he peratingevel. hat rate ncreases,ow much cash to be

collected,he alue t hich laims an e settled,hether income should

be allocatedowards quities,ash or fixed nteresttc? Qualitative

targetsre ery ard o evelop ut hould e worked on. Certainypes

of business re likelyo hold reater ppeal han thers;ew business

targetsan reflecthis. ettlementargetsay indicateroductivityut,

when combined with argetsor minimisinghe number of claims re-

opened nd values or ettlements,an lso ndicateffectiveness.

5.7 Competitiveressures/Pulls

Every ompany is rone o ompetitiveressures.ach one only prospers

if t ffersalue or oney at price hat xceeds ts osts.enerally,

company can adopt ne of two strategies:t can try to avoid competition

by targeting specialistrea that obody else s interestedn and

developingufficientxpertisehat others are daunted by the “learning

curve”. onsider,or xample, estminster otor Insurancessociation

Ltd. In the years o 1991, ts nderwritingrofitveraged 27% of net

premium and was in urplusor very ne of hose ears. y contrast,he

company market’snderwritingoss or otor nsuranceveraged 13% ofnet remium and never howed a surplus!owever, estminsterrites

black ab businessnd has virtuallyornered this market, The niche

strategys enerallyf appeal o the maller ompanies but there is no

reason hy largernsurershould ot perate n whole seriesf niches.

That is urich’statedloballan.

The second trategys to stand out from the crowd, whether by offering

something pecialhich obody lse an match r by being heaper orgiven roduct/serviceevel. riving own costs nd thus rices ends o

be of limited ong erm success ecause t s o easy o copy. Making

customers verly rice onscious ay not be in the supplier’snterests

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longer erm - if hey nly ver ee value n terms f cheapness,ow can

the upplierver e rewarded or dding alue? Providing unique r

at eastifferentnd people riven ervices arder o opy. eople re

not formula:o enerate nd sustainhe ightultures such a huge task

that ew ry nd fewer tillee t hrough.

The planning rocess hould reflecthe validitynd viabilityf the

strategyeing dopted nd the likelyesponsesrom the competition.

What mechanisms nd desiresre n lace o triveonstantlyo develop

the dvantageo that he ompany remains t eastne step ahead of its

rivalsn tshosen arena?

A furtherey issue s he xtent o which management will take account

of the cenariosn ts trategyelection.he whole point f testinghe

Plan s o efinet.he true est f nything,hough, s o ut t ntoffect

and this s he test f time. The control oop of monitoringctual

outcomes gainsthose xpected hould esultn urtherefinementot

just f forecastsut, ore importantly,f activitieso optimise the

company’s osition.herefore,t s italhat oth the lanningrocess

and the cenarioestingre ntegratednto he ecisionaking process f

it s o ake a differenceo performance.

We can bring his loser o home: the essentialeature f insurancebusinesss that the product is sold before knowing its cost. The plan,

which ay includebtainingertainusinessolume and/or profitability

targetsill ave taken nto ccount he ast laims xperiencend the

market nvironment.n subsequentlyritingusinesst:-

5.7.1 may not e able o et usinesst he esired ate

5.7.2 may get usinessut ubsequentlyind ts ates ave een too ow

5.7.3 may obtain he usinesst xpected,n profitableerms.

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For all ases t s italhat he ompany estimatets rue ost s soon as

possible. monitoringystem ould ncorporatedynamic odel of he

officeith ts usinessargetsnd expected laims,nvestments,xpenses

etc nd with he assumptionseing egularlyp-dated ccording o the

emerging experience.

The difficultases re .7.1nd 5.7.2nd highlighthe ain problem ith

the ndustry:hat t s lagued y “Bad Competitors” aa orter. any

companies nsistn doing usinesst uneconomic ates,ither hrough

deliberateolicyo shake ut he arket” r ack f nderstandingf he

business. he logicalourse or an office n this ituations not to

compete n nprofitableines,hus haringhe ossesnd prolonginghe

situation.f t rulyelieves,nd this s he rux f he ase,hat the rates

are too low, hen it ust withdraw. f he “good” fficesollowedhis

course hen ossesustainedould be accentuatednd drive the others

out sooner.

It s ot suallyracticalholly o ithdraw,oping o re-enterhe class

in utureears. t s lso ifficulto e sure f he oss aking ositions

there ill e uncertaintyn claims nd investmenteturns.owever, he

company needs to have a clear trategy;an it discern and enter

profitableiches n he arket nd does t ave he esourceso enable it

do this,inancialnd technical.f it remains in the loss making market,how long will it continue? What sort of losses does it think its

competitorsan ustain?hat needs to happen before it stops?

5.8 Integrationnto Market Model

One of the achievements f Michael orter as to provide way of

looking t the arket hich aided ompanies o develop heirtrategy.

This model is enerallypplicablend can be used for nsurance we

would be unwise o consider hat ur businesss o differenthat ecannot pply eneralitieso it.

191



However, here re differencesnd this s ecognisedn the concessions

made in ts ccountingreatmentnd need or upervisionhroughouthe

world. Through a better nderstandingf how individualnsurance

companies ork and what marks ut he uccessfulrom the oss aking,

the urvivorsrom the ithdrawals,e may be able o suggesthe most

importantactorshich hould e examined n he lanningrocess.

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6 Modelling he ompany in a Market ontext

6.1 General omments

Models re otoriouslyrickyo build,o why bother? he objectivee

propose s ufficientlyorthwhile s to make at leastome preliminary

work justifiable:o aid the practicalanagement of the capital

requirementsn a dynamic ramework. pecifically,o be able to help

answer he uestion,f he anagement does , will he ompany stille

here and in what shape? A secondary bjectives to explain ow

insuranceompanies ork - the business eyond the investmentrust.

The targetudience n this ase ould be investmentnalystsho often

regard nsuranceompanies s responsibleor managing the investment

of the free eserves ith a volatileearing element - the insurance

businesstselfhich eneratesuge lossesnd, ccasionally,ome profit.

We would hope that we could show that there is some value in the corebusinesstselfut he ndustryas not been a good advocate f its own

cause ately.ence the primary objective!

Firstf ll,hough,e need to efine he arket. n he amiliarorld f

privateotor insurance,o we mean the sum total f all rivateotor

policiesold, ll rivateotorists,ll oliciesold through a particular

distributionhannel, r a more specificnd narrow grouping? In

differentircumstances,e probably ean any one of these hings.e

have, hough, o start omewhere and a practicalonstraints the

availabilityf ata. o we probably ean the irstnd would turn o the

DTI returnsnd Lloyd’sata.

We can collatehe iguresrom individualarticipantsnd sum them to

obtain arket figures. lthough it is tempting to ignore the smaller

companies,rivatelyvailableata hows ignificantlytrongerrowth for

most lassesmong those ompanies utsidehe top ten over the past five

years r so. These more aggressiveompanies are often those which are

193



consideredo affectrofitrospectsor the market as a whole - a thesis

which e would ope to est hrough he odel buildingrocess.

Given n aggregation,e can then nalyse ey data o considerhether

there are correlationsetween individual ompany and market

performancend whether his s n a sustainedasis.o companies “pop

up”, ake a nuisance f themselvesnd disappeargain? What are the

featuresf those ho join nd survive if e have ny uccessn finding

some parameters o build model, e could ttempt o projectnto the

future. here are at least hree ays to do this. he firsts demand

based just ow many privatears ill here e? What will e the impact

of he ncreasedax harges n company cars?...he second is to look at

the ggregatearket s it urrentlyxists.hat can its urrentapital

and profitabilityustain?...he third ould be to onsiderach company

on its wn, based n track ecords nd any clues s to futurententionsthat an be gleaned.

The extent o which the three pproaches onverge r diverge ay

indicatehe ature f he ynamics f he arket nd whether ricesill

tend o ise r fallnd when thisight be expected.

One way to test hether his xercises f any value ould be to try o

predicthe previousive ears ased n what we knew five r six earsago. Given that he usiness nvironment ppears o be moving at an

ever ncreasingace, f e could dd littler nothing o he ast iveears,

the ikelihoodf oing o for he utureust be low. This would, though,

give s ome indications o hether nsuranceyclesre predictable.It

is robably easonableo assume that nflatedsset alues eneratedy

bullishtock arkets ill end to exacerbate ompetitiveressuress

companies ttempt o maintain heir eturn n capitalhrough growing

market hare. s they ave all hared n the same good fortune,his

common strategyan have only one outcome!).

194



Any model buildinghould e as simple s possible for xample, e

would start y keeping sset nd liabilityiskseparate. or individual

company modelling,e would need to incorporatehe UK solvency

hurdle o, f hey ailed,hey ould withdraw. he comparison etween

the market as a whole and the sum of individualompanies might be

indicativef the ressureor ew capitalr the need to shed excessive

capital.

Given that model can be developed,e could extend its value by

varyingn individualompany’strategy.

We have ade a starty compilingome data nd lookingt

outstandinglaimsrovisions

unearned premium reserve

)

) as net rittenremiums

)

incurredossatios

paid ossatios

acquisitionost ratios

)

) absolute/relativeo arket

market share.

However, e would ppreciateroader nput nd thoughtsefore seeking

to onsiderhe ature f he odel. s t orthwhile?re we on the right

direction?s he arket oo omplicatednd unknowable to be modelled

successfully?

195



6.2 Comments on Stochasticodelling

We have already rieflyiscussedhe nature f appropriateodelling:

deterministicompared with stochastic.oth approaches have their

champions s ell s heirirtues.he key ssuesre that models need to

be sufficientlyccurate o present alid utcomes and that management

responds ositivelyo those odels. Model buildinghould focus on

causativelements ike nflation,ccident evels,umber of vehicles,

growth n the conomy, he erformance f assets,eather atternsnd

so n. In his ay, anagement ill ome to nderstandomethingf the

dependence f the company’s erformance n these xternalvents,

except to the extent that they add value to the company by taking

appropriateounter easures. he events illccur come what may: in a

given cenario,ome companies ill ail hile thers hrive nd the

differenceetween he wo must be largelyown to he trategiesarried

out.

Stochasticodellings but one tool to aid management to develop those

strategies.elow we indicaten alternativepproach. However, any

outcome hould e tested gainstwo benchmarks. Are both the scenario

and the outcome intuitivelyalid? Some scenariosould be mutually

exclusivend thus e indicativef a weakness in the model. Equally,

poor outcome might ignore some of the control mechanisms in the

company. If ailuref the ompany resultsrom failureo react to theindicators,hat ould lay mphasis n a rapid nd right esponseo that

particulardverse rend nd hence he mportancef those controls.

We see this evelopment s a long rocessut one which will shed light

on the company as a whole in a similaray to the revelationshich

stochasticlaims nalysisas rought. hese methods have not replaced

judgement r deterministicodellingut more probably mproved hem

both. We anticipatesimilarrend n the modelling f companies swhole entities.

196



6.3 Scenariouilding

“You can ee a ot y observing”Yogi Berra.

We have lready ntimatedhat eatureshich can have the most serious

and widespread adverse effects are those which represent

“discontinuities”.ometimes, hey an be arbitrarynd appear as if from

nowhere. In other ases, he resultf a series f visiblencremental

changes an be to lter market n ramatic nd unexpectedays. What

linkshese wo outcomes n he ajorityf cases is that the outcome was

largely re-determined. he events hich eventuallyed to the

discontinuityere alreadyn lace,f only we knew it!

Far too ften ur 20-20 isions ost apparent hen we view our market

with indsight.he causes f the MIG lossesre now well understood

but ere not n ime or ost nderwriterso ake imely nd appropriate

action.ad they seen what was there to be seen, they would have found

huge MIG lossesere a foregone onclusionecause of these events (ie

100% mortgages,he awson boom, notice f ithdrawalf 2x mortgage

reliefn ugust 988, ontrolf eneral nflation ...)nless hey changed

their nderwritingtance.

Understandinghe ey determinantst a given ime for ach classnd

then ggregatinghem may reveal o companies how to keep in balance

because any of those eterminantsill ross lasses. or example,

interestates,rends in the law, the price of property and the EDI

(Electronicata Interchange)nstalledase could all impact a number of

classes.n ther ords, odellinghould e based n inputs atherhan

outputs,he causes of premium growth rather than premium forecasts

from underwritingepartments.

There is ften lag etween hanges n he riginalvent nd its mpact

on insuranceo timing he iscontinuitys ever oing o be easy, Or

important:hat does atter s o identifyhe ausativevents and their

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7 Selectibliography

7.1 A Synopsis nd Analysisf esearch n Surplus equirementsorPropertynd Casualty nsuranceompaniesA Brender, Brown, H PanjerInstitutef Insurance nd Pension esearch,aterloo Ontario,1992.

This aper epresentsn excellenttartingoint for anyone interestedn

the subject f solvency. “Readers’ igest” f books and papers, t

guides he reader hrough he material.he papers re resentedith

brief ummaries oth in alphabeticalrder y (first)uthor nd also y

subject.he eleven ubject eadings re lassicalisk heory,rojection

simulationodels, inancialconomics,oss eserving,tatisticalethods,

regulation.inancialeportingnd surplus anagement, ifensurance,

investmentodels, ate making, and “general”.

From the aper, elyingn the ummaries lone,e refero three papers

which uggest ey factorst east orrelatedo f ot eterminantsf the

financialealth f nsuranceompanies:-

SALZMANN, RE “RLS Yardsticks to Identifyinancialeakness”.

Proceedingsf he asualtyctuarialociety8 (1951) 172-194

Salzmann’sardsticks:-

• reserveevel

• surplusevel

• liquidity

l qualityf assets

• operatingesults

• excessiverowth

l reinsurancerotection

TRIESCHMANN, JS and PINCHES, GE ” A Multivariate Model forPredictinginanciallyistressedL Insurers”.ournal f Risk and

Insurance0 (1973) 27-338

Trieschmann nd Pinches’atios:-

199



7.3 A New Look at Evaluating he Financial ondition f Properlyand Casualty nsurancend ReinsuranceompaniesTM Redman, CE ScudellariCAS 1992

This aper s ritten rom an American perspectivend so some of its

conclusionsay not be idely pplicable.he essentialonclusionsre

that istoricnformationelatingo causes f insolvencysuch as that

included n section .2 can be incorporatednto olvencyvaluation

reviews f nsuranceompanies. his ould seem to rovide solid ase

for the considerationshich should apply in any Dynamic Solvency

Testing.aving nalysedhe ailuresrom 1969 o 1990, hey ake some

interestingbservationsncluding

Insolvencyy policyholder’surplus:-

Surplus Proportionf Insolvencies

< $5m 63%

> $5m < $50m 34%

> $50m 3%

But, he reatestrequencyf nsolvenciesame among the middle group.

Stock ompanies ade up 75% of all nsolvencieslthoughepresenting

only 0% of all nsurers.Ie Mutuals were more secure than stockcompanies).

Roughly 0% of nsolvenciesccurredn companies 15 years old or less.

81% of insolvenciesnvolvedremium growth of more than 25% or a

declinef ore than %

The lessonshe ritersraw from his 2 year istorynclude:-

a) insurances commodity with rice o crucial,ompanies need the

strengtho urvivehe tressf oth ard nd soft arkets.here we are

201



in cycle may have an impact on the level of resources we should be

expecting.

b) company management may be critical but its quality is hard to

evaluate.

c) rapid growth means additional exposure which may be underpriced or

in new and unfamiliar areas.

d) company characteristics including ownership should be considered.

e) weaknesses in past rating agency ratings can be a guide particularly in

such areas as overstated assets and unprotected catastrophe exposure.

f) the future will not follow the past precisely - new issues will emerge

Based on their analysis, the authors suggest certain industry norms:-

i) loss reserves to policyholders’ surplusproperty 50% - 150%

casualty 200% - 300%

ii) reserve development to policyholders’ surplus< 25%

iii) net leverage

[(net premiums + net liabilities)/policyholders’ surplus]

property 250% - 400%


iv) gross leverage[the sum of net leverage and ceded reinsurance leverage]

property 300% - 500%


202



Having arriedut hese ests,he aper xpects he ompany to ocus n

those reas resentinghe reatestxposure. n other ords, o act s a

catalystnd startingoint for management action.

7.3 Standard f Practicen Dynamic Solvency esting for Propertyand Casualty nsuranceompaniesDiscussionraft

Canadian Institutef ctuaries,ay 1993

The current raft as circulatedo embers of the anadian nstitutef

Actuaries.t ttempts o efine ood actuarialracticen ST but oes

not actuallyequire hat t hould e carried ut, or does it uide n

when that ight e a good idea. imply, f sked o carry ut DST, the

actuaryould be expected o follow hese uidelines.heir imetables

looking or finalisationy the end of 1993 so we should xpect n

exposure raft o e availableround onferenceime.

At present,t s ot ntirelylear hether ST is requirementf the

Canadian upervisorr a professionalssue. ather than try ere to

second-guesshe anadians,t s uggestedhat e keep a watchingrief

on theirpproach nd udge ts fficacyver time.

Claritynd consistencyetween he upervisor,rofessionalsnd trade

bodies ould appear o be a requisitef a smooth introductionf any

change o significant.It s nterestingo bserve,hough, hat anada is

also rying o define provisionsor adverse eviations”n respect f

claims evelopment,einsuranceecoverablend interestates. his s

subjectn itselfut it ppears o be their ntentionhat hese FAD’s

would e includedn he ase cenarioor ST - ee ection.5.)

The general pproach s o start ith a base scenario which would

usuallye the usinesslan nd then est he esiliencef he ompany

in varietyf unpleasantircumstances.he draft uidance otes re

practicalnd realisticg “Since he base scenario ay be seen by the

board s a most likelycenario,iscrepanciesith he lan ay put the

actuary t odds with management, thus jeopardizinghe effective

performance f he ctuary’sole”nd “The eport o he oard hould e

203



an interpretiveeport,ot a report rimming with statisticsor each

scenariohat was tested.”

The currentracticeotes nclude basic istf he cenarioso be tested

in relationo their mpact n policy iabilitiesnd other balance sheet

items. t is not intended o be exhaustivend omits changes in the

externalnvironment:-

I Reinsurancerogramme

The occurrence f multiple atastrophicosses n a given ear

includinghe cost of any reinstatement.

The occurrence f one catastrophicoss equal to the probable

maximum catastrophicoss iven he xposure f the company.

A significantncreasen he requencyf ndividualargeosses.

The defaultisk.

II Loss Ratio

Claim requencynd severitywhat if worse than planned?

Rate dequacy hat if lanned ate ncreasesot implemented?

III Investment

Significanthange n nterestates

Significantdverse hanges n nvestmentalues

Liquidityf ssetso eet cash low equirementsf other adverse

scenarios

IV Expense Level and Volume

Businessevelselow expectations

Rapid rowth n xcessf the base scenario

204



Unpaid Claim Liabilities

Impact f dverse eviationrom expectedalues

7.5 Provisionor Adverse DeviationsExposure DraftCanadian nstitutef ctuaries,ay 1993

This aper epresentsn interestingevelopment. any actuariesave

talked bout he ubjectf PFAD’s but the Canadians have dared to set

out not only he featureshich might equire uch a provisionut also

theircale. he paper s uccincto the nterestedeader s irectedo it

hut e can ive flavour.t s plitnto sections:ackground,verview

of he pproach,efinitions,nd then he ariables:laims development,

reinsuranceecoverynd interestate.or each of the ariables,here is

a list f the considerations,descriptionf “high margin” and “low

margin” ituationsnd the suggested pper and lower levelsf these

margins.

For example, n consideringompany claims andling ractice,he

featuresf a low margin ituationre listeds: stablelaims handling

environment, ew significanthanges in claims staff and handling

procedures,o major ystems hanges,nd case eservesstablishedn a

consistentnd responsiveanner.”

In selecting margin for the variabilityn claims evelopment, heguidance ncludeshe following:

“If he claims re discounted,n appropriate argin needs to be

consideredor ayout attern. f laims re ot discounted,he margin

should be reduced appropriately.

“The ember should e guided y the ollowingange:

Low Margin actor 0%

High Margin actor 15%

205

V



“When two or more of the ignificantonsiderationsxist,he member

should se t easthe veragef the high and low situations.”

Chris aykin the overnment ctuary has ritten briefommentary

on the xposure raft s follows:A study y the Insuranceureau of

Canada has suggested hat iscountedeserveslus the PFAD could

come out on average % below undiscountedeserves.owever, this

clearlyepends n the ype f usinessnd the xtentf the PFAD.

“The FAD should e a fair isk harge or ncertainty.owever, unlike

the orrespondingiscussionsn he S, it eems o e acknowledgedhat

uncertaintytselfemands a PFAD and that there is no need to classify

risk s ystematicr diversifiable.

“The anadian nstitutef ctuaries’iew s hat he iscountedeserve,

togetherith he FAD, could oon e expected egularlyo exceed the

undiscountedeserve,aving egard o allingatesf inflation”.

These two Canadian apers ave a common purpose n improving he

solvencyf eneral nsuranceompanies. ST looks littleay into he

future hile FAD recogniseshat ome numbers re more reliablehan

others. ne interestingommon feature s he need to understand he

dynamics f the businessoth in tatisticalerms as well as the “softer”

elements. DST considershe risk involved in pursuing the current

strategyhile FAD reflectshe mpact f ast usinessecisions.t is to

be expected hat here ill,ver ime, e a blurringf these distinctions.

By reactingo the outcome of DST, management should find itself

tending owards he low argin ituations”f FAD as it ecogniseshis

cost lement n ts usinessecisions.

A further eneral question about the two papers is the wisdom ofproducing uidance otes hat ave he ppearance f manuals. Is there

a danger hat ractitionersill ome to egard his uidance s the ceiling

206



rather han the floor f their xplorations?s well as the theory,

worthwhileiscussionould e on the eans of mplementingt.

7.6 Statisticalnd Financialodels of Insurance ricing nd theInsurance irmJ CumminsThe Journal f isk nd Insurance,991

This s fascinatingaper hich s ore of signposthan ourney’snd.Cummins endeavours o reconcilehe ctuarialnd financialodels of

insurance.here is ome very elpfulackground aterialn both the

statisticalnd financialodels; articularlyor those of us with only

limited nderstandingf financialheory, this paper is accessible.

Financialheory ives seful nsightshat may be missing from purely

statisticalodels.

For example, sing he apitalsset ricingodel, he quilibriumate

of eturn n any assets:

where ri the xpected eturnn asset

rf the isk-freeate

of

interest

rm = the xpected eturnn the arket ortfolio

ßi = the ystematicisk oefficientr beta f sset

= Cov( i,rm)/Var(m)

The CAPM model implies that nvestorsill be rewarded for bearing

systematicr beta isk ut not or aking nsystematicisk ecause this

risk an be diversifiedy properlytructuringhe ortfolio.ut this is

only he tartingoint!

From here ummins shows the nsuranceAPM and points o some of

the impracticalssumptions hich limit he viabilityf some of the

conclusionshat re often rawn. One hope is hat ntegrationight

improve the quality f the financialodelling hich tends to make

oversimplisticssumptionss with he laim istributionunctions.he

207

portfolio

dynamic corporate management

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