Risk Models. Dr. Dorothea Diers, ICA 2010, Cape Town
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1 Management Strategies in Multi-Year Internal Risk Models Dr. Dorothea Diers, ICA 2010, Cape Town
2 Overview Increasing challenges on management strategy Internal models in non-life insurance - Structure and results Multi-year models and multi-year risk capital Management strategies Iterative management process Summary and outlook
3 Increasing challenges on management strategy Increase of natural catastrophes Resulting: Increase of reinsurance premiums Negative developments on the capital markets Resulting: completely altered risk situation for insurance industry This led to a substantial decrease in total corporate capital resources in insurance industry. Requirement for a higher level of transparency of the risk situation from - management - regulators (Solvency II for European Union member countries) - rating agencies - insurance holders -...
4 Paradigm shift in insurance industry (1/2) As a result management reacted with a paradigm shift in corporate strategy developing from classical turnover orientation to modern management techniques such as value and risk based management in economic terms. In this context a suitable structure in insurance portfolio together with an adequate asset allocation has become a major task for management directed towards maximum return in relation to the risk taken for capital invested. This requires a strategic management which should follow a multi-year view.
5 Paradigm shift in insurance industry (2/2) Classical Turnover Orientation Value and Risk Oriented (Economical View on Return and Risk) Return = Profit / Loss (statutory balance sheet) Turnover (e.g. premium) Economic Result Risk Capital Solvency II Profit Premium-Ratio... Return on Risk Adjusted Capital (RoRAC)
6 Advantages of internal models Internal models can be used as a base for strategic decisions in value and risk based management. Advantages of internal risk models: Using an internal risk model the individual risk situation of the insurer can be modelled more exactly than using the standard formula form Solvency II, which is often not adequate. Internal models allow the quantification of risk and return of all lines of business and all asset classes. Moreover they can give a more detailed view of the risk and return situation ti e.g. of special risk types such as private or industrial business.
7 Overview Increasing challenges on management strategy Internal models in non-life insurance - Structure and results Multi-year models and multi-year risk capital Management strategies Iterative management process Summary and outlook
8 Structure of an Internal Risk Model Liability Model Portfolio (Underwriting) - Lines of business -Premiums - Number of Insured Policies - PMLs -Premium Cycles -Expansion -etc. Portfolio (Assets) - Asset Classes - Existing and Investment Assets - Rules for Rebalancing, -etc. Stoch. Projections Catastr. Claims Attritional And Large Claims Asset Projections Modellin ng Costs Reinsurance Model Modelling all Contracts Technical Cash Flow Management Rules Modelling of Reserve Risk Re sult and Evaluation Model Economic Scenario Generator Asset Model Source: Diers, Interne Unternehmensmodelle, ifa-verlag Ulm, Germany
9 Catastrophe claims Catastrophe claims refer to loss caused by any single event affecting a large number of insured policies within the same time frame. The following natural catastrophes play an especially important role: Storms, Hail, Earthquakes, Floods.
10 Catastrophe claims dominate the tail of company results In Million ophe LoB s s in Catastro Insurance Results Results of the Company
11 Overview Increasing challenges on management strategy Internal models in non-life insurance - Structure and results Multi-year models and multi-year risk capital Management strategies Iterative management process Summary and outlook
12 Multi-year models Management rules and management strategies in multi-year models: Different rules in different scenarios are needed Management rules: Increase of reinsurance premiums in simulations/scenarios with preceding years of high claim losses Management strategies in simulations with high claim losses, in order to improve results and to avoid negative excess capital. This can be the case for example after scenarios with natural catastrophes or with negative developments at the capital markets. Possible strategies could be: - Stop expansion in building - Introduction of deductibles in building (to limit the effect of storm events) - Higher reinsurance protection - Change in asset allocation (lower risk profile)
13 Multi-year risk capital Defining multi-year risk capital helps management to answer the essential question in order to decide for the best strategy: How many years of catastrophe events or adverse capital market developments can the company withstand at a certain confidence level without needing external capital resources? How much risk capital the company will need to be able to survive the next five years taking five future underwriting years into account without external capital supply?
14 Multi-year risk capital Defining multi-year results Results (per simulation): Incremental vs. cumulative incremental cumulative 1000 Risk capital Results (per simulation): Incremental vs. cumulative Risk capital incremental cumulative
15 Multi-year risk capital Definition of multi-year risk capital Per simulation and per year j we define cumulative losses Cum. Loss (1) = Loss (1) Cum. Loss (j) = Cum. Loss (j-1) + Loss (j) We define the maximum over the years: MaxLoss = Max {Cum. Loss (j)} MaxLoss represents the maximum of the amount that needs to be covered over the years for each simulation. This amount needs to be provided at t=0 in the simulation path to allow the insurance company to cover all losses incurred over the entire period simulated (n years) without external capital supply in this simulation path. The selected risk measure,, can now be applied to the MaxLoss: IR in order to determine the risk-capital requirement.
16 Multi-year risk capital Risk Capital (1 year view) In Million Standalone 9 allocated div. risk capital Insur- ance low level of high- risk investments Invest- Insur- Sum Diversif. Company Investiki t t ment ance benefit diversified ment correlation (investment, insurance): 25%, risk capital: tail-value-at-risk at 99.5%, allocation: tvar-principle
17 Multi-year risk capital Risk Capital (2 years view) In Million Standalone allocated div. risk capital Invest- Insur- Sum Diversif. Company Investment ance benefit diversified ment Insur- ance Increase in % of one-year risk capital +48% +67% +43%
18 Multi-year risk capital Risk Capital (3 years view) In Million Standalone allocated div. risk capital Invest- Insur- Sum Diversif. Company Investment ance benefit diversified ment Insur- ance Increase in % of one-year risk capital +70% +100% +62%
19 Multi-year risk capital Risk Capital (4 years view) In Million Standalone allocated div. risk capital Invest- Insur- Sum Diversif. Company Investment ance benefit diversified ment Insur- ance Increase in % of one-year risk capital +78% +111% +70%
20 Multi-year risk capital Risk Capital (5 years view) In Million Standalone allocated div. risk capital Invest- Insur- Sum Diversif. Company Invest- ment ance benefit diversified ment Insurance Increase in % of one-year risk capital +83% +133% +70%
21 Overview Increasing challenges on management strategy Internal models in non-life insurance - Structure and results Multi-year models and multi-year risk capital Management strategies Iterative management process Summary and outlook
22 Management strategies In practice management has to decide which strategy might improve the risk (and return) situation of a company if not enough (multi-year) risk capital is available lowering risk via change of the asset allocation, lowering risk via introduction of deductibles, extending reinsurance cover, or any suitable combination of these strategies. In this context the appropriate p use of diversification effects plays an important rule. In the paper we studied the effects of different management strategies with regard to the realisation of an optimal return and risk situation of the company in the background of value and risk based management in a multi-year context. We analysed the effects of - different reinsurance structures, - introduction of different amounts of deductibles, - change of asset allocation.
23 Example of management strategies Return and risk situation as a base for value- and risk-based management Risk: Risk Capital Management has to think about strategies so that risk capital requirement decreases (e.g. deductibles, reinsurance). If the insurance has enough economic capital to cover risk capital requirement, no change in strategy is necessary if the return position is adequate. 0 Return: Expected Results These lob create a negative return. Here management should think about strategies to improve the return situation.
24 Example of reduction of risk: Introduction of deductibles Risk Capital in Storm (TVaR 99.5%) Deductibles in Fire Storm Without Ded. Ded. 250 Ded. SB 500 Ded Introduction of deductibles in storm leads to a significant reduction in risk capital.
25 Example of reduction of risk: Finding the adequate reinsurance The strategies and their impact need to be analysed at corporate level, where high diversification effects have a positive effect on total risk capital and economic value added (EVA). In the example portfolio presented in the case study the introduction of deductibles in storm line of business led to growing diversification effects in insurance results (between storm and the other lines of business). The same holds for special types of reinsurance contracts. The effects of these strategies depend on the portfolio structure. Lowering multi-year risk capital and growing diversification effects offer the possibility of extending in lines of business where the return exceeds the capital costs and which show a high diversification towards the other lines of business in the portfolio.
26 Overview Increasing challenges on management strategy Internal models in non-life insurance - Structure and results Multi-year models and multi-year risk capital Management strategies Iterative management process Summary and outlook
27 Iterative management process Management has to define: 2 Optimisation of liabilities (gross) I. Methods II. Time horizon III. Risk Tolerance IV. Required return 1 Simulation of the actual strategy (results, risk capital) and comparison with management requirements Iterative process (repetition with different strategies to find the optimal strategy) 6 3 Optimisation of reinsurance Optimisation of asset allocation Comparison to risk limit, management requirements, decision for a strategy or definition of new strategies if necessary 5 Simulation of the selected strategies for the company 4
28 Iterative management process with conditions The iterative management process should consider the following restrictions: Management requirements concerning the results in the statutory balance sheets (intended investment or technical results, annual surplus, etc.) Regulatory restrictions (actually for European countries: Solvency I and analyses of worse scenarios; in the future: Solvency II)
29 Overview Increasing challenges on management strategy Internal models in non-life insurance - Structure and results Multi-year models and multi-year risk capital Management strategies Iterative management process Summary and outlook
30 Summary and Outlook This management process will influence various company divisions such as development of insurance products, pricing, reinsurance, asset management, marketing. In this context future product development will be oriented towards goals such as required risk capital and use of diversification potential. Instruments such as deductibles for policyholders in storm insurance aimed towards reducing risk capital requirement are gaining in importance. In this context adequate capital allocation methods are needed. Internal models cannot replace the management decision, but they can represent an important base for deciding for the adequate strategy.
31 Central role of internal models in the company Internal models play a central role in management processes of almost all company divisions. Controlling Management Asset-Allocation Risk Management Reinsurance Internal Models Pricing of insurance contracts, Underwriting policy Asset-Liability Management Marketing Data-Warehouse Internal Revision
32 References CEIOPS: Own Risk and Solvency Assessment (ORSA). Issues Paper, (2008) Diers, D.: Interne Unternehmensmodelle in der Schaden- und Unfallversicherung Entwicklung eines stochastischen internen Modells für die wert- und risikoorientierte Unternehmenssteuerung und für die Anwendung im Rahmen von Solvency II. ifa-verlag, (2007a) Diers, D.: : Stochastic Modelling of Catastrophe Risks in DFA Models. ASTIN Colloquium in Manchester, July 2008, Papers_EN.cfm (2008); published in: GRIR, Vol. 5, 2009, Page 53-79, Kortebein et al.: Interne Risikomodelle in der Schaden-/Unfallversicherung. Hrsg.: DAV- Arbeitsgruppe Interne Risikomodelle, Schriftenreihe Versicherungs- und Finanzmathematik, tik DGVFM, Bd. 35, VVW, Karlsruhe (2008)
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