Tag Archives: risk transfer

How to Cope With Shifting Appetites

It’s the nature of our industry that commercial insurance carrier appetites are constantly evolving. As business landscapes shift to accommodate emerging risks, insurers must continuously refine their specialties, products and services. It’s a necessary part of risk transfer; yet it can be confusing for a carrier’s distribution partners.

Because commercial insurance agents and brokers deal with dozens–and sometimes hundreds–of different carriers, they often find themselves struggling to stay abreast of shifting appetites. Brokerages of all sizes struggle to overcome the hurdle posed by “appetite clarity,” and carriers and managing general agencies (MGAs) struggle to find a simple method to demystify the situation.

See Also: Next Generation of Underwriting Is Here

Carriers and MGAs need to evaluate opportunities to leverage online search tools that can integrate into an agent’s daily workflow and enable insurers to communicate appetite. Such tools, like IVANS Market Appetite, operate similar to current search engines. At the start of the search process for a market for new and renewal business, the tools provide agents with an instant list of carriers, MGAs and wholesalers with appetite for the specific risk. These tools can help underwriters overcome the “three major hurdles of underwriting”:

Hurdle #1: Changing Appetites

The carrier or MGA says: “We made substantial changes to our appetite more than a year ago to move away from an industry segment that wasn’t in our specialty wheelhouse. Yet I’m still seeing a high volume of submissions in that category that I’m having to decline. It’s hurting my conversion ratio and confusing my brokers.”

Problem solved:

It takes significant time for changes in appetite to be effectively communicated through a carrier’s network. This requires changing every piece of collateral, market guides and online postings and redistributing the updated assets. Many times, appetites change again in the time it takes to update these assets, exacerbating the issue.

Carriers and MGAs need to leverage online tools that instantly communicate their latest appetite, ensuring products are visible to agents when they begin to search for a market where they can submit their risk. Consistent appetite visibility through online tools also improves carrier and MGA staff’s productivity by increasing the number of in-appetite inquiries and reducing time spent reviewing submissions of no interest, while enabling carriers and MGAs to focus more time on returning quotes and building relationships.

Hurdle #2: Limited Relationships

“I am worried that my competition has a broader network of brokers than I do. I truly value the partners I do have, but I would like to grow my book, and I wish I were seeing more new risks.”

Problem solved:

Even with formidable communications and relationship strategies, carriers can be complex to navigate from the outside, and brokers who have strong relationships with one division may overlook the opportunity to bring an alternative submission type to another business unit. Online market search tools enable underwriters to get in front of brokers and agents that they haven’t interacted with before.

Hurdle #3: Unwanted Submissions

The carrier or MGA says: “I wish I had more time for new business. I spend hours reviewing submissions that ultimately need to be declined. On top of that, I have a thick stack of renewals to get through. There has to be a less time-consuming way to get more profitable new business into my book.”

Problem solved:

Carriers’ and MGAs’ time, and brokers’ time, is exceedingly valuable. IVANS found that 60% of submissions in commercial insurance go unquoted – resulting in significant time wasted on non-revenue-generating activities. Online market search tools increase in-appetite submissions to drive better submissions in the pipeline, allowing carriers and MGAs to focus on the most profitable lines of business and industries. As the market changes, these tools ensure consistent representation of carriers’ and MGAs’ latest appetite, so submission mix remains strong as agents are continuously kept informed.

cyber insurance

Promise, Pitfalls of Cyber Insurance

Cyber insurance is a potentially huge but still largely untapped opportunity for insurers and reinsurers. We estimate that annual gross written premiums will increase from around $2.5 billion today to $7.5 billion by the end of the decade. Many insurers and reinsurers are looking to take advantage of what they see as a rare opportunity to secure high margins in an otherwise soft market.

However, wariness of cyber risk is widespread. Many insurers don’t want to cover it at all. Others have set limits below the levels their clients seek and have imposed restrictive exclusions and conditions – such as state-of-the-art data encryption or 100% updated security patch clauses – that are difficult for any business to maintain. Given the high cost of coverage, the limits imposed, the tight attaching terms and conditions and the restrictions on claims, many companies question if their cyber insurance policies provide real value.

Insurers are relying on tight policy terms and conditions and conservative pricing strategies to limit their cyber risk exposures. But how sustainable is this approach as clients start to question the value of their policies and concerns widen about the level and concentration of cyber risk exposures?

The risk pricing challenge

The biggest challenge for insurers is that cyber isn’t like other risks. There is limited publicly available data on the scale and financial impact of attacks, and threats are rapidly changing and proliferating. Moreover, the fact that cyber security breaches can remain undetected for several months – even years – creates the possibility of accumulated and compounded future losses.

See Also: Better Way to Assess Cyber Risks?

While underwriters can estimate the cost of systems remediation with reasonable certainty, there isn’t enough historical data to gauge further losses resulting from impairment to brands or to customers, suppliers and other stakeholders. And, although the scale of potential losses is on par with natural catastrophes, cyber incidents are much more frequent. Moreover, many insurers face considerable cyber exposures within their technology, errors and omissions, general liability and other existing business lines. As a result, there are growing concerns about both the concentrations of cyber risk and the ability of less experienced insurers to withstand what could become a rapid sequence of high-loss events. So, how can cyber insurance be a more sustainable venture that offers real protection for clients, while safeguarding insurers and reinsurers against damaging losses?

Real protection at the right price

We believe there are eight ways that insurers, reinsurers and brokers could put cyber insurance on a more sustainable footing while taking advantage of the opportunities for profitable growth.

  1. Clarify risk appetite – Despite the absence of robust actuarial data, it may be possible to develop a reasonably clear picture of total maximum loss and match it against risk appetite and tolerances. Key inputs include worst-case scenario analysis. For example, if your portfolio includes several U.S. power companies, then what losses could result from a major attack on the U.S. grid? What proportion of claims would your business be liable for? What steps could you take now to mitigate losses by reducing risk concentrations in your portfolio to working with clients to improve safeguards and crisis planning? Asking these questions can help insurers judge which industries to focus on, when to curtail underwriting and where there may be room for further coverage. Even if an insurer offers no stand-alone cyber coverage, it should gauge the exposures that exist within its wider property, business interruption, general liability and errors and omissions coverage. Cyber risks are increasingly frequent and severe, loss contagion is hard to contain and risks are difficult to detect, evaluate and price.
  2. Gain broader perspectives – Bringing in people from technology companies and intelligence agencies can lead to more effective threat and client vulnerability assessments. The resulting risk evaluation, screening and pricing process could be a partnership between existing actuaries and underwriters who focus on compensation and other third-party liabilities, and technology experts who concentrate on data and systems. This is similar to the partnership between chief risk officer (CRO) and chief information officer (CIO) teams that many companies are developing to combat cyber threats.
  3. Create tailored, risk-specific conditions – Many insurers currently impose blanket terms and conditions. A more effective approach would be to make coverage conditional on a fuller and more frequent assessment of the policyholder’s vulnerabilities and agreement to follow advised steps. This could include an audit of processes, responsibilities and governance within a client’s business. It also could draw on threat assessments by government agencies and other credible sources to facilitate evaluation of threats to particular industries or enterprises. Another possible component is exercises that mimic attacks to test both weaknesses and plans for response. As a result, coverage could specify the implementation of appropriate prevention and detection technologies and procedures. This approach can benefit both parties. Insurers will have a better understanding and control of risks, lower exposures and produce more accurate pricing. Policyholders will be able to secure more effective and economical protection. Moreover, the assessments can help insurers forge a closer, advisory relationship with clients.
  4. Share data more effectively – More effective data sharing is the key to greater pricing accuracy. For reputational reasons, many companies are wary of admitting breaches, and insurers have been reluctant to share data because of concerns over loss of competitive advantage. However, data breach notification legislation in the U.S., which is now set to be replicated in the E.U., could help increase available data volumes. Some governments and regulators have also launched data-sharing initiatives (e.g., MAS in Singapore and the U.K.’s Cyber Security Information Sharing Partnership). In addition, data pooling on operational risk, through ORIC, provides a precedent for more industrywide sharing.
  5. Develop real-time policy updates – Annual renewals and 18-month product development cycles will need to give way to real-time analysis and rolling policy updates. This dynamic approach could be likened to the updates on security software or the approach taken by credit insurers to dynamically manage limits and exposures.
  6. Consider hybrid risk transfer – Although the cyber reinsurance market is relatively undeveloped, a better understanding of evolving threats and maximum loss scenarios could encourage more reinsurers to enter the market. Risk transfer structures likely would include traditional excess of loss reinsurance in the lower layers, and the development of capital market structures for peak losses. Possible options might include indemnity or industry loss warranty structures or some form of contingent capital. Such capital market structures could prove appealing to investors looking for diversification and yield. Fund managers and investment banks could apply reinsurers’ or technology companies’ expertise to develop appropriate evaluation techniques.
  7. Improve risk facilitation – Considering the complexity and uncertainty surrounding cyber risk, there is a growing need for coordinated risk management solutions that bring together a range of stakeholders, including corporations, insurance/reinsurance companies, capital markets and policymakers. Some form of risk facilitator – possibly brokers – will need to bring together all parties and lead the development of effective solutions, including the cyber insurance standards that many governments are keen to introduce. Evaluating and addressing cyber risk is an enterprise-wide matter – not just one for IT and compliance.
  8. Enhance credibility with in-house safeguards – If an insurer can’t protect itself, then why should policyholders trust it to protect them? If the sensitive policyholder information that an insurer holds is compromised, then it likely would lead to a loss of customer trust that would be extremely difficult to restore. The development of effective in-house safeguards is essential in sustaining credibility in the cyber risk market, and trust in the enterprise as a whole.

See Also: The State of Cyber Insurance

Key questions for insurers as they assess their own and others’ security

From the board on down, insurers need to ask:

  • Who are our adversaries, what are their targets and what would be the impact of an attack?
  • We can’t defend everything, so what are the most important assets we need to protect?
  • How effective are our processes, assignment of responsibilities and systems safeguards?
  • Are we integrating threat intelligence and assessments into active cyber defense programs?
  • Are we adequately assessing vulnerabilities against the tactics and tools perpetrators use?

Implications

  • Even if an insurer chooses not to underwrite cyber risks explicitly, exposure may already be part of existing policies. Therefore, all insurers should identify the specific triggers for claims, and the level of potential exposure in policies that they may not have written with cyber threats in mind.
  • Cyber coverage that is viable for both insurers and insureds will require more rigorous and relevant risk evaluation informed by more reliable data and more effective scenario analysis. Partnerships with technology companies, cyber specialist firms and government are potential ways to augment and refine this information.
  • Rather than simply relying on blanket policy restrictions to control exposures, insurers should consider making coverage conditional on regular risk assessments of the client’s operations and the actions they take in response to the issues identified in these regular reviews. This more informed approach can enable insurers to reduce uncertain exposures and facilitate more efficient use of capital while offering more transparent and economical coverage.
  • Risk transfer built around a hybrid of traditional reinsurance and capital market structures offers promise to insurers looking to protect balance sheets.
  • To enhance their own credibility, insurers need to ensure the effectiveness of their own cyber security. Because insurers maintain considerable amounts of sensitive data, any major breach could severely affect their market credibility both in the cyber risk market and elsewhere.

Reimagining Insurance in 2016

After more than 20 years in the insurance industry, working on three continents in various product lines and capacities, I have seen many changes occur alongside a notable constant: Insurance consumers want to pay less, and insurance company returns don’t satisfy shareholders.

Therein lies the rub. The conventional way to increase returns has been for insurers to increase premiums (based on what is presumed to be a fixed risk level), but that approach is contrary to the client’s desire. Yes, insurers also look to improve operational efficiency and claims handling, but those efforts are yielding diminishing returns.

Why not take a different tack and really focus our efforts on reducing the cost of risk? We’d then diminish the tension between insurers and their clients. Client premiums would drop, and insurers’ profitability would rise.

Like many, I believe that insurance is on the cusp of dramatic change. Insurers that thrive will put risk reduction at the forefront of their value proposition. That risk reduction will translate into lower premiums for diminished risk. Clients, and society at large, will be the ultimate winners.

The increasing availability and variety of data, more sophisticated tools to extract insights from that data and technology to cost-effectively support risk reduction will fuel this evolution. Insurers will need to rebalance their resource deployment away from the evaluation of risk for the purpose of assuming liability (underwriting) to the evaluation of risk for the purpose of reducing risk (risk consulting). Clients will come to expect insurers to provide advice on actions they can realistically employ AND the savings they will be guaranteed if they take those actions.

Whether change displaces current insurers or they evolve remains to be seen. Some insurance executives see a future of insurance that delivers a different value proposition to clients. We see a value proposition that primarily focuses on reducing the cost of risk. Insurers will increasingly supplement expertise with data, analysis and technology focused on reducing the cost of risk. They see a future where the industry unlocks the insights in insurers’ own data, integrates external sources as they become available and closes information gaps that exist. They see a future where clients are empowered with clear, objective risk measures that allow them to control their risk level … and their premiums.

In this future, insurers become tech companies where the insurance policy covers the limited remaining risks and in essence serves as a warranty of the risk services provided.

My discussions leave me optimistic that there are like-minded executives who see a different value proposition for insurers. But most I have spoken with draw the conclusion that neither their company nor any they know has the critical mass of support necessary to drive change.

To adapt and stay viable, insurance companies need to think about how evolutions in technology and data science can benefit clients and reshape business models. My goal is to encourage that debate.

I’ll be introducing a topic and perspective every other week that will focus generally on evolutions in the industry and the power of technology to transform the way risk is quantified, along with associated pitfalls. Each piece will conclude with a polling question and, depending on the volume of response, these results will be published.

Coming topics will include:

New Data and New Tools: When we think of data, most think of text and numbers that has been organized. By expanding our thinking, we can add satellite imagery, sensor-derived data, the Internet of Things (IoT), traffic cameras, customer service phone call recordings, pictures and many other potentially valuable sources. Imagine being able to analyze traffic light cameras to understand real-time risk at intersections. Imagine crowdsourcing the analysis of satellite and aircraft imagery to identify properties affected by natural disasters. Imagine being able to review a snapshot of a damaged automobile and adjust many claims without human intervention. Research, and in some case practical applications, exist in these and many other areas. We need to identify the information we need to know to understand risk and then either find the data that will help us or create our own. How do we ensure that the insurance industry is at the forefront of collecting, generating, integrating and analyzing all forms of data to drive deeper insights?

Data, Data Everywhere but Not a Drop for (Clients) to Drink: Every insurance company collects and generates a tremendous amount of data. Some of that data is structured; a much larger volume is memorialized in pdf files, pictures and customer service call recordings. While potentially useful for clients, the data is rarely made available at all and even more rarely in a format that provides insights. Insurers are investing in using that information to drive better claims outcomes, better risk segmentation and better internal processes. Clients expect to benefit from insurers’ resources but generally don’t get the insight they need to effect change. What would it mean if we insurers transformed our business model so that data-driven insights and risk mitigation strategies replace risk transfer as the core of value proposition?

Risk Mitigation Strategies and New Technologies: Imagine being able to identify the moment a risky behavior is occurring and having the ability to automatically intervene or alert the appropriate person. In some realms, that possibility already exists. Applications exist to alert drivers to their own risky behavior. Active technology exists to automatically apply the brakes to prevent collisions. Yet even where appropriate data exists, insurers are hesitant to make definitive recommendations based on specific technologies. Insurers are unique in that they price risk and ensure the realization of financial benefits from investments in risk reduction. Should we as an industry more actively become creators or advocates of risk technology? Can we have enough faith in our recommendations to integrate benefits immediately in prices? Does the traditional insurance policy become a form of warranty that our risk advisory services are effective?

Transparent Risk Indices: We are about to enter an information age where it is possible to quantify risk objectively in real-time. Creating risk indices, making them transparent and using them as the basis for establishing price would give clients confidence in the objectivity of the process and confidence that if they invest in changing those indices they will immediately get the benefit. The indices will also give non-insurance risk capital providers the opportunity to deploy capital against and trade risks that previously lacked the transparency. What can we learn from other financial services that have developed transparent risk indices that allowed capital to be deployed against those risks from a wider variety of sources?

Major Regulatory Change in Asia-Pacific

The global insurance industry is undergoing significant regulatory change, with regulators in the more developed markets endeavoring to synchronize their efforts. Similar occurrences can be observed in the Asia-Pacific region, where a number of countries are reviewing and undergoing changes in their approach to insurance regulation and holistic risk management. Most notably, a number of regulators are either introducing risk-based capital (RBC) or revisiting their existing RBC frameworks. The maturing regulatory approaches in Asia-Pacific will be a significant factor in managing systematic risk and enhancing policyholder protection.

Asia-Pacific is different

While the proposed RBC framework in Asia-Pacific may have similarities with the European Solvency II standard, there is wide disparity in the level of sophistication and application. Many of the changes are being driven by local market nuances, such as characteristics of the insurance products being sold and maturity of the insurers who operate in the various jurisdictions.

For example, Australia has recently implemented its second-generation solvency regime. Singapore and Thailand are consulting with the industry on second- generation RBC frameworks, while others such as China and its Hong Kong SAR are considering moving in that direction. These moves are particularly encouraging in providing a regulatory framework that will allow for a degree of consistency, especially for those insurers that have multiple offices across the region.

In addition to the changes in reserving and solvency calculations, a number of regions are also strengthening their risk management efforts (e.g., China with C-ROSS). This exemplifies how regulators are paying more attention to embedding risk management activities in the business. They look to ensure that senior management has sufficient oversight to allow them to consider and discharge their fiduciary responsibilities. It is important that organizations have an operational infrastructure and that the risk profile is within business risk appetite levels.

What does this mean for insurers?

Advances in regulation in the Asia-Pacific region
are far-reaching. The implications are expected to improve the way businesses will operate to create long-term sustainability. These implications, in our view, will affect product offerings, investment strategy, capital utilization, risk transfer opportunities and infrastructure.

In particular, we foresee several implications:

• Robust regulatory framework will provide comfort to the overall financial soundness of the insurance industry. However, the cost of regulatory compliance is expected to increase significantly.

• Changing regulations will provide more room for innovation and incentives to enhance or change organizational metrics. Better-managed companies will potentially benefit from lower capital requirements, making their products more attractive.

• Companies traditionally focusing on new business value will have to rethink the continuing profitability of past years and will need to understand options available for in-force value management. This will be particularly crucial given that existing forms of new business may be capital-intensive.

• A better understanding of the business risk profile will be needed. This will necessitate implementing sophisticated techniques in modeling/optimizing risk- adjusted returns and outlining a more systematic process for risk appetite.

• Investment will be required to enhance the modeling and reporting systems to meet regulatory timelines.

• Convergence of regulations toward RBC will also mean that there is less disparity between local and foreign players. This will make Asia-Pacific insurance markets potentially more attractive for foreign investments. Moreover, customers may eventually benefit from new ideas and solutions from both foreign and domestic insurers. This will create a healthy competitive market place for policyholders.

Challenges and opportunities

Based on experience in more developed insurance markets, changes in regulations produce both challenges and opportunities for insurers. In the short term, it is anticipated that there will be more investment demands on insurance companies. Insurers have the prerogative to make the best use of these investments to define long-term opportunities.

In Europe, for example, some insurers have used Solvency II as a means to further enhance their risk management systems, capital allocation mechanisms and reporting infrastructure, and redefine their key performance Indicators. This, in turn, has convinced shareholders and analysts that investments because of regulatory changes should not be for mere compliance, but rather as a means of enhancing competitive advantage. We believe that insurers in Asia-Pacific should draw upon the experiences and challenges in more developed markets to establish an approach for Asia-Pacific markets that considers regulation, economic nuances and the purchasing behavior of policyholders.

Looking ahead

There will be many changes within the industry over the next few years, and companies will need to consider the operational implications for their businesses. Based on our conversations and experience in the region, we see an increasing number of insurers making adjustments to their future business plans and investment needs. Some of these modifications are tactical, such as enhancing their existing processes, while others have the potential to have a wholesale effect on entity rationalization and strategic initiatives, such as capital optimization.

We are very engaged with the regulators, industry bodies and insurance companies in the emerging discussions and are helping insurers to consider these regulatory changes with a strategic mindset.

China

The China Insurance Regulatory Commission (CIRC) has adopted a factor-based solvency system similar to Europe’s Solvency I regime. It is composed of internal risk management, solvency reporting, financial analysis and supervision, regulatory intervention and bankruptcy remediation. This solvency regulation system was built from 2003 to 2007.

Over the past 30 years, the Chinese insurance market has become one of the fastest-growing in the world, and its complexity and risk have increased accordingly. The existing static solvency system no longer properly reflects asset and liability risks facing insurance companies. Therefore, it has limitations in providing good guidance for insurers to improve risk management quality and capabilities.

Globally, there is a trend toward more risk-oriented regulation and governance, such as Europe’s Solvency II, the US NAIC’s solvency modernization initiative and Singapore’s RBC 2.

Developing a new solvency system for mainland China would not only meet local market needs but could also provide pragmatic and invaluable experience for other emerging markets, as well as the international insurance community.

Australia

Australia has two primary supervisory authorities, the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC). Both bodies have authority over the entire retail financial sector, comprising deposit-taking institutions, life and non-life insurance companies, friendly societies and superannuation schemes. APRA is responsible for the licensing and prudential regulation of financial institutions, while ASIC deals with consumer protection issues.

The most significant recent enhancement to the regulatory regime is the capital adequacy framework and draft conglomerate supervision. This is supplemented by a corporate governance regime.

Hong Kong

The insurance industry in the Hong Kong SAR has witnessed considerable growth in the past decade. As of Oct. 14, 2014, there were 155 authorized insurers in Hong Kong, including
44 long-term insurers, 92 general business or non-life insurance companies and 19 composite insurers (i.e., life and non-life insurers).

In Hong Kong, the Office of the Commissioner of Insurance (OCI) is the Insurance Authority (IA) under the Insurance Companies Ordinance (ICO) and oversees the financial conditions and operations of authorized insurers. The OCI is part of the Financial Services and the Treasury Bureau of the Hong Kong Government.

India

The Indian life insurance industry has witnessed a phenomenal change in the last 14 years since it was opened to private players. It experienced strong growth (a CAGR of 30%) for almost a decade, until a wave of regulatory changes capped charges for unit-linked products. This compelled insurers to shift focus from unit-linked investments to traditional protection products, significantly slowing industry growth. With reduced shareholder margins on unit-linked plans, sales of traditional products have increased and now constitute at least half of new life insurance business, whereas unit-linked plans are facing negative growth.

General insurers have seen growth of 16% CAGR over the past decade. This is attributed to the evolving regulatory environment, new private companies entering the market, changing demographics, greater disposable income and business development in the corporate sector. In fact, growth was significantly higher in the financial year 2012–13 — up 24%, primarily as a result of policies sold and rate adjustments.

Against the backdrop of a relatively underpenetrated market, there is a significant potential for sustainable long-term growth. Currently, there are 24 life insurance and 28 general insurance companies in the market. A few mergers and acquisitions are in the pipeline.

The industry today is in a state of flux. Surrounded by political uncertainty, slower economic growth, regulatory changes and increased competition, insurance companies are looking to increase profitability, manage expenses and improve persistency.

Indonesia

Indonesia is one of Southeast Asia’s largest economies and presents a huge untapped market for the insurance industry. An expanding middle class and the young demographics of the population is creating a vast platform for savings and investment products, and as life insurance continues to show exponential growth, the microinsurance market is gaining traction with low- income consumers.

Against this backdrop, the Indonesian insurance industry is being shaped by changing regulations and stricter capital requirements that are aimed at introducing greater transparency and stability. In this transformed regulatory landscape, there are more new entrants to the market and greater opportunities for mergers, acquisitions and joint partnerships.

Malaysia 

Malaysia has a well-developed, stable economy that continues to attract insurers. The GDP is growing at nearly 6%, and unemployment and inflation are relatively low. Demographics and strong economic growth have helped to develop a strong market for takaful insurance and bancassurance. In recent years, the country has undertaken wide-ranging reforms aimed at improving regulatory efficiency and opening the door to greater competition in financial services.

The Malaysian insurance industry, like others in the Asia-Pacific region, is struggling with depressed investment returns, higher volatility in capital markets and increased pressure on the cost of capital. Against this business landscape, the industry appears to welcome regulatory changes. However, there are also concerns that some of these changes are diverting attention from key issues, such as improving portfolio returns and new business.

Singapore

The Monetary Authority of Singapore is finalizing the risk calibration and features of the RBC framework, with implementation expected from Jan. 1, 2017.

The RBC framework for insurers was first introduced in Singapore in 2004. It adopts a risk-focused approach to assessing capital adequacy and seeks to reflect most of the relevant risks that insurers face. The minimum capital prescribed under the framework serves as a buffer to absorb losses. The framework also facilitates an early intervention by the Monetary Authority of Singapore (MAS), if necessary.

While the RBC framework has served the Singapore insurance industry well, MAS has embarked on a review of the framework (coined “RBC 2 review”) in light of evolving market practices and global regulatory developments. The first industry consultation was conducted in June 2012, in which the MAS proposed a number of changes and an RBC 2 roadmap for implementation.

South Korea

The regulatory authority for the Korean financial services industry, the Financial Supervisory Service (FSS), introduced RBC in April 2009. In replacing the Solvency I requirement, the RBC scheme aims to strengthen the soundness and stability of the overall insurance industry.

In the rapidly changing insurance market, FSS has to review the RBC regime continuously to ensure that it serves the intended purpose. This effort included some changes in 2012, such as subdividing capital classes and categorizing risk factors in accordance to the types of risks transferred to insurance companies. Moreover, FSS enhanced the RBC calculation methodology by adding reverse margin risk as part of interest rate risk in 2013 and by raising the confidence level of risk factors for insurance risk early in 2014.

In light of the recent enhancements, some insurance companies’ solvency margin ratio has fallen below the FSS’s recommended ratio of 150%. As a result, these insurers have had to raise capital through alternative options such as issuing subordinated bonds.

Thailand

The Office of Insurance Commission (OIC) implemented a risk- based capital (RBC) framework and gross premium valuation (GPV) regime in Thailand in September 2011.

The OIC rolled out two phases of parallel tests before the actual implementation of the RBC framework to gauge the impact on insurers and to gather industry response. The solvency requirement was also increased from 125% at the initial implementation to 140%. This became effective Jan. 1, 2013, to give insurers more time to respond to the changes.

In 2011, the Thai regulator granted temporary RBC exemptions and relaxed some of the restrictions. This was an effort to help local general insurers overcome financial difficulty caused by flood losses that occurred that year, as the floods coincided with implementation of the RBC framework.

The OIC rolled out two phases of parallel tests before the actual implementation of the RBC framework to gauge the impact on insurers and to gather industry response.

Catastrophe Models Allow Breakthroughs

“In business there are two ways to make money; you can bundle or you can unbundle.” –Jim Barksdale

We have spent a series of articles introducing catastrophe models and describing the remarkable benefits they have provided the P&C industry since their introduction (article 1, article 2, article 3, article 4). CAT models have enabled the industry to pull the shroud off of quantifying catastrophic risk and finally given (re)insurers the ability to price and manage their exposure to the violent and unpredictable effects of large-scale natural and man-made events. In addition, while not a panacea, the models have leveled the playing field between insurers and reinsurers. Via the use of the models, insurers have more insight than even before into their exposures and the pricing mechanics behind catastrophic risk. As a result, they can now negotiate terms with confidence, whereas prior to the advent of the models and other similar tools, reinsurers had the upper hand with information and research.

We also contend that CAT models are the predominant cause of the reinsurance soft market via the entry of alternative capital from the capital markets. And yet, with all the value that CAT models have unleashed, we still have a collective sour taste in our mouths as to how these invaluable tools have benefited consumers, the ones who ultimately make the purchasing decisions and, thus, justify the industry’s very existence.

There are, in fact, now ways to benefit customers by, for instance, bundling earthquake coverage with homeowners insurance in California and helping companies deal with hidden volatility in their supply chains.

First, some background:

Bundling Risks

Any definition of insurance usually addresses the concept of risk transfer: the mechanism that ensures full or partial financial compensation for the loss or damage caused by event(s) beyond the control of the insured. In addition, the law of large numbers applies: the principle that the average of a large number of independent identically distributed random variables tends to fall close to the expected value. This result can be used to show that the entry of additional risks to an insured pool tends to reduce the variation of the average loss per policyholder around the expected value. When each policyholder’s contribution to the pool’s resources exceeds the expected loss payment, the entry of additional policyholders reduces the probability that the pool’s resources will be insufficient to pay all claims. Thus, an increase in the number of policyholders strengthens the insurance by reducing the probability that the pool will fail.

Our collective experiences in this world are risky, and we humans have consistently desired the ability to shed the financial consequences of risk to third parties. Insurance companies exist by using their large capital base, relying on the law of large numbers, but, perhaps most importantly, leveraging the concept of spread of risk, the selling of insurance in multiple areas to multiple policyholders to minimize the danger that all policyholders will experience losses simultaneously.

Take the peril of earthquake. In California, 85% to 90% of all homeowners do NOT maintain earthquake coverage even though earthquake is the predominant peril in that state. (Traditional homeowners policies exclude earth movement as a covered peril). News articles point to the price of the coverage as the limiting factor, and that makes sense because of that peril’s natural volatility. Or does it make sense?

Is the cost of losses from earthquakes in California considerably different than, say, losses from hurricanes in Florida, in which the wind peril is typically included in most homeowners insurance forms? Earthquakes are a lot more localized than hurricanes, but the loss severity can also be more pronounced in those localized regions. Hurricanes that strike Florida can be expected with higher frequency than large damage-causing earthquakes that shake California. In the final analysis, the average projected loss costs are similar between the two perils, but one has nearly a 100% take-up rate vs. the other at roughly 10%. But why is that so? The answer lies in the law of large numbers, or in this case the lack thereof.

Rewind the clock to the 1940s. If you were a homeowner then, the property insurance world looked very different than it does today. As a homeowner back then, you would need to virtually purchase separate policies for each peril sought: a fire, theft and liability policy and then a windstorm policy to adequately cover your home. The thought of packaging those perils into one convenient, comprehensive policy was thought to be cost-prohibitive. History has proven otherwise.

The bundling of perils creates a margin of safety from a P&C insurer’s perspective. Take two property insurers who offer fire coverage. Company A offers monoline fire, whereas Company B packages fire as part of a comprehensive homeowners policy. If both companies use identical pricing models, then Company B can actually charge less for fire protection than Company A simply because the additional premium from Company B affords peril diversification. Company B has the luxury of using premiums from other perils to help offset losses, whereas Company A is stuck with only its single-source fire premium and, thus, must make allowances in its pricing that it could be wrong. At the same time, Company B must also make allowances in the event its pricing is wrong, but can apply smaller allowances because of the built-in safety margin.

This brings us back to the models. It is easy to see why earthquake and other perils, such as flood, was excluded from homeowners policies in the past. Without models, it was nearly impossible to estimate future losses with any sort of reliable precision, leaving insurers the inability to collect enough premium to compensate for the inevitable catastrophic event. Enter the National Flood Insurance Program (NFIP), which stepped in to offer flood coverage but never fundamentally approached it from a sound underwriting perspective. Instead, in an effort to make the coverage affordable to the masses, the NFIP severely underpriced its only product and is now tens of billions of dollars in the red. Other insurers bravely offered the earthquake peril via endorsement and were devastated after the Northridge earthquake in 1994. In both cases, various market circumstances, including the lack of adequate modeling capabilities, contributed to underpricing and adverse risk selection as the most risk-prone homeowners gobbled up the cheap coverage.

Old legacies die hard, but models stand ready to help responsibly underwrite and manage catastrophic risk, even when the availability of windstorm, earthquake and flood insurance has been traditionally limited and expensive.

The next wave of P&C industry innovation will come from imaginative and enterprising companies that use CAT models to economically bundle risks designed to lower the costs to consumers. We view a future where more CAT risk will be bundled into traditional products. As they continue to improve, CAT models will afford the industry the confidence needed to include earthquake and flood cover for all property lines at full limits and with flexible, lower deductibles. In the future, earthquake and flood hazards will be standard covered perils in traditional property forms, and the industry will one day look back from a product standpoint and wonder why it had not evolved sooner.

Unbundling Risks

Insurance policies as contracts can be clumsy in handling complicated exposures. For example, insurers have the hardest time handling supply chain and contingent business interruption exposures, and rightly so. Because of globalization and extreme competition, multinational companies are continuously seeking value in the inputs for their products. A widget in a product can be produced in China one year, the Philippines the next, Thailand the following year and so on. It is time-consuming and resource intensive to keep track of not only how much of a company’s widgets are manufactured, but also what risks exist surrounding the manufacturing plant that could interrupt production or delivery. We would be hard-pressed to blame underwriters for wanting to exclude or significantly sublimit exposures related to supply chain or business interruption; after all, underwriters have enough difficulty just to manage the actual property exposures inherent in these types of risks.

It is precisely this type of opportunity that makes sense for the industry to create specialized programs. Unbundle the exposure from the remainder of the policy and treat it as a separate exposure with dedicated resources to analyze, price and manage the risk.

Take a U.S. semiconductor manufacturer with supply exposure in Southeast Asia. As was the case with the 2011 Thailand floods or the 2011 Tohoku earthquake and tsunami, this hypothetical manufacturer is likely exposed to supply chain risks of which it is unaware. It is also likely that the property insurance policy meant to indemnify the manufacturer for covered losses in its supply chain will fall short of expectations. An enterprising underwriter could carve out this exposure and transfer it to a new form. In that form, the underwriter can work with the manufacturer to clarify policy wording, liberalize coverage, simplify claims adjusting and provide needed additional capacity. As a result, the manufacturer gets a risk transfer mechanism that more precisely aligns with the balance sheet affecting risks it is exposed to. The insurer gets a new line of business that can provide a significant source of new revenue using tools such as CAT models and other analytics to price and manage those specific risks. By applying some ingenuity, the situation can be a win/win all around.

What if you are a manufacturer or importer and rely on the Port of Los Angeles or Miami International Airport (or any other major international port) to transport your goods in and out of markets? This is another area where commercial policies handle business exposure poorly, or not even at all. CAT models stand ready to provide the analytics required to transfer the risks of these choke points from business balance sheets to insurers. All that is required is vision to recognize the opportunity and the sense to use the toolsets now available to invent solutions rather than relying on legacy group think.

At the end of the day, the next wave of innovation will not come directly from models or analytics. While the models and analytics will continue to improve, real innovation will come from creative individuals who recognize the risks that are causing market discomfort and then use these wonderful tools to build products and programs that effectively transfer those risks more effectively than ever. Those same individuals will understand that the insured comes first, and that rather than retrofitting dated products to suit a modern-day business problem, the advent of new products and services is an absolute necessity to maintain the industry’s relevance. The only limiting factor preventing true innovation in property insurance is imagination and a willingness to no longer cling to the past.