Hello, my name is Frank Cuypers and this
is a Prime Re Academy webcast. Today we’re going to address the question, why
solvency can be a chance for insurers in spite of the immense and to some extent
even absurd regulatory burden. imagine you’ve just been promoted to be the CEO of an insurance company. What a feeling! now you are empowered! and the first
thing you’ve been asked to do, is to make a decision okay you’ve just been promoted to this
position and it’s going to be a fairly simple decision you just have to choose between two
strategies – just two. what I show here is where your company currently stands in
terms of its profitability. now your planning department provided you with
its profit expectations for the two strategies you have to choose from ok. the first strategy will increase your
profit and the second one is expected to decrease it. now which of the two
strategies will you choose – this is not a trick question. just answer for yourself
or try to figure out what decision your board of directors would endorse.
maybe I could give you some time or you press down the pause button and you
think but don’t think too long – I mean what is the obvious answer to the
question I have asked you well, most of the time, a board of
directors would go for strategy number one and they will argue that it enhances
the value of the company while strategy two destroys it it reduces the value of the company so far so good and it’s quite alright
and with the information I gave you this is probably the best you can do and up
to the end of the 20th century this is actually the most insurers reasoned.
however, although this was not a trick question it might be considered as a ill posed
question today indeed, in the 21st century most insurers
have some idea of the risks they’re taking thanks to their regulatory
solvency exercise, even though for many this may remain a diffuse feeling
inspired by some standard market formula some insurers have a pretty concrete
feeling about the risks they’re taking either because the implemented an internal model or because they perform a realistic quantitative ORSA analysis so if
we now add here the dimension of risk we obtain a completely different picture
and a much more complete one so indeed strategy one which increased the price
increases the profitability also increases the risk and by quite a bit
while strategy two decreases the expected profitability and the same time
reduces the risk of the company and if we are now comparing the two strategies
at hand not just of the expected profitability in
this vertical dimension but also at the same time of the horizontal
dimension actually when you do this on the basis of the risk-adjusted capital,
the RoRAC, the picture is quite different we see now that actually it is company
one which destroys value because it’s RoRAC is less while strategy two which
gives you less profit gives you also much less risk and hence enhances the
value of the company this RoRAC, that is one measure, one
measure of risk-adjusted profitability it’s defined as the quotient of the
expected profit divided by the risk this is a risk-adjusted key performance
indicator that takes into account that high expected performances come together
or are offset by a high-volatility this is nothing else but what we learned in
our first quantitative finance lectures when we addressed the markovitz model
whatever tactical strategic decision we want to take we should always check to
what extend approves or worsens our current RoRAC now there’s one region in
this prophet versus risk plot which we should avoid by all means well clearly you don’t want to reduce
your profit and the same time increase your risk and of course where do we want
to end up well of course is the region where you increase your profit and
reduce your risk and sounds like Santa Claus but maybe it’s not that
unrealistic but the usual quadrant of operations of an insurance company is
the one where we assume the risk of our policyholders and where we obtain a
reasonable reasonable regulation for this now there’s one thing where you may
want to ask the question what is this quadrant the one where we reduce our
risk and frosting some of our prophet well this is exactly what happens when
you buy reinsurance – you seed some of your own risk and in return to reinsure
will get some of the primitive you pay for him now with this very simple machinery you
can start playing numerous smart thought experiments which each come with their
own expected profit and risk and you can plot as dots on this mark of its plot
each of these dots represents a possible business plan which may involve for
instance a modified reinsurance program or the acquisition of new company or the
introduction of the new line of this or whatever may occur to you that might
improve the performance of your company remember you are the CEO now some of
these business plans will have a better risk-adjusted performance and if you
plot sufficiently many of them you will invariably see an efficient frontier
emergen which cannot be outperformed and that is exactly what happens in the
markets model which admittedly is a very simplistic portfolio model but the
phenomenon of the efficient frontier is totally general now here is how does
efficient frontier could look like and here is what it looks like in a
realistic simulation of a stoploss reinsurance program where i explored how
different choices of the priority in the limit affect the profitability on the
vertical axis and the risk on the horizontal axis now you can play the same game in
general and submit to your management port with the recommendation that
whatever strategy to eventually choose implement it must lie on dead efficient
frontier so if they’re much driven by profits
they may want to true strategy a of course they’re going to take more risk
strategy b is less risky but on average promises less profit and finally the
really risk of us board right well true strategy see as you see you can bring a
lot of value to your management board in a very simple and intuitive way and this
way accounts for the risk appetite of your management port and this is a real
value added of solvency not the whole administrative and regularly berean for
this year to use of your risk model because it makes you model exactly this
risk dimension of your company now you probably quite ill advised to use the
solvency to step from which after all well it results from market averages
with wild guesses and loads of political compromises and is quite unlikely did it
reflects anything close to the risks that you are taking but with an internal
model which who may or may not have or with an qualitative or some model which
you probably should have well you have the whole machinery to do
everything we’ve discussed about and even much or so that is why solvency is a chance
for the insurance industry in general and for you in particular! i hope you
found this webcast useful and my colleagues behind the camera and myself
would appreciate any feedback from you please don’t hesitate contacting me if
you wish to address any of the issues we discussed Dr. Frank Cuypers, [email protected] / www.prs-zug.ch/academy