Another year of costly natural catastrophes—including the worst U.S. tornado season in 50 years, massive insured losses arising from the floods in Thailand, the Japan earthquake and consequent tsunami, and further seismic activity in New Zealand—is causing many insurance-industry stakeholders to wonder just how many more unexpected levels of loss they can tolerate.
Concurrent with these events is continuing pressure on bottom-line results from the soft market and historically low investment yields. The volatility of global equity and bond markets is providing additional challenges, particularly to P&C insurers that have adopted aggressive investment strategies.
All of this leads back to an age-old question: How can company leadership better manage their firms’ potential—and actual—exposures?
Even before the National Association of Insurance Commissioners’ preliminary adoption of the U.S. Own Risk & Solvency Assessment (ORSA) in November 2011, many insurers had already implemented enterprise risk-management frameworks—underpinned in many instances by third-party or proprietary catastrophe models, economic-scenario generators (ESGs) and internal capital models—in an attempt to effectively manage risk.
However, these measures may not be enough to protect insurers from unanticipated levels of financial loss. Catastrophe models often have come up short in the past, which has led to rollouts of new versions with much higher parameters.
A small handful of forward-thinking management teams fully appreciate the inherent uncertainty in a risk-taking industry—including in terms of more “known” risks, emerging risks and (sometimes very) ambiguous threats.
They seek to mitigate (or reinsure or otherwise hedge) their concentrations and maximize upside potential via more insightful and comprehensive risk management than their peers. This way of managing risk is a highly complex and demanding discipline—and is very difficult for siloed organizations such as insurance companies to achieve.
Insurers at all stages of risk-management maturity can derive some of the benefits of such an approach by proxy, through understanding and reporting regularly on the estimated financial impact of various stresses across different aspects of their business. These might include the following (severity will differ from company to company):
- Stock-market crashes of 600 to 1,000 points on the S&P 500 Index.
- Haircuts on Eurozone sovereign debt of up to 50 percent (or even more).
- Inflation—potentially driven by rising commodity prices—reaching between 7.5 percent and 15 percent per annum.
- Many economic com-mentators think that the potential collapse of the Euro could be even more cataclysmic than the events of 2008. If the Euro does fail, then the likely resulting failure of one or more systemically important financial institutions is likely to cause a credit-and-liquidity crunch at least on the scale of 2008.
- The failure of one or more major reinsurers could decimate the value of reinsurance assets.
- Economic losses on the scale of the 2011 Thai floods in other emerging markets; the 2011 magnitude 9.0 Japan earthquake in other quake-prone regions; outsized typhoons; or extreme and prolonged hurricane/monsoon conditions. Potential scenarios might also consider areas where extensive manufacturing capabilities have been outsourced, particularly in the high technology and industrial sectors, or where there are call centers for a wide range of global enterprises.
- Mega D&O claims triggered by another corporate failure on the scale of Enron or a Madoff-type scenario could affect a wide variety of financial institutions, professional advisers, and legal and accounting firms.
Once insurers analyze the risk scenarios like the ones we list above, they then can assess modeled losses in the context of current risk appetites; capital and liquidity assumptions/protocols; reinsurance strategies; and hedging strategies. The enterprise-wide insights they gain from analyses like these could be significant—and could lead to the design of governance actions that help safeguard a firm’s financial viability during times of abnormal distress.