By Laurence Townley - Director of Financial Risk, Direct Line Group
Risk optimisation is about ensuring that the risks a business encounters through its strategy and day to day operations remain within an agreed level of tolerance. This exercise requires a high degree of analytics but it is the primary question of risk appetite that must first be answered, and this requires use of risk based models and analytical expertise.
The primary question relates to the amount of risk a company wants to take. This question needs to be framed in the context of a company’s strategy. The answer to the question is in the risk appetite analysis and this output is likely to be a set of statements made by the company that defines its tolerance to risk and defines where the lower and upper limits of this tolerance might lie.
Insurance companies face many risks regardless of their chosen markets. Broadly these risks can be broken down as financial and reputational although these categories are not exhaustive.
Firstly, there is the key risk that the company must hold sufficient capital. The requirement to hold sufficient capital resources that allow for the riskiness of the business has been an important part of the ICA regime in the UK and will be a central part of Solvency 2 when implemented. When pricing policies, general insurance companies face uncertainty on claims costs in terms of timing and amount, and therefore must hold capital resources to allow for this uncertainty. Deciding upon a level of risk appetite is likely to mean answering the question of how much capital the company would like to hold.
Decisions on levels of capital are often made in terms of probabilistic outcomes. These might take the form of statements such as:
- our risk appetite is to hold capital at a 1 in 200 level
- our risk appetite is to hold capital at a 99.95th percentile
These statements can be put against specific time horizons. They can also be linked to regulatory requirements or rating agency models and ratings, for example, being capitalised against a AA rating.
A capital model is becoming the most common approach to calculating the level of capital required against a risk appetite statement. A solid capital model should enable an insurance company to assess the level of capital required to meet its risks at a 1 in 200 year event. Models used by companies are becoming increasingly complex but regardless of complexity the model should be able to assess all of the key risks and translate them into a capital requirement. The risk appetite work will then consider what lower and upper limits around this requirement the company deems acceptable. The capital model would also be useful in defining these limits.
A further financial risk could relate to income. The definition of income should be agreed but is likely to be a profit measure of premiums less claims and expenses allowing for investment income. Companies are likely to want to set limits around the degree of income volatility that is acceptable over a short term time horizon. Setting risk appetite around income can be a hard piece of work but it is likely that a strong quantitative approach will be successful. Key questions to consider might include:
- What is the historical view of income going back as far as possible and applicable to today’s business environment?
- What is the volatility in the historical view of income and were there one-offs in this view?
- What is the volatility in the forward looking view of income implied by the capital model?
The capital model should enable a company to not only consider the amount of capital required at a given point in time but also the distribution of income over the next business cycle. These results could then inform both a risk appetite income statement and the associated limits.
In both of the above examples, it will important for the Risk function to understand the business model since the capital model will be very much influenced by the quality of pricing and planning.
Other Risk Appetite statements may be less quantitative in terms of the skill set required to derive them. Reputational and operational risks are likely to consider questions such as what are the adverse reputational and legal scenarios in addition to the broader risks. Risk registers and stress tests can be used to inform the limits and choice of words making up a risk appetite document. Finally, liquidity is likely to be a consideration and this again will require the capital model.
The outcome should be a set of statements that the business feel engaged to take forward to manage their underlying day to day risks. The process of engagement should be done as carefully as defining the statements. But the outcome should be a clear ambition and a company that understands risk optimisation.
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