Society of Actuaries Commissions Towers Perrin Study on Economic Capital

Business Editors

STAMFORD, Conn.--(BUSINESS WIRE)--May 15, 2008--To further explore the growing importance of economic capital (EC) in quantifying risk within an enterprise risk management (ERM) framework among insurers in North America, the Society of Actuaries (SOA) Committee on Financial Research commissioned a research paper to examine more closely the mechanics and implementation of EC frameworks in North America and globally. The subsequent report was written by the Tillinghast insurance consulting business of Towers Perrin, a global professional services firm, with industry input provided by the SOA’s Project Oversight Group.

EC is an internal calculation of the amount of capital required, based on the insurer’s view of risk, using calculations based on economic principles. In line with the primary research objectives, the report describes common methods for calculating EC, as well as the issues regarding practical application and implementation of EC.

“We are confident that this research paper will provide important and practical information to life insurers who are increasingly relying on EC calculations as the basis for business decisions, and also provide a useful resource for future discussions with regulators and rating agencies," said Steven Siegel, research actuary, SOA.

Two Methods of Calculating EC Emerge as Most Common

The study confirmed the two most utilized approaches in calculating EC: a liability run off approach and a one-year, mark-to-market approach. For the liability run off approach, EC is based on the amount of initial assets needed to cover liabilities at a required confidence level, projected over the lifetime of the business. In practice, different variations of the run off approach exist due to differences in liability valuation basis, measures of interim solvency and degree to which new business is projected. The U.S. regulatory principles-based approach for setting risk-based capital is moving to a liability run off method, using a cost-of-ruin measure.

For the one-year, mark-to-market approach, EC is based on the amount of assets needed to remain solvent over a one-year time horizon at a required confidence level, measured on a mark-to-market basis. The approach is frequently implemented using stress testing. The mark-to-market approach began in the banking industry and is being adopted as the basis for Solvency II, the set of regulatory solvency requirements for insurance companies operating in the European Union.

“The study validated that there are a number of factors that insurers need to consider when developing and implementing EC frameworks, such as their objectives for EC, the type of business they write and what constraints they face,” said Mark Scanlon, senior consultant with Towers Perrin and project manager for the SOA Study. “Overall, the decision regarding what EC approach to use should reflect a balance between simplicity, reliability and practicality, and the amount of capital held should balance the views of all company stakeholders.”

Genworth Financial is a good example of how financial institutions are implementing EC frameworks. "At Genworth, we view EC as an important part of our strategic risk management efforts and have begun the process of integrating it into our insurance processes," said Steve Marco, Genworth vice president and managing actuary, who is the actuarial lead for Genworth's EC project. "We expect that the economic capital framework will provide important information which will help guide our business decisions, both domestically and internationally."

Increased Use of EC

Economic capital is typically used to refer to a measure of required capital under an economic accounting convention -- where assets and liabilities are determined using economic principles.

There are numerous reasons why insurers calculate EC, with capital allocation, performance measurement and strategic decision making being frequently cited. The report discusses how companies are using EC in these and other areas of their business operations. In North America in particular, rating agency considerations are an important factor driving companies to calculate EC. Increasingly, EC is seen as a key component of strategic risk management when rating agencies assess an insurer’s ERM capabilities. Historically, life insurers have been slower than property/casualty insurers to institute EC frameworks. A 2006 ERM survey by Towers Perrin found that only 55% of life insurers globally employed EC calculations, as compared to 65% of all insurers worldwide.

Critical Components of EC Implementation

A key issue with EC is to develop a view on how risks are distributed, particularly in the extreme tails. The approaches to risk modeling depend on the nature of risks and availability of relevant data. For example, the nature of risk could include catastrophe, volatility, parameter and trend risk, all of which are subject to deviations and future changes. For a number of key market, credit and insurance risks, the report discusses the nature of each of the underlying risks, what data are generally available and how relevant the data are in estimating how the risk will emerge in the future, as well as what approaches are used in practice to model the risks.

According to Hubert Mueller, Towers Perrin principal and ERM sales leader in North America, “Implementation of EC will only add value if it is used effectively within the business operations of an insurer. Successful implementation of EC is dependent upon a number of factors, including a recognized commitment to the process from the senior-most levels of the organization, the provision of adequate staffing and technological resources, and dedicated funds.

“In exchange for these efforts, we are starting to see the rating agencies providing credit for EC to those organizations that are successful at embedding EC within their decision-making process, and would expect this trend to pick up speed going forward,” added Mr. Mueller.

The full report and accompanying highlights presentation are available for download at www.soa.org.

About Towers Perrin

Towers Perrin is a global professional services firm that helps organizations improve performance through effective people, risk and financial management. The firm provides innovative solutions in the areas of human capital strategy, program design and management, and in the areas of risk and capital management, reinsurance intermediary services and actuarial consulting. Towers Perrin has offices and alliance partners in the United States, Canada, Europe, Asia, Latin America, South Africa, Australia and New Zealand. More information is available at www.towersperrin.com

About the Society of Actuaries

The SOA is an educational, research and professional organization dedicated to serving the public and its 19,000 members. The SOA's vision is for actuaries to be recognized as the leading professionals in the modeling and management of financial risk and contingent events. The SOA's mission is to advance actuarial knowledge and to enhance the ability of actuaries to provide expert advice and relevant solutions for financial, business and societal problems involving uncertain future events.