Economic Capital Activity Rises, But Enhanced Strategic Approach Needed

A number of factors including Solvency II and Basel II legislation in Europe and rating agency enterprise risk management (ERM) criteria in North America are driving the economic capital trend and insurers are becoming increasingly active in this space, according to participants at the recent Economic Capital Methodology Roundtable.

To date, most major institutions have a program in place and are either trying to launch or embed economic capital with mixed results, said the roundtable participants. Senior insurance executives met to discuss current initiatives and future plans, as well as opportunities and barriers to success in the industry. The roundtable was held by the Insurance and Actuarial Advisory Services (IAAS) practice of Ernst & Young LLP.

The group agreed that the industry is facing an economic capital crossroads, particularly in the U.S. There was no question as to the potential value of economic capital, according to the participants; however, there was agreement that it should not be viewed as the Holy Grail, but rather a valuable business decision tool if developed correctly.

With significant external and internal pressure to put a program in place, participants were frustrated that a formal, industry-wide definition of economic capital has not yet been set. Currently, economic capital means different things to different companies, as well as to different stakeholders including shareholders, policy holders, rating agencies and management. Ultimately, roundtable participants agreed that it is crucial for companies to identify the questions they want economic capital to answer and then develop accordingly.

Achieving future goals
Preliminary results of a survey conducted by IAAS among insurers revealed, and roundtable participants concurred, that organizations currently use economic capital for limited purposes but have significant plans to use it as a major business tool for performance measurement, strategic risk management, product pricing and key business activities.

However, current processes, approaches, technology and organizational commitment are not necessarily aligned with these future goals. In fact, most organizations do not yet have a handle on the resources presently working on economic capital. This will become a bigger issue as they try to push economic capital out to the business lines for performance measurement and other uses.

The survey also found that the number of years insurers had already spent developing their economic capital framework (some one to two years in and some as many as five years in), all responding organizations indicated they were two or fewer years away from production. Roundtable participants suggested this stems from the complexity of implementation and agreed that the further they get into the process, the more they realize needs to be done.

The survey found that the cultural and infrastructure changes necessary to implement economic capital have not been fully appreciated and the group agreed that getting dedicated resources that can focus on economic capital is difficult. C-suite buy-in for implementing economic capital was questioned, with many participants say the C-level is more focused on satisfying the rating agencies.

“The reality is that economic capital is a multi-year journey and there is danger in jumping into it without the upfront, strategic planning that is necessary for the end product to be more than window dressing for the rating agencies,” said Matthew Clark, senior manager IAAS, Ernst & Young LLP. “Companies must carefully think through their economic capital approach and implementation methodology or they will be left with a costly framework that gathers dust.”

A report including additional information from the roundtable, as well as full findings from the Ernst & Young IAAS 2006 Economic Capital Methodology study is available. For a copy of the report, please contact Deanna Decker at 212-752-8338 or ddecker@psbpr.com.

Source: Ernst & Young