27 May 2009

Published in: Risk governance, Insurance risk

Risk and the art of downhill skiing

Insurers can exploit risk knowledge in the same way that skiers do, argues Dave Ingram

Insurers take risks from others and seek to manage those risks to make a profit. In the course of taking and managing those risks, insurers build up a bank of knowledge. Exploiting this risk knowledge is the way that insurers make their profits and survive their losses.

Insurers are not the only ones who live by exploiting risk knowledge. This is also a key skill for competitive skiers. You see, skiing is fundamentally dangerous. A skier is taking a risk every time that they take the slope. A ski racer is trying to get down the slope as fast as they can, potentially maximizing danger (or risk). To consistently win races, the skier must build a library of risk knowledge and then consistently exploit that knowledge to shave their times while keeping the risk of a season-ending, career-ending or life-ending fall acceptably low.

The skier does this on at least two levels. During a race, they need to exploit their knowledge of each flag to find the spot where they can turn and lose the least amount of speed while maintaining control. This knowledge needs to be combined with their in-depth knowledge of their own capabilities to execute the best turn as well as a real-time evaluation of their current energy level. This is how skiers achieve their best times in individual races. They win those races when their risk knowledge and their ability to execute combined with their stamina exceed the other racers.

Hot-shots rarely succeed

Occasionally, one hot-shot racer will take much more risk than the other skiers. Most often, the hot-shot will land in a cloud of snow at some point in the race when their excessive risk will catch up to them. But every once in a while the hot-shot will turn in a breathtaking run where they do not have to pay for breaking all the rules and they win a race. These hot-shot skiers are often not able to repeat their performance but they do get one blaze of glory.

The second way that a ski racer can exploit their risk knowledge is in the way that they select races. They need to use their risk knowledge about how well each hill matches up with their particular skills as well as the timing between races and the time of year and expected weather patterns. This requires detailed knowledge of all the hills that are used for races as well as their own strengths and weaknesses, along with the variables of weather over the season and at the location of each race.

With the right risk knowledge, the skier can put together a schedule of races where they will have a better chance of doing well and at each race find just the right spots to shave off the critical seconds and tenths to win the most races.

How insurers can win

Insurers can have very similar approaches to exploiting risks.

At the strategic level, insurers will leverage the risk and reward knowledge that comes from their years of experience in the insurance markets as well as from their enterprise risk management (ERM) systems to find the risks where their company's ability to execute can produce better risk-adjusted returns. And using ERM technologies they can also seek to optimize the risk/reward mix of the entire portfolio of insurance and investment risks that they hold.

Proposals to grow or shrink parts of the business and choices to offset or transfer different major portions of the total risk positions can be viewed in terms of risk-adjusted return. This can be done as part of a capital budgeting/strategic resource allocation exercise and can be incorporated into regular decision-making. Some firms bring this approach into consideration only for major ad hoc decisions on acquisitions or divestitures and some use it all the time.

There are several common activities that may support the macro- level risk exploitation.

Economic capital

Economic capital (EC) is defined as the capital needed to retire the risks of a firm under pre-specified and usually highly adverse conditions. EC is calculated with a comprehensive risk model consistently for all of the actual risks of the company. Adjustments are made for the imperfect correlation of the risks. Identification of the highest-concentration risks as well as the risks with lower correlation to the highest-concentration risks is risk information that can be exploited. Insurers may find that they have an advantage when adding risks to those areas with lower correlation to their largest risks if they have the expertise to manage those risks as well as they manage their largest risks.

Risk-adjusted product pricing

Product pricing is "risk-adjusted" using one of several methods. One such method is to look at expected profits as a percentage of EC resulting in an expected return-to-risk capital ratio. Another method reflects the cost of capital associated with the economic capital of the product as well as volatility of expected income. The cost of capital is determined as the difference between the price to obtain capital and the rate of investment earnings on capital held by the insurer. Product profit projections then will show the pure profit as well as the return for risk of the product. Risk-adjusted value added is another way of approaching risk-adjusted pricing.

A risk-adjusted compensation approach creates the incentives to sell the products with the best risk-adjusted returns.

Capital budgeting

The capital needed to fulfill proposed business plans is projected based on the economic capital associated with the plans. Acceptance of strategic plans includes consideration of these capital needs and the returns associated with the capital that will be used. Risk exploitation as described above is one of the ways to optimize the use of capital over the planning period. The allocation of risk capital is a key step in this process.

Risk-adjusted performance measurement (RAPM)

Financial results of business plans are measured on a risk-adjusted basis. This includes recognition of the cost of holding the economic capital that is necessary to support each business as reflected in risk-adjusted pricing as well as the risk premiums and loss reserves for multi-period risks such as credit losses or casualty coverages. This should tie directly to the expectations of risk- adjusted profits that are used for product pricing and capital budgeting. Product pricing and capital budgeting form the expectations of performance. Risk-adjusted performance measurement means actually creating a system that reports on the degree to which those expectations are or are not met.

Risk-adjusted compensation

An incentive system that is tied to the risk exploitation principles is usually needed to focus attention away from other non-risk- adjusted performance targets such as sales or reported profits. In some cases, the strategic choice with the best risk-adjusted value might have lower expected profits with lower volatility or lower chance of ruin of the firm. That will be opposed strongly by managers with purely profit-related incentives. Those with purely sales-based incentives might find that it is much easier to sell the products with the worst risk-adjusted returns. A risk-adjusted compensation approach creates the incentives to sell the products with the best risk-adjusted returns.

Choosing the best business opportunities

A fully functioning macro-risk exploitation program will position a firm in a broad sense similarly to the skier who has chosen the best races to enter. They will find and choose the business opportunities with the better risk-adjusted returns to emphasize in their strategic plans. Their competitors may find that their path of least resistance will be the businesses with lower returns or higher risks, just as the skier's opponents may start to avoid some of the races where they seem to have a disadvantage.

Then like the skier finding the right spots during a race, risk knowledge can be exploited by insurers to enhance the risk/reward results for a particular market, coverage or distribution channel.

For example, working within risk classes, risk knowledge can be exploited both to select better risks and to structure risks in a more efficient manner. Within any risk class, there will usually be a range of actual levels of risk. It may be expensive or require uncommon expertise to distinguish between the lower and higher risk opportunities within a class. However, if a firm does happen to have that expertise or if they have a way to make the discrimination economical, they could create the opportunity to "skim the cream" of risks.

Auto insurance example

This process has been applied to a number of risk types. For example in auto insurance, the history of the business for the past 10 years has been an arms race to create finer and finer pricing/underwriting classes. As an example, think of the underwriting/pricing class of drivers with brown eyes. In a commodity situation where everyone uses brown eyes to define the same pricing/underwriting class, the claims' cost will be seen by all to be the same at $200.

However, if the Izquierdo Insurance Company notices that the claims costs for left-handed, brown-eyed drivers are 25% lower than for right-handed, brown-eyed drivers, then they can divide the pricing/underwriting into two groups. They can charge a lower rate for the left-handed, brown-eyed drivers and a higher rate for the right-handed, brown-eyed drivers.

Their competitors will generally lose their left-handed customers to Izquierdo, and keep the right-handed customers. Izquierdo will have a group of insureds with adequate rates, while their competitors might end up with inadequate rates because they expected some of the left-handed people in their group and got few. So their average claims costs go up and their rates may be inadequate. Izquierdo, therefore, has exploited their knowledge of risk to bifurcate the class, get good business and put their competitors in a tough spot.

A fully functioning macro-risk exploitation program will position a firm in a broad sense similarly to the skier who has chosen the best races to enter.

Another example might be credit risk. (Reality is much more complex than this, but for illustration...) You can see the same type of thing with rating categories. If your firm is able to divide the rating agency rating categories into higher- and lower-risk subsets, then the same sort of selection advantage can be had for investments as described above for auto customers.

Another way to exploit risk knowledge in investing is in speed of understanding of changes to values of securities. If a firm is able to identify factors that might lead to downgrade of a credit, it could take action to reduce exposure in advance of the value dip that often accompanies a downgrade. The firm needs not be 100% accurate; it just needs to be accurate enough for the losses that are avoided to overcome the transaction costs on the false negatives.

Risk structuring

Risk structuring is another way to exploit risk knowledge. Usually risk structuring takes advantage of detailed knowledge of a multi-dimensional view of the risk, either over time or across the probability distribution. Using this multi-dimensional knowledge of risk, the risk is structured to focus on that part of the probability distribution or time-frame that has the most favorable risk/reward characteristics.

Competitors without this risk knowledge might take risks without realizing that the average characteristics are not prevalent in all instances. For example, a reinsurer could write a "multi-line aggregate cover." With this structure, even if each line's aggregate distribution looks risky, the reinsurer can set up the cover so that it attaches only if three or four lines all blow up; and since this joint event is much less likely, the product is lower-risk and can be lower-price. Also "structuring" the reinsurance can transform the reinsurer's pay-off distribution from being "feast or famine" towards "modest upside and modest downside."

Insurers do not have races to win. But insurers do win by putting together good risk-adjusted performance over time. In any one year, there will be hot-shot insurers whose unmanaged risks all fell the right way, but the insurer who learns to consistently exploit their risk knowledge will create sustainable earnings.

Dave Ingram, CERA, FRM, PRM, is Senior Vice President, Willis Re, in New York

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