Increasingly insurers are employing economic capital as a measure of required capital and setting target rates of return on this capital Yet, a recent study questions whether there is sufficient understanding and buy-in to ensure that such frameworks are effective. Mark Train and Shyam Venkat consider the findings.

In the face of such uncertainty, economic capital evaluation can provide a better understanding of the trade-off between risk and reward by enabling financial institutions to quantify the risks they face, the capital needed to support them and the real risk-adjusted returns that are being generated or should be targeted. The result is a more incisive basis for decision-making including the ability to identify threats, weaknesses and opportunities that may be missed by competitors. Economic capital can also help to align risk appetite with capital allocation and communicate the tangible strengths and potential of the business to analysts, investors and rating agencies.

The particular benefits for insurers include more informed risk selection, risk pricing and asset-liability management. Economic capital could also provide the clear risk/reward data needed to help insurers transfer particular risks to the financial markets and so release capital for more productive deployment.

Such attractions are helping economic capital to gain critical mass within the financial services industry. A recent survey of more than 200 senior financial services executives from around the world, which was carried out by PricewaterhouseCoopers in partnership with the Economist Intelligence Unit, found that 44% of institutions questioned are already using economic capital and a further 30% plan to do so. The respondents included a significant number of insurers and reinsurers.

The move to risk-based prudential regulation, including Basel II, the UK's new capital assessment regime and the planned EU Solvency II, are clearly providing some of the impetus for the adoption of economic capital.

However, PricewaterhouseCoopers survey revealed that improving strategic planning (68% of those using or planning to use economic capital) and defining risk appetite (65%) were the overriding objectives, compared to just 38% of respondents who cited the need to meet regulatory capital requirements.

BUSINESS BUY-IN

Yet if improving strategic planning is the primary goal, then it is telling that the difficulty of integrating economic capital with management decision-making processes was seen as the major barrier to its successful implementation (64%). One of the underlying problems is that most of those who understand the business applications of economic capital are risk managers rather than risk takers. Only 11% of the board and 14% of business units were seen as extremely knowledgeable compared with 45% of the risk management team. A further drawback is the lack of embedding within many organisations.

Only 11% of respondents said that business units have primary responsibility for managing economic capital. The dissemination of information is also patchy, with 21% of unit heads only receiving economic capital reports on an ad hoc basis and 24% not at all. It is equally telling that only 35% have integrated their financial and risk reporting systems, while a mere 30% use risk-adjusted performance as the basis for key performance indicators (KPIs) and incentive schemes. As a result, economic capital is in danger of being seen as a "black box" of limited relevance beyond specialist risk teams.

Integration with KPIs/compensation and transferring authority for economic capital to individual business units where possible could help boost awareness and uptake. The challenge is how to strike a balance between the technical sophistication needed to model an often complex business and creating a practical and understandable business tool that can be embedded within the organisation.

STAKEHOLDER COMMUNICATION

If firms are struggling to make the most of economic capital internally, the same is true of external reporting. Two-thirds of survey respondents that have adopted economic capital do not disclose the results to outside audiences, with insurers generally more reluctant to make the numbers public than banks. Perhaps, as a result, shareholders are regarded as by far the least knowledgeable of both the methodology and business uses of economic capital. Even when participants do disclose economic capital evaluations in their annual reports few said they include them in rating agency or analyst presentations.

Clearly, the lack of a market-wide standardisation of data and assumptions could inhibit the spread of external economic capital disclosure. However, the pressure and indeed incentives to make more information public is likely to grow in the wake of Basel II and Solvency II. Moreover, while the numbers will need a certain amount of explanation and qualification, disclosure is in itself an opportunity to demonstrate effective risk management to investors, rating agencies and other key stakeholders.

MODEL MEASUREMENT

Naturally, any such model-based evaluation is only as good as the reliability of the data, assumptions and application that underpin it. In particular, buy-in from the organisation depends on the credibility of the output.

It is therefore significant that the difficulty of quantifying certain types of risk (62%) and problems of data integrity (61%) ranked among the most prominent barriers to the successful implementation of economic capital.

Clearly, the measurement and incorporation of hard-to-measure operational risks are a challenge. Insurers face further hurdles including how to evaluate options, guarantees and long-tail liabilities. Many also have to contend with data fragmentation and outdated systems, especially as much of the measurement of risk is still conducted within separate actuarial silos. This lack of integration can make it harder to accurately identify and monitor the kind of risk aggregations and accumulations that can prove so calamitous in the wake of stress events such as Hurricane Katrina.

The quality of risk aggregation also underpins effective economic capital evaluation. One of the key challenges for insurers is therefore how to harness actuarial systems to produce timely, consistent and reliable aggregation data.

Even if the desired data is available, it could be dangerous to give too much credence to model outputs without applying experience and intuition.

This is one key reason to ensure that risk takers on the ground have full involvement in economic capital analysis. It is also now common to link bottom-up economic capital calculations with top-down approaches such as earnings volatility and scenario modelling. Equally, economic capital needs to be tailored to the specific characteristics and risk appetite of the business. Indeed, there is a danger that too much standardisation of data and assumptions could lead to firms making the same or similar mistakes.

EMBRACING CHANGE

Compared with banks, many insurers have been slower to develop the tools for modelling risk and tying their capital to the results. However, as PricewaterhouseCoopers' survey highlights, they are catching up fast.

Formal assessments of risk capital have already begun to drive a better understanding of risk and have led to changes in the way business is managed.

In the right hands, economic capital could lead to smarter capital allocation and greater business rewards.

However, economic capital offers no panacea. A lack of integration between the business and the models can lead to misallocated capital and it is therefore essential to ensure that all evaluations are thoroughly analysed for suitability by senior management. An overly technical focus can also needlessly raise the cost and complexity of the exercise and make it harder to win business approval. To work to best advantage, economic capital ultimately requires openness throughout an organisation and needs embracing by those at the top. The evidence, so far, is that too few senior managers appear to be making that leap.

- Shyam Venkat is a partner, Performance Improvement, Financial Services, and Mark Train is a partner, Actuarial and Insurance Management Solutions at PricewaterhouseCoopers.