Solvency II and improvements in the modelling of risk will make loss reserving more sophisticated, predicts Graham Fulcher.

Actuaries have long been closely associated with the estimation of claims reserves, but this has not translated into detailed financial modelling of loss reserves. Solvency II will highlight explicitly (via the standard formula or a company’s own internal modelling) the capital tied up in back-year reserves.

I expect two developments: first, there will be a move towards more sophisticated modelling of reserves. The amount of capital required will be calculated using the best information available and allow for the effects of reinsurance. Secondly, strategies for releasing this capital by the judicial use of inwards and outwards commutations (see box) will improve.

Over time, non-life financial models have become more sophisticated in their modelling of underwriting risk. Rather than just modeling future claims in aggregate, losses arising from future premium are now typically considered separately as attritional, large and catastrophic. Each of these three types of claim is deemed to have its own unique feature and properties; not least the empirical output of catastrophe models and the impact of reinsurance.

The capital modelling of reserves is expected to more closely reflect the approaches applied to understand and quantify underwriting risk. These approaches are likely to include explicit modelling of claims arising from single large exposures: both historical catastrophes (World Trade Center reserves) and historical accumulations (claims arising from the financial services industry from the credit crunch).

Such exposures may run across a number of lines of business, and their modelling may well be based on the empirical output of standalone claims-specific models; such as many companies currently use to assess credit crunch-type exposures. It is also likely that allowance will be made for other large individual reserves, capturing more accurately the extent of payments to date, the expected set of future outcomes for the claim and the impact of non-proportional reinsurance.

COMMUTATION MODELLING

A key strategic consideration for many insurers is to ensure capital resources efficiently support future aspirations rather than artefacts of past strategies.

Typically, this may be in addressed in several ways, including commutation of complex inwards exposures to free up capital otherwise tied up in supporting run-off lines of business, and commutation of outwards recoveries that are of little value or are subject to dispute. This again ties up capital, particularly with the need for a counterparty risk charge.

An alternative to inwards commutations (and as a way of passing on outward reinsurance issues) is to dispose of inwards exposures (net of outwards protections) to third-party run-off specialists, or to use alternative exit strategies involving Part VII transfers and/or schemes of arrangement.

Multi-year financial models, such as those that may be used in the ORSA (Own Risk and Solvency Assessment) process of Solvency II, can help work out

an optimal commutation strategy. Such models typically start with assessing the shifting financial security of cedents and the softness or hardness of the run-off market; its willingness to buy run-off books and the aggressiveness with which it will commute deals. Appropriately structured models can also allow for the relative skill of the insurer and its counterparties in assessing the true value of the underlying liabilities. The model can then test the effect of different commutation strategies.

Prior-year claims reserves can impose a big capital “drag” on insurers, yet little time has been devoted to developing appropriate modelling and mitigation strategies. Developments in capital modelling offer an opportunity to gain significant competitive advantage for those who can embrace this change.

Graham Fulcher is the principal consultant at Watson Wyatt