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The Actuary The magazine of the Institute & Faculty of Actuaries

Insurance: Capital modelling controls

The European insurance industry is increasingly recognising the need for robust Individual Capital Assessment (ICA) and economic capital modelling results. Now that ICAs and economic capital models are becoming embedded within insurance companies and results are being disclosed, the time is right for adding robust controls and governance: these include external audit-type assurance, around the modelling process to provide comfort to users of the results, while also providing a solid foundation for meeting the demands of future legislation.

Capital modelling has developed significantly over a relatively short period of time. Until recently, insurers have frequently requested ICA and/or economic capital model reviews, either from software providers or independent actuarial consultants. Typically these have been limited in scope, focusing upon key aspects, such as: compliance with FSA guidelines, methodology, and implementation testing. Often they have had two main purposes. Firstly, to provide some assurance to boards, management, and risk committees. Secondly, to provide insight and indications as to how the models could be improved.

With investors, industry analysts and rating agencies placing ever greater reliance upon economic capital disclosures to gauge the health and attractiveness of insurers, boards and audit committees are starting to take the view that the results should be subject to some form of audit examination. Leading insurers, in particular, are moving from reviews of their ICAs or economic capital models to formal independent examinations based upon audit procedures. The banking industry has been through a similar experience in its move to Basel II. One of the key issues to emerge there was the need to develop the controls and processes that supported the production of the Basel II numbers.

Some leading multinational insurers in Europe have made disclosures regarding their capital modelling, with more companies likely to disclose in respect of 2007/2008 results. To date, the information disclosed allows users to identify target confidence levels, ruin measures such as Value at Risk (VaR) or Tail VaR, return measures such as Risk Adjusted Return on Capital (RAROC) or Economic Value Added (EVA) as well as whether the figures are on an internal management information basis or a regulatory basis. However, disclosure is still in its infancy. Research into investor requirements around such disclosure indicates:

>> Almost all investors and analysts would like to see greater disclosure in the future around economic capital management (ECM)
>> Almost all respondents agreed better quality of disclosures implies greater importance of ECM in investment decisions
>> A significant majority expressed a belief that firms unable to demonstrate effective ECM will be penalised by the investor community.

So what are the key issues involved in examining a capital model?

What are the appropriate examination standards to follow for capital modelling?
First, the scope of the examination should be clearly defined. The Chief Risk Officers (CRO) forum has commented that this should be published, along with the figures, to allow the reader to form a view on the amount of comfort the examination provides. The standard against which the examination should be undertaken needs careful consideration if the scope falls somewhere between:

1) Confirming that the prescribed process has been adhered to and that the data, assumptions, methodology, implementation and results are appropriately reviewed and signed off
2) Additionally confirming the results are “true and fair”. That is, that the capital figure quoted, within a specified materiality threshold, is an accurate reflection of reality.

The second standard is much more difficult, some say impossible to achieve than the first. Capital models deal with extreme events, so the results are subject to more uncertainty than a typical set of accounts. In fact, when accounts are subject to too much uncertainty, auditors will typically not be able to give a “true and fair” opinion due to “fundamental uncertainty”. Capital models may well fall under the “fundamental uncertainty” wording, depending on the level of materiality being sought. Therefore the first standard would seem a more realistic goal given the maturity of capital modelling.

Relevant examination standards that may be used include ISAE 3000 and ISRS 4400, which cover scenarios where assurance is being sought but not via a full audit. An example wording could be: We planned and performed our examination so as to obtain all the information and explanations which we considered necessary in order to provide:

(1) Reasonable assurance about whether the data and assumptions used are a reasonable basis for determining the ICA report
(2) Reasonable assurance about whether the methodology used provides a reasonable basis for determining the ICA report
(3) Reasonable assurance about whether the ICA report has been properly prepared, in all material respects, on the basis of the data, assumptions and the methodology described.

It is important to make clear the limitations of such an exercise with respect to the points raised above about uncertainty. An example wording expressed as an “inherent limitation” could be:

Actual experience is likely to be different from that assumed to determine the Internal Capital Assessment and deviations from expected experience may be material. Furthermore, it should be noted the amount of the Internal Capital Assessment depends on assumptions about extreme events, the probability that they occur, and interactions between these events. These events cannot be measured with the same level of precision as best estimates or market prices.

How do insurers prepare to be examined?
Many insurers and their professional advisers are starting to review their processes, controls and documentation. An examination approach is then agreed based upon the chosen final assurance wording, the form of the examination and the proposed disclosures. Typically pre-testing is then undertaken to understand the gap between the ideal state and the current state to provide a clear map of which areas need improvement before examination of the capital model and disclosures.

Can an examination add value and allow innovation to continue?
The examination will give much greater comfort to board members, as well as external parties, that a rigorous process exists behind the disclosed figures. This process will have change control built in, so that new methodologies, data or assumptions can be taken into account and then signed off by the appropriate management structure. In this way the examination adds value, ensuring that the modelling is built upon a solid foundation and that any future improvements can be implemented in a sound and robust manner. Entering into this examination process also represents best practice within the market demonstrating the company is actively engaged in understanding its risks.

How will this link with emerging accounting practices and other disclosures?
Under the current European regime, IFRS 7, requires extensive disclosure of risk management policies, but detailed “Phase II” discussions are ongoing, with the focus upon risk sensitive capital requirements. European solvency regulations are also undergoing a similar revision, again focusing upon risk sensitive capital measures and indeed making allowance for capital models developed by the companies themselves, subject to approval. In particular, for UK companies, the Solvency II internal model approval process is expected to be more rigorous than the current FSA review of the ICA.

It would seem sensible that insurers should seek to leverage the analysis already performed for the ICA or ECM exercise, to fulfil both IFRS and Solvency II needs, with adjustments where necessary. A key element in achieving this will be a robust and rigorous process underlying the capital analysis, provided by an independent audit, particularly if internal model approval is sought.

The need for robust ICA and economic capital numbers is incontrovertible. Independent examinations, while not reducing the inherent uncertainty in undertaking this modelling, will at least ensure that users of the results have the assurance that the process followed is well controlled and robust, as well as creating and providing the ideal platform to build on for future accounting and solvency requirements.

Rodney Bonnard and Andrew Hancock are from Ernst & Young’s Insurance and Actuarial Advisory Services. Chris Gallagher is from AXIS Capital.