KPMG: Economic Capital Modeling Benefits

By Rob Starr, Content Manager, Big4.com

According to the KPMG survey, Economic Capital Modeling in the Insurance Industry, EC modeling is a way of calculating how much capital a business needs to meet its future risk. It has the potential to transform the way organizations control risks and manage their businesses right across the global insurance industry. However, a survey of the world’s top insurers shows that a lack of understanding at the very top could hinder its effectiveness.

All respondents surveyed in Europe are using EC modeling, while North American and South African insurers are adopting it to some extent. In Asia, the rate of adoption differs depending on whether the insurer’s operations are international, regional or national. Overall, 63 percent of companies operating in the region have implemented an EC framework, with the remaining 37 percent intend to introduce a framework within the next three years.

Improving management understanding is critical. Insurers risk losing competitive advantage by not using techniques to drive value, or worse, by placing too much reliance on model results without fully understanding how they should be interpreted. If used ineffectively, EC modeling can mislead management into falsely believing risks are adequately covered, or force them into actions that go against sound business principles.

Over the past 10 years, companies have started to integrate EC frameworks into their operations for two key reasons.

1. A fully integrated EC model gives companies the tools they need to better understand risk, and potentially price it better. If used effectively, EC allows management to identify and quantify the risk exposure of a firm explicitly.
2. Introducing an EC framework enables insurers to comply with growing rating agency and regulatory requirements. Rating agencies increasingly regard it as an indicator of best practice, while the world’s regulators are looking to EC modeling to improve insurance market regulation and increase protection for policyholders.

These results suggest that a short-term focus on regulatory compliance is masking a lack of understanding of the longer-term strategic advantages of having a fuller appreciation of the business’s risk and capital profile.