KPMG: Economic Capital Modeling Benefits Explained

By Rob Starr, Content Manager, Big4.com

A KPMG International survey of the world’s top insurers shows that a lack of understanding at the very top could hinder Economic capital (EC) modeling’s effectiveness.   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. 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.

While 79 percent of survey respondents are using EC modeling for risk management, fewer of them are realizing the potential advantage of using it to other strategic decisions such as to support pricing and underwriting decisions (55 percent). 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.