Insurers’ use of capital models increasing: Moody’s

The use of economic capital models by insurers has grown significantly in recent years and will play an increasingly important role in the rating of such companies, according to a report by Moody’s Investors Service.
“Although banks have led the way in the development of economic capital frameworks, the role of economic capital models has increased dramatically in importance for insurance companies in recent years,” according to Moody’s vice president and senior analyst Steve Hunnisett. “This development has been driven by a number of factors, principally an overall trend to improve risk management and avoid a repeat of the early part of this decade when adverse experience severely weakened many insurers’ balance sheets.”
In its report, Moody’s observes that economic capital models were initially designed almost exclusively for comparing required capital with existing book or regulatory capital internally, but are now being used to improve product pricing, influence hedging decisions and resource allocation among businesses, as well as to communicate capital adequacy externally. “They have become pivotal in relating risk-taking capacity to the financial resources of any financial institution.”
Moody’s says its expectation is that under the increasing convergence between regulatory capital standards and economic capital principles (such as Solvency II in Europe and new NAIC Risk Based Capital calculations in the USA), economic capital will become one of the primary tools of financial strategy and public disclosure of risks.
“The agency believes that the majority of large groups will achieve the standards needed for public disclosure of results within three to five years,” Moody’s says in its announcement about the report.
As capital models develop further, Moody’s says it will “increasingly use the output from such modelswhen forming a view on the capital adequacy of a company.”
Moody’s says it might make adjustments to the models’ output, depending upon individual company deviations from market standards and best practices as they gradually emerge.
“This will have no immediate rating implications, particularly as many models are still in their infancy, but a fully embedded, sophisticated capital model could well become a rating positive for a large insurance group,” Moody’s says. “Additionally, Moody’s would expect such models to be a clearly demonstrable part of the day-to-day risk management of the business and highly influential on any capital-related decisions.”