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Using economic capital as a tool: principles-based management tools can help life insurers make better decisions.

Economic capital is top of mind at just about every major life insurance company today, and with good reason. Regulators worldwide are promoting economic capital frameworks, and rating agencies are using EC models in their ratings processes.

Economic capital frameworks are the principles-based techniques used to understand the capital needed to support the risks that an insurance entity faces. Although EC frameworks have evolved alongside regulatory and rating agency requirements, using EC methodology is more than just a matter of compliance. Nearly 90% of respondents to a recent Ernst & Young survey of North American life insurers say that economic capital is essential to performance evaluation, risk management processes, and making strategic decisions about mergers and acquisitions.

Nevertheless, the majority of U.S. insurers have yet to integrate EC into core decision-making processes. But the pressures to adopt EC measures will not abate, and we can expect to see more U.S. insurers incorporate EC and related risk measures into the following management responsibilities:

* Risk management. EC provides a common basis for measuring and managing risk across the organization. Companies will incorporate economic capital measures into risk management analysis, even though challenges abound. These include reconciling capital requirements with regulatory and/or rating agency, requirements; allocating the diversification benefit across the organization; and managing the restrictions placed on transferring assets/risk across jurisdictions.

* Capital allocation. Allocating capital for performance measurement and pricing may well be the most important use of EC frameworks. To do so, critical issues such as the following will need to be considered: recognition of the differences between economic capital and regulatory and rating agency requirements, capital volatility, availability of previously allocated capital as economic conditions change, and allocation of the diversification benefit.

* Performance measurement. One of the more difficult applications of economic capital, performance measurement requires an infrastructure that produces transparent, consistent, and reliable results on a timely basis. Also essential is a reporting structure that can be integrated into existing management reporting.

* Product development and pricing. EC allows for organizations to better weigh their products' profitability against risk profiles. An important element of such pricing approaches will be building pricing models to support the dynamic behavior of reserves and capital. Insurers must set internal standards for what constitutes acceptable pricing and product design, factoring in risk-related considerations.

* Compensation. Integrating economic capital-based risk and performance measures into management compensation systems will follow its adoption in other basic management functions.

* Public disclosure. Public disclosure of economic capital measures can be valuable in communicating with external stakeholders. But such information should be disclosed only when the supporting infrastructure is robust enough to withstand external scrutiny.

* Cultural acceptance. Strong communication about the role of EC and the business changes that are necessary to support the use of economic capital across the enterprise will be needed. Ultimately, the success of economic capital as a strategic tool will depend on how well the organization understands it and incorporates it in making decisions.

Robert W. Stein, a Best's Review columnist, is global vice chairman of Global Financial Services for Ernst & Young. He may be reached at insight@bestreview.com.
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Author:Stein, Robert W.
Publication:Best's Review
Geographic Code:1USA
Date:Apr 1, 2007
Words:516
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