Will History Repeat?
In the 1980’s a dozen or more firms in the US and Canadian Life Insurance sector created and used what were commonly called required surplus systems. Dale Hagstrom wrote a paper that was published in 1981, titled Insurance Company Growth . That paper described the process that many firms used of calculating what Dale called Augmented Book Profits. An Augmented Book Profit later came to be called Distributable Earnings in insurance company valuations. If you download that paper, you will see on page 40, my comments on Dale’s work where I state that my employer was using the method described by Dale.
In 1980, in the first work that I was able to affix my newly minted MAAA, I documented the research into the risks of Penn Mutual Life Insurance Company that resulted in the recommendation of the Required Surplus, what we would now call the economic capital of the firm. By the time that Dale’s paper was published in 1981, I had documented a small book of memos that described how the company would use a capital budgeting process to look at the capital utilized by each line of business and each product. I was the scribe, the ideas come mostly from the Corporate Actuary, Henry B. Ramsey. We created a risk and profit adjusted new business report that allowed us to show that with each new product innovation, our agents immediately shifted sales into the most capital intensive or least profitable product. It also showed that more and more capital was being used by the line with the most volatile short term profitability. Eventually, the insights about risk and return caused a shift in product design and pricing that resulted in a much more efficient use of capital.
Each year, throughout the 1980’s, we improved upon the risk model each year, refining the methods of calculating each risk. Whenever the company took on a new risk a committee was formed to develop the new required surplus calculation for that risk.
In the middle of the decade, one firm, Lincoln National, published the exact required surplus calculation process used by their firm in the actuarial literature.
By the early 1990’s, the rating agencies and regulators all had their own capital requirements built along the same lines.
AND THEN IT HAPPENED.
Companies quickly stopped allocating resources to the development and enhancement of their own capital models. By the mid-1990’s, most had fully adopted the rating agency or regulatory models in the place of their own internal models.
When a new risk came around, everyone looked into how the standard models would treat the new risk. It was common to find that the leading writers of a new risk were taking the approach that if the rating agency and regulatory capital models did not assess any capital to the new risk, then there was NO RISK TO THE FIRM.
Companies wrote more and more of risks such as the guaranteed minimum benefits for variable annuities and did not assess any risk capital to those risks. It took the losses of 2001/2002 for firms to recognize that there really was risk there.
Things are moving rapidly in the direction of a repeat of that same exact mistake. With the regulators and rating agencies more and more dictating the calculations for internal capital models and proscribing the ERM programs that are needed, things are headed towards the creation of a risk management regime that focuses primarily on the management of regulatory and rating agency perception of risk management and away from the actual management of risks.
This is not what anyone in the risk management community wants. But once the regulatory and rating agency visions of economic capital and ERM systems are fully defined, the push will start to limit activity in risk evaluation and risk management to just what is in those visions – away from the true evaluation of and management of the real risks of the firm.
It will be clear that it is more expensive to pursue the elusive and ever changing “true risk” than to satisfy the fixed and closed ended requirements that anyone can read. Budgets will be slashed and people reassigned.