Provisioning – Packing for your trip into the future
There are two levels of provisioning for an insurer. Reserves and Risk Capital. The two are intimately related. In fact, in some cases, insurers will spend more time and care in determining the correct number for the sum of the two, called Total Asset Requirement (TAR) by some.
Insurers need an realistic picture of future obligations long before the future is completely clear. This is a key part of the feedback mechanism. The results of the first year of business is the most important indication of business success for non-life insurance. That view of results depends largely upon the integrity of the reserve value. This feedback information effects performance evaluation, pricing for the next year, risk analysis and capital adequacy analysis and capital allocation.
The other part of provisioning is risk capital. Insurers also need to hold capital for less likely swings in potential losses. This risk capital is the buffer that provides for the payment of policyholder claims in a very high proportion of imagined circumstances. The insurance marketplace, the rating agencies and insurance regulatory bodies all insist that the insurer holds a high buffer for this purpose.
In addition, many valuable insights into the insurance business can be gained from careful analysis of the data that is input to the provisioning process for both levels of provisioning.
However, reserves are most often set to be consistent with considerations. Swings of adequate and inadequate pricing is tightly linked to swings in reserves. When reserves are optimistically set capital levels may reflect same bias. This means that inadequate prices can ripple through to cause deferred recognition of actual claims costs as well as under provisioning at both levels. This is more evidence that consideration is key to risk management.
There is often pressure for small and smooth changes to reserves and risk capital but information flows and analysis provide jumps in insights both as to expectations for emerging losses as well as in terms of methodologies for estimation of reserves and capital. The business pressures may threaten to overwhelm the best analysis efforts here. The analytical team that prepares the reserves and capital estimates needs to be aware of and be prepared for this eventuality. One good way to prepare for this is to make sure that management and the board are fully aware of the weaknesses of the modeling approach and so are more prepared for the inevitable model corrections.
Insurers need to have a validation process to make sure that the sum of reserves and capital is an amount that provides the degree of security that is sought. Modelers must allow for variations in risk environment as well as the impact of risk profile, financial security and risk management systems of the insurer in considering the risk capital amount. Changes in any of those elements may cause abrupt shifts in the amount of capital needed.
The Total Asset Requirement should be determined without regard to where the reserves have been set so that risk capital level does not double up on redundancy or implicitly affirm inadequacy of reserves.
The capital determined through the Provisioning process will usually be the key element to the Risk Portfolio process. That means that accuracy in the sub totals within the models are just as important as the overall total. The common practice of tolerating offsetting inadequacies in the models may totally distort company strategic decision making.
This is one of the seven ERM Principles for Insurers.