All lines of insurance except personal auto have exhibited greater underwriting volatility than the one-year S&P 500 volatility for five years running, according to the Insurance Risk Study released by Aon Re Global, a unit of Aon Corp.
For corporations and their risk managers, the risk-versus-return tradeoff is in an ever-moving cycle requiring constant rebalancing, according to Aon. Knowing when to retain risk, to transfer risk or to make investments in, for example, the S&P 500, can make the difference between creating high shareholder value vs. facing insolvent circumstances.
“Insurance, if not managed appropriately, can bring higher risk and lower return than other major industries,” said Stephen Mildenhall, executive vice president and chief actuary, Aon Re Services. “Knowing how to price risk adequately and carry appropriate amounts of risk on the books is at the crux of sound decision making for insurance companies.”
The annual study represents an assessment of underwriting risk parameters. This year the study was extended to include quantifications from select European and Asia-Pacific countries, including France, Germany, Greece, the United Kingdom, Australia and Japan.
As underwriting volatility varies significantly across lines of insurance, the Insurance Risk Study also gives information on specific personal and commercial lines. The most volatile major line in the 15-year period of 1992 to 2006 was homeowners, which was significantly impacted by the 2004 and 2005 Atlantic hurricane seasons. Even excluding these catastrophe loss years, homeowners has a risk comparable to commercial auto insurance.
Other high volatility lines include general liability, medical malpractice, and professional liability and directors and officers insurance.
New to the Insurance Risk Study in 2007, Aon Re Global’s price-to-book regression study helps explain how companies can create shareholder value through enterprise risk management (ERM). The findings show that a consistent stream of earnings is strongly correlated with a higher price-to-book ratio.
Aon says insurance companies can use the results as a valuation tool in future calculations and as a measure of the cost of capital.
“Enterprise risk management is especially important in today’s volatile and softening global insurance environment, so any opportunity to illuminate and help mitigate risk is a win for our clients,” Mildenhall said.
Aon Re Global’s Insurance Risk Study examines risk from non-diversifiable risk sources, including changing market rate adequacy, unexpected frequency and severity trends, weather-related losses, legal reforms and court decisions, the level of economic activity and other macroeconomic factors, offering insight on risk from reserve development. Reserve development in long-tailed liability lines has produced upwards revisions in estimated volatility since 2001, as they are booked closer to ultimate each year. For example, the estimate of volatility for other liability claims-made increased from 27 to 41 percent between 2001 and 2006.
The study also looks at the relationship between specific lines of insurance and the underwriting cycle. Researchers found that volatility for most lines is substantially increased by the pricing cycle. Market cycle driven loss ratio correlation between lines increases risk by up to 50 percent and reduces the normal benefits of underwriting diversification.
Impact of Pricing Cycle on Insurance Risk
Line Impact of Pricing Cycle
Reinsurance – Liability 81%
Other Liability – Claims-Made 64%
Workers’ Compensation 49%
Medical Malpractice – Claims-Made 45%
Special Liability 40%
Other Liability – Occurrence 39%
Commercial Auto 37%
Commercial Multi Peril 23%
Private Passenger Auto 6%
“Today, rating agencies, regulators and investors are demanding that insurers provide detailed assessments of their risk profile and quantification of their economic capital,” Mildenhall said. he said the study gives insurers objective, data-driven underwriting volatility benchmarks to address the pressure of providing better risk disclosure, enterprise risk management, economic capital assessment and capital allocation figures.
With the help of this study, underwriters and actuaries can quantify systemic or parameter risk — the major component of underwriting volatility for large books of business — for more than 20 major lines of insurance. Using the Aon Re Global Insurance Risk Study in combination with existing industry and proprietary severity curves, premium volumes and limit and attachment profiles, Aon Re and company actuaries can assess the volatility of their business using the same metrics as catastrophe models. Understanding systemic risk factors helps companies measure their total portfolio underwriting risk — a key component of calibrating Solvency II and enterprise risk management analyses.
The Insurance Risk Study applies sophisticated techniques from risk theory to six years of NAIC Annual Statement data for 1,984 individual U.S. groups and companies. The database, covering all 21 Schedule P lines of business, contains more than 880,000 records of individual company observations. Aon Re Global introduced the Insurance Risk Study in 2003, and the next update, including data from 2007 annual statements, will be available in July 2008.
Source: About Aon Re Global