Capital management supported by stochastic forecasts

Neglecting non-financial risks can lead to a substantial underestimation of the actual volatility of the own funds and the solvency ratio, and thus of the associated solvency risks. Adequately accounting for the full range of underwriting and operational risks might significantly reduce the risk budget available for the investments, or reduces the possibility to pay constant dividends over time. In this paper we introduce the Ortec Finance approach to consistently integrate these underwriting and operational risks within the capital management framework. That is, without the need for a detailed (actuarial) liability model that would dramatically deteriorate the run-time of the calculations.

Applying this methodology to a European insurance company and taking stochastic non-financial risk into account, in the 99.5% worst case scenario the solvency ratio is 8.5% points lower over a 1-year horizon, and around 16% points lower over longer horizons. To keep solvency risks within acceptable levels, the available market risk budget has to be reduced. As a result, the relative allocation to equities is reduced, while the relative allocation to credits and sovereign bonds is increased. Over a five year horizon, this leads to a 5% lower expected cumulative investment return from the portfolio. Taking into account underwriting risk in a consistent way provides a much more accurate reflection of the insurance company balance sheet risks.