Managing Risk of Change – Coping With Uncertainty
We all know that successful underwriting depends on close monitoring of risk factors. Pricing models will quickly lose touch with reality if they don't reflect changes in those risk factors. The very uncertainty about change and what it means for monitoring risk is one of the most challenging aspects of risk management, but reinsurers are ideally suited for addressing that challenge because they can offer what the models can't - experience, expertise and good judgment.
We have come a long way since the concept of risk emerged in the sixteenth century during the Age of Discovery when merchants realized the importance of diversification in overseas trade. Unquestionably, spreading exposure over a large number of uncorrelated risks rather than putting all eggs in one basket can be singled out as the most important approach to mitigating risk in both the investment community and insurance sector.
In the investment community, market swings reflect uncertainties. However, in the insurance sector, uncertainties of a different nature loom in the potential for cumulative events that result from a catastrophe or a series of adverse trends. In insurance it is customary to distinguish between three types of risk: volatility (random), change and error. Traditionally, insurers include the uncertainties under the term “risk of change” as opposed to “volatility risk,” which can be tamed through diversification.
The risk of change is essentially unmeasurable. U.S. economist Frank Knight first made the distinction between “risk” (measurable) and “uncertainty” (unmeasurable) about a century ago. He proposed a number of measures for dealing with risk of change: diversification and monitoring, amongst others. They all appear to be inherent to reinsurance as well.
A reinsurer is ideally placed to monitor risk by participating in the business written by a cedant because both parties’ interests are perfectly aligned. Reinsurers can also support and expand a cedant’s product range and offer competitive premiums as a result of a diversified portfolio (in terms of product and region).
Solvency II implies that reinsurance and capital are more or less perfect substitutes by randomizing the risk of change and treating it like volatility. (Read Darius Weglarz’s blog, What You Need to Know About Solvency II and Reinsurance.) However, replacing reinsurance with higher amounts of retained capital shuts out the cedant from the above-mentioned advantages of a long-term reinsurance partnership in managing the risk of change. The attempt to quantify uncertainty, which is arguably characterized by its immeasurability, could lead to a false degree of certainty.
Insurers cannot anticipate, let alone control, the future development of relevant risk factors. Monitoring them is a key to success and requires experience, expertise and good judgment; these three indispensable characteristics are independent of the models and cannot be substituted by capital alone. They form the backbone of the services reinsurers should continue to offer their customers.
Read my article for more on managing the risk of change.