Does Your Captive Insurance Company Use Forward-Looking Modeling?

My email in-box recently contained an American Property Casualty Insurance Association (APCIA) news release titled "Forward-Looking Models Could Help Insurers Better Understand and Price Risk in California." It quoted APCIA Vice President Mark Sektnan as saying, "Currently, insurance companies are working toward rates that reflect the dramatically increased risk in many California communities. Use of catastrophe models that look forward and reflect the new normal rather than backwards could help insurers better understand and price the increasing risk."

It got me thinking about these models in general and whether captives should be interested in employing them in some fashion.

From there, I decided to do some quick research to see what other literature I could turn up on this subject. Not surprisingly, Swiss Re released a white paper on this concept titled Liability Risk Drivers: Bringing a Forward-Looking Perspective into Liability Modeling. While the 2016 paper is somewhat dated, it certainly provides a wonderful primer on this topic. Therefore, I decided to use it as the basis to explore the question of whether captives would benefit from employing forward-looking modeling. Anyone who knows my proclivity toward scenario modeling and generative thinking can guess the answer to this question.

The Swiss Re white paper contains the following statement: "The re/insurance industry has traditionally used historical data to assess current and future risk exposures. But in today's fast-changing environment, the past is no longer a good predictor of future casualty exposures because risks are becoming increasingly globalized, complex and interconnected. As a result, insurers need to develop new tools and forward-looking approaches to better assess future risks…. A future-oriented risk assessment model, the [Liability Risk Drivers^TM] LRD allows us to extend the basis for liability costing beyond historical data and to include the actual risk factors driving liability."

Swiss Re is not the only reinsurer to employ this type of modeling. In fact, a number of the major actuarial firms now do so as well. So captive insurance companies looking to explore the idea or actually start to use it have options in securing partners.

Interestingly, the use of forward-looking liability modeling is a key factor in the regulatory development of the Own Risk and Solvency Assessment (ORSA), as reported in "ORSA—A Forward-Looking View of Capital and Solvency," by Gavin Conn, Brian Heale, and Craig Turnbull, Moody's Analytics, May 2014. We have noted in the past that ORSA, which is becoming common in the ongoing regulation of primary insurance companies, is likely to get adopted at some point for captives. Educating your management team and board on these tools is probably warranted just from this perspective.

So, what does forward-looking modeling entail? The Swiss Re white paper provides the following explanation.

Forward-looking models (FLM) serve to anticipate future outcomes—for example, the characteristics of future losses—by reflecting the mechanics and processes that drive them. They go beyond a mere roll-forward of past experience and have the built-in flexibility to evolve and take into account current and future changes. They are validated and trained through an understanding of historical experience, which forms a subset of what the model can predict. This allows the model to be applied in situations with and without relevant historical experience.

Forward-looking models go beyond predictive models by acknowledging a structured cause-effect chain. The findings from predictive modeling can thus be transferred from data-rich contexts into the future and to other contexts where experience and data is sparse, for instance in high growth markets. FLM anticipates future outcomes of re/insurance risks in changing economic, societal, technological, and legal conditions, and is becoming a preferred approach to accurately predicting liability risk.

Given the complexity of these models and the use of artificial intelligence (AI) to help engineer them, this is not something the average captive insurance company is likely to do on its own. As we suggested above, your captive will need to partner with a reinsurer, actuarial firm, or broker to provide the heavy lifting involved. This may well be an impediment for some captives to even consider the idea. However, anyone reading the tea leaves can see this is the direction the insurance industry is moving. We have argued before that the big primary insurers, to extract competitive advantages from competitors, are already exploiting big data and AI. Therefore, captives at least need to become educated on what these tools are and how they can be utilized.

The Swiss Re report does an in-depth analysis of the components of a forward-looking model. The following statement appears toward the end of the paper: "The LRD model development started with medium-sized companies simply because very few or no losses had been recorded in this area. A model was therefore needed to make sound predictions. In the meantime, the model has been extended to a much wider range of entities—such as small companies ceded into reinsurance treaties and to large corporate risks in certain industries [emphasis added]. Further options include extensions to car and truck drivers, individuals for private liability, governmental or nongovernmental entities causing accidents, and losses to third parties. The risk driver concept can serve to explain the differences between all these entities."

Note our emphasis above regarding small companies. This would obviously include captives, so if you are a Swiss Re reinsurance client, whether you know it or not, these models are being used to determine if you are a good risk.

We would not be surprised if this is true for many of the large reinsurers playing in the captive market. As the reinsurance market continues to harden and capacity becomes more expensive, those captives that understand these models may have an advantage in placement discussions with their reinsurers. Their view of what your risk exposure looks like may well be very different from the view held by management and the board. Recognizing these educated captives may provide an advantage when talking with the underwriters.

As always, we encourage your feedback and commentary. Please feel free to email John Foehl directly at [email protected].