Risk appetites: for and against a ‘1 in X’

Estimated reading time: 6 minutes

Risk appetites are still a hot topic in the insurance sector. If done right, they ensure the amount and type of risk you are willing to take on is clearly articulated and well understood by all the key stakeholders. However, if poorly developed they become a tick box exercise that can limit effective challenge to business decisions. We take a closer look at the '1 in X' approach to help you determine if this is the right approach to risk appetite for you.

For insurers, the ‘headline’ risk appetite is Solvency. This can be thought of as an overarching appetite that encompasses all the financial risks. Over the last decade, larger firms have considered this in detail and the PRA have clearly set out their expectations in SS4/18 and continue to point firms in the direction of this supervisory statement. 

The ‘1 in X’ appetite has already been adopted by the large firms. Insurers with an internal model can translate their ‘1 in X’ to a minimum solvency buffer by considering the probability distribution generated by the model. With some judgements, this can be translated to a minimum coverage ratio.

However, without the internal models and volumes of data to use a statistical approach, many standard formula firms are not totally on board with this and there have been many debates on this approach.  

What are the pros and cons of this approach?

Pro: a simple and regulatory approved approach

Firstly, setting your solvency appetite in terms of a ‘1 in X’ is fairly simple. It aligns to the regulator’s preferred approach! And we all know how much easier life can be if we take on board expectations and have the regulator onside. In the supervisory statement released in 2018 (SS4/18), the PRA highlighted the following:

"The insurer’s risk appetite statement is expected to include the risk appetite for the levels of capital that are to be maintained in reasonably foreseeable market conditions (e.g. as assessed through stress and scenario tests, or through some suitable alternative approach, to provide no more than a 1 in X probability that Solvency Capital Requirement (SCR) coverage might fall below 100%)."

The example given in the supervisory statement suggests that while the PRA is open to different approaches to get to the answer, their preference is for firms to translate these back to a probability of falling below a 100% coverage. 

Leaving the regulator to one side, using a ‘1 in X’ allows firms to set their risk appetite in real terms that everyone can understand and will easily translate to real implications to the business. How often do you want to have the regulator knocking on your door? How often do you want to have to look at options for raising additional capital or changing business plans? These type of questions will promote open conversations by all members of the board and you will really get a good understanding of what their actual appetite is.

In addition, by separating the risk appetite from the metrics used to set tolerances (likely related to the solvency coverage ratio), you ensure that the appetite will only change based on management’s view of the risk, not movements in the metric itself.

Let’s use an example, if a standard formula company sets an appetite to hold a minimum coverage ratio of 150%. At the time of discussion, this 50% buffer above a coverage ratio of 100% may be enough to ensure the business can withstand a 1 in 30 year event without falling below 100% coverage ratio. However, over time, as the risks within the business and wider market change, then the distribution and shape of key risks may also change. This would mean that the same 150% coverage ratio may now represents a different position and only cover 1 in 20 year scenarios.

On the other hand, if a company’s appetite is set using the '1 in X' approach, say at 1 in 30 years, this will retain the same strength at all times. It is then the responsibility of the risk function to translate this into a solvency metric and regularly monitor the metric, which may move independent of the steady appetite to risk. 

Con: why '1 in X' may not be right for you

The big reason many are against the ’1 in X’ approach is that firms should be doing what works well for their Board and the way they manage the risks in their business. Many firms may not need to use a quantitative analysis and qualitative approaches may be a lot more appropriate, especially if their risk landscape is less complex. This ‘1 in X’ just adds an additional layer, which may not provide the value it does to other firms.

Over reliance on probabilities and actuarial analysis may also provide a false sense of security by suggesting that we have sufficient capital to withstand a say 1 in 20 year event and still be solvent. Stress and scenario testing (SST) is a very useful tool, but we need to remember that the world is changing and we don’t always have credible data to warrant this quantitative approach. The 1 in 20 may be based on selected scenarios and there are many events equally as likely to occur that are excluded. What if one occurs that has a bigger impact than your SST suggested? Then you may not be as strong as you thought! Yes, there are ways of overcoming this, but it is clear that there are endless options for events at any given probability and selecting but a few to estimate the impact may create risks of underestimating or missing key risks. We should not be overly optimistic that our models have it all captured perfectly.

Having all firms set their appetite using a similar approach will enable the regulator to do some sort of benchmarking, however they may be comparing apples with oranges as the capital requirements will use different approaches, particularly with regards to management actions. Therefore a firm coverage may look low but it hasn’t fully recognised all the options available so this approach could be misleading when comparing this top line figure.

Our previous blog which shares tips for developing the right tool for the job can be found here.

If you need support finding the right approach to risk appetite for your business, please contact Kim or Iain who would be happy to help.