In this guest blog, Yuriy Krvavych, Managing Director – Risk Intelligence & Strategic Advisory at ICMIF Supporting Member Guy Carpenter (UK) and William Gibbons, Principal – Insurance Investment, Mercer (UK) discuss integrated risk management within the insurance industry, and Holistic Balance Sheet Management (HBSM) as a tool for insurers to navigate and mitigate complex risks while creating value.

Introduction: the quest for integrated risk management in insurance

Insurance plays a crucial role in enabling socio-economic activities by mitigating risks that would otherwise be impossible or too dangerous to undertake. From ancient times to today, insurance has thrived on the principles of risk pooling and risk transfer, enabling individuals and businesses to navigate uncertainty more safely.

The way the insurance business is run and managed is fundamentally different from how it is done in finance or manufacturing. The insurance business itself is inherently risky, primarily due to the contingent nature of its ‘production cost’ and heightened downside risk. Insurers create value by taking risks – they leverage themselves by issuing their primary debt in the form of promissory notes called insurance policies. This debt is considered ‘risky’ due to the uncertainty in timing, frequency, and impact of insurance events, unlike finance or manufacturing, where the ‘production cost’ is more predictable, if not fixed. Furthermore, insurers face risk profiles that are typically:

a) heavy-tailed due to the extreme and unpredictable nature of insurance events; and
b) asymmetric, with a tendency of being skewed towards adverse outcomes.

To fulfil their promises and create value, insurers must effectively navigate through these complexities, which requires good expertise in integrated risk management and taking a top-down, holistic view to align strategies, risks, and value creation. Effective risk management must be applied at every stage of value creation, along with the agility to adjust strategies based on evolving risks and opportunities, including:

• selecting and taking risks through strong underwriting disciplines,
• pooling risks by building up underwriting and investment portfolios and considering their mix to achieve desired diversification benefits,
• transferring risks using traditional reinsurance and/or alternative risk transfer solutions to meet risk appetite constraints and enhance economic value, and further
• funding, hedging, and controlling the retained risks using a wide range of risk management instruments and adequate risk control processes to ensure operational efficiencies.

Introducing Holistic Balance Sheet Management (HBSM)

HBSM is a powerful framework for managing risk and achieving value creation in the insurance industry. Unlike traditional balance sheet management, which often focuses on individual components – like assets, liabilities, or equity – HBSM views the balance sheet as an interconnected whole. By adopting a holistic perspective, insurance enterprises can navigate the delicate balancing act of risk taking, risk transformation (i.e., risk transfer and risk financing), and risk control.

The use of HBSM enables two important attributes of effective value creation:

• Risk Appetite (RA): Its calibration, setup/renew and maintenance are essential for defining a ‘system of coordinates’ in which an insurance enterprise would know how to operate, under what constraints (risk limits and thresholds), and how it can potentially create value by leveraging its competitive advantages; and
• Strategies: They are crucial for charting a risk-taking path within the established Risk Appetite’s system of coordinates (RA statement and mandate), helping navigate towards efficient use of capital resources and enhanced economic value.

HBSM combines both top-down and bottom-up approaches to calibrate an insurer’s risk appetite at the enterprise level, aligning it with its risk preferences and value goals, which largely focus on:

1. Protecting solvency and ensuring resilience to distress.
2. Maintaining attractive earnings and capital efficiency.
3. Considering stakeholders, challenges, and external constraints, such as regulatory requirements, rating agency constraints, and investor and policyholder expectations.
4. Ensuring operational efficiencies while leveraging growth opportunities by applying adequate controls and risk management disciplines through a) data analysis and risk intelligence, b) risk modelling capabilities, and c) active risk management.

Unlocking the full potential of HBSM

With HBSM, insurers can dynamically evaluate strategies and deals – whether it is optimising underwriting portfolio, adjusting reinsurance programs, optimising asset allocation, or managing the dividend payout in a post-loss situation – by considering multiple risk levers at once and their interconnected impact on the entire balance sheet.

Having good strategies in place means knowing:

• What risks to write, where and in what composition, i.e., how to choose the optimal underwriting portfolio mix.
• What part of assumed risks to retain afterwards, i.e., how to set up optimal reinsurance purchasing / risk mitigations and structure an optimal investment portfolio.
• How to fund the retained risks, i.e., how to optimise capital structure (equity vs. debt vs. structured reinsurance deals, etc.) and capital flow (dividends, contingent capital, capital injections, etc.).

Here, HBSM enables the use of the Economic Value Added (EVA) principles of evaluation, based on the top-down allocation of cost of capital with a strong linkage to risk appetite. This allocation allows insurers to determine the risk-adjusted return on capital attributable to a specific tranche of risk and further use it as a benchmark to measure the economic value added by switching between two strategies: transferring the risk tranche versus retaining and mixing it with other risks.

In our upcoming ICMIF Webinar, Holistic balance sheet management: supporting insurers’ strategic objectives on Thursday 31 October,  we will demonstrate case studies illustrating the application of HBSM in managing both the liability (L) and asset (A) sides of the balance sheet. These examples will highlight how HBSM can enhance risk management, capital efficiency, and overall value creation.

Guy Carpenter and Mercer offer the expertise to help insurers efficiently implement HBSM, supporting sustainable value creation and long-term success.