Lehman/A.M. Best Co. 2nd Annual Conference

"The tools are now available to allow insurers to link risk to the capital they need." Peter Nakada Vice President Business Development ERisk

Enterprisewide Risk Determines Capital Needs

Property/casualty insurers are beginning to look at their enterprise-wide risk to determine how much capital they need, said Peter Nakada, vice president of business development for ERisk.

Several insurance companies, including St. Paul Cos. and XL Capital Ltd., are using this approach to measure their capital, said Nakada, who spoke at the second annual Insurance Conference held in New York May 21 and 22, cosponsored by Lehman Bros. and A.M. Best Co.

"The tools are now available to allow insurers to link risk to the capital they need," he said, noting shareholders and financial rating agencies "ought to be demanding that."

ERisk, which was formed in 1999, completed a study last year, which concluded that the property/casualty industry is 20% to 30% overcapitalized, Nakada said. Insurers, he said, need to hold enough capital to cover the risk of losing money, but they also must be able to explain where the capital is invested.

"The reason that you need that capital is to cover your risks. If you didn't need that capital, you should be giving it back to the shareholders," he said.

Insurers are learning from banks, which dramatically improved their capital management practices in the 1990s, Nakada said. In the past 10 years, banks have focused on return on equity and linked capital to risk. They have used "economic capital" to drive strategic decisions. Nakada defines economic capital as capital insurers need to achieve a target financial strength given a portfolio of enterprisewide risks.

"The impact is real, and insurers ought to be pricing for it," he said. "Ideally what's happening is it's driving insurers to more diversified portfolios."

(By David Hilgen, editor, Best's Review: David.Hilgen@ambest.com )