Financial Modelling for Insurance Business Planning and Capital Decisions

Models and the Decisions They Support

Financial models in insurance serve several distinct purposes, and the requirements of a good model differ depending on which purpose it is built for. A model used to price a new product has different requirements from one used to assess the capital implications of a reinsurance programme change, or one used to support the valuation of a target in a due diligence process.

What is common across all of these is that the model is not the end in itself. It is a tool for supporting a decision. The quality of the decision depends not just on whether the model produces the right numbers -- though that matters -- but on whether the model is asking the right questions, whether the assumptions are understood and defensible, and whether the outputs are communicated in a way that allows decision-makers to use them appropriately.

Insurance financial models have a particular characteristic that makes them demanding: they involve projecting cash flows over long time horizons under uncertainty, using assumptions that are themselves uncertain and that interact with each other in ways that are not always intuitive. A model that appears to work well in base case projections may produce misleading results under stress or when key assumptions are changed.

Business Planning Models

The annual business planning cycle in an insurance company typically produces a financial model that projects the income statement, balance sheet and solvency position over three to five years under the management base case and a set of scenarios. This model is used to set financial targets, assess resource requirements, support the dividend and capital management discussion, and provide the financial content of the strategic plan.

What a good business planning model includes:

Projection of insurance revenue on an IFRS 17 basis, including the expected release of the Contractual Service Margin, insurance finance income and expense, and the expected new business contribution for each year.

Projection of the RBC2 solvency ratio, including the sources of change in both available capital and required capital under the management base case. Capital sensitivity analysis showing how the solvency ratio responds to changes in key drivers -- new business volume, investment returns, catastrophe losses -- is a standard output that boards expect.

Cash flow projection that links the income statement and balance sheet movements to actual cash flows, including dividends from subsidiaries, holding company costs and the cost of reinsurance programmes. An insurer that is profitable on paper but is consuming cash is a different business proposition from one where profitability and cash generation are aligned.

Scenario analysis that tests the business plan against alternative scenarios -- a benign scenario where performance exceeds plan and a stress scenario where adverse experience materialises. The stress scenario should be calibrated to be genuinely testing, not so mild that the management action it implies is trivial.

Common weaknesses in business planning models:

Assumption setting that is optimistic but not clearly identified as such. Revenue assumptions in particular may embed growth rates that are aspirational rather than based on a credible analysis of competitive position, distribution capacity and market conditions.

Solvency ratio projections that are mechanically linked to the income statement but do not properly model the interaction between new business strain, investment experience and capital requirements under the RBC2 framework.

Scenario analysis that is applied at a high level without drilling into the assumptions that drive each scenario, making it difficult to assess whether the scenario is internally consistent.

Capital Modelling and Allocation

Capital modelling in insurance goes beyond the regulatory minimum -- calculating the required capital under the applicable framework -- to address the broader question of how much capital the business needs, how that capital is allocated across business lines, and what the return on capital in each business segment is.

Economic capital models project the distribution of losses in each risk category -- underwriting risk, market risk, credit risk, operational risk -- and combine them to produce a total capital requirement that reflects the actual risk profile of the business rather than the simplified risk charges of the regulatory framework. For sophisticated insurers and reinsurers, economic capital models are the basis for internal capital allocation decisions.

Return on capital analysis by business line provides management with the information needed to make portfolio allocation decisions. A business line that is consuming a disproportionate amount of capital relative to the profit it generates is a candidate for repricing, restructuring or exit. A business line with a high return on capital and growth potential is a candidate for capital deployment. Making these decisions without business-line capital allocation analysis means making them without the key input.

Capital management planning -- the process of deciding how much capital to hold above the regulatory minimum, how to deploy surplus capital and how to plan for capital needs under stress -- requires a multi-year capital projection that connects the business plan, the solvency position and the dividend and capital return policy. This is a board-level decision that requires model support that is transparent and well understood by the board members using it.

Actuarial Modelling in Product Development

New product development in insurance requires actuarial modelling to price the product, assess the capital requirements and project the financial contribution over the life of the product.

Pricing models for life insurance products project the expected cash flows from a new product -- premiums, claims, expenses, investment income -- and calculate the premium rate required to cover those cash flows, provide a margin for uncertainty and deliver a target return on capital. The assumptions in the pricing model -- mortality, morbidity, lapse, investment return, expense -- drive the pricing output, and the sensitivity of the price to those assumptions defines the pricing risk.

Profitability testing for a new product typically involves projecting the expected profit emergence over the policy lifetime and the new business value contribution under IFRS 17. A product that is expected to be profitable at the pricing assumptions used may not be profitable under a range of scenarios, and the stress testing of new product profitability is a standard part of the product development governance.

Volume and market share assumptions in new product modelling are often the most difficult to calibrate. A product that is priced correctly for its expected volume may be uneconomic if sales are lower than planned, because fixed costs are spread over a smaller in-force book. Conversely, a product that is very successful in generating volume may cause capital strain if the capital requirements of the new business were underestimated.

M&A and Due Diligence Modelling

Acquisition modelling in insurance has features that distinguish it from non-financial company M&A.

Valuation models for insurance targets typically involve a combination of embedded value analysis for life insurers, appraisal value projections that capitalise future new business value, and comparable company analysis using multiples appropriate to the target's market and line of business.

Reserve adequacy adjustment in acquisition models requires the actuarial due diligence findings to be incorporated into the valuation. If the independent actuary concludes that reserves are inadequate, the purchase price model needs to reflect both the reserve strengthening required and the earnings impact that follows.

Synergy modelling for insurance acquisitions tends to be more conservative than in non-financial transactions because the regulatory constraints on post-acquisition restructuring -- including the need for regulatory approval for material changes to a licensed entity's operations -- slow the realisation of synergies. Acquirers that model synergies on a fast realisation timeline are routinely disappointed.

Pro forma capital position post-acquisition needs to be modelled carefully. An acquisition that consumes a significant proportion of the acquirer's capital headroom changes the risk profile of the combined entity and may affect its regulatory capital ratios. Boards approving acquisitions should see the projected capital position of the combined group, not just the acquisition price.

Model Governance

Good models require good governance. The assumptions used in financial models are often subjective, and the people who build models are sometimes the same people whose performance is measured by the outputs of those models. Without appropriate oversight, there is a risk that models embed assumptions that are too favourable and that errors or weaknesses are not identified.

Model validation by a party independent of the model builder is standard practice for actuarial models used in regulatory submissions and should be applied to material business planning and capital models as well. Validation reviews both the technical correctness of the model and the reasonableness of the assumptions.

Assumption setting governance that separates the assumption-setting process from the business planning process, with formal approval of key assumptions by the appointed actuary, CFO or board risk committee, reduces the risk of assumption optimism contaminating the model.

Model documentation that allows a competent person who did not build the model to understand its structure, run it and interpret its outputs is a requirement for any model used in a governance or regulatory context. Documentation that exists only in the model builder's head is a key-person dependency that creates operational risk.

We provide financial modelling and actuarial consulting services to insurance companies and financial institutions across Asia Pacific, including business planning model build and review, capital modelling, product development modelling and M&A due diligence support. If your organisation is reviewing the quality of its financial models or needs support with a specific modelling task, our team is available to discuss your requirements.