Insurers are under increasing pressure from ratings agencies, regulators and investors to provide detailed assessments of their risk tolerance and to quantify the adequacy of their economic capital. The Insurance Risk Study Tolerance by Aon Re Global provides a unique set of underwriting volatility benchmarks to help them carry out these assessments, leading to greater capital efficiency while meeting solvency requirements. The study quantifies the systemic risk for each line of business, representing the risk to a large portfolio from nondiversifiable risk sources, such as:

• Changes to market rate adequacy.
• Misestimating plan loss ratios.
• Frequency and severity trends.
• Weather-related losses.
• Legal reforms and court decisions.
• Level of economic activity and macroeconomic factors.

For insurers with large books of business, systemic risk is the major component of underwriting volatility, and it cannot be diversified through further premium growth. The research revealed variations in volatility across a number of lines and countries as shown in "Global Volatility" below.

As Aon's study indicates, several interesting patterns emerge:

• Some lines are consistently less volatile than others across all regions. For instance, Personal Motor is consistently the least volatile line.
• Similar lines generally have similar rankings across countries, but there are notable exceptions. For example, Commercial Property/Fire has a coefficient of variation of 21 percent in Germany, one-third lower than that in the United States and United Kingdom. The high volatility of U.S. Homeowners at 43 percent is due in large part to the active 2004 and 2005 Atlantic hurricane seasons.
• As a relative measure of volatility, it is interesting to note that Personal Motor is the only U.S. line to exhibit less volatility than the S&P 500 since 1992. (One-year average S&P 500 volatility since 1992 measured by the VIX index = 19 percent).

IMPACT OF THE INSURANCE UNDERWRITING CYCLE

Volatility for most lines of business is increased by the insurance underwriting and pricing cycle. Because the underwriting cycle acts simultaneously across many lines of business, it increases correlation between them and amplifies the effect of underwriting risk to primary insurers and reinsurers.

Detailed analysis of U.S. data shows that although the cycle increases volatility substantially for all major commercial lines (see "Impact of Pricing Cycle" below), the ultimate effect varies by line. For example, the underwriting volatility of the line that includes directors' and officers' liability claims (Other Liability—Claims-Made) increases by 64 percent, whereas Workers' Compensation increases by 49 percent, Commercial Auto by 37 percent, and Other Liability—Occurrence by 39 percent. Personal lines, which are more highly regulated and formula-rated, show a much lower cycle effect, with Private Passenger Auto volatility increasing by only 6 percent because of the cycle.

One goal of enterprise risk management for insurers is to reduce this "self-inflicted" volatility penalty, allowing them to write at greater leverage and to lower their cost of capital over the long term.

APPLYING the data learned from the underwriting volatility cycle

By combining factors from this research with severity curves and an analysis of their business, premium volumes, and limit and attachment profiles, insurers can now assess the volatility of their portfolio using the same metrics as catastrophe models. For example, it is possible to estimate the aggregate loss potential over an accident year, both with and without the impact of the pricing cycle, analogous to catastrophe model aggregate probable maximum losses. Until now there has been no definitive, objective source of the risk parameters needed to complete such an analysis.