InsuranceRisk Management

Insurance and the Efficient Frontier: What Happens in a Soft Market?

By March 9, 2021No Comments

NeuGroup members respond to Willis Towers Watson’s risk strategy of using modern portfolio theory for insurance. 

Willis Towers Watson recently presented to NeuGroup members an approach to modernizing how corporates buy insurance. As NeuGroup Insights explained last week, it involves modern portfolio theory and the efficient frontier.

  • The presentation intrigued many members, including one who said WTW provided a great overview of the central idea. He wondered how treasury would effectively convey this new way of managing risk to the CFO and the board, including the idea of buying less or none of some coverage.
  • WTW said the process requires a lot of preparatory meetings, ideally face-to-face, and that no one answer fits all companies.

What if insurance market softens? In a follow-up interview, another member who attended raised some questions about the approach if the current, hard insurance market were to soften. Among her comments:

  • “My guess is that this strategy is popping up right now due to the fact that the market is tougher in certain spaces than it has been in the past.  Without a firm policy on what you’re buying insurance on and what you’re seeking to protect, this is something that will fall on its face if the market softens.
  • “I agree that insurance is a method of risk management that is likely not being used effectively relative to a company’s desired outcome. This approach is one way to solve it. 
    •  “But without goal setting and benchmarking, when the correlations break down, there will be a lot of 20/20 hindsight on this methodology. It only works if you have the right infrastructure in place.
  • “I’m not sure I would be interested in buying on the efficient frontier, as correlations work until they don’t. That being said, I find there is little guidance or understanding internally as to why we’re buying insurance and what we’re really trying to protect. 
  • “For us, this session was helpful, as I think we would approach it as a goal-setting exercise. What is our goal? What are we trying to protect? What is our anticipated outcome? How do we benchmark our results?
  • “Then we would look to [WTW] to analyze our exposures and tell us which strategy best achieves our goals, and where we should be investing in insurance, regardless of market conditions.”

WTW’s responses. A spokeswoman for WTW provided these responses:

  • “It is Willis Towers Watson’s position that this is a market correction. Due to climate change, social inflation and many other factors, we do not expect insurance prices to fall. [See] our 2021 Marketplace Realities.
  • “While it is true that the cost component will matter less if the market softens, the risk component is much bigger. Considering all risks together in portfolio is the only way to get an accurate picture of the risk an organization faces, and only then can they make decisions aligned with their corporate financial goals.
    • “It’s still valuable to take a portfolio view regardless of the cost of insurance.
  • “There are certainly good reasons for organizations not to move all the way to the efficient frontier. Not every insurance decision is a financial decision based on the numbers; there are qualitative considerations as well.
  • “We have seen organizations decide that moving toward the efficient frontier (reducing risk and cost, but not to their minimums) works for them.
  • “The assumption of no correlation is an assumption of 0 correlation, or independence of every risk. Our position is that we know that the assumption of total independence, or zero correlation, is wrong. While any assumption about correlation is also possibly wrong, it’s ‘less wrong.’”
Justin Jones

Author Justin Jones

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