Too dominant in the ESG space?
Posted on 26-08-2009 by John Hibbert | 0 comments
We are sometimes asked to comment on the claim that we are just "too dominant in the ESG space". Notably, European insurance regulators raise the issue deep in the 'white text' of their July 2009 Consultation Paper #56 on internal model approval in paragraph 10.29
Whilst we could choose to interpret these questions as backhanded compliments, they do raise some interesting questions for us (as a commercial organisation) and our clients and prospective users of our models and services. Below I address some possible concerns here.
Abuse of dominant position
Whilst there are technical challenges in developing ESG models and their development requires both financial and management resource, there are no other significant barriers to entry to the modelling business. Indeed, we do have credible competitors today and I expect this to continue in future. I like to think that our position is simply the result of the quality of our products and services. Any attempt to abuse this position through pricing would be checked by competitors.
Firms gain significantly as a result – our economies of scale allow many clients to benefit from our investment in people, intellectual property and technology. As explained before, we can offer modelling solutions at a fraction of the cost (and risk) of in-house development.
A systematic risk?
There are a number of possibilities here. Firstly, there is the possibility that a large number of firms are exposed to a common error in model implementation or calibration. However, even if firms had adopted a common approach (they do not), they are now required to apply the same level of testing and validation to external models as internal models so this possibility requires the failure of all firms’ testing and validation (and the collective failure of regulators to identify the shortfall).
Secondly, a possibility exists that software fails simultaneously and completely across a large number of firms. Whilst there must be some probability of this sort of failure, our testing and release procedures are designed to stop this happening – either accidentally or maliciously – and we believe this risk is very small. Firms have access to different versions of the software which could also mitigate the impact of such an event.
The other side of risk
Given the high cost and complexity of ESG model development (together with the paraphernalia required to meet emerging regulatory demands) it must make sense for the industry to share these costs through outsourcing. When we look at the potential operational risk associated with small in-house teams, the external model provider with critical mass in analytical areas plays a vital role in minimising this far more material risk. Now - if I were a regulator - that is the operational risk that would keep me awake at night.
Naturally, we would like to hear client views on this subject so please use the facility to comment.
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