Reinsurance as a Capital Management Tool
1. Has ERM been successful in better management of risk on an integrated basis through companies and company groups?
2. How has this changed the role of reinsurance in companies? Is it used effectively as a capital management tool?
3. Have organizational structures been changed to assure effective communication and management of risk information?
4. Are insurers and reinsurers making effective use of capital markets to supplement industry capital in risk bearing?
5. Will integrated risk and capital management expand the market potential for a broader range of now insurable risks globally? How?
Many current trends are reshaping the role of reinsurance in today’s markets. Enhancements in risk quantification have provided better understanding of risk exposures (e.g., catastrophe models). Refinements in risk management in the comprehensive enterprise risk management (ERM) approach addresses the relationship between risk assessment, pricing and capital backing for insurance/reinsurance companies, insurer groups and their clients. ERM has also become the foundation for a more risk-based, company-specific approach to regulatory solvency requirements (e.g., Solvency II). Opportunities to reduce regulatory capital requirements has increased use of internal company models to better relate overall capital levels to the full range of risks assumed. “Use test” requirements in regulatory solvency rules have encouraged use of internal models in managing company and group business. Enhanced modeling approaches (e.g., economic capital) allow risk aggregation and disaggregation to better plan business strategies for business mix, pricing and capital allocation, and to manage unit risk assumption.
Traditionally, reinsurance was used within particular lines of insurance business to transfer risk beyond feasible retention levels and to provide additional capacity to support business growth. It was also used to provide surplus relief. It was the province of the underwriting and risk management stream of companies, separate from the CFO functions of capital management and financial analysis.
Over the last few years reinsurance has become more integrated in financial planning and management. Risk-based capital analysis has illustrated that line-by-line assessment of reinsurance protection needs did not fully account for, or optimize, the aggregate impact on capital application to the various risks. This integration does not do away with the need for consideration of risk coverage needs at the line and geographic level. It does require a reassessment at a company and group level to assure the most efficient use of capital.
Aggregate analysis of reinsurance leads to a different view of the role of reinsurance. It becomes an alternate capital tool for spreading risk. Retention analysis becomes an optimization exercise for efficient use of capital, reinsurers capital becoming an alternative basis for supporting primary underwriting.
At the same time, capital markets have become an important alternative to traditional reliance on reinsurer capital. Insurers and reinsurers now weigh the relative merits of deploying their own capital to support certain risk pools with the potential for relying on capital markets via insurance-linked securities (ILS).
As capital management is integrated with overall risk management, companies look at once fragmented activities, such as reinsurance purchase, product design, pricing, reserving, business origination and capital management, together
Risk considerations in such diverse lines as natural catastrophe coverage and life insurance guarantees present complex capital/reinsurance coverage questions. But, considered as a whole, companywide reinsurance programs may be made more efficient, at lower cost, while maintaining appropriate coverage structures by line. Risk appetite, risk tolerances and risk limits by line, are now part of comprehensive ERM risk profiles and help to refine retention limits and create desired insuring capacity. Integration in ERM programs can then lead to consideration of alternative reinsurance types and structures, including reinsurer credit exposures, that take best advantage of the overall pool of risks assumed by the company or group.
The recent financial crisis dampened enthusiasm for ILSs, but there have been growing signs of resumption of market growth with new issues of catastrophe bonds and other structures. The ILS market developed a broad spectrum of investors prior to the crisis and appears poised to reestablish and broaden investor interest. ILS offer a wide range of loss protection with some structures paying off on the occurrence of certain types and severities of natural disasters, on particular areas, or losses over a particular amount. The March 2011 Japan earthquate/tsunami is not expected to trigger a significant portion of the estimate $12 billion market in outstanding catastrophe bonds. Though still relatively small, the ILS market is expected to grow as investors seek diversity of risk from traditional stock and bond markets.
ILS is becoming just another capital option to be considered in determining efficient risk-based capital positions in insurers and reinsurers. The lessons of the recent financial crisis and catastrophe events are not that use of capital markets is a bad idea but rather that the risks need to be understood. The systemic risks need to be taken seriously even when they can’t be measured completely.
As the analysis and financing structures become increasingly complex and interdependent there is the risk that we lose our understanding of our net exposure. As was the case when reinsurers accepted risk through slips representing portions of risk pools, that made it difficult to maintain a good accounting of aggregate risk on particular areas, use of sophisticated models to determine risk-capital optimization can result in a false sense of security. Models can be very powerful tools so long as the underlying assumptions are sound and the results are understood for what they say and don’t say. As illustrated in the recent crisis, the potential for extreme tail loses, including those that historical data don’t represent, must be part of the analysis.
Apart from capital efficiency, integrated risk-based analysis provides important performance measures and a better opportunity to optimize performance within risk tolerances. Risk capital management is not just for determining capital requirements for a given risk pool. Disaggregation by subsidiary company and line of business provides valuable information that should be used to reassess business strategies, business mix, new market entry, market exit, pricing, underwriting standards, reserving and other operating systems.
1. How have the economic crisis and aftermath affected insurance lines, e.g., higher claims, decline in sales, growth in sales, new products?
2. How has the experience in financial services affected the direction of insurance regulation? Is insurance regulation affected by mistaken assumptions about industry needs and norms, e,g., excessive restriction on the use of needed hedging facilities?
3. How will the recent experience change risk management practices in the industry?
4. Will problems in the derivatives markets reduce or change the use of capital markets for insurance activities?
5. What new market opportunities are created by the recent crisis?