designing a re insurance program

8/2/2019 Designing a Re Insurance Program

http://slidepdf.com/reader/full/designing-a-re-insurance-program 1/30

Use of a DFA Model to EvaluateReinsurance Programs

Case Study

Presented by:Robert F. Conger, FCASTillinghast – Towers Perrin

1999 CAS Seminar on Financial Risk ManagementApril 12-13, 1999Denver, Colorado



2

Discussion Outline

The Challenge: How Much Reinsurance to Buy, and What Mix?

Conceptual Framework

Methodological Approach

Case Study: XYZ Insurance

Key Issues



The Challenge: How Much Reinsurance to Buy,and What Mix?



4

Given the behavior of today’s insurance and financial markets, many property/casualty

insurers are re-evaluating their reinsurance programs

Buy less reinsurance?

We have excess capital

Keep net premiums up

Eliminate unnecessaryexpenses and transactioncosts

Why share profits?

Maximize investable assets

Buy more reinsurance?

Regulatory and rating agency

pressure

It’s cheap

Everyone else is grabbing this

deal

Let the reinsurers share the

coming unprofitable results Predictions of future

catastrophes and mass torts

Support the higher limits we’re

selling

We can’t lose on this latest

reinsurance proposal

Better safe than sorry

Buy different protection?

Securitization

Non-P/C reinsurers (e.g.,

Life/Health for workers

compensation)

Contingent debt/equity capital

CAT futures

Blended products that gobeyond traditional hazard risk

Chief Financial Officer



5

The design of a reinsurance program involves complex issues, and is material to mostinsurers’ bottom lines

Despite favorable market conditions, reinsurance is still a significant cost item for

many insurers

Reinsurance decisions are becoming more challenging

Benefits have always been difficult to evaluate in relation to costs

How does reduction in underwriting volatility affect capital and returnrequirements?

Decisions are often made at the program level, but need to be placed in overallenterprise context

Need to avoid inefficient reinsurance activity

Proliferation of reinsurance products expands alternatives to consider

Alternatives to reinsurance products are becoming available, but add further tocomplexity of analysis

Securitization of risk Contingent debt/equity capital

Reinsurance price volatility creates short-term tactical opportunities that can bemore effectively played against a long-term strategy baseline



6

Case Study: Reinsurance Strategy for XYZ Insurance

Large multi-line company, organized into business units

Reinsurance purchasing occurs at corporate and business unit level

Corporate buys major treaties covering enterprise

Business units buy additional coverage to protect their results

Study focuses on three questions:

Which elements of the reinsurance program add value over the long term?

Which elements are good tactical buys today, due to market conditions?

How can the program be restructured to create more value?



Conceptual Framework



8

The answers to reinsurance questions must be specific to XYZ Insurance

Compared to XYZ Insurance, no other insurance company has exactly the same

Volume and mix of business

Profitability history and outlook

Exposure to large claims, mass torts, and catastrophes

Investment strategy and performance

Capital amount and structure

Loss reserve adequacy

Reinsurance choices

Risk appetite/aversion

Corporate affiliates

Corporate structure

Stakeholder expectations

Rating agency and regulatory considerations

Therefore, the “right” choice of reinsurance for XYZ Insurance willbe different than for any othercompany . . . And may be differentnext year than this year.



9

Components of a reinsurance program can be compared to each other, and to otheralternatives, by viewing reinsurance as “rented” capital

Is reinsurance a cost effective source of capital? It adds value when this cost ofcapital is below the cost of alternatives

GrossCapital

Requirement

Cost of “Rented”

Reinsurance Capital=

Cost of Reinsurance

Reduction in Required Capital

Reinsurance

Net CapitalRequirement

Reduction in

Required Capital

ExpectedCeded

PremiumCeding

Commission

Expected CededLosses

Cost ofReinsurance



10

Reinsurance strategy alternatives can be compared using anAsset/Liability Efficient Frontier (ALEF) framework

0%

10%

20%

30%

40%

50%

0.0% 0.5% 1.0% 1.5% 2.0%

Level of Risk

E x p e c t e d

R e t u

r n

M

N

A

G

H

J

O

B

Q

I

D

C

K

E

L

F

R

P



11

Either conceptual framework begs several questions

How to quantify an insurer’s projected financial results and the potential for

variability in these future results?

Gross of reinsurance

Net of reinsurance(for each alternative reinsurance program)

How to measure the Cost of a Reinsurance program and its effect on an insurer’s

Expected Returns?

How to translate “the potential for variability” in future results into a usable and

meaningful measure of Risk?

What is an insurer’s Required Capital?

With no reinsurance

With current reinsurance

With alternative reinsurance portfolios



Methodological Approach



13

To quantify projected financial results, XYZ constructed a comprehensive multi-yearmodel

Line of Business A

•Business volume•Business characteristics

•Pricing

•Claims

• Paid and Reserved

•Expenses

•Cash flow pattern

•Reserving patterns

•Policyholder dividends

Line of Business B

Line of Business C

. . .

Line of Business Z

Starting BalanceSheet

FinancialCalculator

•Balance Sheet

•Income StatementGAAP

Statutory

Economic

Year 1Financial Results

Measures of

•Risk

•Return

•Capital Requirements

Analyzer

ReinsuranceProgram

InvestmentStrategy

CapitalStructure

TaxCalculator

Non-InsuranceIncome

AffiliateResults

Corporate Elements



14

Modeled financial outcomes are translated into “Risk Measures” specific to the insurer

Control variability of reported financialresults

Reduce capital needs

Long-term

Finance growth

Satisfy regulatory or rating agencyconstraints

Support pricing of primary products

Offer new insurance products

Allow discounting of reserves

Current reinsurance price is belowcost

Etc.

Identify Key Reasons toBuy Reinsurance

Define RiskMeasures that

capture the keyobjectives of thereinsurance

program



15

We have explored several illustrative alternatives to traditional statistical measures ofrisk and variability

Different reinsurance programs result in different distributions of operating results,and therefore different degrees of “risk”

The Risk Measures must be customized to the specific company

Target Return

Capital

Operating Profit Operating Loss

Unfunded obligations

“Below Target Return” measure

“Expected Policyholder Deficit” measure

Probability of Operating Result = X$



16

The advantage of Below Target Risk over standard deviation can be illustrated byan example

These two return probability

distributions have the sameexpected return of 13%, and thesame standard deviation

Using a target return of 3%(roughly equivalent to a zeroreal return), the top distributionhas a BTR of 17.6%; the bottom

distribution has a BTR of 27.7%

The top return distribution ispreferable: more upside andless downside

13%

P r o b a b i l i t y

Rate of Return

P

r a b a b i l i t y



17

The Cost of Reinsurance may be modeled several ways

Current proposals from reinsurers/intermediaries

Actual

Hypothetical, based on current market conditions and market knowledge

Nature of long-term relationship with reinsurers

Explicit deal

Implicit expectations

Conceptual model of reinsurance pricing

In the current market, where reinsurers are aggressively seeking top-line growth,short term tactical opportunities may lead to different reinsurance buying decisionsthan in the long run

The choice of methods will depend on the objectives of the analysis, theexpected duration of the reinsurance arrangement, and the nature of informationavailable.

Ceding CommissionExpected Ceded

Premium

Expected CededLosses

Cost ofReinsurance

CedingCommission



18

The definition of “Required Capital” likewise will vary depending on company

perspective

Illustrative definitions of required capital with current reinsurance program

Current capital

Estimated capital at threshold of specified A.M. Best rating

Multiple of RBC

Capital that keeps Expected Policyholder Deficit < x%

With alternative reinsurance programs, we can

Model the different amount of Required Capital that would produce the samelevel of risk, or

Determine the change in level of risk, given the same amount of capital



19

While probability of ruin is the simplest form of risk-capital constraint, more complexconstraints can be defined

Probability Metric

Time Period and Form of Threshold

Measurement Basis

Perspective

Likelihood of occurrence

Expected excess severity above threshold

Expected excess over threshold

Loss from single event or risk factor

Annual accounting result

Results over multi-period planning horizon

Experience on runoff basis

Statutory GAAP

Economic

Absolute result

Result relative to peers

Result versus rating agency or regulatory norm

Result relative to investor expectations

Dimensions of Risk-Capital Constraints

Examples: “Less than a 1% chance of GAAP operating loss equal to or greater than 25%

of reported equity”

“Economic capital sufficient to reduce expected unfunded policyholder

obligations to less than .25%”



Case Study: XYZ Insurance



21

As a first step, XYZ identified the highest cost components of the reinsurance program

Top 15 Programs by Normative Net Annual Cost

0 2 4 6 8 10 12 14 16

Casualty Clash

Special Property QS

Prof Liab XS

Aviation XS

Marine XS

Casualty High XS

Surety QS

Std Property Risk XS

Umbrella QS

Property High Cat

Work Comp Working XS

E&O Program XS

Special Property Fac

Property First Cat

Casualty Working XS

Millions $



22

XYZ measured each component’s contribution to reducing insolvency risk, and

translated that into a reduction in required capital

Marginal Reduction in Required Capital

0 20 40 60 80 100 120 140

Casualty Clash

Special Property QS

Prof Liab XS

Aviation XS

Marine XS

Casualty High XS

Surety QS


Umbrella QS

Property High Cat


E&O Program XS


Property First Cat

Casualty Working XS

Millions$



23

Some program elements appear to add significant value; others may be inefficient

Implied Marginal (Normative) Cost of Reinsurance Capital

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0%

Casualty Clash

Special Property QS

Prof Liab XS

Aviation XS

Marine XS

Casualty High XS

Surety QS



Umbrella QS

Property High Cat

E&O Program XS

Casualty Working XS


Property First Cat



24

In evaluating strategy alternatives, the focus was narrowed to the three least efficientprograms

Strategy

A

B

C

D

E

F

G

CasualtyWorking XS

No Change

Double Retention

Double Retention

Double Retention

Treble Retention

Treble Retention

Treble Retention

Work CompWorking XS

No Change

No Change

Double Retention

Double Retention

Double Retention

Treble Retention

Treble Retention

Aviation XS

No Change

No Change

No Change

Double Retention

Double Retention

Double Retention

Treble Retention

The same framework can be used to evaluate alternative programs, in additionto changes to the existing program structure



25

Each strategy was evaluated in terms of its impact on risk and return

10%

11%

12%

0.9% 1.0% 1.1%

Below Target Risk

E x p e c t e d

R e t u r n

A

B

D

C

E F G



Key Issues



27

An essential feature of the model is the interaction between its components andacross time

Correlations between lines of business

“Runs” of good or bad years

Relationships between historical and future results

Macro-economic trends over time

Correlations between inflation, equity returns, and interest rates

Relationships between underwriting results and investment results

Relationship between gross-of-reinsurance results and recoveries

Patterns of reserve inadequacy/redundancy

Patterns of variation in cash flow

Influence of past results on future management strategies and actions

Investment strategy dependent on yield curve and/or asset duration

Shareholder dividends dependent on operating results



28

The model is run in a wide variety of scenarios over multiple future years

Future inflation rates

Future interest rates and investment returns

Catastrophes

Random large losses

Loss ratio movement

Long term patterns Shocks

Year-to-year variability

As with the company model itself, inter-relationships between elements are anessential feature of the modeling



29

Sensitivity testing is an essential step of the process

Some of the elements to be subjected to sensitivity testing include

Alternative choices of Risk Measures

Different definitions of Required Capital

Selected measure of reinsurance cost

Modeling time horizon

Years of business

Years of runoff Parameters used to model reinsurable losses (e.g., size-of-loss distribution)

Degree of correlation of results across lines of business and across years

Base level of company profitability and growth

Different combinations of reinsurance components

The objective of the sensitivity testing is to satisfy ourselves that the results arerobust, and not driven by one of the modeling choices



30

Of course, modeling does not replace management judgment

Modeling results will depend on key management perspectives, such as the choice

of Risk Measure

The final trade-off between risk and return is a matter of preference

But this modeling approach provides strong support to allow making the keydecisions in a well-informed manner.

designing a re insurance program

Documents