Presentation on theme: "Use of a DFA Model to Evaluate Reinsurance Programs"— Presentation transcript:
1 Use of a DFA Model to Evaluate Reinsurance Programs Presentation TitleUse of a DFA Model to Evaluate Reinsurance ProgramsCase Study1999 CAS Seminar on Financial Risk Management April 12-13, 1999 Denver, ColoradoFriday, March 31, 2017Presented by: Robert F. Conger, FCAS Tillinghast – Towers Perrin
2 Discussion OutlineThe Challenge: How Much Reinsurance to Buy, and What Mix?Conceptual FrameworkMethodological ApproachCase Study: XYZ InsuranceKey Issues
3 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 programsBuy less reinsurance?We have excess capitalKeep net premiums upEliminate unnecessary expenses and transaction costsWhy share profits?Maximize investable assetsBuy more reinsurance?Regulatory and rating agency pressureIt’s cheapEveryone else is grabbing this dealLet the reinsurers share the coming unprofitable resultsPredictions of future catastrophes and mass tortsSupport the higher limits we’re sellingWe can’t lose on this latest reinsurance proposalBetter safe than sorryBuy different protection?SecuritizationNon-P/C reinsurers (e.g., Life/Health for workers compensation)Contingent debt/equity capitalCAT futuresBlended products that go beyond traditional hazard riskChief Financial Officer
5 The design of a reinsurance program involves complex issues, and is material to most insurers’ bottom linesDespite favorable market conditions, reinsurance is still a significant cost item for many insurersReinsurance decisions are becoming more challengingBenefits have always been difficult to evaluate in relation to costsHow does reduction in underwriting volatility affect capital and return requirements?Decisions are often made at the program level, but need to be placed in overall enterprise contextNeed to avoid inefficient reinsurance activityProliferation of reinsurance products expands alternatives to considerAlternatives to reinsurance products are becoming available, but add further to complexity of analysisSecuritization of riskContingent debt/equity capitalReinsurance price volatility creates short-term tactical opportunities that can be more effectively played against a long-term strategy baseline
6 Case Study: Reinsurance Strategy for XYZ Insurance Large multi-line company, organized into business unitsReinsurance purchasing occurs at corporate and business unit levelCorporate buys major treaties covering enterpriseBusiness units buy additional coverage to protect their resultsStudy 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?
8 The answers to reinsurance questions must be specific to XYZ Insurance Compared to XYZ Insurance, no other insurance company has exactly the sameVolume and mix of businessProfitability history and outlookExposure to large claims, mass torts, and catastrophesInvestment strategy and performanceCapital amount and structureLoss reserve adequacyReinsurance choicesRisk appetite/aversionCorporate affiliatesCorporate structureStakeholder expectationsRating agency and regulatory considerationsTherefore, the “right” choice of reinsurance for XYZ Insurance will be different than for any other company And may be different next year than this year.
9 Components of a reinsurance program can be compared to each other, and to other alternatives, by viewing reinsurance as “rented” capitalGross Capital RequirementReinsuranceReduction in Required CapitalNet Capital RequirementExpected Ceded PremiumCost of ReinsuranceCeding CommissionExpected Ceded LossesCost of ReinsuranceReduction in Required CapitalCost of “Rented” Reinsurance Capital=Is reinsurance a cost effective source of capital? It adds value when this cost of capital is below the cost of alternatives
10 Important considerations include time horizon reporting interval Reinsurance strategy alternatives can be compared using an Asset/Liability Efficient Frontier (ALEF) frameworkPresentation Title0%10%20%30%40%50%0.0%0.5%1.0%1.5%2.0%Level of RiskExpected ReturnMNAGHJOBQIDCKELFRPFriday, March 31, 2017Each point is a strategy as to Assets, Liabilities, Reinsurance and Capital StructureFor example, Strategy C could be a $1-million occurrence retention and a 15% allocation to stocksStrategy K is superior to C because it offers a higher expected return for the same level of riskExpected return and level of risk metrics can be customized to fit the perspective of the clientBut the choice of performance and risk metrics can have an impact on the relative ranking of strategiesImportant considerations includetime horizonreporting intervalsingle period vs. cumulative volatilitymaximum tolerable period volatilitySTAT vs. GAAP measuresWe prefer to look at performance in terms of change in the economic value of the company (or business) and to look at risk as “below target risk”, a measure designed to focus on downside risk.
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 reinsuranceNet 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 reinsuranceWith current reinsuranceWith alternative reinsurance portfolios
13 Year 1 Financial Results To quantify projected financial results, XYZ constructed a comprehensive multi-year modelLine of Business ABusiness volumeBusiness characteristicsPricingClaimsPaid and ReservedExpensesCash flow patternReserving patternsPolicyholder dividendsCorporate ElementsStarting Balance SheetReinsurance ProgramInvestment StrategyCapital StructureTax CalculatorFinancial CalculatorNon-Insurance IncomeAffiliate ResultsLine of Business BBalance SheetIncome StatementGAAPStatutoryEconomicYear 1 Financial ResultsLine of Business C. . .Line of Business ZAnalyzerMeasures ofRiskReturnCapital Requirements
14 Identify Key Reasons to Buy Reinsurance Modeled financial outcomes are translated into “Risk Measures” specific to the insurerIdentify Key Reasons to Buy ReinsuranceControl variability of reported financial resultsReduce capital needsLong-termFinance growthSatisfy regulatory or rating agency constraintsSupport pricing of primary productsOffer new insurance productsAllow discounting of reservesCurrent reinsurance price is below costEtc.Define Risk Measures that capture the key objectives of the reinsurance program
15 The Risk Measures must be customized to the specific company We have explored several illustrative alternatives to traditional statistical measures of risk and variabilityProbability of Operating Result = X$“Below Target Return” measure“Expected Policyholder Deficit” measureTarget ReturnCapitalUnfunded obligationsOperating ProfitOperating LossDifferent 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
16 The advantage of Below Target Risk over standard deviation can be illustrated by an example These two return probability distributions have the same expected return of 13%, and the same standard deviationUsing a target return of 3% (roughly equivalent to a zero real return), the top distribution has a BTR of 17.6%; the bottom distribution has a BTR of 27.7%The top return distribution is preferable: more upside and less downside13%
17 The Cost of Reinsurance may be modeled several ways Current proposals from reinsurers/intermediariesActualHypothetical, based on current market conditions and market knowledgeNature of long-term relationship with reinsurersExplicit dealImplicit expectationsConceptual model of reinsurance pricingIn the current market, where reinsurers are aggressively seeking top-line growth, short term tactical opportunities may lead to different reinsurance buying decisions than in the long runCost of ReinsuranceExpected Ceded PremiumCeding CommissionCeding CommissionExpected Ceded LossesThe choice of methods will depend on the objectives of the analysis, the expected duration of the reinsurance arrangement, and the nature of information available.
18 The definition of “Required Capital” likewise will vary depending on company perspective Illustrative definitions of required capital with current reinsurance programCurrent capitalEstimated capital at threshold of specified A.M. Best ratingMultiple of RBCCapital that keeps Expected Policyholder Deficit < x%With alternative reinsurance programs, we canModel the different amount of Required Capital that would produce the same level of risk, orDetermine 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 complex constraints can be definedDimensions of Risk-Capital ConstraintsProbability MetricTime Period and Form of ThresholdMeasurement BasisPerspectiveLikelihood of occurrenceExpected excess severity above thresholdExpected excess over thresholdLoss from single event or risk factorAnnual accounting resultResults over multi-period planning horizonExperience on runoff basisStatutoryGAAPEconomicAbsolute resultResult relative to peersResult versus rating agency or regulatory normResult relative to investor expectationsExamples: “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%”
21 Presentation TitleAs a first step, XYZ identified the highest cost components of the reinsurance programTop 15 Programs by Normative Net Annual Cost246810121416Casualty ClashSpecial Property QSProf Liab XSAviation XSMarine XSCasualty High XSSurety QSStd Property Risk XSUmbrella QSProperty High CatWork Comp Working XSE&O Program XSSpecial Property FacProperty First CatCasualty Working XSMillionsFriday, March 31, 2017$
22 XYZ measured each component’s contribution to reducing insolvency risk, and translated that into a reduction in required capital$
23 Some program elements appear to add significant value; others may be inefficient
24 In evaluating strategy alternatives, the focus was narrowed to the three least efficient programs Casualty Working XSNo ChangeDouble RetentionTreble RetentionWork Comp Working XSNo ChangeDouble RetentionTreble RetentionAviation XSNo ChangeDouble RetentionTreble RetentionStrategyABCDEFGThe same framework can be used to evaluate alternative programs, in addition to changes to the existing program structure
25 Each strategy was evaluated in terms of its impact on risk and return 12%11%GFEExpected ReturnDCBA10%0.9%1.0%1.1%Below Target Risk
27 An essential feature of the model is the interaction between its components and across time Correlations between lines of business“Runs” of good or bad yearsRelationships between historical and future resultsMacro-economic trends over timeCorrelations between inflation, equity returns, and interest ratesRelationships between underwriting results and investment resultsRelationship between gross-of-reinsurance results and recoveriesPatterns of reserve inadequacy/redundancyPatterns of variation in cash flowInfluence of past results on future management strategies and actionsInvestment strategy dependent on yield curve and/or asset durationShareholder dividends dependent on operating results
28 The model is run in a wide variety of scenarios over multiple future years Future inflation ratesFuture interest rates and investment returnsCatastrophesRandom large lossesLoss ratio movementLong term patternsShocksYear-to-year variabilityAs with the company model itself, inter-relationships between elements are an essential feature of the modeling
29 Sensitivity testing is an essential step of the process Some of the elements to be subjected to sensitivity testing includeAlternative choices of Risk MeasuresDifferent definitions of Required CapitalSelected measure of reinsurance costModeling time horizonYears of businessYears of runoffParameters used to model reinsurable losses (e.g., size-of-loss distribution)Degree of correlation of results across lines of business and across yearsBase level of company profitability and growthDifferent combinations of reinsurance componentsThe objective of the sensitivity testing is to satisfy ourselves that the results are robust, 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 MeasureThe final trade-off between risk and return is a matter of preferenceBut this modeling approach provides strong support to allow making the key decisions in a well-informed manner.