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Use of a DFA Model to Evaluate Reinsurance Programs. Case Study. 1999 CAS Seminar on Financial Risk Management April 12-13, 1999 Denver, Colorado. Presented by: Robert F. Conger, FCAS Tillinghast – Towers Perrin. Discussion Outline. The Challenge: How Much Reinsurance to Buy, and What Mix?

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use of a dfa model to evaluate reinsurance programs

Use of a DFA Model to Evaluate Reinsurance Programs

Case Study

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

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

discussion outline
Discussion Outline
  • The Challenge: How Much Reinsurance to Buy, and What Mix?
  • Conceptual Framework
  • Methodological Approach
  • Case Study: XYZ Insurance
  • Key Issues
slide4

Chief Financial Officer

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 unnecessary expenses and transaction costs
  • 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 go beyond traditional hazard risk
slide5
The design of a reinsurance program involves complex issues, and is material to most insurers’ 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 return requirements?
    • Decisions are often made at the program level, but need to be placed in overall enterprise 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 to complexity of analysis
      • Securitization of risk
      • Contingent debt/equity capital
  • Reinsurance price volatility creates short-term tactical opportunities that can be more effectively played against a long-term strategy baseline
case study reinsurance strategy for xyz insurance
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?
the answers to reinsurance questions must be specific to xyz insurance
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 will be different than for any other company . . . And may be different next year than this year.

slide9

Reduction in Required Capital

Reinsurance

Gross CapitalRequirement

Net Capital Requirement

Cost of Reinsurance

ExpectedCededPremium

Ceding Commission

Cost of Reinsurance

Reduction in Required Capital

Components of a reinsurance program can be compared to each other, and to other alternatives, by viewing reinsurance as “rented” capital
  • Is reinsurance a cost effective source of capital? It adds value when this cost of capital is below the cost of alternatives

Expected Ceded Losses

Cost of “Rented” Reinsurance Capital

=

slide10

50%

40%

L

F

K

30%

J

I

R

H

Q

C

Expected Return

O

D

N

E

20%

P

G

B

A

M

10%

0%

0.0%

0.5%

1.0%

1.5%

2.0%

Level of Risk

Reinsurance strategy alternatives can be compared using an Asset/Liability Efficient Frontier (ALEF) framework
either conceptual framework begs several questions
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
to quantify projected financial results xyz constructed a comprehensive multi year model

Starting Balance Sheet

Financial Calculator

Non-Insurance Income

AffiliateResults

TaxCalculator

Reinsurance Program

Investment Strategy

Capital Structure

Line of Business Z

. . .

Line of Business C

Line of Business B

Year 1Financial Results

  • Balance Sheet
  • Income Statement

GAAP

Statutory

Economic

Analyzer

To quantify projected financial results, XYZ constructed a comprehensive multi-year model
  • Line of Business A
  • Business volume
  • Business characteristics
  • Pricing
  • Claims
    • Paid and Reserved
  • Expenses
  • Cash flow pattern
  • Reserving patterns
  • Policyholder dividends

Corporate Elements

  • Measures of
  • Risk
  • Return
  • Capital Requirements
modeled financial outcomes are translated into risk measures specific to the insurer
Modeled financial outcomes are translated into “Risk Measures” specific to the insurer
  • Control variability of reported financial results
  • Reduce capital needs
    • Long-term
    • Finance growth
    • Satisfy regulatory or rating agency constraints
  • Support pricing of primary products
  • Offer new insurance products
  • Allow discounting of reserves
  • Current reinsurance price is below cost
  • Etc.

Identify Key Reasons to Buy Reinsurance

Define Risk Measures that capture the key objectives of the reinsurance program

slide15
We have explored several illustrative alternatives to traditional statistical measures of risk and variability

Probability of Operating Result = X$

  • 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

“Below Target Return” measure

“Expected Policyholder Deficit” measure

Target Return

Unfunded obligations

Capital

Operating Loss

Operating Profit

the advantage of below target risk over standard deviation can be illustrated by an example
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 deviation
  • Using 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 downside

13%

the cost of reinsurance may be modeled several ways

Cost of Reinsurance

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 decisions than in the long run

Expected Ceded Premium

Ceding Commission

Ceding Commission

Expected Ceded Losses

The choice of methods will depend on the objectives of the analysis, the expected duration of the reinsurance arrangement, and the nature of information available.

the definition of required capital likewise will vary depending on company perspective
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 same level of risk, or
    • Determine the change in level of risk, given the same amount of capital
slide19
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

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

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%”

as a first step xyz identified the highest cost components of the reinsurance program

Top 15 Programs by Normative Net Annual Cost

Casualty Working XS

Property First Cat

Special Property Fac

E&O Program XS

Work Comp Working XS

Property High Cat

Umbrella QS

Std Property Risk XS

Surety QS

Casualty High XS

Marine XS

Aviation XS

Prof Liab XS

Special Property QS

Casualty Clash

0

2

4

6

8

10

12

14

16

Millions

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

$

slide22
XYZ measured each component’s contribution to reducing insolvency risk, and translated that into a reduction in required capital

$

in evaluating strategy alternatives the focus was narrowed to the three least efficient programs
In evaluating strategy alternatives, the focus was narrowed to the three least efficient programs

Strategy

A

B

C

D

E

F

G

Casualty Working XS

No Change

Double Retention

Double Retention

Double Retention

Treble Retention

Treble Retention

Treble Retention

Work Comp Working 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 addition to changes to the existing program structure
each strategy was evaluated in terms of its impact on risk and return
Each strategy was evaluated in terms of its impact on risk and return

12%

11%

G

F

E

D

Expected Return

C

B

A

10%

0.9%

1.0%

1.1%

Below Target Risk

an essential feature of the model is the interaction between its components and across time
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 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
the model is run in a wide variety of scenarios over multiple future years
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 an essential feature of the modeling

sensitivity testing is an essential step of the process
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 are robust, and not driven by one of the modeling choices
of course modeling does not replace management judgment
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 key decisions in a well-informed manner.