VIP Conger

download VIP Conger

of 25

Transcript of VIP Conger

  • 8/8/2019 VIP Conger

    1/25

    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

  • 8/8/2019 VIP Conger

    2/25

    2

    Discussion Outline

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

    s Conceptual Framework

    s Methodological Approach

    s Case Study: XYZ Insurance

    s Key Issues

  • 8/8/2019 VIP Conger

    3/25

    3

    Given the behavior of todays insurance and financial markets, manyproperty/casualty insurers are re-evaluating their reinsurance programs

    Buy less reinsurance?

    s We have excess capital

    s Keep net premiums up

    s Eliminate unnecessaryexpenses and transactioncosts

    s Why share profits?

    s Maximize investable assets

    Buy more reinsurance?s Regulatory and rating

    agency pressure

    s Its cheap

    s Everyone else is grabbing

    this deal

    s Let the reinsurers share the

    coming unprofitable resultss Predictions of future

    catastrophes and mass

    torts

    s Support the higher limits

    were selling

    s We cant lose on this latest

    reinsurance proposal

    s Better safe than sorry

    Buy different protection?s Securitization

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

    Life/Health for workers

    compensation)

    s Contingent debt/equity

    capital

    s CAT futuress Blended products that go

    beyond traditional hazard

    risk

    Chief FinancialOfficer

  • 8/8/2019 VIP Conger

    4/25

    4

    The design of a reinsurance program involves complex issues, and ismaterial to most insurers bottom lines

    s Despite favorable market conditions, reinsurance is still a significant cost

    item for many insurers

    s Reinsurance decisions are becoming more challenging

    u Benefits have always been difficult to evaluate in relation to costs

    How does reduction in underwriting volatility affect capital andreturn requirements?

    u Decisions are often made at the program level, but need to be placedin overall enterprise context

    Need to avoid inefficient reinsurance activity

    u Proliferation of reinsurance products expands alternatives to consider

    u Alternatives to reinsurance products are becoming available, but addfurther to complexity of analysis

    Securitization of risk Contingent debt/equity capital

    s Reinsurance price volatility creates short-term tactical opportunities thatcan be more effectively played against a long-term strategy baseline

  • 8/8/2019 VIP Conger

    5/25

    5

    Case Study: Reinsurance Strategy for XYZ Insurance

    s Large multi-line company, organized into business units

    s Reinsurance purchasing occurs at corporate and business unit level

    u Corporate buys major treaties covering enterprise

    u Business units buy additional coverage to protect their results

    s Study focuses on three questions:

    u Which elements of the reinsurance program add value over the long

    term?

    u Which elements are good tactical buys today, due to marketconditions?

    u How can the program be restructured to create more value?

  • 8/8/2019 VIP Conger

    6/25

  • 8/8/2019 VIP Conger

    7/25

    7

    Components of a reinsurance program can be compared to each other, andto other alternatives, by viewing reinsurance as rented capital

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

    GrossCapital

    Requirement

    Cost of RentedReinsurance

    Capital

    =Cost of Reinsurance

    Reduction in Required Capital

    Reinsurance

    Net CapitalRequirement

    Reduction in

    RequiredCapital

    ExpectedCeded

    PremiumCeding

    Commission

    Expected CededLosses

    Cost ofReinsurance

  • 8/8/2019 VIP Conger

    8/25

    8

    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

    ExpectedRetu

    rn

    M

    N

    A

    G

    H

    J

    O

    B

    Q

    I

    D

    C

    K

    E

    L

    F

    R

    P

  • 8/8/2019 VIP Conger

    9/25

    9

    Either conceptual framework begs several questions

    s How to quantify an insurers projected financial results and the potential

    for variability in these future results?u Gross of reinsurance

    u Net of reinsurance(for each alternative reinsurance program)

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

    an insurers Expected Returns?s How to translate the potential for variability in future results into a

    usable and meaningful measure ofRisk?

    s What is an insurers Required Capital?

    u With no reinsurance

    u With current reinsurance

    u With alternative reinsurance portfolios

  • 8/8/2019 VIP Conger

    10/25

    10

    To quantify projected financial results, XYZ constructed a comprehensivemulti-year model

    Line of Business A

    Business volumeBusinesscharacteristics

    Pricing

    Claims

    Paid andReserved

    Expenses

    Cash flow pattern

    Reserving patterns

    PolicyholderdividendsLine of BusinessB

    Line of BusinessC

    . . .

    Line of BusinessZ

    Starting BalanceSheet

    FinancialCalculator

    Balance Sheet

    IncomeStatement

    GAAP

    Statutory

    Economic

    Year 1Financial Results

    Measures of

    Risk

    Return

    Capital Requirements

    Analyzer

    ReinsuranceProgram

    InvestmentStrategy

    CapitalStructure

    TaxCalculator

    Non-InsuranceIncome

    AffiliateResults

    Corporate Elements

  • 8/8/2019 VIP Conger

    11/25

    11

    Modeled financial outcomes are translated into Risk Measures specific tothe insurer

    s Control variability of reportedfinancial results

    s Reduce capital needs

    u Long-term

    u Finance growthu Satisfy regulatory or rating

    agency constraints

    s Support pricing of primary products

    s Offer new insurance products

    s

    Allow discounting of reservess Current reinsurance price is below

    cost

    s Etc.

    Identify KeyReasons to BuyReinsurance

    Define RiskMeasures that

    capture the keyobjectives ofthe reinsurance

    program

  • 8/8/2019 VIP Conger

    12/25

    12

    We have explored several illustrative alternatives to traditional statisticalmeasures of risk and variability

    s Different reinsurance programs result in different distributions ofoperating results, and therefore different degrees of risk

    s The Risk Measures must be customized to the specific company

    TargetReturn Capital

    Operating Profit Operating Loss

    Unfunded obligations

    Below Target Returnmeasure

    ExpectedPolicyholder Deficitmeasure

    Probability of OperatingResult = X$

  • 8/8/2019 VIP Conger

    13/25

    13

    The advantage of Below Target Risk over standard deviation can beillustrated by an example

    s These two return probability

    distributions have the sameexpected return of 13%,and the same standarddeviation

    s Using a target return of 3%(roughly equivalent to azero real return), the top

    distribution has a BTR of17.6%; the bottomdistribution has a BTR of27.7%

    s The top return distributionis preferable: more upsideand less downside

    13%

    Probability

    Probability

    Rate of Return

    Pra

    bability

    Rate of Return

    P

    rabability

  • 8/8/2019 VIP Conger

    14/25

    14

    The Cost of Reinsurance may be modeled several ways

    s Current proposals from reinsurers/intermediaries

    u Actual

    u Hypothetical, based on current market conditions and marketknowledge

    s Nature of long-term relationship with reinsurers

    u Explicit deal

    u Implicit expectations

    s Conceptual model of reinsurance pricing

    s In the current market, where reinsurers are aggressively seeking top-linegrowth, short term tactical opportunities may lead to differentreinsurance buying decisions than in the long run

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

    CedingCommission

    ExpectedCeded

    Premium

    Expected CededLosses

    Cost ofReinsurance

    CedingCommission

  • 8/8/2019 VIP Conger

    15/25

    15

    The definition of Required Capital likewise will vary depending oncompany perspective

    s Illustrative definitions of required capital with current reinsurance

    programu Current capital

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

    u Multiple of RBC

    u Capital that keeps Expected Policyholder Deficit < x%

    s With alternative reinsurance programs, we canu Model the different amount of Required Capital that would produce the

    same level of risk, or

    u Determine the change in level of risk, given the same amount ofcapital

  • 8/8/2019 VIP Conger

    16/25

    16

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

    Probability Metric

    Time Period and Form of Threshold

    Measurement Basis

    Perspective

    s Likelihood of occurrence

    s Expected excess severity above threshold

    s Expected excess over threshold

    s Loss from single event or risk factor

    s Annual accounting result

    s Results over multi-period planning horizon

    s Experience on runoff basis

    s Statutorys GAAP

    s Economic

    s Absolute result

    s Result relative to peers

    s Result versus rating agency or regulatory norm

    s Result relative to investor expectations

    Dimensions of Risk-Capital Constraints

    Examples: Less than a 1% chance of GAAP operating loss equal to or greaterthan 25% of reported equity

    Economic capital sufficient to reduce expected unfundedpolicyholder obligations to less than .25%

  • 8/8/2019 VIP Conger

    17/25

    17

    As a first step, XYZ identified the highest cost components of thereinsurance 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 QSProperty High Cat

    Work Comp Working XS

    E&O Program XS

    Special Property Fac

    Property First Cat

    Casualty Working XS

    Millions$

  • 8/8/2019 VIP Conger

    18/25

    18

    XYZ measured each components 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

    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$

  • 8/8/2019 VIP Conger

    19/25

    19

    Some program elements appear to add significant value; others may beinefficient

    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

    Std Property Risk XS

    Work Comp Working XS

    Umbrella QS

    Property High Cat

    E&O Program XS

    Casualty Working XS

    Special Property Fac

    Property First Cat

  • 8/8/2019 VIP Conger

    20/25

    20

    In evaluating strategy alternatives, the focus was narrowed to the threeleast efficient programs

    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 Retentions The same framework can be used to evaluate alternative programs, in

    addition to changes to the existing program structure

  • 8/8/2019 VIP Conger

    21/25

    21

    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

    ExpectedR

    et

    urn

    A

    B

    D

    C

    E F

    G

  • 8/8/2019 VIP Conger

    22/25

    22

    An essential feature of the model is the interaction between its componentsand 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

  • 8/8/2019 VIP Conger

    23/25

    23

    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

    u Long term patternsu Shocks

    u Year-to-year variability

    As with the company model itself, inter-relationships betweenelements are an essential feature of the modeling

  • 8/8/2019 VIP Conger

    24/25

    24

    Sensitivity testing is an essential step of the process

    s Some of the elements to be subjected to sensitivity testing include

    u Alternative choices of Risk Measures

    u Different definitions of Required Capital

    u Selected measure of reinsurance cost

    u Modeling time horizon

    Years of business

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

    distribution)

    u Degree of correlation of results across lines of business and acrossyears

    u Base level of company profitability and growth

    u Different combinations of reinsurance components

    s The objective of the sensitivity testing is to satisfy ourselves that theresults are robust, and not driven by one of the modeling choices

  • 8/8/2019 VIP Conger

    25/25

    25

    Of course, modeling does not replace management judgment

    s Modeling results will depend on key management perspectives, such as

    the choice of Risk Measure

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

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