10 March 2010

Published in: Capital - models, Insurance risk

Reinsurance shifts from risk mitigation to capital management

Reinsurance offers more flexibility than the capital markets since its structure can be adjusted to the development of the risk profile every year, says Margarita von Tautphoeus, head of Solvency consulting at Munich Re

Under Solvency I, an insurance company's underwriting capacity is calculated as a multiple of its available capital - or own funds. The capital requirement is simply determined as a percentage of the company's premium volume. When Solvency I was introduced, reinsurance was perceived as a capacity provider and measured on the premium basis. For that reason, proportional reinsurance showed the clearest capital relief effect in support of portfolio growth strategies.

Solvency II adds a strong qualitative aspect to the numbers: insurers must establish a large variety of risk management functions and integrate them into daily business. Risk management will become the key element of running the business, combining qualitative and quantitative elements: identifying, measuring and monitoring all the risks an insurance company is exposed to. And risk management will also be the foundation of every insurer's capital management.

In the new Solvency II world, primary insurers will reap fresh benefits from partnering reinsurers: the latter's experience in managing global risks and assessing and modelling complex perils such as natural catastrophes allows them to enhance their own level of risk management. Reinsurers can perform a "coaching function" for their cedants' risk management expertise and thus support their capital management.

Risk mitigation and capital management 

Traditionally, capital management was mostly about handling a company's own funds. Under the Solvency II regime, risk management assumes greater importance. To allow a more precise calculation of the required and available capital amounts, risk mitigation instruments become fully fledged capital management tools. As reinsurance is the most important form of risk mitigation, it becomes a powerful option for capital management: more flexible and better adjustable to individual risk portfolios than many other techniques for capital management.

Solvency II provides two options to determine the quantitative capital requirement before and after reinsurance: the standard formula and a partial/full model. The two options will most certainly lead to different numbers for capital requirement and capital relief.

The standard formula can be seen as a large extension of the old Solvency I world. The capital is still derived from the premium and reserve volume, meaning that capacity is a diversified multiple of the available capital. The impact of reinsurance remains limited and is still geared to premium and reserve volume.

In the second option, the internal model is tailor-made and directly linked to the risk position. Incoming business and ceded business are precisely measured. Therefore, the resulting capital relief of reinsurance largely reflects the type and arrangement, including terms and conditions.

Whichever option is selected, we have to assume that:

• capital requirements will go up;
• less capital will be considered as "own funds", especially hybrid capital; and
• insurers will see themselves caught between higher capital requirements and less or more expensive access to capital.

Increase in cost of capital 

As a consequence, it is expected that there will be a widespread and extensive raising of capital across the European insurance industry, which will most likely increase the cost of capital on the financial markets. This, in turn, could force insurers to fundamentally re-examine their business models, also affecting issues such as product design, matching asset classes, pricing, distribution and, of course, reinsurance strategy.

Turning to the capital market has further, secondary effects on primary insurers:

• their financial flexibility could be adversely affected as it is neither easy nor cheap to convince investors about impending changes of business strategies and business models;
• insurers will need to communicate much more intensely with investors than they have been used to - a development which requires a learning process and could pose confidentiality problems.

In comparison with the capital market option, reinsurance is a more flexible way to reduce the capital gap as its structure can be adjusted to the development of the risk profile every year.

Insurance-linked securities (ILS) will also gain importance, although they will have to pass extensive tests for full recognition - because of the extent of the basis risk and because placing an ILS transaction will most likely require having an internal model approved and in place.

Optimizing capital relief

An efficient reinsurance-buying strategy is about optimizing the capital relief, resulting in the best possible contribution to the insurance company's overall capital management. Thus, it can be expected that decisions on reinsurance cessions - risk mitigation - will be increasingly taken by the company's risk managers. The overall cross-portfolio and multiline reinsurance risk-mitigation impact and result will become even more important. Thus the risk-return profile, which shows the achievable risk and return options, will have to be considered. This brings insurance closer to the banking world where portfolio theory and risk-return charts are a traditional portfolio-management tool. The capital asset pricing model (CAPM) describing optimal asset (banking) portfolios under risk is currently widely employed in the investment sector.

In order to keep up with this trend, procedures and tools are required to measure, precisely and efficiently, the different risk and capital positions. One such solution is the PillarOne dynamic reinsurance analysis (PODRA), a specialized service that describes, analyses and measures non-life underwriting risk. Based on the PillarOne.RiskAnalytics open-source software platform (www.pillarone.org), PODRA is run jointly by the cedant and Munich Re.

The type of analysis that is required would cover the following issues:

• What is the overall annual risk situation?
• What are the main risk drivers?
• What is the overall capital requirement for the insurance policies written?
• What capital relief does the reinsurance programme provide?
• What is the solvency capital requirement (SCR) under Solvency II regulations? Where is it possible to extend a reinsurance relationship in order to relieve the capital situation?
• Which line of business promises the biggest reduction in capital requirements (assuming similar cession amounts)?
• What type of coverage promises the biggest reduction in capital requirements (quota share, surplus, WXL, CXL)?
• Is a (high) retention level appropriate for the client's overall risk situation?

Once the effect of different reinsurance structures has been assessed and the reinsurance programme best suited to a company's particular risk profile has been decided, the results of the analysis can be taken as the starting point towards implementing a partial/full internal model under Solvency II.

Reinsurance has always been a valuable risk-mitigation instrument. As the measurement of the underlying risk and the related capital becomes more holistic and more sophisticated, reinsurance will prove to be an even more efficient capital-management instrument.

Margarita von Tautphoeus is head of Solvency consulting at Munich Re

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