Property Insurance: The Intersection of Reinsurance, Catastrophe Modeling and Exposure Management

As regulators, financial examiners and analysts perform risk assessments of insurance organizations with significant property insurance business, it is important to understand the relationships between reinsurance, catastrophe modeling and exposure management. The objectives of the reinsurance program should be clear and well-defined, catastrophe modeling should support the terms and conditions of the program, with exposure management providing the mechanism for management monitoring.

The effectiveness of an insurer’s overall risk management program often boils down to how well it structures its reinsurance program around its risk appetite, quantified with robust catastrophe modeling and monitored with rigorous exposure management.

This information serves to assist regulatory examiners and analysts in their risk assessments of property insurance, and illustrates the intersection of reinsurance, catastrophe modeling and exposure management. It also outlines the practical considerations when reviewing a company’s reinsurance program as part of Risk-Focused Financial Examinations.

Reinsurance Program Objectives
An insurer’s goal in its reinsurance program may be any one or a combination of the following:

• Increase capacity to write more business or meet the specific needs of larger accounts
• Mitigate earnings volatility
• Provide surplus relief to improve financial leverage

Different reinsurance structures are designed to satisfy these objectives (e.g., quota-share treaties, excess-of-loss treaties, property catastrophe treaties, and surplus share treaties, to name a few).

Financial examiners and analysts should be comfortable that management has a good understanding of their reinsurance program objectives and can articulate this clearly. Management should be able to prioritize its objectives so that the reinsurance program can be structured effectively and efficiently, without gaps or unnecessary overlaps.

For example, a company that has a functional operational model and acceptable performance metrics, but is surplus-challenged, may find that a simple quota share arrangement could “free up” capital by temporarily ceding off a portion of the written premium.

Another example could involve a company with surplus to write property risks up to a certain amount--- say $5 million. However, the insurer has a business model, distribution sources and underwriting expertise that could support much larger accounts---say up to $50 million. In this case, an excess of loss treaty could support the company expanding its strategic objectives by writing larger accounts.

How Much Risk Should Be Retained?
The question of how much risk should be retained is fundamental to the risk management assessment. As an example, for a traditional excess-of-loss treaty, a primary insurer’s risk management strategy is built on its retention and reinsurance coverage limit. Let’s assume the insurer has capital and surplus of $100 million, written premium of $150 million, and a target annual profit of $10 million (i.e., 10 percent of capital and surplus). Management needs to then consider how much of a net loss it is willing to absorb from one large claim (or one large catastrophe event). The amount can be a percentage of surplus, a percentage of earnings, number of combined ratio points, or a combination of these metrics.

In this case, management may decide the insurer can reasonably absorb a large individual claim of up to 2 percent of surplus ($2 million per claim) or 2 points of combined ratio ($3 million per claim) or 15 percent of earnings ($1.5 million per claim).

From these metrics, management may settle on a retention of $2 million per claim. While this is an oversimplification, the point is that management needs to determine the metric (or combination of metrics) and actual dollar amounts of risk the insurer is willing to accept.

The reinsurance coverage limit might revolve around the insurance policy limits the company offers. For casualty coverages, suppose the company offers policy limits as high as $10 million per claim, with most policies equal to or less than $5 million per claim. Then, assuming the retention defines the company’s risk tolerance for any individual claim, the reinsurance coverage limit could be the amount in excess of the retention.

Based on this example, it might mean an excess-of-loss reinsurance treaty of $8 million excess of $2 million per claim. This could also be accomplished using an excess-of-loss treaty of $3 million excess of $2 million per claim, with facultative reinsurance purchased on an as-needed basis for policies with limits above $5 million.

Here are some additional considerations for structuring reinsurance:

• Adopt a formal process. Although the level of analysis and sophistication may vary, risk tolerance ultimately is a management judgement; nonetheless, insurers should have a disciplined process to inform these decisions with reasonable frequency.
• Conduct benchmarking. Benchmarks can be obtained and examined through a variety of sources. Reinsurance intermediaries may be helpful. Also, publications, such as A.M. Best Reports, provide information on reinsurance structures of peer companies (such as personal lines, standard commercial lines, workers’ compensation, excess and surplus lines carriers, etc.).
• Evaluate quota-share arrangements. The use of quota-share reinsurance enables primary carriers to partner with – and potentially benefit from – the underwriting expertise of a reinsurer, especially on new lines of business where the reinsurer may have a certain underwriting expertise. 

Aim for diversification. For a large reinsurance program, it is beneficial for there to be a panel of reinsurers diversified around those with high ratings or fully collateralized (by letters of credit, trust funds or other funds held arrangements). It is preferable not to have an inordinate portion of the reinsurance program with a single reinsurer, even a highly rated one.

• Consider reinsurance market conditions. When pricing is soft, as has generally been the case in recent years, primary insurers might opt to purchase reinsurance below the levels of their otherwise determined risk appetite. For example, if the reinsurance cost for the $1 million to $2 million layer is less than the company’s estimated cost of retaining these losses, then it may be cost effective to transfer this risk to the reinsurance market.
• Recognize the necessity versus cost of the reinsurance program evaluations. Suppose an insurer needs to obtain a certain amount of reinsurance from a risk management standpoint, but the cost is prohibitive; this could suggest there may be issues with its business model. For instance, it may have too much risk concentration – in a specific coverage line, geography or a class of business or it may be too small from the standpoint of scale.
• Review insurer’s surplus position versus its reinsurance needs. Insurers that have “excess surplus” (i.e., more surplus than is otherwise needed to support the business model) might notionally earmark the excess to replace some reinsurance coverage. “Excess surplus” may be defined as that in excess of a specified statutory risk-based capital (RBC) ratio or an A.M. Best BCAR or some other qualitative measure.

Using the previous example of an insurer’s surplus position, let’s assume the company is considering an excess-of-loss reinsurance treaty for $3 million excess of $2 million per claim. Let’s say the company has “excess surplus” of as much as $5 million and this excess margin is more than sufficient to fund expected losses in the $2 million to $2.5 million layer. In this scenario, the insurer might choose an excess-of-loss reinsurance treaty of $2.5 million excess of $2.5 million (as opposed to $3 million excess of $2 million), thereby reducing its reinsurance costs by self-funding the $2 million to $2.5 million layer with “excess surplus.”

Addressing Catastrophe Risk
A critical element of assessment for insurance companies writing property business involves addressing catastrophe risk. The process begins with understanding the insurer’s risk appetite and process around exposure management.

The effective use of catastrophe modeling enables insurers to quantify their risk profile, determine their risk appetite and ultimately structure an appropriate property catastrophe reinsurance program.

Working with their reinsurance broker/intermediary or an independent modeling firm, the insurer provides detailed, policy-level exposure data on its property business (i.e., zip code, street address, construction type, exposed values, etc.).

The data are run through various catastrophe models to establish a risk profile. While not perfect, the output provides benchmarks and insight for developing a property catastrophe reinsurance program.

Consider this hypothetical example:

A probable maximum loss (PML) is shown for various time-frames (such as a 100-year, 250-year, 1,000- year event, etc.). PMLs are derived from the models by overlaying the company’s specific risk profile against the model assumptions with respect to weather-related or other natural catastrophes. The 100- year PML represents the company’s expected gross loss (before reinsurance) from an event that might occur once every 100 years (or with a 1 percent probability).

Assume the PML summary for our hypothetical company with surplus of $100 million is as follows:

Next, management selects the PML it wants its catastrophe reinsurance program to protect against and the net loss it is comfortable retaining from a large catastrophe event. Suppose management is comfortable retaining a net loss of up to $5 million from any one large catastrophe event (i.e., 5% of its surplus). Further, assume that at the top end, management decides to protect against a 100-year PML event.

Thus, the company would seek to secure a catastrophe reinsurance treaty for $70 million excess of $5 million per event. The tower of this reinsurance program, $75 million, matches the 100-year PML amount.

Some points to consider:

• Be aware of standard benchmarks. Regarding PML levels to protect against, common industry benchmarks are generally in the 100-year to 250-year level.
• Understand modeling capabilities and limitations. Catastrophe modeling tends to be far more granular than discussed in this example. Notably, PMLs are typically shown by peril (i.e., wind/hail, winter storms, tornadoes, earthquake, etc.) and geographic region, as well as other nuances.
• Articulation of risk appetite. An insurer’s risk appetite/tolerance statement might be expressed as: The company is willing to lose “X percent” of its surplus from a “Y-year” PML event.
• Variations of coverages in the reinsurance layers. Catastrophe reinsurance programs typically are far more complex than the examples provided in this article; there typically are multiple coverage layers in a reinsurance program, with the primary insurer participating in certain layers.

Keys to Effective Exposure Management
Once an insurer determines its risk appetite, the next step involves management monitoring the portfolio to ensure the company’s actual business stays on track. Following are some keys to effective monitoring that the regulatory examiner or analyst might look for:

• Obtain robust data. Effective management starts with detailed policy data, which must be granular and readily accessible to produce management monitoring reports.
• Generate regular reports (monthly or more frequently). Show actual total insured values (TIVs) by granular geographic areas (such as zip code or specified distance from the shore, etc.). Management should monitor that actual TIVs in sensitive areas are in line with the assumptions underlying the catastrophe modeling and reinsurance program. Any areas growing beyond the risk appetite levels should then be identified, researched and acted upon.
• Scrutinize TIV capacity allocation. Some insurers allocate TIV capacity to individual agents, consistent with the general risk appetite determinations, and then monitor actual TIVs by agent against their respective allocated capacities. Others do not explicitly allocate TIV capacities to individual agents, but rather monitor the TIVs and deal with issues as they arise. The key is to be diligent in monitoring and acting, as needed.
• Define responsibilities. There should be established clear accountabilities for maintaining the data and producing the monitoring reports, as well as reviewing the reports and reporting to underwriting and/or senior management. It should be clear as to who is responsible for recommending or initiating actions on the red flags. Management must be committed to the process from a risk management standpoint and willing to make difficult business decisions when necessary.

Request Assistance When Necessary
When performing risk assessments of insurance organizations with significant property insurance business, it can be complex determining the intersection of reinsurance, catastrophe modeling and exposure management. Be sure to get help from insurance advisors to navigate the challenges and conduct a successful Risk-Focused Financial Examination.

When reviewing a company’s reinsurance program as part of Risk-Focused Financial Examinations, it’s important to address practical considerations of reinsurance, catastrophe modeling and exposure management. Our team of insurance advisors can help.

WE CAN HELP