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:
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:
Calculating risk assessment of property insurance while analyzing reinsurance, catastrophe modeling and exposure management is a complex process. Our team of insurance advisors can help simplify the process.
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.
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:
|Time Horizon||PML Amount|
|50 Year||$25 million|
|100 Year||$75 million|
|250 Year||$200 million|
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:
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:
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.