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? Conceptual Framework Methodological Approach Case Study: XYZ Insurance Key Issues

The Challenge:

How Much Reinsurance to Buy, and What Mix?

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

Buy less reinsurance?

Buy more reinsurance?

Regulatory and rating agency

Buy different protection?

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

We have excess capital Keep net premiums up Eliminate unnecessary expenses and transaction costs Why share profits? Maximize investable assets

pressure
Its cheap Everyone else is grabbing this

Life/Health for workers compensation)

Contingent debt/equity capital CAT futures Blended products that go

deal
Let the reinsurers share the

coming unprofitable results

Predictions of future

beyond traditional hazard risk

catastrophes and mass torts

Support the higher limits were

selling
We cant lose on this latest

reinsurance proposal
Better safe than sorry
Chief Financial Officer

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

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?

Conceptual Framework

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.

Components of a reinsurance program can be compared to each other, and to other alternatives, by viewing reinsurance as rented capital
Reduction in Required Capital

Reinsurance Gross Capital Requirement

Net Capital Requirement

Cost of Reinsurance Expected Ceded Premium Ceding Commission Expected Ceded Losses

Cost of Rented Reinsurance Capital

Cost of Reinsurance Reduction in Required Capital

Is reinsurance a cost effective source of capital? It adds value when this cost of

capital is below the cost of alternatives

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Reinsurance strategy alternatives can be compared using an Asset/Liability Efficient Frontier (ALEF) framework

50%

40% L Expected Return 30% H 20% K R C D E F

Q
O P B

N A

M 10%

0% 0.0% 0.5% 1.0% Level of Risk 1.5% 2.0%

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Either conceptual framework begs several questions

How to quantify an insurers 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 insurers

Expected Returns?
How to translate the potential for variability in future results into a usable and

meaningful measure of Risk?

What is an insurers Required Capital? With no reinsurance With current reinsurance With alternative reinsurance portfolios

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Methodological Approach

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

Line of Business A Business volume Business characteristics Pricing Claims Starting Balance Sheet Reinsurance Program Capital Structure Non-Insurance Income Investment Strategy Tax Calculator Affiliate Results Corporate Elements

Paid and Reserved

Expenses Cash flow pattern Reserving patterns Policyholder dividends Financial Calculator

Line of Business B Line of Business C

Year 1 Financial Results Balance Sheet

... Line of Business Z

Income Statement

GAAP Statutory Economic

Analyzer

Measures of Risk

Return
Capital Requirements

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Modeled financial outcomes are translated into Risk Measures specific to the insurer Identify Key Reasons to Buy Reinsurance
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

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

cost
Etc.

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We have explored several illustrative alternatives to traditional statistical measures of risk and variability
Probability of Operating Result = X$
Below Target Return measure

Expected Policyholder Deficit measure

Target Return Capital Operating Profit Operating Loss Unfunded obligations

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

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The advantage of Below Target Risk over standard deviation can be illustrated by an example
These two return probability

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

Prabability

Probability

distributions have the same expected return of 13%, and the same standard deviation

Rate of Return

13%

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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
Expected Ceded Premium Ceding Commission Ceding Commission Expected Ceded Losses Cost of Reinsurance

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.
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

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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

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While probability of ruin is the simplest form of risk-capital constraint, more complex constraints can be defined
Dimensions of Risk-Capital Constraints
Probability Metric

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

Time Period and Form of Threshold

Measurement Basis

Perspective

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%

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Case Study: XYZ Insurance

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

10

12

14

16

$ Millions
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XYZ measured each components contribution to reducing insolvency risk, and translated that into a reduction in required capital

Marginal Reduction in Required Capital

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

20

40

60

80

100

120

140

$ Millions

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Some program elements appear to add significant value; others may be inefficient

Implied Marginal (Normative) Cost of Reinsurance Capital

Property First Cat Special Property Fac Casualty Working XS E&O Program XS Property High Cat Umbrella QS Work Comp Working XS Std Property Risk XS Surety QS Casualty High XS Marine XS Aviation XS Prof Liab XS Special Property QS Casualty Clash

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

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

Strategy A B C D E

Casualty Working XS

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

No Change
Double Retention Double Retention Double Retention Treble Retention Treble Retention Treble Retention

F
G

Treble Retention

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

to changes to the existing program structure

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Each strategy was evaluated in terms of its impact on risk and return

12%

Expected Return

11% E D C B A 10% F

0.9%

1.0% Below Target Risk

1.1%

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Key Issues

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

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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

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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

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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.

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