Reinsurance in Risk and Capital Management

Table of Contents

Acknowledgements

Abstract

List of Tables, Figures and Abbreviations

List of Laws, Directives, Rules and Regulations

1. Introduction
1.1 Background Information
1.2 Relevance of Study
1.3 Research Objective
1.4 Scope and Limitations
1.5 Dissertation Overview

2. Literature Review – Principles of Risk and Capital Management
2.1 Introduction
2.2 The Concept of ‘Economic Capital’
2.3 Economic Capital and Regulatory Capital
2.3.1 Solvency II – A Risk-Based Capital Framework 8
2.4 Economic Capital in Enterprise-wide Risk Management (ERM)
2.5 The Benefits of ERM
2.6 The Other Side of the Coin
2.7 Conclusion

3. Literature Review – Reinsurance as a Risk and Capital Management Tool
3.1 Introduction
3.2 Basic Principles of Reinsurance
3.2.1 Methods of Reinsurance
3.2.2 Types of Reinsurance
3.2.3 Forms of Reinsurance
3.3 Reinsurance within an ERM Framework
3.3.1 Risk Management Strategy
3.3.2 Identification and Assessment of Underwriting Risk
3.3.3 Definition of Risk Appetite
3.3.4 Risk Mitigation
3.3.5 Risk Measurement
3.4 Functions of Reinsurance in Risk and Capital Management
3.4.1 Capacity
3.4.2 Risk Spreading
3.4.3 Stability
3.4.4 Economic and Regulatory Capital Relief
3.4.5 Other Financial Benefits
3.4.6 Expertise
3.4.7 Protection
3.5 The Costs and Risks of Reinsurance
3.5.1 The Costs of Reinsurance
3.5.2 Risks Arising from Reinsurance
3.6 Reinsurance Management
3.6.1 Reinsurance Management Strategy (RMS)
3.7 Development of an Optimal Reinsurance Program
3.7.1 Setting Retentions
3.7.2 Choosing the Method of Reinsurance
3.7.3 Choosing the Type of Reinsurance
3.7.4 Choosing the Form of Reinsurance
3.7.5 Selecting Reinsurers
3.7.6 The Role of Reinsurance Brokers
3.8 The Impact of the Reinsurance Program on Economic Capital
3.8.1 Solvency I
3.8.2 Solvency II
3.9 Alternative Risk Transfer Mechanisms (ARTs)
3.9.1 Types of ARTs
3.9.2 The Benefits of ARTs
3.9.3 The Future of ARTs

4. Research Methodology
4.1 Introduction
4.2 Research Method
4.2.1 Preliminary Data Collection
4.2.2 Literature Review
4.2.3 The Empirical Phase
4.3 Reasons for the Choice of Methodology
4.4 Design of the Interview Schedule
4.5 Data Analysis
4.6 Conclusion

5. Findings
5.1 Introduction
5.2 ERM
5.2.1 ERM Pillars
5.2.2 Capital Management within ERM
5.2.3 Responsibilities for ERM
5.2.4 Benefits and Challenges of ERM
5.3 RMS
5.4 Functions of Reinsurance in Risk and Capital Management
5.5 The Costs and Risks of Reinsurance
5.5.1 Costs of Reinsurance
5.5.2 Risks Arising From Reinsurance
5.6 Development and Implementation of the Reinsurance Program
5.6.1 Setting Retentions
5.6.2 The Methods of Reinsurance
5.6.3 The Form and Type of Reinsurance
5.6.4 Selecting Reinsurers
5.6.5 Impact of the Reinsurance Program on Economic Capital
5.6.6 Technical Results
5.7 ARTs
5.8 Conclusion

6. Discussion of Findings
6.1 Introduction
6.2 ERM
6.2.1. The State of ERM
6.2.2. Perceptions of ERM
6.2.3. The Approach Towards Risk Management
6.2.4. The Approach Towards Capital Management
6.3 Reinsurance Management Practices
6.3.1 RMS
6.3.2 The Involvement of the Board
6.3.3 The Role of the Reinsurance Broker
6.4 The Process of Setting Retentions
6.4.1 The Initial Setting of Retentions
6.4.2 Changes in Retentions
6.4.3 Methodology Underlying Retention Changes
6.5 The Method, Form and Type of Reinsurance
6.5.1 The Methods of Reinsurance
6.5.2 The Forms and Types of Reinsurance
6.5.3 Exclusive Use of Non-Proportional Reinsurance
6.6 Selecting Reinsurers
6.7 Conclusion

7. Summary, Conclusions and Recommendations
7.1 Introduction
7.2 Summary
7.3 Conclusions
7.4 Recommendations
7.4.1 Recommendations for Local Companies
7.4.2 Recommendation for Managed Companies
7.4.3 Recommendations for the Regulator
7.5 Areas for Further Research
7.6 Concluding Note

Appendices
1 Interview Schedule – Local Companies A-1
2 Interview Schedule – Managed Companies A-8
3 Interview Schedule – Insurance Regulator A-15

References

List of Tables, Figures and Abbreviations

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Acknowledgements

This dissertation would not have been possible without the support of my tutor, Dr. Carmel Cascun BA, FCII, M.Jur., ACI Arb., LL.D, who guided and supported me throughout the entire research process. Sincere thanks to the special assistant on this dissertation, Mr. Peter Spiteri FCII, MIRM, whose technical insights and knowledge about every aspect of the subject matter proved invaluable. Thank you both for your time and patience.

My sincere gratitude goes to all the persons who helped me with the preliminary analysis, the formulation of the title and the preparation of the research proposal. I would also like to express my thankfulness towards all the interviewees who were willing to answer my questions honestly and diligently.

Finally, special thanks to Ms. Tanya Causon ACII, an ex-colleague at the MFSA and a wonderful friend, for sharing her experiences in the field.

Abstract

Widely advertised corporate failures and the European Commission’s Solvency II initiative are exerting pressure on insurers worldwide to improve their risk and capital management capabilities and to adopt a unified and integrated approach towards the management of their risk profile and capital base. Against the backdrop of these developments, the study focuses on one of the fundamental risk and capital management tools available to insurance companies worldwide, namely reinsurance. The objective is to evaluate reinsurance within the risk and capital management structures and processes of local insurance providers writing general business of insurance.

A rigorous literature review introduces economic capital as the concept which lies as the heart of Enterprise-wide Risk Management (ERM) by providing the link between risk and capital. It stresses the importance of an ERM framework that permeates the organisation and provides for maximisation of economic value through the amalgamation of risk and capital management. The literature review proceeds to discuss the manner in which reinsurance fits within ERM. First, it analyses the full implications of reinsurance, including the benefits, costs and the risks arising from reinsurance contracts. Subsequently, it emphasises the necessity of a sound reinsurance management strategy to serve as a basis for the development and implementation of the reinsurance program, thus enabling the company to recognise and manage the implications of reinsurance diligently and effectively.

The empirical process consists of in-depth personal interviews with Maltese insurance companies falling within the scope of the study and the Maltese insurance regulator. The former are divided into two groups, namely companies predominantly writing risks situated in Malta(‘local companies’)and managed companies writing risks situated outside Malta(‘managed companies’). The findings reveal that whilst both local and managed companies understand the theoretical risk and capital management properties of reinsurance, local companies are encountering difficulties in understanding the actual implications of reinsurance on the company’s aggregate net risk exposure and risk-based capital. These difficulties stem from a number of factors, namely, the absence of risk models, fragmented risk management, reliance of capital management on a deficient solvency regime that lacks a clear connection between risk and capital and heavy dependence on reinsurance brokers.

In light of the literature review and the empirical findings, the study concludes with a number of recommendations for local companies, managed companies and the regulator. These recommendations revolve around the need to strengthen and integrate the ERM pillars and to formalise and solidify reinsurance management structures and processes. These improvements require substantial efforts, cultural changes and management commitment, coupled with regulatory and supervisory initiatives. Nonetheless, the suggested improvements should empower Maltese companies to obtain an improved and holistic understanding of the true implications of reinsurance, thereby leveraging reinsurance decisions, maximising shareholder value and equipping themselves for the challenges of the upcoming Solvency II.

KEYWORDS: Reinsurance, Risk Transfer, Risk Management, Capital Management, Economic Capital, Enterprise-wide Risk Management, ERM.

Abbreviations

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List of Laws, Directives, Rules and Regulations

Laws of Malta

Cap. 403 of the Laws of Malta
Insurance Business Act, 1998

Cap. 123 of the Laws of Malta
Income Tax Act, 1949

Insurance Regulations

Legal Notice 286 of 2007

Insurers’ Assets and Liabilities Regulations, 2007

Legal Notice 158 of 1999 as amended by Legal Notice 41 of 2007

Insurance Business (Criteria of Sound and Prudent Management) Regulations, 1999

Insurance Rules and Directives

Insurance Rule 6 of 2007

Schemes of Operations Relating to Business of Insurance

Insurance Directive 27 of 2005
Insurers’ Internal Controls

EU Directives

2007/0143 (COD)- Amended Proposal for a Directive of the European Parliament and of the Council on the Taking-up and Pursuit of the Business of Insurance and Reinsurance; Solvency II; Recast

Directive 2005/68/ECof the European Parliament and of the Council of 16 November 2005 on reinsurance and amending Council Directives 73/239/EEC, 92/49/EEC as well as Directives 98/78/EC and 2002/83/EC.

Chapter 1 Introduction

1.1 Background Information

The term “reinsurance” has been defined in different ways by various writers. The most prevalent and arguably the most concise definition is that reinsurance is insurance for primary or direct insurance companies. Reinsurance contracts therefore insure contractual liabilities to pay claims arising out of contracts of insurance (Carter et al, 2000).

The reinsurance contract is an agreement between the insurer and the reinsurer and is separate and distinct from the insurance contract entered into by the policyholder and the insurer. Therefore, unless cut-through clauses oblige the reinsurer to pay amounts directly to the beneficiaries of the original policies in certain specified circumstances, the reinsurance contract does not establish any kind of legal link between the insured and the reinsurer (Cascun, 1994).

Since reinsurance is a form of insurance, it follows that certain basis principles, practices and concepts pertaining to direct insurance apply equally to reinsurance. In fact, both primary insurance contracts and reinsurance contracts fundamentally embody a promise of future payment upon the happening of specified uncertain future events, in return for the payment of a premium. Yet, reinsurance is such a specialised and distinctive form of insurance that it often merits consideration as a category of its own. In spite of its peculiarities, reinsurance remains an integral and indispensable part of the insurance system, providing policyholders with higher security at lower cost.

1.2 Relevance of Study

“For insurance companies worldwide, the ability to identify and manage risks as well as to use and allocate capital efficiently is becoming increasingly important”(KPMG, 2005; pg 2).

In the wake of high profile corporate failures and tough market conditions, insurers worldwide are under pressure to improve their risk and capital management. Indeed, providers of capital, rating agencies, regulators and other stakeholders are placing risk and capital management at the forefront in their evaluation of insurance companies.

The impetus behind these developments stems from the increased recognition of the benefits that stand to be derived from a unified risk and capital management framework. Undoubtedly, higher awareness of risk and capital management is also being heavily reinforced by the European Commission’s Solvency II initiative, which should be finalised and brought into force in 2012. Although the project is still undergoing changes and significant developments, Solvency II will certainly overhaul the regulatory framework within which European insurance companies operate. It will completely detach itself from its predecessor by determining capital adequacy on the basis of the true nature and extent of the risks faced by an insurance company.

Notwithstanding its importance, risk and capital management is a highly complex subject that remains elusive for most insurance companies. The complexity stems from the extensive variety of risks to which insurers are exposed, all of which carry their capital implications. It also results from the wide spectrum of tools, techniques and approaches which insurers may employ in order to manage their risks and capital.

Undoubtedly, “reinsurance is one of the major risk and capital management tools available to primary insurance companies” (Swiss Re, 2004; pg 3). Reinsurance enables an insurer to obtain its desired risk profile by transferring those risks which it cannot or does not wish to retain fully for its own account. It thus enhances the insurer’s underwriting capacity and alleviates capital strain. In addition, reinsurance homogenises insurance portfolios and stabilises financial results, thus protecting capital from depletion and aiding the preservation of an adequate solvency position.

Against the backdrop of the abovementioned recent developments, a significant number of foreign insurance markets have been subjected to various studies into the state of their risk and capital management and the manner in which reinsurance is employed as a principal risk and capital management technique. The local insurance sector is however devoid of these insights and hence lies the need to achieve the research objective outlined in the next section.

1.3 Research Objective

The objective of this study is to evaluate the role played by reinsurance in the risk and capital management of local insurance providers. In order to reach this objective, the study analyses and assesses: -

- risk and capital management within the local insurance sector;
- the functions and implications of reinsurance as a risk and capital management tool for Maltese insurers, including the effects, benefits and costs of reinsurance as well as the risks arising from reinsurance contracts; and
- reinsurance management within the local scenario, in particular the formulation and implementation of a reinsurance management strategy.

1.4 Scope and Limitations

In order to keep the dissertation within reasonable limits, companies carrying on long­term business of insurance fall outside the scope of this study. In addition, in as far as companies writing general business are concerned, this study considers only those companies whose head office is situated in Malta (hereafter referred to as “Maltese insurance companies”).

In light of the above, the study seeks to reach its objective by analysing relevant literature and by ascertaining the perspectives, views and opinions of Maltese insurance companies and the Maltese insurance regulator.

1.5 Dissertation Overview

This first chapter has introduced the dissertation. The next two chapters examine literature relevant to the subject matter of the study. Chapter 2 outlines the fundamental concepts of risk and capital management, thus providing the foundation for Chapter 3, which delves into reinsurance as a risk and capital management tool. Chapter 4 provides a detailed overview of the research methodology used to reach the study’s objective. Chapter 5 presents the empirical findings of the study, which are then discussed and thoroughly analysed in the subsequent chapter. Finally, Chapter 7 summarises the study, reaches conclusions and presents recommendations.

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Chapter 2 Literature Review

2.1 Introduction

This chapter introduces the concept of economic capital and distinguishes it from regulatory capital. It subsequently discusses Enterprise-wide Risk Management (ERM) which rests on economic capital to provide a clear link between risks and capital. Finally, this chapter delineates the benefits and challenges of an integrated approach towards risk and capital management.

2.2 The Concept of ‘Economic Capital’

An insurer’s capital must always be aligned to its risk profile and risk appetite, which implies that risk management and capital management are inextricable. A company that allocates its capital efficiently is able to assume more risks and conversely sound risk management lowers the capital required to support the business.

The key concept in risk and capital management is that ofeconomic or risk-based capital,defined as the capital required to serve as a buffer against unexpected losses, given a defined time horizon and a specified level of risk tolerance (KPMG, 2005). The insurer’s technical provisions meet expected losses; capital then cushions the risk of unexpected losses assumed by the company or inherent in its business activities (Swiss Re, 2004).

Chapter 2 Literature Review

2.3 Economic Capital and Regulatory Capital

“Lessons learned from 2000-2002, when financial markets fell sharply and from insurance company failures have increased the scrutiny of both the industry and regulators on the importance of best risk management practice”(CEA and Tillinghast Business of Towers Perrin, 2006; pg. 2).

Regulators worldwide have now moved away from emphasising risk management as an isolated concept towards recognising the importance of intertwining risk management with capital management. Therefore, they are increasingly emphasising the importance of solvency regimes that are sensitive to the risks faced by an insurance company and that remain adequate at all times as the company’s risk profile changes.

The current solvency framework, Solvency I, embodied within the Assets and Liabilities Regulations, 2007 (“the Regulations”), focuses mainly on underwriting risk and specifies capital requirements for general business in terms of a simple set of parameters that are applied to technical provisions and premiums, as shown in Table 1. These simple factors cannot adequately capture the diversity of risks contained within a typical insurance portfolio. In fact, the regime contains a number of contradictions. For example, it does not take account of the strength of technical provisions, penalising insurers that set more prudent reserves rather than rewarding them with lower solvency requirements. Similarly, a company which increases its general business premiums without changing its liabilities increases its capital requirements, despite the obvious reduction in insolvency risk.

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Table 1 - Required Margin of Solvency for General Business

Compiled from: Second, Third and Fourth Schedules to the Assets and Liabilities Regulations, 2007

In addition to the above, investment risk and credit risk are taken into account in a rather crude and approximate manner in the calculation of the actual margin of solvency.¹ Other risk areas, such as operational risk are completely ignored and no allowance is given for diversification and risk mitigation techniques such as financial hedges (Swiss Re, 2006).

These limitations led to the widespread recognition that Solvency I causes a significant divergence between regulatory and economic capital, imposing regulatory capital requirements that are either too low to ensure adequate solvency or alternatively excessively high, locking in capital that could be applied more profitably elsewhere. Insurance companies and supervisors alike do not enjoy the comfort of a regulatory capital requirement that reflects the true economic capital required by the company. Thus, supervisors lack the tool for fostering high quality integrated risk and capital management, which is undoubtedly fundamental to policyholder protection. On the other hand, insurers are left with the option of either developing their own economic capital models or else basing their entire capital management on a simplistic and flawed regulatory capital framework.

2.3.1 Solvency II – A Risk-Based Capital Framework

In 2001, the weaknesses of Solvency I spurred the European Commission into the initiation of the Solvency II project. Solvency II will be based on three main pillars, summarised in Table 2 below.

Table 2 - The Three Pillars of Solvency II

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Pillar 1 will prescribe two capital requirements with different purposes. The Minimum Capital Requirement (MCR) will represent the bottom level of capital below which the risk of insolvency escalates to unacceptable levels. Breaches of the MCR will thus trigger immediate and drastic supervisory intervention. On the other hand, the Standard Capital Requirement (SCR) will be designed to absorb significant unforeseen losses, enabling the insurance company to meet all its obligations as they fall due over a one-year time horizon, with a tolerated probability of ruin of 0.5%² (EC, 2005). The SCR is therefore nothing more than risk-based economic capital (GDV, 2006).

Being the bottom capital level, the MCR will invariably be calculated using an EU-wide simple and robust formula, thus promoting a high level of consistency and transparency.

A different approach will however be taken with the SCR (Dhaene & Sterzynski, 2006). A standard formula will be prescribed that computes a capital charge for the different risk areas faced by an insurance company, as shown in Table 3. These charges will then be aggregated, giving appropriate recognition to diversification benefits and risk-mitigation techniques (ABI, 2006).

In a further attempt to align economic and regulatory capital, Solvency II will provide for two important measures.

The first measure will allow insurers to depart from the standard formula wholly or partially and to calculate regulatory capital using their own internal models (Kredittilsynet, 2006). Understandably, internal models will be subject to supervisory review and approval and will be required to meet a prescribed set of criteria. One of the most important of these, outlined in Article 118 of the Solvency II Framework Directive³, will require the model to meet the ‘use test’ by playing a central role in the company’s system of governance and capital assessment and allocation processes. Hence, Solvency II will attempt to put an end to corporate cultures that perceive solvency capital calculations as a necessary regulatory exercise detached from business operations.

The second measure will give regulators power to impose an add-on to the SCR, in those exceptional circumstances where it fails to reflect economic capital, namely where:

- the standard formula does not appropriately reflect the company’s risk profile;
- the internal model adopted by the company and approved by the supervisor ceases to capture certain quantifiable risks adequately; or
- the company’s system of governance deviates significantly from the qualitative requirements of Pillar 2.

Table 3 - Risks Addressed by the Standard SCR Formula

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2.4 Economic Capital in Enterprise-wide Risk Management

The risk-based capital concept embedded at the core of Solvency II “will reinforce insurers’ focus on risk/return fundamentals and will increase professionalism regarding risk-adequate pricing and risk and capital management in the insurance sector” (Swiss Re, 2006). Nevertheless, as the rationale underlying Pillar 2 implies, the value of economic capital will not be fully exploited if the concept remains an isolated one which exists solely to meet regulatory requirements. To leverage the underlying concept, economic capital must be fully embedded within the organisation’s culture, policies and procedures through an Enterprise-wide Risk Management (ERM) framework.

ERM emerged in the wake of widely advertised massive losses and corporate collapses, which highlighted the ineffectiveness of traditional fragmented approaches to risk management. ERM focuses on increasing shareholder value through holistic, integrated risk management, which enables aggregation and netting of risks and a proper evaluation of the impact of different scenarios over the entire organisation. Given that the overall risk faced by an insurance company is a complex combination of many different factors, economic capital provides a common measure that allows a company to aggregate the effect of completely different risks and to estimate the capital needed to withstand such risks. Thus, the concept of economic capital must necessarily provide the foundation for every sound ERM system (Financewise, 2007).

An insurance company’s ERM must rest on the following pillars: -

- A Risk Management Strategy

Aligned with and embedded within the company’s overall strategy and objectives, the risk management strategy should lay the foundation for the other pillars. The strategy must be formulated concisely at Board level and clearly communicated, such that it cascades downwards and is embraced by employees at all levels.

The formulation of the strategy must be underpinned by the statutory requirement outlined in Article 8(1)(b) of the Insurance Business Act, 1998, which states that an insurance company’s activities must be limited to business of insurance and any other business arising therefrom. Hence, for example, Insurance Rule 6 of 2007 – ‘Schemes of Operations Relating to Business of Insurance’ (“Insurance Rule 6”) prohibits investment risks that originate from speculative investment trading.4 In this regard, the strategy must ensure that any risks assumed by the company arise directly from its business of insurance.

-Risk Identification and Assessment

In order to feed the risk management strategy and to provide a basis for on-going risk management, an insurance company must establish processes for the identification of key risk exposures and must devise and monitor proper indicators of any material changes in such exposures.

Identified risks must be thoroughly assessed, not on a silo basis but with a clear understanding of the potential correlations among the various risks.

-Definition of Risk Appetite

The insurance company must use the insights obtained from its risk assessment process to define its risk appetite, ideally expressed as the maximum probability of default tolerated within a given time horizon. The risk appetite must then be translated into a statement of the nature and magnitude of risks that the company wishes to retain.

Defining the risk appetite can prove taxing and requires a thorough understanding of the fundamental trade-off between risk and return. Although the trade-off implies that a company that assumes more risks earns a higher return on a long-run average basis (Jones, 2002), management must understand that on a short-term basis, the very act of assuming risk necessarily means that actual returns may be lower than expected. Economic capital should exist in fact to cover such volatility risk.

-Risk Mitigation

The company must mitigate those risks that exceed its desired risk retention. One of the most important tools for risk mitigation is risk transfer. This is where reinsurance comes in as a vital risk transfer mechanism, as described in the next chapter.

-Risk Measurement

The next pillar involves the development of appropriate risk measures which are capable of measuring the amount of capital needed to withstand the retained risk exposure during a defined time horizon with the defined level of confidence (Deloitte, 2006).

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¹ Refer to the asset admissibility rules and asset exposure limits contained in Part IX of the Regulations and the Seventh Schedule to the Regulations.

² From a regulatory perspective, ruin occurs when the amount of admissible assets falls below the amount of technical provisions.

³ 2007/0143 (COD) - Amended Proposal for a Directive of the European Parliament and of the Council on the Taking-up and Pursuit of the Business of Insurance and Reinsurance - Solvency II – Recast