Reinsurance

Managing risk in reinsurance

Managing risk lies at the heart of what reinsurers do. In recent decades, the scope of risk management has widened significantly. It is no longer confined to traditional underwriting risk, but also encompasses risks to a company’s investments, its capital base and liquidity positions.

While it might look like reinsurers take a bet on whether an adverse event will happen or not, decisions about risk-taking are made in a controlled way and enabled by a very sophisticated risk management framework. It is about anticipating, identifying, assessing, modeling and controlling risks.

Risk management has to start at the top of the organisation and it is important to clarify roles and responsibilities and distinguish between the risk owner (board), the risk taker (business unit) and the risk controller (independent risk manager). Senior management is the ultimate risk owner of the company and plays an important risk management role by defining the company strategy. Business unit managers are the actual risk takers and have the responsibility for properly assessing and pricing risks. The specific risk management function, under the stewardship of the chief risk officer, is responsible for risk governance, risk oversight and independent monitoring of risk-taking activities. Each risk that the company assumes contributes to the overall risk profile and affects capital requirements.

A reinsurer’s capacity to safely assume complex and large risks depends, not only on its capital strength, but also on its ability to spread its risks. Reinsurers achieve a high degree of diversification by operating internationally, across a wide range of different lines of business and by assuming a large number of independent risks. Diversification over time is also an important factor. The more risks meeting these criteria that are added to a reinsurer’s portfolio, the lower the volatility of that reinsurer’s results. Lower volatility translates into reduced capital requirements, or alternatively, allows the reinsurer to take on more risk with its existing capital base.

The core business of insurers is to take insurable risks off households’ and firms’ shoulders. Before assuming these risks on their balance sheet, insurers examine, classify and price them. The underwriting process in the reinsurance industry is very similar; the major difference is that the risks are assumed from insurance companies.

An insurer seeking coverage provides the reinsurer with the relevant data. The reinsurer then determines whether additional information about the characteristics of the insured objects or persons is needed. In non-life reinsurance, this usually includes information about an object’s specific location, value and particular exposure to certain risks. For individual buildings, for example, the specific exposure can be established through flood or wind zone maps. In life reinsurance, underwriting decisions are essentially based on information about the risk of death or illness of the policyholder, such as age, gender, medical and lifestyle factors.

When assessing risks, any insurer or reinsurer must take into account the fundamental principles – and limitations – of insurability. Disregarding these constraints would ultimately jeopardise the (re)insurer’s solvency and ability to honour its obligations. But that also means that certain exposures remain uninsurable.

The insurance business has two sides. One is taking the risks; the other is managing assets to cover those risks. Reinsurers collect premiums and, in exchange, they provide their clients with protection. Reinsurers are thereby obliged to indemnify their client after a claim event. Generally, there is a time-lag between the premium payment and the claim payment during which the funds are held on the reinsurer’s balance sheet and can be invested in different asset classes. How long the funds are held differs significantly between lines of business and contract structure and influences the investment decision.

This may appear a straightforward task, but assets and liabilities move: the value of invested reserves and estimated future claims can both change significantly with fluctuations of the capital markets. Matching and then managing the relative changes between liabilities and investments is a core competency of any reinsurance company. This process is known as Asset-Liability Management (ALM). The ALM process also takes into account other investment constraints, apart from the matching of the liabilities, such as the company’s overall risk tolerance and regulatory restrictions.

For any insurer or reinsurer, capital is the prerequisite for assuming underwriting, financial market, counterparty credit and operational risks. Capital provides a buffer against unexpected losses. These could come from different sources, such as when claims payments exceed premiums and investment income, when loss reserves turn out to be insufficient or assets are impaired (for example, during severe stock market slumps, as we witnessed in 2001-2003 and 2008-2009). Capital management must ensure that the company is able to withstand unexpectedly high levels of loss. Any discrepancy between a reinsurer’s risk profile and its capital base needs to be addressed by raising additional capital, transferring risk to third parties (for example, through retrocessions, which are cessions to other reinsurers, or Insurance-Linked Securities) or by reducing the amount of risk assumed in underwriting and investment activities.

Liquidity management ensures that the company is able to pay claims and meet all financial obligations when they fall due. Insurance and reinsurance companies generate liquidity in their core business through the premiums they receive up-front when providing a (re)insurance cover. As such, they effectively pre-fund future claims payments. Therefore, liquidity risk is limited. Nevertheless, it is important to monitor and manage liquidity actively to have sufficient liquidity even in extreme situations. A reinsurer’s capital and liquidity management have to respond to various and partially conflicting stakeholder interests: Customers, that is, primary insurers, care about the prompt payment of claims. Regulators focus on policyholder protection and – in light of the financial crisis – overall systemic stability. Rating agencies are primarily interested in capital being sufficiently available to honour obligations to policyholders and debt holders. And investors seek attractive risk-adjusted returns and put pressure on companies to maximise capital efficiency. While all stakeholders agree that a reinsurer should have an adequate capital position, there are different views as to how capital adequacy should be measured.
These differences in perspective reflect the dynamics of the regulatory, accounting and competitive environments and add significantly to the complexity of a reinsurer’s capital and liquidity management processes. The convergence of these perspectives towards a consistent economic view has gathered pace recently (partly driven by Solvency II) and is ultimately expected to prevail.

Conclusion

Over the last twenty years, risk management has evolved into an independent discipline driven by a combination of external events, advances in modeling and an increasing awareness of large-scale and interconnected risks. Initiatives such as Solvency II in Europe and SAM in South Africa will drive risk management further as they demand more transparency. Transparency is a non-negotiable quality of the entire risk management process. Indeed it can be argued that it is the major driver of the successful implementation of quantitative risk management and risk governance.

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