Raising the bar on reinsurance

Jennifer Ah-Kin and Richard Rodriguez consider the how, why, and wherefore of outwards reinsurance optimisation

While price optimisation continues to be a hot topic in certain fields, reinsurance optimisation and analysis is often a neglected subject. Yet each year, companies routinely spend significant amounts on their outwards reinsurance purchase in exchange for shelter from the worse of adverse claim experiences.

Over the last three years, company returns across a number of Lloyd's syndicates indicate an average reinsurer loss ratio of some 50%, while insurers can be seen often to load gross premiums by a factor of 10% or more in anticipation of expected profits being passed out to their reinsurer (see figure 1).

So, given the cost of cover and the potential profits being retained by the reinsurance sector, why are insurers not acting further to ensure they purchase the most efficient and effective reinsurance programmes possible given the business they write and their appetite for retaining risk?

Last year's programme seemed fine to me

Despite the tractability of a simple optimisation analysis exercise, it’s often at this first step that many falter. Lack of resource and expertise are commonly cited as well as credibility issues regarding the resulting technical analysis, in a field where the decisions made are based at least, if not much more, on human factors rather than quantitative reasons.

Existing broker relationships, reluctance to deviate from the previous year’s ‘perfectly adequate’ programme, and the potential fragmentation of the reinsurance purchase structure (with local branches making individual purchase decisions) all contribute to inaction in this potentially contentious area.

However, the inherent uncertainty of results, always present in any type of technical analysis, is no reason to dismiss the exercise straight out. Even if decisions ultimately come down to a management judgement call, any change to the reinsurance programme can potentially have a significant enough effect on profitability that doing nothing in this area cannot be a reasonable course of action.

The case for optimisation

Financial benefits are often the most persuasive argument, and given the sizable proportion of gross premiums ceded to reinsurers, it’s not difficult for even a seemingly small alteration in the outwards reinsurance structure to reap significant results in terms of efficiency. Beware though, for while a reduction in reinsurance expenditure is often the anticipated outcome from an exercise such as this, it may not actually be the case when optimising for the most effective reinsurance programme.

Even the act of building a model for analysis is a sure-fire way to improve understanding of past and current programmes and performance to date, as well as establishing a clearer picture of the gross claims environment driving the need for reinsurance in the first place. With large insurers in recent years opting out of lower level purchases, the need to fully understand your business’ underlying claims profile has never been greater. Establishing a comprehensive view on what reinsurance does (and should do) for your business will also benefit you in broker and other third-party negotiations, come the next renewal season.

The current ICA regime has already encouraged businesses down this path, and the advent of Solvency II and the implementation of the ‘use test’ will further necessitate a much finer look at reinsurance modelling in general, especially given the recognised weaknesses of the Solvency II standard formula in regards to non-proportional reinsurance. With a strong move in the UK towards bespoke internal models, many companies have already laid the groundwork for a reinsurance optimisation analysis exercise, even if they have yet to carry out the process.

Things to consider

Given that any reinsurance exercise will draw upon several areas of expertise and management, there are a number of elements on which decision makers must come to a common understanding:

Risk appetite – How risk-averse are we as a company? Is a 1 in 200 year risk of insolvency a reasonable measure, or do we use a different view? Any change to the current reinsurance programme will require a framework in which to measure the potential impact.

Value of reinsurance – For some insurers, an adequate reinsurance programme is an absolutely necessity, especially for smaller and newer market players, to allow for growth and maintenance of underwriting capacity; for others, reinsurance is merely a useful tool, to be used as and when required.

Reinsurance objectives – What purpose does the current reinsurance programme serve? Capital adequacy, support of premium volumes, and profit stability may all be valid yet conflicting objectives when it comes to outwards reinsurance purchase. The idea of optimisation is all very well, but it must be underpinned by a clear understanding of what 'optimal' means for the company in question.

Then there's the consideration of external factors: the availability and cost of raising additional capital, what the reinsurance market is offering in terms of structure, capacity, price and security, and regulatory and rating agency requirements, to name just a few. Broker and supplier relationships also come into play, as does the balancing of local versus global objectives.

Indeed, the latter is a common point of debate that many companies face during such an analysis: the issue of satisfying local targets and the need for managers to control their business, while also accessing economies of scale and diversification on a global level. Of course, centralisation issues are hardly a new topic for large insurers, but with reinsurance, unlike say a large software acquisition, there is scope to heavily affect local ways of operation and, perhaps more poignantly, remuneration.

The process

Firstly, the data. The higher the quality and the finer the detail, the easier it will be to extract the necessary information. Items such as claims amounts (gross and net of reinsurance), payment patterns, premiums, commissions, and reinsurance contract details will commonly be required.

After adjusting for inflation and other trends, the next step is to construct a gross model of premiums and claims. Here, key decisions must be taken as to the level of detail required for the exercise, in relation to the current (and future) reinsurance programme – for example, what classes of businesses will be considered (and how they will be aggregated), how to deal with multiple entities, and the modelling of catastrophe perils. This will often take the form of a simulation-based model, allowing the investigating of extreme events as well as average results.

The next stage will model the existing reinsurance programme and produce summary output for further analysis. Here, outputs can be verified by the relevant stakeholders, to gain initial confidence in the new project. Given the initial analysis, further reinsurance options can be implemented and reviewed and key scenarios filtered out for in-depth analysis and discussion. It therefore is important that this area of analysis is carried out in a flexible modelling framework, to allow alternative programmes to be tested and reviewed as efficiently as possible.

The whole process should allow for outputs that are easy to generate, interpret, communicate, and audit.

So what now?

Any discussion of reinsurance ultimately leads back to a discussion of capital: capital requirements, capital allocations, capital returns. And with reinsurance playing a crucial role in these key areas, even the simplest optimisation analysis can yield surprising, and often beneficial, results.

With more and more emphasis being placed on understanding a company's underlying risks, by both internal and regulatory sources, many companies stand to gain from a closer look at this potential area of technical analysis; even if, ultimately, human and market factors continue to drive the current purchase process.

Reinsurance optimisation is a key area where we actuaries can increase our profile and deliver the big benefits to the business. Let's not waste it.

Richard Rodriguez is a Partner and Jennifer Ah-Kin is a Consultant at EMB, the international actuarial and business consultancy.