FROM BUSINESS STRATEGY TO LIMIT SYSTEM (PART 2)

Transcription

1 Solvency Consulting Knowledge Series FROM BUSINESS STRATEGY TO LIMIT SYSTEM (PART 2) A case study of a property-casualty insurer Contacts Martin Brosemer Tel.: mbrosemer@munichre.com Dr. Marcus Drometer Tel.: mdrometer@munichre.com Dr. Norbert Kuschel Tel.: nkuschel@munichre.com Lars Moormann Tel.: lmoormann@munichre.com Dr. Thomas Schaffrath-Chanson Tel.: tschaffrath@munichre.com June 2010 A specimen company, LIMIT, and its solvency situation Following on from Part 1 of From business strategy to limit system (Introduction to the theory), which covered the basic principles of a limit system, Part 2 uses a case study of an average European propertycasualty insurer, LIMIT, to provide an illustration of the theory. Fig. 1: Investment and portfolio structures of LIMIT Investment structure 18% 3% LIMIT s premium income for the current year can be broken down as follows: 189m for motor third-party liability 97m for motor own damage 54m for general accident 73m for property Figure 1 shows the investment and portfolio structure (breakdown of premium income): Portfolio structure 13% 18% 2% 12% 65% 23% 46% Other investments Bonds Equities Other Property Participations Motor liability Other motor (own damage) Homeowners /householders comprehensive General accident

2 Page 2/6 At 99.95%, the company s combined ratio for the current financial year means that it should just about achieve an underwriting profit. Under Solvency I, after allowing for reinsurance, the company required risk of 63m compared to its of 112m, giving it a solvency ratio of 178%. Fig. 2: LIMIT s solvency balance sheet and QIS requirement Market value of assets 342m Economic 186m For the Quantitative Impact Study (QIS), LIMIT produced a solvency balance sheet to enable it to determine its economic and calculated risk on the basis of the prescribed standard approach (Solvency Capital Requirement, SCR). It was then possible to derive the solvency ratio under Solvency II from the two figures. Fig. 3: LIMIT s strategic roadmap Liabilities (best estimate) 142m margin 14m for Solvency II was higher than for Solvency I, rising from 63m to. An analysis showed that the rise in the requirement was driven mainly by underwriting risk. However, the economic view of the balance sheet resulted in an increase in equity under Solvency II from 122m to 186m, producing a new solvency ratio of 130%. Figure 2 shows the Solvency II balance sheet and the SCR. LIMIT s business and risk strategies At LIMIT s last strategy meeting, its Board discussed the cornerstones of future business development and associated strategies, and drafted the strategic roadmap shown in Figure 3: Business strategy Growth target: 25% increase in motor liability premiums strategy Liquidity: Sufficient at all times to meet payment obligations tolerance: Solvency ratio 125% Reinsurance: Optimise diversification effects

3 Page 3/6 Business strategy The business strategy comprises business growth objectives the risk strategy and its parameters. The risk strategy includes both liquidity and reinsurance parameters. tolerance is a given parameter. Business objectives In the course of LIMIT s annual business planning, it became apparent that motor liability was the line of business with the highest growth potential and that having an effective sales organisation would be key to realising that potential. It was decided at the strategy meeting to exploit every opportunity for growth in motor liability. As a result, the objective is to increase premiums by 25% in the next financial year. The risk strategy and parameters tolerance At the same time, the Board decided on risk tolerance and the methodology for measuring it. Security was the main consideration. The company s aim was to continue to offer its clients above-average security, which implied a minimum rating of A. In Solvency II terms, this meant that LIMIT had to achieve a solvency ratio of at least 125%. Reinsurance A core component of LIMIT s risk strategy was a non-proportional reinsurance cover to place an upper limit on its risks, which led to a reduction in requirements. According to the risk strategy, the reinsurance was to be designed to improve diversification effects in the company s retention. This meant exploiting as far as possible the potential for diversification by more targeted and specific reinsurance cessions within each class of business. Liquidity One of the pillars of LIMIT s value proposition is the payment of all sums due on time and in full. It was therefore extremely important to LIMIT s directors for the investment management parameters to prescribe a high degree of safety and for the necessary liquidity to be available at all times. All risk management considerations had to take account of this qualitative objective set out in the risk strategy. Scenario analysis The financial control, risk management and reinsurance departments supported the Board in assessing whether the growth targets could be achieved within the defined risk tolerance. The scenario analysis indicated that the planned sharp rise in premium income in motor liability would cause the solvency requirement to increase to 150m. With available at 186m, the solvency ratio would fall from 130% to 124%, breaching the risk tolerance. on cost grounds. Therefore, further reinsurance options were examined. Since the retentions in the current non-proportional reinsurance covers were somewhat low in comparison to the market, there was no case for reducing them further. Various proportional-reinsurance options were therefore analysed with a view to improving the solvency ratio: a) 20% quota share treaty in motor liability b) 15% quota share treaty in all lines of business Results The calculations showed that for both options the SCR would be with a 25% growth in business, which meant that both reinsurance options would be in line with the defined risk tolerance, as in both cases the solvency ratio would again reach 130%. The reinsurance parameter defined in the risk strategy was used to decide which of the additional reinsurance options to choose. The parameter required that particular importance be attached to diversification aspects. Since motor liability was already LIMIT s most significant business segment, additional growth meant a deterioration in diversification. The company therefore decided on option a). Consequently, it was established that the planned growth in motor liability could not be achieved with the current level of and existing reinsurance. Initially, covering the growth target with a increase was considered, for example by raising hybrid, but this was rejected

4 Page 4/6 LIMIT s risk tolerance Fig. 4: LIMIT s risk-bearing capacity As explained in Part 1 (theory), the risk-bearing capacity indicates the total amount of economic available to cover all of a company s risks, whilst the risk tolerance defines how much of this should be used to cover all significant risks. Market value of assets 342m Economic 186m Buffer Surplus 43m bearing capacity LIMIT s current situation: The figures show a healthy relationship between risk-bearing capacity and the SCR, with room for growth. LIMIT has a buffer of 43m (see Figure 4). margin 14m Liabilities (best estimate) 142m Market value of liabilities In the planning process, the Board defined the amount of risk to be used for each of the company s business objectives, thereby also quantifying risk tolerance, which is dependent on the Board s appetite for risk. As shown in Figure 5, it comprises the SCR calculated for existing risks and planned growth:, Fig. 5: LIMIT s risk tolerance Surplus 43m Surplus 37m 3 3m 2 3m for risks difficult to quantify for new risks, e.g. growth in excess of plan the tolerated scope for new risks: 3m, a contingent for risks difficult to quantify: 3m. 1 for existing risks and planned growth tolerance -bearing capacity

5 Page 5/6 The limit system Fig. 6: Allocation of LIMIT s risk ( m) Allocation of risk The business and risk strategies are based on not changing the existing risks, which results in a risk requirement of. This risk was allocated to the different risk categories. To do this, LIMIT used the calculations from the risk modelling in the standard formula (see Figure 6) The risk amounts then need to be further allocated to lower levels and translated into clear figures suitable for day-to-day reference. 0 Nonlife Health Market risk Credit risk Diversification BSCR 1 Op SCR To take the example of underwriting risk for non-life, 120m of the total risk was allocated to the nonlife risk category (motor liability, motor own damage and property). Conversion to limits LIMIT s actuaries compared an allocation in proportion to premiums with Allocation in proportion to premiums No 25% growth in Scaled growth motor liability to 100% an alternative allocation using the covariance method, and the results were quite different: Motor liability 46% 57.5% 58.4% 64.5% Motor own damage 23% 23% 23.3% 18.3% Property 18% 18% 18.3% 17.2% Covariance method For ease of presentation, a simple proportional allocation based on gross premiums was used, producing the following adjusted risk amounts for the individual classes of business, as shown in Figure 7: Motor liability 70m Motor own damage 28m Property 22m Fig. 7: Allocation of limits for non-life underwriting to individual classes Non-life underwriting 120m Allocation pro rata to premiums 58.4% 23.3% 18.3% Motor liability 70m Motor own damage 28m Property 22m tolerance for growth in motor liability 3m 1 Basic solvency requirement as per QIS definition. Motor liability 73m Motor own damage 28m Property 22m

6 Page 6/6 A further 3m was added to the risk tolerance for growth in new risks in excess of plan, which for profitability reasons was allocated to motor liability business. Thus risk for motor liability was expanded to 73m. In practice, it is difficult to integrate these limits into an insurer s risk controls, so they therefore need to be translated into suitable management figures. LIMIT decided to use premium volume, as this is a practicable management figure for sales staff. To this end, the allocated limit in motor liability was translated into a maximum premium volume figure. The premium limit thus calculated in motor liability was 246.4m Threshold: 95% utilisation of premium limit ( 234.1m) Action: Daily report on utilisation of premium limit Reduce active marketing 2. Threshold: 97.5% utilisation of premium limit ( 240.2m) Action: Prepare reinsurance alternatives and risk transfer Reduce unprofitable risks Advise sales of limit utilisation Confine sales to the most important lines of business 3. Limit: 100% utilisation of premium limit ( 246.4m) Action: transfer to ease limit utilisation Avoid increasing risks (part with selected unprofitable risks or decline new business) Threshold values Threshold values were defined to facilitate the utilisations of limits: Conclusion The LIMIT case study shows how a risk tolerance level on which a limit system can be based can be derived from consistent business and risk strategies. An additional 20% quota share cession in motor liability enabled LIMIT to implement its strategic growth target of 25% in motor liability whilst still complying with the risk tolerance defined in its risk strategy (solvency ratio 125%). 2 The premium volume of 189m was increased by growth of 25%, compared to the risk of 70m from the model, and finally adjusted to reflect the increased risk base of 73m. Reinsurance can be a key component of risk management as it can be used to reduce requirements. Furthermore, reinsurance has an effect on a company s business operations, as reflected in an increase in the limits by more than a quarter: With new Without new motor liability motor liability quota share quota share Limit (100%): 246.4m 197m 2010 Münchener Rückversicherungs-Gesellschaft Königinstrasse 107, München, Germany Order number