Risks. Insurance. Credit Inflation Liquidity Operational Strategic. Market. Risk Controlling Achieving Mastery over Unwanted Surprises

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1 CONTROLLING INSURER TOP RISKS Risk Controlling Achieving Mastery over Unwanted Surprises Risks Insurance Underwriting - Nat Cat Underwriting Property Underwriting - Casualty Reserve Market Equity Interest Rate Credit Inflation Liquidity Operational Strategic 2 1

2 Introduction For each risk, we will talk about Description Definition of the risk Characteristics Important aspects of experience holding this risk Acceptance How does an insurer come to be exposed to this risk? Measurement Common metrics used to track amount of risk Mitigation Common actions that are taken to reduce risk exposure Risk Appetite and Limits How much is acceptable? Response What do companies do when they find that they have too much of this risk? 3 Risk management control cycle Identify Risks Assess Response Plan Monitor Take Risks Action Steps Mitigate 4 2

3 Average Risk Profile Interest Rate and Equity Risk Source: Willis Re Estimates of BCAR Components Source: Willis Re Survey 5 Market Equities Description Common stocks and other equity holdings including private equity Characteristics Risk can come from individual securities and from general stock market movements 6 3

4 Total Market Risk 7 Equity Market Risk 8 4

5 Specific Risk 9 Market Equities Risk Acceptance Usually through Investment Policy (Strategic) and annual (Tactical) planning for purchases and sales of securities Limits for size of any one stock holding May be sector or other limits Measurement Most often measured in terms of Rating agency capital factors AM Best factor is 15% In the past 43 years S&P 500 has lost 15% 3 times and one time had a return of -14.7% Third party asset managers often have plenty of analytics available BCAR Factor based upon a 15% stock market value drop 10 5

6 Market Equities Mitigation Generally little if any mitigation for equity risk Risk On, Risk Off strategy Risk Off is more common since large losses of early 2000 s Could consider Sector concentrations Compared to insurance risks Possible to buy hedges to offset extreme losses Just like cat reinsurance 11 Market Equities Risk Appetite, Limits Risk appetite for stocks usually is a decision made to obtain extra return on excess capital Rating Agency view of stocks is a moderate concern Best s opinion of stocks remains so benign Factor is 15% 12 6

7 Credit Description Counterparty Credit mostly from Reinsurers and Investment Default Failure to pay amounts owed either because unable or unwilling to pay Characteristics Low frequency, moderate severity risk Usually diversified portfolio of investments but small concentrated group of reinsurers who are mostly on the same sorts of risks as the ceding company Need to be concerned with both likelihood of default AND recovery percentage 13 Credit Risk is Lumpy For A rated bond 25 out of the last 32 years have seen zero defaults Average default rate over all 32 years is 0.06% Average default rate in the 7 years where there was a default was 0.27% 78% frequency of no default 22% frequency of 0.27% default Highest default rate was 2009 at 0.39% (44% above average) 14 7

8 Credit Risk Acceptance Through Investment Policy (Strategic) and annual (Tactical) planning for purchases and sales of securities Strict limits for size of exposure to a name Strict limits on lower credit quality bonds Process for reviewing and approving reinsurers Measurement Most insurers simply look at percentage of bonds in various credit rating levels High amount of sophisticated credit analytics available Reinsurers credit ratings tracked 15 Average Default Rates AA.01% AA-.02% A+.05% A.06% A-.07% BBB+.15% BBB.24% BBB-.30% 16 8

9 Credit Mitigation Insurers do little to mitigate investment credit risk. Most take very little in the first place May adjust name limits May try to sell at first hint of credit problems Few use CDS to adjust exposures Often hold on to defaulted bonds through workout. Reinsurer counterparty risk often more actively managed Careful monitoring of reinsurer credit standing Adjustments to list of acceptable reinsurers Early settlement of claims with questionable reinsurers 17 Counterparty Reinsurer Credit Consider a Loss Portfolio Transfer (LPT) Insurer transfers reserve risk to reinsurer Replacing the risk of large reserve fluctuation with risk of reinsurer default Per AM Best BCAR Reinsurer Credit risk is 10% Reserve Risk varies from 37% to 50% Line of Business Loss Reserve Personal Property 37% Personal Motor 38% Commercial Motor 38% Occupational Accident 39% Comm'l Multi Peril 40% Construction&Engineering 40% Med Mal (Occ) 50% Med Mal (C/M) 44% Special Liab(M.A.T.) 45% Other Liab (Occ) 45% Other Liab (C/M) 42% 18 9

10 Credit Risk Appetite, Limits & Reaction Usually investment credit limits are stated in terms of percentage of portfolio allowed in each level of credit quality May be limited awareness of risk levels for different ratings Weighted average rating may be highly misleading Limits to amount outstanding with any single reinsurer 19 Example of Bond Portfolio 20 10

11 Inflation Description Increase of dollar cost of future obligations (and decreased value of future expected payments) Characteristics Inflation is a broad economic phenomena Driven mainly by differences between changes in money supply and economic growth Is not a random occurrence usually results from combined central bank and government actions Prices increase, savings decrease, claims settle at higher values In extreme longstanding inflationary environment, contracts shift to indexing

12 Inflation History Inflation Last 20 years Under 4% - 20 years Prior 20 years Under 4% - 5 years 23 Inflation Risk Acceptance Rarely an explicit acceptance process for inflation risk Is accepted when company writes long tailed lines Leading Indicators Gold prices TIPS rates / treasury yield curve Commodity and interest rate futures prices Center for Business Cycle Research (CIBCR) Measurement CPI / PPI Trend PCE Deflator / GDP Deflator 24 12

13 Inflation Mitigation Investment Strategically change the duration of the Investment portfolio; Diversify portfolio and shorten overall portfolio duration. Utilize multiple sources for investment management Claims Resolving long tail claims as early as reasonably possible Maintaining sexual misconduct sub limits. Ongoing development of PPO network Expanded efforts to reduce medical utilization Accelerate claim closures Reserves Reserves carried at the high end of the range Quarterly reserve review process Company carries a reserve redundancy 25 More mitigation strategies for inflation Reinsurance Maintain level of per occurrence reinsurance retentions Keeping moderate per occurrence reinsurance retentions Reduce casualty reinsurance net retentions Pricing Monitoring of inflationary pressures, Adjusting pricing as required Diversification Maintain diverse geographic footprint Focus growth efforts on business that is not as sensitive to inflation. Diversified business mix of short and long-tailed lines Diversified business mix of niches/markets Resilience Sufficient surplus to absorb impact 26 13

14 Inflation Risk Appetite and Limits These should mirror anticipated inflation in the financial markets. Though inflation differs from anticipation, market is the best predictor. During normal periods inflation tends to be 2-3% in the U.S. and is specifically targeted as such by the Federal Reserve. Responses Diversify markets by geography, niche and length of tail. Reduce casualty reinsurance net retentions. Monitor inflationary pressures and adjust pricing as needed. Accelerate claim closures; resolve long term claims quickly. Change mix and duration of investment portfolio. Carry conservative reserves ( redundancy). 27 Underwriting Nat Cat Description Potential for high insurance claims in the event of a hurricane, earthquake or other extreme natural event. Mainly applies to property insurance but other coverages (business interruption, workers comp, life, A&H) are also effected. Some perils (flood, earthquake) are often excluded or limited from general property insurance, but are covered in separate policies. Tor/Hail in mid west Characteristics High severity, low frequency risk. Tor/Hail more frequent Single very large policies increase risk Losses vary significantly with variations in location and construction of structures and sizes of policies 14

15 Volatility due to Sizes Insurance fundamentally depends upon the idea of diversification Best diversification if all policies are of the same size When a company starts writing policies on a wide range of sizes of risks Diversification effect drops, volatility rises Models may be less reliable Harder to calibrate Business interruption coverage troublesome here Underwriting Nat Cat Risk Acceptance through an underwriting process. Companies set standards and premium classes. Some companies severely limit their exposures by location and/or by type of construction. Measurement Most companies use 3rd party cat modeling firms. Models simulate the potential losses of insurer s individual exposures for each of a very large set of possible events. Results are in the form of event and aggregate loss distribution. Rating agencies and many companies focus on 1 in 100 or 1 in 250 losses. 15

16 Risk Measurement For firms with property exposure, Cat can dominate the risk profile Three models Three different answers 16

17 Underwriting Nat Cat Mitigation Reinsurance has historically been the most common mitigation. Cede risk from largest cases Usually structured per event may need to buy again after first event Reinsurers manage their cat risk exposures too Companies tailor their reinsurance coverage specifically to rating agency capital requirements New capital markets instruments provide an alternative. Reinsurance Structures EXCESS OF LOSS Property Catastrophe Excess of Loss Layer 2 $20M xs $20M $1M Property Excess Per Risk Layer 2 $500K xs $500K Layer 1 $300K xs $200K Retention $200K Layer 1 $10M xs $10M Retention $10M $40M 34 17

18 Reinsurance Structures PRO RATA $2M Quota Share with 30% ceded $1M 70% of premium and loss on each risk is retained 30% of premium and loss on each risk is ceded $0 35 Reinsurance Structures XYZ Re Retain VVV Re ABC Re Florida Cat Pool 90% 70% Retention Quota Share 36 18

19 Impact of Reinsurance 37 Underwriting Nat Cat Risk Appetite & Limits - examples 10% of Surplus in a 1/100 year storm 15% of Surplus with cost of reinsurance reinstatement 1:250 OEP All Region-Peril < 20% Capital impact of a 1 in 100 yr single event of 25% of surplus Risk Limits are set at a county/metro level, as needed VaR/TVaR metrics for individual business units 2% of Gross PML 38 19

20 Underwriting Nat Cat Reactions if loss exceeds appetite Use Quota share reinsurance to decrease aggregate retention Decrease retention going forward Buy more coverage for higher layers Non-renew policies Increase underwriting restrictions Increase rates Raise capital Withdraw from territory 39 Underwriting Workers Compensation Description Characteristics 40 20

21 Underwriting Workers Compensation Risk Acceptance Measurement 41 Underwriting Workers Compensation Mitigation 42 21

22 Underwriting - Workers Compensation Risk Appetite, Limits Reactions to Breaches 43 Reserves Definition Potential for loss due to the need to strengthen reserves Characteristics Fat Tailed loss distribution High likelihood of minor fluctuations Inflation can be a major driver of smaller fluctuations Low likelihood of major reserve strengthening But higher than Normal Distribution would suggest Some causes of increased claims will effect multiple years of issue 44 22

23 Reserve Risk 45 Reserves Risk Acceptance Is accepted when long tailed coverages are written But there tends to be an issue with responsibility Measurement Relatively rare to measure reserve risk Most measurement is part of Economic Capital Modeling Will be stated in terms of VaR or TVaR 46 23

24 Reserves Mitigation Most common mitigation is careful setting of initial reserve Initial claims may be a small fraction of assumed ultimate claims Use of pricing assumptions as starting point for reserves while giving low credibility to emerging early experience is potential problem with recognizing new problems But over reliance on initial claims experience can lead to excessive reserve fluctuations A carefully constructed reinsurance program can help to protect against surprises Loss Portfolio Transfers Adverse Development Covers 47 Reserves Risk Appetite, Limits Choose initial reserve at high end of range Maintain a z% reserve cushion Rare Reserve Strengthening Reaction Bad experience often results in major reserve strengthening to put the problem behind us Loss Portfolio Transfers 48 24

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