Key Considerations for Reinsurance John Carroll Head of Broking, Aon Benfield
Reinsurance 101 Role of Reinsurance Different Approaches Key Considerations
Reinsurance = Capital
Reinsurance is insurance purchased by an insurance company Income smoothing Surplus/Capital Relief but what functions does it perform? Arbitrage Access to Reinsurer expertise Creating a manageable & profitable portfolio of risks Managing cost of capital for an Insurer
Key Functions of RI: Transfer Risk Increases economic efficiency by: Reducing consumer exposure to catastrophic events Fund & Adjust Losses Accumulating capital resources to pay for losses Identify & Price Risk Helping consumers factor in long term loss potential and risk into economic decision making before the loss event
Reinsurance is killing me In fact, reinsurance lowers the cost of insurance as, by buying reinsurance, insurers are tapping into a global diversified balance sheet which allows them to purchase capital/capacity for a cheaper price than if they had to provide it themselves. Therefore, rather than reinsurance being a cost to the Insurer, it is an enabler, freeing up capital that Insurers would otherwise have to put aside for claims and allowing them to reinvest that capital in their business proposition to their customers Anthony Day CEO Suncorp Commercial Insurance White paper: Reinsurance Villain or hero? [March 2012]
Reinsurance is killing me really? Incredibly simplistic analysis Assumes RI spend is only CTXL Ignores investment aspects Ignores capital charges, rating impacts Ignores actual RI recoveries Ignores increased volatility With RI No RI Premium Revenue 9,135,000 9,135,000 Outward RI Expense (817,000) 0 Regulatory Capital 4,262,000 11,536,360 Prescribed Capital Amount 2,558,000 6,908,000 includes ICRC 150,000 4,500,000 PCA Multiple 1.67 1.67 Net Profit/Loss 776,000 1,593,000 Average Equity 4,756,000 12,873,517 Return on Equity 16.32% 12.37% Avge Equity based on Regulatory Capital ratio
Diversification benefits Consider two population distributions on islands in an ocean: (A) 1,000 people on one island (B) 1 person on each of 1,000 islands Assume hurricanes hit one island/year, no two islands are hit in one year (A) is less efficient than (B), because the (A) economy must maintain considerable slack resources to rebuild
Diversification benefits Portfolios which can be pooled with other uncorrelated portfolios will: Form a new portfolio with lower variance Require (relatively) less capital Pay a lower price for risk transfer This effect is fundamental as to why (re)insurance is economically efficient Less obviously, is why Australia and New Zealand have far lower costs of capital than Florida: Florida risk can only be diversified in 4-5 places Australia/New Zealand risk can be diversified in many places
Different approaches to reinsurance Proportional Quota Share Surplus Non-Proportional Excess of Loss Aggregate Stop Loss Function of company sophistication, capital strength and access to capital Each method provides capital relief Each method has pros and cons No one size fits all solutions! Retention is a function of Profit Margin Capital Base Risk Willingness Volatility
Some Key Considerations: Cost of reinsurance does not equal the spend on reinsurance Reinsurance capital is cheaper than that of an Insurer Reinsurance is a powerful, flexible, readily available capital substitute Reinsurance operates best in the volatility space
Some Key Considerations: Reinsurance decision just one piece of capital framework Cost of Reinsurance Capital, Earnings, Volatility protections Selection of reinsurers Security, Relationship, Financial Performance Capital charges Strategic vs Capacity vs Opportunistic Domicile, Product offering Sustainability vs Flexibility / Long vs Short term objectives