Use of a DFA Model to Evaluate

Reinsurance Programs
Case Study

1999 CAS Seminar on Financial Risk Management

April 12-13, 1999
Denver, Colorado

Presented by:
Robert F. Conger, FCAS
Tillinghast – Towers Perrin
Discussion Outline

■ The Challenge: How Much Reinsurance to Buy, and What Mix?

■ Conceptual Framework

■ Methodological Approach

■ Case Study: XYZ Insurance

■ Key Issues

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Given the behavior of today’s insurance and financial markets, many
property/casualty insurers are re-evaluating their reinsurance programs

Buy less reinsurance? Buy more reinsurance? Buy different protection?

■ We have excess capital ■ Regulatory and rating ■ Securitization

■ Keep net premiums up agency pressure ■ Non-P/C reinsurers (e.g.,

■ It’s cheap Life/Health for workers
■ Eliminate unnecessary
expenses and transaction ■ Everyone else is grabbing compensation)
costs this deal ■ Contingent debt/equity
■ Why share profits? ■ Let the reinsurers share the capital
■ Maximize investable assets coming unprofitable results ■ CAT futures
■ Predictions of future ■ Blended products that go
catastrophes and mass  beyond traditional hazard
torts risk  
■ Support the higher limits
we’re selling

■ We can’t lose on this latest
reinsurance proposal
■ Better safe than sorry Chief Financial
Officer

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The design of a reinsurance program involves complex issues, and is
material to most insurers’ bottom lines

■ Despite favorable market conditions, reinsurance is still a significant cost

item for many insurers
■ Reinsurance decisions are becoming more challenging
❑ Benefits have always been difficult to evaluate in relation to costs
− How does reduction in underwriting volatility affect capital and
return requirements?
❑ Decisions are often made at the program level, but need to be placed
in overall enterprise context
− Need to avoid inefficient reinsurance activity
❑ Proliferation of reinsurance products expands alternatives to consider
❑ Alternatives to reinsurance products are becoming available, but add
further to complexity of analysis
− Securitization of risk
− Contingent debt/equity capital
■ Reinsurance price volatility creates short-term tactical opportunities that
can be more effectively played against a long-term strategy baseline

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Case Study: Reinsurance Strategy for XYZ Insurance

■ Large multi-line company, organized into business units

■ Reinsurance purchasing occurs at corporate and business unit level

❑ Corporate buys major treaties covering enterprise
❑ Business units buy additional coverage to protect their results

■ Study focuses on three questions:

❑ Which elements of the reinsurance program add value over the long
term?
❑ Which elements are good tactical buys today, due to market
conditions?
❑ How can the program be restructured to create more value?

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The answers to reinsurance questions must be specific to XYZ Insurance

Compared to XYZ Insurance, no other insurance company has exactly the

same
■ Volume and mix of business

■ Profitability history and outlook

■ Exposure to large claims, mass torts, and catastrophes

■ Investment strategy and performance

Therefore, the “right” choice
■ Capital amount and structure of reinsurance for XYZ
Insurance will be different
■ Loss reserve adequacy than for any other
company . . . And may be
■ Reinsurance choices
different next year than this
■ Risk appetite/aversion year.

■ Corporate affiliates

■ Corporate structure

■ Stakeholder expectations

■ Rating agency and regulatory considerations

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Components of a reinsurance program can be compared to each other, and
to other alternatives, by viewing reinsurance as “rented” capital

Reinsurance Reduction in
Required
Gross Capital
Capital
Requireme Net Capital
nt Requirement

Cost of
Reinsurance
Expected
Ceded Ceding
Premium Commission
Expected Ceded
Losses

Cost of “Rented” Cost of Reinsurance

Reinsurance =
Reduction in Required Capital
Capital
■ Is reinsurance a cost effective source of capital? It adds value when this
cost of capital is below the cost of alternatives

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Reinsurance strategy alternatives can be compared using an
Asset/Liability Efficient Frontier (ALEF ) framework

50%

40%
L
F
Expected Return

30% K
J I R
H Q C
O
N D
20% G P E
B
A
M
10%

0%
0.0% 0.5% 1.0% 1.5% 2.0%
Level of Risk

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Either conceptual framework begs several questions

■ How to quantify an insurer’s projected financial results and the potential

for variability in these future results?
❑ Gross of reinsurance
❑ Net of reinsurance
(for each alternative reinsurance program)
■ How to measure the Cost of a Reinsurance program and its effect on
an insurer’s Expected Returns?
■ How to translate “the potential for variability” in future results into a
usable and meaningful measure of Risk?
■ What is an insurer’s Required Capital?
❑ With no reinsurance
❑ With current reinsurance
❑ With alternative reinsurance portfolios

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To quantify projected financial results, XYZ constructed a comprehensive
multi-year model

Line of Business A
Corporate Elements
•Business volume
•Business Starting Balance Reinsurance Investment
characteristics Sheet Program Strategy
•Pricing
•Claims Capital Tax
Structure Calculator
•Paid and
Reserved
•Expenses Non- Affiliate
Financial Insurance Results
•Cash flow pattern Calculator Income
•Reserving patterns
•Policyholder
dividends
Line of Business Year 1
B Financial Results
Line of Business
C •Balance Sheet
... GAAP
•Income
Statement Statutor
Line of Business y
Z
Economi
c

Measures of
Analyzer
•Risk
•Return
•Capital Requirements

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Modeled financial outcomes are translated into “Risk Measures” specific to
the insurer

Identify Key
Reasons to Buy
Reinsurance
■ Control variability of reported
financial results
■ Reduce capital needs
Define Risk
❑ Long-term
Measures that
❑ Finance growth capture the key
❑ Satisfy regulatory or rating objectives of
agency constraints the reinsurance
■ Support pricing of primary products program
■ Offer new insurance products

■ Allow discounting of reserves

■ Current reinsurance price is below

cost
■ Etc.

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We have explored several illustrative alternatives to traditional statistical
measures of risk and variability

Probability of Operating
Result = X$

“Below Target Return”

measure

“Expected
Policyholder Deficit”
measure

Target
Return Capital Unfunded obligations

Operating Profit Operating Loss

■ Different reinsurance programs result in different distributions of

operating results, and therefore different degrees of “risk”
■ The Risk Measures must be customized to the specific company

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The advantage of Below Target Risk over standard deviation can be
illustrated by an example

■ These two return probability

distributions have the same
expected return of 13%,
and the same standard

Probability
deviation

Probability
■ Using a target return of 3%
(roughly equivalent to a
zero real return), the top
distribution has a BTR of
17.6%; the bottom
distribution has a BTR of
27.7%
■ The top return distribution
is preferable: more upside
Prabability
Prabability

and less downside

Rate of Return
Rate of Return

13%

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The Cost of Reinsurance may be modeled several ways

■ Current proposals from reinsurers/intermediaries

❑ Actual
❑ Hypothetical, based on current market conditions and market
knowledge
■ Nature of long-term relationship with reinsurers Cost of
Reinsuranc
❑ Explicit deal Expected
Ceded Ceding
Ceding
e

Premium Commission
Commission
❑ Implicit expectations Expected Ceded
Losses

■ Conceptual model of reinsurance pricing

The choice of methods will depend on the objectives of the analysis,
the expected duration of the reinsurance arrangement, and the nature
of information available.

■ In the current market, where reinsurers are aggressively seeking top-line

growth, short term tactical opportunities may lead to different
reinsurance buying decisions than in the long run

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The definition of “Required Capital” likewise will vary depending on
company perspective

■ Illustrative definitions of required capital with current reinsurance

program
❑ Current capital
❑ Estimated capital at threshold of specified A.M. Best rating
❑ Multiple of RBC
❑ Capital that keeps Expected Policyholder Deficit < x%

■ With alternative reinsurance programs, we can

❑ Model the different amount of Required Capital that would produce the
same level of risk, or
❑ Determine the change in level of risk, given the same amount of
capital

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While probability of ruin is the simplest form of risk-capital constraint, more
complex constraints can be defined

Dimensions of Risk-Capital Constraints

Probability Metric ■ Likelihood of occurrence

■ Expected excess severity above threshold
■ Expected excess over threshold

Time Period and Form of Threshold ■ Loss from single event or risk factor
■ Annual accounting result
■ Results over multi-period planning horizon
■ Experience on runoff basis

Measurement Basis ■ Statutory

■ GAAP
■ Economic

Perspective ■ Absolute result

■ Result relative to peers
■ Result versus rating agency or regulatory norm
■ Result relative to investor expectations

Examples: “Less than a 1% chance of GAAP operating loss equal to or greater

than 25% of reported equity”
“Economic capital sufficient to reduce expected unfunded
policyholder obligations to less than .25%”

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As a first step, XYZ identified the highest cost components of the
reinsurance program

Top 15 Programs by Normative Net Annual Cost

Casualty Working XS
Property First Cat
Special Property Fac
E&O Program XS

Work Comp Working XS

Property High Cat
Umbrella QS
Std Property Risk XS

Surety QS
Casualty High XS
Marine XS

Aviation XS
Prof Liab XS
Special Property QS
Casualty Clash

0 2 4 6 8 10 12 14 16
$ Millions

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XYZ measured each component’s contribution to reducing insolvency risk,
and translated that into a reduction in required capital

Marginal Reduction in Required Capital

Casualty Working XS
Property First Cat
Special Property Fac
E&O Program XS
Work Comp Working XS
Property High Cat
Umbrella QS
Std Property Risk XS
Surety QS
Casualty High XS
Marine XS
Aviation XS
Prof Liab XS
Special Property QS
Casualty Clash

0 20 40 60 80 100 120 140

$ Millions

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Some program elements appear to add significant value; others may be
inefficient

Implied Marginal (Normative) Cost of Reinsurance Capital

Property First Cat

Special Property Fac

Casualty Working XS

E&O Program XS

Property High Cat

Umbrella QS

Work Comp Working XS

Std Property Risk XS

Surety QS
Casualty High XS

Marine XS

Aviation XS

Prof Liab XS

Special Property QS

Casualty Clash

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0%

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In evaluating strategy alternatives, the focus was narrowed to the three
least efficient programs

Casualty Work Comp

Strategy Working XS Working XS Aviation XS
A No Change No Change No Change
B Double No Change No Change
C Retention Double No Change
D Double Retention Double
E Retention Double Retention
F Double Retention Double
G Retention Double Retention
Treble Retention Retention Double
Treble Retention Treble Retention Retention
■ The same framework can be used to evaluate alternative programs, in
Treble Retention Treble Retention
addition to changes to the existing program structureTreble Retention

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Each strategy was evaluated in terms of its impact on risk and return

12%
Expected Return

11% G
F
E
D
C
B

10%

0.9% 1.0% 1.1%

Below Target Risk

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An essential feature of the model is the interaction between its components
and across time

✔ Correlations between lines of business

✔ “Runs” of good or bad years

✔ Relationships between historical and future results

✔ Macro-economic trends over time

✔ Correlations between inflation, equity returns, and interest rates

✔ Relationships between underwriting results and investment results

✔ Relationship between gross-of-reinsurance results and recoveries

✔ Patterns of reserve inadequacy/redundancy

✔ Patterns of variation in cash flow

✔ Influence of past results on future management strategies and actions

✔ Investment strategy dependent on yield curve and/or asset duration

✔ Shareholder dividends dependent on operating results

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The model is run in a wide variety of scenarios over multiple future years

✔ Future inflation rates

✔ Future interest rates and investment returns

✔ Catastrophes

✔ Random large losses

✔ Loss ratio movement

❑ Long term patterns
❑ Shocks
❑ Year-to-year variability
As with the company model itself, inter-relationships between
elements are an essential feature of the modeling

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Sensitivity testing is an essential step of the process

■ Some of the elements to be subjected to sensitivity testing include

❑ Alternative choices of Risk Measures
❑ Different definitions of Required Capital
❑ Selected measure of reinsurance cost
❑ Modeling time horizon
− Years of business
− Years of runoff
❑ Parameters used to model reinsurable losses (e.g., size-of-loss
distribution)
❑ Degree of correlation of results across lines of business and across
years
❑ Base level of company profitability and growth
❑ Different combinations of reinsurance components

■ The objective of the sensitivity testing is to satisfy ourselves that the

results are robust, and not driven by one of the modeling choices

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Of course, modeling does not replace management judgment

■ Modeling results will depend on key management perspectives, such as

the choice of Risk Measure
■ The final trade-off between risk and return is a matter of preference

But this modeling approach provides strong support to allow making the
key decisions in a well-informed manner.

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