Transcript The Role of Reinsurance and Solvency

Preparing for Solvency II : case study
for a multinational reinsurer
Presented by Michel M. Dacorogna
International Insurance Symposium, CPI-Workshop,
Johannesburg, South Africa, February 2, 2007
© Converium
Outline
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 1

New context for the industry and new solvency regulation

Use of internal models and DFA

How to optimize a reinsurance cover

Case study: multi-lines and cat covers

Conclusion
© Converium
A Changing environment
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 2

Environment of the insurance industry in the European Union has
undergone fundamental changes in the past few years.

Deregulation in the 90ies gave the insurance companies more
freedom and independence:
 New Opportunities
 New challenges and increased self-responsibility

Insurance companies and regulatory authorities are equally affected
by the changes.

In-force regulations are only partly successful (insolvency of
Mannheimer!).

Under the name “Solvency II”, a new supervisory framework is being
developed on a European level.
© Converium
Why new solvency regulations ?
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 3

In-force solvability rules have a number of deficiencies. Examples:
 Premium-based methods hardly reflect the true risk.
 Factor-based methods are unable to adequately take into
account complex forms of risk transfer.
 Investment risks is not included in the required solvency.
 Dependencies between assets and liabilities or between lines of
business are not taken into account.

As a result, there is an unrealistic or wrong estimation of capital
levels. On the other hand, insurers already have technically mature
methods for risk analysis and capital allocation.

Moreover: Because of different regulations, there are opportunities for
regulatory arbitrage between banking and insurance industry (e.g.
credit insurance).
© Converium
Solvency II: Key elements
3-pillar structure, Pillar 1
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 4
Quantitative requirements

Solvency capital shall be derived from the actual total risk and shall
essentially correspond to the economic risk capital.

Market-based valuation approach (‚mark-to-market‘).

Distinction between minimum and target solvency capital.

Minimum capital determined by a simple standard model.

Target capital can be determined by internal risk models.
Supervisory system shall favor the use of such models.

Interplay of assets and liabilities shall be taken into account (ALM).
© Converium
Solvency II: Key elements
3-pillar structure, Pillar 2
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 5
Supervisory process and internal risk management

Insurance companies shall be made responsible for implementing
risk management processes. Examples:
 Actuarial principles regarding reserving practice
 Asset Liability Management (ALM)

Supervisory processes are guided by capital requirements and the
actual capital margin (capital which counts towards meeting
requirements).
 Supervisory process shall be more guided by the individual risk
profile of a single company.
 Intervention zone between minimal and target solvency capital,
within which the supervisory authority can intervene before the
company falls short of the minimum solvability capital.
© Converium
Solvency II: Key elements
3-pillar structure, Pillar 3
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 6
Market transparency and discipline

Aimed at increasing transparency in the insurance industry.

The goal of the disclosure of the actual risk and return situation is an
increase of the market transparency that shall lead to an increased
market discipline.

Strongly follows Basel II and future IFRS guidelines.

Remark: The EU Commission seems to be aware of the dangers
that increased disclosure requirements can have (e.g. capital drain
in the case of a deterioration of the risk situation of an insurance
company).
© Converium
Context of Solvency II
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 7

Solvency II is part of a changing regulatory environment:
 Basel II (regulatory framework for banks)
 IFRS (International Financial Reporting Standard, currently
under development)

Solvency II is an European project:
 Solvency II is initiated and driven by the EU Commission.
Solvency II is developed in close cooperation with national
supervisors and international professional bodies (e.g.
actuaries).

Solvency II is an ambitious project:
 Aims at a risk-based determination of adequate capital levels.

Solvency II is still under development. In force by 200X or 20XX only.
© Converium
The Swiss Solvency Test
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 8

In May 2003, the Swiss Federal Office for Private Insurers (FOPI)
together with the Swiss insurance industry launched the SST project.

The aim of the project was to elaborate a risk-based solvency
regulation.

For once, the Swiss were faster than the rest of Europe!:
 initial concept in December 2003
 further refined up to May 2004
 Field-test runs with 45 insurers (90% of the market) in 2005
 Insurance Supervision Act became legally binding as of 2006
 Full SST calculation for small insurers and Reinsurers by 2008

After a transition period of five years the solvency targets have to be
met by 1 January 2011.
Internal risk models in the context
of Dynamic Financial Analysis
Control / Optimization
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 9
Generic structure of
current DFA systems
(vendor – independent)
Analysis / Presentation
Output Variables
Company Model
Strategy
Note: real control and
optimization
functionality only rarely
implemented
Risk Factors
Scenario Generator
Calibration
Note: DFA is actually a
combination of software,
methods, processes and
skills; skilled people are
the most important
ingredient!
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 10
Risk Simulation
dependence
Risk 1
Risk 2
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 11
Dynamic Risk Simulation
Risk Simulation generates
thousands of interacting
outcomes of selected risk
scenarios.
The output is a range of
possible values with their
respective likelihoods instead
of a single “point” estimate.
Probability Distribution of the Year-end Profits
2.5%
Dynamic signifies a time
varying impact of risk
scenarios which takes
account of history and
feedback loops.
Probability
2.0%
1.5%
1.0%
0.5%
0.0%
-20
-
20
40
60
80
Profit in Million USD
Expected Profit
100
120
© Converium
Internal Risk Models: Applications
and Benefits
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 12
Profitability Analysis
Investment
RBC Allocation
Strategy
‚What-if‘ Analysis
Planning
ALM
Solvency
Risk
Management
testing
Risk Mitigation,
Supervisors
Rating Agencies
RI Optimization
Internal Risk Model
… we will look at this aspect
© Converium
Risk Management for Insurance
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 13
An insurer has several possibilities to mitigate overall business risk:
Short term

Buy reinsurance

Change investment strategy

Raise capital

Change underwriting policy
Long Term
© Converium
The Capital of an Insurance Company
Unrealized
capital gains
Latent taxes
Discount in loss
reserves
Capital as reported
in financial statement
Signaling Capital
Less reinsurance
RBC
for underwriting risk
More reinsurance
RBC for investment risks
RBC for other risks
Economically adjusted
capital:
Available Capital
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 14
Capital required given
management’s risk appetite:
Risk-Based Capital
© Converium
Reinsurance Protection
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 15

For an insurance company, reinsurance is a substitute for capital.

The main drivers of strategic reinsurance are:
1. Protection of the available capital, we need to keep our RBC
within reasonable ranges of the available capital.
2. Diversification effect resulting in more effective use of our RBC.
3. Reduction in RBC, leading to a reduction in Cost of Capital.

The basis for designing a reinsurance program is the internal model,
where the RBC for the different risks is calculated.

We judge the efficiency of a reinsurance-cover against the cost of
capital saved by it.
© Converium
An Economic View on Reinsurance
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 16

Conventionally, reinsurance premiums are perceived as isolated
costs related to the reduction of insurance risk. Accordingly,
recoveries and premiums should balance on the long run.

However, this view misses the fact that reinsurance is a substitute
for risk capital.

Risk capital is not for free. Investors expect an adequate return on
their investment. By substituting risk capital, reinsurance thus is
lowering capital costs.

The basic idea: Reinsurance should be structured to leverage
reinsurance premiums and capital costs optimally, which means
reinsurance should be structured to minimize the total cost of
capital and reinsurance.
Illustration: Trade-off Between Risk
Capital and Reinsurance
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 17
Same Level of Risk
Minimal
Risk Capital
Cost of Servicing
Risk Capital
Cost of reinsurance
Underwriting
Results
Investment
Income
Excess Return =
Added Shareholder Value
Lot of
Reinsurance
Lot of
Risk Capital
Minimal
Reinsurance
© Converium
Case Study:
The Insurance Company (I)
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 18

Typical European P&C insurer.

Has a group structure with four independent legal entities.

In addition, there is also considerable Cat business written on group
level (European wind storm).

Premium volume (Mio USD)
Premium Volume
Firm 1
Fire
61.5
GTPL
52.7
Storm
N/A
Total
114.2
Firm 2
9.0
4.7
N/A
13.7
Firm 3
19.6
15.4
N/A
35.1
Firm 4
consolidated
2.2
92.4
2.8
75.6
N/A
11.6
5.0
179.6
© Converium
The Insurance Company (II)

Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 19
Capital allocation (Mio USD)
Asset Split
Class
Market Value
Bonds
382.5
Cash
22.5
Equity
45.0
Total Assets
450.0
Relative Weight
Investment
85.0% Gov. Bond Portfolio (USD)
5.0%
USD
10.0%
Equity Index (DJA)
100.0%

Total investments: 450 Mio, equity 122 Mio.

Gross solvency margin (Solvency I rule, premium index): 3.4

Reinsurance structure:
 TPL- and Property: Complex QS- and XL-program.
 Stop-Loss reinsurance for Cat business.
© Converium
The Problem
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 20

Declining profitability during the last few years
 What is the economic value of the written business?

Complex and not transparent reinsurance program
 What is the total risk on group level?
 How efficient is the reinsurance program?
 Is there a possibility to keep more risk on the balance sheet, is
it possible to make better use of the risk capital?

What is the expected solvency margin over the next four years if
premiums grow by 4% p.a.? Is this growth sustainable?

Cat business
 The volatility grew constantly over the past few years.
 Is it possible to optimize the reinsurance program?
© Converium
Economic value of written business
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 21

The Goal: Assessment of economical value and efficiency of existing
reinsurance cover.

Return measure
 Expected NPV of net underwriting result including cost of capital.

Risk measure
 Expected Shortfall of NPV of net underwriting result, again
including cost of capital.

Time horizon: 1 year (underwriting year)
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 22
Risk based Capital
RBC With and Without Reinsurance (Exp. Shortfall at 1% , in M io USD)
120.0
100.0
80.0
60.0
40.0
20.0
Without Reinsurance
Firm 4
Firm 3
Firm 2
Firm 1
Firm,
consolidated
0.0
With Reinsurance

For a risk tolerance level of 1 %, reinsurance reduces the allocated risk
based capital from 100 to 60 Mio USD.

Is this worth the cost of reinsurance? The answer to this question
depends on the cost of capital…
Underwriting Result including Cost
of Capital (group level)
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 23
Expected Underw riting Result incl. Cost of RBC (in M io USD)
5.00
0.00
-5.00
-10.00
-15.00
-20.00
-25.00
-30.00
0.01%
0.10%
1.00%
Without Reinsurance
10.00%
100.00%
Risk Tolerance Level
With Reinsurance

First result: Given the current reinsurance structure and including capital
costs, the economical value of business written is marginally positive.

Second result: On group level and for all risk tolerance levels, the
reinsurance program is efficient. However, this is not the case for all firms…
© Converium
Optimization of Cat reinsurance


Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 24
The existing Cat cover was not performing satisfactory during the last
few years:

In years with low to moderate claim experience, the reinsurance
structure did not bring any or only partial relief.

In years with large claims (e.g. 1999, Lothar), the cover was not
sufficient.

Reinsurance costs are perceived as too high for this limited use.
Reinsurance strategy

Increase of priority and limit of cover.

For example: 200% xs 200% instead of 85% xs 125%.

Result: Lower reinsurance premiums and higher economical
value of reinsurance program.
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 25
Cat cover: Effect of Reinsurance
Gesamtschadenverteilung vor und nach Rückversicherung
Probability / Bin
25%
20%
15%
snet
10%
sgross
Problem
5%
0%
0
50
Gross Claims Incurred
Mean
99.00% Quantile
100
150
Net Claims Incurred
Mean
99.00% Quantile
200
Millions €
Existing Stop-Loss lowers 1%-VaR (38.3%) and standard deviation
(28.7%) of aggregated loss distribution.
 Biggest simulated annual gross loss is 639 Mio USD, net 509 Mio USD.

© Converium
Cat business: RBC as a function of
Risk Tolerance
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 26
RBC as a Funct ion of Risk Tolerance Level (in M io USD)
100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0
0.10%
0.40%
1.00%
2.00%
5.00%
10.00%
Risk Tolerance Level
Without RI

With RI
With RI, new structure
RBC is reduced considerably and especially around the 1% risk
tolerance level.
Cat business: Gross and net riskreturn profile
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 27
Expected Underw riting Result incl. Cost of Capital (discounted, in M io USD )
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
-1.2
-1.4
-1.6
0.0
-10.0
Without RI

-20.0
-30.0
-40.0
-50.0
Risk (1% -Excepted Shortfall of Underwriting Result)
With RI
With RI, new structure
The risk-return profile is improved considerably with the new
reinsurance structure.
© Converium
Cat business:
Efficiency of Reinsurance
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 28
Expected Underw riting Result incl. Cost of RBC (discounted, in M io USD)
1.00
0.00
-1.00
-2.00
-3.00
-4.00
-5.00
0.01%
Without RI

0.10%
1.00%
With RI
10.00%
100.00%
Risk Tolerance Level
With RI, new structure
The reinsurance structure is efficient for risk tolerance levels below
5% (‘1-in-20-year event‘). It is more efficient than the existing
program for risk tolerance levels below 2% (‘1-in-50-year event‘).
An Example of Analysis of CAT
Retro-covers
© Converium
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 29
Income incl. Cost of Capital
10
50 xs 75
Income (mUSD)
5
0
Cat Bond M
-5
-10
50 xs 75 2.Event
-15
Cat Bond Z
-20
-25
75 xs 125 2.Event
-30
175 xs 125
-35
0.1%
0.4%
1.0%
2.0%
5.0%
10.0%
Risk Tolerance Level

The profitability of each layer depends on the retro-premium, the expected
recoveries and the cost of capital saved by the layer.

This in turns depends on the risk tolerance level (the lower the tolerance, the
higher is the RBC and the more RBC is saved by the retrocession).
© Converium
Conclusion
Preparing for Solvency II
Johannesburg, Feb. 2, 2007
Michel Dacorogna
Page 30

The approach combines financial analysis and risk modeling and is in
line with the spirit of the new solvency regulations.

It is a quantitative tool that allows to assess the overall risk of an
insurance company.

It allows to assess the economic value of different strategies.

Thus, it helps design optimal risk mitigating strategies.

It needs good data and a fair amount of modeling efforts.