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5 strategic challenges chief risk officers can address through reinsurance

Corporate Risk Consulting|Riskhanteringsverktyg & -teknologi|Insurance Consulting & Technology|Reinsurance
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By Dave Ingram and Brian Ingle | May 13, 2019

Insurers aspire to identify and acquire all the risks that can be insured at a profit. But they’re limited by their capital. Hence the need for reinsurance.

Insurers aspire to identify and acquire all the risks that can be insured at a profit. But they’re limited to taking on the volatility that their capital can absorb. Hence insurers need what Gaddis calls a strategy — a plan to align those unlimited aspirations for profitable risk acquisition with their limited amount of capital.

The strategic chief risk officer (CRO) uses whatever means available to help with the alignment process, primarily by helping to loosen the capital constraints to allow aspirations to align. Reinsurance is perhaps the most powerful tool that the CRO can use in that process.

Reinsurance is a powerful risk management tool at insurers’ disposal. This article in our Year in the Life of the Strategic CRO series provides a number of ways that it can be used as a strategic tool.

In advance of annual strategy and planning discussions, the CRO should review all of the ways that reinsurance can help the insurer achieve company goals. A reinsurance broker can be a strategic partner in this process by bringing deep knowledge of the reinsurance market, understanding of a wide variety of reinsurance structures and experience with a full range of insurer circumstances and strategies that have proven successful.

Strategic issue 1: Capital for growth

The rate of growth and ultimate size of the company are fundamental aspects of strategy. Most insurers are aware that business growth is constrained by their capital. Reinsurance is often used strategically by these insurers. In fact, many have taken to looking at reinsurance as a source of capital for their business — where the primary insurer is seen to be using the capital of the reinsurer to fund some of their risk. This can be done in three ways:

  • Financing-style treaties, which actually provide capital
  • Quota share reinsurance, which share capital obligations with the reinsurer
  • An excess of loss (XOL) treaty, which reduces volatility and thus the demand for capital

The strategic CRO who is well advised regarding reinsurance market possibilities can, on the fly during the strategy discussions, provide insight into the viability of obtaining reinsurance capital to support the capital needs of a higher growth strategy.

Strategic Issue 2: Entering a new territory or product line

One of the most difficult strategic undertakings is stepping into the unknown. Crossing a state line to expand business may not seem like heading into the unknown, but in many cases, it is. An insurer may not even realize all the ways that it knows the subtle ins and outs of doing business successfully in its current territories. And you likely don’t know how things are different right next door.

A partnership with a good broker and reinsurer can help eliminate some of the unknown. The broker and reinsurer can provide some of the insight needed — usually with regard to underwriting and extreme risk — based upon their experience reinsuring the desired new targeted business. This goes for forays into new product lines and coverages as well.

Strategic issue 3: Maintain rating

Insurers may be sensitive to ratings because of concerns of their customers, distributors or even their boards. Ratings can come under pressure for a variety of reasons but the most common is that the level of capital is less than the amount expected by the rating agency for the amount of risk that the company retains.

Reinsurance can solve this misalignment, enabling an insurer to continue to pursue its marketing strategy. Reinsurance has a dual benefit of enhancing the Best’s Capital Adequacy Ratio (BCAR) value by reducing required capital and reducing the risk of loss to reported surplus. In addition, insurance can address earnings strength and volatility in the operating performance evaluation for the rating process.

Strategic issue 4: Provide coverage for a valued distributor

Most insurers have some types of risk that simply do not fit into their risk appetite, and thus they generally will not write that cover. But there are always exceptions, usually at the request of an important distributor or customer. In this case, an insurer may not want to send their distributor or customer to a competing insurer. The strategic CRO can help to find a reinsurer that will take the business via reinsurance. In small volumes, it may be via facultative treaties or in larger volumes through a fronting arrangement.

Strategic issue 5: Take advantage of diversification with internal reinsurance

As insurers grow and write different types of insurance, strategic CROs might point out that they can take advantage of their diversity of business by retaining more of the risks that their separate business units may have wanted to reinsure. They may want to replace some of the external reinsurance with an internal reinsurance arrangement whereby a corporate fund acts as the reinsurer of first resort, taking premiums and paying claims just like an external reinsurer.

What seems initially like a sure win has sometimes turned around and bitten some companies. They may try to use market rates, but without any direct market discipline. More importantly, an individual insurer rarely has the required diversification that reinsurers can bring to their pricing and risk management.

The bad news comes when there is a year with very high claims, often natural catastrophe related, where expected diversification is less effective than expected, and the internal reinsurance pool is found to be undercapitalized for the actual size of its pool of risks, and the actual amount of loss that has been retained is found to be unacceptable.

The ‘Swiss Army knife’ for the strategic CRO

Reinsurance really is the Swiss Army knife of strategic risk management. More insurers have recognized the utility of reinsurance, and CROs have been given responsibility for the reinsurance function. In other cases, the strategic CRO needs to have a close working relationship with the reinsurance manager.

Authors

Dave Ingram
Head of Willis Re ERM Advisory

Brian Ingle
Analytics Leader, Willis Re North America