September 25th, 2008

Don’t Step on Your Long Tail

Posted at 6:21 PM ET

Eddy Vanbeneden, Managing Direcor

With casualty reserves, it can be difficult to determine how much is too much. Unlike property reserves, which are mostly for specific known events, casualty reserves have to be sufficient to cover events that may unfold well into the future. A lot can happen in 15 or 20 years, which only serves to compound the uncertainty that casualty carriers face. Further complicating matters, there has been a dearth of viable ways to mitigate the plethora of risks that could converge on a casualty portfolio, leaving risk-bearers to learn that reserves are lacking years after they have accepted a risk.

The management of casualty reserves requires capital…and that capital has a price. With Solvency II, the importance of capital management will increase substantially across Europe in general. As a result, reserve risk is becoming increasingly important to European casualty carriers.

A unique characteristic of casualty risks is that they accumulate over time. All casualty carriers write business without truly knowing what the outcome will be and can spend decades trying not to step on their own “long tails.”

Most casualty writers struggle with a specific fear—that everything that can go wrong will … at the same time. Of course, the opposite end of the spectrum is quite positive; any carrier would be thrilled to see a convergence of good news. But, this is not the scenario that keeps risk managers awake at night. Instead, (re)insurers worry about jumps in claims inflation, legal trends that can make you liable for coverage you didn’t intend to provide, or the next latent damage or disease. For the first time in more than one decade, increases in general inflation could last for years—and could inflict significant damage on casualty reserves.

Several risks, including systemic risks, could materialize at the same time, affecting years of accumulated exposure across multiple lines of business. Reserves would be depleted quickly, and losses would mount. Since these are long-tail risks, carriers may struggle finding viable strategies.

Acceptance is one strategy for managing casualty reserve risk. There are other alternatives available, but each has significant shortcomings. Traditional reinsurance offers more protection than many realize, but it has to be managed over time. Loss portfolio transfers and adverse development covers address the threats directly, but they tend to be purchased only in special situations (e.g., to facilitate an acquisition). The lack of an active market limits their use as ongoing capital management solutions. Covering a significant portion of reserve risk would also require ceding more premium at a time when many carriers are trying to retain it.

It seems as though casualty carriers are destined to remain exposed to substantial casualty reserve risk for the foreseeable future. Modeling has not caught up to the complexities of the risk faced, and risk transfer tools do not address carriers’ specific needs. Diversification doesn’t always offer sufficient comfort. Fortunately, capital markets may offer a new approach.

Capital markets may offer the depth to overcome the stubbornness of casualty reserve risk. (Re)insurers are beginning to explore the securitization of this particular threat to their portfolios. Packaging and tranching long-tail risk moves it away from carrier balance sheets while bringing to capital markets a new form of risk to use in managing their own portfolios. This method is still in its early stages, with single-carrier issuances being explored. But, the process could mature into an index-based risk-transfer method (most likely starting in the United States before gaining momentum internationally) using industry-wide data, allowing carriers to hedge the difficult systemic risks that threaten (re)insurer capital.

Better techniques for understanding and managing casualty reserve risk is an ongoing issue for the (re)insurance industry. So far, risk transfer has not been a big part of the risk management toolbox, and carriers have had to accept that they remain exposed. Some recent modeling innovations and new risk management strategies imposed on companies by evolving regulatory regimes and markets are leading to alternatives. Risk transfer mechanisms must still be clarified. New developments in capital markets, though, may ease the burden on (re)insurers in the future. Securitization could shift long-tail risks to capital markets—and take the guesswork out of casualty portfolio management.

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