December 11th, 2008

The Adverse Development Super-Catastrophe

Posted at 1:05 AM ET

Gary Venter, Managing Director, Instrat®
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Property catastrophes make the news. Tangible and visual, the carnage can be conveyed with ease, and all can grasp the direct implications immediately. Yet for (re)insurers, there’s another type of catastrophe that could be far more destructive to balance sheets. This threat, which can remain hidden in a portfolio for decades, can arise with little warning and have profound consequences.

Factors beyond a carrier’s control can lead to devastating losses on policies that are decades old, and risk-bearers have few ways to protect themselves. Despite the development of new techniques to transfer this adverse reserve development risk, a reasonably effective method already exists. Simply securing additional casualty excess cover can prevent a long tail from throwing a (re)insurer off balance.

Models, Mistakes, and Mayhem

Adverse loss reserve development is a growing problem, affecting an increasingly large population of casualty carriers. Risk accumulates over time, resulting in the potential for simultaneous substantial claims increases from several years. Since the policies have been written -sometimes deep in the past-a carrier’s only real defense is to have access to sufficient capital - or reinsurance - when faced with the obligation to pay. A lack of preparedness can lead to devastating insured losses … and possibly a threat to solvency.

In effect, adverse development “super-catastrophes” are like a property mega-catastrophe, only less frequent and more severe.

Earlier this year, abundant capital led many casualty insurers to increase their casualty per occurrence retentions. Excess capital had to be put to work, after all. With models to support their decisions, in addition to strong capital positions, the logic was valid. Unfortunately, one of the premises was flawed. Many carriers, it seems, relied on faulty models to determine how much risk they could absorb, particularly the accumulated risk of adverse loss reserve development. In doing so, they may have overlooked broader accumulations that now remain hidden in their portfolios.

While it is easy to blame models, doing so would mask a broader problem-and one that can be managed. Actuarial judgment plays a role in coping with adverse loss reserve development risk. However, some of that risk comes from macroeconomic events that cannot be predicted. At best, actuaries can account only for the probability that they might occur. Adverse development risk can accumulate under even the most watchful eye, and flawed models are not the only reason why.

Costs are driven by price levels at the time of payment-not those at the year of accident. Thus, after several years have passed, a claim (or deluge of them) could have a greater impact than expected, leaving the carrier with insufficient resources to meet its newfound obligations. The unexpected loss would cause the carrier to make up the difference with a transfer of capital into loss reserves … and trigger a disproportionate loss of market capitalization, sometimes several times the size of the capital depleted.

Cost changes can be unpredictable, rendering even the savviest actuary seemingly powerless to take preventive action. Claims inflation, for example, demonstrates that adverse development risk is random. What makes this prospect particularly disconcerting is that forces such as claims inflation are not limited in scope to the future; their impacts can be retrospective, as well. Consequently, claims inflation can affect several years’ loss reserves at the same time. While a talented actuary can quantify the likelihood of accumulated adverse development risk, anticipating the actual values of random factors such as claims inflation is virtually impossible.

What Can You Do?

Despite the frustration associated with adverse loss reserve development risk, remediation is surprisingly easy to accomplish. Simply purchasing casualty excess cover over time can soften the potential adverse risk blow. The claims to which casualty (re)insurers are exposed over time are those most likely to be covered by casualty excess reinsurance. The mundane, essentially, is a natural fit for the complex.

Since larger claims tend to take longer to pay out, the loss reserves from older accident years tend to include a greater number of large claims than the total ceded/net split for the year would have suggested originally. These larger claims are also more likely to be covered by reinsurance, particularly as a given accident year matures. Further, when a claims trend spikes unexpectedly and causes adverse loss development, more claims are pushed above the retention into ceded layers. With excess casualty cover, essentially, claims yet to be paid are more likely to be covered, mitigating the effects on a casualty carrier’s balance sheet.

While not all of the loss development risk can be handled by traditional casualty excess reinsurance, specific examples show that the protection can be substantial. Due to the two leverages mentioned above-the longer payout of large losses and inflation pushing more losses into the higher layers-the percentage of loss reserve development that is ceded can be twice as much as the percentage of total losses ceded. For instance, ceding 20 percent of accident year losses consistently over time can end up ceding 40 percent of adverse loss development when the reserve catastrophe occurs.

Insurers have been turning to risk modeling to address the complexity of casualty retention. To be effective, it is important that the models used in designing reinsurance programs take into account all of the principal risks. Guy Carpenter’s Instrat┬« unit, for example, has developed models to quantify loss reserve risk-including stochastic trend risk-and methods to test the impact of casualty excess reinsurance on it. Working with the Guy Carpenter broker and an insurer’s ceded managers and risk modelers, this methodology can help inform the reinsurance buying decision, ultimately producing a program that has the best tradeoff of cost and risk, including loss reserve risk.

Sometimes, the most vexing problems have straightforward resolutions. Adverse loss reserve development risk poses a serious threat to casualty (re)insurers, especially those with high retentions. Securing casualty excess cover for an exposed portfolio can reduce this risk without requiring intricate programs or exotic tools. The products and markets exist: casualty writers need only take action.

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