March 26th, 2012

Alternative Risk Transfer: Part I, Adverse Development Cover, Aggregate Stop Loss

Posted at 1:00 AM ET

Alternative risk solutions are used to address the following client motivations: rating agency issues, adverse development, earnings stability, reserve and premium leverage issues, reinsurance recoverables, terrorism risk, capital optimization constraints, mergers and acquisitions, discontinued lines of business, provide coverage for gaps in traditional placements and optimizing costs. The structured risk team designs customized solutions to achieve a particular client’s goals. An optimal reinsurance structure is determined by capacity needs, risk tolerances, capital management, cost of risk and degree of confidence in results. A cedent will need to balance the cost of transferring sources of risk with not only its own capital management strategies but also capital requirements imposed by rating agencies.

With respect to rating agency goals, a company’s existing A.M. Best rating can be maintained by minimizing the impact of factors that may offset positive ratings. Such factors include potential adverse loss development where surplus has been impacted by the emergence of adverse development on recent accident years, significant growth in premium volume whose impact has reduced the level of excess capital that existed in prior years and maintaining profitable results in a softening cycle where reduction of prior year reserve redundancies to support operations increases the importance of accurate pricing.

Structured risk products can be beneficial to meet risk transfer and capital management goals. The structures are designed to achieve these goals. If clients have risk concerns, the structures can be designed on a funds withheld basis.

Net premium written and loss reserves are typically the two largest components of an insurance company’s capital charge components. We provide an overview here of the products that can be used to minimize and optimize capital associated with such risk factors.

Adverse Development Cover

To address the loss reserve risk component of a company’s Best’s Capital Adequacy Ratio (BCAR), an adverse development cover (ADC) may have a positive effect on a company’s BCAR score. This cover decreases the capital charge associated with larger loss reserves by providing adverse loss development protection. Because the reserve risk charge goes down by more than any increase in the credit risk charge, the BCAR score is improved.

To be most effective, the ADC cover should be designed to efficiently reduce a company’s required capital relative to cost. That is, the ADC should provide coverage for the company’s more capital intensive exposures and it should be structured to attach at or above A.M. Best’s view (including deficiency) of carried reserves up to the amount of capital A.M. Best requires for such an exposure. However, including all of a company’s exposures in such a cover may not be efficient as the cost to reduce the required capital for certain lines may exceed the benefit.

Other benefits of an adverse development cover include mitigating the future impact of potential adverse development on calendar year earnings, protecting ROE, safeguarding the reserve to surplus ratio and protecting against future impact of trend and changes in tort reform and judicial systems.

Aggregate Stop Loss Cover

To address the net premium risk capital charge, various solutions can be pursued. These include aggregate stop loss covers, quota shares and working layer excess of loss covers. To optimize the required capital associated with premium risk, the structure may be written on a whole account basis or on specific lines of business. The structures will be customized to achieve the client’s desired capital and risk transfer goals. Typically, these are structured on an option basis where the cedent pays a margin to lock in capacity, and if the cover is triggered then future premiums will be due.

Depending on the credit worthiness of the cedent, a stop loss would typically be structured on a funds withheld basis. In the event of a loss to the cover, the additional premium (AP) due would be credited to the funds held account with interest credited back to inception.

In addition to providing capital relief, other benefits of an aggregate stop loss include providing frequency and severity protection for net retained business, systemic risk protection and calendar year protection if purchased every year and significant cost savings to the cedent in the event the cover is not triggered.

There has been an increased interest in aggregate loss covers during 2011 to address the drop in earnings and surplus associated with property cat losses. Solutions to address this issue can be single year or multi-year and can be designed as an aggregate stop loss or an excess of loss cover.

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