So what can be done to mitigate such cyclical effects? The first steps are to acknowledge them and to try to quantify their impact. The latter is more of a challenge than the former. Most internal capital models are not truly multiyear and arguably fail to adequately capture both the correlation between lines of business and in particular across accident years. Cycle (and recognition pattern) scenario testing is a good way to achieve this. This provides a neat and practical way to correlate between years and lines of business.
A reconsideration of the construction of reinsurance buying strategy is needed. Before that reconsideration, however, it is worth remembering exactly how reinsurance (particularly for long-tail lines) can impact both earnings and capital both in the present and the future. The figure below shows this.
Reinsurance buying strategies have traditionally focused too much on the present cost and benefits and not nearly enough on the future costs and benefits. The industry could be accused of being tactical in this respect and not strategic. Short-termism can be damaging. For example many companies will consider reinsurance decisions in the context of economic value added (EVA)(1). This can be a sound approach but requires consideration of the definition of capital. It should theoretically be “total capital” but in most cases “underwriting risk capital” is used. This makes the EVA calculation appear to ignore the reserve risk capital benefits associated with buying reinsurance. Guy Carpenter has challenged this approach for some time and introduced the concept of the reserve value added (RVA) metric to capture this effect in reinsurance decision making (2). RVA is analogous to the Solvency II risk margin - the calculation is very similar and it captures the time dimension of risk. Under Solvency II companies should be considering the impact on risk margin of their reinsurance strategy particularly where the liabilities are very long-tailed and the risk margin will be substantial and will not diversify away against shorter tail risks.
(1) EVA is defined as the change in expected economic value that results from pursuit of a certain reinsurance strategy either versus the status quo or against buying no reinsurance with economic value defined as the expected profit or loss less the cost of capital associated with supporting the business.
(2) See Jenkins, Leong, “The Total Value of Reinsurance” for more details click here.