Chris Klein, Global Head of Business Intellience
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The primary role of the reinsurance broker is to help insurers move risk out of their portfolios, most often — unsurprisingly — via the purchase of reinsurance. Cedents have three basic objectives for the use of reinsurance: reduce risk held, optimize the productivity of capital and manage earnings. The first is clear — reinsurance entails the act of transferring risk to another party. In doing this, the cedent gains flexibility in deploying the capital it has on hand, which produces revenue, market share and market capitalization growth opportunities. Insurers also use reinsurance to remove some volatility from their earnings. Consequently, reinsurance is much more than a tactical risk management tool; rather, it is of strategic value to every cedent in the marketplace.

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Financial Intelligence Team
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Introduction

When Solvency II becomes effective in 2012, group support — which would have allowed capital held at the group level to cover the requirements of any company in the group — will be not permitted. This prohibition will require group entities to hold capital according to the Solvency Capital Requirements (SCR) in each individual entity. The application of group-level diversification benefits to individual entities will not be allowed. This last-minute change to the original framework directive may cause some groups to change their structures. At a minimum, they are likely to rethink how much risk capital will be carried at the group level versus the operating entity level given that the risk capital needed in the group will increase without recognition of group support.

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John Tedeschi, ACAS, MAAA, Managing Director and Chief of Catastrophe Modeling
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There are many modeling perspectives for a reason. Even among the three largest firms — AIR, RMS, and EQECAT — differences are noticeable, as each company has developed its own set of unique strengths. The breadth of results only serves to benefit (re)insurers … as long as they take advantage of it. Limiting catastrophe modeling efforts to only one of the major vendors, even if it’s best-suited to a particular region or peril, can lead to gaps in coverage, unanticipated insured losses, and the destruction of shareholder value. As cedents diversify among perils, regions, and even among reinsurers, therefore, they also could protect their capital by diversifying the models they use.

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Christopher Klein, Global Head of Business Intelligence
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The time-honored principle of diversification used in many areas of financial management applies equally well to reinsurance placements. From the ancient days of river commerce in China, where merchants divided their cargo between barges to avoid total loss, diversification has been a key principle of insurance and later reinsurance markets. Given the current financial turmoil in reinsurance markets, there is a legitimate pressure from investors, top management, and the rating agencies for cedents to seek only the highest rated of reinsuring partners. But this worthy objective needs to be balanced with the diversification principle, so that cedents can reduce their probability of zero recovery, as demonstrated in the above analysis.  

This series is limited to consideration of diversification among a panel of reinsurers. Cedents also have options to diversify to other forms of risk transfer, notably risk securitization. In particular, catastrophe bonds as currently structured may reduce the credit risk practically to zero, because they mandate a full collateralization of the limit at risk.

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Christopher Klein, Global Head of Business Intelligence
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Instrat®, Guy Carpenter’s quantitative services unit, has developed a reinsurer credit model. It allows an analyst to input a mixture of reinsurers and measure the impact of the diversification effect. The model allows for the specification of correlation levels for reinsurer defaults. It also allows for the chance of partial recoveries.

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Christopher Klein, Global Head of Business Intelligence
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In many instances, a common and useful approach to risk management issues involves establishing metrics and monitoring actions in light of certain benchmarks. Risk metrics are generally easier to understand and capture important summary information as opposed to trying to deal with, for example, a comparison of entire probability distributions.

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Christopher Klein, Global Head of Business Intelligence
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Case 1: Base Case

A hypothetical ceding company contracts for the USD200 million casualty cover from a single Aaa rated reinsurer. The probability of a default is 1 percent, with a loss of USD200 million, while the probability of no default is 99 percent and would carry no loss.

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Christopher Klein, Global Head of Business Intelligence
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Cedents are becoming increasingly concerned about the security of their reinsurers, particularly in light of the global financial catastrophe. Diversification, a time-honored approach to managing risk, may offer part of the solution. Cedents may benefit from diversifying reinsurance placements among many reinsurers. Thus, the approach applied to asset management can be applied to reinsurance placements, as well. The syndication process carried out within the broker market results in an important reduction of the “no recovery” potential that could arise from reinsurer defaults. Diversification may reduce the probability of no recovery, even if the likelihood of default among reinsurers is correlated.

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Donald Mango, Chief Actuary
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The financial catastrophe currently tearing through financial markets has changed the face of risk. Diversification, once the standard for reducing exposure, has been weakened by a convergence of threats on both sides of the balance sheet. (Re)insurer capital is under assault, and a more robust risk management technique is needed. Enterprise Risk Management (ERM) may help the situation, offering an integrated view of portfolio perils and the tools necessary to develop an effective risk transfer strategy.

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