REINSURANCE SOLUTIONS - Risk

1 REINSURANCE SOLUTIONSM anaging Economic And Rating Agency CapitalJune 2009reDEFININGC apital | Access | Advocacy | InnovationContentsCapital Management Challenges Eased Through REINSURANCE Placements 3 REINSURANCE Benefits Quantified 3 REINSURANCE Opportunities 4 Earnings Volatility Management 6 Conclusion 7 analysis 9 Discussion of analysis 9 Proposed REINSURANCE SOLUTIONS Best and S&P Capital Models 11 Economic Capital Model 11 Results of Capital Modeling 12 REINSURANCE Purchasing Decision 16 AON BENFIELD 3 Capital Management Challenges Eased Through REINSURANCE Placements Aon Benfield s analysis of the impact of the current credit and liquidity crisis suggests that, on average, equity capital has declined, between 25 to 35 percent for property and casualty insurers worldwide.

2 This level of capital erosion has substantially eliminated the excess capital cushion in the industry. Many Chief Financial Officers (CFOs) now face capital management challenges to meet current underwriting risk levels and potentially increasing economic risk for many asset classes. REINSURANCE has been an effective lever in a number of recent placements to assist insurers in maintaining existing levels of underwriting risk. Most property and casualty insurers had little debt leverage as the credit and liquidity crisis began, with debt to total capital ratios in the 20 to 25 percent range for the industry.

3 The decrease in equity capital has caused this leverage to increase to a range of 25 to 35 percent. Debt maturities are more expensive to replace; many debt arrangements are not being replaced due to current market conditions or the desire to bring debt-to-total capital ratios back to reasonable tolerance levels. Where the proceeds of past debt issuances have been downstreamed as capital to the operating insurance entities, REINSURANCE has been effectively used to match the capital reductions caused by debt maturities that have not been refinanced.

4 Distress among certain global insurers has also created opportunities for some property and casualty insurers to grow as the insurance market potentially hardens. This potential has extended the challenges of capital management beyond the reestablishment of the status quo. Conservatively, many CFOs are waiting for the insurance market to show definite signs of price increases before committing to find the capital necessary for growth. Some have rekindled relationships with reinsurers that can provide significant capacity for potential opportunities with the intent to execute treaties when the needed industry changes materialize.

5 REINSURANCE Benefits Quantified REINSURANCE is often viewed by CFOs as an effective risk transfer mechanism for traditional line of business needs, as well as for a portfolio of business units. The substantial quantitative tools now utilized by most CFOs, in connection with enterprise risk processes, materially assist evaluation of the accretive potential of REINSURANCE . Tools such as Aon Benfield s ReMetrica have standard formats to reveal: The quantity of the gross underwriting risk transferred The capital freed-up through the transaction using: The company s economic capital models Rating agency capital models and stress models Regulatory capital models The cost of freeing up capital or ceded return on equity (ROE) The comparative value of alternative capital sources The impact of buying REINSURANCE at business unit or corporate levels REINSURANCE SOLUTIONS .

6 MANAGING ECONOMIC AND RATING AGENCY CAPITAL 4 REINSURANCE Opportunities Aon Benfield is serving the capital management needs of many of the industry s leading insurers by demonstrating the value of capital relief transactions. A hypothetical European company was created to analyze the impact on capital of a range of REINSURANCE SOLUTIONS . Table 1 presents the very transparent manner in which REINSURANCE opportunities can be evaluated for this company and the analysis on page 8 provides a more detailed discussion. Table 1 Capital Management Transactions Form of REINSURANCE Underwriting Volatility Ceded Economic Capital Ceded ROE Best Ceded ROE S&P Ceded ROE Reducing retentions to EUR10mn per risk EUR2bn ADC attaching at EUR1bn below carried reserves EUR1bn ADC attaching at carried reserves EUR1bn ADC attaching above carried reserves 20% quota share EUR1bn additional catastrophe covers EUR1bn debt reduction with 20% quota share The REINSURANCE options

7 Evaluated are a mix of traditional risk transfer SOLUTIONS such as a quota share and catastrophe excess of loss, as well as structured SOLUTIONS such as an adverse development cover (ADC). When reviewing an ADC, as discussed in the analysis , the attachment point and limit have a significant impact on the treatment of the REINSURANCE in the capital models, and it is important for a company to understand the differences, which is why three different structures are presented. When assessing the accretive value of REINSURANCE , it is imperative to evaluate the cost of capital, or ceded return on equity (ROE), of the REINSURANCE compared to the company s internal cost of capital.

8 It is also important to understand how much volatility has been transferred to the reinsurer, recognizing that neither debt nor equity transfer volatility. As explained in the analysis , the worked example is based on a company with significant casualty exposures and meaningful, though smaller, property exposures. When comparing REINSURANCE SOLUTIONS , it is important to recognize how REINSURANCE impacts a casualty driven company compared with a property driven company. Casualty driven companies generally view reserves as the key contributor to capital requirements, whereas property companies view premiums and catastrophe probable maximum loss (PML) charges as the key.

9 Therefore, a casualty company s goal is to decrease reserves; a property company s goal is to decrease premiums and the net PML, all at a cost that is accretive to the company. While this paper focuses on a traditional property and casualty composite company with significant casualty exposures, there are REINSURANCE products that provide substantial capital for property based companies as well. In general, catastrophe excess of loss provides a significant capital benefit at typically a low cost of capital, and effectively reduces the PML, which is likely to be material for a property writer.

10 A second event catastrophe cover will provide capital relief in Best s catastrophe stressed Best s Capital Adequacy Ratio (BCAR) calculation, which considers two occurrence based losses. A reinstatement premium protection cover reduces the net PML under both Best and S&P s capital model by reducing the reinstatement premiums included in the net PML. An aggregate stop loss is favorable for a property company, as the rating agencies will lower property capital factors based on the attachment and exhaustion point. Finally, a quota share is generally beneficial to both casualty and property AON BENFIELD 5 companies, as the cedent is transferring both premiums and future reserves, which reduce overall capital requirements.