European Commission. 31 January 2002 Contract no: ETD/2000/BS-3001/C/44. KPMG This report contains 157 pages Appendices contain 16 pages mk/nb/552

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1 European Commission Study into the methodologies for prudential supervision of reinsurance with a view to the possible establishment of an EU framework 31 January 2002 Contract no: ETD/2000/BS-3001/C/44 KPMG This report contains 157 pages Appendices contain 16 pages mk/nb/552

2 Contents 1 Introduction Summary General Approach 5 2 Similarities and differences between insurance, reinsurance and other risk transfer methods Scope Approach Definitions Similarities between insurance and reinsurance Differences between insurance and reinsurance Other methods of risk transfer Preliminary conclusions 15 3 Reinsurance and risk Scope Approach Risks Systemic risks Assessing the importance of different risks Conclusion 27 4 Description of the global reinsurance market Scope Approach The global reinsurance market The major reinsurance products The role of offshore locations Captives The future evolution of the market and developments in products Competitive position of EU reinsurers from a global perspective 38 5 Description of the different types of supervision approaches currently used in the EU as well as other major Non-EU countries Scope Approach Introduction: reasons for supervision Supervising authority Forms of supervision Supervision of reinsurance in the EU Supervision of reinsurance in major non-eu countries 61

3 6 The rationale with regard to supervisory parameters Scope Approach Extent of supervision Overview of supervisory parameters Parameters relating to direct supervision Parameters relating to indirect supervision 97 7 The arguments for and against reinsurance supervision and a broad cost-benefit analysis Scope Approach Arguments for reinsurance supervision Arguments against reinsurance supervision Impacts on the different approaches to supervision Cost-benefit analysis Summary of reinsurance market practice for assessing risk and establishing technical provisions Scope Approach Market practice for assessing risk Establishing adequate technical provisions Management of underwriting risks Monitoring credit risk Management of investment risks Management of foreign currency risks The role of securitisation Financial condition reporting Summary 141 Appendix I Description of certain reinsurance arrangements 142 Appendix II Overview of other important captive domiciles 146 Appendix III Lloyd's: summary of the regulatory approach 147 Appendix IV Detailed description of actuarial reserving methods used 151 Appendix V Main sources 155 This report was commissioned by Internal Market Directorate General of the European Commission. It does not however reflect the Commission s official views. The consultant, KPMG Deutsche Treuhand Gesellschaft, Cologne, is responsible for the facts and the views set out in the document. Reproduction is authorised, except for commercial purposes, provided the source is acknowledged.

4 Foreword by the Commission Services The reinsurance sector has seen important changes during the last few years. The concentration to a few large players has continued through mergers and acquisition, new financial products have been developed and new information technology tools have emerged. The tragic events of 11 September 2001 will also have strong repercussions on the reinsurance industry, both as regards practices and available capacity. These developments make it even more important that a solid system of reinsurance supervision is in place to ensure that companies fulfil their obligations. The security of the reinsurance arrangements of a primary insurer is clearly of vital importance for the protection of its policyholders. In a changing market it is important that supervisory practices keep pace with developments. In the EU there is currently no harmonised framework for reinsurance supervision, and this has led to significant differences in approach between Member States. Such differences may duplicate administrative work and may also create barriers to a properly functioning internal market for reinsurance services. In January 2000, the Commission Services and Member States therefore decided to initiate a project on reinsurance supervision to investigate the possible establishment of a harmonised EU system. As a thorough investigation of all the different aspects involved is very complex and extensive, the Commission Services and Member States agreed to commission a study to provide the working groups with background research and discussion material. The Commission Services are pleased to present this study, which was prepared by a team from the KPMG under the supervision of Keith Nicholson and Joachim Kölschbach. We believe that the study presents a clear and pedagogical overview of the reinsurance market and reinsurance supervision. We also hope it will stimulate further debate in Member States, at the EU level and internationally. Please note that although the study was commissioned by the Directorate- General Internal Market, it does not express the Commission s official view. The consultants remain responsible for the facts and the views set out in the report. The Commission Services invite interested parties to send their comments on this study to: Please also note that the Insurance Unit of the Commission has a website, where other documents of interest can be found: Brussels, January 2002 Jean-Claude Thébault Director 3

5 1 Introduction This report outlines our findings on the Study into the methodologies for prudential supervision of reinsurance with a view to the possible establishment of an EU framework. 1.1 Summary Chapter 2 of this report gives an overview of similarities and differences between insurance, reinsurance and other risk transfer methods. The section focuses on those similarities and differences which are relevant to the prudential supervision of insurance and reinsurance. The major methods of risk transfer in reinsurance business are described. The concept of alternative risk transfer solutions is also considered, by reference to different types of contracts. Chapter 3 identifies the main risks that reinsurance companies are exposed to. The section differentiates between different kinds of products, different lines of business and other activities performed by reinsurance companies. This section summarises the most relevant risks in a risk matrix and gives preliminary views of mitigating strategies. The section includes a discussion of specific risks relating to different reinsurance activities. Chapter 4 provides an overview of the global reinsurance market. It discusses the main market players, different jurisdictions, the role of offshore locations, the major reinsurance products and the likely evolution of the market and product developments. Chapter 5 provides a description of the different approaches to supervision adopted in the EU and in major non-eu countries. It includes a comparison of the principal characteristics and differences of major or leading jurisdictions, with the aim of clarifying the rationale underlying the adopted supervisory approach. This section is based on discussions with industry specialists within the relevant jurisdictions (both within and outside KPMG). Chapter 6 analyses the rationale underlying various supervisory parameters and the relative importance and feasibility of supervising the parameters in question. Based on key risks, the analysis prioritises the products / activities of reinsurance companies by their relative need for supervision. Chapter 7 analyses the arguments for and against reinsurance supervision. Based on the goals of supervision, the risk analysis, and current practices, this section includes a broad cost-benefit analysis of supervisory approaches. Chapter 8 provides a summary of techniques currently employed for monitoring key risks. It analyses the impact of securitisation and how reinsurers measure or take into account portfolio diversification in assessing their own capital requirements. The study also examines approaches adopted by reinsurance companies and other interested parties (such as rating agencies) to assess and monitor reinsurance risks. The study considers the ways in which supervisory approaches may benefit from existing market practices. Our analysis is focused on individual reinsurance companies as well as on reinsurance groups. 4

6 1.2 General Approach The work was performed using our knowledge of the reinsurance industry and based on detailed information requested from various KPMG offices. We have also researched information sources to obtain articles and data. We have had regard, in particular, to the Issues Paper on Reinsurance 1 produced by the International Association of Insurance Supervisors (IAIS) Working Group on Reinsurance (dated February 2000), and references are made as appropriate throughout the report. We have conducted a programme of visits to a wide selection of reinsurance undertakings in order to obtain detailed views and opinions on a variety of issues within the scope of the study. 1 Reinsurance and reinsurers: relevant issues for establishing general supervisory principles, standards and practices, February

7 2 Similarities and differences between insurance, reinsurance and other risk transfer methods 2.1 Scope In accordance with the Terms of Reference, this chapter provides an overview of the similarities and differences between insurance, reinsurance and other risk transfer methods especially from the supervisory point of view. 2.2 Approach In reporting on the above objective, we undertook the following approach: Use of existing specialist knowledge to describe various major methods of risk transfer using examples of policies and contracts. 2.3 Definitions Insurance As defined by the IAIS Working Group on Reinsurance, insurance can be defined as an economic activity for contractually reducing risk for the policyholder in return for a premium. Whilst the transfer of risk is the underlying feature of all insurance products, there are other financial elements which may be present in certain types of contract, such as guarantees, investment components and derivatives. The Insurance Steering Committee of the International Accounting Standards Committee suggests the following definition of an insurance contract: An insurance contract is a contract under which one party (the insurer) accepts an insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or other specified beneficiary if a specified uncertain future event adversely affects the policyholder or other beneficiary (other than an event that is only a change in one or more of a specified interest rate, security price, commodity price, foreign exchange rate, index of process or rates, a credit rating or credit index or similar variable). 2 2 Draft Statement of Principles (DSOP); Insurance Steering Committee, IASC, June

8 2.3.2 Reinsurance The IAIS Working Group defines reinsurance as the form of insurance where the primary insurer reduces the risk by sharing individual risks or portfolios of risks with a reinsurer against a premium. Reinsurance is insurance for insurers. The basis of most reinsurance arrangements is the spreading of risk and, in essence, reinsurance allows the insurer to take on an insurance risk and subsequently pass on all or part of that risk to a reinsurer. As a result, the original company is left with only a part of the original risk (although in law the insurer remains liable to the policyholder for the full amount of the claim, and if the reinsurer defaults or becomes insolvent the insurer is obliged to meet the full amount of any claims). Reinsurance contracts can take a number of different forms. Appendix 1 provides details of the common forms of reinsurance contract. Reinsurance business is similar to insurance business in a number of ways, and supervisors in certain jurisdictions, both within and outside the EU, have developed regulatory regimes for insurance business which encompass reinsurance. In some cases, whilst the legislative framework of regulation makes little or no distinction between insurance and reinsurance, supervisors may take a somewhat different approach in practice. In other cases, reinsurance is treated differently within the regulatory legislation. Despite the similarities, there are fundamental differences between insurance and reinsurance, which can have a significant impact upon supervisory objectives. In order to assess the rationale for different supervisory approaches, it is necessary to examine those similarities and differences between reinsurance and insurance which are of relevance to prudential supervisors. 2.4 Similarities between insurance and reinsurance The areas of similarity between insurance and reinsurance business help to explain the rationale for a similar regulatory approach in certain jurisdictions. The main similarities are discussed below Transfer of insurance risk Both insurance and reinsurance contracts allow for the indemnification of an insured (or reinsured) in the event of loss in consideration of a premium. The key features of the business cycle involved in both cases are very similar, through underwriting, investment, claims, control over expenses, and the reinsurance (and for reinsurers, retrocession) programme. Both the insurance and reinsurance cycles generally have similar types of systems and controls. The types of risk which both types of business are exposed to are also broadly similar, for example, occurrence of claims events, timing and quantum of claims, severity, development, and specifically for life business, mortality, morbidity and longevity. Reinsurers are subject to the same sources of risk, for example, the random occurrence of major claims events and fluctuations in the number and size of claims. 7

9 Because the transfer of risk is a common feature, it could be assumed that the reasons for purchasing insurance and reinsurance protection are also similar. Insurance provides protection for policyholders; reinsurance also provides protection, to primary insurers. However, there are a number of reasons why insurers buy reinsurance: it allows the insurer to increase capacity to underwrite business; it allows insurers to limit their exposure to risk and reduces volatility and uncertainty in the insurer s results; reinsurers can provide experience and expertise in new lines of business or new geographical markets; reinsurers can provide a financing role. Primary insurers are dependent, to a varying extent, upon the reinsurance industry. A key feature of reinsurance is the need to diversify risk. The spreading of insurance risk around the market through the use of reinsurance creates a highly inter-related marketplace in which a major loss event can impact upon many participants in the market. At a fundamental level, failure in the reinsurance industry will have an impact upon insurers and in turn on their policyholders. The special case of financial reinsurance is described in section Credit risk (exposure to bad debts) Among the risks faced by both insurers and reinsurers is the possibility of exposure to bad debts. For insurers, whilst bad debts can arise from a variety of sources (including intermediaries), exposure usually arises principally from the outward reinsurance programme, and the same is true for reinsurers in respect of their retrocessionaires. From a supervisory point of view, the security of reinsurers (and retrocessionaires) is a major issue when assessing the financial position of an insurance or reinsurance undertaking Investment risk A key feature of both insurance and reinsurance business is the investment of assets to support insurance and reinsurance liabilities. Investment return is usually a key component of total profits generated by such operations. Both insurers and reinsurers need to manage their investment risks, balancing the need to maintain a prudent spread of investments, whose risk is appropriate to the risk profile of the insurance and reinsurance liabilities, with the need for adequate investment returns. Whilst some in the industry argue that investment activities are managed separately from the underwriting activities, there is a trend towards the view that investment activities are an integral part of the management of insurance or reinsurance business. In either case, reliance on investment returns is a major feature of insurance and reinsurance, and exposure to the variability of stock market performance and interest rate movements is common. In the case of non-life insurers and reinsurers, investment in equities is generally less common, although shareholders assets can be significantly affected by changes in values of equities and, to a lesser extent, bonds. 8

10 From a supervisory point of view, it is important to be able to distinguish between the underwriting results and the results of investment activities. It is difficult to assess real trends in underwriting performance if the results are obscured by investment returns. Also, it is important to be able to assess the additional strains on capital arising from investment losses. This applies to insurance and reinsurance Distribution channels: Use of intermediaries and direct writers Both insurers and reinsurers have traditionally obtained business through the use of intermediaries. In recent years, various insurance companies have set up direct selling operations to market and sell their products avoiding the use of intermediaries. Direct selling can reduce costs and puts insurers in direct contact with their customers at the point of sale. It also creates potential for greater understanding of their policyholders and increased opportunities for marketing their products. However, the traditional involvement of brokers continues to be important. A similar trend has occurred in the reinsurance industry, where a number of companies have started to deal directly with their customers in the primary insurance market. The reasons cited include the potential for developing direct long term relationships as well as savings in commissions paid to brokers. Nevertheless, brokers in the reinsurance markets continue to have an important role. 2.5 Differences between insurance and reinsurance Types of contract and complexity Whilst the effects of insurance and reinsurance contracts are fundamentally similar (that is, the transfer of risk), the types of contract involved are usually different. Broadly, insurance usually involves the use of standardised policies. This is certainly the case in personal lines business (such as private motor and household). For commercial lines (including industrial risks), it is common to find more customised policies, especially for larger risks. Reinsurance contracts, however, usually tend to be drawn up on an individual basis to meet the particular requirements of the cedant. Reinsurance contracts may include limitations and exceptions that are not common or permitted for direct insurance contracts. These contractual provisions usually limit the reinsurer s exposure to risk. A contract of insurance usually involves coverage of a single risk, or a package of risks, between the policyholder and the risk carrier. Reinsurance is often underwritten on a treaty basis. Whilst facultative reinsurance involves an individual risk, treaty business covers a portfolio of insurance contracts over a specified period. Appendix 1 provides examples of the common types of arrangement. These differences should be of importance to supervisors because the population of risks in a reinsurer s portfolio is usually more complex. Reinsurers not only underwrite contracts with primary insurers, but also other reinsurers, as retrocessionaires. These factors mean that a deep understanding of the business is required in order to be in a position to make sensible assessments of a reinsurer s true financial position. 9

11 2.5.2 Volatility Reinsurance business tends to be more volatile than primary insurance. There are a number of reasons for this: for insurers involved in conventional personal and commercial lines business, the book of business usually consists of a greater number of policies, each of which has relatively small exposure. Reinsurers tend to write business on a treaty basis, and are exposed to the accumulation of losses and greater likelihood of significant losses; primary insurers generally tend to have lower retentions than reinsurers; the outward reinsurance programme offloads risk and reduces uncertainty at the level of the primary insurer; reinsurers are involved, particularly in relation to non-proportional (excess of loss) business, in higher levels of cover, where the incidence of claims is less frequent but larger in amount. Exposure to catastrophes is a particular feature of the reinsurance industry. A single catastrophic event will usually lead to claims on numerous reinsurers, as risks are typically spread around the market. The volatility of business is closely linked to the underlying complexity in reinsurance business, and this has implications when assessing financial strength. However, the effects depend upon the individual situation; volatility, whilst still present, will be lesser for a reinsurer which allows for better diversification and pooling of individual risks within a larger or well structured portfolio. Also, volatility will be mitigated to some extent by retrocession arrangements. It has not been proven that the residual risk of pure reinsurance companies is higher than the risk of direct insurance companies Globalised portfolios Reinsurance is normally a global business. Companies tend to reinsure risks from a number of insurers located in many jurisdictions. Therefore, reinsurers usually have a broad range of geographical exposures. This is a key feature of reinsurance in achieving diversification of risks. The insurance industry, on the other hand, tends to be more local in nature. Whilst there are some global insurance companies, they usually operate with local subsidiaries in different territories. The reinsurance industry is far more concentrated in the hands of a small number of major global participants, combining international risks within one portfolio. Due to the nature of reinsurance business, diversification in the portfolio is an essential feature in the risk management process. Diversification tends to be geographical as well as by risk-type. From a supervisory point of view this is a key difference. Supervisors tend to be aligned on the basis of nation states, but reinsurers often manage their business on a wider geographical basis. The globalised nature of a reinsurer s business means that supervision on a local basis is inherently difficult. For example, global knowledge of major claims events in markets in which the reinsurer has exposure can be of critical importance in assessing the impact on the financial position of a company. 10

12 2.5.4 Delay in claims reporting, other information, and cash flows Compared to insurance business, reinsurance is often characterised by time delays in the receipt of information about contracts entered into. Reinsurance is at least one additional stage removed from the underlying insured event. There are various reasons for delays: insurers need to process policies and claims first before passing on information, which in turn may be passed via brokers; reinsurance contracts often involve a number of different reinsurers taking lines; a reinsurer may lead or follow on a contract. Even with central processing and settlement systems, there can be time lags in the receipt of information; insurance companies may also suffer from some time lags in receipt of information, but the position for reinsurers is usually worse as they rely on the submission of information from cedants. Reinsurers receive their premiums later than ceding companies, (due to procedures for settlement of accounts), but may on the other hand be required to make immediate cash payments when large losses occur. This can result in fewer opportunities to compensate underwriting losses by investment income ( cash flow underwriting ) than for direct insurers. A related issue is that reinsurers will not necessarily know about the impact of certain claims events until the claims have worked through the retentions and lower levels of cover. A reinsurer therefore needs to have effective processes to monitor exposures and the likely impacts of claims events in the markets. For example, the incidence of subsidence claims on household policies may take some time to accumulate to the point where insurers start to make recoveries on their excess of loss protections. From the supervisory perspective, these differences are important because they can make it more difficult to detect potential problems which may impact upon a reinsurer s financial position Reliance on others knowledge As a result of various intermediaries involved (insurers or lead reinsurers), the reinsurer may have a diluted understanding of the risk being transferred. Reinsurers therefore tend to be reliant on second-hand knowledge to obtain an understanding of the underlying risks. They also need to have sound management systems and controls in order to ensure that sufficient understanding of the book of business being reinsured is obtained. This applies both to underwriting and claims management. In proportional treaties, for example, the reinsurer follows the fortunes of the reinsured and, in order to make accurate assessments about the risk involved in writing a treaty, needs to know not only the type of business being written, but also the risks posed by the insurer s own internal arrangements, the quality and track record of its management, its systems and controls over acceptance of risks and claims, and its approach to risk management and pricing. Various examples can be cited to demonstrate this lack of knowledge or understanding of the underlying risks, which has ultimately led to financial difficulties for reinsurers. For example European reinsurers, writing employers and environmental liability policies in the United States faced a subsequent surge in claims, particularly relating to asbestosis. 11

13 The larger reinsurers tend to be in a better position to cope with such problems, having resources to acquire deeper technical expertise in the markets and lines of business in which they are involved. The relative remoteness of reinsurers from the underlying risks, and the consequent reliance on information supplied by insurers and intermediaries, combined with the ways in which reinsurance contracts operate, results in the possibility for sudden impacts upon claims provisions as information becomes available to the reinsurer. This tendency is important in understanding the financial position of a reinsurer and is therefore relevant to prudential supervisors Profit commissions and premium adjustments Due to the generally higher uncertainty and less detailed knowledge of reinsurers of the underlying risks, the pricing mechanisms in reinsurance contracts are often adjustable. Insurance contracts can also have adjustable terms, but this tends to occur in the case of commercial lines, especially for larger risks, rather than personal lines business. This feature of the contract gives the reinsurer more scope to collect further premiums should the business turn out to be less profitable than expected. Profit commissions, reinstatement premiums and premium adjustments are incorporated in contracts as a way of sharing the risks and rewards with the cedant as well as minimising the costs of reinsurance. The risk exposure in the case of reinsurance contracts with adjustable pricing arrangements tends to be lower than that in the case of those with fixed price arrangements. Accordingly, an understanding of the types of contract written is important in making an assessment of a reinsurer s overall risk profile Professional counterparties Reinsurance business takes place in the professional marketplace. Whether directly with primary insurers, or through intermediaries, reinsurers deal in virtually all cases with professional counterparties. Whilst this would be relevant in the context of conduct of business issues, the question arises as to the relevance from the viewpoint of prudential supervision. The point is relevant because it can be argued that the inter-professional market place is to some extent self-regulating Use of rating agencies As part of an insurer s assessment of the credit-worthiness of a reinsurer, there is normally a significant reliance on the ratings provided by rating agencies. The largest reinsurance companies all have ratings from the main agencies. Credit ratings are also important in the context of primary insurance companies, but tend not to be used extensively where private consumers are concerned, due to the protection afforded by guarantee schemes in many territories. From a supervisory perspective, this difference is of relevance because there may be scope for supervisory authorities to make greater use of the market mechanisms which exist in relation to credit ratings. Also, downgradings in credit ratings will act as signals to supervisors, particularly as financial difficulties of reinsurers may in turn result in difficulties for insurers, with consequent implications for the protection of policyholders. 12

14 2.6 Other methods of risk transfer Other methods of risk transfer include the following: Securitisation of the risk Derivatives Financial reinsurance Global Reinsurance magazine in its June 2000 issue described Alternative Risk Transfer (ART) as a creative approach to funding the predicted losses in a risk area. There is however no generally accepted definition of ART. ART arrangements usually include a substantial retention level by the reinsured, with only a partial transfer of risk that includes elements of a traditional reinsurance contract. Some ART products are essentially a form of deferred lending, and most include a financing element of some kind. ART programmes include a variety of mechanisms such as: large deductible programmes; self-insured retention programmes; individual and group self-insurance; captive insurance companies; risk retention and purchasing groups; and finite risk and integrated insurance programmes. The importance of ART products is likely to increase, particularly in view of the contracting market for retrocession and the increasing involvement of investment banks in alternative solutions. ART solutions are driven by a number of factors and often some form of arbitrage may be involved, whether connected with accounting, taxation or regulation, or a combination of factors. There is generally little transparency in the accounting of ART products, and this can make it difficult for regulators to understand the true effects of transactions and the motivational factors underlying them. It is essential for supervisors to understand the commercial effects and substance of transactions. Understanding the amount of credit risk assumed by the reinsurer is also important Securitisation Securitisation is a process where the risk is transferred through a Special Purpose Vehicle ( SPV ) and swapped into bonds. In this case, bond holders themselves act as reinsurers to the risk. Thus, capital markets can also act as reinsurers in the process of risk transfer. Some reinsurers invest in such bonds themselves, in order to derive a further return from underwriting with enhanced interest rates. 13

15 Commonly, the SPV is established in an offshore location, and this in itself may be a source of regulatory arbitrage. A number of investment banks have established reinsurance vehicles in such locations, particularly Bermuda. Reinsurers themselves have begun to invest in bonds issued by such vehicles as a means of increasing investment returns, and this results in insurance risk appearing on the assets side of the reinsurers balance sheet, in addition to its liabilities Financial reinsurance Pure financial reinsurance contracts, with little or no transfer of insurance risk, have ceased to be effective in most major jurisdictions due to accounting and regulatory constraints. However, finite risk solutions, in which a limited transfer of underwriting risk takes place, have become more common. Products which combine underwriting risk transfer with financial elements can provide direct insurers with significant benefits. In a single reinsurance programme, insurers can obtain multiyear and multi-line cover, and benefit from reduced rates and transaction costs. With this type of package it is also possible for insurers to include risks which have traditionally been considered uninsurable (such as political and financial markets risks). Such products may have an impact upon cyclical trends in the insurance markets, by tying in rates for a number of years and establishing long term relationships between reinsurers and their clients, facilitating insurers access to the capital of reinsurers. Financial reinsurance is sometimes seen as an effective means of regulatory arbitrage. An example can be a financial guarantee contract involving risk transfer, which in its purest form is a mechanism to access capital markets through insurance markets rather than banking markets. The motivation for the development of these products, which often take the form of financial guarantee insurance contracts, is the relative advantage in regulatory assessment for solvency calculations under insurance contracts rather than banking contracts. As Reinsurance magazine, in its September 2000 edition, pointed out, in recent times there has been a marked increase in financial guarantee insurances that compete directly with the bank guarantees and standby letters of credit that have been a substantial area of business for banks. The likelihood is that increasing market share will pass to insurance companies because of the pricing advantage enjoyed by insurers as a result of their different regulatory costs. However, there is another school of thought which suggests that insurers and reinsurers are not adequately pricing these risks. In particular, some are of the view that the models used by insurers to price such risks are not always as sophisticated as those used by banks (although monoline insurers often do use sophisticated modelling techniques). It is not clear to what extent the competitive advantage gained by insurers is as a result of potentially lower costs of regulatory capital. 3 The Tillinghast report provides details of the special features of the regulatory aspects of securitisations 14

16 Derivatives Derivatives in themselves are derived from a particular product and provide protection against adverse movements in the product exposure. Examples of derivative products, which are similar to products offered by the insurance industry, include weather derivatives which provide protection against possible climate changes that could result in natural calamities. These products are primarily offered by Banks. Like securitisations, derivatives can be obtained by reinsurers in connection with their investment and underwriting activities in order to increase investment income. Derivative transactions can result in assets and /or liabilities, and the important point is that the risk profile of the reinsurer s assets can be significantly affected. 2.7 Preliminary conclusions Insurance and reinsurance are both designed to achieve the same basic objective: a transfer of insurance risk in return for a premium. Although the objectives are the same, there are some key differences which are of relevance to prudential supervisors: the greater complexity of reinsurance business; greater volatility of reinsurance; the (increasingly) global nature of reinsurance business; and the fact that reinsurance is transacted in the professional marketplace and there is no direct relationship with policyholders of insurers. The broad similarities between reinsurance and insurance lead to common regulatory approaches in many territories, but the differences are significant. In particular, the greater potential for volatility in reinsurance business (especially higher levels of excess of loss business) leads to greater uncertainty in the outcome of contracts and, ultimately, the potential for reinsurers to encounter financial difficulties and insolvency might be greater. Volatility will be lesser for a reinsurer which allows for better diversification and pooling of individual risks within a larger or well structured portfolio. Reinsurance companies are professional market players. There is usually no direct link between reinsurance companies and the policyholders. Primary insurers are usually able to pursue marketing and risk selection strategies that enable them to obtain homogeneity of risks in their portfolios of business. They are able to maximise the pooling effect of a large portfolio of risks, reducing the risk of random deviations from the mean value. For reinsurers, this effect is usually present to a lesser extent and the risk of random deviation is usually more significant. However, the reinsurance marketplace is a professional one, in which ceding companies generally have the ability to assess the claims paying ability of their reinsurers. Nevertheless, despite the expertise of the participants in the market, it has not been unknown for reinsurance companies to face financial difficulties, or for insolvencies to occur. 15

17 3 Reinsurance and risk 3.1 Scope In accordance with the Terms of Reference, the objective of this chapter is to identify the main types of risks that a reinsurance undertaking is exposed to (including systematic risks in the reinsurance sector) and make an assessment of the general importance of the different risks. 3.2 Approach 3.3 Risks In reporting on the above objective, we undertook the following approach: use of existing specialist knowledge; use of questionnaires to KPMG offices and a limited number of interviews with reinsurers; and reviews of existing published sources. The risks of reinsurance business can be considered at the following levels: risks specific to the individual reinsurance undertaking; systematic risk faced by the reinsurance industry; and systemic risk faced by the local / global economy Risks specific to the individual reinsurance undertaking The risks faced by the individual reinsurers are similar to those faced by insurers, but the weighting and importance of the various risks impacting on an individual reinsurer depend on many factors, including: classes of business underwritten and geographical coverage, which will affect the nature and severity of losses and the length of tail for claims development; types of contract underwritten (for example losses occurring contracts compared to risks incepting or claims made contracts, proportional compared to non-proportional treaty, conventional risk transfer compared to alternative risk transfer, etc); the underwriting philosophy of the reinsurer; the retention policy and the retrocession programme. A summary of the main risks facing a reinsurance undertaking is set out below. 16

18 Underwriting risk The fundamental risk associated with reinsurance business is that the actual cost of claims arising from reinsurance contracts will differ from the amounts expected to arise when the contracts were priced and entered into. The key risk is that the reinsurer has either received too little premium for the risks it has agreed to underwrite and hence has not enough funds to invest and pay claims, or that claims are in excess of those projected 4. This could occur for the following reasons: 1. Risk of mis-estimation: the expectations regarding losses are based on an inadequate knowledge of the loss distribution, or the underlying assumptions are erroneous. This can be due, for example, to sampling errors, or lack of experience with new insurance risks. This risk can be mitigated, to some extent, by diversification of risks. 2. Risk of random deviation: expected losses deviate adversely due to a random increase in the frequency and/or severity of claims or because losses fluctuate around their mean. Reasons for this kind of deviation are, for example, that one event triggers multiple losses (accumulation, for example, in the case of natural catastrophes); or a loss experience triggers other events (for example, contagious diseases in health insurance or a fire which affects neighbouring industrial properties leading to business interruption claims). The significance of this type of risk in a portfolio depends on various factors, such as the number of risks involved, the distribution of probabilities of incurrence of claims and probable maximum losses. This risk is systematically decreased by the pooling approach, that is, assembling as many homogenous and independent risks as possible in the portfolio (pool). 3. Risk of change: adverse deviation of expected losses due to the unpredictable changes in risk factors that have brought about an increase in the frequency and/or severity of losses or payment patterns (for example, changing legislation, changing technology, changing social and demographic factors, changes in climate and weather patterns). Again, diversification of the reinsurer s portfolio of business may contribute to the mitigation of this type of risk. 4. Reserving (provisioning) risk: In addition to the insured risk itself, there is a derived risk caused by the reserving process of the insurer. This is the risk that technical provisions are insufficient to meet the liabilities of the reinsurance undertaking (reserve risk). If sufficient data on historical claims development is available, this risk may, to a limited extent, be mitigated by proper actuarial estimation of the provisions for claims incurred but not reported (IBNR) and those incurred but not enough reported (IBNER). The risk can rarely be completely extinguished, even where sophisticated actuarial estimation methods are used, due to the inherent uncertainties of insurance (and reinsurance) business. 4 Babbel, D. / Santomero, A.: Risk Management by Insurers: An Analysis of the Process, in: Wharton Financial Institutions Center Research Papers, No ,

19 As reinsurance is essentially a form of insurance the key risk facing reinsurers is driven by the quality of underwriting. The underwriting risk is therefore exposed to the following factors: competence and expertise of underwriters; level of underwriting control and the quality of information available to underwrite risks; and nature of the risks underwritten. The extent of exposure is therefore driven by the level of control exercised in accepting risks suitable to the company. Poor underwriting from a lack of knowledge of the underlying risks could have severe impacts on the resulting claims profile. This can be a particular problem when entering new lines of business. Proper management of underwriting exposure is therefore key. This includes the need to maintain effective expertise and knowledge of the areas which can impact upon the reinsurer s business. This risk category does not include the risks arising from management override. This includes, for example, the risk that management overrides the pricing process in order to charge premiums that have been consciously calculated in order to gain market share. In addition to the risk resulting from inadequate or incomplete information there is a risk resulting from the use of false information obtained from fraudulent cedants. The correctness of the reinsurer s risk assessments depends significantly on information provided by cedants. However, since reinsurance is a professional market with relatively few reinsurance companies involved, fraudulent behaviour of one cedant, when detected, will rapidly be known within the industry and result in the exclusion of this cedant from the market. On the other hand, the higher the underwriting risk the more careful reinsurers will be in assessing information received by cedants. Nevertheless, fraudulent actions of cedants is a risk that in principle exists in the reinsurance market. Underwriting risk is unique to insurance and reinsurance business. Reinsurers tend to manage risk by pooling and, for unique risks, diversification. Pooling is easier to achieve for a larger reinsurer than a smaller one. However, reinsurers do tend to accumulate risks, and it is quite possible, even for a large reinsurer, to build up accumulations of exposure in particular geographical regions, with consequential significant exposure to catastrophes in those regions. The reinsurers approach of managing risk by pooling, and diversification, is in contrast to the traditional approach to risk in banking, banks tend to manage risk by hedging. This has implications for reinsurers as they begin to enter into an increasing number of ART transactions with investment banks Retrocessions The risk management techniques employed by the reinsurer itself play a critical role in the sustainability and solvency of the business. A key part of this process includes the purchase of adequate reinsurance protection (known as retrocession). The extent and quality of retrocession purchased will establish the level of protection available to the reinsurer. The purchase of insufficient cover can lead to financial difficulties in the event of major unexpected claims. Accordingly, the risk of an inadequate retrocession programme should be recognised as a key risk. 18

20 It is typical for reinsurance to split up large and unique risks and to distribute the risks on the international reinsurance market. This allows cover to be obtained even for risks which are too large for the largest individual reinsurers. Such risks are shared by many reinsurers Credit risk The use of retrocession as a key part of the reinsurer s risk management process creates a significant level of credit risk that amounts due under a retrocession contract are not fully collectible owing to insolvency. Underlying the process of retrocession is the essential need for the financial stability of the retrocessionaires. In particular, the reinsurer usually makes a significant upfront payment of premium in the hope of future recoveries when it settles claims. The time period which elapses between the payment of premium and claims recovery can be significant, particularly where long tail business is concerned. Consequently, the management of credit risk is of critical importance, particularly in placing retrocession cover. In addition, there is also some risk that the failure of intermediaries could result in bad debts Investment risk Investment risks affect the assets of a reinsurance undertaking. A major element of investment risk is market risk. This includes the risks of asset and liability value changes associated with systematic (market) factors. Some forms of market risk relating to investment risk are, for example, variations in the general level of interest rates and basis risk (the risk that yields on instruments of varying credit quality, liquidity, and maturity do not move together).. Other risks that have to be considered in relation to investments of a reinsurance undertaking are the default risk / credit risk, call risk, prepayment risk, extension risk, convertibility, real estate risk and equity risk. Investment risks can result in: lower investment yields than expected when pricing insurance contracts due to a changing capital market environment (for example, changing interest rates, changing currency rates, adverse development of borrowers credit rating with respect to interest payments on a bond); asset losses (for example, due to a decrease in the value of equity investments as a result of systematic risk or as a result of the performance of the issuing company); and cash-flow risks (for example, reinsurers operate in markets where they may receive clustered claims due to natural catastrophes. Their assets, however, are sometimes less liquid, particularly where they invest in private placements and real estate). The area of investment risk will be investigated further in the insurance solvency study 5. 5 A KPMG study commissioned by Internal Market Directorate General of the European Commission: Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision (2002). 19

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